Stablecoins

Stablecoins have emerged as a cornerstone in the financial architecture of Web3, offering a digital bastion of stability amidst the tumultuous seas of cryptocurrency markets. As we navigate through their evolution, from the de-pegging shockwaves sent by UST to the innovative solutions crafting resilience in their wake, we’ll dissect the intricate web of challenges they face—including the Stablecoin Trilemma, regulatory headwinds, and centralization concerns—and the groundbreaking new mechanisms poised to redefine their future. Now, let’s delve into the dynamic stablecoin landscape, unveiling the strategic innovations and forecasting the trends set to shape the trajectory of digital assets. If you’re not already familiar, there are generally 3 types of Stablecoins:

Fiat Collateral: Fiat collateral refers to the usage of off-chain fiat currencies like the US dollar stored in banks. They back the stablecoin’s value with a redemption process allowing a 1:1 exchange between it and its fiat equivalent. This category of Stablecoins holds 90% of the stablecoin market share, a testament to the market’s preference for security and the direct peg to stable fiat values.

Crypto over-collateral: This includes various digital assets from blockchain systems. Stablecoins are issued against these assets using an over-collateralized model. Due to digital asset volatility, there’s usually more than $1 of the asset for every $1 stablecoin, ensuring a 1:1 backing.

Algorithmic Stablecoins: These stablecoins don’t rely on tangible collateral. Instead, they use algorithms and smart contracts to adjust the stablecoin’s supply based on its demand automatically. This mechanism aims to maintain the stablecoin’s peg to a target, like the US dollar. While they eliminate the need for reserves, their stability heavily depends on user trust and the algorithm’s effectiveness. In scenarios where trust erodes, these stablecoins can be susceptible to volatility and de-pegging, as seen from the Terra-Luna incident, which we have covered previously.

As seen from Figure 1, fiat-collateralized stablecoins remain the most popular type of stablecoins, at 67.5B in USD, despite the bear market conditions in the last year or so. The preference for fiat-collateralized stablecoins suggests that investors or users might seek safety and stability in assets closely tied to the real economy. Why might this be? Let’s delve into the details.

The Growth and Resilience of Stablecoins

Growth and Adoption of Stablecoins

Building on the strong foundation set by fiat-collateralized stablecoins, the stablecoin industry has seen historical growth, escalating from less than $10bn to a peak of $162bn in five years. However, this growth trajectory experienced a notable shift, declining by 39% in market cap since March 2022.

A defining moment in the recent downturn of stablecoins was the collapse of LUNA – US Terra (UST). LUNA, which had previously provided stability to UST, encountered a liquidity drought, undermining the pegged value of UST. As the confidence in the LUNA-UST mechanism faltered, many UST holders sought redemption, further exacerbating the sell-off. This move deteriorated the confidence in the stablecoin ecosystem, particularly in full-algorithmic stablecoins, and resulted in a large redemption of other stablecoins.

[For a detailed analysis of what happened back then, read our insights on UST Depegging event]

Furthermore, in March 2022, the Federal Reserve took measures to counteract persistent inflation by increasing interest rates. This move aimed to make traditional investment vehicles, especially US Treasury Bills, more enticing to investors. As interest rates climbed, the potential returns on traditional investments became comparatively higher. As a result, investors started to reassess their portfolios, preferring these traditional avenues over more volatile assets like cryptocurrencies.

This shift starkly contrasted with the steady growth and widespread adoption stablecoins had enjoyed at their peak. According to the article “The Relentless Rise of Stablecoins”, at its peak, stablecoins settled 6.5 times as many transactions as Fedwire, a key system federal institutions use for significant fund transfers. This statistic highlights the increasing traction of stablecoins, but it’s essential to contextualize this with other well-established transaction systems.

Comparisons to TradFi Equivalents

Stablecoins can be seen as the transaction system of the Crypto world. However, compared to traditional transaction systems like the Automated Clearing House and Visa, stablecoins still have a considerable journey ahead. Stablecoins have processed around 4% of the transaction volume in the Automated Clearing House system, facilitating credit transfers such as payroll and debit transfers and showcasing their inroads in global transactions. However, when juxtaposed against giants like Visa, stablecoins have a long journey ahead, accounting for less than 1% of Visa’s mammoth transaction numbers. This disparity underscores the nascent yet growing influence of stablecoins in the global transaction ecosystem and also illuminates their vast untapped potential as a burgeoning force in large-scale financial exchanges.

