Stablecoins are not a new crypto product. The first stablecoin USDT has been around for ten years. Collectively stablecoins have achieved significant product market fit accounting for 70%+ of on-chain transaction volume and represent over $130b in value on-chain.
So why do we need another stablecoin? Why do we need USDh? And why is the delta-neutral design an attractive alternative to the existing models?
There are two main approaches to stablecoins today:
- RWA backed stablecoins
- Overcollateralized stablecoins
Each of the approaches comes with its pros and cons.
1. RWA backed stablecoins
RWA backed stablecoins, most notably USDT and USDC, hold assets such as bank deposits, treasuries notes, t-bills, and reverse repo agreements within the fiat banking system and represent their value on-chain as stablecoin tokens.
The key benefit of this approach is scalability.
The fiat system is highly liquid and its infrastructure is well established, which allows firms like Tether and Circle to scale their stablecoin offerings to tens of billions of dollars.
On the flipside, since the assets are held in the fiat banking system, the stablecoins are reliant on that system to be a) operational and solvent as well as b) friendly to the crypto industry.
Both of these dependencies have been challenged recently.
The collapse of Silicon Valley Bank in March of 2023 led to USDC trading 12% below peg because Circle held $3.3b in reserves at the insolvent bank. The event sent shock waves through the crypto industry as a number of DeFi protocols’ risk management systems were not equipped to deal with the prolonged depegging of such a systemically important asset as USDC.
The event showed just how dependent the existing DeFi ecosystem is on the centralized US banking system. For an industry that aims to offer an alternative to the existing system, relying on traditional finance for solvency undermines its core mission.
Additionally, the last few years have shown that we cannot rely on the regulatory environment, especially in the US, to be friendly to the crypto industry. An unfavorable government body can, with the stroke of a pen, make operating a RWA backed stablecoin extremely difficult or outright impossible. The impact this would have on the current stablecoin ecosystem is hard to predict but could, in magnitude and scope, far outweigh what we’ve seen during the SVB crisis.
If we are to build a truly decentralized financial system based on Bitcoin, it is clear that we have to reduce, and eventually eliminate, dependency on the incumbent fiat financial system. The path to do this is clear: We need to create alternative stablecoin products that are backed by Bitcoin and do not rely on the solvency or proper functioning of the banking system.
2. Overcollateralized stablecoins
One stablecoin design that addresses these issues is the overcollateralized design pioneered by MakerDAO and DAI and more recently by Liquity. This approach involves locking crypto assets into smart contract vaults, enabling users to borrow a fraction of the locked value — typically 30–70% — as a newly minted stablecoin.
This design is fully outside the fiat banking system and can be fully backed by bitcoin. In fact, it can be highly decentralized as all funds are held on-chain — one of its key benefits.
That being said, the approach has a number of issues that have prevented the protocols from accruing any significant value. For example, Liquidity’s LUSD experienced a dramatic market cap decline, falling from its peak of over $1.5 billion in 2021 to approximately $70 million at present, representing a 95% decrease.
The main issues with the overcollateralized design include:
- Capital inefficiency: Due to the need to overcollateralize the stablecoin only a fraction of the Bitcoin locked in the protocol can be represented on-chain as dollars. A large amount of the collateral that is parked in smart contracts is idle and cannot be used for other productive purposes.
- Poor UX: The overcollateralized nature of the design necessitates the creation of leverage and, as a consequence, liquidation risk. If the BTCUSD price declines, the user has to either pay back the borrowed stablecoins or add more collateral to the smart contract. This need to manage liquidation risk can lead to significant stress for the user and makes for an overall subpar user experience, especially during highly volatile markets.
- Difficult to arbitrage / maintain the peg: Some of the overcollateralized designs tie a smart contract vault and the minted stablecoin amount to a specific user. In turn, only that user can take advantage of a depegging by buying the stablecoin below peg and redeeming it for a full dollar from the smart contracts. However, most users are neither equipped nor interested in performing this key function to maintain the peg. Professional market makers, who typically profit from market disparities, cannot perform the arbitrage at scale because they’re unable to interact with all the vaults. This limitation has historically led to some overcollateralized stablecoins trading significantly below peg, which is an obvious flaw of a product designed for stability.
3. Delta-neutral stablecoins
The delta-neutral stablecoin design is fully Bitcoin backed and outside the banking system. It solves all major issues of the overcollateralized design (while adding a little cherry on top), and is the ideal approach to build an alternative stablecoin system that scales.
But, there’s no free lunch. If we want to solve the key issues that have prevented scaling overcollateralized designs, we are going to have to give up something in exchange.
The main trade off is around decentralization and custody. To access perpetual futures liquidity, the protocol has to trade on centralized exchanges, requiring its funds to be stored off-chain in institutional-grade custodians like Copper and Ceffu, rather than on-chain in smart contracts.
While this is a less decentralized design, data published by Into The Block shows that storing assets in smart contracts comes with the risk of losing all the funds, with a probability of around 4% per annum. Institutional grade custodians, on the other hand, have not suffered any hacks or loss of customer funds since their inception.
The benefits of the delta-neutral design are manifold:
- Capital efficiency: Because the protocol hedges out the exposure to BTCUSD, it can represent 100% of the BTC value on-chain as a stablecoin.
- Improved UX: The short perpetual futures position eliminates BTC price exposure and removes liquidation risk. This means the user does not have to manage collateral ratios or the health of his smart contract vault.
- Easy to arbitrage / maintain the peg: The protocol design allows Approved Participants (market makers and trading firms) to efficiently arbitrage the peg since they can mint and redeem large amounts at any time. This allows the protocol to maintain the $1 dollar peg more efficiently.
And lastly there’s the cherry on top.
- Bitcoin native yield: Because the protocol is short the Bitcoin perpetual futures market, it generates a Bitcoin native yield from funding rate payments. This yield fluctuates with the demand for long leverage, averaging around 12% APY over the last 5 years, and reaching up to 25% during bull markets. Users that stake USDh receive the liquid staking token sUSDh, which automatically accrues the yield over time.
USDh addresses the key limitations of both RWA-backed and overcollateralized stablecoins and introduces a scalable stablecoin design that does not rely on the US fiat banking system.
USDh offers improved capital efficiency, better user experience, and easier peg maintenance, all while being fully Bitcoin-backed. Moreover, it provides users with a unique opportunity to earn Bitcoin-native yield, making it an attractive option for those seeking stability and potential returns.
