The Frax community recently approved a proposal to make its FEI stablecoin fully backed by USD equivalents, instead of maintaining a semi-algorithmic, partially backed stablecoin. With Frax’s decision, the days of experimenting with algorithmic stablecoins might finally be behind us.
The decentralized stablecoin space has only proven effective with stablecoins backed by ETH, USDC, and BTC. The failure of algorithmic stablecoins (like UST) and the decoupling of overleveraged stablecoins (like MIM) has become one of the main reasons for the loss of confidence in decentralized stablecoins.
The decentralized stablecoin space is still small
Decentralized stablecoins make up 5.5% of the total stablecoin supply. The MarkerDAO DAI dominates most of this with 71% dominance. Decentralized stablecoin transfer volumes are largely dominated by DAI and have declined since Q3 2022, suggesting activity across the sector is still muted.
During the 2021 and 2022 bull run, platforms like Abracadabra and Luna flourished due to higher returns, but when the market turned negative, these stablecoins were some of the first to crash. Luna’s UST stablecoin crashed in May 2022 after major withdrawals from the stablecoin disrupted its algorithmic mechanism.
Prior to its collapse, UST had become the third largest stablecoin with a larger supply than BUSD and behind only USDT and USDC. However, the ripple effects of the Luna collapse caused Abracabra’s MIM stablecoin to lose its peg due to the widespread drop in the prices of the assets that back MIM. Sell-offs piled up on the platform with no buyers, causing frequent dips below the $1 peg level.
Only a few headlines remain standing
MakerDAO’s DAI stablecoin is the oldest decentralized alternative, with significant market share. While DAI’s design promoted decentralization, the token became a victim of centralization, with more than 50% of the assets backing DAI made up of USDC from Circle.
The MakerDAO community has progressively taken steps to diversify support for the platform. In October 2022, the community voted to convert $500 million USDC into US Treasuries.
Recently, MarkerDAO and the decentralized stablecoin space took another hit after a court ruling in England forced the platform to include an option to seize a user’s assets. It creates considerable regulatory risk for platforms that use and launch decentralized stablecoins.
Apart from MakerDAO, Liquity has built a decent reputation in DeFi as a purely ETH-backed stablecoin platform. Liquity is censorship resistant as it only provides smart contracts on Ethereum, which are not managed by administrators. The total supply of LUSD is 230 million, with LQTY as the utility token of the platform.
The project’s native token, LQTY, doubled in price after its listing on Binance on February 28, 2023. There was alleged insider trading activity behind the price increase. reported by anonymous chain analysis portal An Ape’s Prologue. Still, the token’s low issuance rate and actual performance on protocol fees could give you many advantages over government-only tokens like Uniswap’s UNI token.
Stablecoin platforms build liquidity and trust over time
Frax’s decision to migrate from a partially algorithmic design to a fully backed stablecoin could lead to an increase in demand for FEIs. In addition, Frax is a major holder of Curve’s CRV and Convex Finance’s CVX token, allowing the DAO to incentivize liquidity provision on Curve. This is notable because adequate liquidity is one of the first requirements for a successful stablecoin.
Related: Stablecoin Adoption Could Lead to DeFi Growth, Says Aave Founder
Currently, the volatility of the crypto market discourages many users from minting crypto-collateralized stablecoins. The lack of trust in decentralized stablecoins and the long-standing permeability of centralized stablecoins on numerous exchanges makes it difficult for decentralized alternatives to gain market share.
Still, the long-term market opportunity for decentralized stablecoins is significant. Over time, decreased volatility and regulatory clarity around cryptocurrencies will likely increase demand for crypto-backed stablecoins.
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