The Trilemmas of Crypto
Trilemma (noun): A situation in which a difficult choice has to be made between three alternatives, especially when these are equally desirable. (Source: Oxford)
If you have been around crypto for a while, you would be pretty familiar with the word “trilemma.” It seems like every single concept in crypto has a “trilemma” behind it, namely the “scalability” and “stablecoin” trilemmas. Today let’s look at what we mean by both these concepts.
Scalability Trilemma
The first trilemma that we will be looking at is the scalability or blockchain trilemma. The main challenge for a blockchain ecosystem is to balance scalability, decentralization, and security. The trilemma states that a blockchain can’t prioritize all these three factors at once equally. So, if you prioritize two elements, you will inevitably neglect the third one.
Let’s take an example. Visa can consistently do ~1700 transactions per second, making it pretty scalable. Plus, it also has a high degree of security. But, it is centralized.
How do cryptocurrencies address the scalability trilemma?
Since cryptocurrencies have a decentralized architecture, they require a special protocol called “consensus algorithms” to conduct their operations. The design choices behind these algorithms determine which side of the trilemma the protocol leans towards.
Let’s take an example.
Bitcoin uses proof-of-work. There are two things that Satoshi wanted to implement with the consensus design — the network should be decentralized, and Bitcoin should be highly secure. Seeing the amount of money the Bitcoin network deals with daily, it makes sense why they chose security over speed. Unfortunately, as a result, the Bitcoin network isn’t that scalable, managing only 7–10 transactions per second.
Many protocols like EOS and Tron have attempted to speed up their processes by opting for consensus algorithms requiring fewer validators. While these protocols are faster than Bitcoin and Ethereum, they are significantly more centralized.
So, what’s the solution?
Many are looking to implement layer-2 solutions like sidechains and rollups to scale up the network without breaking the trilemma. Sharding is a cool layer-1 solution that breaks up the network into tinier “shards” and allows the network to solve them in parallel.
Stablecoin Trilemma
Oh yes, we are back talking about stablecoins again!
The three elements in the stablecoin trilemma are — peg stability, decentralization, and capital efficiency.
- Peg stability: The purpose of the stablecoin is to maintain a peg to a fiat currency — like the US Dollar. One unit of a stablecoin should be worth $1. Obviously, a stablecoin breaking its peg will remove its main utility.
- Capital efficiency: How much value is required to create one unit of an issued stablecoin. A stablecoin needs to be highly capital efficient for it to scale up. If more than 1 unit of value is required to create 1 unit of stablecoin, then it’s capital inefficient.
- Decentralization: Who is issuing the stablecoin? Is it a centralized issuer? Or is the issuance done via a smart contract or an algorithm?
The two biggest stablecoins in the world — USDT and USDC — have a stable peg (most of the time) and are highly capital-efficient (only 1 USD is needed to issue 1 unit of USDT/USDC). However, they are issued by a centralized entity (Tether Foundation for USDT and Circle for USDC).
Now, let’s look at MakerDAO’s DAI — a decentralized stablecoin. The Maker protocol opted for a capital-inefficient system to make the peg stable, where 1 unit of collateral would be required to produce <1 unit of DAI.
Finally, what about the last combination? Well, we sort of saw what happened with this recently, didn’t we? Terra’s UST is an algorithmic stablecoin that was decentralized and capital efficient. Unfortunately, that combination choice made the peg unstable…and well…the rest is history.
My Thoughts
Every second layer-1 coming out claims to have “solved” the scalability trilemma. I am not sure how much of that is a factual claim vs unbridled optimism that has yet to be stress-tested at scale. Regarding the stablecoin trilemma, the most important thing is to maintain a stable peg in all market conditions.
Now, do you like the centralized route taken by USDT/USDC or the decentralized yet unscalable route taken by DAI? There are no wrong answers here, as far as I am concerned.
