Author: Caesar; Compiler: Shenchao TechFlow

Yielding stablecoins are considered the next revolution in the growing stablecoin ecosystem. Over the past year, many projects have emerged dedicated to developing yield-generating stablecoin products.

In this article, I will provide a comprehensive overview of the interest-bearing stablecoin landscape, highlighting the main categories in this space: LSD-backed stablecoins, Treasury-backed stablecoins, and other income-generating stablecoins. Following this, I will conduct a user analysis focused on identifying which types of users may or may not find interest-bearing stablecoins attractive.

I will conduct a SWOT analysis of interest-bearing stablecoins to shed light on potential areas of risk and opportunities for improvement in this space. Finally, I will share my thoughts on whether interest-bearing stablecoins meet market fit.

Overview of interest-bearing stablecoins

Interest-bearing stablecoins are a type of stablecoin that can provide holders with a return on investment by simply holding the asset.

The emergence of several stablecoins focused on delivering predictable and sustainable yields has generated tremendous optimism in the crypto ecosystem. Many view these interest-bearing stablecoins as virtually risk-free investments that promise to occupy a sizable niche in the stablecoin market. Well-known figures such as Nic Carter are particularly optimistic, predicting that interest-bearing stablecoins may occupy 20-30% of the stablecoin market share in the next few years.

However, skeptics, including myself, also question the long-term viability and potential of these interest-bearing stablecoins.

“The key thing about stablecoins with APR is this: while interesting, their inherent growth-oriented monetary policies run the risk of slowing the velocity of money, and if that happens, it will often lead to an economic slowdown. In short: if Your money might be worth more tomorrow, so why spend it today? If everyone thought that, would the economy really prosper?"

Let’s analyze these protocols one by one to better understand the case for interest-bearing stablecoins. To do this, we will analyze LSD-backed, Treasury-backed, and yield-generating stablecoins separately.

a) LSD-backed stablecoin

The stablecoins supported by LSD are CDP model stablecoins that need to be over-collateralized with liquidity collateral tokens, and there is a liquidation risk. They allow holders to earn yield while retaining the key attributes of crypto-backed stablecoins.

The main features of LSD supporting stablecoins can be summarized as follows:

• Utilize LSD derivatives;
• Relies on Ethereum staking rewards;
• Requires over-collateralization and carries liquidation risk;
• Unlock locked Ethereum liquidity.

Recently, as the amount of staked Ethereum has increased, investors have seen the potential of LSD-backed stablecoins, and LSD-backed stablecoins have become a hot category. As the amount of staked Ethereum increases, the market share of LSD-backed stablecoins is likely to increase as well.

The first wave of LSD-backed stablecoins such as $GRAI, $R, and $eUSD proved that there is a demand for stablecoins that utilize LSD derivatives, however, the existing flaws of these stablecoins will cause difficulties in the future. On the other hand, new LSD-backed stablecoins like $mkUSD and $crvUSD bring some improvements to the existing model, which could be an exciting development. It should be noted that Ethena Labs’ $eUSD is a completely new model and could inspire other developers to develop similar models.

I believe that an LSD-backed stablecoin can serve as an effective leverage primitive for Ethereum investors, but it fails to achieve stablecoin functionality due to capital inefficiencies caused by over-collateralization requirements and liquidation risk. Additionally, LSD-backed stablecoins do not inherently function as currencies, as their primary purpose is to provide income to their holders and therefore cannot serve as a medium of exchange.

b) Treasury-backed stablecoin

Treasury-backed stablecoins are the latest innovation in the ecosystem. As U.S. interest rates rise, some realize this could be a great opportunity to offer investors risk-free interest. Ondo Finance’s $USDY and Mountain Protocol’s $USDM are two prime examples in this space.

The main characteristics of Treasury-backed stablecoins can be summarized as follows:

• Requires permission/KYC; *Earnings depend on U.S. interest rates;
• The income source is not as volatile as DeFi.

While $USDM is a rebasing token, $USDY is an immutable token. Therefore, $USDM will be challenging to integrate into DeFi protocols, while $USDY will definitely encounter issues in terms of user experience.

I think Treasury-backed stablecoins provide the best solution from the perspective of exchange rate stability and risk-free interest rates. However, their growth depends on U.S. interest rates, which is beyond their control. Therefore, external factors will play a key role in the future development of this category.

