2023 is an extraordinary year for builders exploring the potential of new DeFi primitives. One of the most notable developments during this period is the rise of the Liquidity Staking Derivatives (LSD) protocol and the subsequent establishment of a protocol built on the LSD project, known as LSDfi.

These LSDfi projects can be divided into several different parts. In this article, I mainly focus on stablecoins supported by LSD.

What is LSD? What is LSDfi?

Liquidity Staking Derivatives (LSD) is a financial instrument that represents ownership of staked tokens in DeFi protocols. These instruments allow users to stake their tokens while retaining the freedom to use these LSD in various applications. Some LSD protocols include Lido Finance and Rocket Pool. LSDs provide many benefits to the ecosystem as they unlock previously locked capital while providing security to the network.

LSDfi refers to projects that build financial primitives using LSD protocols, such as Pendle Finance and Unsheth. By providing additional interest-bearing opportunities, LSDfi protocols allow LSD holders to leverage their assets and maximize their returns.

However, as a subcategory, there are also LSD-backed stablecoins such as Raft, Gravita, Ethena, Prisma, and Lybra, which we will now evaluate.

LSD-backed stablecoins are stablecoins based on the CDP model that require overcollateralization with staked tokens and carry liquidation risks. They allow holders to earn interest while preserving the key properties of stablecoins backed by cryptocurrencies.

It can be seen that LSD-backed stablecoins do not differ significantly from established stablecoins such as $LUSD, $FRAX, or $DAI. The main value proposition offered by LSD-backed stablecoins is the yield on $ETH while allowing users to continue accessing DeFi applications. And, the new projects also offer some innovative features.

To better understand this category, let’s take a look at each of these protocols.

Prisma Finance( $mkUSD)

Prisma is an LSD-backed stablecoin and a fork of Liquity with significant improvements. Prisma allows users to mint $mkUSD backed by various LSDs like $wstETH, $cbETH, $rETH, $sfrxETH, and $WBETH. $mkUSD will earn incentives on Curve and Convex Finance to create a capital-efficient flywheel where users can earn trading fees, $CRV, $CVX, $PRISMA, and staking rewards on $ETH.

My thoughts on $mkUSD are as follows:

1. Competitive value proposition: While each LSD-backed stablecoin offers yield on $ETH to users, depositors of $mkUSD in the Curve pool can earn trading fees, $CRV, $CVX, and $PRISMA rewards, which may make $mkUSD more competitive among its peers.
2. Not a medium of exchange: $mkUSD is a yield-bearing stablecoin, and the protocol does not prioritize using it as a medium of exchange. Most users hold $mkUSD to earn the annualized rate provided by holding $mkUSD.
3. Interest-bearing asset: As $mkUSD can generate returns for holders, some may choose to hold it as a store of value. This can be a good way to earn $ETH returns if users trust its anchoring stability.
4. Innovative tokenomics: vePrisma holders will be able to incentivize specific pools, creating a positive feedback loop for LST providers to incentivize $mkUSD with their own LST. This can create demand for $mkUSD. According to the whitepaper, voters can steer the issuance towards using specific collaterals to keep active borrowing using specific collaterals and reward any LP token holders. Given the importance of deep liquidity in maintaining anchoring stability, this will be a crucial differentiation factor for Prisma.
5. Multiple LSD collaterals: There are several LSDs that can be used as collaterals, such as $wstETH, $cbETH, $rETH, $sfrxETH, and $WBETH, with varying market values. Due to the unique token economics, these protocols can incentivize users to mint $mkUSD, increasing exposure to Prisma.
6. Capital efficiency limitations: The overcollateralization model means that $mkUSD has limitations in terms of capital efficiency, as users need to input more funds than they receive. Additionally, there is always a liquidation risk as the collateral ratio should always be maintained above 120%.
7. Powerful Supporters: Despite entering the market late compared to competitors, Prisma Finance has garnered support from several powerful backers such as Curve Finance, FRAX, and Convex.

Raft( $R)

Raft is a protocol for minting the R stablecoin, which is backed by LSD with over-collateralization and carries liquidation risk. Users can earn sustainable yield by depositing at the savings rate.

