LST-Backed Stablecoins: A New Frontier in DeFi Innovation and Opportunity

Stablecoins are cryptocurrencies designed to maintain a stable value relative to another asset, such as the US dollar, gold, or cryptocurrency. Stablecoins - with a total market cap of $143.073bn - are important for decentralized finance (DeFi), as they enable users to transact, lend, borrow, and invest without worrying about the volatility of the crypto market.

However, not all stablecoins are created equal. There are different types of stablecoins, each with its own mechanism to maintain its peg and distribute rewards. Some of the most common types of stablecoins are fiat-backed, crypto-backed, algorithmic, and commodity-backed.

In this article, we will focus on a new stablecoin type backed by liquid staking tokens (LSTs) - the LST-backed stablecoins.

What are Stablecoins?

Stablecoins are cryptocurrency that tries to keep a consistent value by linking their market value to an external reference. This reference could be a fiat currency like the U.S. dollar, a commodity like gold, or another financial instrument. Stablecoins aims to provide an alternative to the high volatility of popular cryptocurrencies like Bitcoin (BTC), which can make these digital assets less suitable for everyday transactions.

Source: Researchgate

There are different types of stablecoins, each with its own mechanism to maintain its peg and distribute rewards. Some of the most common types of stablecoins are:

• Fiat-backed stablecoins: These are backed by fiat currencies, such as the US dollar, the euro, or the yen. Centralized entities issue fiat-backed stablecoins, redeemable for the underlying fiat currency at a fixed rate. Examples of fiat-backed stablecoins are USDT, USDC, TUSD, etc.
• Crypto-backed stablecoins: These are backed by other cryptocurrencies, such as Bitcoin, Ethereum, or Dai. Crypto-backed stablecoins are issued by decentralized protocols, such as MakerDAO, Synthetix, or Curve, and are overcollateralized to account for the volatility of the underlying crypto assets. Examples of crypto-backed stablecoins are DAI, sUSD, yUSD, etc.
• Algorithmic stablecoins: These are stablecoins not backed by any asset but rather by an algorithm that adjusts the supply and demand of the stablecoin to maintain its peg. Algorithmic stablecoins are issued by decentralized protocols, such as Terra Luna, Alchemist, or Frax, and are influenced by market forces and incentives. Examples of algorithmic stablecoins are Luna UST, ALUSD, FRAX, etc.
• Commodity-backed stablecoins: These are backed by physical or digital commodities, such as gold, silver, oil, or carbon credits. Commodity-backed stablecoins are issued by centralized or decentralized entities, such as Paxos, and are redeemable for the underlying commodity at a fixed rate. Examples of commodity-backed stablecoins are PAXG, etc.

Each type of stablecoin has its advantages and disadvantages, depending on the use case, the level of trust, the degree of decentralization, the cost of issuance and redemption, the scalability, and the stability.

How Did Stablecoins Maintain Their Peg?

Stablecoins maintain their peg to the underlying asset by using different mechanisms, depending on the type of stablecoin. There are two main categories of mechanisms: asset backing and algorithmic controls.

Asset Backing

Asset-backed stablecoins are backed by tangible or digital reserves, providing a direct correlation between the stablecoin’s value and its underlying assets for trust and reliability. Asset-backed stablecoins can be divided into three subtypes: fiat-backed, crypto-backed, and commodity-backed.

• Fiat-backed stablecoins

Fiat-backed stablecoins are backed by fiat currencies, such as the US dollar, the euro, or the yen. Fiat-backed stablecoins are issued by centralized entities, such as banks or exchanges, and are redeemable for the underlying fiat currency at a fixed rate. Examples of fiat-backed stablecoins are USDT, USDC, BUSD, etc.

Fiat-backed stablecoins maintain their peg by holding the equivalent amount of fiat currency in a bank account or a trust company as collateral. The stablecoin issuer is responsible for ensuring that the reserve is audited and transparent and that the stablecoin can be redeemed at any time. Fiat-backed stablecoins are relatively stable and easy to use, but they also face some drawbacks, such as centralization, regulation, and counterparty risk.

• Crypto-backed stablecoins

Crypto-backed stablecoins are backed by other cryptocurrencies, such as Bitcoin, Ethereum, or Dai. Crypto-backed stablecoins are issued by decentralized protocols, such as MakerDAO, Synthetix, or Curve, and are overcollateralized to account for the volatility of the underlying crypto assets. Examples of crypto-backed stablecoins are DAI, sUSD, yUSD, etc.

Crypto-backed stablecoins maintain their peg by locking up the collateral in smart contracts, which automatically adjust the collateral ratio and the issuance and redemption of the stablecoin according to market conditions. The stablecoin users can also participate in the governance and risk management of the protocol, and earn rewards for providing liquidity and stability. Crypto-backed stablecoins are more decentralized and trustless than fiat-backed stablecoins, but they also face some challenges, such as scalability, complexity, and liquidation risk.

