Beyond USDT dominance: incentivised stable coins

DEFI has the tools to build safer and more incentivised stablecoins than USDT/USDC. How long will their utmost dominance last?

While we’re crafting stablecoins, our designer crafts nice banners.

Abstract

Circle and Tether currently dominate the stablecoin market, despite the fact that USDC and USDT are among the rare non-incentivized tokens in the highly incentivized Defi landscape.

These two stablecoins benefit from their security features and network effects, while their competitors lack strong incentivization, arguably for their lackluster underlying profitability.

USDT/C has increased their stable dominance lately. Will DEFI strike back? Late 2023 and 2024 could be interesting years.

We assert that stablecoin protocols have the potential no only to improve upon USDRT/C security, but also to achieve higher profitability by engaging in collateral farming through operations called AMO and provide working capital in sectors with high short-term profitability.

By enhancing security and profitability, protocols can incentivize stimulate the wider adoption of their stablecoins.

Defi: a tale of security, revenues and incentives

Circle and Tether hold a significant majority in the use of stablecoins within the Defi ecosystem, with an impressive 87% dominance as reported by Defillama. Remarkably, this level of dominance has been achieved even though Circle and Tether, as the issuing companies, retain all the revenues generated from the collateral for their shareholders, meaning holders of USDT/C receive negative real returns — lower than Fiat money interest!

How to explain the dominance of incentive-less Tether and Circle in the incentive-dominated DEFI world?

Security as a foundational trust layer

The dominance of USDC and USDT certainly illustrates the importance of security and fungibility.

Perception of security and fungibility, together with widespread adoption, explains why these soon historical currencies serve as the base reserve for other stable coins.

We argue that it is possible to enhance security both of offchain redeemable coins (such as USDT and USDC) and of fit for DEFI onchain stable coins.

In a 5%+ interest rate environment, tokenised money market funds could be at least as fungible as USDC and USDT, with greater transparency than USDT (money market funds disclose their investment policy and holding), better risk management than USDC (investment in liquid assets rather than uninsured investments in local banks), and greater yields for holders than USDC and USDT.

Money market funds, have transparent and professional investments. Once tokenised, better than USDT and USDC?

Any stable coin can improve the security of its base reserve (USDT, USDC, or soon tokenised Money Market funds) with security enhancements. Enabling instant freeze capabilities for derived coins would facilitate swift action in case of any hacking attempts. Tether and Circle have faced criticism for their delay in freezing accounts related to the recent Multichain “incident”. As regulated entities, these companies require a court order or legal restraint to freeze accounts.

Security and fungibility are the base layer of trust.

For any additional smart contract layer, security requires formal development processes, including audit, challenges and insurance for any releases that interacts with critical functions such as mint, burn or transfer funds.

For smart contracts, top-notch security requires the use of proven processes. USDC and USDT standards can arguably be enhanced.

Incentives, profitability and value accrual tokenomics

The DEFI world is not just driven by utility, it also is largely driven by incentives.

Stablecoins play a vital role (aka utility) in the Defi ecosystem by serving as a bridge between traditional finance liquidity and Defi. They remain the basis or unit of transaction thus are associated with largest fees in Defi. They have experienced a consistent growth in supply and market dominance.

Stable coins TVL dominance prove their utility. In July 2023, according to Defillama, the TVL of all chains is of $50Bn excluding stables, while stables have a $125Bn TVL.

Long-lasting incentives potentially define the next protocol dominance. Incentives depend of a mix of protocol revenue and value accumulation principles :

• the protocol token needs to accrue value to be efficiently used as incentive.
• sugar-rush inflationary incentives can only help kick-start initial growth, or ride on animal spirits (as well as apes, sugar daddies, and other strange Defi creatures)

Lackluster revenues from stable coin protocols

The majority of stablecoin protocols lack sustained revenue sources. This hinders their ability to incentivise adoption within the Defi ecosystem.

Most protocols generate approximatively 5% yield on the backing assets, and are thus only able to incentivise the adoption of their coin in their early stage. Then, beyond the historically relevant DAI and the special case BUSD which both have a $4Bn circulating supply, no other stable coin has been able to capture and retain a significant share of the $125Bn and counting stable market.

Typically, most protocols generate a meagre 5% yield by staking or lending their underlying assets. Lack of ability to fund incentives explains why no stablecoin has successfully captured and maintained a significant portion of the continuously expanding $125 billion stablecoin market.

Greater revenue opportunities

There are multiple avenues to achieve higher revenues, such as offering services, strategically deploying capital to areas requiring it the most, and participating in the Defi ecosystem to collect fees and farming rewards.

