Original author: 0x Edwardyw
The new interest-paying stablecoin generates yield from three different sources: real-world assets, Layer 1 token staking, and perpetual contract funding rates.
Ethena offers the highest yield but also the greatest volatility, while Ondo and Mountain protocols restrict access to U.S. users to reduce regulatory risk in order to distribute interest income.
Lybras model redistributes $ETH staking income to stablecoin holders and is the most decentralized model, but faces incentive problems.
Based on the number of holders and DeFi usage scenarios, Ethenas USDe and Mountains USDM are leading in stablecoin adoption.
Part I: Diverse Sources of Income
Unlike the last crypto bull cycle, when algorithmic stablecoins relied on subsidies or native token inflation to provide very high but unsustainable returns, ultimately leading to the collapse of projects like Terra/Luna’s UST, the current cycle’s yield-based stablecoin innovations provide returns from legitimate sources.
The new wave of interest-paying stablecoin innovation relies mainly on three sources of income:
Proceeds from U.S. Treasury bonds
Centralized stablecoins are backed by US dollar deposits and short-term US government treasury bills, which are considered the safest assets in the traditional financial market. Currently, the two largest stablecoins, USDT and USDC, earn billions of dollars in interest income each year from their holdings of US Treasury bonds, but do not return these interest income to stablecoin holders.
In contrast, new entrants in the centralized stablecoin market aim to challenge the dominance of USDT and USDC by returning interest income earned on backing assets to stablecoin holders. Ondo’s USDY and Mountain Protocol’s USDM are two typical examples, both of which offer stablecoin holders a yield of about 5%.
Income from Layer 1 blockchain staking
The second source of income is the staking income from the native tokens of Layer 1 blockchains. Lybra’s eUSD on Ethereum and Marginfi, which will be launched on Solana soon, allow users to use liquid staking tokens (LST), such as stETH and jitoSOL, as collateral to mint stablecoins. These are typical collateralized debt position (CDP) type stablecoins, and their mechanism is similar to MakerDAO’s DAI.
Unlike traditional CDP stablecoins, when minters use LST as collateral to borrow stablecoins, they do not incur any borrowing costs or interest on the stablecoin loan. The borrowing costs and interest on the stablecoin loan are paid by the income generated by LST as collateral. In other words, minters redistribute the staking income earned by LST to stablecoin holders.
Benefits from structured strategies
Ethenas USDe is a synthetic stablecoin backed by delta-neutral BTC and ETH positions and earns revenue from funding rates. Users can deposit their ETH or liquid staked ETH (such as stETH) to mint Ethena-issued stablecoin USDe. The protocol then opens an ETH short position on a centralized exchange against the ETH held by the protocol. This puts the Ethena protocol in a delta-neutral position, ensuring that it is not affected by price changes. The protocol works with major derivatives exchanges including Binance, OKX, Deribit, and others.
The protocol uses an over-the-counter MPC secure custody account to leverage the liquidity of centralized exchanges. This means that the protocol is not subject to the custody risks associated with centralized exchanges, as all protocol assets are held by regulated institutional-grade digital asset custodians.
The stablecoin USDe is backed by a delta-neutral strategy. The protocol generates income from two sources: 1) ETH staking income and 2) funding rate income. Historically, participants who short ETH positions have always received positive funding rates. In the current bull market, most market participants are long ETH, and the funding rate for short positions is very considerable.
Part 2: Characteristics of interest-paying stablecoins
Ethena’s USDe relies on a positive funding rate
Ethenas USDe offers an incredible yield of up to 30% from positive funding rates in the perpetual futures market. In the perpetual futures market, the funding rate mechanism regularly adjusts the cost between long and short positions. When long demand is higher than short demand, the funding rate is positive, and the funding rate is paid by long futures buyers to short futures buyers. During the cryptocurrency bull market, the positive funding rate can be very high, allowing Ethenas short positions to earn significant funding rate income.
According to Ethena, positive funding rates have historically been present even during bear markets. For example, funding rates were 18% in 2021, 0.6% in 2022, and 7% in 2023. This means that Ethena is able to provide higher stablecoin yields even in bear market conditions, as major stablecoins had yields below 1% during the 2022/2023 crypto bear market. However, past performance is no guarantee of the future, and yields are highly sensitive to market conditions. During market pullbacks, returns generated by positive funding rates can fluctuate wildly as demand for longs decreases. Due to the recent market pullback, USDe yields have fallen from 35% to 15%.