Resilience during market downturns

Besides being the transaction system for the crypto world, Ethereum-based stablecoins, which boast the highest market cap among all blockchains, experienced a notably lower drawdown of 39% in market cap compared to a benchmark index composed equally of BTC and ETH, which saw a substantial reduction of 72% in the same period from March 2022 to October 2023. This indicates a trend where investors, adopting a risk-off strategy, are shifting from volatile cryptocurrencies to stablecoins, possibly aiming to re-enter the market at more opportune moments.

Furthermore, the confidence in stablecoins remains robust, highlighted by the resilience shown during the UST saga. Despite an outflow of the stablecoin market cap, the market has continued to rely on stablecoins as a stable intermediary. This resilience speaks volumes about investors’ trust and credibility in these assets, perhaps viewing them as dependable anchors during turbulent market phases. Consequently, the trend emphasizes the diversification advantages of integrating stablecoins into a crypto portfolio and their essential role as a buffer against the extreme volatilities in cryptocurrencies like BTC and ETH. This insight into drawdown differentials also informs future investment strategies, prompting stakeholders to reconsider the proportion of stablecoins in their portfolios and the prominence of Ethereum as a pioneering platform for financial innovation.

The 4 largest Ethereum stablecoins by market cap (USDT, USDC, DAI, BUSD), have also shown stability in their pegs to the USD over time. However, a striking deviation was observed on 10 March 2023. Amidst the failure of Silicon Valley Bank (SVB) and Signature Bank, the USDC’s peg notably faltered, dropping its value to a low of $0.87. This deviation highlights the inherent centralization risks associated with stablecoins and the vulnerabilities of having considerable concentrations of assets with specific financial institutions. The value dip was largely attributed to revelations regarding Circle, the organization behind USDC, potentially having exposure to about $3.3 billion with SVB, which then faced massive deposit withdrawals. The incident showed the world the potential perils of over-reliance on centralized entities, even in decentralized finance. Fortunately, in this instance, regulators intervened to protect the bank’s creditors, restoring USDC’s peg. In the following sections, we’ll delve deeper into the nuanced risks of fiat-backed stablecoins.

Stablecoins Market Overview

Having explored the growth and resilience of stablecoins thus far, we now turn our gaze to the broader stablecoin market, where the dynamics have evolved significantly over the last year. As we delve deeper, we’ll unravel the factors behind USDT’s rise to prominence, the impacts of banking crises on market stability, and the strategic preferences shaping user choices across different blockchain platforms.

The dominance of Tether (USDT) in the stablecoin market

Since 2022, Tether has dominated the stablecoin market. It boasts a market cap of $90B and has an average daily trading volume of $51B. Looking at the rest of the market, Tether’s closest competitor, USDC, has noticeably shrunk since earlier this year, with a market cap of $24B and an average daily trading volume of $7B. What has caused this shrinkage in market share?

One plausible explanation for USDT’s recent outperformance relative to USDC can be traced back to the banking crisis involving SVB. This crisis jeopardized the stability and trust in USDC, while USDT remained comparatively less volatile and rose above its Peg to a high of $1.077 during the event. Subsequently, confidence in USDC has waned, positioning USDT as the preferred fiat-pegged stablecoin for on-chain liquidity and cash-holding purposes.

The battle for Stablecoin transaction supremacy

Amongst various blockchains, there has also been a notable shift in the market dynamics around transaction volumes over the past year, with Tron standing out and commanding 42% of all on-chain stablecoin transactions. This leading position is attributable to the multiple strategic advantages that the platform holds. First, Tron’s infrastructure is technologically adept and capable of managing high transaction volumes seamlessly. Coupled with this is Tron’s competitive fee structure, which offers cost-effective transaction rates that appeal to frequent users. Additionally, Tron’s wide-reaching partnerships and integrations with key wallets and exchanges have broadened its accessibility, attracting a diverse user base. Continual innovation remains at the heart of Tron’s value proposition, with the platform regularly introducing novel features, such as shielded transactions, to cater to the dynamic needs of the crypto community. A testament to its efficacy and user trust is the notably high transaction rate among active USDT users, averaging 5.8 transactions weekly. Moreover, Tron’s strategic marketing initiatives bolstered Justin Sun’s presence, and further solidified its position, allowing it to eclipse competitors like the Binance Chain in transaction volume occasionally.