• The large volatility in the crypto space makes the Mint and Burn approach very profitable is conducted in a counter-cyclical manner. See this theorem.
• AMO, that is, farming protocol reserves and using revenue to incentive the usage of the stable coin in Defi is an interesting approach that can yield 25%+ revenue on backing capital. See this explainer (link to follow)
• Hedgers in the Symm/io space need low-risky yet highly profitable working capital to expand their services. Dei relaunched could potentially funnel working capital where needed.
• After all, basic economics theory dictates that the highest risk-adjusted rewards are generated by directing capital to areas where it is critically required. Financing typically involves different risk tranches, from safest (that’s stable-coin-like funding) to riskiest (that’s equity financing).

Conclusion

Most onchain stable coin have faltered relative to USDC and USDT, as their tokenomics and sources of revenue did not permit them to continuously incentivise their usage.

This arguably leaves room for more financially robust stable coin to persistently incentivise their usage.

Interestingly enough, many of the needed ingredients are part of the core DNA of the Deus protocol, with notably value accrual tokenomics, advanced knowledge of Defi farming ecosystems and collaboration with liquidity hubs, and an ecosystem partner, Symm/io, which hedgers need working capital to answer the need for their products.

Appendix

The typical 5% stable coin yield on backing assets

Stable coins can generate approximately 5% returns by staking or lending collateral, which gives little leeway to incentivise usage and accrue wealth in the protocol token. The typical approximate 5% return can be obtained:

• Overcollateralised stable coins protocols may generate the yield through Liquid Staked Derivatives (staking user-deposited Eth, or letting users deposit staked Eth and charging a fee). Yield: approximately 5%
• All stable coins, maybe lend their backing assets (main backing assets are USDC, ETH or WBTC). Lending yields are also about 5% — same order of magnitude for the riskless money market yields when backing assets are invested off-chain.

Using AMO/farming to maximising revenue on backing assets

Farming is the typical way to maximise asset revenues in DEFI, and farming has already benefit some stable coin protocols… which probably essentially missed more sustainable tokenomics.

• The Abracadabra protocol aimed to enhance liquidity for leveraged farming. In January 2022, their stable coin, MIM (Magic Internet Money), reached a supply of $4.5 billion. The market downturn and liquidation cycle shrank an alarming 95% of the MIM supply, which currently stands at $85 million. The absence of value-accrual principles now makes it challenging for the protocol to boost the use of MIM and widen its adoption.
• The FRAX protocol introduced AMO, a revolutionary concept where the USDC backing can be paired with some protocol-generated Frax without proper backing, and only used for farming. The Frax protocol, however, did not use its tools in a value accrual framework, and essentially dissipated the value it created through both mint/burns (the algo part) and even through the AMOs.

High yielding real world assets

Real world assets can also yield significant profits. Barriers to entry explain the underuse:

• Defi can potentially help finance real world assets. Although some stable coins have entered this arena, there are still challenges to be offset (regulatory discrepancies, liquidity and fungibility of real world assets, especially the less liquid real estate), as well as transparency on the debt (stable-coin) and equity financing mix.
• Higher yielding real world assets can potentially be tokenised (securitised with on-chain receipts) and serve in overcollateralised stable coin as a higher yielding collateral than Eth.
• Similar but arguably much more simple is to finance on-chain working capital. Simpler as everything happens within the same ecosystem: same tules, transparent proofs, guaranteed transferability.

Stablecoin adoption

On Juyl 13, according to Defillama and Coingecko:

• USDT has a massive 65% dominance with $83Bn supply, despite lack of transparency of reserves
• USDC has a much reduces 22% dominance, supply falling 50% from it’s summer highs to $27 Bn. The SVB bankruptcy proved Circle had poor collateral management.
• DAI, the historical pure onchain stable coin, has a $4Bn supply, a 60% fall from its 2022 highs. This is partly explained by lower collateral value (DAI has large Eth backing, and Eth halved in value since the peak), and potentially by a dependence on the centralised USDC
• BUSD also has a $4Bn supply, impacted by the Binance Sec crackdown.
• TrueUSD follows with $3Bn, and Frax with $1Bn (including protocol-owned Frax, the backed and redeemable Frax is lesser, see a detailed analysis here).
• Stable coin as a service and RWA-linked stable coins are so far quite down in the league.

Sources:

• Defillama provides the easiest-to-read data for Dominance
• Better historical graphs in CoinGecko: USDT, USDC, DAI, FRAX, MIM
• “An unreal Primer on Real World Assets”: An interesting analysis of the difficulties associated with onchain RWAs (real world assets).
• To read our previous research on stable coin, visit this publication’s Tokenomics section