Penetrating the Current Stablecoin Landscape: Opportunities and Challenges for Newcomers Beyond USDT and USDC

Written by: Caesar

Compiled by: Shenchao TechFlow

Due to the significant alignment of stablecoins with market demand, they remain a central topic of discussion within the ecosystem. As a result, developers and enthusiasts are actively exploring ways to create stablecoins that can have a lasting impact on the ecosystem. However, so far, progress in this effort has been relatively limited.

I believe that the inherent limitations of cryptocurrency-backed stablecoins have not been sufficiently discussed. As we will explore in this article, current projects fail to attract users because, compared to fiat-backed stablecoins, cryptocurrency-backed stablecoins have limitations in capital efficiency, liquidation risk, limited use cases, and liquidity.

In this article, I will present some statistics regarding the current state of the stablecoin market and share some thoughts on it. Then, I will discuss the concept of stablecoin functionality to help us understand the reasons behind the state of the stablecoin market. Finally, I will focus on cryptocurrency-backed stablecoins and address their issues.

Current Stablecoin Market Statistics

The following data comes from DeFiLlama:

• The total market capitalization of stablecoins is approximately $125 billion, with nearly 87% being USDT and USDC.
• About 92% of the market share is held by fiat-backed stablecoins, totaling approximately $116 billion.
• Only about $7 billion is held by cryptocurrency-backed stablecoins, with DAI holding around $5 billion.
• The total market capitalization of algorithmic stablecoins is approximately $2 billion, with FRAX and USDD accounting for 75% of the market share.

These data provide several insights into the market situation:

USDT and USDC are projects that have achieved product-market fit and align with market and user demand.

• Despite the increasing number of projects in the cryptocurrency-backed stablecoin category, the dominant market share of USDT and USDC proves that there is currently no demand for alternatives.
• Although the increase in DAI's savings rate temporarily helped DAI gain market share for a period, DAI has failed to maintain its market capitalization in USD terms over the past year, while its dominance among cryptocurrency-backed stablecoins remains undisputed.
• As the most widely adopted cryptocurrency-backed stablecoin, DAI's shift towards including real assets like U.S. Treasury bonds highlights the lack of a scalable stablecoin that can resist censorship and be immune to counterparty risk.
• Apart from DAI, the adoption rate of other cryptocurrency-backed stablecoins is limited, indicating that their success and potential may be overestimated. The viability of algorithmic stablecoins is uncertain, as FRAX also attempts to move away from algorithmic mechanisms.
• Unless a significant event undermines the credibility of USDT and USDC or a breakthrough project emerges, the stablecoin market landscape is unlikely to change significantly.

Why Do Users Prefer USDT and USDC?

Cryptocurrency initially began as a movement defined by a belief in freedom, decentralization, and skepticism towards centralized participants. However, the current state of the stablecoin market is the opposite. It is clear that as the ecosystem's adoption increases and more people enter the space, the purity of the ecosystem is diminishing, as most newcomers are not motivated by decentralization or censorship resistance.

The most centralized and perhaps the least transparent projects have become market leaders. The main reason for this situation can be explained by a new concept I propose called stablecoin functionality:

Stablecoin functionality is a new concept used to understand some of the main issues in the stablecoin space:

1. The market dynamics between users and stablecoin projects;
2. Why some stablecoins are adopted while others are not;
3. The vision that stablecoin project developers should possess.

I believe stablecoins should be viewed as digital versions of the off-chain assets they are pegged to. Therefore, in our case, fiat-backed stablecoins need to represent the functionality of the U.S. dollar. These functionalities can be integrated into stablecoins, including:

• Medium of exchange: Stablecoins should be viewed by users as a tool for exchanging cryptocurrencies or trading with others, and they need to be available on major protocols (such as centralized exchanges and established DeFi projects like Uniswap, Balancer, Curve, etc.) with basic trading pairs.
• Value storage / Anchoring stability: Stablecoins should have a historical performance of maintaining their pegged stability, as even a 1% fluctuation can be seen as a failure from the user's perspective.
• Capital efficiency: If a stablecoin requires over-collateralization or has liquidation risks, it lacks capital efficiency, which will limit user adoption, as most users understandably prefer their assets to be free from these risks or limitations.
• Fiat exchange channels: If a stablecoin does not provide fiat exchange solutions, it becomes harder to use, as the lengthy process of converting crypto assets to cash dollars makes the entire process expensive and cumbersome.
• Censorship resistance: Stablecoins should protect their users from arbitrary actions by centralized participants by becoming a safe haven for privacy and self-custody, without relying on centralized entities like banks.

