This article illustrates the decentralized stablecoins and their models in today’s crypto market, offering a way to evaluate decentralized stablecoins by comparing their pros and cons. We hope you can benefit from the learning framework of decentralized stablecoins demonstrated below.

Statistics that appear in this article are recorded from July 2021 to February 7, 2022. We focused on decentralized stablecoins with a total supply of over $100 million, covering their market performance from the May 19 crash to recent falls. In particular, normal market observation covers the six months from July 1 to December 31, 2021, while market statistics registered from January 19 to February 2 are reserved for stress tests (during this period, the BTC price once plummeted by around 23%, and DeFi protocols witnessed massive liquidation, which makes it a great time for stress tests).

What is a decentralized stablecoin?

Prices are determined by supply and demand. Essentially, currencies are also a type of commodity, which means that their prices also conform to the most fundamental economic principle. When it comes to legal currencies in the real world, countries rely on central banks and financial policies to maintain the dynamic balance of monetary supply and demand and to stabilize its price. By doing so, the purchasing power of legal currencies is kept within a comparatively predictable range of fluctuation.

In the blockchain space, decentralized stablecoin protocols play the role of central regulators and control the issuance and stability of their stablecoins through smart contracts, which adjust the supply and demand of a stablecoin by finetuning the major protocol parameters (e.g. the collateralization rate, the proportion of coins required for minting, seigniorage) to ensure that the stablecoin is stably pegged to the target currency.

Factors to consider when observing decentralized stablecoin protocols

When analyzing decentralized stablecoin protocols, one should account for three factors:

1.Stability: Whether a stablecoin is pegged to the target legal currency, and whether the deviation is within an acceptable range;

2.Utilization rate of assets: The essential mechanism of most decentralized stablecoins is to print more money using money, and the capital efficiency of this process is also a major asset for protocols;

3.Earning power of protocols: How a protocol profits from the issuance of stablecoins, and the source & stability of revenue.

Market Landscape

Let’s begin with a quick overview of the current stablecoin market. Most stablecoins issued in the market are USDC and USDT, which account for 74% of the total supply of all stablecoins, while 16% is taken up by decentralized stablecoins. Meanwhile, USDT contributed 84% of the total trading volume registered by the market. Overall, the proportion of decentralized stablecoins in the total market cap of all stablecoins is not that high, and they are also traded less frequently. Despite this, from the perspective of growth, the market share of decentralized stablecoins is rising.

In today’s market, there are four types of decentralized stablecoin protocols: the over-collateralized, the partially collateralized, the ecosystem type, and the derivative type. Moreover, many extensively adopted protocols (by the total supply and trading volume) are over-collateralized, while the derivative type is a new category of decentralized stablecoin protocol, and most of such protocols are under testing or just launched. The picture below shows the market share of the four types of protocols by total supply.

1. Over-collateralized stablecoin protocols

Over-collateralized stablecoins are deployed on protocols that allow users to mint crypto assets by depositing crypto collaterals that are worth less than the cryptos to be minted. These highly stable protocols use such over-collateralized assets to cushion assets on the protocol, and users’ positions will be liquidated when their collateralization rate reaches the liquidation level. The disadvantage of such protocols is equally clear — low utilization rate of assets.

Currently, over-collateralized protocols that are well-established (over $100 million in total supply) include MakerDAO (DAI), Liquity (LUSD), Mai Finance (MAI), Alchemix (ALUSD), Kava Lend (USDX), and Spell (MIM). It is also clear that DAI and MIM are the absolute leaders in this category in terms of total supply and trading volume (>90% when put together).

In terms of stability, through the statistical comparison between the normal observation period and the stress test period, we can tell that significant market swings had virtually no impacts on the DAI price, which even became more stable during the stress test period. Although MIM significantly fluctuated after the slump (the MIM price dropped to around \(0.99, a decrease of 1%), the price soon rebounded. Based on the overall performance recorded by the protocols during the stress test period, MIM stood out in terms of stability. Protocols with poor stability include Kava Lend (USDX) and Mai Finance (governance token: QI). The prices had been below \)1 for a long time. Moreover, the prices slumped and became more volatile during the stress test period.

MIM and LUSD are the worst performers in terms of the total supply. The supply of both stablecoins has dropped by approximately 40%, while that of other protocols in the same category has stayed relatively stable, which may indicate a lack of confidence in MIM and LUSD (the drop in the MIM supply can be largely blamed on MakerDAO’s co-founder, who tweeted that MIM and UST are Ponzi schemes).

Generally speaking, over-collateralized stablecoins did not show significant volatility under the stress test.

In terms of the utilization rate of assets, protocols including DAI, LUSD, and USDX focus on prudent mainstream coins, while ALUSD, MAI, and MIM introduced interest-earning assets as collateral to further release liquidity. The revenue sources of the protocols are basically the same, covering lending & borrowing, liquidation, and mint fees.

