The Decentralized Stablecoin Trilemma

Enter the trilemma of designing a decentralized, non-custodial stablecoin. This design faces the challenge of optimally balancing the aspects of decentralized (here: exogenous) collateral, peg stability and scalability. Finding the right balance while considering the trade-offs is referred to as the decentralized stablecoin trilemma. The trilemma suggests that there is always unavoidable risk.[1] As the next step, we propose how to manage and reduce risk by adding the dimension of time to peg stability considerations to avoid compromising on the other two aspects.

By decentralized collateral we understand the degree to which exogenous collateral in the design is decentralized. Non-USD linked collateral typically indicates some level of decentralization. Zero decentralization can be found in any custodial stablecoin (i.e., USD linked tokens like Tether, USD Coin), while maximum decentralization can be found in Bitcoin. Decentralization must be understood as a spectrum (a level of given risk). For example, a custodial stablecoin can achieve a better level of decentralization with the use of smart contracts (LP tokens etc.), the trade-off being added levels of smart contract, correlation, or complexity risks – while the token stays a risk pass-thru vehicle for the underlying USD-linked collateral risk. Paradoxically, many decentralized stablecoins heavily depend on custodial stablecoins as the source of primary value for the design.

Peg stability refers to the ability of the stablecoin to maintain a stable price relative to an arbitrary value (i.e., USD $1). This is generally understood as a high time preference/must be always there-requirement, simply because existing stablecoin designs cannot automatically resolve for the possibility of an unpredictable destabilization or black swan event creating an under peg scenario.

Generally, a stable price for a non-custodial stablecoin comes from a combination of custodial stablecoins and various stability mechanisms such as swap-based price bonding curves, liquidity provisions, arbitrageurs, liquidators and other economic (dis-)incentives or market operations.

Finally, scalability is linked to capital efficiency. As discussed previously, overcollateralized stablecoin designs are known not to scale long-term and suffer from severe adoption hurdles, typically due to limited coin supply. Conversely, efficient but undercollateralized designs suffer from price instability due to financial risks: Users may lose confidence in a protocol which does not have the full/automated ability to replenish reserves, triggering a run leading to large redemptions and eventually a terminal collapse.

[1] Kwon, Y., Kim, J., Kim, Y., & Song, D. (2021). The Trilemma of Stablecoin. Available at SSRN 3917430. 5.

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