From the perspective of stable currency competition, will LUSD be the best choice in the future?

Original title: “Stablecoin Competitive Landscape: Will LUSD Become the Best Choice Over USDC and USDT?” "

Written by: Rxndy444

Compilation: Deep Tide TechFlow

**Deep Tide Note: This report is produced in cooperation with Rxndy444 and Liquity Protocol, and does not constitute investment advice. *

The cryptocurrency narrative has its ups and downs, but stablecoins will always be there as a core component of on-chain financial infrastructure. Currently, there are over 150 stablecoins on the market, and it seems like a new one is launched every week. How should the user filter through the various options?

When evaluating the pros and cons of different stablecoins, it is helpful to categorize them by design elements. So what are the basic changes in stablecoins? The main differences between the different stablecoins include:

1. Collateral Assets - Are these tokens fully backed by assets? partial support? Still no support?
2. Centralization - Does the collateral involve government-backed assets such as USD, GBP, or Treasuries? Or is it made up of decentralized assets like Ethereum?

Keeping these properties in mind, we can start to build a framework from which to compare different stablecoins.

A Deep Dive into Decentralized Stablecoins

Looking at the top ten stablecoins by trading volume, we can see that centralized stablecoins are essentially just on-chain dollars, but are the most widely used. These stablecoins cannot provide censorship resistance, nor are they immune to traditional financial crises. For example, when Silicon Valley Bank went bankrupt in March, USDC holders had to worry about their reserves at the bank. Many are rushing to exchange their USDC for a more reliable option, and this isn’t the first time we’ve seen the decentralization premium play out.

The ultimate goal of stablecoins is to find one that can solve the trilemma of decentralization, capital efficiency and anchoring, and USDC and USDT are obviously not doing well enough. To advance the stablecoin industry, we must look beyond these two options — so what does the current competitive landscape look like?

Of this top 10, only 3 can be considered somewhat decentralized: DAI, FRAX, and LUSD.

Frax: algorithmic stablecoin route

Frax is a fractional reserve stablecoin that uses an AMO (Algorithmic Market Operations) system to adjust its collateral ratio and anchor the price. At the most basic level, AMO increases the collateralization ratio when the price is below $1, and decreases the collateralization ratio when the price is higher than $1. For FRAX holders, this means exchanging stablecoins based on current collateralization levels. If the collateral ratio is 90%, then 1 converted FRAX will pay 0.90 USDC + AMO minted FXS (Frax shares) worth 0.10 USD from the protocol reserve. Due to the dynamic nature of the collateral ratio, it is difficult to calculate the actual amount of collateral backing FRAX at any given time.

Recently passed proposals show community support for moving to a fully collateralized model. The reason here is mainly due to the increased regulatory scrutiny of algorithmic stablecoins after Terra’s UST issue.

Overall, algorithmic stablecoins are still a highly experimental area of the market, and while Frax has successfully grown using its AMO model, that looks to be changing.

DAI: Partial Decentralization

DAI has proven to be the most successful stablecoin besides on-chain USD such as USDC and USDT through its CDP (Collateralized Debt Position) model. The main limitation here that most people may not be aware of at first is that borrowing of DAI tends to be collateralized against the same centralized stablecoin, exposing it to the same centralization risk. Since expanding to a multi-collateral model, these centralized stablecoins have become a significant portion of DAI backing, sometimes exceeding 50%.

DAI Collateral Types by Dominance

Now that we’ve identified the reserve uncertainty of Frax and DAI, let’s look at the rest of the decentralized stablecoin market. Which stablecoins are both decentralized and only have cryptoassets as collateral?

Market share of crypto-backed stablecoins

LUSD

In the space of stablecoins that only use crypto assets as collateral, LUSD is by far the most important. It achieved this status by building on solid foundations: immutable smart contracts, an economically sound peg mechanism, and capital-efficient features that allow it room to grow without jeopardizing collateral ratios.

While Liquity’s smart contracts will always remain on Ethereum, LUSD has also now bridged to L2, with a combined liquidity of over $11 million on Optimism and Arbitrum.

