Written by: Caesar
Compiled by: TechFlow TechFlow
2023 is an extraordinary year for builders exploring the potential of new DeFi primitives. One of the most notable developments during this time has been the rise of Liquidity Collateralized Derivatives (LSD) protocols, and the consequent protocol built on top of the LSD project, known as LSDfi.
These LSDfi projects can be divided into several different parts. In this article, my main focus is on LSD-backed stablecoins.
What is LSD? What is LSDfi?
Liquidity Collateralized Derivatives (LSD) are financial instruments that represent ownership of tokens pledged in a DeFi protocol. These tools enable users to stake their tokens while retaining the freedom to use these LSDs in a variety of applications. Some LSD protocols include Lido Finance and Rocket Pool. LSD provides many benefits to the ecosystem as they free up capital that was previously locked up while providing security to the network.
LSDfi refers to projects that utilize the LSD protocol to build financial primitives, such as Pendle Finance and Unsheth. By providing additional revenue generation opportunities, the LSDfi protocol allows LSD holders to leverage their assets and maximize returns.
However, as a subcategory, there are also some LSD-backed stablecoins, such as Raft, Gravita, Ethena, Prisma, and Lybra, which we will now evaluate.
The stablecoin supported by LSD is a stablecoin of the CDP model, which requires over-collateralization through liquidity pledge tokens and has liquidation risks. They allow holders to earn intrinsic returns while retaining the key attributes of cryptocurrencies that underpin stablecoins.
As can be seen, LSD-backed stablecoins are not that different from established cryptocurrency-backed stablecoins such as $LUSD, $FRAX, or $DAI. The main value proposition offered by an LSD-backed stablecoin is the staking yield of $ETH, while enabling users to continue to have access to DeFi applications. However, the new project also offers some innovative features.
To better understand this category, let’s look at these protocols one by one.
Prisma Finance( $mkUSD)
Prisma is an LSD-backed stablecoin that is a fork of Liquidity, but with significant improvements. Prisma enables users to mint $mkUSD collateralized by multiple LSTs such as $wstETH, $cbETH, $rETH, $sfrxETH, and $WBETH. $mkUSD will be incentivized on Curve and Convex Finance to create a capital efficient flywheel where users can earn trading fees, $CRV, $CVX and $PRISMA, as well as staking rewards for $ETH.
My thoughts on $mkUSD are as follows:
Competitive value proposition : Each LSD-backed stablecoin provides users with $ETH earnings, however, since the $mkUSD pool is deployed on Curve, users who deposit $mkUSD can earn transaction fees, $CRV, $CVX and $PRISMA rewards, which could make $mkUSD more competitive among competitors.
Not a medium of exchange : $mkUSD is a yield-bearing stablecoin and the protocol does not prioritize its use as a medium of exchange. Most users hold $mkUSD in order to earn the annual interest rate offered by holding $mkUSD.
Yielding Assets : Since $mkUSD generates income for its holders, there are bound to be people who simply use it as a store of value. This can be a great way to earn $ETH if users trust the stability of its peg.
Innovative Token Economic Model : vePrisma holders will be able to incentivize specific pools and, therefore, LST providers may be interested in incentivizing $mkUSD with their own LST. This can create a positive cyclical effect on the demand for $mkUSD. According to the whitepaper, voters can direct issuance to mint using specific collateral to maintain active lending using specific collateral and issue rewards to any LP token holder. Considering that deep liquidity is critical to maintaining anchor stability, this will be an important factor differentiating Prisma from its competitors.
Multiple LST collateral : There are several types of LST that can be used as collateral, such as $wstETH, $cbETH, $rETH, $sfrxETH and $WBETH, with different market caps. Due to the unique token economic model, these protocols can incentivize users to mint $mkUSD, thereby increasing exposure to Prisma.
Insufficient Capital Efficiency : The overcollateralization model means that $mkUSD is limited in terms of capital efficiency, as users need to stake more funds than they receive. Additionally, since the collateralization ratio should always remain above 120%, there is always the risk of liquidation.
Strong Backers : Although Prisma Finance entered the market late compared to its competitors, the protocol is backed by several strong backers such as Curve Finance, FRAX, and Convex.
Raft($R)
Raft is a protocol for minting the R stablecoin, which is over-collateralized by LST and subject to liquidation risk. Users can earn sustainable income by depositing savings interest rates.
My thoughts on $R are as follows:
Lack of innovation : Raft is a fork of Liquidity with only some minor changes, so there is not much innovation in the product, so it may be easily surpassed after the launch of Liquidity v2, which will take advantage of LST.
