The Stablecoin Trilemma
Why we have yet to see a stablecoin that is decentralized, stable, and capital efficient.
Over the past several years, the usefulness, potential, and opportunity within the realm of stablecoins have come front and center. This is not just true within the cryptoasset industry but among academics, governments, and businesses. The ability of stablecoins, a blockchain-based digital asset whose value is typically tied to a stable asset (like the U.S. dollar), to remove market volatility and enable value transfer to be instantaneous, transparent, and virtually free is unprecedented.
Accordingly, the stablecoin sector stands as the largest opportunity in crypto, with a total addressable market (TAM) equivalent to the value of the world’s money (M2), or more than $90T. Moreover, as detailed in Sébastien Derivaux’s Crypto Banking 101, stablecoins also enable holders self-custody and instant redemption of their wealth without assuming the risks associated with traditional financial institutions that participate in fractional reserve banking. As a result, since January 1, 2021, the total stablecoin market cap has ballooned more than +475% to a jaw-dropping $158B.
But stablecoins are not without their trade-offs. Much like “The Blockchain Trilemma,” which states that networks cannot be fully decentralized, secure, and scalable, we have yet to see a stablecoin that is completely decentralized, stable, and capital efficient. This phenomenon, known as “The Stablecoin Trilemma,” states that a stablecoin must sacrifice one of the aforementioned attributes. Said differently, stablecoins issuers/creators must decide how collateral is held, how tokens are issued (decentralization), how to maintain a 1:1 peg (stability), and how much capital is required to mint $1 worth of a token (capital efficiency).
Because the world has yet to see a stablecoin that solves the trilemma by being sufficiently decentralized, stable, and capital efficient, it’s essential to understand what it means for a stablecoin to have these three characteristics and to what degree. After reading this piece, you can expect to better understand each of these properties, their respective trade-offs, various stablecoin designs, and the opportunities that exist in solving the stablecoin trilemma.
What Is Decentralization?
A stablecoin is considered decentralized when there is little to no reliance on a centralized party to either issue and/or manage the stablecoin’s underlying collateral; such is the case for Dai (DAI) and Magic Internet Money (MIM). Conversely, when one or more entities have the power to alter a stablecoin’s supply and/or self-custody its collateral, the stablecoin is considered more centralized - think Circle’s USDC stablecoin and Tether’s USDT stablecoin.
While more centralization can enable stability and greater capital efficiency, more decentralized stablecoins are not always burdened by counter-party risk, regulatory risk, or capital efficiency limitations. However, note that for this to be the case, projects/protocols must also be able to prove they are “sufficiently decentralized,” as outlined by Polygon’s Chief Legal Officer Marc Boiron. For example, market participants don’t have to trust that a centralized entity will efficiently manage reserves and that the stablecoin is collateral-backed as promised. Nor do they have to worry about regulators potentially limiting the stablecoin’s usefulness in the same way as centralized stablecoins.
Consider Tether’s latest transparency report, which disclosed that nearly 6.8% of reserves are in “Secured Loans,” and 8.4% are in “Other Investments (including digital tokens).” Additionally, the U.S. Treasury Department’s ban on Ethereum coin mixer Tornado Cash on August 8, 2022, lends insight into the value behind decentralized stablecoins. Data from Dune Analytics shows that Circle froze over 75,000 USDC worth of funds linked to the 44 Tornado Cash addresses sanctioned by the U.S. Office of Foreign Assets Control’s Specially Designated Nationals and Blocked Persons (SDN) list. The unprecedented move showcases how centralized stablecoins are far from censorship-resistant, meaning that nation-states can have more control and influence than desired.