2. Partially collateralized stablecoins

Partially collateralized stablecoins are normally minted using mainstream stablecoins and their governance tokens at a certain ratio. Since the governance tokens of infant projects are backed by little value, most of such stablecoins will eventually become victims of the death spiral, and very few could survive.

When it comes to partially collateralized protocols, a unique concept called PCV (Protocol Control Value) should be noted. We can think of PCV as a protocol’s treasury, which constitutes an asset entirely owned by the protocol and cannot be redeemed by users. PCV grows in value through the interest-earning operations and fees of the protocol. A stablecoin is considered over-collateralized when the PCV exceeds its market cap. The size of PCV determines the scale of the supply of stablecoins and the level of risks.

Right now, partially collateralized protocols that are comparatively mature include Fei Protocol (FEI) and Frax (FRAX), which together account for about 91% (Frax: 60%; FEI: 31%) of the market share.

To assess their stability, such stablecoins were also stress-tested. We found that FEI and FRAX had been just as stable as most over-collateralized stablecoins, which are thought to be more stable, during the stress period or normal period. In terms of stability, they have even outperformed most over-collateralized stablecoins. Such a strong performance is largely the result of successful PCV. The collateralization ratio (PCV/market cap) of FEI has reached 132%, while that of FRAX has stabilized at 85% through its mechanisms.

The stability performance of AMPL is rather poor because its unique Rebase mechanism led to drastic price swings.

In terms of the utilization rate of assets, FRAX features the mixed minting of governance tokens (FXS+USDC), which means more stablecoins can be minted. As such, the minting of FRAX can be considered to be 100%-collateralized, and there is no risk of liquidation because the governance tokens are directly minted and collateralized. In the case of FEI, which can be directly minted using ETH and DAI, the liquidation risk is zero, and the stablecoin is also 100%-collateralized. Stablecoins in this category are roughly the same in terms of earning power, which is backed by protocol revenue and interests generated by PCV asset management.

3. Ecosystem type stablecoin protocols

Ecosystem type stablecoins can be minted and redeemed using their public chain coins (USDT-margined) at a 1:1 ratio. The value of such stablecoins is backed by the value of the entire public chain ecosystem.

At the moment, only Terra’s UST and Waves’ NUSD have increased their circulating supply. In particular, UST accounts for 96% of the market share.

UST is now almost as stable as DAI thanks to its fast-growing ecosystem. Though it had been hit by tweets from MakerDAO’s founder, the price just slightly fluctuated, and neither the average price nor the circulation value was much affected. Waves performed badly with respect to stability, which might be related to the fact that the protocol’s ecosystem is not fully-fledged and that there are not enough application scenarios.

Overall, the depth of ecosystem-based stablecoins is closely bound up with their ecosystem. A sound ecosystem facilitates strong stability performance and improves the number of coins in circulation.

Of the four categories, the ecosystem type stablecoins showed the highest utilization rate of assets because the collateralization of these coins is backed by the growth of the entire ecosystem, which means that the maximum number of coins that can be minted is subject to the ecosystem’s market cap. In addition, the earning power of such stablecoins is also correlated with the adoption of their ecosystem — Each transaction and contract execution performed on the public chain brings in revenue for the ecosystem.

4. Derivative type stablecoin protocols

Most derivative type stablecoins remain in their infancy in terms of the circulating supply or the period since issuance. As such, few valid statistics are available. The circulating supply of agEUR, a EUR-pegged stablecoin issued by Angle Protocol, is comparatively large in this stablecoin category. In addition, UXD Protocol issued approximately 10 million USD-pegged UXD; Hubble Protocol issued around 30 million USD-pegged USDH. These protocols use on-chain derivatives to hedge the collaterals used to mint their stablecoins and to have their USDT-margined value locked at a certain level, which mitigates the liquidation risk and stabilizes the anchoring. For instance, both agEUR and UXD come with an asset utilization rate of 100%, which means that these stablecoins can be minted using their risky assets at a 1:1 ratio. Moreover, as the hedging of minting collaterals requires the shorting of on-chain futures, considerable liquidity is injected into the derivatives market, which can be regarded as another source of value of derivative type protocols.

The preferred valuation of different models

According to our observation, the circulating supply of stablecoins and the Fully Diluted Valuation (FDV) of the governance token are not significantly correlated, and there is median regression during certain periods (see the picture below). Therefore, we believe that (FDV of the governance token)/(the circulating supply) could be an effective way to evaluate decentralized stablecoin protocols. It should be noted that the derivative type stablecoins were not included due to the unavailability of samples.

After averaging the FDV/supply ratios of all intervals, we arrived at several interesting findings. Firstly, among over-collateralized stablecoins, protocols that use interest-earning assets as collateral (i.e. the utilization rate of assets is higher) come with higher market caps. Our second finding is that the market of stablecoins differed according to their categories: regular over-collateralized protocols < over-collateralized protocols that generate interests ≈ partially collateralized protocols < ecosystem type protocols. Considering our discussions of stability, the utilization rate of assets, and earning power, it seems appropriate to conclude that the market is most concerned with the utilization of assets when evaluating decentralized stablecoin protocols.

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