Following Tron, Binance Chain (BSC) has carved out a significant position, capturing 38% of the market share, a feat propelled by its impressive roster of active addresses, which alone comprises 32% of the global figure. At the core of this achievement is the USDT BEP20 stablecoin. Leveraging on the inherent efficiencies of BSC, known for its rapid and cost-effective transaction capabilities, the USDT BEP20 ensures users benefit from instantaneous transactions with minimal associated costs. Over 1 million weekly active USDT users on BSC engage in an average of 10.8 transactions, attesting to its functional prowess. Beyond its transactional aspect, the integration of USDT BEP20 with trailblazing DeFi platforms, including but not limited to PancakeSwap and Venus, marks its crucial role in the evolving decentralized finance sector.

Unlike Tron and BSC, Ethereum’s share in stablecoin transactions is a mere 4%. The platform’s high transaction costs are the primary deterrent for users resulting in reduced activity. In comparison, active USDC users on Ethereum average 4.5 transactions per week.

The remaining 16% of the total stablecoin is a combined transaction throughput of other rapid and cost-effective chains and Layer 2 solutions, such as Arbitrum, Optimism, Polygon, Avalanche, and Fantom.

As observed, the cryptocurrency ecosystem is undergoing a dynamic shift. Users are increasingly gravitating towards chains that promise efficiency and affordability. However, Ethereum, despite facing a setback in its share of stablecoin transactions, continues to reign as the cornerstone of DeFi, boasting a TVL of $23.8 billion across its protocols. As we witness this evolving landscape, one wonders: Will Ethereum’s innovation in other domains compensate for its loss in this sector, or will new strategies emerge to reclaim its dominance in stablecoin transactions?

Crypto exchange volumes: Stablecoin transaction volumes vs. centralized exchange volumes

Besides blockchain volumes, Stablecoin transaction volumes exhibited a markedly higher resilience compared to spot trading volumes on prominent CEXs such as Binance and Coinbase. Since May 2021, there has been a 92.2% decline in CEX spot trading volumes. In contrast, on-chain stablecoin transaction volumes saw a 72.4% decline.

One plausible hypothesis for this disparity between CEX transaction volume and stablecoin volume is the heightened prudence exhibited by market participants in response to crypto market volatilities. Traders and investors might favor short-term positions, promptly reverting to stablecoins to capture profit, rather than committing to longer-term strategies that ride the protracted bullish waves in riskier assets prevalent at that time.

Notably, stablecoins trading volumes have exceeded CEXes since May of 2022, reflecting a strategic shift among investors toward stability and risk aversion amid market volatility. This trend highlights stablecoins’ growing role as preferred vehicles for value transfer in the digital asset ecosystem.

Analyzing the Aggregated CEX Flows chart every month from November 2021 to Oct 2023 reveals a significant outflow of USDT from CEXes in November 2022, suggesting an erosion of trust. Conversely, USDC maintains steady activity, reinforcing its consistent market adoption in the DeFi space, largely driven by strategic integrations with leading trading platforms, wallets, and DeFi initiatives. Interestingly, there’s an overarching trend towards potential outflows in recent months, especially for DAI, BUSD, and TUSD.

Outstanding Supply by Chain

Historically, Ethereum has dominated the stablecoin supply landscape. However, recent data suggests a shifting dynamic: although Ethereum still commands a substantial 57% of the stablecoin supply, Tron is rapidly gaining traction and currently accounts for approximately 36%.

Challenges to Stablecoins

Despite their promises and utility, stablecoins grapple with a multitude of challenges. These include ensuring constant price stability, navigating evolving regulatory landscapes, maintaining liquidity, and ensuring trustworthiness in their backing claims. Additionally, the balancing act between decentralization, capital efficiency, and stability presents its intricacies.

The Stablecoin Trilemma

In decentralized finance, the proliferation of stablecoins, which aim to maintain a stable cryptocurrency value, often raises questions about their necessity and differentiation. At their core, stablecoins strive to achieve three primary objectives: price stability, capital efficiency, and decentralization. However, the pursuit of one objective frequently involves trade-offs, potentially compromising the others.

[Read our analysis and breakdown of the Stablecoin Trilemma here]

Currently, the Stablecoin Trilemma may also no longer be the definitive framework for assessing all risks in the current landscape, especially in light of various incidents impacting different stablecoins post-Terra-LUNA.

