Little bit of history
After events like what happened with UST, where many people, protocols, DAO’s and other ecosystem players lost money and trust in equal parts, there is no doubt that the rules established so far about stable coins will change, especially when the expected regulation in jurisdictions like the US or the EU arrives. Stable currencies are assets (cryptocurrencies) whose price is linked to the value of a fiat currency or any other asset, in order to give them a backing and to maintain a 1:1 stability in their price. The first important use case that stable coins had was undoubtedly to be able to trade with them in exchanges (centralized companies), since exchanging assets for a token that is not subject to high volatility generates great opportunities in buying/selling and above all they help to create a market. Then they came to the DeFi sector, where they were not only the core of the ecosystem, but indirectly drove the creation of other types of stable currencies, with different mechanisms to provide price stability and with different options to provide a backing, all of them in a decentralized environment.
USDT (Tether) was one of the first stable currencies under a fiat backing, in fact, it created a category where all stable currencies within it are linked to the value of a fiat currency. Due to the role of the US dollar (USD) as a global exchange currency, this was the fiat currency chosen to back stable fiat-backed currencies. Backing a digital asset with a real fiat currency (in this case with the dollar) requires the issuer of the stable currency to have a centralized banking structure, applying a strong centralization and lack of transparency in this custody and backing process. For this reason and some others, the cryptographic industry itself promoted the appearance of stable currencies with another type of backing. The best example of this new category being DAI from MakerDAO. Crypto-backed stable coins can only be minted in decentralized protocols, if the value of the deposited collateral (e.g. ETH, LINK, BAT, etc.) exceeds the value of the minted stable coins. For the proper functioning of this other type of stable coins, both the protocol and the user must always take into account the volatility (price) of the asset used as collateral, to ensure that the minted stable coins are fully backed, therefore, the responsibility for the health of that backing lies with both the issuing entity and the user.
The capital inefficiency presented by this type of stable currencies (specifically their anchoring mechanism), led to a new narrative and model of stable currencies, the algorithmic ones, gaining great momentum (especially market share in the decentralized sector) and traction. The most prominent example of an algorithmic stable coin was TERRA’s UST. To summarize and not get into technical, mathematical and financial debates, let’s say that its 1:1 peg to the dollar is achieved through an algorithm that manages to balance the supply and demand of the stable coin through the use of 2 tokens, providing stability to the price of the stable coin, in this case it was with TERRA and UST. However, after the hard and irrecoverable fall of UST, we all witnessed that this type of mechanism fails to maintain the 1:1 linkage in adverse conditions.
The challenge of solving a difficult trilemma
We can agree that the fundamental objective and purpose of a stablecoin is to maintain a stable value linked to the value of another asset, based on having an optimal balance between stability, capital efficiency and decentralization. We know that this is achieved when the issuing protocols of these stablecoins minimize the volatility of the stablecoin, thus the stablecoin perfectly fulfills its purpose of being stable. However, to achieve this success in its operation, one cannot avoid compromising in some way the decentralization of the system or its capital efficiency.
Stability relies primarily on the stablecoin and its backing asset(s) being continuously linked within a very liquid market, thus ensuring 1:1 parity over the long term. It is very important that the assets that serve as collateral or backing, have a great specific weight, for example, in the case of stablecoins linked to the dollar, a 1:1 collateralization with USD guarantees that each stablecoin in circulation is backed by 1 USD and since the dollar is a currency that meets the premises of being liquid, robust and with a great weight, a long-term separation is improbable. Therefore, only if the system used to guarantee, as well as the guarantee used, do so even in very adverse conditions, it can be said that we have a stable currency with a high degree of stability.
Capital efficiency can be viewed as the amount of value needed to create one unit of stablecoin, as well as to scale the demand and supply of the stablecoin. If, for example, it takes more capital than $1 to create a stablecoin, the stablecoin design would be described as capital inefficient. If, on the other hand, less than $1 is needed, the system can be considered capital efficient. This is a feature that encompasses and affects the growth of the stablecoin itself, therefore, capital efficiency is a highly demanded feature.
Undoubtedly, decentralization plays a crucial role in the design of any token or protocol. Stablecoins have become an important part (by native integration) of decentralized finance as well as the Web3 ecosystem, seeking by their nature, decentralization (usually in governance) to mitigate the single points of failure and risks attached to centralization. Following certain essential properties of the base layer by decentralized issuers of stablecoins will in the future lead to a strengthening and most importantly, a real alternative to censorship, control and manipulation, where properties such as transparency, inclusiveness and solvency of an individual will be highly rewarded.
Knowing that, logically, it will not be possible to achieve a balance in these 3 important points at the same time, we must continue to deal with the risk involved in using stable currencies, since they make major concessions in one or two of the above points (the one that gains in stability, loses in decentralization and efficiency, or vice versa) to date. It is true that there have been many approaches in different designs to tackle this problem (trilemma), thus managing to have in a single stable currency the three characteristics together, but these tests have not been able to fulfill with sufficient guarantees and for a short period of time, to solve the tensions to which they have been subjected.