The Stablecoin Trilemma: What Is It?

Key Takeaways

• The stablecoin trilemma speculates that each stablecoin currently on the market requires a trade-off between varying degrees of decentralization, price stability, and capital efficiency.
• Fiat-backed and commodity-backed stablecoins tend to trade off decentralization for price stability and capital efficiency.
• Crypto-backed stablecoins tend to trade off capital efficiency for price stability and decentralization.
• Algorithmic stablecoins tend to trade off price stability for decentralization and capital efficiency.

Stablecoins are one of the most critical components of decentralized finance (DeFi). Their wide-ranging applications stretch through all financial sectors, including spot and derivatives markets, lending protocols, cross-border payments, remittances, etc.

The total addressable market for stablecoins is technically the sum of all money globally. This colossal opportunity has spurred several designs of stablecoins aiming to capture a significant share of the market. However, they all face the same challenge of trade-offing between varying degrees of decentralization, price stability, and capital efficiency – the stablecoin trilemma.

Our last article introduced the basics of stablecoins, the different types, and how people use them. Today we will be looking at the features that a cryptocurrency needs to become a global stablecoin.

Decentralization

Decentralization measures the degree of dependency on a central system. A centralized stablecoin is controlled by a single entity or small group of participants. In a centralized system, it is difficult for other users to verify the value of the reserve backing the stablecoin, thus defaulting to a trust system. Conversely, a decentralized stablecoin reserve can be verified by anyone.

Price Stability

Price stability measures how well a stablecoin maintains its peg to the underlying sovereign currency or reference asset. Unlike speculative cryptocurrencies like BTC and ETH, stablecoins are designed to maintain a constant purchasing power similar to the pegged asset even in volatile market conditions. A functional stablecoin should be able to maintain its peg in all market conditions.

Capital Efficiency

Capital Efficiency measures the cost of minting a stablecoin relative to its value. i.e., does it cost more or less than $1 to mint a $1 equivalent of a dollar-pegged stablecoin? Inefficient stablecoins have to lock up and spend more than $1 to mint the $1 equivalent of the stablecoin. The lesser the cost of minting a new stablecoin, the more efficient it is.

Types of Stablecoins and Their Trade-offs

As discussed in our last article,  they are mainly four types of stablecoins, and each tends to make some trade-off between the three corners of the stablecoin trilemma.

Fiat-backed and Commodity-backed Stablecoins

Fiat-back and commodity-backed stablecoins trade-off decentralization for capital efficiency and price stability. Because these stablecoins are backed by centralized forms of money, they are at the mercy of the centralized issuers. These stablecoins rely on trust, as the users have to trust that the issuers' reserve claims are valid and that the issuers will be good actors. These stablecoins do not conform to the ethos of blockchain and are not optimal for the global adoption of decentralized finance. A prime example of a fiat-backed stablecoin is USDT.

Crypto-backed Stablecoins

Crypto-backed stablecoins tend to trade off capital efficiency for decentralization and price stability. These stablecoins require excess collateral to provide a buffer against the volatility of the reserve assets - cryptocurrencies. A typical example is DAI from the MakerDAO protocol. DAI is a US dollar-pegged stablecoin that is 150% overcollateralized by cryptocurrencies. To mint a $1 worth of DAI, users will have to lock up $1.5 worth of accepted cryptocurrencies. Crypto-backed stablecoins are inherently wasteful and not optimal for the global adoption of decentralized finance.

Algorithmic Stablecoins

Algorithmic stablecoins are decentralized and capital efficient, but their reflexivity makes them unstable. They tend to be over-reliant on social sentiments, thus, making them only as good as the market believes them to be. The fragility of these stablecoins tends to show in market sell-offs.

They are several algorithmic stablecoins designs with different approaches to the stablecoin trilemma. The most common is UST which uses the burn and mint mechanism. Terra’s UST burns its native token LUNA to mint  UST and vice versa.

Delta-neutral stablecoins are another example of algorithmic stablecoins. Delta-neutral stablecoins are fully backed by delta-neutral positions on futures and perpetual markets like SynFutures.

Final Thoughts

Stablecoins are critical to the mass adoption of decentralized finance. As users continue to join the space, demand for stablecoins will rise. They have been several stablecoin designs in the brief history of cryptocurrency, though many have failed. However, the industry will continue to research and develop new techniques, and we can expect to see new stablecoins enter the crypto and DeFi markets in the future.

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