Redemption Risks

In the world of stablecoins, redemption is a linchpin for maintaining value, yet it’s often the Achilles’ heel in times of crisis. Some assets held in reserve might not be easily convertible to cash, especially during market downturns. If many stablecoin holders seek redemption simultaneously, and the reserves are not liquid enough to meet these demands, it could compromise the stable value of the coin. For example, Polygon-based stablecoin, Real USD (USDR), which is backed by real estate assets, saw a dramatic drop in value to approximately $0.51 after its treasury was emptied of its DAI holdings. On-chain data from Tangible DAO, which manages USDR, revealed the treasury holds no DAI. The only available liquid asset is an insurance fund valued at around $6.2 million, which contrasts sharply with the 45 million USDR in circulation, theoretically worth $45 million if maintained at its peg. Although the treasury also holds the TNGBL token, it has limited liquidity with a 24-hour trading volume below $300K, according to CoinGecko. Consequently, traders sold off USDR at considerably reduced prices, and USDR has not regained its $1 peg since the incident.

Regulations Risks

Regulations play a pivotal role in the trajectory of stablecoins. In March 2023, Binance experienced a significant outflow of over $6 billion from its branded stablecoin, BUSD, following a halt on its issuance by New York’s financial regulator due to concerns related to Binance’s association with Paxos. This regulatory intervention, coupled with intensified scrutiny on the crypto sector by US authorities, saw BUSD’s circulation drop by over a third, potentially impacting Binance’s financials given that BUSD accounted for approximately 20% to 40% of the exchange’s trading volume in the past year. Following this regulatory action, major exchange Coinbase delisted BUSD. Subsequently, Binance CEO, Changpeng Zhao, announced intentions to scale back investments in the US market following a series of SEC enforcement actions against the crypto industry.

Additionally, central banks and international entities are intensively analyzing financial risks from the crypto sector, emphasizing the need for regulatory refinement. Key efforts are focused on ‘global stablecoins’ – stablecoins with potential widespread use across multiple jurisdictions, which could become systemically significant. In the US, regulatory scrutiny might fall on the stablecoin industry after the U.S. House Committee on Financial Services released a proposed regulation draft. The proposed legislation intends to make the Federal Reserve the primary regulatory body for stablecoins and requires non-bank entities to register. The bill also imposes a moratorium on algorithmic stablecoins. Besides that, the Committee recently met with some stakeholders from the industry to discuss the issues plaguing the space. Elsewhere in the US, Circle’s public listing plans gain relevance. Circle aims to enhance its financial stability as a stablecoin issuer by going public through a SPAC merger. A successful public listing would enable Circle to potentially secure more funds for investing in risk-free instruments, thus bolstering the security of its stablecoin offerings. However, these plans are contingent on SEC approval, highlighting the heightened regulatory dependence within the sector.

In China, the use of CBDC, specifically the digital yuan (e-CNY), has been a significant move following the nationwide ban on private cryptocurrencies. The People’s Bank of China (PBOC) has developed e-CNY, which relies on private-sector banks for distribution and maintenance. Since its pilot in late 2019 in four cities, e-CNY has expanded and seen substantial use across various consumer applications. As of May 2022, there have been 260 million transactions amounting to over 83 billion renminbi through the e-CNY system, highlighting its growing role in China’s financial ecosystem. The digital yuan offers several benefits, including financial inclusion for those without bank accounts, support for KYC protocols, reduced compliance costs for banks, and the potential to simplify government subsidy programs. This approach positions the digital yuan as a geopolitical tool, offering an alternative to the US-dominated international payment systems and aid in reducing financial crimes.

Ultimately, the evolving landscape of regulations and government interventions in the stablecoin sector highlights a complex future. Despite regulatory challenges, stablecoins are poised to remain a vital part of the DeFi economy. However, increasing government oversight and censorship could drive market dynamics, possibly impacting stablecoins like USDT and USDC, which are more susceptible to regulatory pressures. This shifting trend towards a more regulated stablecoin environment could potentially influence their role and acceptance in global financial systems.

Liquidity Risks

Liquidity refers to which an asset can be rapidly traded without substantially affecting its price. When liquidity is scanty, referred to as “thin liquidity,” the market depth is inadequate, heightening the risk of price deviations. A substantial number of stablecoins, particularly the nascent ones or those devoid of robust market affiliations, have yet to garner broad-based acceptance, culminating in thin liquidity in certain market segments. Such liquidity constraints can precipitate marked price slippages, even with modest trading volumes, thereby compromising the inherent stability attribute of stablecoins. Additionally, this poses integration dilemmas for DeFi platforms, which might be reluctant to incorporate these thinly traded stablecoins due to potential pricing volatilities. Consequently, end-users are confronted with potential impediments, be it challenges in facilitating large transactions or delays in reconverting stablecoins to fiat or other digital currencies. To counter this, Stablecoin Issuers often have to offer good incentives for liquidity providers on exchanges.

