The Frax community recently approved a proposal to make its FRAX stablecoin fully backed by U.S. dollar equivalents rather than maintaining a partially backed, semi-algorithmic stablecoin. With Frax’s decision, the days of experimentation with algorithmic stablecoins could finally be behind us.

The decentralized stablecoin space has only proved effective with stablecoins backed by Ether (ETH), USD Coin (USDC) and Bitcoin (BTC). The failure of algorithmic stablecoins like TerraUSD (UST) and depegging of overleveraged stablecoins like Magic Internet Money (MIM) are some of the primary reasons for the loss of confidence in decentralized stablecoins.

The decentralized stablecoin space is still tiny

Decentralized stablecoins account for 5.5% of the total stablecoin supply. MarkerDAO’s Dai (DAI) commands the lion’s share, with 71% dominance. The transfer volumes of decentralized stablecoins are largely dominated in Dai and have declined since Q3 2022, suggesting that activity across the sector is still inhibited.

90-day moving average of decentralized stablecoin transfer volume. Source: Dune

During the bull run of 2021 and 2022, platforms like Abracadabra and Terra flourished due to higher yields, but when the market took a negative turn, these stablecoins were some of the first to collapse. Terra’s UST stablecoin crashed in May 2022 after major withdrawals disrupted its algorithmic mechanism. 

Before its collapse, UST had become the third-largest stablecoin, with a larger supply than Binance USD (BUSD) and only behind Tether (USDT) and USDC. However, the ripple effects of Terra’s collapse caused Abracabra’s MIM stablecoin to lose its peg due to a widespread drop in the prices of assets backing MIM. Liquidations piled across the platform with no buyers, leading to frequent dips below the $1 peg.

Only a few incumbents remain standing

MakerDAO’s Dai stablecoin is the longest-standing decentralized alternative, with a significant market share. While Dai’s design promotes decentralization, the token has become a victim of centralization, with USDC comprising more than 50% of the assets backing Dai.

The MakerDAO community has progressively taken steps to diversify the platform’s backing. In October 2022, the community voted to convert 500 million USDC to U.S. Treasury bonds.

Recently, MakerDAO and the decentralized stablecoin space received another blow after a court ruling in England forced the platform to include an option to seize assets from a user, creating a considerable regulatory risk for platforms using and launching decentralized stablecoins.

Besides MakerDAO, Liquity has earned a decent reputation in decentralized finance as a purely ETH-backed stablecoin platform. Liquity is censorship-resistant, as it only provides smart contracts on Ethereum, which are not managed by administrators. The total supply of LUSD is 230 million, with LQTY as the utility token of the platform.

LQTY doubled in price after being listed on Binance on Feb. 28. However, there was alleged insider trading activity behind the price surge, as reported by anonymous on-chain analytics portal An Ape’s Prologue. Still, the token’s low issuance rate and real yield in protocol fees could give it a lot of advantages over governance-only tokens like Uniswap’s UNI (UNI) token.

Stablecoin platforms building liquidity and trust over time

Frax’s decision to migrate away from a partially algorithmic design to a fully backed stablecoin could see a rise in demand for FRAX. Moreover, Frax is a significant holder of Curve’s CRV and Convex Finance’s CVX token, enabling the DAO to incentivize liquidity provision on Curve. This is notable because adequate liquidity is one of the first requirements for a stablecoin’s success.

Related: Stablecoin adoption could lead to DeFi growth, says Aave founder

Currently, crypto market volatility discourages many users from minting crypto-collateralized stablecoins. The lack of trust in decentralized stablecoins and the long-standing permeability of centralized stablecoins across numerous exchanges make it harder for decentralized alternatives to gain market share.

Still, the long-term market opportunity for decentralized stablecoins is significant. Over time, decreased volatility and regulatory clarity around cryptocurrencies will likely increase the demand for crypto-backed stablecoins.

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