It is understandable that $USDT and $USDC possess most of these functionalities, including medium of exchange, value storage, capital efficiency, and fiat exchange channel solutions, but both stablecoins are centralized and therefore lack censorship resistance. Although USDT and USDC do not achieve complete success under the stablecoin functionality framework, they are the most successful within this framework, thus achieving product-market fit. Furthermore, the early advantages of these projects and their brand recognition have led to widespread adoption by users.

It is evident that for stablecoin projects to threaten the dominance of $USDT and $USDC, they need to meet these five main requirements and then build brand recognition within the community.

However, we need to consider whether there is a possibility of challenging $USDT and $USDC within the current model/technical development of cryptocurrency-backed stablecoins. Let us delve into some existing stablecoin projects that may be seen as challengers to $USDT and $USDC.

Cryptocurrency-Backed Stablecoins

In this section, I will focus on several stablecoins that I believe are worth analyzing, as they cover all aspects that must be considered for cryptocurrency-backed stablecoins.

Before diving into each stablecoin, I want to emphasize that I believe the limitations of the collateralized debt position (CDP) model are a major issue faced by every cryptocurrency-backed stablecoin. CDPs require users to lock up crypto assets in an over-collateralized loan, which carries liquidation risks, thus imposing inherent limitations on scalability.

The lending relationship between users and protocols has issues in several aspects that are not suitable for stablecoin functionality:

Medium of exchange: Users do not use these stablecoins for trading, as they create lending positions through minting, aside from leveraged mining and leveraged trading. Therefore, cryptocurrency-backed stablecoins are not viewed as mediums of exchange.

Capital efficiency: Due to the CDP's requirement for over-collateralization and liquidation risks, it is not capital efficient from the user's perspective, as there are more capital-efficient ways.

Thus, we can say that cryptocurrency-backed stablecoins do not meet product-market demand; however, we need to analyze these stablecoins individually to better understand their limitations and drawbacks while also highlighting opportunities.

$DAI

$DAI is an over-collateralized CDP stablecoin issued by MakerDAO, one of the largest cryptocurrency-backed stablecoins, attracting billions of dollars in funding and achieving good adoption within the DeFi ecosystem. However, with the launch of new cryptocurrency-backed stablecoins and the decoupling of $DAI from $USDC, this stablecoin has lost some market share. Nevertheless, with the introduction of enhanced DAI savings rates, the protocol has regained some momentum, although discussions about sustainability continue.

While the protocol leverages its treasury holdings as one of the most profitable businesses in the ecosystem, it also faces challenges regarding why I should use $DAI instead of $USDC.

To my knowledge, $DAI will face the following challenges:

1. Lack of innovation: $DAI is minted through over-collateralized CDP positions, thus lacking any significant technological advantage compared to competitors. The introduction of enhanced DAI savings rates also indicates that the project is struggling to attract users.
2. Reliance on centralized participants: $DAI is not a fully decentralized stablecoin, as its asset reserves primarily consist of $USDC and RWA, with income generated through treasury bonds, meaning that the custody of assets is handled by centralized participants.
3. No clear value proposition: The main value proposition of cryptocurrency-backed stablecoins is decentralization and censorship resistance. As a trade-off, these protocols implement the CDP model, requiring over-collateralization and carrying liquidation risks. However, despite $DAI maintaining these drawbacks, it does not provide any value proposition in terms of decentralization. Thus, it combines the worst aspects of fiat-backed stablecoins and cryptocurrency-backed stablecoins.

On the other hand, $DAI also has opportunities:

1. High adoption rate: $DAI is one of the most well-known and adopted stablecoins in the ecosystem. Additionally, $DAI exists in most mature DeFi protocols, providing strong liquidity. Considering that launching liquidity for each stablecoin project is the most challenging part, $DAI is in a very favorable position.
2. Medium of exchange: Many people consider $DAI to be a medium of exchange, which can be evidenced by its use for trading and buying/selling crypto assets, as well as its deep liquidity across different protocols.
3. Value storage: By distributing treasury bond income to DAI holders through enhanced DAI savings rates, $DAI can become a reliable source of yield and value storage, thereby increasing adoption.