The Iron Finance Titan Token incident, a stark example of liquidity risks in DeFi, began with Iron Finance’s TITAN token and its role in collateralizing the IRON stablecoin, pegged to $1. This setup was functioning until TITAN’s price, which had soared to $65, suddenly retracted to $60. This price drop triggered panic among large investors, leading to a massive sell-off of TITAN tokens. This sell-off resembled a ‘bank run’, where many users attempted to liquidate their holdings at once. The thin liquidity of TITAN exacerbated this scenario. As large amounts of TITAN were sold, it became increasingly difficult to sell without further plummeting its price, causing significant slippage. The rapid and substantial price decline destabilized IRON’s peg to the dollar. The protocol’s mechanism of stabilizing IRON by minting more TITAN, only added to the oversupply and further depressed TITAN’s price in a destructive feedback loop. The culmination of these events led to TITAN’s price crashing to almost zero dollars and illustrates the severe impact of thin liquidity in amplifying market collapses, particularly under panic selling conditions.

Potential Solutions to the Challenges

Following our coverage of the problems of existing stablecoins, numerous stablecoins have emerged in the DeFi sector, presenting diverse approaches to address the challenges that stablecoins face.

Tokenized T-Bills Stablecoins

Firstly, we have the Tokenized T-Bill stablecoins. A common problem for fiat-based stablecoins is that they do not earn a significant, consistent yield in DeFi, and they also are vulnerable to interest rate changes in the traditional finance world. As seen from the chart, DeFi lending rates for USDC and USDT across AAVE and Compound exhibit marked volatility, peaking notably in mid-2020.

However, by 2023, these rates converge, indicating potential market stabilization. Meanwhile, the steady rise of the US 3 Month Treasury Yield post-2021 suggests its growing competitiveness with DeFi offerings. As seen from the chart, the US 3-month Treasury Yield has surpassed the lending rates of USDC and USDT on AAVE in June 2023, indicating that the Treasury Yields are considerably more attractive. To mitigate this problem, innovative companies have developed T-Bill-backed stablecoins, giving users access to interest-rate-proof stablecoins that provide an attractive yield.

Key problems solved:

Price Stability Risks: Tokenized T-Bill stablecoins, backed by government Treasury Bills, have an inherent price stability derived from the trust in government securities.
Capital Inefficiency Risks: With T-Bill-backed stablecoins, users can earn a more competitive yield in DeFi than traditional fiat-based stablecoins, making capital deployment more efficient.

Key risks:

Redemption Risks: Redeeming T-Bill-backed stablecoins for the underlying Treasury Bills might face challenges or delays, especially during market volatility.
Regulations Risks: Governments and regulatory bodies may impose regulations on the issuance, trade, or redemption of T-Bill-backed stablecoins, impacting their adoption and usage.
Centralization Risks: By relying on government-issued securities, these stablecoins face centralization issues associated with the governmental issuance of bonds.

The potential of tokenized T-Bills as a stablecoin solution must be carefully evaluated in light of several significant risks. Despite their promise of enhanced stability and efficiency, the inherent redemption, regulatory, and centralization risks present considerable challenges. The centralization risk of these stablecoins is a fundamental concern. Governments, having significant control over the underlying T-Bills, could exert considerable influence on these tokenized assets. While tokenized T-Bills offer certain advantages, their susceptibility to government intervention and the challenges inherent in their structure might make them less than ideal as a comprehensive solution for the cryptocurrency market’s needs.

Protocol Stablecoins

Secondly, we are seeing the rise of Protocol stablecoins – designed to maintain a stable value and are directly issued and governed by DeFi protocols. The advent of proprietary stablecoins within DeFi protocols serves a 2-pronged strategic objective. Firstly, it empowers these protocols with autonomy, directly influencing the stablecoin’s growth trajectory. Secondly, it diminishes reliance on external centralized entities. Full ownership of a stablecoin further enables protocols to centralize revenue channels, bolstering their financial robustness, self-sufficiency, and revenue potential. The ongoing competition between Aave’s GHO and Curve’s crvUSD exemplifies the nuanced evolution of stablecoins within the DeFi sector.

