If you’ve been in the crypto world long enough, you’ve probably heard about the term stablecoin trilemma. Nowadays, there are around 200 stablecoins, all pegged to the US dollar. But why so many if they all serve the same purpose? It’s because none of them are perfect.
Imagine if a digital asset seamlessly combines the decentralized nature of Bitcoin, the stability of the US dollar, and the sufficient scalability to handle global transactions. Unfortunately, this scenario faces an obstacle known as the stablecoin trilemma. Let’s discuss this in more detail.
What Is Stablecoin Trilemma And Why Does It Exist?
This trilemma represents the challenge of creating stablecoins that can simultaneously achieve three critical attributes: capital efficiency, price stability, and decentralization. Each is pivotal to efficient stablecoin performance, but achieving all three at once has been shown to be a substantial challenge.
The stablecoin trilemma arises since each attribute conflicts with the rest. For example, price stability requires strong collateral backing, which may lower capital efficiency because of the need for over-collateralization. As capital efficiency tries to reduce the amount of needed collateral, this can result in price stability risks.
What Are the Components of the Stablecoin Trilemma?
To become a global stablecoin, a digital asset needs the following attributes:
Decentralization
This measures the degree to which a stablecoin depends on a central system. So, are stablecoins decentralized? Most aren’t. If they are, they are more resistant to manipulation and censorship yet harder to stabilize and manage.
Decentralization of stablecoins implies that a stablecoin is governed by several control points rather than a single central authority, and its value is upheld through protocols and algorithms. While this represents an ideal decentralized stablecoin scenario, most stablecoins are still either partially or entirely centralized.
Capital Efficiency
This refers to how well a stablecoin uses its collateral (backing assets) to maintain its value steady. In other words, it’s how much value the stablecoin requires to keep in reserve to verify that every stablecoin unit is worth as it should.
If the collateral needed to keep the value is higher, the capital efficiency will be lower. For instance, a stablecoin that requires $1.50 in collateral to generate $1 worth of stablecoins is not as capital efficient as one that only needs $1.10 in collateral for the same $1 issuance. An excellent example of this type of stablecoin is DAI.
Price Stability
This is a stablecoin’s capacity to maintain a consistent value relative to a reference asset, typically a fiat currency. Stablecoins need price stability to function as a reliable medium of exchange and store of value.
A functional stablecoin should keep its peg throughout all market conditions, allowing people to use it for everyday transactions like traditional money. Moreover, people in high-inflation countries can use stablecoins to protect their savings.
So, to sum up, what are the three points of the blockchain trilemma? They are decentralization, security, and scalability.
Types of Stablecoins and Their Trade-Offs
Now that we know what the trilemma of cryptocurrency is, let’s discuss the types of stablecoins and their trade-offs.
Fiat-Backed Stablecoins
These types of stablecoins sacrifice decentralization for price stability and capital efficiency. As centralized forms of money back these stablecoins, they depend on centralized issuers. They rely on trust that the issuers’ reserve claims are genuine and that they will act responsibly. USDT is a good example of fiat-backed stablecoin.
Crypto-Backed Stablecoins
Other cryptocurrencies back this type of stablecoins. To ensure the value of stablecoins that promise a permanent $1 worth, it’s crucial to lock up more than $1 worth of another crypto in a digital vault. For instance, you can deposit $1.50 worth of ETH so that the additional 50 cents act as a safeguard to absorb fluctuations in the value of ETH and ensure the stablecoin remains pegged at $1.
These stablecoins are usually overcollateralized to reduce the collateral’s volatility. Even though they achieve a fair level of price stability and decentralization, they are, unfortunately, capital-inefficient since they need a lot of collateral to guarantee stability. A good example is DAI.
Many platforms also allow users to earn interest on stablecoins, making them a popular option for generating passive income.
Algorithmic Stablecoins
These stablecoins use algorithms to keep their peg. The circulating supply of these coins can fluctuate significantly as the algorithm adjusts the supply to maintain price stability. If the price begins increasing, the algorithms push the price down by creating more coins.
Conversely, if the price drops, they increase the price by reducing the supply. These stablecoins are usually capital-efficient and decentralized but face challenges with price stability, as it heavily depends on algorithms that can fail under pressure and on market demand.
Conclusion
The stablecoin trilemma represents the challenge of creating stablecoins that can simultaneously achieve three critical attributes: capital efficiency, price stability, and decentralization. Fiat-backed stablecoins sacrifice decentralization for price stability and capital efficiency. Since centralized forms of money back these stablecoins, they depend on centralized issuers.
As the name suggests, other cryptocurrencies back crypto-backed stablecoins. Even though they achieve a fair level of price stability and decentralization, they are, unfortunately, capital-inefficient since they need a lot of collateral to guarantee stability. Algorithmic stablecoins use algorithms to keep their peg. These stablecoins are usually capital-efficient and decentralized but face challenges with price stability.