Looking back at the evolution trend of stablecoins, why has it always been a battleground?

Original title: "A Battleground for Stablecoins"

Original author: Zeke, YBB Capital Research

Foreword

According to CoinGecko data, the total market value of stablecoins has exceeded the 200 billion US dollar mark. Compared with when we mentioned this track last year, the overall market value has nearly doubled and exceeded the previous historical high. I once compared stablecoins to a key link in the crypto world, serving as a key entry point in various on-chain activities as a stable means of value storage. Now stablecoins are beginning to move into the real world, demonstrating financial efficiency that exceeds that of traditional banks in retail payments, business-to-business transactions (B2B), and international transfers. In emerging markets such as Asia, Africa and Latin America, the application value of stablecoins has gradually been reflected. The strong financial inclusion enables residents of third world countries to effectively cope with the high monetary inflation caused by government instability. Through stablecoins, they can also participate in some global financial activities and subscribe to the world's most cutting-edge virtual services (such as online education, entertainment, cloud computing, and AI products).

Entering emerging markets and challenging traditional payments is the next step for stablecoins. In the foreseeable future, the compliance and accelerated adoption of stablecoins will become inevitable, and the rapid development of AI will also further strengthen the demand for stablecoins (computing power purchases, subscription services). Compared with the development in the past two years, the only thing that remains unchanged is that Tether and Circle still have a high degree of dominance in this track, and more start-up projects have begun to turn their attention to the upstream and downstream of stablecoins. But what we are going to talk about today is still the issuers of stablecoins. Who can take the next piece of the pie in this extremely involuted track of hundreds of billions?

1. Evolution of trends

In the past, when we mentioned the classification of stablecoins, we generally divided them into three categories:

1. Fiat-collateralized stablecoins: These stablecoins are backed by fiat currencies (such as the US dollar and the euro) as reserves and are usually issued at a 1:1 ratio. For example, each USDT or USDC corresponds to one US dollar stored in the bank account of the issuer. These stablecoins are relatively simple and straightforward, and in theory can provide a high degree of price stability;

2. Overcollateralized stablecoins: These stablecoins are created by overcollateralizing other high-quality crypto assets (such as ETH and BTC) that are volatile and liquid. In order to cope with potential price volatility risks, these stablecoins often require a higher collateral ratio, that is, the value of the collateral must significantly exceed the value of the minted stablecoins. Typical representatives include Dai, Frax, etc.;

3. Algorithmic stablecoins: The supply and circulation of stablecoins are completely regulated by algorithms. This algorithm controls the supply and demand of currencies and aims to peg the price of stablecoins to a reference currency (usually the US dollar). Generally speaking, when prices rise, the algorithm will issue more coins, and when prices fall, it will buy back more coins on the market. Its representative is UST (Luna's stablecoin).

In the few years since the collapse of UST, the development of stablecoins has mainly been micro-innovation around Ethereum LST, and some over-collateralized stablecoins have been built through different risk balances. No one mentions the term "calculated stability" anymore. However, with the emergence of Ethena at the beginning of this year, stablecoins have gradually determined a new development direction, that is, high-quality assets combined with low-risk financial management, thereby attracting a large number of users through higher yields, creating an opportunity to snatch food from the tiger's mouth in the relatively solidified stablecoin market structure, and the three projects I mention below all belong to this direction.

2. Ethena

Ethena is the fastest growing non-fiat-collateralized stablecoin project since the collapse of Terra Luna. Its native stablecoin USDe has surpassed Dai with a volume of US$5.5 billion and is currently ranked third. The overall idea of the project is based on Delta Hedging of Ethereum and Bitcoin collateral. The stability of USDe is achieved by Ethena shorting Ethereum and Bitcoin on Cex at the same value as the collateral. This is a risk hedging strategy that aims to offset the impact of price fluctuations on the value of USDe. If the prices of both rise, the short position will lose money, but the value of the collateral will also rise, thereby offsetting the loss; vice versa. The entire operation process relies on OTC settlement service providers to implement, that is, the protocol assets are hosted by multiple external entities. The project's income comes mainly from three sources:

1. Ethereum staking income: LST pledged by users will generate Ethereum staking rewards;

2. Hedging transaction income: Ethena Labs' hedging transactions may generate funding rates (Funding Rate) or basis spreads (Basis Spread);

3. Liquid Stables' fixed rewards: deposited in Coinbase in the form of USDC or in other exchanges in the form of other stablecoins to obtain deposit interest.

