Stablecoin War #1: 3C framework
Understand differences between stablecoins
Stablecoins can be unstable. You may have learnt this the hard way.
Use the 3C framework to get 10x better at assessing stablecoins. I can’t promise you won’t lose money on them, but you’ll make much better investments.
All you need is 3 minutes. Let’s dive in. 👇
A little quest
Before we get to the first C, I’ve a little quest for you. 😉
Imagine that it's 2014. The cryptocurrency world approached you to design the ultimate stablecoin. And because they’re cute, they told you that they want Doge coin to be *that* stablecoin. 🐶
Are you up for it?
The goal: 100 DOGE = 100 USD. So you’re sitting on the beach, under the stars. Trying to get inspiration. (And hating them for choosing Doge. 😡) How will you design the stablecoin?
We got ya a hint.
Remember, it’s 2014. So even the smartest crypto bro is still pretty dumb! Let’s just stick with a super simple design.
Ready?
If you answered- well, I just need to have 100 USD in my bank account, you’re right! This is the simplest solution- for each DOGE, you just need a USD so that you can swap them when someone asks for it.
Oh, and you've just discovered the first C!
The first C
Our first C is collateral. This sounds like a big word, but it’s really easy. Suppose you want to invite your dream crush to your house party, and you say you’ve 10 homies who will be there.
Your collateral are the 10 homies supporting you. 💪
And this solution has a name!
You are using a *fiat-backed* solution. You have 100 USD in your bank, and you allow for anyone to swap 1 DOGE for 1 USD anytime!
Ok, now we gotta move to level 2 of the quest. 😎
Leveling up in our quest
You thought that the crypto world will be delighted at your solution, but instead, they are outraged. 🤬
“How dare you back DOGE with actual fiat money! Haven’t we created crypto so that we can get away from fiat?”
Crap. Time for another solution!
If you answered- well, I just need to have 100 USD worth of another crypto asset (say ETH) to back up my 100 DOGE, you’re 50% right!
So what's the mistake?
Remember how most crypto prices move in fucking circles? 😁
If you back your 100 DOGE with only 100 USD worth of ETH, your ETH may only be worth 70 USD tomorrow! Uh-oh, your DOGE holders may panic, and they will try to dump their DOGE. Not good.
What should you do then?
If you figured out that all you need is having >100 USD worth of ETH to back your DOGE, bingo!
The second C
This brings us to our second C- capital efficiency. Another big concept, so let’s go back to our house party analogy.
If your homies are flaky, then you need to invite more than 10 of them. But your house can only fit 10 homies, so some of them have to sit outside. Not a very efficient use of their time. 😔
Thus, *crypto-backed* stablecoin has a big downside.
Because you always need to over-collateralize (>100 USD worth of ETH for 100 USD of DOGE), a crypto-backed stablecoin will have low capital efficiency.
But life ain't perfect, so we gotta live with imperfections. 🙃
Alright, final part of our quest!
Final quest
The crypto world issues you their final challenge- backing with crypto is great, but you are still in charge. Too much power!
Back to the drawing board- how will you design a solution so that a single entity does not hold too much power?
The third C
I’ll give you some time to think, so let’s go through our third C- centralisation. House party analogy- are you the only person making decisions? Or will your homies take turn?
Alright, time for a solution to the centralisation problem!
This is a little more complicated, but we can replace you with smart contracts. No worries, we won’t ask your dream crush to date some lines of code, but we can use code to simulate a central bank!
How will this work?
The smart contract will control DOGE supply so that 1 DOGE = 1 USD. Trivially, the contract will increase DOGE supply when 1 DOGE > 1 USD, and decrease DOGE supply when 1 DOGE < 1 USD.
This is an *algorithmic* stablecoin.
Recap and examples
Yay, we've passed the quest! Let’s recap our 3Cs.
Collateral
Capital efficiency
Centralisation
All 3 types of stablecoins- fiat-backed, crypto-backed and algorithmic, trade off between these 3Cs.
Let’s look at some concrete examples.
Fiat-backed: Tether’s USDT. Collateralised with fiat, capital efficient, but highly centralised.
Crypto-backed: MakerDAO’s DAI. Over-collateralised with crypto, capital inefficient, but less centralised (no one person has absolute control over the underlying asset.)
Algorithmic: Terra’s UST (RIP). Under-collateralised, capital efficient, and decentralised. However, the algorithm failed the stress test of panic selling.
How should you assess stablecoin projects?
There is no model that is absolutely better. The key idea- treat your stablecoins as an investment! This is also true for your fiat currencies- a black swan event may make them unusable.
You’ve to decide which combination of the 3Cs makes you the most comfortable.
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Sources:
I’ve borrowed heavily from Haseeb Qureshi’s fantastic piece on stablecoins. Honestly, the original piece was so good that all I did was repackage his article into a cuter one.
The DeFi Edge’s thread on stablecoins was another great inspiration.