How Maker and Frax Are The Diplomats of DeFi

Stablecoins Face Challenges In Wake Of Tornado Sanctions

Earlier this month, the crypto world was rocked by the Office of Foreign Asset Control’s move to sanction 44 addresses associated with Tornado Cash, putting the decentralized protocol on their Specially Designated Nationals and Blocked Persons list. 

With the announcement, it became outright illegal for US citizens to access the privacy-preserving protocol or otherwise face hefty fines and jail time. As a preemptive measure, Centre, the consortium behind USDC, froze $75,000 worth of USDC that were located in Tornado Cash’s smart contracts and nearly doubled the number of their banned addresses. The aftermath of the sanctions has resulted in intense discussions among crypto community members about censorship risks that exist throughout the ecosystem. 

In particular, stablecoins have been a flashpoint of this debate and for good reason. Stablecoins have proven to be one of the most utilized application areas of crypto. Today, there are over $150 billion worth of stablecoins in circulation and tens of billions of dollars in volume. Although the majority of activity comes from traders, stablecoins have been increasingly used for everyday activities such as salaries, remittances, payments, etc. Whatever the case, stablecoin use is growing and will continue to grow as more and more participants are onboarded to DeFi.

Yet, as the shadow of the USDC blacklisting looms, heated discourse online has fueled an array of emotional reactions. Decentralization purists have blasted DAI and FRAX for having USDC as collateral and have espoused alternatives that boast their anti-centralization prowess. Do they have a point though? What good is a stablecoin if it could be censored as simply as with an off switch? The answer is much more nuanced than what has proliferated. 

The Stablecoin Trilemma 

When it comes to designing a stablecoin, everyone is faced with the same three issues to tackle — decentralization, scalability, and peg. And right now, you can only choose two. 

USDC and USDT are fiat-backed centralized versions that have chosen the most extreme version of scalability by sacrificing decentralization completely. On the opposite end of the spectrum, stablecoins such as sUSD, LUSD, and RAI have prioritized decentralization above all else, yet are constrained in their growth by the amount of decentralized collateral available. 

Is there a middle ground that doesn’t sacrifice decentralization for scalability and yet can consistently maintain its peg? 

Currently, FRAX and DAI are leading the charge in this area. Both stablecoins have over $1 billion in market capitalization even after the bear market. One advantage that these stablecoins hold is that, unlike USDC and USDT, their custody does not lie in a central entity, but in permissionless smart contracts. By originating natively on-chain, their collateral can be transparently accounted for and allows them to adapt to the speed of crypto. 

Yet, they have been criticized for their reliance on centralized collateral in their bids to scale, with critics going so far as to say that there is nothing innovative about them and they are merely wrappers for USDC. 

While it is easy to have “holier than thou” decentralization purity contests, it’s harder to have a plan for adoption. This is not the first time people have fallen into this trap, especially those in the Ethereum community. Before 2021, few could have imagined a multichain world. 

Yet, at the beginning of that year, Binance Smart Chain took the space by storm, onboarding thousands of new users and paving the way for more economical chains such as Polygon, Avalanche, Fantom, etc. What maximalists failed to realize was how the overwhelming majority of the world does not abide by their mindset because they can’t afford to.

The hard truth that people must accept is that even if DAI and FRAX were to rid themselves completely of any centralized collateral, not only would they shrink in size, but USDC and USDT would grow even larger and take over any potential market share DAI and FRAX would have had.

Through the power of sheer network effects, it would only be a matter of time before USDC and USDT would command such a large lead that there would be no chance for any stablecoin, hybrid or fully decentralized, to catch up. The ramifications of overwhelming centralized stablecoin adoption would mean greater censorship risk for the entire crypto ecosystem.

Diplomacy

As the two most popular hybrid stablecoins, the role that DAI and FRAX have claimed for themselves is that of “Diplomats of DeFi.” Both stablecoins must walk a delicate tightrope between the on- and off-chain worlds. 

Allowing for decentralized experiments to grow, DAI and FRAX act as a barrier against outright centralization. FRAX in particular has gone out of its way to intertwine itself with the rest of DeFi with its positive-sum approach to partnerships. In fact, the majority of FRAX’s USDC collateral does not lie in solely USDC but has been placed in USDC/FRAX liquidity pairs on Curve and Uniswap, effectively having the LP tokens (and therefore smart contracts) from these protocols themselves back FRAX. 

By integrating deeper into DeFi while distancing itself from the USDC collateral, Circle would be forced to blacklist Curve and Uniswap smart contracts in order to blacklist FRAX. This would effectively not only destroy DeFi but also Circle’s business model.

Yet, even if Circle were to blacklist DAI and FRAX, one can speculate that they wouldn’t do so without warning. Too many everyday people would be affected by the decision if it were to be made in such a brash manner. In addition, just as banks receive margin calls if they have tens or hundreds of millions of collateral on the line, I’d imagine similar conversations will happen here. 

DAI and FRAX are two of the largest holders of USDC on-chain, and so, just blacklisting them outright would seem infeasible.

Conclusion

DAI and FRAX are a reflection of the scalability available on-chain. Right now, the only way to scale is with USDC but as Ethereum grows in market cap and more debt instruments come online, DAI and FRAX could wind down USDC dependence without compromising their pegs and scalability. One debt experiment that is starting very soon is the launch of Fraxlend which will allow for custom “term sheet” lending.

Although it is a noble pursuit, only pursuing decentralized collateral stablecoins is a fool’s errand. If scalability isn’t considered at all, then fiat-backed stablecoins will have no competition at all and reign supreme. The DeFi community should proactively be promoting different stablecoin experiments that play with different levels of decentralization and scalability.