That is to say, the essence of USDe is a packaged Cex low-risk quantitative hedging strategy financial product. Combining the above three points, Ethena can provide a floating annualized rate of return of up to dozens of points (currently 27%) when the market is good and liquidity is excellent, which is higher than the 20% APY of Anchor Protocol (the decentralized bank in Terra) at that time. Although it is not a fixed annualized rate of return, it is still extremely exaggerated for a stablecoin project. So in this case, does Ethena have the same high risk as Luna?

Theoretically, the biggest risk of Ethena comes from the collapse of Cex and custody, but this black swan situation is unpredictable. Another risk is to consider the run. The large-scale redemption of USDe requires a sufficient number of counterparties. Considering the rapid growth of Ethena, this situation is not impossible. Users quickly sell USDe, causing the secondary market price to decouple. In order to restore the price, the protocol needs to close positions and sell spot collateral to buy back USDe. The whole process may convert floating losses into actual losses and eventually aggravate the vicious cycle. "1" Of course, this probability is much smaller than the probability of UST single-layer barrier breaking, and the consequences are not so serious, but the risk still exists.

Ethena also experienced a long period of lows in the middle of the year. Although the revenue dropped sharply and its design logic was questioned, there was indeed no systemic risk. As a key innovation in this round of stablecoins, Ethena provides a design logic that integrates on-chain and Cex, introducing a large number of LST assets brought by the mainnet merger into the exchange, becoming scarce short liquidity in the bull market, and also providing a large amount of handling fees and fresh blood for the exchange. This project is a compromise but extremely interesting design idea, which can achieve high returns while maintaining good security. In the future, with the rise of order book Dex and matching more mature chain abstraction, I wonder if there is a chance to achieve a completely decentralized stablecoin according to this idea?

Three, Usual

Usual is an RWA stablecoin project created by former French MP Pierre PERSON, who was also an adviser to French President Macron. Affected by the news of the launch of Binance Launchpool, the project has been greatly popular in the near future, and its TVL has also rapidly jumped from tens of millions to about 700 million US dollars. The native stablecoin USD0 of the project adopts a 1:1 reserve system. Unlike USDT and USDC, users no longer exchange fiat currency for equivalent virtual currency, but exchange fiat currency for equivalent U.S. Treasury bonds. This is the core selling point of the project, sharing the profits obtained by Tether.

As shown in the figure above, the left side is the operating logic of the traditional fiat currency collateral stablecoin. Taking Tether as an example, users will not receive any interest in the process of casting fiat currency into USDT. To some extent, Tether's fiat currency can also be regarded as "getting something for nothing". The company used a large amount of fiat currency to purchase low-risk financial products (mainly U.S. Treasury bonds), and its income last year alone was as high as US$6.2 billion. Finally, these incomes were transferred to high-risk areas for investment, realizing lying and making money.

On the right is the operating logic of Usual, whose core concept is Become An Owner, Not Just A User. The project is also designed around this concept, redistributing infrastructure ownership to total locked value (TVL) providers, that is, the user's fiat currency will be converted into RWA of ultra-short-term US Treasury bonds, and the entire implementation process is carried out through USYC (USYC is operated by Hashnote, which is currently a leading on-chain institutional asset management company and supported by DRW's partners). The final proceeds enter the protocol's treasury and are owned and governed by the protocol token holders.

Its protocol token USUAL tokens will be distributed to locked USD0 holders (locked USD0 will be converted to USD0++) to achieve revenue sharing and early alignment. It is worth noting that this lock-up period is as long as four years, which is consistent with the redemption time of some US medium-term Treasury bonds (US medium- and long-term Treasury bonds are generally 2 to 10 years).

The advantage of Usual is that it maintains capital efficiency while breaking the control of a number of centralized entities such as Tether and Circle over stablecoins, and dividing the profits equally. However, the longer lock-up period and the relatively low yield rate compared to the currency circle may make it difficult to achieve the large-scale growth of Ethena in a short period of time in the short term. For retail investors, the attraction may be more focused on the value of Usual's tokens. In the long run, USD0 has more advantages. First, it enables citizens of other countries who do not have US bank accounts to invest in US Treasury bond portfolios more easily; second, it has better underlying assets as support, and the overall scale can be much larger than Ethena; third, the decentralized governance method also means that the stablecoin is no longer so easy to be frozen, which will be more preferred for non-trading users.