Not a medium of exchange : $R is a yield-bearing stablecoin and the protocol does not prioritize its use as a medium of exchange. Most users hold $R in order to earn the annual interest rate that holding $R provides.
Anchoring Stability : $R is currently worth around $0.98 and the team is working hard to find a solution to restore the anchor. The team proposes to implement an interest charge instead of a one-time fee to mint $R. By doing so, they aim to restore the anchor by stimulating buying pressure in the market. The reasons for the peg can be attributed to one-time fees for minting R, lack of liquidity, and lack of use cases to create organic demand.
Limited value proposition compared to competitors : At this point, users don’t pay interest fees to borrow $R, so they can leverage their $ETH positions. This is the primary value proposition of $R. However, if the team decided to change this model, Raft would have no value proposition.
Yielding Assets : Since $R generates income for its holders, there are bound to be people who simply use it as a store of value. This can be a great way to earn $ETH if users trust the stability of its peg.
Insufficient Capital Efficiency : Since $R is a CDP model stablecoin that requires over-collateralization and has liquidation risk, it is not a capital-efficient model for retail users. This will limit its ability to grow as expansion possibilities are limited.
Gravita($GRAI)
Gravita is a fork of Liquidity that accepts different LSD products as collateral. It enables users to borrow money without interest and without taking a cut of the earnings generated from deposited LST. The redemption mechanism is not activated in the initial stage but is gradually released throughout the process. This may be the reason why $GRAI has remained around $0.98 since the beginning, which will undoubtedly cause trust issues among users.
My thoughts on $GRAI are as follows:
Lack of innovation : As mentioned, Gravita is a fork project of Liquidity without much innovation in the product, so it may be easily surpassed after the launch of Liquidity v2 using LST.
Limited value proposition compared to competitors : users can borrow $GRAU without paying interest fees, so they can leverage their $ETH positions. Furthermore, allowing $bLUSD to be used as collateral without any liquidation risk and without any fees from staking proceeds is the value proposition offered by Gravita.
Not a medium of exchange : $GRAI is a yield-bearing stablecoin and the protocol does not prioritize its use as a medium of exchange. Most users hold $GRAI for the annual interest rate that $GRAI offers.
Anchoring Stability : Since the launch of $GRAI, the price has been fluctuating around $0.98. This is likely because redemptions of $GRAI were not allowed during the launch period and then gradually released, which could lead to an oversupply that would lower the price without arbitrage opportunities. Furthermore, low liquidity and lack of use cases to create organic demand may have limited demand growth for $GRAI, which also exacerbates the situation.
Yielding Assets : Since $GRAI can generate income for holders, there will definitely be demand for it to be used as a store of value. This can be a great way to earn $ETH if the user trusts the stability of the peg.
Multiple LST Collateral : There are several types of LST that can be used as collateral, such as $WETH, $rETH, $wstETH, and $bLUSD. This can be used as an advantage and provides users with several opportunities.
Lack of Capital Efficiency : The over-collateralization model means that $GRAI is limited in terms of capital efficiency, as users need to stake more funds than they receive. Additionally, there is always the risk of liquidation, which will limit growth.
Lybra( $eUSD)
$eUSD is a stablecoin backed by collateralized $ETH. Owning $eUSD will provide a steady income stream with an annualized rate of return of approximately 8%. The protocol also has a governance token called $LBR, but its utility is limited. With the launch of Lybra v2, several new features were released that are expected to improve the shortcomings of the protocol.
Here’s my take on $eUSD:
Lack of Capital Efficiency : The over-collateralization model means that $eUSD is limited in terms of capital efficiency, as users need to stake more funds than they receive. Additionally, there is always a risk of liquidation as the collateralization ratio should always be above 150%.
Limited value proposition compared to competitors : To have the potential to grow, emerging LSD-backed stablecoins need to have a unique value proposition. However, despite $eUSD’s early advantages, it doesn’t offer competitiveness in terms of collateral requirements or any major improvements.
Not a medium of exchange : $eUSD is a yield-bearing stablecoin and the protocol does not prioritize its use as a medium of exchange. Most users hold $eUSD for the high annualized returns that holding $eUSD provides.
Anchoring Stability : $eUSD holders are eligible to receive rewards for staked $ETH. Therefore, most users prefer to buy $eUSD in the market, which creates demand pressure. The resulting demand for $eUSD exceeded supply, pushing it above the $1.00 peg. Unless the system changes, $eUSD will not be able to find its peg. This could cause long-term problems for holders.
Yielding Assets : Since $eUSD can generate income for holders, there will definitely be demand for it to be used as a store of value. This can be a great way to earn $ETH if the user trusts the stability of the peg.
