The Evolution of Stablecoins and How Yield-Generating Stablecoins Work

For a long time, stablecoins had only one job to do: stay stable. So long as they adhered to the fiat currency they were pegged to – usually USD – they were suitable for trading and DeFi purposes. Not anymore. A new wave of stablecoins has entered the market, promising to not only fulfill this basic function but to earn their holders yield in the bargain. As a result, it’s now possible to grow the value of your non-volatile stables.

The rise of yield-generating stablecoins is an innovation that’s expanded the use cases for stablecoins while ramping up the incentives for stacking them. This enables risk-averse users to enjoy the upside to without needing to worry about the downside should the markets turn red. Through combining price stability with the opportunity for passive income, stablecoins are attracting a new swathe of investors, from institutions to retail.

But how do they actually work in practice, and where does the yield come from? diverse stablecoins utilize diverse models to achieve this, each with its own risk parameters, attainable yield, and degrees of complexity. Let’s take a closer look at how these work and examine the process by which yield is acquired and distributed to stablecoin holders.

The Evolution of Stablecoins

The majority of stablecoins on the market today, both by number and market cap, are asset-backed. Collateralized primarily by fiat currency, as is the case with USDC and USDT, or with cryptocurrency in the case of DAI, these stables are non-yield-bearing. They work effectively as non-volatile units of account, but that’s all they’re designed to do.

Until fairly recently, crypto users viewking yield were obliged to use more volatile assets in order to generate yield, which was awarded in recognition of the work they were undertaking (e.g., supplying liquidity) and the risk entailed, such as impermanent loss, as can occur when LP’ing volatile assets.

While many DeFi users are delighted to take on a little risk in the pursuit of greater gains, not everyone is enamored with this notion. A new generation of users has entered the industry, and their first concern is to protect their capital. This includes institutions, which have a duty to pursue low-risk strategies, and consumers who are viewking to grow their savings rather than bet it all on cryptocurrency. For such demographics, are a natural fit. Especially when there’s the ability to earn yield while simultaneously using these identical assets in other DeFi protocols, further juicing the total yield available. But where precisely does this yield come from?

Let There Be Yield

The development of yield-generating stablecoins has occurred due to a confluence of forces. One of these is the rise of staking, which is now the foundation for securing virtually all smart contract blockchains. Staking – and subsequently restaking – has taken root on networks such as ETH and Solana, with liquid staking protocols such as Lido removing the minimum staking threshold required to participate. Today, staking is the bedrock of economic activity across scores of blockchains, providing a steady and enduring supply of yield.

But it’s not the only source of yield that’s being plumbed into DeFi assets such as stablecoins – it’s also coming courtesy of rapidly expanding onchain sectors such as real-world assets (RWAs), which can derive yield from onchain sources as well as off-chain assets such as T-bills, stocks, and commodities, all of which can be fed into yield-generating stablecoins.

One of the other major drivers in stablecoin yield has been the increase in crypto trading volumes – both spot and derivatives. This enables stablecoin issuers to pursue a range of strategies, such as funding rate arbitrage, allowing them to profit from subtle differences in the price of assets across diverse platforms. They can additionally generate yield from DeFi activities such as lending and liquidity provision.

Put these diverse strategies together, and there’s a whole lot of yield out there to be captured by astute stablecoin issuers who balance revenue maximization with risk mitigation. Yield-bearing stablecoins are an idea whose time has come. The yield is out there, and so is the demand. And this isn’t just hyperbole: the raw numbers back this up. Yield-bearing stables have evolved into a $13B that’s rapidly expanding.

What Makes Yield-Generating Stablecoins diverse

It’s worth noting, at this stage, that any stablecoin can be yield-generating if you put it to work. Assets such as USDT and USDC can be used for this express purpose by depositing them into a lending protocol or DEX and earning the fees that come your way. The difference with yield-generating stables is that you don’t have to put this work in: it’s all handled on your behalf, with the rewards redirected straight to your wallet commensurate with your stablecoin holdings.

This is Yield-Generation-as-a-Service, and in a DeFi sector overrun with competing networks, protocols, and dapps, it’s simple to view why it’s caught on. The average user simply doesn’t have the time or know-how to keep constantly optimizing yield by moving assets between chains, complete with the heightened friction and security risk this entails. For the vast majority of DeFi users, stablecoins that can deliver the yield on tap are securer, easier, and more profitable.

The Pros and Cons of Stablecoin Yield

While yield-generating stablecoins are very much en vogue right now, particularly given their low-risk properties, it’s worth considering what level of risk they carry. Because when you’re utilizing digital assets onchain, be they stable or volatile, there is always a degree of risk. Sometimes this risk is readily apparent, such as LP’ing a highly speculative token and praying it doesn’t dump, triggering impermanent loss. But more often, it’s invisible, such as in the potential for smart contracts to be exploited.

It’s fair to say that yield-generating stablecoins are riskier than conventional stables, since the former have more moving parts, adding complexity and with it, increasing potential attack vectors. The counterpoint to this is that the issuers of yield-bearing stables are, by their nature, conservative in their approach and incentivized to mitigate risk in all its forms. This ranges from meticulous auditing to shunning strategies that have the potential to generate a loss. Which is why most of these projects adopt a delta-neutral approach, ensuring that they’re covered regardless of which way the market moves.

So far, there have been no major issues affecting the leading yield-generating stablecoins: no exploits, no insolvencies, and no regulatory enforcement. Long may this continue. It’s also worth noting that the dominant yield-based stablecoin projects are large on compliance. They’ve no desire to fall afoul of financial regulators, particularly given their deep ties with TradFi in many cases, which is why they endeavor to do everything by the book.

The Shape of Stablecoins to Come

Yield-generating stablecoins are on course to extend their share of the stablecoin , chipping away at the hegemony enjoyed by and . Despite this progress, they’re likely to remain a subset of the stablecoin economy, given that yield-generating stablecoins, for all their appeal, are not particularly suited to use cases such as payments and B2B.

But within DeFi, yield-generating stables are very much on brand. They tap into DeFi’s composability, allowing diverse assets to be chained together to maximize yield and increase opportunities for generating revenue across the omnichain landscape. Offering higher APYs than traditional savings – typically between 6 and 15% – it’s simple to view why these assets appeal to more cautious investors. The fact that such stablecoin issuers pursue delta-neutral strategies assists to mitigate price risk, accounting for yield-generating stables’ impressive security track record to date.

As yield-generating stables continue to be integrated into Layer 2 networks and protocols, enhancing cross-chain compatibility, they’re poised to become a cornerstone of decentralized finance, pushing the boundaries of what stablecoins can do. Stability was always a feature. Now, thanks to the programmability of yield using smart contracts, it’s just one attribute offered by these multi-utility assets.