Total circulation of LUSD

Since the beginning of the year, the circulating supply of LUSD has increased by over 100 million units, of which over 10 million entered the L2 network.

In 2023, Rollup Technologies has amassed substantial total value locked (TVL), with Arbitrum’s TVL increasing from $980 million to over $2.3 billion, and Optimism’s TVL increasing from $500 million to $900 million. Not only mainnet users value decentralized stablecoin options, this provides ample opportunity for LUSD to gain more market share on the L2 network.

In addition to the circulating supply, the number of Troves has also climbed significantly this year, approaching all-time highs. More than 1,200 active Troves have not been seen since the 2021 bull market, and considering that the price of Ethereum is still well below the level at that time, it indicates that these users value stablecoins more than Ethereum leveraged transactions.

Stablecoin Market Trends

Forking

It’s often said that imitation is the highest form of flattery, and some new stablecoins are copying Liquity’s model. Most use the same CDP style, but with staked ETH as collateral. This makes perfect sense given the focus on Ethereum and its LSDs (staked ETH) in the first half of 2023, and with withdrawals now available, staked ETH is more liquid and attractive.

Is pledged ETH better than ETH as collateral? It’s hard to say definitively, but there are definitely some tradeoffs to consider. The main advantage of using LSD like stETH as a stablecoin backing is its interest-bearing property.

The main disadvantage may be the combination of the risk of being reduced and the risk of LSD breaking away from the anchor. Therefore, a higher minimum collateral ratio is usually used relative to LUSD.

In addition to these risks, the contracts of these stablecoins are upgradable and controlled by multi-signatures, unlike the smart contracts behind Liquity, which are immutable. This means that parameters such as collateralization rates may change. Collateralized ETH-backed stablecoins are indeed interesting, highly rated for decentralization and yield generation, but less capital efficient than pure ETH for added risk.

Dollar risk and decentralization premium

We mentioned at the beginning of this article that it is worth revisiting the traditional financial banking crisis. Silvergate, SVB, and First Republic are the three largest bank failures in U.S. history, all within the past few months.

The real question behind these events is, where would you feel safest to keep your money in times of crisis?

Not all dollars are created equal, and as recent bank failures remind us, deposits can be wiped out in an instant. Sure, the FDIC (Federal Deposit Insurance Corporation) provides insurance up to $250,000, and the government has shown a willingness to bail out failing banks, but with the U.S. dollar on a fractional reserve system, people still seek a safe haven in uncertain times .

This means a bank run, and we’ve seen firsthand the effect on fiat-reserve-dependent stablecoins like USDC and SVB.

In times of uncertainty, decentralized stablecoins have relevant use cases for those concerned with asset protection, offering true non-custodial ownership. So, from a resilience perspective, which stablecoin would you choose as an option over a time period of more than 5 years? If it’s based on immutable smart contracts and is always redeemable for a fixed amount of decentralized assets, then you’re on the right track.

This is why LUSD typically sees a premium in times of crisis: people want to hold it when other, more centralized stablecoins look riskier. Putting decentralization at the forefront of the stablecoin trilemma is what sets LUSD apart from many other stablecoins and has allowed Liquity to grow its total value locked (TVL) by over $380 million in the bear market.

Summarize

Every bank failure re-emphasizes the value of a truly decentralized stablecoin, and the market consistently sees LUSD as the stablecoin to hold in times of crisis.

Adding bridges and liquidity venues on the L2 network opens up LUSD to a wider range of market participants, while preserving the immutability that makes the protocol so resilient. We have all witnessed the shortcomings of centralized stablecoins, and while algorithmic stablecoins have the potential to offer similar decentralization, they have not yet reached a level of reliable use.

LUSD is designed to stand the test of time and adverse market conditions, as evidenced by its continued growth in bear markets. Now that staked ETH has become the dominant asset in cryptocurrencies, we are seeing new protocols emulating Liquity with LSD as collateral, further evidence of the strength of their design.