Staking stablecoins are a type of stablecoin that provides investment returns to holders simply by holding assets.
Written by: Caesar
Translated by: Deep Tide TechFlow
Interest-bearing stablecoins are considered the next revolution in the evolving stablecoin ecosystem. Over the past year, many projects have emerged dedicated to developing interest-bearing stablecoin products.
In this article, I will comprehensively outline the situation of staking stablecoins, emphasizing the main categories in this field: LSD-backed stablecoins, government bond-backed stablecoins, and other interest-bearing stablecoins. Following this, I will conduct a user analysis, focusing on identifying which types of users may or may not find interest-bearing stablecoins attractive.
I will conduct a SWOT analysis of interest-bearing stablecoins, elucidating potential risk areas and improvement opportunities in this space. Finally, I will share my perspective on the market fit of interest-bearing stablecoins.
Overview of Interest-Bearing Stablecoins
Staking stablecoins are a type of stablecoin that provides investment returns to holders simply by holding assets.
The emergence of several stablecoins focused on providing predictable and sustainable returns has generated significant optimism in the crypto ecosystem. Many view these interest-bearing stablecoins as nearly risk-free investments that are poised to capture a substantial niche market in the stablecoin space. Notable figures such as Nic Carter are particularly optimistic, projecting that interest-bearing stablecoins may capture 20-30% of the stablecoin market share in the coming years.
However, skeptics, including myself, question the long-term viability and potential of these interest-bearing stablecoins.
"The key to interest-bearing stablecoins lies in their inherently growth-oriented monetary policy, which poses the risk of slowing down the circulation of money. If this happens, it often leads to economic slowdown. In short: if your money might be worth more tomorrow, why spend it today? If everyone thinks this way, will the economy really prosper?"
Let's analyze these protocols one by one to better understand the situation of interest-bearing stablecoins. For this, we will analyze LSD support, government bond support, and interest-bearing stablecoins separately.
a) LSD-Backed Stablecoins
LSD-backed stablecoins are CDP model stablecoins that require over-collateralization with liquidity-pooled tokens and carry liquidation risk. They allow holders to earn returns while retaining the key properties of crypto-backed stablecoins.
The main features of LSD-backed stablecoins can be summarized as follows:
Utilize LSD derivatives;
Rely on Ethereum collateral rewards;
Require over-collateralization and carry liquidation risk;
Unlock locked Ethereum liquidity.
Recently, with the increase in pledged Ethereum, investors have seen the potential of LSD-backed stablecoins, making LSD-backed stablecoins a popular category. As the amount of pledged Ethereum increases, the market share of LSD-backed stablecoins may also increase.
The first wave of LSD-backed stablecoins, such as $GRAI, $R, and $eUSD, demonstrated the demand for stablecoins utilizing LSD derivatives. However, the existing shortcomings of these stablecoins may pose challenges in the future. On the other hand, new LSD-backed stablecoins such as $mkUSD and $crvUSD have made some improvements to the existing model, which could be an exciting development. It should be noted that Ethena Labs' $eUSD is a completely new model that can incentivize other developers to develop similar models.
I believe LSD-backed stablecoins can serve as an effective leverage primitive for Ethereum investors. However, due to the capital inefficiency caused by over-collateralization requirements and liquidation risk, they cannot fulfill the function of stablecoins. Additionally, LSD-backed stablecoins inherently do not serve as a medium of exchange because their primary purpose is to provide returns to holders, and therefore cannot function as an exchange medium.
b) Government Bond-Backed Stablecoins
Government bond-backed stablecoins are the latest innovation in the ecosystem. With the rise in US interest rates, some have realized that this may be an excellent opportunity to provide risk-free interest to investors. Ondo Finance's $USDY and Mountain Protocol's $USDM are two major examples in this category.
The main features of government bond-backed stablecoins can be summarized as follows:
Require permission/KYC;
Returns depend on US interest rates;
Returns are less volatile compared to DeFi.
Although $USDM is a rebase token, $USDY is an immutable rebase token. Therefore, integrating $USDM into DeFi protocols will be challenging, and $USDY will certainly face issues in user experience.
I believe that from the perspective of exchange rate stability and risk-free interest rates, government bond-backed stablecoins provide the best solution. However, their growth depends on US interest rates, which are beyond their control. Therefore, external factors will play a crucial role in the future development of this category.