Key problems solved:

Price Stability Risks: Proprietary stablecoins, being integrated within DeFi protocols, can benefit from internal mechanisms and controls designed to ensure price stability
Capital Inefficiency Risks: By owning their stablecoin, protocols can better optimize the capital flow within their ecosystem, ensuring that funds are used efficiently and with fewer intermediary costs
Centralization Risks: Creating their own stablecoin allows protocols to reduce dependencies on external stablecoin providers, decreasing central points of failure

Key risks:

Liquidity Risks: New proprietary stablecoins might not be as liquid as more established stablecoins initially, posing potential issues for users looking to move large volumes in and out of the token quickly.
Redemption Risks: Proprietary stablecoins may face challenges when users attempt to redeem or convert them outside their native ecosystem, especially if they aren’t widely accepted or recognized.

TradFi Coins

Increasingly, the Traditional Finance world is becoming more interested in getting involved in the crypto scene, and PayPal is one such organization. PayPal has launched a stablecoin because it sees itself as a leader in payments innovation, said one person familiar with the plan, and CEO Dan Schulman has envisioned it being eventually used for payments. Currently, the supply of PayPal USD stands at a modest 120M, a figure relatively insignificant when compared to the total stablecoin market cap of $71bn. However, there is potential for a substantial increase in supply as more institutions enter the crypto space and show a greater willingness to use a well-known brand like PayPal.

What’s next for the stablecoin market?

Expanding on the multifaceted challenges that stablecoins face, from maintaining price stability to navigating complex regulatory frameworks, we will now focus on the major stablecoins that could play an instrumental role in addressing these challenges. Ideally, a stablecoin that will thrive in the future can resolve all, if not most, of the challenges that existing stablecoins face.

Which Stablecoin has the highest potential to address the challenges?

FRAX
One notable innovation that may answer the challenges raised is Frax Finance’s stablecoin, FRAX. FRAX has great potential to fulfill the stablecoin market’s challenges because it has evolved over 3 versions to become an almost all-weather stablecoin. FRAX has a market capitalization of $668M and an average daily trading volume of $12M at the time of writing.

Frax v1 introduced its hybrid fractional-algorithmic stablecoin, where the FRAX stablecoin’s supply is partly backed by collateral and partly unbacked, stabilized algorithmically, using locked liquidity for LPs to prevent bank runs. This locked mechanism prevented FRAX from collapsing during the catastrophes of Celsius, Terra, and FTX, which solved the problems of liquidity risks and redemption risks. Having locked liquidity in LP pools, FRAX resisted sudden market panics and mass redemptions, effectively mitigating the risk of drastic price volatility. FRAX, collateralized by on-chain assets, exhibited reduced susceptibility to centralization risks. Additionally, as a Decentralized Autonomous Organization (DAO), it demonstrated a lower vulnerability to regulatory risks. This structure enhances its stability and appeal in the decentralized finance sector, offering a more resilient alternative to traditional centralized financial models.

Frax v2 expands on this by introducing the Algorithmic Market Operations (AMO) Controller concept. AMOs are autonomous contracts that can enact FRAX monetary policies, adjusting the collateralization ratio of FRAX whenever FRAX de-pegs above and below the USD. At the same time, Frax Finance developed a Lending AMO, which lent out its USDC on its balance sheet, earning a yield on its underlying assets. Frax also developed a Curve AMO, which ensured that there was sufficient liquidity for the FRAX-USDC trading pair. This then solves the problems of Liquidity risk and Price stability Risk for FRAX.

FRAX v3 is the newest version of the stablecoin, supported by various assets outside of the cryptocurrency market. It uses special AMOs and internal protocols like Fraxlend and Fraxswap, in addition to Curve, to keep its value stable. The v3 update focuses on incorporating Real World, like U.S. Treasury bills, to back the stablecoin, especially because, as mentioned, T Bills can offer a better rate than DeFi yields. FRAX v3 connects to the Federal Reserve’s Interest on Reserve Balances rate, implying that when this rate is high, FRAX leans more on real-world financial assets, and when it’s low, it relies more on lending strategies. This version dynamically balances between real-world assets and crypto-based lending strategies to efficiently tackle capital inefficiency risks.

Frax Finance is also engineering a hybrid rollup, Fraxtal uniquely combines Optimistic rollups with zk-rollups, distinguishing itself from other L2 solutions in terms of scalability, transaction finality, and security. This marks a critical stride in Frax Finance’s quest to enhance decentralization and interoperability in DeFi. A novel feature of Fraxtal is its use of frxETH as the gas token, integrating Frax Finance’s liquid staking derivative product into its chain’s gas economics. Furthermore, Fraxtal’s implementation of account abstraction contracts promises increased programmability and user flexibility compared to traditional Externally Owned Accounts. Scheduled for launch in February this year, Fraxchain’s success could bolster Frax Finance’s position in the DeFi market, offering a more interconnected and user-centric experience within its ecosystem. The successful implementation of Fraxchain may set a new precedent in DeFi, potentially spurring a new era of innovation and interconnected DeFi ecosystems.