• Commodity-backed stablecoins

Commodity-backed stablecoins are backed by physical or digital commodities, such as gold, silver, oil, or carbon credits. Commodity-backed stablecoins are issued by centralized or decentralized entities, such as Paxos, Digix, or Nornickel, and are redeemable for the underlying commodity at a fixed rate. Examples of commodity-backed stablecoins are PAXG, DGX, Palladium, SLVT, etc.

Commodity-backed stablecoins maintain their peg by holding the equivalent amount of the commodity in a vault or a blockchain as collateral. The stablecoin issuer is responsible for ensuring that the reserve is audited and transparent and that the stablecoin can be redeemed at any time. Commodity-backed stablecoins offer a way to tokenize and trade real-world assets on the blockchain, but they also face some drawbacks, such as storage costs, regulation, and market fluctuations.

Algorithmic Controls

Algorithmic stablecoins are not backed by any asset but rather by an algorithm that adjusts the supply and demand of the stablecoin to maintain its peg. Algorithmic stablecoins are issued by decentralized protocols, such as Terra Luna, Alchemist, Basis Cash, or Frax, and are influenced by market forces and incentives. Examples of algorithmic stablecoins are Terra UST, ALUSD, AMPL, BAC, FRAX, etc.

Algorithmic stablecoins maintain their peg by using smart contracts that automatically increase or decrease the supply in response to market demand, creating a dynamic equilibrium between the stablecoin’s price and its peg. The stablecoin users can also benefit from the supply changes, as they receive more or fewer stablecoins depending on the price movement. Algorithmic stablecoins offer a fully decentralized and autonomous approach to peg maintenance without physical reserves or collateral. Still, they face some challenges, such as price stability, user adoption, and governance.

What are Liquid Staking Tokens?

Liquid staking tokens represent the staked amount of a cryptocurrency on a Proof-of-Stake (PoS) blockchain. Staking is the process of locking up a certain amount of cryptocurrency to support the security and operation of a PoS blockchain and earning rewards in return. However, staking has some drawbacks, such as illiquidity, opportunity cost, and slashing.

Liquid staking tokens solve these problems by creating a secondary market for staked assets. Liquid staking tokens are issued by liquid staking protocols, which allow users to stake their coins and receive a corresponding token that represents their stake. For example, if a user stakes 10 ETH on a liquid staking protocol, they will receive 10 LST-ETH, which is a liquid staking token that represents ten staked ETH.

Liquid staking tokens have several advantages, such as:

• Liquidity: Liquid staking tokens can be freely traded or used in other DeFi protocols without having to unstake the coins and lose the rewards.
• Diversification: Liquid staking tokens can be used to hedge against the volatility and risk of the underlying asset, or to gain exposure to other assets or protocols.
• Innovation: Liquid staking tokens can enable new use cases and functionalities for staked assets, such as cross-chain interoperability, composability, or governance.

What are LST-Backed Stablecoins

LST-backed stablecoins use liquid staking tokens (LSTs) as collateral. They are issued by decentralized protocols, such as Gravita, Curvance, Prisma, Ethena, and Gyroscope, that enable users to deposit their LSTs and mint a corresponding stablecoin pegged to a fiat currency, such as the US dollar or the euro. For example, if users deposit $100 worth of wETH on Gravita, they will receive 100 $GRAI, a stablecoin pegged to the US dollar.

LST-backed stablecoins maintain their peg using different mechanisms, depending on their type. Three main types of LST-backed stablecoins are rebase tokens, rewards-bearing tokens, and yield-bearing tokens.

Rebase Tokens

Rebase tokens are stablecoins that adjust their supply according to the price deviation from the peg. Rebase tokens are issued by decentralized protocols, such as Ampleforth, and are influenced by market forces and incentives.

Rebase tokens maintain their peg using smart contracts that automatically increase or decrease the stablecoin supply in response to market demand. This creates a dynamic equilibrium between the stablecoin’s price and its peg. The stablecoin users can also benefit from the supply changes, as they receive more or fewer stablecoins depending on the price movement. Rebase tokens offer a fully decentralized and autonomous approach to peg maintenance without physical reserves or collateral, but they also face some challenges, such as price stability, user adoption, and governance.

Rewards-bearing Tokens

Rewards-bearing tokens are stablecoins that distribute the staking rewards of the underlying LSTs to the stablecoin holders. Rewards-bearing tokens are issued by decentralized protocols, such as Gravita, Curvance, or Prisma, and are backed by overcollateralized LSTs. Examples of rewards-bearing tokens are GRAI, CRVUSD, PRISMA, etc.

Rewards-bearing tokens maintain their peg by locking up the LSTs in smart contracts, which automatically adjust the collateral ratio and the issuance and redemption of the stablecoin according to market conditions. The stablecoin users can also participate in the governance and risk management of the protocol, and earn rewards for providing liquidity and stability. Rewards-bearing tokens are more decentralized and trustless than fiat-backed stablecoins, but they also face some challenges, such as scalability, complexity, and liquidation risk.

Yield-bearing Tokens

Yield-bearing tokens are stablecoins that generate yield from the underlying LSTs by lending, borrowing, or investing them in other DeFi protocols. Yield-bearing tokens are issued by decentralized protocols, such as Ethena, Gyroscope, or Raft, and are backed by hedged or diversified LSTs. Examples of yield-bearing tokens are eUSD, GYRO, R, etc.

