The Stablecoin Trilemma and baoUSD
Over the past few years, stablecoins have become a considerable part of the crypto industry. The combined market cap of stablecoins as of December 2022 stands at over $140b, and it is easy to see why. They remove market volatility while enabling instant, transparent, and virtually free value transfer anywhere, at any time. They also give their holders access to the growing world of completely open and fair Defi applications. Depending on how they are implemented, they can also remove the risks associated with traditional financial institutions.
Even during the bear market lasting the entirety of 2022, stablecoins continue to settle more value than previous years, with 2022 expecting to finish with around $8T in total value settled. For reference, this is more than MasterCard and American Express and could easily surpass VISA in 2023, which settled $11.6T this year
Despite the meteoric growth, we are still very early in the adoption curve for stablecoins — the total addressable market is equivalent to the world’s money supply of more than $80T, and we have yet to see any stablecoins that address all three properties that make an excellent stablecoin well. It may be the case that we never will, which could be a good thing because there would be a slew of popular coins that address different use cases and diversify the risk of a single token collapsing.
The three properties that make an excellent stablecoin are:
— Peg stability: Stability is a crucial goal for stablecoin designers, as it is the primary reason that people use stablecoins in the first place. They can be a valuable tool for storing and transferring value without the volatility often associated with cryptocurrencies like Bitcoin or Ethereum.
— Decentralization: The extent that a central party controls the stablecoin. Many design aspects can be centralized or decentralized, resulting in a wide range of offerings from fully decentralized to centralized and everything in between. Some areas that could have central control are the collateral types and storage, issuance, and governance.
— Capital efficiency primarily refers to the amount of capital required to mint the stablecoin. Another aspect is the ability to put that collateral to work, earning yield.
The Trilemma
The stablecoin trilemma refers to the difficulty that stablecoin designers face trying to balance these properties because one must be compromised to improve another.
Stability
Stability is crucial when choosing which stablecoin to hold. After all, it is the whole point of owning a stablecoin. The market cap of centralized stablecoins, which traditionally have good stability, highlights that importance.
Stability poses a significant challenge to decentralized stablecoins because they cannot be backed 1:1 with dollars in a bank. Let’s look closely at different implementations of stablecoins, the challenges they face with stability, and the mechanisms available to overcome those challenges.
Centralized stablecoins
Centralized stablecoins are often very stable because they can be redeemable 1:1 with dollars in a bank. If the peg is lost, it is usually due to the mismanagement of funds. It could be for regulatory reasons too — for example, if a stablecoin issuer’s bank account gets frozen or they are banned from operating, there would no longer be any backing, and it will quickly lose its peg.
CDP (collateralized debt position) stablecoins
CDP stablecoins ensure their collateral value is always greater or equal to the value of the stablecoins. They use various forms of collateral to back and mint new pegged tokens, then allow liquidators to repay loans to seize the collateral if it gets too close in value to the debt (often referred to as an “at-risk position”). The most prominent example of a CDP stablecoin is DAI, which allows users to mint and borrow new DAI with many collateral types.
CDP stablecoins have several methods of maintaining a peg — a fixed value on the platform they are minted, a stability pool, and variable interest rates. We will explore the stability mechanisms below.
A fixed value on the CDP platform where the stablecoin is minted: Users can repay their positions at a discount when the stablecoin is below the peg or open new ones and sell for a profit when above the peg. This works to a certain extent but only provides a “loose” peg unless other stablecoins are used as collateral. For example, many CPD stablecoins often trade slightly below peg (0.97–0.99) because the demand for borrowing against their collaterals is too high compared to the need for holding the stablecoin. A significant discount must be available before users are willing to close their positions. Then, when the stablecoin gets close to the peg again, the demand for leverage takes over as the supply of users ready to borrow and sell at a discount outweighs those willing to buy at the same value to close positions.
It is possible to have demand the other way around, as with LUSD right now. It consistently trades a few cents above its peg. It is highly decentralized and uses pristine collateral, which drives demand higher than the supply of those willing to mint it using volatile collateral. Only allowing ETH collateral makes sense for immutable contracts because it is the only collateral you can always guarantee will have liquidity on Ethereum. However, LUSD growth is restricted by the demand for borrowing against ETH, especially during a bear market.
DAI, which is widely accepted and the most decentralized of the large-cap stablecoins had a similar issue — it traded above peg for a long time. Users were willing to pay a small premium to hold it instead of a centralized alternative like Tether or USDC. They introduced a stability pool to trade closer to the peg, which we will explore next.