Said ambiguity can be a legitimate concern for market participants and weigh on demand. But on the other hand, centralization can unlock operational efficiencies. That is to say, stablecoin issuers, like Tether and Circle, can make more informed and swift decisions relating to governance and allocation of reserves. Contrary to MakerDAO, which recently saw a proposal for more centralization amid internal debate surrounding the DAO’s struggle to make informed and timely decisions, centralization opens the door to greater operational efficiency. For example, instead of reaching a consensus on what paths to pursue and how to allocate reserves optimally, centralized issuers can make said decisions at their own accord and alongside a dedicated team with domain expertise. This compares to relying on passive token holders with little-to-no relevant experience and knowledge. If a stablecoin cannot adapt and innovate alongside the ever-changing crypto market, there will forever be a risk of falling into irrelevance.
Notwithstanding the trade-offs, centralized stablecoins remain the dominant leader in the world of stablecoins. At the time of writing, USDC and USDT collectively make up more than 73% of the total stablecoin market cap. Meanwhile, decentralized stablecoins are the minority share, as evidenced by the Maker’s DAI, the fourth largest stablecoin, comprising 4.6% of the total stablecoin market cap.
What Is Stability?
At the heart of stablecoins lies price stability; to truly be a stablecoin, it must be able to maintain its peg. A stablecoin can lose its credibility and, thus, market demand by failing to prove stable in both the best and worst of times. Stability can largely be determined by how it is collateralized, or the type and amount of assets backing it. Though the most successful stablecoins have maintained their peg by being fully collateralized with the U.S. dollar (1 token is backed by $1), others have explored overcollateralizing and undercollateralizing to achieve stability and also reap other benefits.
The appeal of having a stablecoin backed 1:1 with cash and/or cash equivalent assets is rather obvious; assuming the issuer is honest and transparent, there is little reason to be concerned that the stablecoin won’t keep its peg. Though this comes at the expense of decentralization, market volatility is mainly irrelevant. Thus, the stablecoin is more appealing since it can be used in other platforms/protocols without the risk of contagion.
In the case of overcollateralization, a surplus of reserves exists to maintain a 1:1 peg because the stablecoin is backed by relatively volatile assets, like crypto. Under this design, it’s common that a programmatic monetary policy exists to manage token supply while arbitragers are incentivized to maintain an overcollateralized peg. The automation of managing the stablecoin’s token supply via smart contracts makes the stablecoin more decentralized. But note that overcollateralization does not completely alleviate the risk of a black swan event resulting in a death spiral.
The most popular overcollateralized stablecoin to date is DAI, which has reserves consisting of crypto-backed loans secured by assets such as Ethereum (ETH), USDC (USDC), Wrapped Bitcoin (WBTC), and others. In the case of DAI, reserve diversity exists to meet an increase in redemption demand should one of the assets experience extreme volatility. As shown above, DAI has deviated from its peg in its early life. Be that as it may, DAI has become increasingly stable over time, even when ETH has experienced extreme bouts of price volatility.
Undercollateralized stablecoins (typically referred to as “algorithmic stablecoins”) possess a programmatic stability mechanism that attempts to maintain a peg despite minimal collateralization. These stablecoins, which are typically more decentralized, will sometimes use another token that expands and contracts in supply as the stablecoin is created or burned. As great as that might be, they’ve historically been the least stable because they require a minimum level of demand, rely on arbitragers to ensure stability, and aren’t backed by real assets. Nevertheless, the opportunity is ripe to prove otherwise.
The most recent collapse of the Terra stablecoin (UST) reminded the market that when an undercollateralized stablecoin loses its peg and fails to attract a strong enough demand to restore its peg, a loss of confidence can lead to a death spiral. Therefore, the future of algorithmic/under-collateralized stablecoins remains up in the air, with no proven model yet for avoiding a death spiral.
What Is Capital Efficiency?
Because stablecoins are supposed to maintain a $1 peg, it’s essential to consider how much money has to go into a stablecoin system to get back $1 worth of tokens. If it costs $1 to get $1 worth of tokens, a stablecoin has a capital efficiency of 1 ($1 out / $1 in). However, suppose a $1 peg can be achieved and maintained with only 90% of its backing coming from fiat stablecoins. In that case, the stablecoin is considered 10% more capital efficient with a capital efficiency of 1.11 ($1 out / $0.9 in). If a stablecoin is capital efficient, its advantages often come at the cost of stability (undercollateralized) or centralization (1:1 collateralized).
