Article author: rxndy444

Article translation: Block unicorn

The cryptocurrency narrative has fluctuated, but stablecoins, as a core component of on-chain financial infrastructure, have been steadily established in the market. There are more than 150 stablecoins on the market, and new stablecoins seem to be released every week. How can users choose among all the different options?

When evaluating the pros and cons of different stablecoins, it helps to categorize them based on common design elements. So, what are some of the fundamental ways in which stablecoins vary?

The main differences between different stablecoins include:

1. Collateralization: Are these tokens fully asset-backed? Partially backed? Or not backed at all?

2. Centralization: Does the collateral involve government-backed assets such as dollars, pounds, or treasuries? Or is it composed of decentralized assets such as Ethereum?

With these properties in mind, we can begin to build a framework for comparing different stablecoins. Let’s look at how some of today’s major players stack up against each other.

Learn more about decentralized stablecoins

Looking at the top 10 stablecoins by transaction volume, we can see that centralized stablecoins, which are basically dollars on a chain, are the most commonly used. These stablecoins do not provide censorship resistance or protection from traditional financial banking crises. For example, when Silicon Valley Bank collapsed in March, USDC holders had to worry about the fate of the reserves kept there. Many people rushed to redeem their USDC with more robust options, including LUSD, and this is not the first time we have seen the decentralization premium play out.

The ultimate goal of stablecoins is to find an option that is both decentralized and capital efficient while also maintaining price stability, something that USDC and USDT clearly cannot do. To advance the stablecoin space, we must go beyond these two options - so how does the current playing field look?

Of these top ten stablecoins, only 3 can be considered somewhat decentralized; DAI, FRAX, and LUSD.

Frax: The Path to Algorithmic Stablecoins Frax is a fractional reserve stablecoin that uses an AMO (Algorithmic Market Operation) system to vary its collateral ratio and keep the price close to the anchor price. At the most basic level, AMO increases the ratio when the price is below $1, and decreases it when the price is above $1. What this means for FRAX holders is that the satisfaction of redemptions depends on the current collateral level. If the ratio is 90%, then redeeming 1 FRAX will receive $0.90 from the protocol reserve + $0.10 worth of FXS (Frax shares) newly generated by AMO. Due to the dynamic nature of the collateral ratio, it is difficult to determine the actual amount of collateral behind FRAX at any given time.

A recently passed proposal shows community support for moving to a fully collateralized model. The main motivation here is mainly due to the increased regulatory scrutiny of algorithmic stablecoins following Terra’s UST woes. Overall, algorithmic stablecoins remain a highly experimental part of the market, and while Frax has been able to successfully develop using its AMO model, it looks to be shifting.

DAI: Partial Decentralization

DAI has become the most successful stablecoin outside of on-chain USD like USDC and USDT, thanks to its CDP model. The main problem here is that most people may not initially realize that DAI borrowing is often collateralized with the same centralized stablecoins, exposing it to the same centralized risk. Since expanding to a multi-collateral model, these centralized stablecoins have become the majority of DAI backing, sometimes exceeding 50%!

Given our uncertainty about the reserves of Frax and DAI, let’s look at the rest of the decentralized stablecoin market. Continue to look at which stablecoins are decentralized and collateralized only by crypto assets.

LUSD

By far, LUSD is the most prominent stablecoin in the field that is fully collateralized by crypto assets. LUSD has achieved this status by building a solid foundation: immutable smart contracts, an economically sound anchoring mechanism, and capital efficiency that provides room for growth without jeopardizing the collateral ratio. Although Liquity's smart contracts will always stay on Ethereum, LUSD has now also been bridged to L2, with a combined liquidity of over $11 million from Optimism and Arbitrum.

Since the beginning of the year, the circulating supply has increased by over 100M LUSD, and over 10M has been transferred to L2. Rollups have accumulated significant TVL in 2023, with Arbitrum growing from $980 million to $2.3 billion and Optimism growing from $500 million to $900 million. Mainnet users are not the only ones valuing decentralized stablecoin options, providing ample opportunity for LUSD to capture more market share on L2.

Along with the circulating supply, the number of Troves has also risen sharply this year, approaching all-time highs. We haven't seen more than 1,200 active Troves since the 2021 bull run. Considering that the price of Ethereum is far from returning to that level, these users seem to prefer stablecoins rather than Ethereum leverage.

Stablecoin Market Trends

Fork

It is often said that imitation is the highest form of praise, and the Liquity model is being copied by a number of new stablecoins. Most are doing the same CDP style, but using collateralized ETH. Given the attention ETH and its LSDs received in the first half of 2023, and withdrawals now enabled, collateralized ETH is clearly more liquid and more attractive.

Is collateralizing ETH better than ETH? It’s hard to say with certainty, but there are certainly some trade-offs to consider. The main benefit of using an LSD like stETH as a backing for a stablecoin is the interest yield feature. The main disadvantage looks to be a combination of slashing risk and the risk of the LSD unpegging. For these reasons, higher minimum collateralization ratios are typically used relative to LUSD. In addition to these risks, the contracts of most of these stablecoins are upgradeable and controlled by multi-signatures, unlike the immutable contracts behind Liquity.

This means that parameters such as collateralization ratios may change. Collateralized ETH-backed stablecoins are certainly interesting and perform well in terms of decentralization and generating yield, but are less capital efficient than regular ETH due to the added risk.

Dollar Risk and the Decentralization Premium

One issue worth reviewing that we mentioned at the beginning of this article is the traditional financial banking crisis. Silvergate, SVB, First Republic, the three largest bank failures in US history, all occurred in the past few months.

The real question behind these events is, where would you feel safest to keep your funds in times of crisis? Not all dollars are created equal, and as recent bank failures have reminded us, bank deposits can disappear in a flash. Sure, there is FDIC insurance up to $250,000, and the government has shown a willingness to bail out failing banks, but, because of the fractional reserve system that the dollar operates on, people will still seek safety in uncertain times. This means bank runs, and we’ve already seen for the first time how this affects stablecoins that rely on fiat reserves, like USDC and SVB.

In times of uncertainty, for those who care about protecting their assets during a crisis, decentralized stablecoins have relevant use cases, offering true non-custodial ownership. So, which stablecoin would you choose as your choice for 5+ years from a resilience perspective? If it runs on an immutable smart contract and can always be redeemed for a fixed amount of a decentralized asset, then you are in the right place.

This is why LUSD often sees a price premium in times of crisis: people want to hold it when other more centralized stablecoins look risky. Putting decentralization at the top of the stablecoin trilemma is what distinguishes LUSD from many other stablecoins and has enabled Liquity to add more than $380 million in TVL during the bear market.

Summarize

Every bank failure reaffirms the value of a truly decentralized stablecoin, and LUSD has long been viewed by the market as the stablecoin to hold when things get hairy. Adding bridges and liquidity venues on L2 opens LUSD to a wider range of market participants while still retaining the immutability that makes the protocol so powerful. We have all seen the shortcomings of centralized stablecoins, and while algorithmic stablecoins have the potential to provide similar decentralization, they have not yet reached the point where they can be reliably used. LUSD is designed to withstand the test of time and adverse market conditions, as evidenced by its continued growth during the trough of the bear market. Now that collateralized ETH has become a dominant asset in crypto, we are seeing new protocols fork Liquity and use LSD as collateral, which further illustrates the superiority of its design.