- Designing stablecoins is challenging.
- Stablecoins are faced with “the stablecoin trilemma” and have to trade-off between various degrees of decentralization, scalability, and control over the peg.
Stablecoins are a crucial component of DeFi infrastructure.
As more users enter the DeFi space, demand for stablecoins is rising. In November 2021, the market capitalization of the five largest stablecoins exceeded $130 billion.
Stablecoins are attractive to many users as they allow them to participate in DeFi applications without taking risks of extreme price volatility. Significant interest and demand for this type of cryptocurrency leads to the appearance of new stablecoins designs and poses challenging questions for practitioners and regulators:
What are the trade-offs and vulnerabilities inherent in the design of different stablecoins? Is there a stablecoin design that optimally balances these trade-offs? Below we discuss that any stablecoin issuer faces the trade-off between degrees decentralization, scalability, and control over the peg. This trade-off is referred to as “the stablecoin trilemma” (see related notes  and ).
A deeper dive into the stablecoin trilemma
By “decentralization” we understand the degree to which the minting process (i.e. issuance of new coins) of a stablecoin is decentralized. The issuance of stablecoins with centralized minting technology is controlled by one entity that can decide on the stablecoin supply. When the issuer increases the number of coins in circulation, it is difficult (if not impossible) for other participants to verify 100% backing (i.e. the amount of collateral locked up in smart contracts) of this stablecoin. One well-known example of such a stablecoin is Tether.
On the contrary, with a decentralized minting process, every market participant can mint new coins under the same collateral requirements written in smart contracts. Maker DAO’s DAI or Reflexers labs RAI is an example in this case. The issuer of a stablecoin with decentralized minting technology is still able to impact the coin supply but only to a limited extent as it requires locking up the corresponding collateral, as for any other user. In other words, the issuer of a stablecoin with decentralized minting does not have preferential access to the creation of new coins compared to other market participants. The backing of stablecoins with decentralized minting is transparent and verifiable on-chain by any user. In contrast, stablecoins with a centralized minting process require trust in the issuer.
“Scalability” describes the speed of stablecoin adoption and its capacity to increase stablecoin use cases. Scalability decreases with the collateralization ratio (the ratio of the collateral amount to the number of minted coins). Over-collateralization requirement leads to capital inefficiency and may discourage some participants to use the stablecoin as users need to lock up more funds than they are able to use after minting. For instance, if the collateralization ratio is 1.5 (also called c-ratio), a user that has $300 will be able to mint stablecoins worth only $200.
Such excessive lock-up of capital implies that participants may miss other attractive investment opportunities. This decreases the demand for stablecoin and slows down its wide adoption. An example of an over-collateralized stablecoin is DAI which is less scalable than Tether. As of November 2021, the market capitalization of Tether is almost $74 billion while that of DAI is around $6.5 billion.
Finally, “control over the peg” refers to the ability of a stablecoin to maintain its price at the peg (USD $1, EUR €1, etc.). As prices of cryptocurrency fluctuate in response to the constantly changing demand of market participants, stablecoins have various price stabilization mechanisms.
Depending on a design, deviations from the peg can be mitigated by arbitrage flows, the issuer’s actions to decrease/increase the number of coins in circulation, and/or other economic price stabilization mechanisms.
Stablecoin design should also take into account the possibility of “a black swan event”, i.e. a large unpredictable change in the market. If a stablecoin is not 100% backed by transparent and liquid assets, users may lose confidence in the free redemption of their collateral. This can lead to a large demand for stablecoin redemption, similar to a “bank run” in traditional finance, and a drop of a stablecoin price.
For fiat-backed stablecoins, price stabilization is achieved by actions of arbitrageurs. For instance, when a stablecoin price rises above $1, investors are incentivized to mint new stablecoins and sell them at a crypto exchange which drives the price back to $1.
Price stabilization of crypto-collateralized stablecoin DAI involves changes in stability fees and the debt ceiling. A stability fee is a variable interest rate paid on minted DAI that drives DAI’s minting and burning. Additionally, its protocol also includes the debt ceiling mechanism, i.e. a limit on the amount of DAI that can be generated by users. This additional stabilization mechanism improves the protocol’s ability to maintain the peg but further limits Dai’s scalability.
What is the balance of these trade-offs for DigitalDollar (DUSD)?
DUSD will be 100% backed by USD, the same for its future D-EUR/GBP/CHF versions.
Therefore, it is not over-collateralized: $1 deposited to the DUSD treasury account gives 1 DUSD.
Compared to centralized stablecoins, DUSD achieves a certain level of decentralization. When a user intends to mint a certain number of stablecoins, the validator node verifies whether the user has enough fiat currency in his account. If so, stablecoins are minted via the open-source minting process that will be controlled by the community. More information on the technical details can be found in the doc’s.
Users’ collateral can also be stored off-balance in partner banks’ treasuries selected by the DAO. 100% backing is enforced by the smart contract and verifiable by all users on-chain and via APIs directly querying the treasury accounts.
Price stabilization will be achieved by arbitrage flows from investors that are incentivized to profit from price deviations, sending the price back to $1. FluidFi can also act as an arbitrageur by depositing dollars to the treasury and minting new DUSD with their own balance if necessary.
Regardless of 3rd party markets, FluidFi itself always honors a 1:1 conversion, minus minimal fees.
The article serves as a high-level exploration for later research.
We would like to dive deeper into FluidFi’s DUSD and all the other potential use-cases that can be built by bridging/merging CeFi & DeFi, with a future in-depth paper.