Key Points

• The stablecoin trilemma refers to the challenge of creating a stablecoin that balances decentralization, price stability, and efficiency in the use of funds.

• There are several different types of stablecoins, including fiat-backed stablecoins, cryptocurrency-backed stablecoins, and algorithmic stablecoins, which prioritize different aspects of the trilemma and make different trade-offs.

• Potential solutions to the stablecoin trilemma include adopting hybrid models, risk management strategies, and advanced algorithms.

Introduction

Stablecoins are cryptocurrencies designed to track the value of an underlying asset such as fiat currency. However, creating a stablecoin that balances decentralization, price stability, and efficiency in the use of funds is extremely challenging. In this article, we will explore the stablecoin trilemma and its key components, different types of stablecoins and their trade-offs, and potential solutions.

An introduction to the stablecoin trilemma and why it exists

The Stablecoin Trilemma refers to the challenge of designing a stablecoin that simultaneously achieves three key properties: decentralization, price stability, and high capital efficiency. Each of the three aspects is critical to the effective performance of a stablecoin, but it has proven to be extremely challenging to achieve the best levels of all three simultaneously.

The stablecoin trilemma exists because each property is inherently in conflict with the others. For example, to maintain price stability, strong collateral is usually required, and this need for excess collateral may reduce the efficiency of fund use. To improve fund efficiency, it is necessary to minimize the amount of collateral required, but this may lead to risks in terms of price stability.

Components of the Stablecoin Trilemma

Decentralization

Decentralization refers to the dispersion of control and decision-making power from a single centralized institution. In the case of stablecoins, decentralization means that stablecoins are guided by multiple control points rather than a single centralized institution, while maintaining their pegged status through protocols and algorithms. It is worth noting that this is the ideal situation for decentralized stablecoins, and most stablecoins still have partially or even completely centralized characteristics.

Price stability

The price stability of a stablecoin means that its value is always pegged to an underlying asset (such as a fiat currency). This is essential for stablecoins to be used as a medium of exchange and a secure store of value in the long term, even during periods of market volatility. In fact, this property allows people to use stablecoins for daily transactions just like traditional currencies.

For example, if a stablecoin is pegged to the U.S. dollar, then 1 of that stablecoin should always be worth 1. That is, the price of a cup of coffee in stablecoins today will be the same as the price of that cup of coffee in stablecoins tomorrow, next week, or next month.

In addition, people in high-inflation countries can also use stablecoins to protect their savings. For example, in Argentina, the purchasing power of the local currency has been reduced by severe inflation. Many people have turned to stablecoins to protect their savings from rapid depreciation.

Efficiency of capital use

Fund efficiency refers to how well a stablecoin uses its backing assets (i.e. collateral) to maintain its value. You can think of it as: how much value does a stablecoin need to reserve to ensure that the value of each unit of the stablecoin is exactly the same as it should be. The more collateral required to maintain the value of a stablecoin, the lower its fund efficiency.

For example, a stablecoin that requires $1.50 worth of collateral to issue $1 worth of stablecoin is a less efficient use of funds than a stablecoin that only requires $1.10 of collateral to issue $1 worth of stablecoin.

DAI is a typical example of a stablecoin with low capital efficiency. For example, to issue $1 worth of DAI, a user may need to lock up $1.50 worth of Ether (ETH). This helps maintain the stability of DAI, but it is a low capital efficiency because the value it is bound to exceeds the value it represents.

Types of stablecoins and the trade-offs they make

Stablecoins backed by fiat currencies

Fiat-backed stablecoins are cryptocurrencies that are backed by fiat currency reserves held by a centralized entity. Currently, the more popular fiat-backed stablecoins include Tether (USDT) and USD Coin (USDC).

While fiat-backed stablecoins can maintain stable prices and have high capital efficiency (i.e., they can effectively utilize reserve currencies), they rely on a centralized structure, which means that their price stability and high capital efficiency come at the expense of decentralization.

Algorithmic Stablecoins

Algorithmic stablecoins are stablecoins that use algorithms to maintain their pegs (i.e. keep their value stable). For example, algorithmic stablecoins can use algorithms to automatically adjust their supply to ensure that they maintain a fixed value. If the price starts to rise, the algorithm will create more tokens to lower the price. If the price falls, the algorithm will reduce the token supply to drive the price back up.

Algorithmic stablecoins aim to achieve decentralization and high capital efficiency, but often have difficulty maintaining price stability. The reason is that their stability depends largely on market demand and algorithms, which may fail and decouple under pressure.

Stablecoins backed by cryptocurrencies

Crypto-backed stablecoins are stablecoins that are backed by other cryptocurrencies. For example, a stablecoin promises that its value will always be $1. To ensure this value, you can lock more than $1 worth of another cryptocurrency in a digital vault. For example, to get $1 worth of this stablecoin, you might need to deposit $1.50 worth of ETH. This extra $0.5 acts as a safety net to absorb fluctuations in the value of ETH, helping to maintain the value of the stablecoin at $1.

Stablecoins backed by cryptocurrencies are often overcollateralized to reduce the volatility of collateral. Although such stablecoins achieve a certain degree of decentralization and price stability, they are usually less efficient in terms of capital use because they require overcollateralization to ensure stability.

DAI is one of the most popular crypto-backed stablecoins. It uses ether and other cryptocurrencies as collateral to maintain its value close to $1.

The solution to the stablecoin trilemma

There is no perfect solution to the stablecoin trilemma, but various ideas have been proposed to address this problem.

Hybrid Model

Hybrid models combine elements of different stablecoin types in an attempt to solve the stablecoin trilemma. For example, stablecoins can be partially collateralized by fiat assets and crypto assets. This has the potential to improve the efficiency of capital use while maintaining a certain degree of decentralization and stability.

Advanced Algorithms

Advanced algorithms are designed to improve the stability and resilience of stablecoins. Their goal is to reduce algorithmic stablecoins' dependence on market sentiment and enhance their ability to withstand market fluctuations, thereby effectively maintaining price stability.

Algorithmic stablecoins can achieve extremely high capital efficiency and decentralization. If they can also effectively maintain price stability, it is possible to solve the stablecoin trilemma. But in reality, it is easier said than done.

Insurance and Risk Management

Developing insurance mechanisms and risk management strategies can provide an additional layer of security for stablecoins. This may require setting aside funds to cover potential collateral losses, or implementing protocols to manage liquidity and volatility risks.

Conclusion

The stablecoin trilemma highlights the challenges that stablecoins face in balancing decentralization, price stability, and efficiency in the use of funds. Different types of stablecoins prioritize different aspects of the trilemma and make different trade-offs. Potential solutions to the stablecoin trilemma include the use of hybrid models, advanced algorithms, and risk management strategies.

Further reading

• Why do stablecoins decouple?

• What is Tether (USDT)?

• What is MakerDAO (DAI)?

• What is the blockchain trilemma?

Disclaimer: Unauthorized stablecoins are subject to certain restrictions in the European Economic Area (EEA) under the Markets in Crypto-Assets Act (MiCA). For more information, please click here.

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