However, this is not to say that FRAX is risk-free. The stablecoin is still vulnerable to some centralization risks because of the $23M USDC on its balance sheet, representing around 3.2% of the total FRAX circulating supply. Moreover, incorporating U.S. Treasury Bills as part of its asset backing brings additional layers of regulatory risk. It necessitates compliance with a range of legal and regulatory frameworks that govern traditional financial securities. These could include adhering to specific reporting requirements, audit standards, and regulatory oversight that may not typically apply to purely digital asset-based protocol. That said, this blend of traditional financial tools with innovative DeFi mechanisms like Fraxlend, Fraxswap, and integration with the Curve protocol suggests FRAX’s commitment to a stablecoin that is adaptable, transparent, and well-designed for long-term growth.

USDe by Ethena
The unreleased USDe, or the “Internet Bond” by Ethena, also directly tackles some of the stablecoin challenges by balancing scalability, stability, and censorship resistance. Its innovative approach involves delta-neutral positions against staked Ethereum, enabling 1:1 collateralization that is highly scalable. This scalability is enhanced by a short perpetual ETH position, which allows the stablecoin to gain an embedded yield on both the staked ETH and the funding rate if it’s positive. With this embedded yield and no over-collateralization, USDe solves the issue of Capital efficiency risk. Additionally, as it is secured by crypto, USDe is resistant to Regulatory risks.

The USDe ensures that price stability is maintained through market-neutral positions that mitigate the impact of price volatility. These delta-neutral strategies ensure that the USDe’s value remains stable relative to the dollar, regardless of fluctuations in the crypto market. This design aims to provide a consistent and reliable peg to the dollar, a critical feature for user trust and practical use in transactions.

The censorship resistance of USDe stems from its operation on a decentralized infrastructure, free from control by any central authority. By leveraging decentralized protocols for yield and collateralization, USDe offers a global, permissionless stablecoin option. This autonomy from traditional banking systems upholds the fundamental principle of decentralization intrinsic to cryptocurrency’s ethos, and effectively removes the centralization risks of USDe.

However, as USDe is still unreleased, and there is potential that it may not live up to the potential issues that it is intended to solve. For one, Ethena has yet to address how it intends to secure liquidity for USDe on exchanges to ensure limited price slippage. Also, price stability may be at risk when there are large swings in prices because of possible shortcomings in readjusting the hedged positions.

These two stablecoins could be a growth in adoption fueled by the growing regulatory scrutiny around fiat-collateralized stablecoins like USDT, which are mired with centralization issues and exposure to the traditional financial system’s regulatory risks. Market players are showing a rising interest in innovative stablecoin designs that promise to offer a decentralized alternative without compromising on price stability or the ability to scale effectively, a development that could redefine the fabric of the crypto economy if such stablecoins deliver on their promise.

Will we ever see a reversal in the stablecoin market capitalization?

Stablecoins thrived in the previous cycle, largely fueled by the high yields achievable through the mere possession of cash-like instruments. With an uptick in risky asset pricing and yields, we anticipate a pivot in capital flows away from stablecoins. Looking ahead to a possible crypto bull cycle, borrowing demand is expected to increase. Assets with bullish potential, or those integral to profitable activities such as yield farming, may see increased interest rates as borrowers contend for capital.

Therefore, stablecoins with inherent bullish potential or those crucial for yield-generating activities like yield farming are likely to drive this increase. Consequently, we might see interest rates surge due to increased competition for capital among borrowers. Meanwhile, reduced deposit contributions to lending platforms such as AAVE could trigger a liquidity crunch, which would require higher interest rates to offset the intense competition for limited resources.

In November, the stablecoin market exhibited signs of a notable turnaround, marked by a $10 billion infusion. This capital inflow signifies a potential shift in investor sentiment and could be indicative of broader market confidence, suggesting that investors are on-ramping into crypto by minting more stablecoins. The recovery in market capitalization is particularly significant as it may influence liquidity and stability within the cryptocurrency market.

Conclusion

The exploration of the stablecoin landscape has unveiled the intricate dynamics of this rapidly evolving sector. From their nascent stages to their current prominence in the crypto economy, stablecoins have demonstrated remarkable resilience and adaptability. However, the journey is marred by challenges, including the Stablecoin Trilemma, regulatory complexities, and the need to balance decentralization and stability.

