Stablecoin Wars
Decentralized stablecoins took a hit when UST collapsed, but DAI, FRAX, and LUSD held strong. Now, GHO & crvUSD are preparing to join the space, bringing new innovations. Meanwhile regulators cracking down on BUSD and might target other players like Circle. Should we now be bullish on DeFi stablecoins or still rely on the big players out there? With this article we want to focus on custodial and decentralized stablecoins and who will win the PVP.
Custodial Stablecoins
Stablecoins have become a popular financial instrument in the crypto space due to their ability to offer a stable value and enable fast, low-cost transactions. In recent times, stablecoin issuers have established a lucrative business model by backing stables on the short end of the yield curve, without taking on excessive risk.
As interest rates on the short end of the yield curve have risen, stablecoin issuers have been able to generate significant returns on their investments, without having to go all the way to the end of the risk curve by backing stables on risky commercial loans. This has enabled them to offer attractive yields to users, which has further increased the demand for stablecoins.
However, the total circulation of stablecoins has dropped after a crypto market peak, particularly during times when yields are going up. This suggests that as yields rise, users may choose to deposit their dollars in bank accounts to earn interest, rather than holding stablecoins on-chain.
This is when the stablecoin issuers will start a competition among themselves to offer the highest returns to their users. The first one who positions themselves accordingly, delivers a strong unique selling proposition, and expands their dominance, will be the winner in this race.
Circle, Tether, and other stablecoin issuers have essentially created a virtual printing press and have been able to generate significant profits through their stablecoin businesses. However, they will need to continue to innovate and offer attractive returns to stay ahead of the competition and retain their user base.
It remains to be seen whether stablecoin issuers will be able to sustain their business model in the long run, particularly as the regulatory landscape around stablecoins continues to evolve. Nevertheless, it is clear that stablecoins have become an important part of the cryptocurrency ecosystem and will continue to play a significant role in the years to come.
Decentralized Vs. Custodial
If custodial backed stablecoins begin to issue a yield to holders, then stablecoins backed by algorithms, crypto, and partially by real-world assets will face significant headwinds. However, the user base that prefers a permissionless and censorship-resistant stablecoin over a yielding one is only a fraction of the crypto native users. Therefore, decentralized stablecoins must compete with custodial variants on a yield basis to gain sufficient demand in the long run. To address the yield issue, users could collateralize T-bills in AAVE or MakerDAO and take out a loan against them, providing a higher yield than centralized versions in case decentralized versions reintroduce a yield to users.
For instance, Tether generates around $3.2 billion and Circle around $1.6 billion on T-bills per year, assuming a 4.7% yield on U.S. 1 Year Treasuries. After Terra’s collapse, overcollateralized models such as DAI and RAI and semi-algorithmic models like FRAX offer sufficient security, even when the collateral is declining rapidly. Curve and AAVE are launching new decentralized, overcollateralized stablecoins like crvUSD and GHO that are similar to existing products. However, decentralized stablecoins presently cannot provide comparable yields and liquidity to custodial versions, which is a significant disadvantage, especially for the most decentralized stablecoins that are only backed by $ETH.
To be competitive, MakerDAO takes a path where up to 25% of the collateral consists of RWAs, leading to revenue growth but still unable to compete on the yield level without venturing to the end of the risk curve with loans. The way to scalability in stablecoins is still clearly in centralization, and the best opportunity is to find a way for users to put T-bills into those protocols in a non-KYC manner.
Real World Assets
One of the most exciting product launches for us is Ondo Finance, which aims to tokenize popular investment funds on the blockchain. Ondo’s initial offering includes the US Government Bond Fund (OUSG), which invests exclusively in Blackrock-issued short-term US Treasuries ETFs. By offering a solution for stablecoin holders to generate a risk-free yield without having to redeem or sell their USDC, Ondo can prevent stablecoin outflows and gain disproportionately due to stablecoin issuers not passing on yields to their users. Although Ondo requires KYC for issuing and redeeming new funds, we believe it’s important to bring treasuries on-chain and allow their deposit into money markets or CDPs in the long term.
The Ondo fund tokens are not fully permissionless and are described by the team as follows:
“Investors can transfer these tokens between each other to effect changes in fund ownership. Investors can also use smart contracts to facilitate their financial arrangements such as by engaging in lending and trading activities with each other. The tokens themselves have transfer restrictions that will ensure they do not end up in the hands of anyone not appropriately qualified as an investor in the fund. Smart contracts that investors wish to use will also need to be approved by the fund through a compliance review to make sure they are not being used to subvert these transfer restrictions. Ondo Finance Inc. will manage the tokenization as a technology services provider.”
We envision a future where ZK technology can prove identity when issuing and redeeming new funds and depositing treasuries permissionlessly into protocols such as MakerDAO or AAVE against a DAI or GHO loan.
We are also closely monitoring other protocols, such as backedFi, which brought the first variants of a physically backed token by the S&P 500 on-chain and made it tradeable on Uniswap without KYC. In the subsector of off-chain collateralized or undercollateralized loans, Goldfinch and Centrifuge seem to be unaffected by the bear market since they only deal with creditors outside the blockchain ecosystem. Conversely, the active loans of other protocols like Maple were lent massively to market makers in crypto, causing their active outstanding loans to fluctuate strongly with the market and implode over the year.
Conclusion
Stablecoins have become an important part of the crypto ecosystem due to their ability to offer a stable value and enable fast, low-cost transactions. Stablecoin issuers have established a lucrative business model by backing stables on the short end of the yield curve and have been able to generate significant profits through their stablecoin businesses. However, as interest rates on the short end of the yield curve rise, users may choose to deposit their dollars in bank accounts to earn interest, rather than holding stablecoins on-chain. This will create a competition among stablecoin issuers to offer the highest returns to their users. Decentralized stablecoins must compete with custodial variants on a yield basis to gain sufficient demand in the long run. However, presently, decentralized stablecoins cannot provide comparable yields and liquidity to custodial versions. The stablecoin market is evolving, and it remains to be seen whether stablecoin issuers will be able to sustain their business model in the long run, particularly as the regulatory landscape around stablecoins continues to evolve. Nevertheless, stablecoins will continue to play a significant role in the cryptocurrency ecosystem in the years to come.
Who We Are
Moonrock Capital is a Blockchain Advisory and Investment Firm, incubating and accelerating early stage startups since 2019.
Website: https://www.moonrockcapital.io
Twitter: https://twitter.com/MoonrockCapital
Disclaimer: None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product or financial instrument, to make any investment, or to participate in any particular trading strategy.