$FRAX

$FRAX was initially an algorithmic stablecoin supported by an algorithmic mechanism and under-collateralized cryptocurrency reserves. However, the collapse of $UST led to a loss of trust in algorithmic stablecoins, prompting the FRAX team to change this model. Therefore, they decided to use $USDC as reserves to achieve 100% collateralization. However, as $FRAX became "the poor man's $USDC," this model faced criticism.

However, with the upcoming release of FRAX v3, this model will also change. Although not all details are public, rumors suggest that they will abandon their reliance on $USDC, and the FRAX ecosystem and its stablecoin $FRAX will be backed by U.S. Treasury bonds.

$FRAX will face several challenges:

1. Reliance on centralized participants: One of the most common criticisms is that $FRAX relies on $USDC. If $FRAX is backed by $USDC reserves, what is the reason for holding it? Although they are changing the model, the reliance on centralized participants will continue, as they will collaborate with other centralized participants for FED master account transactions.
2. Leadership team's indecision: There is controversy over whether this criticism is valid, but the FRAX leadership team has indeed focused on too many developments in a short time and frequently changed their roadmap.
3. Lack of $FRAX holders/users: According to Etherscan statistics, $FRAX has about 8,000 holders, with a market capitalization of approximately $800 million. The value proposition of $FRAX is not as a medium of exchange, thus limiting its potential to challenge $USDT and $USDC. Frax is not widely used in the ecosystem. Apart from products built on Frax, it is only used on Curve. The reason is the incentives paid to the $FRAX pool by Curve, which is due to Frax's position in Curve Wars. The sustainability of Curve is also an important parameter for $FRAX.

On the other hand, $FRAX has some opportunities:

1. Capital efficiency: Currently, users can deposit 1 $USDC and receive 1 $FRAX, which is a capital-efficient way. It can be assumed that this capital efficiency will continue to exist through the migration to the new model, thus providing a competitive advantage for $FRAX.
2. Established FRAX ecosystem drives use cases for $FRAX: Most stablecoins face the issue of use cases, meaning there are not enough places to utilize the underlying stablecoin. However, $FRAX can be effectively used through the universal FRAX ecosystem, including Fraxswap, Fraxlend, and Fraxferry, and perhaps in the future on Fraxchain.

$LUSD

$LUSD is one of the most forked stablecoin projects in the ecosystem, as it provides a unique solution for offering a censorship-resistant stablecoin. It is backed by $ETH, allowing users to borrow against their $ETH holdings with a minimum collateralization ratio of 110%.

Some features that make $LUSD competitive:

1. Immutable smart contracts;
2. No governance required;
3. No interest charged;
4. Quality of collateral.

Additionally, from the latest announcements of the Liquity Protocol, it can be seen that with the launch of Liquity v2, they will develop a new model that maintains collateral value using a risk-free approach. This will be a new stablecoin separate from existing projects.

$LUSD will face several challenges:

1. Limited scalability: Although $LUSD is one of the most inspiring projects in the ecosystem, it is also one of the least scalable projects, as it requires over-collateralization, carries liquidation risks, and only accepts $ETH as collateral.
2. Lack of $LUSD holders/users: Due to the limited scalability of $LUSD, the stablecoin has only about 8,000 holders, with a market capitalization of approximately $300 million, according to Etherscan data.
3. Lack of use cases: Due to the limited scalability of $LUSD, it cannot find sufficient liquidity in major protocols, hindering the adoption of $LUSD.
4. Insufficient capital efficiency: Liquidity requires over-collateralization and carries liquidation risks, making it not a good choice in terms of capital efficiency, which limits $LUSD's ability as a medium of exchange.

