Capital Efficiency in Stablecoin Design

If you think the crypto market will continue to grow, then maybe crypto-backed stablecoins are more capital-efficient than you think.

Note: This article is not financial advice. Hubble Protocol does not endorse any tokens or platforms mentioned in this article.

Stablecoins are one of the most widely used assets in decentralized finance (DeFi). However, no two stablecoins are built 100% alike, and a variety of these tokens have been developed, relying on various designs.

This article will take a look at the ways stablecoins are designed and put a special focus on capital efficiency.

Three Main Kinds of Stablecoins on the Market Today

Currently, three main families of stablecoins can be defined:

  • Fiat-collateralized
  • Crypto-collateralized (CDP)
  • Algorithmic (seigniorage)

Each stablecoin family suffers inefficiencies in design stemming from the “Stablecoin Trilemma.” This trilemma forces stablecoin designers to focus on mechanisms that can sacrifice either decentralization, price stability, or capital efficiency.

Image credits: Tezos
  • Price Stability: Is the price stable, whatever the market conditions? People won’t use a stablecoin that can’t maintain 1:1 parity with USD.
  • Capital Efficiency: What is the capital required to create $1 worth of tokens?
  • Decentralization: Does the stablecoin rely on a centralized entity?

How the Stablecoin Trilemma Plays Out

Usually, a stablecoin can fully respect only two of three conditions, but not all of them at the same time.

A fiat-collateralized stablecoin can have a very stable price and be somewhat capital efficient. One dollar of collateral is placed into an account and then recorded on-chain as a single token.

Fiat-backing ensures each stablecoin is worth $1, because it can be redeemed for cold hard cash, even if the token's price flies off peg. It does mean, though, that a private entity needs to bank these dollars.

This makes fiat-collateralized stablecoins the least decentralized type of stablecoin.

For crypto-collateralized stablecoins, the price will be heavily stable as well, since each token is overcollateralized by crypto assets. Instead of dollar bills in a bank account, all backing assets are managed on-chain, which makes these tokens decentralized as well as stable.

On the other hand, while over-collateralization increases peg stability, it can also reduce capital efficiency. These stablecoins need more than $1 in backing to create $1 on chain, and since crypto markets can be incredibly volatile, this usually means much more than $1 is necessary to back $1 of stable tokens.

Regarding algorithmic stablecoins, they are considered capital efficient, as they do not require much (or any) collateralization, and they are fully decentralized. Still, when it comes to price stability, algorithmic stablecoins have consistently failed.

Algorithmic stablecoins require far too much cooperation from different market players to work long-term. There's an element of trust necessary between those who redeem a seigniorage token and those who redeem a stablecoin to maintain price parity with USD, and if this trust is upended, then a bank run occurs.

In conclusion, when a stablecoin focus on securing capital efficiency, it introduces some existential risk, which is highly inefficient should this risk play out. Nobody wants to have their funds frozen (fiat-backed) or lose their held value (algorithmic) because of price instability.

Can Crypto-backed Stablecoins Be Capital Efficient After All?

Crypto-collateralized stablecoins can offer capital efficiency through many use cases like leverage, loans, or even arbitrage. Unlike fiat-backed or algorithmic stablecoins, users can leverage their capital with a collateral debt position (CDP).

Let’s say users are bullish on SOL. Instead of just holding SOL, they can deposit their tokens on Hubble, for instance, and mint USDH.

So now they still have custody of their SOL deposited, but in addition to that, they have USDH. They can use USDH to take a larger position in SOL to increase their exposure to the market, so basically they can use stablecoins as leverage.

Users can also use USDH to earn stablecoin yields from providing liquidity on a DEX or lending. DeFi gives users a lot of options!

If users need cash quickly, they can use crypto as collateral to mint stablecoins to pay for short-term liabilities. So, it's possible that users can pay their bills without exiting their crypto positions.  

This gives users more options than swapping for stablecoins through a DEX. It also allows them to maintain directional exposure to their underlying crypto assets, which a delta-neutral position cannot.

In conclusion, there are three kinds of stablecoins available today, and one of them, crypto-backed stables like USDH, helps maintain exposure to a growing crypto market. For users who think the crypto market will continue to grow, then maybe crypto-backed stablecoins are more capital-efficient than everyone thinks.

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