Key Takeaways

  • Stablecoins have proven to have strong product-market fit, growing from around $25B to over $150B in market cap since 2021 began.
  • Aave and Curve have announced their own stablecoins: GHO and crvUSD. If successful, they will likely spark the growth of more protocol specific stablecoins.
  • Benefits for having a native stablecoin include an additional revenue stream, increased governance token value accrual, interest rate changes for a desired outcome, external strategy deployment, and creating a competitive moat.
  • Risks include code complexity, a decline in user experience, and liquidations potentially leading to large balance sheet losses.

Stablecoins continue to have the greatest product-market fit of any product in crypto, as they allow dollar exposure in DeFi to either trade, make payments, store value, or earn yield. The market capitalization of all stablecoins has been steadily rising since their inception, with over $150B dollars amongst the largest players.

Decentralized stablecoins have also seen a large rise in adoption, growing to a peak of nearly $35B, with some more experimental options, most notably UST, failing along the way.

This has been the most exciting area of stablecoin development, as it (in theory) aims to solve one of the biggest problems with centralized stablecoins: censorship. This is especially important with the recent blacklisting and censorship by Circle for USDC holders who utilized Tornado Cash. In addition to this, protocols that have created their own stablecoin have also leveraged the ability to facilitate and denominate debt in USD terms, while using parameters within their control to increase the value accrued by the protocol.

Given the immense adoption of stablecoins, and the desire for protocols to innovate and provide value to their token holders and product users, there has been a growing trend in protocol specific stablecoins. Recently, both Aave and Curve announced their GHO and crvUSD stablecoins, which they plan to offer in the near future. While some argue this is a clear progression of DeFi protocols, others argue such experiments will prove to be futile, especially as liquidity and demand are not guaranteed.

Why Create a Protocol Specific Stablecoin?

The first and primary reason a protocol would choose to launch its own stablecoin has to do with an increase in protocol revenue. If it is a standard overcollateralized model, the more debt taken out in the stablecoin the more revenue to protocol continuously brings in. You can think of this as the protocol itself becoming a lender and accruing all of the interest from its loans. While we can expect most models to fall under the overcollateralized category, if there is an algorithmic component like FRAX, the protocol can charge a small fee any time a user mints or redeems stablecoins with the share token.

To give a sense of the revenue increase a protocol could obtain by creating its own stablecoin, we can project revenue increases for Aave as a result of launching GHO. Aave has ~$10.5B in assets deposited on its platform, with outstanding loans of around ~$3B in volatile assets and ~$1B in stablecoins. Most stablecoin pools are given a reserve factor of 10% which is taken from the borrow yield and given to the treasury. Aave targets an optimal borrow rate for most stablecoins at 4%, which means they capture around 40 basis points for lending in an optimal state.

If we were to assume that Aave’s GHO will charge the same rates as Maker’s DAI, which currently switching to 3% for ETH-B, we can make estimates for the increase in revenue as a result of launching GHO, taking to account both current stablecoin loans that switch to GHO and newly created GHO supply.

This revenue is entirely kept by the protocol. As of now, ~$18M of Aave’s total interest of ~$150M is kept by the protocol and distributed to the DAO, so if GHO were to grow to a supply of around $700M it would double the amount of protocol revenue.

Beyond just revenue, protocols can also use the stablecoin as a way to increase the value accrual and utility of the governance token. For example, holders of stkAAVE will be able to mint GHO at a favorable rate to normal borrowers, giving large users of the platform an incentive to buy and stake AAVE. This is in addition to the value accrual due to the increase in revenue being distributed to token holders in some fashion. If the staked version of a governance token can also be put up as collateral, taking SNX and sUSD as an example, that provides even further utility.

Protocols will also be able to create favorable rates than what would otherwise be offered for lending platforms. For example, the optimal variable USDC borrow rate for Aave is 4%, and is calculated based on the demand for leverage with respect to the amount of liquidity provided on the supply side. With GHO, governance can decide the lending rate. This means they could vote to offer more favorable rates than the market in order to incentivize users to borrow their stablecoin if an increase in supply is needed to match external demand, or offer a higher rate if to capture revenue if leverage is in high demand or reduce the stablecoins supply if there is too much liquidity relative to its demand.  

These protocols also have the ability to expand and contract the supply for certain yield-bearing or market demand strategies. For example, stablecoin issuers can set up direct deposit modules in order to meet borrow demand on other lending platforms, as seen through Maker’s D3M with Aave. The protocol can also deploy collateral and expanded stablecoin supply in yield-bearing strategies like LP pools or staking, similar to FRAX AMOs.

In addition to more quantifiable improvements to protocols, the introduction of a stablecoin also helps in increasing the protocol's moat and decreases susceptibility to a fork or vampire attack. If the stablecoin is able to become liquid and in high demand, not only does this increase revenue for the protocol but makes it much less likely for other protocols to compete, because they will have to go through the difficulty of bootstrapping not only the protocol’s TVL and user base but also the growth and adoption of the stablecoin.

While these are all reasons a protocol may choose to create its own stablecoin, what’s clear is that projects that are most likely to pursue this are ones that have already achieved a level of product-market fit elsewhere and have a high level of TVL that could be used as collateral. Aave and Curve are examples of two products that have already gained TVL and product-market fit in their niche and therefore have the ability to create a stablecoin that can likely gain enough liquidity and demand that a new project would likely not be able to. In addition, lending protocols are also much more likely to issue their own stablecoin, because it doesn’t involve too much of a pivot from their core value proposition and codebase, it simply shifts them from providing a platform to match borrowers with lenders into becoming the lender itself.

What Are the Risks?

