Stablecoins 101 & the Stablecoin Trilemma

For Decentralized Finance, Stablecoins are, without any sort of a doubt, the most important and most useful application to have. In a world of volatility, stability as a use case is highly needed to allow the economic activity happening on-chain to reflect itself in a constructive way onto the real economy. The key to building a necessary relationship between DeFi and the real world economy on solid foundations is the achievement of a Stablecoin issuance model that will successfully provide the necessary guarantees on security, scalability and transparency. It is important to note that, at a very fundamental level, Stablecoin issuers are tackling the same logical problem which also concerns the issuance of legal tender currency through central banking. Let's then consider what the main requirements for a working, fairly sustainable, stablecoin are:

• Peg stability: For example the target exchange rate can be the price of 1$ or the CPI index.

• Supply elasticity: To prevent the stablecoin from undergoing alterations in terms of price and precisely to keep its value stable relatively to the peg, its supply must be able to expand and contract to counteract the effect of the any buying or selling pressure.

• Collateralization of the emissions: As a matter of fact, the issuer must be able to back the value of the stablecoins and face redemptions at 100% of the equivalent value during a phase of supply contraction. Thus, the collateral must be accumulated and be required to mint new stablecoins into circulation when the supply needs to expand, all according to market demand.

If we consider money as a useful technological tool for measuring value and pricing assets, we need to think in these terms. For example: If we take the US dollar into consideration, its target exchange rate is the CPI or the cost of living. To keep its relative stability to the peg, the supply can be inflated or deflated through Quantitative Easing (QE) or Quantitative Tightening (QT). Unfortunately, after 1971 the United States went off from the Gold Standard removing any sort of collateralization from the dollar. When collateral is not required to mint new currency, if conflict of interest or bad policies cause the supply expansion to exceed market demand, you get debasement (the peg is lost). Obviously, the lack of collateralization does not offer any guarantee of reimbursement in case of debasement or loss of the peg. (As we can all immagine, trust is not an acceptable form of collateral but this was only possible because the US dollar was a monopoly imposed through military supremacy).

CeFi Stablecoins

We can find another iteration of these concepts in Centralized Stablecoins, or Stablecoins 1.0: They are cryptocurrencies pegged to the value of 1$ and require dollars as collateral to be minted on the blockchain. Those dollars are held in custody by a middleman, a private company, and should be redeemable 1:1 when the stablecoins are burned and removed from circulation. The stablecoin's supply contracts and expands on-chain as market demand requires and the physical dollars are redeemed or put up as collateral through the banking system directly in the middleman's bank accounts. This business model is very simple and scalable but only as secure as the transparency of the issuer goes. In fact, since the collateral is not posted on-chain, the issuer's solvency status is not verifiable by the end user and this poses some serious trust issues, especially if we consider that, in order to be profitable as a business, these private companies tend to invest the collateral to earn yield on it. Even in the most conservative case, a non-zero percentage of the collateral is converted into T-Bills, which will guarantee an economic return to the company and offset the volatility risk if the assets are held until maturity. This means that, in a backrun scenario, if for any reason the market participants require a full contraction of the supply before the maturity of the credit assets is reached, those businesses are only solvent if the value of their treasuries hasn't dropped in the open markets. The low volatility of the front end of the Treasury markets guarantees a certain degree of security, the need to place trust in the responsible work of the issuer, however, can raise some concerns, especially when not all issuers have behaved in a sufficiently transparent manner and the treasury markets are likely to face some serious stress due to the current macroeconomic conditions. In other words the state of their solvency is negatively correlated with their profitability as a business. In addition to this, there is a risk that users' funds will be frozen and transactions and accounts will be blacklisted.

DeFi Stablecoins

Decentralized Stablecoins or Stablecoins 2.0, came after the centralized model as a natural evolution to try and solve the trust issues that CeFi stablecoins have. The issuer in this case is not a private company but a Decentralized Autonomous Organization (DAO) that achieves trust minimization, mostly, by keeping the collateral transparently posted on-chain.

Together with Decentralized Stablecoins, a series of more complex economic models have emerged, each with their own pros and cons and new set of risks. The main and most noteworthy ones are for sure: Undercollateralized Stablecoins run through Seigniorage minting, also called Algorithmic Stablecoins, Overcollateralized Stablecoins running through their Money Markets, also called Debt Markets and more recently, Δ Neutral Stablecoins an important and interesting novelty in the space. We are going to take a look at each of these economic models in the next sections to get a better overall picture and understand how to make them converge into a model that integrates their strengths without inheriting each of their weaknesses.

The Trilemma

In an open market all stablecoins issuers will have to compete over:

• SECURITY

• SCALABILITY

• PROFITABILITY

The goal of any issuer should be to succeed in all of these three areas at the same time, though usually and at best, as two of the variables increase the third decreases. For instance, Overcollateralized Stablecoins are very secure but struggle with scaling and adoption. Undercollateralized Stablecoins usually have good profitability and a good adoption rate, but become progressively less secure as they scale.