main ideas

  • The stablecoin trilemma refers to the challenge of creating a stablecoin that strikes a balance between decentralization, price stability, and capital efficiency.

  • There are different types of stablecoins, such as crypto-backed, cryptocurrency-backed and algorithm-backed, with each type prioritizing different aspects of the trilemma, leading to many trade-offs.

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

the introduction

Stablecoins are digital currencies designed to track the value of underlying assets, such as local, certified currencies. However, creating a stablecoin that strikes a balance between decentralization, price stability, and capital efficiency is a challenge. In this article, we will highlight the trilemma of stablecoins, its main elements, and the different types of... Stablecoins, swaps and their potential solutions.

What is the stablecoin trilemma and why does it exist?

The stablecoin trilemma refers to the challenge of designing stablecoins that can achieve three key attributes simultaneously: decentralization, price stability, and capital efficiency. Each of these aspects is important for effective performance. For stablecoins, achieving all three features together is a major challenge.

The stablecoin trilemma exists because each of these attributes is inherently at odds with the others. For example, price stability often requires strong collateral, which can reduce capital efficiency due to the need to To over-collateralize, while capital efficiency aims to reduce the amount of collateral required, but this may lead to some risks in terms of price stability. 

Elements of the stablecoin trilemma

Decentralization

Decentralization refers to the distribution of control and decision-making away from a central authority. In the context of stablecoins, decentralization means that a stablecoin is subject to multiple points of control rather than a single central authority and that its connection is maintained through some protocols and algorithms. It is worth noting that this situation is ideal for stablecoins. Decentralization and that most stablecoins are still partially or completely centralized.

Price stability

Stablecoins' price stability refers to their retention of a fixed value pegged to an underlying asset, such as certified local currencies

For example, if a stablecoin is pegged to the US dollar, the value of one stablecoin should be 1 USD, which means you can buy a cup of coffee today knowing that its price in stablecoins will be the same tomorrow, next week, or the next month. 

Furthermore, individuals in countries experiencing high inflation can use stablecoins to protect their savings. For example, the local currency in Argentina experienced significant inflation that reduced its purchasing power, thus, Many have turned to stablecoins to protect their savings from the rapid decline in the value of the currency.

Capital efficiency

Capital efficiency refers to how well a stablecoin uses its backing assets (collateral) to keep its value stable. You can think of it as how much value a stablecoin needs to hold in reserve to ensure that the value of each stablecoin unit is exactly equal to its value. It has to be, and the higher the collateral required to maintain the value of the stablecoin, the lower the capital efficiency of the coin. 

For example, a stablecoin that requires a collateral of $1.50 to issue $1 worth of stablecoin is less capital efficient than one that requires only $1.10 of collateral for the same $1 issue.

A practical example of a stablecoin that lacks capital efficiency is DAI. For example, imagine that in order to issue $1 worth of DAI coins, a user might need to reserve $1.50 worth of Ethereum (ETH), which helps... Maintaining DAI stability, but affecting capital efficiency due to more value being tied than what the stablecoin itself represents.

Stablecoins backed by the approved local currency

LCC-backed stablecoins are digital currencies backed by reserves of LCC held by a central entity. Popular examples of LCC-backed stablecoins include Tether (USDT) and USD Coin (USDC). 

Stablecoins backed by approved local currencies can maintain a stable price and capital efficiency (i.e. they use reserve funds efficiently), but they rely on a centralized structure, which means that price stability and capital efficiency come at the expense of decentralization.

Algorithmic stablecoins

Algorithmic stablecoins are stablecoins that use algorithms to maintain their correlation (i.e. keep their value stable). For example, algorithms may automatically adjust the supply of an algorithmic stablecoin to help it stay at a fixed value. If the price starts to rise, the algorithms create more coins as the price falls, and if the price falls, they reduce the supply so the price rises again.

Algorithmic stablecoins aim to be decentralized and capital efficient, but they often have difficulty with price stability. The reason is that their stability depends heavily on demand in the market, and some algorithms May fail and lead to disengagement under pressure.

Cryptocurrency-backed stablecoins

Cryptocurrency-backed stablecoins are stablecoins backed by other cryptocurrencies. Imagine a stablecoin that promises to always be worth $1, and to guarantee that value, you have to secure it by staking another cryptocurrency worth more than $1 in a digital vault. For example, to get $1 worth of this stablecoin, you would need to deposit $1.50 worth of ETH, where the additional value ($0.5) is used as a safety net to absorb changes in the value of ETH and help keep the value of the stablecoin constant at $1. 

Cryptocurrency-backed stablecoins are typically over-collateralized to mitigate collateral volatility, and while they achieve a degree of decentralization and price stability, they often lack capital efficiency because they require over-collateralization to ensure stability.

DAI is one of the most popular cryptocurrency-backed stablecoins, using Ethereum and other cryptocurrencies as collateral to keep its value close to $1.

Solving the stablecoin trilemma

There is no perfect solution to the stablecoin trilemma, but there are several ideas proposed to address the problem.

Mixed models

Hybrid models combine elements from different types of stablecoins to solve the stablecoin trilemma. For example, a stablecoin may be partially collateralized by both certified local currencies and crypto assets, which can enhance capital efficiency while maintaining a degree of decentralization and stability.

Advanced algorithms

Advanced algorithms are designed to improve the stability and resilience of stablecoins. The goal is to reduce the dependence of algorithmic stablecoins on market trends and enhance their ability to withstand market fluctuations, helping them effectively maintain price stability. 

Algorithmic stablecoins can achieve significant levels of capital efficiency and decentralization, and if they can effectively maintain price stability, they may solve the trilemma, but it is worth noting that the practical application may be more difficult than the theoretical talk.

Insurance and risk management

Incorporating insurance mechanisms and risk management strategies can help provide an additional layer of security for stablecoins, and this may include setting aside funds to cover potential collateral failures or implementing liquidity management protocols a-156> and volatility risk.

Concluding thoughts

The stablecoin trilemma highlights the challenge of balancing decentralization, price stability, and capital efficiency for stablecoins. Different types of stablecoins prioritize different aspects of the trilemma, leading to many trade-offs. Potential solutions include hybrid models, advanced algorithms, and management strategies. Risks.

Disclaimer: In compliance with the requirements of the Digital Assets Act (MiCA), unauthorized stablecoins are subject to specific restrictions for users in the European Economic Area. For more information, please click here.

Disclaimer: This content is provided to you “as is” for general information and educational purposes only, without any representations or warranties of any kind, and should not be construed as financial, legal or professional advice, nor is it intended as a recommendation to purchase any product or service In particular, you must seek the assistance of specialized advisors to provide advice. If the article is provided by a third party, please note that the opinions expressed are those of that third party and do not necessarily reflect the views of Binance Academy. Please read our full disclaimer here for more details. Digital asset prices can be volatile, the value of your investment may increase or decrease, and you may not get back the amount you invested. You are solely responsible for your investment decisions, and Binance Academy is not responsible for any losses you may incur. This article should not be construed as financial, legal or professional advice. For more information, please see Terms of Use and Risk Warning.