Here are my thoughts on $R:

1. Lack of innovation: Raft is a fork of Liquity with only minor changes, so there isn’t much innovation on the product side. It may be easily surpassed after the launch of Liquity v2, which will leverage LST.
2. Not a medium of exchange: $R is a yield-bearing stablecoin, and the protocol doesn’t prioritize its use as a medium of exchange. Most users hold $R to earn the annualized yield it provides.
3. Anchoring stability：$R is currently valued at approximately $0.98 USD, and the team is working hard to find a solution to restore its peg. The team proposes implementing interest fees instead of one-time fees to mint $R. By doing so, they aim to restore the peg through incentivizing buying pressure in the market. The reasons for the de-peg can be attributed to the one-time fees for minting R, lack of liquidity, and lack of organic demand-generating use cases.
4. Limited value proposition compared to competitors: At this point, users don’t need to pay interest fees to borrow $R, so they can leverage their $ETH holdings. This is the primary value proposition of $R. However, if the team decides to change this model, Raft will have no value proposition.
5. Interest-bearing asset：Since $R can generate yield for holders, it can definitely be used as a store of value. This can be a good way to earn $ETH returns if users trust its anchoring stability.
6. Inefficient capital utilization：As $R is a stablecoin based on a CDP model, requiring over-collateralization and facing liquidation risk, it is not a capital-efficient model for retail users. This will limit its growth potential as scalability is restricted.

Gravita( $GRAI)

Gravita is a fork of Liquity and accepts different LSD products as collateral. It allows users to borrow without interest and does not take a cut from the yield generated by deposited LST. While the redemption mechanism has not been launched initially, it will be gradually released throughout the process. This may be the reason why $GRAI has been maintained around $0.98 from the start, which raises trust concerns for users.

Here are my thoughts on $GRAI:

1. Lack of innovation: As mentioned, Gravita is a fork of Liquity with minimal innovation. This makes it potentially vulnerable to being surpassed after the launch of Liquity v2, which uses LST.
2. Limited value proposition compared to competitors: Users can borrow $GRAI without paying interest fees, allowing them to leverage their $ETH positions. Additionally, allowing $bLUSD as collateral without any liquidation risk and without charging any fees from pledge yield are the value propositions provided by Gravita.
3. Not a medium of exchange: $GRAI is a yield-bearing stablecoin, and the protocol doesn’t prioritize its use as a medium of exchange. Most users hold $GRAI to earn the annualized yield it provides.
4. Anchoring stability: The price of $GRAI has been fluctuating around $0.98 since launch. This may be due to not allowing redemption of $GRAI during the launch and then gradually releasing it, which could lead to oversupply and lower the price without arbitrage opportunities. Additionally, low liquidity and lack of use cases to create organic demand may limit the demand growth for $GRAI, exacerbating the situation.
5. Interest-bearing asset: Since $GRAI can generate income for holders, there will definitely be demand to use it as a store of value. This can be a good way to earn $ETH returns if users trust its anchoring stability.
6. Multiple LST collaterals：There are several LSTs that can be used as collateral, such as $WETH, $rETH, $wstETH, and $bLUSD. This can be an advantage and provide users with several options.
7. Lack of capital efficiency：The over-collateralization model means $GRAI is limited in terms of capital efficiency, as users need to put in more funds than they receive. Additionally, there is always liquidation risk, which will limit growth.

Lybra( $eUSD)

$eUSD is a stablecoin backed by collateralized $ETH. Holding $eUSD generates a stable stream of income with an approximate annual yield of 8%. The protocol also has a governance token called $LBR, but its utility is limited. With the release of Lybra v2, several new features have been introduced that are expected to address the shortcomings of the protocol.

Here are my thoughts on $eUSD:

1. Lack of capital efficiency: The overcollateralized model means that $eUSD is limited in terms of capital efficiency as users need to put in more funds than they receive. Additionally, there is always a liquidation risk as the collateral ratio should always be above 150%.
2. Limited value proposition compared to competitors: In order to have potential for growth, emerging LSD-backed stablecoins need to have unique value propositions. However, while $eUSD has an early advantage, it does not offer competitiveness in terms of collateral requirements or any significant improvements.
3. Not a medium of exchange: $eUSD is a yield-bearing stablecoin, and the protocol does not prioritize using it as a medium of exchange. Most users hold $eUSD for the high annualized yield it provides.
4. Anchoring stability: $eUSD holders are eligible to receive rewards in the form of staked $ETH. As a result, most users prefer to buy $eUSD on the market, creating demand pressure. This causes $eUSD to exceed its anchoring of 1.00 USD. Unless there are changes to the system, $eUSD may struggle to restore its peg, leading to long-term issues for holders.
5. Interest-bearing asset: With the ability to generate income for holders, $eUSD can certainly have demand as a store of value tool. This is contingent upon users trusting the anchoring stability as it can be a good way to earn $ETH returns.
6. Multiple LST collaterals: With the release of Lybra v2, new LST collaterals such as $rETH and $WBETH can be used, increasing the potential for $eUSD minting. However, we should not overestimate their impact.
7. Poor tokenomics:$LBR is the governance token of this protocol. However, due to almost all the revenue from LSD flowing to $eUSD instead of $LBR, the token has almost no utility. The poor tokenomics also lead to a persistent premium of $eUSD, causing it to always trade above its peg. Users are incentivized to hold $eUSD because it is an interest-bearing stablecoin, resulting in a much greater demand for holding $eUSD than for minting $eUSD.

