Stablecoins 2.0: When Your Dollar Makes Dollars
Stablecoin Musings #2
The first generation of stablecoins such as USDT and USDC, brought stability to the crypto ecosystem but came with significant limitations in terms of user benefits. They maintain substantial reserves that generate yield through various investments, yet this yield has historically not been passed on to token holders but to the issuer.
The innovation of yield-bearing designs
In response to these limitations, a new generation of yield-bearing stablecoins has emerged. Projects like Ethena Labs's USDe and Paxos International's USDL represent innovative approaches to stablecoin design. These protocols automatically provide holders with passive interest earnings while maintaining the core stability feature of stablecoins.
Some various mechanisms used to generate yield are:
Investment in traditional financial instruments and real-world assets
Delta-neutral trading strategies
Leveraging Ethereum staking rewards
Users can now earn these returns without surrendering custody of their assets or navigating complex yield farming protocols. Note, the yields offered are often comparable to traditional high-yield savings accounts.
The market impact and demand
Yield-bearing stablecoins have a huge drive.
User expectations for earning yield on their holdings (who doesn’t???).
Emphasis on efficient capital utilization and driving demand for assets that can simultaneously provide stability and generate returns.
Users are increasingly attracted to the combination of stable value and meaningful yield, addressing both the volatility concerns of traditional cryptocurrencies and the yield limitations of conventional stablecoins.
Of course, the sustainability of these high-yield models and viability in a potential hypothetical low-interest-rate environment is questionable at times.
Yield-bearing stablecoins are fundamentally enhancing liquidity in DeFi platforms by offering competitive yields without complex protocol interactions, while simultaneously pressuring centralized exchanges to adapt their product offerings and driving institutional interest through improved portfolio diversification and treasury management opportunities.
The impact of these stablecoins extends well beyond the crypto ecosystem, presenting a significant challenge to traditional banking products through their superior yields, constant accessibility, and global reach.
Looking at GHO
Central to the functionality of GHO is the discount rate mechanism, which allows holders of staked AAVE tokens to borrow GHO at a reduced interest rate. This incentivizes participation in the Safety Module, enhancing the protocol's security while providing users with financial benefits.
The supply of GHO can be adjusted based on market conditions through the facilitator system and GHO maintains its peg to the U.S. dollar through a dynamic mint-and-burn mechanism, with active governance oversight ensuring that interest rates and supply caps are responsive to fluctuations in demand.
Yield Generation Mechanisms
Interest from lending
Users deposit assets into lending protocols, which are then loaned to borrowers. The interest paid by borrowers generates yield for depositors, with rates influenced by supply and demand dynamics. Traditional lending operates similarly but often involves intermediaries like banks, which may reduce efficiency and returns compared to direct DeFi lending.
Protocol fee distribution
DEXS like Uniswap charge protocol fees on trades, redirecting a percentage of transaction fees from liquidity providers (LPs) to the protocol's treasury or governance token holders
These fees serve as an additional revenue stream for the protocol, supporting development and rewarding stakeholders while balancing liquidity incentives.
Liquidation rewards
Liquidators in DeFi earn rewards by repaying under-collateralized loans and receiving collateral at a discount. This mechanism ensures platform solvency while incentivizing liquidators through profits from discounted assets
Liquidation events are automated via smart contracts, with rewards structured to cover costs like gas fees and maintain competitiveness among liquidators.
Treasury management
Protocols manage treasuries by investing idle funds into yield-generating opportunities such as staking, lending, liquidity provision, etc.
Risks
Smart contract vulnerabilities represent a critical concern for yield-bearing stablecoins as it depends entirely on code for managing transactions, yield generation, and core functionality. Risks from code vulnerabilities and potential exploits by malicious actors to challenges with smart contract upgrades make it necessary to conduct rigorous third-party audits, formal verification techniques, bug bounty programs, and carefully planned gradual rollouts of new features.
Another thing we must keep in mind is that yield-bearing stablecoins face significant challenges related to their collateralization structure. The stability and yield generation capabilities of these assets are fundamentally tied to their underlying collateral and prevailing market conditions, making them vulnerable to the volatility of crypto assets and potential liquidation events during market downturns. The ongoing pressure of maintaining sufficient collateralization ratios during periods of market stress is one of the biggest killers.
The Future
The future of yield-bearing stablecoins are promising. With potential for significant growth and innovation in the coming years as the crypto market matures and regulatory frameworks become clearer. We cannot forget about the integration of real-world assets (RWAs) and traditional financial instruments into yield generation mechanisms which could further enhance the stability and attractiveness of these stablecoins. However, the success of yield-bearing stablecoins will largely depend on their ability to navigate regulatory challenges, maintain security, and provide transparent, reliable yield sources to users. Trust is important and always consider your instincts when APY is set too high!
As stablecoins continue to evolve, yield-bearing stablecoins are becoming increasingly attractive to both retail and institutional investors, offering programmable financial products that transcend geographical limitations and traditional banking constraints.
References:
https://cryptoslate.com/demand-for-high-yield-propels-makes-ethenas-usde-third-largest-stablecoin/
https://coinbureau.com/education/what-are-yield-bearing-stablecoins/
https://www.theblock.co/post/300330/the-funding-yield-bearing-stablecoins-future
https://docs.gho.xyz/concepts/how-gho-works/interest-rate-discount-model