On the other hand, $LUSD has some opportunities:

1. Censorship resistance: The most unique aspect of $LUSD is that it is the best project in terms of decentralization and censorship resistance. I believe there is no competition in this area.
2. Strong brand: The long-term success of $LUSD in decentralization and anchoring stability, along with the team's success in gaining trust within the community, makes the $LUSD brand a strong brand that can be leveraged by the team.
3. Liquity v2: The Liquity team recognizes the issues regarding protocol scalability, and their goal is to scale without compromising. Developing a risk-free model that uses primary protection methods to prevent losses caused by volatility can address scalability issues to some extent.

$eUSD

$eUSD is a stablecoin backed by staked $ETH as collateral. Holding $eUSD will provide a stable income stream, with an annual yield of approximately 8%. It is a CDP stablecoin that requires over-collateralization and carries liquidation risks.

In my view, $eUSD will face several challenges:

1. Insufficient capital efficiency: The over-collateralization model means that $eUSD is limited in capital efficiency, as users need to put in more funds than they receive and bear liquidation risks.
2. Limited use cases: Due to insufficient demand for stablecoins to provide liquidity for multiple pools, the use cases for $eUSD are limited, which restricts its scalability.
3. Limited growth potential: Emerging stablecoins need to have unique value propositions to have growth potential; however, while leveraging LSD products can be seen as a good way to scale, it is limited due to intense market competition.
4. Not a medium of exchange: $eUSD is a yield-bearing stablecoin, and the protocol does not prioritize its use as a medium of exchange. Although this is also an important value proposition, it limits growth potential.
5. Anchoring stability: eUSD holders are entitled to rewards in the form of collateralized $ETH. For this reason, demand for eUSD exceeds supply, leading to its peg exceeding $1.00. Unless the system changes, eUSD will not be able to maintain its peg.

On the other hand, $eUSD has some opportunities:

1. Yield-generating asset: Since $eUSD can generate yield for holders, there will certainly be demand to use it as a value storage. If users trust its anchoring stability, it can become a good way to earn $ETH yield.
2. Exposure to LSD products: LSDfi is a growing market that has certainly achieved product-market fit, and leveraging LSD to mint stablecoins is a profitable business for both protocols and users.

$crvUSD

$crvUSD is a CDP stablecoin project that requires over-collateralization and carries liquidation risks. What makes $crvUSD unique is its liquidation mechanism called LLAMMA. Through this method, LLAMMA gradually sells portions of the collateral within different price ranges instead of immediately selling all collateral at a specified liquidation value. Therefore, as the price of the collateral decreases, portions of the collateral will be auctioned off in exchange for $crvUSD.

So far, the stablecoin has achieved gradual growth in market capitalization without any significant decoupling. However, while it has about $100 million in liquidity, it only has around 600 holders, which raises concerns about the product's scalability.

To my knowledge, $crvUSD will face several challenges:

1. Insufficient capital efficiency: Since $crvUSD is an over-collateralized CDP position with liquidation risks, it does not differ in capital efficiency from its competitors, thus limiting its scalability.
2. Limited use: Due to the low liquidity of $crvUSD and lack of scalability, the use cases for this stablecoin are limited. Although there are several staking pools for $crvUSD, considering the trade-offs, it is not very attractive.
3. Insufficient holders: As mentioned earlier, $crvUSD has only about 600 holders, which is due to insufficient demand for CDP stablecoins. Therefore, despite offering a unique liquidation mechanism superior to other CDP stablecoins, $crvUSD will face challenges in attracting new holders.

On the other hand, $crvUSD also faces some opportunities:

1. Unique liquidation mechanism: The soft liquidation mechanism of $crvUSD is a great innovation that competitors will certainly emulate, as it can increase the scalability of CDP stablecoins to some extent and avoid hard liquidations.
2. Curve support: Curve is a mature stablecoin exchange platform that has existed in the ecosystem for years, with deep liquidity. $crvUSD can potentially leverage this in the future to effectively enhance its scalability.

Conclusion

While this article is lengthy, there is one simple thing you should remember.

The future of cryptocurrency-backed stablecoins will be determined by a simple question:

"Can users buy stablecoins instead of just borrowing them?"

The current model does not provide a good solution for achieving stablecoin functionality. Therefore, $USDT and $USDC may continue to dominate this space.

However, they also have some limitations, particularly in terms of decentralization, censorship resistance, and self-custody. I believe there can be new models to address these issues and achieve stablecoin functionality, but I am also very certain that the current models are problematic and difficult to succeed.