Fourth, f(x)Protocol V2

f(x)Protocol is the current core product of Aladdindao. We have introduced the project in detail in last year's article. Compared with the above two star projects, f(x)Protocol is less famous. The complex design also brings it quite a lot of defects, such as easy to be attacked, low capital efficiency, high transaction costs, complex user access, etc. But I still think that this project is the most noteworthy stablecoin project born in the 23-year bear market. I will give a brief introduction to the project here. (For details, please refer to the white paper of f(x)Protocol v1)

In version V1, f(x)Protocol created a concept called "floating stablecoin", which is to split the underlying asset stETH into fETH plus xETH. fETH is a "floating stablecoin" whose value is not fixed, but will follow small changes in the price of Ethereum (ETH). xETH is a leveraged ETH long position that absorbs most of the fluctuations in the ETH price. This means that xETH holders will bear more market risks and returns, but it also helps stabilize the value of fETH, making fETH relatively more stable. At the beginning of this year, following this idea, the rebalancing pool was designed. In this framework, there is only one stablecoin with strong liquidity and pegged to the US dollar, namely fxUSD. All other stable derivative tokens in stable leverage pairs no longer have independent liquidity, but can only exist in the rebalancing pool or as a supporting part of fxUSD.

· A basket of LSDs: fxUSD is supported by multiple liquid pledge derivatives (LSDs) such as stETH, sfrxETH, etc. Each LSD has its own stable/leverage pair mechanism; · Minting and redemption: When users want to mint fxUSD, they can provide LSD or withdraw stable currency from the corresponding rebalancing pool. In this process, LSD is used to mint stable derivatives of that LSD, and then these stable derivatives are deposited in the fxUSD reserve. Similarly, users can also redeem fxUSD back to LSD.

So in simple terms, this project can also be regarded as a super-complex version of Ethena and early hedging stablecoins, but in the on-chain scenario, this balancing and hedging process is very complicated. First, the volatility is split, and then the margin of various balancing mechanisms and leverage. The negative impact on user access has exceeded the positive attraction. In the V2 version, the entire design focus shifted to eliminating the complexity brought by leverage and better supporting fxUSD. In this version, xPOSITION was introduced. This component is essentially a high-leverage trading tool, that is, a non-homogeneous, high-beta (i.e., highly sensitive to market price changes) leveraged long position product. This feature allows users to conduct high-leverage transactions on the chain without worrying about individual liquidations or paying funding fees, and the benefits are obvious.

· Fixed leverage ratio: xPOSITION provides a fixed leverage ratio, and the user's initial margin will not be required to be increased due to market fluctuations, nor will it cause unexpected liquidations due to changes in leverage ratios;

· No liquidation risk: Traditional leverage trading platforms may cause users' positions to be forced to close due to drastic market fluctuations, but the design of f(x) Protocol V2 avoids this from happening;

· Exemption from funding fees: Normally, using leverage involves additional funding costs, such as interest on borrowed assets. However, xPOSITION does not require users to pay these fees, reducing overall transaction costs.

In the new stable pool, users can deposit USDC or fxUSD with one click to provide liquidity support for protocol stability. Unlike the V1 stable pool, the V2 stable pool acts as an anchor between USDC and fxUSD. Participants can conduct price arbitrage in the fxUSD-USDC AMM pool and help fxUSD achieve stability. The source of income for the entire protocol is based on the opening, closing, liquidation, rebalancing, funding fees, and collateral income of positions.

This project is one of the few non-overcollateralized and fully decentralized stablecoin projects. For stablecoins, it still seems a bit too complicated and does not meet the minimalist design premise of stablecoins. Users must also have a certain foundation to get started with peace of mind. In extreme market conditions, the framework design of various defense barriers when a run occurs may also in turn harm the interests of users. However, the goal of this project does meet the ultimate concept of stablecoins for every crypto person, a native decentralized stablecoin backed by top crypto assets.

Conclusion

Stablecoins will always be a battleground for strategists, and it is also a track with extremely high barriers in Crypto. In last year's article "Falling into a Dying Situation, but Stable and Not Stopping Innovation", we briefly introduced the past and present of stablecoins, and hope to see some more interesting decentralized non-overweight stablecoins appear. Now a year and a half has passed, and we have not seen any startups other than f(x)Protocol working in this direction, but fortunately Ethena and Usual have provided some compromise ideas, at least we can choose some more ideal and Web3 stablecoins.

References

1. Mario's View on Web3: In-depth Analysis of the Reasons for Ethena's Success and the Risk of Death Spiral

2. fxUSD: The Nuts and the Bolts

3. What is Usual?

This article is from a contribution and does not represent the views of BlockBeats.