Additionally, it should be noted that government bond-backed stablecoins do not provide a strong value proposition for the crypto community, as these stablecoins require permission, meaning not everyone can mint or use them, and a 5% interest rate is not competitive in other protocols. These protocols may target users in developing countries, but with a lack of liquidity and potential decrease in future returns, they are at a disadvantage in competition with USDC and USDT. Furthermore, government bond-backed stablecoins inherently do not serve as a medium of exchange because their primary purpose is to provide returns to holders, and therefore cannot function as an exchange medium.
c) Interest-Bearing Stablecoins
Interest-bearing stablecoins provide automated DeFi returns to holders by using collateral in several protocols. To mint these stablecoins, users need to collateralize with USDC or other stablecoins. Sperax and Overnight can be examples of this category.
Many view interest-bearing stablecoins as stablecoins, but I disagree with this view. These stablecoins do not serve the function of stablecoins but rather act as LP tokens. This means that interest-bearing stablecoins do not serve as a currency but as LP tokens that allow users to earn returns simply by holding them. While this criticism can be directed at every interest-bearing stablecoin, it is clear that stablecoins like $USDs and $USD+ do not even attempt to add other uses besides being LP tokens.
The main features of interest-bearing stablecoins can be summarized as follows:
Not a medium of exchange;
Existence of counterparty risk;
USDC wrapping;
DeFi returns.
Many believe that interest-bearing stablecoins may be an exciting initiative, but I do not consider them stablecoins; they are providers of USDC collateral. Therefore, they do not have a unique value proposition in the ecosystem. As a result, I am not optimistic about the future of this category, as products can be easily replicated or adopted by existing projects with lower risk.
Staking Stablecoin Market: User Analysis
To determine whether a protocol fits the product-market fit, we need to look at potential customers/users and how they will view/use the protocol.
For stablecoins, I believe we can analyze three main categories:
a) Institutions
Government bond-backed stablecoins can be an excellent way for new institutional entrants exploring the DeFi space. Since these platforms require KYC/AML requirements and permission, institutions will not encounter difficulties in terms of regulations and security, while also being able to benefit from government bond-backed stablecoins.
For institutions in developing countries with restricted access to US dollars, these stablecoins can be very effective.
Additionally, LSD-backed stablecoins can be an excellent tool for institutions familiar with the Ethereum and DeFi ecosystems to increase their exposure to Ethereum or the entire Ethereum ecosystem.
b) Whales/LPs
I believe whales/LPs are the most exciting user category for interest-bearing stablecoins, as these users have sufficient knowledge, experience, and capital to leverage staking stablecoins for high returns through developing leveraged trading strategies.
Most interest-bearing stablecoins can be used in several ways:
Collateralizing debt positions;
Earning returns;
Internet bonds;
Leveraged liquidity mining.
For these use cases, whales/LPs can effectively develop trading/mining strategies and benefit from interest-bearing stablecoins.
LSD-backed stablecoins and interest-bearing stablecoins can be excellent tools for whales/LPs to utilize/diversify or increase exposure to certain assets. I believe that, although the user count may not be high, the TVL of these stablecoins can reach significant levels.
c) Retail Users
Interest-bearing assets do not meet the requirements of stablecoin functionality. In short, according to the concept of stablecoin functionality, stablecoins must have specific functions to be used as currency in the digital space, such as:
Medium of exchange;
Store of value;
Capital efficiency;
Fiat on/off ramp;
Anti-censorship.
I believe that if a stablecoin cannot meet these requirements, it cannot scale, and therefore will not become a larger participant in the stablecoin market.
For interest-bearing stablecoins, I believe that none of them fulfill the function of stablecoins because they cannot be considered as a medium of exchange and do not have capital efficiency. These issues limit the ability of interest-bearing stablecoins to be used for trading or buying/selling crypto assets. As retail traders primarily use stablecoins for these reasons, interest-bearing stablecoins are difficult for this user category to adopt. Additionally, the lack of liquidity and use cases are also major barriers for retail traders to use interest-bearing stablecoins.
Furthermore, considering that most retail users use stablecoins for trading, and the primary purpose of interest-bearing stablecoins is to hold stablecoins to earn returns, there is a mismatch between user interests and the protocols. Therefore, I believe that any stablecoin not considered as a medium of exchange will not be widely adopted by retail users.
SWOT Analysis of Interest-Bearing Stablecoins
Strengths
Dollarization: The dollar is a highly recognized asset in the developing world, and interest-bearing stablecoins are extending the influence of the dollar to these regions, where hyperinflation and devaluation of local currencies have reduced purchasing power.
Sharing inherent returns: Circle and Tether do not share the inherent returns of the dollars deposited in their protocols with users. However, interest-bearing stablecoin protocols share these returns with holders, empowering users.
New revenue sources: While Ethereum collateral-based interest-bearing stablecoins introduce Ethereum returns to institutions, government bond-backed stablecoins bring US returns into DeFi, creating new opportunities for both types of investors.