Yield-bearing tokens maintain their peg by using different strategies to optimize the return and risk of the LSTs, such as hedging, diversifying, or compounding. The stablecoin users can also benefit from the yield generation, as they receive a share of the profits or losses from the LSTs. Yield-bearing tokens offer a way to enhance the utility and value of the LSTs, but they also face some drawbacks, such as dependency, volatility, and impermanent loss.

Different LST-Backed Stablecoins

In this section, we will explore some of the existing LST-backed stablecoins, such as crvUSD, mkUSD, and USDe, and how they work.

crvUSD

Source: Curve website

crvUSD is a stablecoin that is backed by Curve’s liquid staking tokens (crvLSTs), which are tokens that represent the staked amount of Curve’s governance token (CRV) on the Curve DAO. crvUSD is issued by Curvance, a decentralized protocol that enables users to deposit their crvLSTs and mint a corresponding stablecoin that is pegged to the US dollar. For example, if users deposit $100 worth of tBTC on Curvance, they will receive $100 crvUSD, a stablecoin pegged to the US dollar.

crvUSD is a rewards-bearing stablecoin which distributes the staking rewards of the underlying crvLSTs to the stablecoin holders. crvUSD holders can also participate in the governance and risk management of Curvance, and earn rewards for providing liquidity and stability. crvUSD maintains its peg by locking up the crvLSTs in smart contracts, which automatically adjust the collateral ratio and the issuance and redemption of the stablecoin according to market conditions.

mkUSD

Source: Prima Finance

mkUSD is a stablecoin issued by Prima Finance and backed by PrimaLST. mkUSD is a decentralized protocol enabling users to deposit their LSTs and mint a corresponding stablecoin pegged to the US dollar. For example, if users deposit $100 worth of weETH on Prima Finance, they will receive $100 mkUSD, a stablecoin pegged to the US dollar.

mkUSD is a rebase stablecoin, which means that it adjusts its supply according to the price deviation from the peg. mkUSD is influenced by market forces and incentives. mkUSD maintains its peg by using smart contracts that automatically increase or decrease the supply of the stablecoin in response to market demand, creating a dynamic equilibrium between the stablecoin’s price and its peg. The users of the stablecoin can also benefit from the supply changes, as they receive more or fewer stablecoins depending on the price movement.

USDe

Source: Ethena website

USDe is a stablecoin that is backed by Ethena’s liquid staking tokens (stETH), which are tokens that represent the staked amount of ETH. USDe is issued by Ethena, a decentralized protocol that enables users to deposit their LSTs and mint a corresponding stablecoin that is pegged to the US dollar.

USDe is a yield-bearing stablecoin, which means that it generates yield from the underlying LSTs by lending, borrowing, or investing them in other DeFi protocols. USDe holders can also benefit from the yield generation, as they receive a share of the profits or losses from the LSTs. USDe derives its peg stability from executing automated and programmatic delta-neutral hedges with respect to the underlying collateral assets.

LST-Backed Stablecoins: Why They Matter

LST-backed stablecoins matter for DeFi users, as they offer several benefits, such as:

• Passive income: LST-backed stablecoins can provide a steady and predictable income stream for stablecoin holders, as they distribute the staking rewards of the underlying LSTs. Depending on the type of LST-backed stablecoin, the rewards can be in the form of supply changes, interest payments, or yield generation. LST-backed stablecoins can also offer higher returns than fiat-backed stablecoins, as they leverage the high staking rates of PoS networks.
• Access to liquidity: LST-backed stablecoins can provide access to liquidity for stakers, as they enable them to use their staked assets as collateral for stablecoins, without having to unstake them and lose their rewards. LST-backed stablecoins can also be used as a medium of exchange, a unit of account, and a store of value in the DeFi ecosystem, as they are compatible with other DeFi protocols, such as lending, borrowing, or yield farming.
• Risk reduction: LST-backed stablecoins can reduce the risk for stakers, as they hedge against the volatility and risk of the underlying asset, or diversify their exposure to other assets or protocols. LST-backed stablecoins can also mitigate the risk of slashing, which is the process of reducing or confiscating the staked amount if the staker behaves maliciously or fails to meet the protocol’s requirements. LST-backed stablecoins can also offer more security and trust than fiat-backed stablecoins, as they are decentralized and transparent.

Conclusion

LST-backed stablecoins are a new frontier in DeFi, as they combine the benefits of staking and stablecoins, while also creating new possibilities and challenges for the crypto space. According to DefiLlama, the total value locked in liquid staking is over $59.2bn. This shows the huge potential and demand for LST tokens, as they can unlock the value and utility of the staked assets, while also providing stability and security.

However, LST-backed stablecoins are not without risks and limitations. They are still experimental and nascent, and they face various technical, regulatory, and market challenges. They also depend on the performance and security of the underlying PoS networks and the liquid staking protocols. Therefore, users should be cautious and informed before using or creating LST-backed stablecoins and always do their own research and due diligence.