Ethena( $USDe)

Ethena Labs is an upcoming project that introduces an innovative Delta-Neutral Stability model, differentiating it from competitors. Through this model, the project creates a spot-long and 1x short position on exchanges using LSD as collateral, mitigating the volatility of the collateral. $USDe will be more capital efficient as it offers a 1:1 collateral ratio and provides funding fee returns from the delta-neutral model. However, users are not exposed to price fluctuations of $ETH.

Here are my thoughts on $USDe:

1. Innovation: Among all the existing projects, Ethena is the only one offering an innovative solution. I believe the delta-neutral model can successfully address some of the key issues with LSD-backed stablecoins such as capital efficiency, lack of scalability, and anchoring stability.
2. Capital efficiency: Due to the incremental-neutral model, the protocol does not require overcollateralization to maintain anchoring, allowing for a 1:1 collateral ratio. Therefore, $USDe performs the best in terms of capital efficiency among its competitors.
3. Anchoring stability: $USDe maintains anchoring stability through the delta-neutral position. In theory, the creation of a spot-long and 1x short position on exchanges will always protect the value of the collateral. However, it is important to observe the practical results.
4. Medium of exchange: With the 1:1 collateral ratio, $USDe can address the scalability issue of existing crypto-backed stablecoins. Thus, $USDe can serve as a medium of exchange between platforms with deep liquidity.
5. Strong value proposition compared to competitors: $USDe has two main unique advantages in the market, differentiating it from its competitors. Firstly, it offers a 1:1 collateral ratio, which is more attractive to users. Additionally, $USDe provides funding fee returns in addition to LSD rewards, making it more competitive among existing projects.
6. User adoption: Like any innovative project, Ethena will also face some skepticism from the community as the Delta-Neutral approach is not widely known, so it will take some time for Ethena to educate users and try out this approach.
7. Not affected by ETH volatility: Users are not exposed to the risk of $ETH price fluctuations as the deposited collateral is used to create hedged positions. Risk-averse users may see it as a benefit, however, $ETH maxis may perceive it as a drawback.

Reflection on the Overall Landscape of LSD-supported Stablecoins

So far, I have shared my thoughts on each LSD-supported stablecoins to gain a better understanding of the dynamics and analyze the opportunities and limitations. I believe this analysis helps understand the competitive landscape of LSD-supported stablecoins and showcases the trade-offs of each individual stablecoin.

Now, I will provide an overview of the overall landscape of LSD-supported stablecoins to predict how this category might evolve thru a SWOT analysis:

Note: It should be emphasized that conducting a general SWOT analysis for each LSD-supported stablecoin does not provide a comprehensive overview as each stablecoin has different values/characteristics. This is especially true for Ethena Labs, as their Delta-Neutral mechanism is completely distinct from the CDP model. For instance, factors such as capital efficiency, medium of exchange, and limited use cases do not apply to Ethena’s stablecoin $eUSD.

Strengths

Value Storage: LSD-supported stablecoins serve as a reliable value storage tool as most of them have achieved price stability while providing $ETH returns to users. Therefore, they can act as low-risk yield opportunities and value stores, increasing their market share in the near future. Adoption will grow as people realize that LSD-supported stablecoins empower users by sharing inherent returns with them.

Yield Opportunities: While the 5-8% annualized yield of stablecoins might not be attractive for retail traders, it presents a good opportunity for large holders and leveraged traders, considering the limited high-yield opportunities in the DeFi ecosystem, especially during continued bear markets.

Unlocking Liquidity: LSD provides a good way to unlock collateralized $ETH liquidity, and LSDfi, particularly LSD-supported stablecoins, further improve this situation, creating new use cases for LSD that will undoubtedly enhance ecosystem opportunities.

Increased $ETH Exposure: LSD-supported stablecoins are effective tools for expanding the Ethereum ecosystem as they improve users’ $ETH exposure and create new use cases, generating more organic demand.

Weaknesses

Growth Depends on LSDfi Adoption: LSDfi is a new category that requires further exploration. As pioneers in this category, LSD-supported stablecoins will heavily depend on overall market growth, somewhat independent of their individual impact.

