Stablecoins have become a key element in the cryptocurrency ecosystem, providing stable value in a market known for extreme volatility. From facilitating day-to-day transactions to supporting complex decentralized finance (DeFi) operations, stablecoins are critical to the functioning of the broader crypto economy. However, its design involves several complex trade-offs, collectively known as the “stablecoin trilemma.”
Source: Medium
1. Understanding the Three Dilemmas of Stablecoins
The stablecoin trilemma refers to the fact that when designing a stablecoin, it is almost impossible to simultaneously achieve the following three key goals:
Exchange rate stability: maintains a stable value, usually pegged to a fiat currency such as the U.S. dollar. This is crucial for user confidence, as stablecoins should always keep their value stable.
Capital efficiency: Efficient use of collateral or supporting assets. Ideally, a stablecoin should rely as little as possible on collateral to maintain its exchange rate, thereby increasing the efficiency and scalable functionality of the system.
Decentralization: Decentralized control through the Internet, getting rid of centralized control. Decentralization is a core principle of cryptocurrency, ensuring transparency and reducing the risk of single points of failure.
Striking a balance between these three is extremely challenging, and most stablecoins tend to prioritize one or two of these goals at the expense of others. In this article, we’ll explore how different types of stablecoins—specifically algorithmic and fiat-backed stablecoins—address this trilemma.
2. Algorithmic Stablecoins: Innovation and Risks
Algorithmic stablecoins attempt to maintain exchange rate stability through algorithms and market mechanisms rather than directly pledging assets. The most notorious example of an algorithmic stablecoin is TerraUSD ($UST), a project that captured the attention of the crypto world with its innovative approach but ultimately collapsed dramatically.
1. TerraUSD ($UST): The rise and fall
Launched by the Luna Foundation (LFG), $UST aims to maintain its 1:1 peg to the U.S. dollar through a balancing mechanism with the network’s native TokenTerra ($LUNA). The design philosophy is to mint $UST by destroying $LUNA and vice versa, thereby keeping $UST stable through supply and demand dynamics.
This mechanism, coupled with the high annualized returns (APRs) provided by Anchor Protocol, has attracted a large number of investors and users. At its peak, $UST was one of the most widely used stablecoins, and $LUNA’s market cap soared.
However, when market confidence faltered, the collapse of the system began. In May 2022, a massive sell-off caused $UST to decouple, losing its $1 value. As panic spread, the algorithm that was supposed to stabilize $UST instead exacerbated the problem, leading to a so-called "death spiral" in which the value of both $UST and $LUNA plummeted.
The collapse of $UST had widespread ramifications, wiping out billions of dollars in value and sending shockwaves through the broader crypto market. The incident also triggered widespread scrutiny from regulators, highlighting the risks inherent in algorithmic stablecoins. As you may remember, after the collapse of $LUNA, the crypto market’s winter became even more severe, ushering in an “ice age.”
While algorithmic stablecoins may offer high capital efficiency and decentralization, their reliance on market dynamics makes them vulnerable to extreme volatility and loss of confidence.
2. FRAX: Transition from algorithm stability to legal currency support
$FRAX was originally launched as a partial algorithmic stablecoin, with supported assets including $USDC and its native token $FXS. The system balances stability and capital efficiency by dynamically adjusting the ratio of $USDC and $FXS.
However, after the collapse of TerraUSD ($UST), the $FRAX team reconsidered its strategy. To avoid similar risks, $FRAX is gradually moving to a fully fiat-backed model, relying 100% on $USDC reserves. This strategic shift is designed to enhance stability and reduce vulnerabilities associated with algorithmic mechanics, positioning $FRAX as a safer option in the stablecoin industry.
Source: Medium
3. Stablecoins backed by legal currency: stability at the expense of decentralization
In contrast to algorithmic stablecoins, fiat-backed stablecoins like Tether (USDT) and USD Coin (USDC) maintain their exchange rate stability by holding fiat currency or equivalent asset reserves. This model provides strong exchange rate stability and capital efficiency, making these stablecoins indispensable in the cryptocurrency market.
