Frax: The Road to Algorithmic Stablecoins
Frax is a fractional reserve stablecoin that uses the AMO (Algorithmic Market Operations) system to change its collateral ratio and keep the price close to the target price. At its most basic level, when the price is below $1, AMO increases the ratio, and when the price is above $1, it decreases the ratio. This means that the degree to which FRAX holders are redeemed depends on the current collateral level. If the ratio is 90%, redeeming 1 FRAX will get you $0.90 from the protocol’s reserves plus $0.10 worth of FXS (Frax Shares) newly minted by AMO. Due to the dynamic nature of the collateral ratio, it is difficult to determine the actual collateral amount behind FRAX at any given time.
A recent proposal passed shows that the community supports a move towards a fully collateralized model. The main motivation here is due to increased regulatory scrutiny on algorithmic stablecoins following Terra’s UST debacle. Overall, algorithmic stablecoins are still a highly experimental part of the market, and while Frax has been able to successfully develop using its AMO model, it looks like it is transitioning.
DAI: Partial Decentralization DAI has become the most successful stablecoin outside of on-chain dollars like USDC and USDT, thanks to its CDP model. The main issue here is that most people may not initially realize that DAI borrowing is usually collateralized with the same centralized stablecoins, exposing it to the same centralized risk. Since expanding to a multi-collateral model, these centralized stablecoins have become a major component of DAI’s backing, sometimes over 50%!
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With our uncertainty over the reserves of Frax and DAI, let’s take a look at other situations in the decentralized stablecoin market. Continuing to observe which stablecoins are decentralized and collateralized only by crypto assets.
LUSD
So far, LUSD is the most outstanding in the stablecoin field that is fully collateralized by crypto assets. LUSD has achieved this by building a solid foundation: immutable smart contracts, economically sensible anchoring mechanisms, and capital efficiency that provides room for growth without compromising collateral ratios. Although Liquity’s smart contracts will forever remain on Ethereum, LUSD is now also bridged to L2, and combined liquidity on Optimism and Arbitrum exceeds $11 million.
Since the beginning of this year, the circulating supply has increased by over 100M LUSD, with over 10M already moved to L2. Rollups accumulated significant TVL in 2023, with Arbitrum growing from $980M to $2.3B and Optimism growing from $500M to $900M. Mainnet users aren’t the only ones paying attention to decentralized stablecoin options, providing ample opportunity for LUSD to capture more market share on L2.
Alongside the circulating supply, the number of Troves has also risen significantly this year, approaching its all-time high. We haven’t seen over 1,200 active Troves since the 2021 bull market. Considering that Ethereum’s price hasn’t returned to that level yet, these users seem to be more inclined towards stablecoins than Ethereum leverage.
Stablecoin Market Trends
Forks
As they say, imitation is the highest form of flattery, and the Liquity model is being copied by some new stablecoins. Most are doing the same CDP style but with ETH as collateral. Given the attention ETH and its LSDs received in the first half of 2023, as well as the withdrawals now enabled, collateralizing ETH is clearly more liquid and attractive.
Is collateralizing ETH superior to ETH? It’s hard to say for sure, but some trade-offs need to be considered. The main benefit of using LSDs like stETH as backing for the stablecoin is the interest-earning characteristics. The main drawbacks seem to be the combination of reduced risk and LSD de-pegging risk. For these reasons, higher minimum collateral ratios are typically used compared to LUSD. In addition to these risks, most of these stablecoin contracts are upgradable and controlled by multisig, unlike the immutable contract behind Liquity.
This means that parameters such as collateral ratio may change. Collateralized ETH-backed stablecoins are definitely interesting, performing well in decentralization and yield generation, but are less capital efficient than plain ETH due to increased risk.
Dollar Risk and Decentralization Premium
One question worth revisiting that we mentioned at the beginning of this article is – traditional finance banking crises. Silvergate, SVB, First Republic, the three largest bank failures in US history have all happened in the past few months.
The real issue behind these events is where to keep your funds safe during a crisis. Not all dollars are created equal, as recent bank failures have reminded us, bank deposits can disappear in an instant. Of course, with FDIC insurance coverage up to $250,000 and the government showing willingness to bail out failing banks, people will still seek safety in uncertain times due to the fractional reserve system that drives the US dollar. This means bank runs, and we’ve already seen how this affects stablecoins that rely on fiat reserves, like USDC and SVB.
In uncertain times, decentralized stablecoins have a relevant use case for those who care about protecting their assets during a crisis, offering true non-custodial ownership. So, from a recoverability standpoint, which stablecoin would you choose as your 5-year+ choice? If it runs on immutable smart contracts and is always redeemable for a fixed amount of decentralized assets, then you’re in the right place.
This is why LUSD often sees a price premium during times of crisis: people want to hold it when other more centralized stablecoins appear riskier. Putting decentralization first in the stablecoin trilemma is what sets LUSD apart from many other stablecoins and has allowed Liquity to add over $380 million in TVL during bear markets.
Summary
Every bank failure reiterates the value of truly decentralized stablecoins, and LUSD has long been seen as the stablecoin to hold when things get tricky. Adding bridging and liquidity venues on L2 opens up LUSD to a wider market of participants while still retaining the immutability that makes the protocol so strong. We’ve all seen the drawbacks of centralized stablecoins, and while algorithmic stablecoins may offer similar decentralization, they haven’t yet reached a point where they can be reliably used. LUSD was designed to withstand the test of time and adverse market conditions, a fact that has been proven by its continued growth during bear market lows. Now, with ETH serving as a dominant asset in cryptocurrencies, we’re seeing new protocols fork Liquity and use LSD as collateral, further demonstrating the superiority of its design.
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