Capital Efficiency: As most LSD-supported stablecoins implement the CDP model, they require overcollateralization and face liquidation risks. Therefore, capital efficiency becomes a core challenge for users.

Medium of Exchange: LSD-supported stablecoins are primarily designed for yield opportunities and rely on the CDP model, making them unfit for use as a medium of exchange. This limits the scalability of these products.

Limited Use Cases: While being a sustainable yielding asset is a compelling value proposition, liquidity fragmentation and lack of liquidity restrict the use cases of LSD-supported stablecoins. There are hardly any other ways to utilize these stablecoins apart from holding.

Opportunities

ETH Staking Adoption: With the continued trust in the security of the Ethereum ecosystem and $ETH staking rewards, ETH staking is one of the areas where further growth will be seen. LSD-supported stablecoins can benefit from this as the future increase in $ETH staking rates can be predicted.

Value Storage Against Inflation: Due to inflation, there will always be a strong demand for yield assets. As we can see from attempts to build inflation-resistant stablecoins/pegged coins, there is a significant demand for them. While LSD-supported stablecoins do not inherently exist for the purpose of hedging against inflation or as value stores against inflation, they demonstrate their potential as powerful tools against inflation.

Threats

Lack of Innovation: I believe that stablecoins supported by LSD are mostly forks of Liquity, lacking significant differentiation. As a result, they do not offer much value proposition compared to Liquity, except for the ability to use LST as collateral. While Liquity v2 will accomplish this, it remains uncertain whether investors will continue to utilize these stablecoins.

Possible Yield Reduction: As $ETH staking rewards can decrease at any time, the yields of LSD-supported stablecoins will also decrease. This may discourage users from choosing these stablecoins. Considering there will be more $ETH staking in the future, this is an inevitable outcome for LSD-supported stablecoins.

Low Demand and Liquidity: So far, most LSD-supported stablecoins have struggled to maintain a peg around $1. While there are specific reasons for this situation, a common problem is the lack of strong demand and liquidity for these stablecoins.

Liquidity Fragmentation Due to Competition: Currently, several teams are attempting to build LSD-supported stablecoins, and there is no clear winner in this race. This means that liquidity is dispersed among competitors, limiting their growth potential and hindering the effectiveness of the products or generating revenue. All of this may have long-term implications for the success of LSD-supported stablecoins.

End of Bear Market: Most investors choose LSD-supported stablecoins as yield assets because there are no better solutions/alternatives during bear markets. However, when a bull market begins, funds can flow towards more profitable projects as the 5-8% annualized yield may not be attractive in a bull market. However, it is worth noting that the end of a bear market will certainly help these protocols grow as the overall market value will further increase.

Future Impact: Making LSD-Supported Stablecoins More Efficient

Clearly, with the rise of LSDfi products, interest in LSD-supported stablecoins is growing. I believe this trend will continue to grow. However, I think most of the current LSD-supported stablecoin models are either not suitable for the product market or lack a competitive edge.

Stablecoins supported by LSD, such as $R, $GRAI, and $eUSD, do not have a clear value proposition when compared to existing projects like $crvUSD and $LUSD. These protocols may potentially capture market share from the previously mentioned projects.

Prisma Finance is an interesting case; they are developing a unique tokenomic model to increase returns for stablecoin holders and create value for governance token holders. Although the current CDP model of this stablecoin is not unique and doesn’t offer a new value proposition, the protocol might have a chance because its token economy model creates organic demand, deepens liquidity, and thus makes it easier to maintain the peg.

Ethena Labs is a unique model that challenges existing ones. This protocol is more efficient and, due to the protocol’s open risk-free positions, can generate more revenue through funding costs. This is crucial because this model creates organic returns on top of existing LST yields, making the protocol more competitive. However, it’s worth noting that in the CDP model, borrowers profit when the collateral price rises. In Ethena’s case, users forfeit potential profits from the volatility of $ETH’s price increase due to maintaining the peg through risk-free positions.

In summary, the future of LSD-supported stablecoins will depend on:

• New models improving capital efficiency;
• New sources of revenue;
• Scale expansion of ETH staking;
• Adoption of LSDfi.

Let’s wait and see.

Disclaimer：

1. This article is reprinted from [techflowpost]. All copyrights belong to the original author [Caesar]. If there are objections to this reprint, please contact the Gate Learn team（gatelearn@gate.io）, and they will handle it promptly.
2. Liability Disclaimer: The views and opinions expressed in this article are solely those of the author and do not constitute any investment advice.
3. Translations of the article into other languages are done by the Gate Learn team. Unless mentioned, copying, distributing, or plagiarizing the translated articles is prohibited.