Additionally, it should be noted that Treasury-backed stablecoins do not offer a strong value proposition to the crypto community, as these stablecoins require permissions, meaning not everyone can mint or use them, whereas the 5% interest rate found in other protocols is not competitive. These protocols may target users in developing countries, but a lack of liquidity and lower future returns puts them at a disadvantage competing with USDC and USDT. Additionally, Treasury-backed stablecoins do not inherently function as currencies, as their primary purpose is to provide income to their holders and therefore cannot serve as a medium of exchange.

c) Yield-generating stablecoins

Yield-generating stablecoins provide holders with automated DeFi yields through the use of collateral across several protocols. To mint these stablecoins, users need to stake USDC or other stablecoins. Sperax and Overnight can be used as examples of this category.

Many people consider yield-generating stablecoins to be stablecoins, but I disagree. These stablecoins do not function as stablecoins, but as LP tokens. This means that revenue-generating stablecoins do not function as currencies, but rather as LP tokens that users can earn revenue by simply holding. While this criticism can be leveled at every interest-bearing stablecoin, it’s clear that yield-generating stablecoins like $USDs and $USD+ don’t even attempt to add uses other than being LP tokens.

The main characteristics of yield-generating stablecoins can be summarized as follows:

• Not a medium of exchange;
• There is counterparty risk;
• USDC package; *DeFi earnings.

Many people think that yield-generating stablecoins could be an exciting move, but I don't think of them as stablecoins, but rather as USDC collateral providers. Therefore, they have no unique value proposition in the ecosystem. Therefore, I am not optimistic about the future of this category because the products can be easily copied or adopted by existing projects with lower risk.

The market for interest-bearing stablecoins: user analysis

To determine if a protocol meets product market fit, we need to look at potential customers/users and how they will view/use the protocol.

For stablecoins, I think we can analyze 3 main categories:

a) Organization

Treasury-backed stablecoins can be a great way to get into DeFi for new institutions that are exploring the space. Since these platforms require KYC/AML conditions and licensing, institutions do not face difficulties with regulations and security, while also taking advantage of the benefits of Treasury-backed stablecoins.

These stablecoins can be very effective for institutions in developing countries where access to the U.S. dollar is limited.

Additionally, LSD-backed stablecoins could be an excellent tool for institutions familiar with Ethereum and the DeFi ecosystem to increase their exposure to Ethereum or the Ethereum ecosystem as a whole.

b) Whale/LP

I believe that whales/LPs are the most exciting user class for interest-bearing stablecoins because these users have sufficient knowledge, experience, and capital to exploit interest-bearing stablecoins at high yields by developing leveraged trading strategies.

Most interest-bearing stablecoins can be spent in several ways:

• Collateralized debt position;
• Profit; *Internet bonds;
• Leveraged liquidity mining.

Due to these use cases, whales/LPs can effectively develop trading/mining strategies and benefit from interest-bearing stablecoins.

LSD-backed stablecoins and yield-generating stablecoins can be great tools for whales/LPs to leverage/diversify or increase exposure to certain assets. I think that although the number of users may not be high, the TVL of these stablecoins can reach considerable levels.

c) Retail users

Assets with income do not meet the requirements for stablecoin functionality. In short, according to the concept of stablecoin functions, stablecoins must have specific functions to be used as currencies in the digital space, such as:

• Medium of exchange;
• Store of value;
• Capital efficiency;
• Fiat currency entry/exit;
• Censorship-proof.

I believe that if a stablecoin cannot meet these requirements, it cannot scale, so it will not become a larger player in the stablecoin market.

Regarding interest-bearing stablecoins, I believe that none of them fulfill the stablecoin function because they cannot be considered a medium of exchange and are not capital efficient. These issues limit the ability of interest-bearing stablecoins to be used in trading or buying and selling cryptoassets. Since retail traders primarily use stablecoins for these reasons, interest-bearing stablecoins are difficult to adopt among these users. In addition, lack of liquidity and lack of use cases are also major obstacles for retail traders to use interest-bearing stablecoins.

Furthermore, considering that most retail users use stablecoins for transactions, and the main use of interest-bearing stablecoins is to hold stablecoins to earn income, there is a mismatch between user interests and the protocol. Therefore, I don't think any stablecoin that is not considered a medium of exchange will be widely used by retail users.

SWOT analysis of interest-bearing stablecoins

Advantage

• Dollarization: The U.S. dollar is a highly recognized asset in the developing world, and interest-bearing stablecoins are extending the U.S. dollar’s influence into regions where hyperinflation and devaluation of national currencies have reduced purchasing power.
• Sharing of inherent returns: Circle and Tether do not share with users the inherent returns of dollars deposited into their protocols. However, interest-bearing stablecoin protocols share these earnings with holders, thereby empowering users.
• New revenue streams: While interest-bearing stablecoins based on Ethereum collateral bring Ethereum revenue to institutions, Treasury-backed stablecoins bring U.S. revenue into DeFi, so both categories create new opportunities for investors.
• Store of value: Interest-bearing stablecoins are resistant to inflation as they can provide users with a yield of approximately 5-8% USD, making them a good choice for users.