Multiple LST collateral : With the launch of Lybra v2, new LST collateral such as $rETH and $WBETH are available. This will increase the likelihood of $eUSD casting, but we should not overestimate its impact.
Bad Token Economics : $LBR is the protocol’s governance token, however, since almost all proceeds from LSD go to $eUSD rather than $LBR, the token has little utility. Bad token economics also perpetuate a premium on $eUSD so it always exceeds the peg because users are incentivized to hold $eUSD and since it is an interest-bearing stablecoin the demand to hold $eUSD is significantly greater than Requirements for casting $eUSD.
Ethena($USDe)
Ethena Labs is a new project that has not been released yet. The project differentiates itself from competitors by offering an incrementally neutral support model that differs from the CDP model. Through this model, the project will use LSD as collateral to create a spot long, 1x short position on the exchange, thereby protecting against the volatility of the collateral. $USDe will be more efficient as it will provide a 1:1 collateralization ratio and will provide incremental neutral model funding fee returns in addition to LSD returns. However, users will not be affected by $ETH price fluctuations.
My thoughts on $USDe are as follows:
Innovation : Of all the existing projects, Ethena is the only one that offers innovative solutions. I believe that the incremental neutral model can successfully solve some of the major problems of LSD-backed stablecoins, such as capital efficiency, lack of scalability, peg stability, etc.
Capital Efficiency : Due to the delta-neutral model, the protocol does not require over-collateralization to maintain the peg and can therefore offer a 1:1 collateralization ratio. Therefore, in terms of capital efficiency, $USDe performs best among its competitors.
Anchor Stability : $USDe will use incremental neutral positions to maintain peg stability. Consider that in theory "creating a spot long, 1x short position on an exchange" will always protect the value of the collateral. However, it is important to see practical results.
Medium of Exchange : Since $USDe offers a 1:1 collateralization ratio, it can solve the scalability issues of existing cryptocurrency-based stablecoins. Therefore, $USDe can serve as a medium of exchange between platforms with deep liquidity.
Strong value proposition compared to competitors : $USDe has two main unique advantages in the market that differentiate the product from its competitors. First, it can provide a 1:1 mortgage ratio, which is more attractive to users. In addition, in addition to LST earnings, $USDe will also provide funding fee earnings, which is more competitive among existing projects.
User Adoption Rate : As every innovative project faces the same issues, $USDe will also face some skepticism from the community as the Delta-Neutral approach is not widely known, so Ethena will take some time to educate users and try this approach.
Not affected by ETH fluctuations : Since the collateral deposited is used to establish hedging positions, users are not exposed to the risk of $ETH price fluctuations. Risk-averse users may see this as a benefit, however, $ETH maxis may see it as a drawback.
Thoughts on the overall pattern of stablecoins supported by LSD
So far, I have shared my thoughts on individual LSD-backed stablecoins so that we can better understand the dynamics of these stablecoins while analyzing their opportunities and limitations. I believe this analysis helps understand the competitive landscape of LSD-backed stablecoins and demonstrates the trade-offs for each individual stablecoin.
Now, I will share my general overview of the LSD-backed stablecoin landscape so that we can predict how this category is likely to develop. To do this, I will conduct a SWOT analysis:
Note: It should be emphasized that a general SWOT model analysis of each LSD-backed stablecoin cannot provide a good overview, as they each have different values/characteristics. This applies especially to Ethena Labs because their Delta-Neutral mechanism is completely different from the CDP model. For example, in the weakness section, capital efficiency, medium of exchange, and limited use cases don't apply to Ethena's stablecoin $eUSD.
Advantage
Store of Value: LSD-backed stablecoins are great stores of value as most of them have achieved price stability while providing users with $ETH yields. Therefore, they can serve as low-risk yield opportunities and stores of value, increasing market share in the near future. Adoption will grow as people realize that LSD-backed stablecoins empower users by sharing inherent benefits with them.
Yield Opportunities: For retail traders, the 5-8% annualized returns of stablecoins may not be attractive, but for large traders and leveraged traders, this is a great opportunity, considering the DeFi ecosystem Limited opportunities for medium and high returns, especially as the bear market continues.
Unleashing Liquidity: LSD is a great way to unlock liquidity in collateralized $ETH, and LSDfi, especially LSD-backed stablecoins, further improves this situation, creating new use cases for LSD, which will definitely add to the ecosystem further Opportunity.
Increasing $ETH Exposure: LSD-backed stablecoins are a great tool for expanding the Ethereum ecosystem because they improve how users are exposed to $ETH and create new use cases for it, thereby adding more Much organic demand.