Store of value: Interest-bearing stablecoins can hedge against inflation, as they can provide users with approximately a 5-8% USD yield, which is a good option for users.
Weaknesses
Medium of exchange: Interest-bearing stablecoins are inherently limited in their use as a medium of exchange for several reasons, including capital inefficiency, limited or permissioned use cases, and lack of liquidity. Most importantly, because these stablecoins generate returns simply by holding, no one wants to use them for transactions as it would mean losing out on returns. Therefore, the reasons for using interest-bearing stablecoins as currency are limited.
Permission/censorship: Government bond-backed stablecoins require permission, and some individuals (such as US citizens) are not allowed to use them. Therefore, there are limitations in adopting these stablecoins. Additionally, there may be censorship risks as protocols must comply with regulatory orders.
Lack of use cases/lack of liquidity: Interest-bearing stablecoins face issues of lack of liquidity and use cases due to several issues, including scalability, liquidation risk, capital inefficiency, or permissioned use cases, limiting the potential for growth.
Opportunities
Unique value proposition compared to fiat-backed stablecoins: With the increasing empowerment of users in the ecosystem, there will be more criticism pointing out that fiat-backed stablecoins do not share the inherent returns of the dollars with holders. This could be a good opportunity for interest-bearing stablecoins to differentiate themselves from other stablecoins.
Institutional adoption: Government bond-backed stablecoins can be a good entry point for overseas institutions to bring new capital into DeFi.
Threats
Competition: Most projects do not have a competitive advantage over other projects, so some protocols may disappear in a few years due to this competitive environment and lack of innovation/differentiation.
Profitability of protocols: The competitive nature of this space forces protocols to bring more profits to users, which in turn reduces the profitability of these protocols. Therefore, these projects may burn through their capital and may not survive for long.
Fragmentation of liquidity: Due to the competitive environment, the ecosystem may face liquidity fragmentation issues, reducing the capital efficiency of these interest-bearing stablecoins.
Sustainability of returns: While some interest-bearing stablecoins depend on government bond rates, others follow Ethereum collateral rates. The issue with this approach is that government bond rates will definitely decrease in the future, and the sustainability of the business is questionable as low rates may not be attractive to users. On the other hand, if the Ethereum collateral ratio increases, the yield will correspondingly decrease, which may be a future issue for these protocols as lower yields may not be attractive.
Do these interest-bearing stablecoins meet market demand?
The various types of interest-bearing stablecoins discussed in the article each cater to different markets. Instead of analyzing them as a single category, it would be more beneficial to rank them based on their product-market fit, and then evaluate the reasons behind the ranking. This will provide more insight.
Ranking interest-bearing stablecoins based on product-market fit:
Government Bond-Backed Stablecoins: With the rise in US interest rates aligning with the rise of stablecoin builders, they have realized that government bond-backed stablecoins can be an excellent tool for users. While it is clear that regular DeFi users will not use government bond-backed stablecoins due to privacy, censorship, lack of use cases, and liquidity reasons, institutional investors outside the US may be excited to use government bond-backed stablecoins. However, I should note that these stablecoins will no longer have further utility compared to fiat-backed stablecoins when returns decrease. Therefore, I believe government bond-backed stablecoins can be an excellent tool for institutions or accredited investors to access US dollars globally, but the market may not be as large as many people think.
LSD-Backed Stablecoins: I am skeptical about the potential of LSD-backed stablecoins to achieve the vision of many, as the design of these protocols includes many flaws such as capital inefficiency, liquidation risk, ease of replication, lack of true innovation, etc., which limit the ability of these stablecoins to scale/expand and be seen as a medium of exchange. However, it is clear that they are a good financial primitive for Ethereum leverage, so while LSD-backed stablecoins will have a place in the market, they will not be as large as many people envision. On the other hand, new protocols like Ethena have created a new model to address these issues using LST.
Interest-Bearing Stablecoins: I do not believe that interest-bearing stablecoins provide a differentiated value proposition in the stablecoin market. I believe these products simply wrap USDC or LP tokens, allowing users to earn interest through stablecoins while taking on some counterparty risk. Additionally, other stablecoins can very easily replicate this business model by simply creating interest-bearing versions of stablecoins, challenging interest-bearing stablecoins. Therefore, I believe the product-market fit of interest-bearing stablecoins is the lowest.
The stablecoin market is still in its early stages, and there are several upcoming projects aimed at challenging the current models. Let's see how the landscape of interest-bearing stablecoins will develop in the near future. However, it should be noted that we still have time to find product-market fit in this niche market.
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