The Trilemma of Stablecoin

Executive summary

Stablecoins have been proposed to address the high price volatility of traditional cryptocurrencies such as Bitcoin. But, ironically, the existing stablecoin designs are often criticized for their unstable prices. Even though people have continued to propose new (complicated) designs of stablecoins to solve the issue, the "perfect" solution has not been discovered yet. In addition, since each design has a different kind of risk that threatens price stability, it is not easy to say which of the existing designs is the best (or currently, there is a debate on this).

The status quo gives us some questions: Can we find the perfect design of stablecoins? Otherwise, would there be unavoidable risks that threaten the price stability of stablecoins? If so, what are the risks? And which risk would most (or least) hinder the price stability?

Our paper identifies three sources of price instability in stablecoins and theoretically proves that there is a trilemma among the three. The trilemma states that no matter how well you design a stablecoin, you cannot attain perfect stability. Instead, our trilemma leaves stablecoin issuers a crucial design choice to make: which source of price instability among the three they will carry while accepting to have its limitation. We then conduct a large-scale global survey, which aims to provide some guidelines to stablecoin market makers by showing how the general public in different countries perceives the risks of the trilemma.

The trilemma

To put it simply, the trilemma suggests that any stablecoin design can avoid at most two of all the following risks: (1) downward price instability from $1 due to moral hazards of the system, (2) downward price instability from $1 when the system is exposed to external market risk and has a poor financial performance, and (3) upward price instability from $1 caused by limited coin supply. More concretely, the first price instability element of the trilemma means that the coin price may not be recovered from below $1 if the moral hazards of the system occur. The second price instability element means that the coin price may not be recovered from below $1 when the system suffers from a poor financial performance. The last price instability element means that the coin price may not be recovered from above $1 because the system limits the coin supply.

Then what does the trilemma come from? To derive the trilemma, we first need to consider that, to properly control the market supply and demand for the downward price stability, the system should maintain sufficient reserves per coin in circulation. This reserve requirement can be achieved either by maintaining a high value of reserves or limiting the total number of coins in circulation. The trilemma occurs when choosing between keeping a high value of reserves and limiting new coin issuance.

Keeping a high value of reserves: Among the three price instability elements of the trilemma, the first two arise when the system decides to hold a high value of reserves. Here, which of the two price instability elements the system bears depends on whether the reserves are stored in the target assets (e.g., US dollars) or non-target assets. When reserves are in the form of the target assets, it bears the moral hazard risk of the system because transactions of the target asset, such as a national currency, cannot always be transparent. On the other hand, when the system decides to store reserves in non-target assets, it can avoid the moral hazard risk by employing blockchain-based digital assets. While it enables transparent reserve operations, the downside is that the value of reserves consisting of non-target assets can fluctuate so that the system has to replenish the reserves. This brings another risk as the system may fail to meet the reserve requirement when it does not have enough cash flow due to the external market risk or its own poor financial performance.

Limiting new coin issuance: Lastly, to avoid these risks, the system should limit the coin supply. However, with a limited supply, the system cannot freely increase the market supply of stablecoins to meet the market demand, thereby failing to lower the price. This brings upward price instability, which the third element of the trilemma describes.

For the formal proof of the trilemma, please refer to Section 3 in our paper.

Trilemma found in the existing stablecoins

Our paper examines the existing stablecoins suffer from the trilemma. In particular, the systems that we usually call centralized stablecoins (e.g., Tether) correspond to the first category abandoning the first price instability element of the trilemma. On the other hand, many systems that are regarded as algorithmic stablecoins (e.g., Terra and Basis) suffer from the second price instability element. But, note that the existing algorithmic stablecoins don't cover the entire second category abandoning the second price instability. Indeed, it's possible to design numerous stablecoins that belong to this category because there are significantly various ways to make up for reserves. Also, the most popular mechanism, which falls into the third category suffering from the third price instability element, is over-collateralization (e.g., MakerDAO). Similar to the second category, the third category would also have many designs other than over-collateralization. For details, please refer to Section 4 in our paper.

As such, the trilemma suggests that there can be various designs for stablecoins depending on which type of price instability they carry. And it's difficult to reach a consensus on which type of risks is superior to the others. This fact recalls the status quo of the stablecoin market: existing stablecoins vary in their design, some touting their excellency over others.

Public preference on the trilemma

Considering the trilemma, the next step would then be to investigate how we can manage or reduce the risks. From that perspective, we conducted a large-scale global survey to investigate how (potential) users perceive each type of risk in the trilemma. The survey was executed in 34 countries covering six continents, with a total of 17,550 respondents.

In the survey, we presented three currencies, each of which bears a different price instability element of the trilemma. That is, these stablecoins cannot completely eliminate the first, second, and third price instability element of the trilemma, respectively. We refer to the fictional currencies as moral hazard (MH), poor financial performance (PFP), and limited supply (LS). That is, the price of MH is fixed at $1 but drops if the system misappropriates the reserves. The price of PFP is fixed at $1 but drops if the system faces financial difficulties. The price of LS can be unstable between $1 and $1.50 (for the set price range, please refer to Section 5 in our paper).

We asked participants to choose which one among the three fictional currencies they consider more stable, where the coin issuers were given as one of six global companies, Amazon, Facebook, Google, JPMorgan Chase, Netflix, and Walmart.

Our survey results indicate that most people perceive that the coins in the third category are more stable than others, which global companies may have overlooked. Further, as shown in the above figure, the choices were significantly different at the country level, suggesting that a stablecoin design can be customized. These findings not only help issuers design a stablecoin, but it also indicates that commitment to business ethics and monitoring of financial risks should be much more strengthened.

However, the current stablecoin market is moving away from the global preference; for example, global companies such as Facebook and Walmart are planning to create currencies that can be affected by moral hazard.

For details, please refer to Section 5 in our paper.

Despite the trilemma, can we still improve the price stability?

Sure! Although the trilemma implies that stablecoins have limited price stability, it is still possible to improve the stability. For example, we can decrease the instability by finding or creating relatively stable digital assets to use as reserves. Regulation is another way to achieve higher price stability. For example, policymakers can introduce institutional devices such as auditing, systematic monitoring, requirements for market entry, and safety nets to reduce moral hazards or financial risks. Moreover, to decrease price instability due to limited coin supply, governments may consider limiting stablecoin trade upon a sudden price shock through a policy like a trading halt.

Concluding remark

The fact that any stablecoin cannot avoid the trilemma doesn't necessarily predict a bleak future for stablecoins. Instead, we would like to point to the importance of better managing the risk that stablecoins bear. Also, note that our global survey doesn't necessarily suggest that the existing decentralized stablecoin designs are superior to the centralized stablecoins. Rather, the survey result would let us know that the possibly best stablecoin that the general public thinks might fall into the third category, which abandons the third price element of the trilemma. This would be useful for us to determine the direction of future stablecoin design. Finally, we believe that this work provides insight into the factors weighing the stablecoin market from the perspectives of both currency issuers and regulators.