While negative funding rates can occur when demand for long positions is lower than short positions, negative funding rates are not persistent and tend to revert to a positive mean. When the overall return on ETH staking and funding rates is negative, the protocol has a reserve fund that can step in to ensure that users do not pay negative returns for holding USDe.
Ethenas USDe is backed by $ETH structured trading strategies. While $ETH is a crypto-native asset, trading and hedging strategies are conducted on centralized exchanges and involve regulated crypto custodians. Therefore, USDe is not a decentralized stablecoin.
Lybra’s eUSD needs to incentivize stablecoin minters
Lybras eUSD is minted using overcollateralized liquidity to pledge $ETH, and the stablecoins income comes from $ETH staking income. This approach utilizes crypto native assets and is executed on-chain, so it can be considered a decentralized stablecoin. The staking income of minters is redistributed to stablecoin holders. While this provides sustainable real income for stablecoin holders, it lacks sufficient incentives to attract stETH holders to mint stablecoins and give up staking income. Therefore, the protocol has to rely on the issuance of its native token $LBR to subsidize stablecoin minters.
Additionally, while a 5% yield on an interest-bearing stablecoin is attractive in a bear market, it is less attractive in a bull market because more established stablecoins can earn returns of over 10% through DeFi lending.
USDY and USDM are restricted to US users
Ondo Finance and Mountain Protocol’s interest-paying centralized stablecoins target a niche market that is not adequately served by USDC and USDT. Due to regulatory uncertainty in the United States, neither USDC nor USDT distribute the interest income earned to stablecoin holders. Their concerns are that paying interest on stablecoins could lead to classification as securities, or that they could violate the law by offering interest without a banking license. USDY and USDM have chosen to serve only non-US users, limiting the use of their stablecoins by US citizens.
Part 3: Application scenarios and stability
A good stablecoin should have a wide range of use cases in DeFi, deep liquidity in exchanges, and a large number of holders. Although these emerging interest-paying stablecoins cannot challenge the market position of USDT and USDC in the foreseeable future, they have adopted different strategies to expand their application scenarios.
Mountain’s USDM and Ethena’s USDe have shown pretty good adoption rates in terms of the number of holders and DeFi use cases.
Most of the USDM exists on the Ethereum mainnet, followed by Manta Pacific, with small balances on Base, Arbitrum, and Optimism. Mountain Protocol has partnered with Ethereum Layer 2 Manta Pacific, and USDM is the main stablecoin in the Manta Pacific ecosystem and is used in DeFi. USDM can be used as collateral on Manta Pacifics largest lending protocol, LayerBank.
Ethena, currently the hottest new stablecoin project, has established partnerships with major DeFi protocols in the Ethereum ecosystem. The partnership with MakerDAO and Morpho allows users to mint up to 1 billion DAI using USDe as collateral.
Ondo Finances USDY is still in the early adoption phase. The protocol has already established partnerships with Tradfi giant BlackRock and leading layer 1 and layer 2 chains such as Solana, Mantle Network, and Sui. These partnerships have the potential to greatly increase its adoption. Ondo Finance is the hottest project in the current real world asset (RWA) narrative with a high fully diluted market capitalization (FDV). Despite having strong supporters and partnerships, it should be noted that both products, USDY stablecoin and OUSG on-chain US Treasury, currently have very limited holders, with less than 1,000 holders of USDY and less than 100 holders of OUSG.
stability
Mountain’s USDM and Ethena’s USDe trade very close to their pegs of $1, while Ondo’s USDY is an interest-bearing token that trades above $1. Ondo is currently working on launching a rebasing version of USDY so that it can be used as a regular USD stablecoin.
Lybra’s eUSD has been trading below $1 for a long time. eUSD is fully collateralized by liquid staked ETH with a minimum collateralization ratio of 150%. The protocol is secure and backed by sufficient collateral. The depegging can be attributed to a design choice of the protocol mechanism. For an overcollateralized stablecoin like eUSD, if the stablecoin is trading below $1, arbitrageurs can profit by buying the stablecoin at a discount on the open market and then redeeming the underlying collateral in full. This arbitrage behavior pushes the price of the stablecoin up to $1. Interestingly, for Lybra Finance, stablecoin minters can choose whether to allow arbitrageurs to redeem their positions. Many users choose not to activate the redemption option, which prevents the execution of arbitrage.
Liquidity on DEX
We measure the liquidity of stablecoins by the slippage when exchanging 100K and 1M for USDT in the DEX Aggregator LlamaSwap. USDe has the best liquidity with no slippage when exchanging 1 million tokens. It is worth noting that despite the smaller market cap of the USDM stablecoin, its liquidity is quite good.
