The Importance of Decentralized Stablecoins

Level 3 - DeFi Virgin Analyst

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Crypto is one of our best chances to make progress building a decentralized, open, fair, and financial system that can be lucrative for everyone, not just legacy institutions and the people who work at them.

To succeed, crypto protocols and blockchains needs to succeed at either bringing a lot of legacy finance transactions onchain. It will be a slow, arduous process but it’s possible the incoming Trump administration will accelerate the adoption of DeFi.

There are significant barriers in the current system from banks and regulators. For example, did you know the U.S. SEC collects a fee on the sale of almost every stock and securities sale (Section 31 Transaction Fee)? They earn $27.8 per million dollars in sale proceeds, an increase from $8 as of May 22, 2024. What would happen to those fees in a crypto-centric financial system?

Meanwhile, centralized ecosystems and centrally backed assets like USDC have succeeded over decentralized alternatives. Centralized finance is not going to keel over and die that easily. We believe the market should decide the winner, and that DeFi offers significant advantages in cost and operational efficiency over CeFi, not to mention more fairness and transparency. The first step to DeFi adoption is giving people an alternative to centralization.

Many applications and chains are becoming increasingly reliant on USDC for its operations. Today we explore a potential solution in the form of a battle tested DeFi primitive - the CDP stablecoin.

Stablecoin Recap

Stablecoins are tokenized dollars on the blockchain. Investors deposit stablecoins to increase the “cash” balance of their exchange account in order to place and maintain margin based trades or to acquire assets in the spot markets.

Early crypto exchanges used Altcoin/BTC pairs, whereby Bitcoin was exchanged for altcoins. It’s not impossible to use Bitcoin as the unit of account on a crypto exchange, but Bitcoin’s volatility makes it inconvenient. Without the ability to use stablecoins, an exchange would be far less attractive and we’d speculate it would be very difficult to achieve product-market fit. For better or worse, traders typically wish their profit and loss to be denominated in US dollars. That means onchain exchanges (the most valuable product in crypto today) have no choice but to use stablecoins.

Although Bitcoin denominated “quanto” futures exist, they never got traction beyond Bitmex.

The use of centralized stablecoins comes with a unique set of risks.

USDC is issued by Circle, a US headquartered organization. Although “bearer money” in the from of fiat-backed stablecoins has been tolerated by regulators, this apparent leniency goes against the prevailing trend since 9/11/2001: regulatory insistence on improved traceability of fund flows and identification of beneficial owners. Crypto products, including stablecoins, have been alleged to facilitate money laundering, terrorist financing, sanctions evasion. In short, this is considered a matter of national security.

The smart contract software code which controls USDC on Ethereum-compatible chains has a “Blacklist” function. This enables Circle, whether on its own initiative or following request/order from government/regulators/courts, to freeze funds on-chain. This is accomplished by denying transfers out of any specified Ethereum account address.

Sidebar: Overview of Crypto x US Sanctions

The US Treasury Department - Office of Foreign Assets Control (OFAC) made history by applying the US sanctions regime to a smart contract for the first time in 2022. Legal penalties for using Tornado Cash include up to 30 years in jail and multimillion dollar fines. Read our contemporaneous coverage here. At the time of writing, the protocol’s developer remains in jail.

OFAC (Office of Foreign Assets Control) administers and enforces economic sanctions against high profile individuals including major international terrorists, drug trafficking kingpins, and the financial/political elite of certain countries deemed hostile to American interests. OFAC ensures that Americans cannot legally do business with Cuba, Iran, Iraq, North Korea, etc without special government approval.

The blacklist function of USDC (and USDT) is used routinely against addresses associated with crypto cybercriminals. Although the smart contract addresses of a DeFi protocol have never been blacklisted by Circle to our knowledge, this provides no assurance they won’t be in the future. The technical capability exists, and the legal system could allow innocent parties affected by the freeze to KYC to redeem their funds. This would be similar to how innocent users of Tornado Cash can recover their funds through the US government without being in breach of the sanctions regime.

In our opinion, sanctions and other national security level priorities are unlikely to change significantly depending on whether Republicans or Democrats control each of the 3 branches of the US Federal government. Any “friendliness” towards the crypto industry by one party / President is likely to focus on regulated corporate actors doing “legitimate” crypto business rather than the wild west of sovereign blockchains running permissionless financial protocols. For now, we can expect regulators and politicians to understand Bitcoin, maybe Etherum/Solana/Ripple…and anything else - especially where it involves national security and financial crime - is a niche issue not worth expending political capital on. Don’t expect Tornado Cash to be unblocked any time soon, and don’t expect North Korean hackers to be able to use USDC indefinitely.

The transparency of a public ledger makes it easy to prove that criminals are taking advantage of DeFi’s permissionless nature. This fact makes action by regulators more likely and could negatively impact protocols if regulators take an antagonistic approach to building permissionless products in crypto. While the incoming U.S. administration is pro crypto, crypto protocols need to be built in a way that allows them to survive across changes in political leadership.