1. Tether ($USDT): Pioneer
Tether ($USDT) was one of the first stablecoins to be widely adopted and remains the largest stablecoin by market capitalization. In theory, each USDT is backed by $1 or equivalent in reserves. This model has proven effective in maintaining exchange rate stability when Tether experiences significant market volatility.
However, Tether has been facing questions about the transparency of its reserves. Debate in the market over whether $USDT is fully backed by U.S. dollars, or whether Tether holds riskier assets in reserves, has prompted regulatory investigations and market questions. Despite these concerns, Tether still dominates the stablecoin market due to its liquidity and widespread adoption.
2. USD Coin ($USDC): Regulated Alternative
USD Coin ($USDC), issued by Circle in partnership with Coinbase, is positioned as a more transparent, regulated stablecoin alternative to Tether. $USDC’s reserves are regularly audited and are fully backed by cash and short-term U.S. Treasuries. This transparency makes $USDC a popular choice for institutions and DeFi projects looking for a reliable stablecoin.
However, $USDC is not without risks. The collapse of Silicon Valley Bank (SVB) in early 2023 affected $USDC, as a portion of its reserves were held at the bank. This led to a temporary decoupling of $USDC, with its value briefly falling to around $0.9, amid concerns that its reserves could suffer losses. Although the issue was eventually resolved, the incident exposed how fiat-backed stablecoins can be affected by external financial shocks even when fully collateralized.
3. Centralization Risks and Stablecoin Ecosystem
Both $USDT and $USDC illustrate the trade-offs inherent in fiat-backed stablecoins. Although they offer strong exchange rate stability and capital efficiency, they are still centralized entities that rely on trust in the issuing company. This centralization brings risks such as regulatory intervention, reserve mismanagement, or external shocks like the banking crisis that affected Circle.
Furthermore, the centralization of these stablecoins stands in sharp contrast to the idea of decentralization widely promoted in the cryptocurrency world. Many users and developers are wary of relying on centralized entities that may impose censorship, address bans, or other controls that undermine the permissionless nature of blockchain technology.
Despite these concerns, fiat-backed stablecoins have become an integral part of the cryptocurrency ecosystem. Their stability and liquidity allow them to play an important role in trading, DeFi, and even cross-border payments. However, due to its centralization and associated risks, people continue to explore more decentralized and stable solutions.
4. Conclusion: A realistic test of the stablecoin trilemma
The stablecoin trilemma poses fundamental challenges to the cryptocurrency industry. Algorithmic stablecoins like TerraUSD and early forms of $FRAX pursue decentralization and capital efficiency, but struggle to remain stable under market pressure. Fiat-backed stablecoins like $USDT and $USDC offer stability and efficiency at the expense of decentralization and introduce trust risks.
Each type of stablecoin represents a different approach to solving this trilemma, and their successes and failures provide valuable lessons for the future of digital finance. As the market evolves, we may see new models emerge that attempt to balance these trade-offs more effectively.
In the following article, we will explore crypto-asset-backed stablecoins, focusing on “$DAI”, a decentralized and over-collateralized stablecoin that has become a cornerstone of the DeFi ecosystem. Despite its low capital efficiency, $DAI has achieved significant success by leveraging Ethereum’s capabilities and maintaining a strong decentralized structure. We’ll analyze how $DAI responds to the trilemma, and its implications for the broader cryptocurrency market.
I hope this article has given you a deeper understanding of the stablecoin ecosystem and the challenges faced by these digital assets.
[Disclaimer] There are risks in the market, so investment needs to be cautious. This article does not constitute investment advice, and users should consider whether any opinions, views or conclusions contained in this article are appropriate for their particular circumstances. Invest accordingly and do so at your own risk.
This article is reproduced with permission from: "Deep Wave TechFlow"
Original author: Kenji Mitsusada