Introducing a protocol specific stablecoin also comes with a set of risks that protocols need to be aware of. The first is the introduction of increased complexity, as there are now additional attack vectors for exploits or the ability to cause harm to other areas of the protocol. Two examples that highlight the risks here would be Cashio, an overcollateralized stablecoin project on Solana that was completely exploited by a user who continuously minted the stablecoin without collateral, and Acala who recently suffered a similar hack where users took advantage of one collateral type that allowed an increase in stablecoins minted. Adding a stablecoin to the platform introduces these additional attack vectors and increases the risk of insolvency for a lending protocol.

Beyond code, complexity is also an issue when it comes to both the brand and user experience of the protocol itself. Instead of just borrowing USDC or another established stablecoin with sufficient liquidity and an off-ramp if needed, to use the new protocol specific stablecoin a user would need to be more well-versed in understanding where there’s liquidity, where they can utilize the stablecoin, and other slightly more complex parameters. By introducing further complexity for the user, they may be more likely to use another platform that prioritizes UX.

There is also steep competition in the stablecoin space, with some decentralized stablecoins that have established large moats of on-chain liquidity and deep partnerships with other protocols. Therefore, it may prove to be very difficult to establish the stablecoin’s presence and create sufficient liquidity. Liquidity is going to be extremely important for a stablecoin, especially for an overcollateralized model, as there will be a large amount of demand to borrow and sell the stablecoin, and this is not necessarily a given unless you garner enough demand or participate in the Curve wars which will come at a cost.

In addition, one of the difficulties around overcollateralized stablecoins is their ability to remain decentralized while also maintaining a strong peg in certain demand climates, and most have implemented some version of Maker’s PSM, where users can deposit a stablecoin like USDC 1:1 for DAI. If the majority of a stablecoin is backed by centralized collateral, as DAI and FRAX currently are, this introduces a further risk vector if Circle tries to censor their reserves or there are further sanctions or regulations. Rune, MakerDAO’s co-founder, is currently constructing a roadmap with this future in mind with DAI ultimately de-pegging from USD. Therefore, it will be difficult for protocols to both remain decentralized while also maintaining a strong peg for their stablecoin.

Finally, a very important aspect of overcollateralized stablecoins is the process for liquidations. If liquidations are not properly executed, the protocols could end up with large losses on its balance sheet. This process also includes selected collateral assets, since those with higher price volatility or low on-chain liquidity would introduce much more risk to the protocol. Michael Egorov, founder of Curve, highlighted this important aspect in a protocol stablecoin, and said crvUSD will be defined by its novel liquidation mechanism.

Some might make the comparison between protocols issuing their own stablecoin and private bank notes in the Free Banking era, most of which traded significantly below par. Their lack of success was majorly influenced by the bank’s collateral, as most of them used state debt which ultimately failed. Therefore, it is extremely important that collateral is sufficiently maintained and liquid for these protocols that issue their own stablecoin. If there isn’t ample liquidity, liquidations aren’t correctly implemented, or a bad code makes funds susceptible to hacks, they will suffer a similar fate.

Who Wins in This Future?

This discussion certainly begs the question: in a future with many of these protocol specific stablecoins who benefits the most? Given the many benefits a protocol specific stablecoin can provide, if executed correctly a protocol that creates a successful stablecoin would be deemed as a winner, as they will likely be able to create an additional revenue stream while increasing their moat to competitors.

The other beneficiaries are those who directly benefit from an increase in stablecoins and their desire for liquidity: Curve and Frax. Any stablecoin issuer will need to get involved in the Curve wars in order to ensure sufficient on-chain liquidity, and the more Curve pools exist the more revenue and TVL for Curve. Frax also benefits from this being heavily tied into the flywheel of the Curve wars with its large accumulation of CVX and its FraxBP basepool (FRAX-USDC). Frax has openly declared it will direct emissions to pools that are created with FraxBP, and therefore protocols that start to create their own stablecoin will likely find their liquidity directly paired with this pool.

Final Thoughts

While the idea of a protocol specific stablecoin seems promising, most notable GHO and crvUSD experiments have yet to launch and prove for certain whether the model can work and provide value to the protocols and their users. Maker has been able to scale DAI to almost $10B at its peak and $150M in cumulative income since 2019, but it also benefited immensely from a first-mover advantage. Therefore, these are still ideas and experiments and are not necessarily guaranteed to make an impact.

As said previously, the projects that are most likely to adopt a stablecoin of their own are projects with a strong product-market fit and a large amount of TVL or user deposits. If GHO and crvUSD prove to be successful, the most likely protocols to issue their own stablecoin will be Compound, Lido, and Uniswap. Compound could follow in Aave’s footsteps given a very similar protocol model and TVL, Lido could create a stablecoin backed by ETH deposits with native yield from staking rewards, and Uniswap could create a stablecoin backed by LPs or the UNI token similar to that of Curve. However, as the stablecoin space becomes more saturated it gets even harder to compete and protocols may be better off directly integrating with or partnering with another protocol who has already captured market share in that area.

It has become clear that big protocols want to create empires and have more and more of the technology stack. Therefore, while stablecoins are the next thing for protocols to create, it likely won’t stop there. The combination of a stablecoin, AMM, and lending platform is the “holy trinity” of DeFi, as many protocols are creating or directly integrating these layers. Apps are even looking to “own” their own L1 through app-chains, as seen through the dYdX move from StarkEx to its own native Cosmos chain. It would not be surprising to see large applications begin to create their own wallet or direct on/off ramp to even further cement their value accrual and relationship with their users. As apps continue to grow, they will look towards growing their market share and moat in increasingly creative ways, and will be a space to watch as DeFi develops.