Disadvantages

• Medium of Exchange: Interest-bearing stablecoins are inherently limited from use as a medium of exchange for several reasons, including capital inefficiencies, limited or permissioned use cases, and lack of liquidity. But, most importantly, since these stablecoins generate earnings just by holding them, no one wants to use them in transactions because they will lose the earnings. Therefore, there are limited reasons to use interest-bearing stablecoins as currencies.
• Licensing/Censorship: Treasury-backed stablecoins require licensing, and some people (such as US citizens) are not allowed to use them. Therefore, there are limitations to adopting these stablecoins. Additionally, there may be a risk of censorship as the agreement must comply with orders from regulators.
• Lack of use cases/lack of liquidity: Interest-bearing stablecoins suffer from a lack of liquidity and use cases due to several issues, including scalability, liquidation risk, capital inefficiency, or permissioned use cases, which limits the potential for growth.

Chance

• Unique value proposition versus fiat stablecoins: As user power increases in the ecosystem, there will be growing criticism that fiat stablecoins do not share the inherent benefits of the U.S. dollar with their holders. This could be a good opportunity for an interest-bearing stablecoin to differentiate itself from other stablecoins.
• Institutional adoption: Treasury-backed stablecoins can be a good starting point for institutions outside the United States, bringing new capital inflows to DeFi.

threaten

• Competition: Most projects have no competitive advantage over other projects, so in a few years some protocols may disappear due to this competitive environment and lack of innovation/differentiation. *Protocol profitability: The competitive nature of this space forces protocols to be more profitable for users, which in turn reduces the profitability of these protocols. As a result, these projects may burn through their own capital and not survive for long.
• Liquidity fragmentation: Due to the competitive environment, the ecosystem may face liquidity fragmentation issues, which reduces the capital efficiency of these interest-bearing stablecoins.
• Sustainability of earnings: While some interest-bearing stablecoins rely on Treasury rates, others follow Ethereum mortgage rates. The problem with this approach is that Treasury interest rates are certain to fall in the future, and the sustainability of the business is questionable, as low interest rates may not be attractive to users. On the other hand, if the Ethereum collateral ratio increases, the yield will decrease accordingly, which may be a future issue for these protocols, as lower yields may not be attractive.

Do these income stablecoins meet market demand?

The various types of interest-bearing stablecoins discussed in the article each target a different market. Rather than just analyzing them as a single category, it would be more beneficial to rank them based on their product-market fit and then evaluate the reasons behind the ranking.

Ranking interest-bearing stablecoins based on product-market fit:

1. Treasury-backed stablecoins: As rising U.S. interest rates coincide with the rise of stablecoin builders, they realize that Treasury-backed stablecoins can be a great tool for users. While it is clear that the average DeFi user will not use Treasury-backed stablecoins due to privacy, censorship, lack of use cases, and liquidity reasons, institutional investors outside of the U.S. dollar may be excited to use Treasury-backed stablecoins. However, I should point out that when returns decline, these stablecoins will have no further utility relative to fiat-backed stablecoins. Therefore, I believe that Treasury-backed stablecoins can be an excellent vehicle for institutional or accredited investors to access U.S. dollars across the globe, but the market may not be as large as many believe.
2. LSD-backed stablecoins: I am skeptical about LSD-backed stablecoins realizing the potential that many envision, because the design of these protocols contains many flaws, such as capital inefficiency, liquidation risk, easy to be copied, and no real innovation etc., which limits the ability of these stablecoins to grow/scale and be considered a medium of exchange. However, it is clear that they are a good financial primitive for Ethereum leverage, so while LSD-backed stablecoins will have a place in the market, it won't be as big as many assumed. On the other hand, new protocols such as Ethena leverage LST to create a new model that eliminates these problems.
3. Yield-generating stablecoins: I do not believe that yield-generating stablecoins offer a competitive value proposition that is distinctive in the stablecoin market. I think these products simply encapsulate USDC or LP tokens and allow users to earn interest on stablecoins while taking on some counterparty risk. Moreover, other stablecoins could very easily replicate this business model by simply creating a liquid-collateralized version of the stablecoin to challenge the yield-generating stablecoin. Therefore, I believe that revenue-generating stablecoin products have the lowest market fit.

The stablecoin market is still in its infancy, with several upcoming projects aiming to challenge the current model. Let’s take a look at how the interest-bearing stablecoin landscape will develop in the near future. However, it should be noted that we still have time to find product-market fit in this niche.