Stability pools allow swapping of the stablecoin and another asset and assume the value will be the same, helping keep their market values close. While this can be effective, it can lead to reliance on another stablecoin and needs for demand to be higher than supply (being above peg) for the stability pool to get filled with the other asset. DAI has a stability pool using USDC, and they have issues preventing the DAI backing from being too much USDC. Despite many efforts to reduce their reliance, they are around 30% backed by USDC. Not ideal for a supposedly decentralized stablecoin.
Variable interest rates can help to control the peg of a stablecoin too. By increasing the interest rate users are incentivized to repay their loans, and the opposite is true when interest rates are low. While effective, they do have limitations. Volatile interest rates are not attractive for borrowers, and if they are very low, the protocol will earn little revenue from the expansion of supply. DAI calls its interest rate a stability fee, which is adjusted per collateral type via governance. Many CDP stablecoins choose to rely on other methods to keep their pegs by offering fixed or even 0% interest rates; however, they usually are the stables that trade slightly below the peg resulting in borrowers losing value from the discounted token when they use it. MAI, VST, and MIM are examples of fixed-rate stablecoins.
Even with these mechanisms in place to help keep a CDP stablecoin pegged, there is still a potential for collapse if risks are not carefully managed for each collateral. Stablecoins like DAI, MIM, VST, and MAI allow many types of collateral that need careful monitoring. Users of those stablecoins are constantly at risk of one of the collaterals becoming illiquid, losing value too quickly, or risk parameters failing to be set correctly. A good example of this recently was seen with MIM, which used a considerable amount of FTT collateral as backing. It is unlikely the FTT collateral could have been safely liquidated on-chain. During the FTX collapse, they didn’t end up with crippling bad debt because those loans were repaid by the parties that took them out. It was a close call for them and highlights the risks taken by holders of multi-collateral stablecoins and why they often trade a little below the peg.
You can read more about what can cause bad debt here: https://medium.com/risk-dao/on-insolvency-tackling-bad-debt-in-defi-6c2ac5028348
Algorithmic Stablecoins
There have been many attempts to create a fully algorithmic stablecoin. They have failed dramatically when their holders lose confidence in the algorithm’s ability to keep the peg, causing a bank run. With no backing, there is nothing to stop the price of the stablecoin from dropping to 0.
Frax has a hybrid approach with algorithms providing stability for their stablecoin backed around 90% by USDC. So far, this approach has worked well with the USDC backing providing enough of a backstop for their various stability algorithms to perform their jobs.
They have also pioneered the AMO (Algorithmic Market Operations) that helps control market liquidity to help maintain a tighter peg. For example, their curve AMO can add and remove liquidity from the curve pool.
baoUSD Stability
BaoUSD is a CDP stablecoin, meaning its collaterals are crucial in helping it keep its peg. The safest collateral is ETH because it will always be liquid on the Ethereum network. To improve on stability compared to other CDP stablecoins, we need other stable assets to make up some of the backing. Still, there are no good examples of a fully decentralized stablecoin that can perform that function. The approach the bao community has chosen is to spread risk between a basket of stablecoins.
bSTBL contains the most robust stablecoins on the market while earning yield on battle-tested protocols with them and charging 0 fees. This is a safer approach than allowing individual stablecoins as collateral because the community can vote to change the underlying assets without forcing users to close their positions. If the community wants to reduce reliance on a stablecoin, it will change the weightings or underlying assets for bSTBL. Simple! It also means that users with bSTBL positions do not need to worry about switching protocols they earn a yield on because that, too, is managed by BAO holders.
baoUSD also has another important weapon in its arsenal to help it stay pegged — the FED. The FED is a smart contract that controls the supply of baoUSD available to borrow and at the same time, the interest rate paid by borrowers, which is tied directly to the amount of baoUSD there is available to borrow.
By increasing the supply available to borrow, interest rates are reduced, and more borrowing is incentivized — this is handy if there is upwards pressure on the peg. In the same way, the supply available can be reduced, increasing interest rates paid by borrowers and incentivizing people to buy baoUSD and repay their loans which will be a big help in situations where there is downward pressure on the peg.
Decentralization
Centralized entities fail us time and time again. It is the entire reason that crypto exists in the first place — to solve the problems with trust and censorship that have plagued us with the traditional financial system. This includes the risk of fraud, mismanagement, or regulatory controls imposed by overbearing constituencies.
Stablecoins like UDSC, USDT, and BUSD compromise decentralization to improve the other two goals of stability and capital efficiency — they use collateral controlled by a centralized institution that users can redeem at $1 for each token. It works very well for stability and capital efficiency but introduces counterparty risks that crypto is supposed to free us from — something that can seem low risk until it isn’t. The FTX drama and USDC freezing of tokens inside a Defi protocol with no warning are a testament to that. The lack of transparency for collateral backing USDT and Tether’s track record of lying about it seems like a disaster waiting to happen.