Market participants can expect varying capital efficiency depending on how the stablecoin is collateralized. A 1:1 collateralized stablecoin backed by U.S. dollars is somewhat capital efficient. For instance, in the case of USDC and USDT, users can expect to pay $1 to get $1 worth of tokens in return since both stablecoins are 100% fiat-backed. Though the stablecoin is also stable, it isn’t decentralized.
Meanwhile, overcollateralized stablecoins can require more than $1 to get $1 worth of tokens. DAI requires users to open a collateralized debt position (CDP), or smart contract loan agreement with the MakerDAO Pool, before depositing 150% of the DAI they want to take out. Although decentralized, DAI isn’t as stable as some of its peers and is also highly capital inefficient; users must deposit $1.5 worth of value to get $1 worth of tokens. On top of that, if the value of their collateral declines, they’ll have to deposit more. Not to mention, by depositing crypto as collateral, the user misses out on a yield from staking or lending their crypto.
When it comes to undercollateralized stablecoins, capital efficiency is highest. Though undercollateralized stablecoins are about as decentralized as they get, they’ve historically been incredibly unstable. However, because they tend to have little-to-no collateral backing, they’re extremely capital efficient since no new money has to go into capital reserves. Instead, an algorithm or mechanism will burn tokens when the supply is too high or mint new tokens when the supply is too low.
Capital efficiency is essential because it largely dictates how scalable the stablecoin can be. By being more capital efficient, it is easier to have increasingly more assets back the stablecoin, which unlocks the ability for the stablecoin to grow alongside market demand, be used in various other decentralized finance applications, and innovate in ways necessary to remain competitive, attractive, and widely usable. If a stablecoin cannot scale well, its application and demand will hit a ceiling that will arguably render it useless over a long enough period.
We believe that the advent of on-chain Real World Assets creates a monumental opportunity for stablecoin protocols. Therefore, Fortunafi has identified some key design elements that stablecoin protocols should consider:
Decentralization at the protocol level to allow stablecoin protocols to offer greater utility than those with a centralized model. Because decentralization only scales with a highly efficient governance system, decentralized stablecoins should optimize for a governance model that enables operational efficiency.
To truly scale, decentralized stablecoins must incorporate native digital assets & on-chain real world assets and drive value to users by offering highly competitive yields. Given that demand for stablecoins is greater than the supply of high-quality native digital assets, the best decentralized stablecoins will need to attract the highest quality collateral on-chain and off-chain.
A decentralized stablecoin that wants to maintain stability (while also being backed by on-chain and off-chain collateral) must be capable of ensuring transparency around asset liability management while also being capable of trustlessly valuing all balance sheet assets to validate liquidity & solvency.
The rise of Layer 1 and Layer 2 blockchain technologies indicates that native cross-chain stablecoin implementations will greatly benefit from said newfound demand. For example, the transfer volume on Stargate, a decentralized exchange and bridge on the LayerZero omnichain interoperability protocol, reflects strong demand for transferring assets across blockchains. Accordingly, cross-chain innovation suggests that stablecoins must be flexible to remain competitive.
As discussed, the stablecoin trilemma remains one of the greatest puzzles in crypto, and for a good reason. Because of the usefulness of stablecoins, there remains an arms race to design a stablecoin with all the right properties for the right applications. While the stakes are high, the challenges remain. The world has yet to see what mix of decentralization, stability and capital efficiency can be achieved while still being most desired across various applications/uses. Though such a stablecoin has yet to come to market, the reality is that the opportunity is real.
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Disclaimer: The information contained herein is general information, intended for educational purposes only, and is not intended to constitute legal, tax, accounting, or investment advice. Information, opinions and views are solely of Fortunafi and none of the information contained should be used as the basis for an investment decisions. To ensure suitability, contact a licensed investment professional when making any investment decisions and do your own research.