Stablecoins are cryptocurrencies designed to track the value of underlying assets like fiat currencies. However, creating a stablecoin that balances decentralization, price stability, and capital efficiency is highly challenging. The stablecoin trilemma essentially describes a fundamental conflict faced in the design of stablecoins. It draws on the concept of the "impossible trinity" from international finance, analyzing the three core objectives of stablecoins together.
The Three Core Objectives of Stablecoins
Capital Efficiency: This refers to the ability to issue stablecoins without providing an equivalent amount of reserve assets for each unit of stablecoin. It means that fewer resources can be used to issue more stablecoins, thus improving capital utilization. It represents how efficiently a stablecoin leverages its backing assets (i.e., collateral) to maintain value stability.
Price Stability: A core goal of stablecoins is to keep their price stable relative to a pegged asset, such as the U.S. dollar, without experiencing significant fluctuations. For example, under ideal conditions, if a stablecoin is pegged to the U.S. dollar, 1 unit of that stablecoin should always be worth 1 U.S. dollar. This means that the price of a soda in stablecoins should remain the same today, tomorrow, next week, or next month.
Decentralization: This refers to minimizing reliance on centralized institutions during the issuance, management, and circulation of stablecoins, ensuring that the system is more transparent, resistant to censorship, and less prone to manipulation.
Three Common Types of Stablecoins
Collateralized Stablecoins: These are backed by reserves of fiat currency, digital assets, or other tangible assets to guarantee the value of the stablecoin. This method provides better price stability and redeemability, but tends to be less decentralized. USDC is an example of this type of stablecoin.
Algorithmic Stablecoins: These use complex algorithms to regulate the supply of stablecoins in order to maintain price stability. While this method tends to be more decentralized, it comes with significant risks regarding price stability. Algorithmic stablecoins aim to achieve decentralization and high capital efficiency, but they often struggle to maintain price stability. Their stability largely depends on market demand and algorithms, which may fail under stress, leading to de-pegging. UST is an example of an algorithmic stablecoin.
Hybrid Stablecoins: These combine features of both collateralized and algorithmic stablecoins, attempting to strike a balance between the two.
The Stablecoin Trilemma
Capital Efficiency + Price Stability: To achieve both high capital efficiency and price stability, centralization is often required. For example, stablecoins like USDT (Tether) use a partial reserve mechanism (i.e., they do not need to hold 100% reserves) to achieve capital efficiency, while central management ensures price stability. However, this design sacrifices decentralization.
Price Stability + Decentralization: To maintain price stability while remaining decentralized, over-collateralization mechanisms are usually used. For instance, DAI is pegged by over-collateralizing digital assets. However, this approach significantly reduces capital efficiency, as issuing $1 of DAI may require more than $1 worth of crypto assets as collateral.
Capital Efficiency + Decentralization: To improve capital efficiency and maintain decentralization, algorithmic stablecoins are often used, such as Ampleforth (AMPL) or early designs of UST (TerraUSD). These stablecoins adjust supply through algorithms, but they often face significant challenges with price stability and are vulnerable to market fluctuations, which can lead to de-pegging.
The stablecoin trilemma highlights a fundamental challenge in current stablecoin design: issuers cannot achieve perfect balance across capital efficiency, price stability, and decentralization. Different stablecoins make trade-offs among these three factors, resulting in distinct advantages and limitations.
