The Stablecoin Trilemma and Why Capital Efficiency Matters?

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Chi Protocol

6 min readOct 19, 2023

The Stablecoin Trilemma

Stablecoins are cryptocurrencies designed to mimic the price of another asset, most commonly USD. Despite the total market cap of stablecoins being significantly large at $125b, no protocol has yet been capable of building a stablecoin that is capital-efficient and decentralized.

The goal of stablecoins is to be stable, but this is often achieved at the expense of adding centralized collateral assets or through additional layers of safety with over-collateralization. This is also called the “stablecoin trilemma” — a problem that Chi Protocol has solved.

The stablecoin trilemma is the major limitation to the growth of DeFi as stablecoin protocols require their users to put in more dollar value in collateral than the amount received in stablecoins. When minting stablecoins, the goal is to maintain the mint value as close to $1 as possible, a topic that is known as capital efficiency. If you have $1 million that could earn approximately 5% interest in traditional banks, a stablecoin with only 50% capital efficiency would need to offer a yield of over 10% to remain competitive. Thus, this factor holds significant importance.

Stablecoins on the Market

The total market capitalization of stablecoins is currently at $125b, of which 90% dominance comes from Tether and Circle.

You can see that most of the stablecoin issuance derives from multiple centralized players, as the most capital-efficient ones are redeemable stablecoins, which usually offer 1:1 direct dollar-to-dollar parity.

So, let’s look at what’s on the market for stablecoins.

Fiat Collateralized Stablecoins

Stablecoins within the Fiat-Collateralized category are issued with fiat currencies like USD, EUR, and others serving as collateral. Examples of these stablecoins include Tether (USDT), USD Coin (USDC), and TrueUSD (TUSD). Typically, centralized institutions issue and oversee these stablecoins and maintain a close to 1:1 collateral ratio. This means that for each stablecoin issued, an equivalent unit of legal currency is required as collateral.

Centralized stablecoins issuers have easier access to real-world money, benefitting the most from almost perfect efficiency with close to 100% collateral ratios.

Overcollateralized Stablecoins

Cryptocurrency-collateralized stablecoins are stablecoins issued with cryptocurrencies (e.g., ETH, WBTC, stETH) as collateral, such as DAI, LUSD, and crvUSD. The collateral ratio of these stablecoins is relatively high, usually in the range of 1:1.5 or 1:2.5, which means that to issue every one of a stablecoins, $1.5 or $2.5 worth of cryptocurrencies need to be deposited as collateral. Overcollateralized models provide stability at the expense of capital inefficiency for their users, as shown by the collateral ratios below.

Stablecoins Backed by Centralized Assets

Cryptocurrency-collateralized stablecoins can also be backed by centralized stablecoins (e.g., USDC). Stablecoins of this type include FRAX, which mainly uses USDC as collateral.

The design of FRAX results in a trust-constrained model for a stablecoin originally introduced as decentralized (e.g., de-peg of USDC stablecoin implies de-peg of FRAX as shown in March 2023).

Despite some recent innovations with soft liquidation mechanisms, available options of decentralized stablecoins on the market do not provide a design which combines decentralization with pure capital efficiency (1:1 with USD).

Why is capital efficiency important?

Capital efficiency is the ability to mint the stablecoin for a collateral ratio of 100%. For perfect capital efficiency, for each 1 USD worth of collateral deposited, the users should get back 1 unit of the stablecoin. Capital efficiency is the primary driver of growth for a stablecoin.

You can see that the largest stablecoins (i.e., USDT and USDC) are the most capital-efficient, and those who want to preserve the decentralization of their design (below 8.5) have limitations with their scalability to get in $billions.

A few stablecoins have attempted to be capital efficient in the past, but without real assets backing the outstanding supply. Notable examples include UST, which grew to a $18b market cap but eventually collapsed due to a highly fragile collateral (LUNA).

You might expect that decentralized stablecoins forgive capital efficiency to maintain a more stable peg with over-collateralization. Surprisingly, we observe the opposite. It’s intriguing to note a strong correlation where the most excessively collateralized stablecoins tend to exhibit the weakest peg. In reality, the positive correlation is between size and peg, which newly shows the importance of capital efficiency.

About Chi Protocol:

Chi is an Ethereum-based protocol issuing a decentralized and capital-efficient stablecoin, known as USC, designed to bring stability, scalability and greater economic incentives to the world of decentralized finance. USC is the first stablecoin issued by Chi Protocol. LSTs are used as collateral to back it, and it relies on a dual stability mechanism to maintain the price at 1 USD.

Chi’s primary goal is to scale DeFi with a capital-efficient and yield-generating stablecoin known as USC. This is achieved by always enabling users to mint USC with their LST/ETH deposits at a 100% collateral ratio and combining this with the dual stability mechanism to generate a stablecoin yield source for USC stakers.

An additional important component of Chi Protocol is the CHI governance token, which can be staked to receive the LST yield of the USC reserves. Alternatively, users can lock CHI for a customizable period and have allocated a respective veCHI amount that is used to participate in the governance decisions of the protocol. Furthermore, veCHI lockers are entitled to CHI incentives and can earn trading fees earned from POL (Protocol Owned Liquidity) on top of their ETH rewards.

One unique aspect of Chi Protocol is its opportunity for users to generate a steady income through real yield. Users can earn more USC from the dual stability mechanism by staking USC. This income is drawn from the case where the stablecoin trades below 1 USD, and the reserves to back it are in excess. In this scenario, the algorithm buys back USC and distributes it to USC stakers. Furthermore, Chi Protocol also runs a Governance Bootstrapping Program, where USC stakers are entitled to veCHI, yielding additional revenue sources in ETH and CHI.

To keep updated on future key announcements, stay in touch with us on our socials at:

Twitter: https://twitter.com/ProtocolChi

Discord: https://discord.com/invite/d5BswV5scv

Website: https://chiprotocol.io/

Docs: https://chi-protocol.gitbook.io/docs/background/chi-protocol

References:

stablecoins overview: https://defillama.com/stablecoins

usdt: https://tether.to/en/transparency/#usdt

usdc: https://www.circle.com/en/transparency

dai:https://daistats.com

tusd: https://www.tusd.io/

frax: https://facts.frax.finance/frax/balance-sheet