Key Points

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

  • Different types of stablecoins, such as those linked to fiat currencies, those linked to cryptocurrencies and algorithmic ones, prioritize different aspects of the trilemma, resulting in imbalances (trade-offs) between these aspects.

  • Potential solutions to the stablecoin trilemma include 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, it is challenging to create a stablecoin that balances decentralization, price stability and capital efficiency. In this article, we will explore the stablecoin trilemma, its main components, the different types of stablecoins and their trade-offs, as well as possible solutions.

What is the stablecoin trilemma and why does it exist?

The stablecoin trilemma refers to the challenge of designing stablecoins capable of simultaneously achieving three main attributes: decentralization, price stability and capital efficiency. Each of these aspects is crucial to the effective performance of stablecoins, but achieving the optimal level for all three at the same time has proven to be a significant challenge.

The stablecoin trilemma exists because each of the attributes conflicts with the others. For example, price stability often requires strong collateral (collateral), which can reduce capital efficiency due to the need for overcollateralization. Capital efficiency aims to minimize the required value of collateral, but this can pose risks to price stability. 

Components of the stablecoin trilemma

Decentralization

Decentralization refers to the distribution of control and decision-making. In other words, it is when there is no central authority. In the context of stablecoins, decentralization implies that a stablecoin is guided by multiple points of control rather than a single central authority and its pegged value is maintained through protocols and algorithms. It is important to note that this would be an ideal case of a decentralized stablecoin. Most stablecoins are still partially or fully centrally managed.

Price stability

In the case of stablecoins, price stability means maintaining a consistent value pegged to an underlying asset, such as a fiat currency . This is essential for its use as a medium of exchange and a secure store of value over time, even during periods of high market volatility. In practice, this allows people to use stablecoins for everyday transactions, just as they would use traditional money.

For example, if a stablecoin is pegged to the US dollar, 1 stablecoin must always be worth 1 USD. This means you can buy a cup of coffee today and know that its price in stablecoins will be the same tomorrow, next week or next month. 

Additionally, people in countries with high inflation can use stablecoins to protect their savings. For example, in Argentina, the local currency is facing high inflation, reducing its purchasing power. Many have turned to stablecoins to preserve their savings from rapid devaluation.

Capital Efficiency

Capital efficiency refers to how well a stablecoin uses its pegged assets (collateral) to keep its value stable. Think of this as the value that the stablecoin needs to hold in reserve to ensure that each unit of the stablecoin is worth exactly what it should be. The greater the collateral required to maintain the value of a stablecoin, the less capital efficient it is. 

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

A practical example of a stablecoin with low capital efficiency is DAI. Imagine that to issue $1 worth of DAI, you might need to lock $1.50 worth of Ether (ETH). This helps maintain the stability of DAI, but is capital inefficient because it locks in more value than the stablecoin itself represents.

Types of stablecoins and their trade-offs

Stablecoins pegged to fiat currencies (Fiat-backed)

Fiat-backed stablecoins are cryptocurrencies backed by reserves of fiat currencies held by a central entity. Popular examples of stablecoins pegged to fiat currencies include Tether (USDT) and USD Coin (USDC). 

While stablecoins pegged to fiat currencies can maintain a stable price and are capital efficient (i.e., they use reserve money effectively), they rely on a centralized structure. In other words, they sacrifice decentralization to offer price stability and capital efficiency.

Stablecoins algorĂ­tmicas

Algorithmic stablecoins use algorithms to keep their value pegged (i.e. keep their value stable). For example, algorithms can automatically adjust the supply of an algorithmic stablecoin to help it maintain a fixed value. If the price starts to rise, the algorithms create more coins to bring the price down. If the price drops, they reduce supply to raise the price.

Algorithmic stablecoins aim to be decentralized and capital efficient, but often struggle with price stability. The reason is that its stability depends greatly on demand and market algorithms that can fail and lose the value attached in pressure situations.

Stablecoins pegged to cryptocurrencies (Crypto-backed)

Stablecoins pegged to cryptocurrencies are collateralized by other cryptocurrencies. Imagine a stablecoin that promises to always be worth $1. To secure that value, you protect it by locking more than $1 worth of another cryptocurrency in a digital vault. For example, to get $1 of this stablecoin, you may need to deposit $1.50 worth of ETH. The extra $0.5 acts as a safety net to absorb changes in the value of ETH and help keep the stablecoin's value fixed at $1. 

Stablecoins pegged to cryptocurrencies are typically overcollateralized to mitigate collateral volatility. While they offer a degree of decentralization and price stability, they are often capital inefficient because they need additional collateral values ​​to maintain stability.

DAI is one of the most popular stablecoins pegged to cryptocurrencies. It uses Ether and other cryptocurrencies as collateral to keep its value close to $1.

Solution to the stablecoin trilemma

There is no perfect solution to the stablecoin trilemma, but several ideas have been proposed to solve the problem.

Hybrid models

Hybrid models combine elements from different types of stablecoins to address the stablecoin trilemma. For example, a stablecoin can be partially collateralized (collateralized) by fiat assets and crypto assets. This can increase 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 aim is to reduce algorithmic stablecoins' dependence on market sentiment and increase their ability to withstand market fluctuations, helping them maintain price stability efficiently. 

Algorithmic stablecoins can achieve high levels of capital efficiency and decentralization. If they were also able to maintain price stability efficiently, they would potentially resolve the trilemma. In practice, however, this is not so simple.

Insurance and risk management

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

Final considerations

The stablecoin trilemma refers to the challenge of balancing the decentralization, price stability, and capital efficiency aspects of a stablecoin. Different types of stablecoins prioritize different aspects of the trilemma, resulting in various trade-offs. Potential solutions include hybrid models, advanced algorithms and risk management strategies.

Further reading

Disclaimer: In line with MiCA requirements, unauthorized stablecoins are subject to certain restrictions for EEA users. For more information, please click here.

Disclaimer: This content is presented to you “as is” for informational and educational purposes only, without warranty of any kind. The content should not be construed as financial, legal or professional advice, and is not intended to recommend the purchase of any specific product or service. You should seek your own advice from professional advisors. In the case of contributions and articles submitted by third-party contributors, please note that the opinions expressed are those of the respective author and do not necessarily reflect the opinions of Binance Academy. For more details, please read our disclaimer here. Digital asset prices can be volatile. The value of your investment may increase or decrease and you may not get back the amount invested. You are solely responsible for your investment decisions and Binance Academy is not responsible for any of your possible losses. This material should not be construed as financial, legal or professional advice. For more information, please see our Terms of Use and Risk Warning.