Disadvantages
Growth depends on LSDfi adoption: LSDfi is a new category that needs further exploration. As first movers in the category, LSD-backed stablecoins will be highly dependent on the overall growth of the market, which is somewhat independent of their impact.
Capital efficiency: Since LSD-backed stablecoins mostly implement the CDP model, they require over-collateralization and face liquidation risk. Therefore, capital efficiency becomes a core challenge for users.
Medium of Exchange: LSD-backed stablecoins are inherently used for revenue opportunities, and they all rely on the CDP model, so LSD-backed stablecoins cannot be treated as a medium of exchange, which will limit the scalability of these products.
Limited Use Cases: While a good value proposition as a sustainable yield asset, liquidity fragmentation and lack of liquidity limit the use cases for LSD-backed stablecoins. There are few other ways to utilize these stablecoins other than holding them.
Chance
ETH Staking Adoption: ETH staking is one of the areas where we will see further growth as trust in the security of the Ethereum ecosystem and the benefits of $ETH staking continues. With the potential increase in $ETH staking rates in the future, it can be predicted that LSD-backed stablecoins will benefit from this.
Inflation-proof store of value: Due to inflation, there will always be a strong demand for yielding assets. As we can see from attempts to build inflation-proof stablecoins/stablecoins, there is a huge demand for them. Although LSD-backed stablecoins do not inherently exist to protect against inflation or serve as a store of value against inflation, they have proven that they can serve as a powerful tool in the fight against inflation.
threaten
Lack of innovation: I think LSD-backed stablecoins are mainly forks of Liquidity with little difference. Therefore, they do not offer much of a value proposition compared to Liquidity, other than allowing the use of LST as collateral. Liquity v2 will achieve this goal, will investors continue to use them?
Yields may decrease: Since $ETH staking returns may decrease at any time, the returns on LSD-backed stablecoins will also decrease. This may discourage users from choosing these stablecoins. Considering there will be more $ETH staked in the future, this is an inevitable outcome for LSD-backed stablecoins.
Low demand and liquidity: So far, most LSD-backed stablecoins have been unable to maintain a peg around $1. While there are specific reasons for this, the common problem is the lack of strong demand and liquidity for these stablecoins.
Liquidity fragmentation due to competition: Currently, there are several teams trying to build LSD-backed stablecoins, and there is no clear winner in this race. This means liquidity is fragmented among competitors, limiting the ability to grow and thus prevent the product from being more effective or generating revenue. All of this could have long-term implications for the success of LSD-backed stablecoins.
The end of the bear market: Most investors choose LSD-backed stablecoins as income-generating assets because there is no better solution/alternative in a bear market. However, when the bull market begins, funds can flow to more profitable projects, because annualized returns of 5%-8% may not be attractive in a bull market. However, it is worth noting that the end of the bear market will definitely help these protocols grow, as the overall market capitalization will increase further.
Future impact: Making LSD-backed stablecoins more efficient
It’s clear that with the rise of LSDfi products, there is growing interest in LSD-backed stablecoins. I believe this trend will continue to grow. However, I believe that most current LSD-backed stablecoin models are either not suitable for the product market or have no competitive advantage against competitors.
There is no clear value proposition between some LSD-backed stablecoins like $R, $GRAI, and $eUSD versus existing projects like $crvUSD and $LUSD. These agreements may be able to reduce the share of the aforementioned projects.
Prisma Finance is an interesting case study in that they are developing a unique token economic model to increase returns for stablecoin holders and create value for governance token holders. While the stablecoin’s current CDP model is not unique and does not offer a new value proposition, the protocol may have an opportunity as its token economic model creates organic demand for users, deepening liquidity and making it easier to sustain Anchored.
Ethena Labs is a unique model that challenges existing models. The protocol is more efficient and can generate more revenue through funding fees due to the risk-free positions opened by the protocol. This is important as this model creates organic revenue on top of existing LST revenue and makes the protocol more competitive. However, it is worth noting that in the CDP model, when the price of collateral increases, the borrower makes a profit. However, in the case of Ethena, users are giving up profits that would have come from the rising volatility of $ETH by maintaining the peg through a risk-free position. Overall, I think Ethena can solve some of the major problems of LSD-backed stablecoins, such as capital efficiency, lack of scalability, peg stability, etc.
Overall, the future of LSD-backed stablecoins will depend on:
new models to improve capital efficiency;
new revenue streams;
ETH staking adoption expands;
Adoption of LSDfi.
let us wait and see.