Decentralized Stablecoins - Overview

For a primer on what stablecoins are and why they’re important, refer to our earlier coverageor review the full course module at DeFi Academy. In short: stablecoins are a crypto asset designed to be redeemable for $1 in value, allowing crypto participants to hold value on-chain without exposure to volatile crypto asset prices. The BTC/stablecoin and ETH/stablecoin pairs facilitate the “risk on” and “risk off” trade in the crypto markets.

Stablecoins have a huge market - $172b worth of tokenized dollars are circulating.

The most successful stablecoin is Tether, with 70% of the market. The Company earns ~$14 million per day, ~$5b per year, from interest on the ~$120b fiat reserves backing USDT (weighted average interest rate ~4.1%). It achieves these enormous revenues with ~100 employees. Runner up Circle (slated for IPO in 2025) controls the second largest stablecoin and earns ~$1.5b on ~$34b of USDC issued.

None of that revenue flows to the holders of USDT or USDC.

Ironically, two of the most profitable crypto businesses, Tether and Circle, offer 'return-free risk,' highlighting the limitations of DeFi's disintermediation. These businesses have internalized the returns earned from cash deposits and treasuries, but the users bear all the risk - Tether and Circle stablecoins have depegged as much as 5% in the past, proving that they are not “risk free”. Funds parked in fiat based stablecoins are subject to counterparty and operational risks, and both issuers have reserved to themselves the right to blacklist your tokens

What would a true DeFi solution look like?

Recall that the demand for stablecoins is some $172b. The market cap of Bitcoin is over $2T and the market cap of ETH is ~$400b. The major crypto assets are sufficiently large, liquid, and robust to underwrite a stablecoin based on a collateralized debt position - CDP.

The first DeFi protocol to implement this model was MakerDAO, and their stablecoin DAI grew to around 5% of the total stablecoin market. The original collateral was ETH, the native asset of the Ethereum ecosystem. Holders of ETH could deposit their collateral in a vault and use it to generate/borrow the USD-pegged DAI stablecoin. In the initial design, DAI could always be redeemed for at least $1 worth of ETH, guaranteeing protocol solvency.

The caveat is that to get a CDP stablecoin into circulation, holders of the collateral asset (e.g. ETH) must deposit and borrow. Demand for a decentralized stablecoin vastly outstripped supply (ETH holders wishing to generate DAI), a key reason why MakerDAO failed to grow DAI as a fully decentralized stablecoin.

The initial low supply and high demand for DAI led to prices exceeding $1, increasing the debt repayment cost for borrowers. This is undesirable and MakerDAO chose to solve the problem by backing DAI with centralized assets rather than just ETH. The first external collateral was USDC, then later a panoply of off-chain “Real World Assets” backed by complex legal agreements. This article isn’t about Maker, but to summarize having a stablecoin backed by government bonds custodied off-chain carries obvious risks. MakerDAO has suffered from a complex structure, departure of key personnel, and issues with governance culminating in a recent failure to execute a rebrand. However, unlike fiat stablecoins it does pay yield to holders via the DAI savings rate. We’re not currently using MakerDAO/DAI.

A “Pure” DeFi Stablecoin

Many in the DeFi community disagreed with MakerDAO’s design decision to trade scalability for decentralization. The Liquity team developed a “pure” version of MakerDAO’s original idea, a CDP stablecoin with:

• no governance

• immutable deployment (protocol cannot be altered or shut down)

• accepts only pristine on-chain collateral (ETH)

• the only external dependency is a Chainlink oracle for ETH/USD price

• decentralized frontends run by the community, not the team

These design choices earned LUSD full marks from BlueChip, a stablecoins ratings agency, on the dimensions of Governance, Management, and Decentralization. LUSD was the only DeFi stablecoin to achieve an overall grade of A.

Liquity Protocol is a lending app which is immutable and free of any governance. v1 issued the stablecoin LUSD; the safest DeFi stablecoin as there is no need to trust a counterparty or governance. Risks associated with humans are eliminated and risks associated with software code are accepted and minimized.

Concluding Thoughts

Stablecoins are one of the most successful crypto products of all time and a lynchpin of DeFi, the new financial system which securely and rapidly settles tens of billions of dollars value every day.

A community governed decentralized blockchain must have a native community governed stablecoin backed by pristine collateral in order to avoid the regulatory risks inherent in using fiat asset backed stablecoins.

And the economic benefits are obvious: fiatcoins offer “return free risk”, sharing none of the yield on the underlying dollars which is internalized to drive enormous profits. Those yields should belong to the depositor. DeFi makes this disintermediation a reality.

As an example using Hyperliquid, if there is $2b deposited in Hyperliquid and participants are able to achieve an average yield equal to the risk free rate on US treasuries, there would be over $80 million annually added to the Hyperliquid ecosystem. Beyond the yield, unlocking capital efficiency with a proven and safe model would increase the economic activity on the chain significantly, benefiting HYPE holders.

We think the “pure” version of the CDP primative, using only pristine on-chain collateral as implemented by Liquity v2 provides the most robust model for a native stablecoin.

In our next post for paid subscribers we’ll cover a project we recently became interested in along these lines.

Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.

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