The turmoil of UST and USDC has not only tested the resilience of these digital assets but also highlighted the need for robust, innovative solutions. The emergence of FRAXv3, USDe, T-Bill-backed stablecoins, and protocol stablecoins marks a significant stride towards addressing these challenges, offering varied approaches to maintain stability, enhance capital efficiency, and reduce centralization risks.

As the landscape continues to mature, we may witness a gradual yet decisive shift from traditional fiat-collateralized stablecoins toward more decentralized alternatives. This transition, driven by the growing skepticism towards centralized models and heightened regulatory scrutiny, is paving the way for a new era in the stablecoin narrative.

The stablecoin market stands at a crucial juncture, where innovation and regulation will shape its future trajectory. The ongoing developments in this space are not merely about maintaining a stable digital currency but represent a broader movement toward redefining the financial paradigms of the digital age. As we venture into this uncharted territory, the stablecoin market remains a critical area to watch, offering insights and opportunities that could redefine the essence of digital finance.

Appendix

Liquity USD / eUSD (Backed by ETH)
- Liquidity is a decentralized borrowing protocol that allows you to draw interest-free loans against Ether used as collateral. Loans are paid out in LUSD (a USD-pegged stablecoin) and must maintain a minimum collateral ratio of 110%.
- Underlying Asset: Staked Ether
HAY (Backed by BNB)
- HAY is a decentralized, unbiased, collateral-backed de-stablecoin soft-pegged to the US Dollar. Users who have collateralized their BNB/BUSD via Helio Protocol can take out a loan in HAY against their collateral. HAY is generated, backed, and kept stable through collateral assets deposited into CeVault, functioning as the Helio collateral vault.
- Underlying Asset: BNB and BUSD
FRAX
- FRAX always aims to be backed by assets worth at least $1 for every FRAX coin. This backing includes digital contracts and real-world assets chosen by the community.
- Underlying Asset: Multiple Assets (TBILL, USDC, FXS)
USDe (ETHENA)
- Ethena Labs is developing a decentralized stablecoin protocol on Ethereum, offering a crypto-native solution that doesn’t rely on the traditional banking system. This protocol will introduce the ‘Internet Bond’.
- Underlying Asset: Delta Neutral Staked ETH
USDM (Mountain Protocol)
- Mountain Protocol manages and oversees the USDM stablecoin (US Bonds ERC-20 Stablecoin), ensuring its stability and backing by short-duration US Treasuries and other credit instruments, investors are able to generate interest on their holdings daily too.
Matrixdock Short-term Treasury Bill Token (STBT)
- Earn risk-free US treasury yields on-chain, fully backed by US treasury securities within 6 months of maturity and reverse repos.
- An ERC 14 standard token exclusively designed for accredited investors.
OpenEden
- TBILL Vault provides investors with direct exposure to a pool of short-dated T-Bills through the Vault’s TBILL token, which is backed 1:1 by the T-Bills as well as USD Coin (“USDC”) and U.S. Dollar (“USD”) reserves. TBILL holders will receive a return on their capital that reflects the returns provided by the underlying T-Bills assets held by the Vault. At any given time, the Vault will hold a portfolio of T-Bills, USDC, and USD in designated on-chain and off-chain venues.
GHO
- GHO is a decentralized, overcollateralized stablecoin native to the Aave Protocol and is aligned to the U.S. Dollar’s value. It’s minted on the Ethereum Mainnet by users who supply collateral to the Aave Protocol. Upon repayment or liquidation, GHO is returned to the Aave pool and destroyed. Interest from GHO minting goes to the Aave DAO treasury.
- Underlying Assets: Multiple Crypto Assets
crvUSD
- crvUSD is its novel liquidation mechanism ‘LLAMMA’ which turns borrower’s collateral into an LP position to enable continuous collateral rebalances using a special-purpose AMM (“soft liquidations”) as a borrower-friendly, less-volatile alternative to forceful liquidation processes typically implemented on other borrowing platforms.
- Underlying Assets: Multiple Crypto Assets
MiM
- MIM stablecoin is designed to be cross-chain compatible. This means that the MIM token can be incorporated into platforms and products built on the Arbitrum, Avalanche, Ethereum, Fantom, and Binance Smart Chain blockchains, respectively, amongst others. While several protocols allow users to use popular assets like wrapped bitcoin (wBTC) and wrapped ether (wETH) as collateral to achieve some degree of interoperability.
- Underlying Assets: Multiple Crypto Assets

Stablecoins in Flux: Growth, Challenges, and the Future of Crypto Stability