Why are stablecoins not stable?
The primary purpose of a stablecoin, as understood by every market participant, is to hold a stable value pegged to the value of another asset, usually a fiat currency, thereby creating a safe haven from market volatility.
However, in most stablecoin designs, the goal of achieving this price stability comes with a tradeoff in either the decentralization of the system or its capital efficiency
Much like โThe Blockchain Trilemma,โ where networks have to sacrifice either one of decentralization, security, or scalability,
In the same manner, Stablecoins must trade either stability, capital efficiency, or decentralization
In other words, issuers face critical decisions in determining:
โCollateral management; establishing token issuance mechanisms (decentralization)
โEnsuring a 1:1 peg (stability)
โCapital required for minting $1 worth of a token, with a focus on enhancing capital efficiency
Since these characteristics cannot be found in one stablecoin, issuers have to make tradeoffs
Here's a general overview of these characteristics:
1) Decentralization
- As the name implies, these are stablecoins whose system of issuance has little or no reliance on any central authority or organization but managed via smart contracts
- Stables under this category are usually CDPs meaning they're overcollaterised in order to account for the volatility of underlying collateral, essentially sacrificing capital efficiency for decentralization. Ex: Dai ($DAI) and Magic Internet Money ($MIM).
- On the other hand, centralized stables like $USDT and $USDC offer more stability and capital efficiency but with existing counter-party risk, regulatory risk, and other forms of censorships
Regardless of the trade-offs, centralized stablecoins remain the dominant leader.
2) Stability
- This is the primary purpose of a stablecoin, to peg its value against a real-world currency and maintain said peg in other to create a no-volatility zone.
- A stablecoinโs level of stability is determined by the type of collateralization backing the minting process
For highly stable systems, the ideal collateralization method is the 1:1 stable-to-reserve ratio as there are limited concerns for a depeg. However, this level of stability comes at the expense of decentralisation.
In overcollaterised systems, even though collateral is in surplus of minted stables, the system remains susceptible to black swan events and wild price volatility of underlying assets which could result in a death spiral
Below is a chart showing the deviation of $DAI depeg in its early stages.
Undercollaterised systems are the most susceptible to depegs as reserves do not meet up with minted stables.
While they enjoy capital efficiency, they carry a significant risk of depeg which could lead to a loss of consumer confidence and potentially a death spiral.
An example of this is the infamous UST crash
3) Capital efficiency
- This describes the smallest amount of capital (in the form of collateral) required to mint $1 worth of stables.
- In this case, undercollateralized stablecoins are the most capital-efficient, as they rely more on programmed mechanisms than fully collateralized reserves. ($1 issued again 90 cents)
- Fiat-collateralised stablecoins with a 1:1 collateralization ratio return $1 stablecoin for every dollar in reserve, making it less capital efficient but more stable, however centralised
- On the other hand, Overcollaterised systems require more than $1 in reserve to mint $1 worth of tokens sometimes up to 150% collateral making the system non-efficient, for the sake of stability and decentralisation
Innovation comes from challenges, and the stablecoin trilemma is one such challenge.
Hope you enjoyed reading this explainer post and learnt something from it soldier!โ๏ธ
Aurelius marches to Mantle! ๐
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