More decentralized stablecoins, such as DAI, are governed by a network of users who use smart contracts to maintain stability. However, they are only partially decentralized. They use collateral controlled by a central authority (wBTC, USDC, and others), which means it is subject to the same risks as traditional financial institutions.
Fully decentralized stablecoins like LUSD are the gold standard in this field, with no governance and immutable contracts. Holders can be confident that no one can ever make a change to allow a more risky collateral type, censor transactions, or mismanage collateral in any way, making it attractive to hold for users.
baoUSD Decentralization
Guardians at BAO hold LUSD in high regard for these features and favor taking a similar approach with baoUSD in the long run. We could make its contracts immutable so that no further changes can be made and focus on having fully decentralized collaterals where possible. We hope that in the future the decentralized stablecoin market has matured so that bSTBL can also become immutable, locking it down to include the best-decentralized stablecoins (other than baoUSD of course!). In the meantime, baoUSD is governed by BAO holders, and collateral is transparently visible on-chain at all times. Our goal is to make it a leading example of a decentralized stablecoin.
Capital Efficiency
Capital efficiency is the third goal that stablecoin designers must balance. Stablecoins that use capital efficiently will be more attractive, but a balance is still needed between the other two goals, or efficient capital use will be in vain.
Algorithmic stablecoins attempt to offer the best possible capital by using complex algorithms to automatically manage the supply of the stablecoin and maintain its peg to the stable asset. Meaning little to no capital is needed to mint them. In practice, this has yet to work. Frax is the closest to pulling something like this off with their hybrid approach, although in theory, they are backed 1:1 with a mixture of volatile and stable assets. FRAX can also put its capital backing to work, meaning it can earn yield. The yield goes to FRAX and FXS holders rather than those minting their stablecoins.
Centralized stablecoins typically store cash or cash equivalents in a bank account and mint a digital token that can be redeemed for dollars to help maintain its peg. They usually are backed 1:1, although it is hard to tell sometimes, especially with Tether’s USDT. They, too, can earn a yield on the underlying assets, but again it goes to the institution backing the stablecoin.
CPD stablecoins must be less capital efficient to keep their peg. They need more than $1 of collateral to mint $1 stablecoin because there needs to be an incentive for liquidators to claim at-risk collateral and sell it to repay loans. With volatile assets as collateral, there often needs to be a further reduction in capital efficiency to ensure quick price movements do not impact the ability to liquidate at-risk positions. CDP stablecoins perform a different use case than centralized stablecoins and stables like FRAX; they allow users to unlock value in their volatile assets without selling them; they can create new dollars using another backing.
baoUSD Capital Efficiency
Since baoUSD is a CPD stablecoin, users become the minters of baoUSD, allowing them to keep access to any yield generated on the assets used as collateral. For now, users can mint baoUSD with bSTBL, our stablecoin basket, which earns returns for holders across several battle-tested protocols. Up to 90% of bSTBL’s value can be unlocked and used for other purposes while remaining in control of all your bSTBL and the yield it earns.
Conclusion
The stablecoin Trilemma is impossible to “solve”, so you should be wary of any stablecoins that say they do. We have explored various implementations, including capital-efficient and well-pegged centralized stablecoins; capital-efficient, decentralized but badly pegged algorithmic stablecoins; and multiple degrees of decentralized stablecoins that either compromise capital efficiency or decentralization. Choosing which stablecoin to hold or use can be a complicated decision — there is always a risk of some kind, so it is essential to know what they are before using one.
The BAO community is a big fan of decentralization; we believe the trend for stablecoins will be in that direction as more and more problems emerge with centralized options — after all, crypto is meant to be decentralized to free us from these issues, so it makes sense that our stablecoins will be too, which will favor baoUSD.
If you would like to support the growth of baoUSD and get rewarded simultaneously, you can provide liquidity to our gauges. Rewards will start on December 28!
The BAO you earn can be staked for voting power, a share of revenue, and up to a 2.5x boost to rewards.
How to use baoUSD
- Navigate to https://app.bao.finance/
- Deposit the collateral of your choice.
- Borrow baoUSD
- Use your baoUSD to supply liquidity to our gauges or trade for other cryptos while keeping control of your collateral.
Please be careful, especially when using volatile collateral like ETH, to make sure you keep a health factor above 1. For more detailed instructions, you can follow our guides here
