The Stablecoin Trilemma
Every stablecoin charges you in fraud risk, censorship risk or blow-up risk — find out which.
- Difficulty
- Advanced
- Time to result
- ~days to results
- Steps
- 6
- Confidence
- 91%
This framework comes straight out of a Naval tweet: crypto stablecoins — choose between blow up risk, censorship risk and fraud risk. The setup is that cryptocurrencies do best when everything is on the blockchain, but a stablecoin has to peg to something in the real world, and that creates a seam. The input is any pegged crypto asset; the mechanism is classifying it into one of three categories and naming the cost that category imposes. Category one is opaque fiat-backed, which he associates with the suspicion around Tether: for every token they issue they claim to have a dollar somewhere, but what if they do not — you are trusting them, back to the trusted third-party model of just putting your money in the bank. Category two is regulated and well known, like Coinbase's USDC: no fraud concern, but no advantage over normal dollars either, and censorship risk arrives when the government says it does not like this character and to seize their account — Coinbase can turn off your USDC, so you are no longer decentralised and sovereign the way you are with bitcoin. Category three is algorithmically collateralised, like Maker's Dai, backed by bitcoin and ethereum, where the hope is that the collateral will not move so drastically that the peg breaks. Naval is careful to say he has no evidence of fraud — the point is structural, not accusatory.
Origin
Naval published this as a tweet in the days before the October 2020 recording, compressing an observation about the DeFi boom: everyone building a decentralised Wall Street needed a dollar-denominated unit, and nobody was pricing what that unit actually cost them.
Core principles
- 01There is no free lunch: converting an inherently volatile asset into a stable one has a cost, and someone is paying it.
- 02People believe they are getting the stability aspect for free, and they are not — they are paying in one of three risks.
- 03Fiat-backed opaque coins charge fraud risk: the issuer claims a dollar per token, and you simply cannot verify it.
- 04Regulated, trusted issuers charge censorship risk: a government instruction can freeze your account, which returns you to the trusted third-party model you left the bank to escape.
- 05Crypto-collateralised algorithmic coins charge blow-up risk: if the collateral moves drastically the peg breaks and you lose money on your so-called stablecoin.
- 06A coin can charge more than one of the three, and combinations are common.
How to run it
- 1
Establish that the stability is not free
Start from the premise that you have a volatile underlying asset and you are trying to convert it into a stable one, so there has to be a cost for that. Tim's analogy in the conversation is the subprime mortgage crisis — repackaging risk does not delete it.
Pro tip If you cannot name where the cost went, you have not found it yet.
- 2
Classify the coin into one of three categories
Sort it as opaque fiat-backed (Tether-style), regulated custodial (USDC-style) or crypto-collateralised algorithmic (Maker/Dai-style). Each category maps to a different cost.
Watch out Marketing language will not tell you the category; the backing mechanism will.
- 3
Test for fraud risk
For fiat-backed coins, ask whether the claimed dollar per token actually exists somewhere and who has verified it. Naval's framing: they claim to have a dollar somewhere, but what if they do not, and you just do not know.
Pro tip Ask what an audit would look like and whether one has ever been produced.
Watch out Naval explicitly says he is not alleging fraud and has no evidence — the exposure is that you cannot check.
- 4
Test for censorship risk
For regulated issuers, ask who can turn your balance off. If a government instruction can freeze the account, your stablecoin has basically been seized and you are not decentralised or sovereign.
Pro tip Compare directly against a bank account — if the answer is the same, you gained nothing.
Watch out Trust and regulation remove fraud risk by installing censorship risk; that is a trade, not an upgrade.
- 5
Test for blow-up risk
For collateralised coins, identify the collateral and ask how far it can move. Maker is collateralised with bitcoin and ethereum, and the hope is that their prices will not move so drastically that the peg breaks and you lose money on your so-called stablecoin.
Pro tip Stress the collateral against its own historical drawdowns, not against a calm month.
Watch out A peg that has held is not a peg that is safe; it is a peg that has not yet been tested.
- 6
Name the combination and size accordingly
Conclude which risk or combination of risks you are taking on, and size the holding to that risk rather than to the advertised stability.
Pro tip Write the named risk next to the position so the assumption is visible later.
In the wild
Naval describes the fraud-risk category using the suspicion around Tether: the thing says it is backed by dollars but may not actually be backed by dollars, and you do not know whether the company has the dollars underneath, so you have to take their word for it. That puts you back in the trusted third-party model you were trying to escape.
→ The holder is exposed to issuer solvency they cannot audit — bank risk without bank regulation.
The second category is dealing with someone like Coinbase — well known, trusted, regulated — but then it is no different from holding normal dollars, and if the government says it does not like this character and to seize their bank account, Coinbase can turn off your USDC account.
→ Your stablecoin has basically been seized, and you are no longer decentralised and sovereign the way you are with bitcoin.
The third category is something like Maker, which is collateralised, but collateralised with bitcoin and ethereum. What the system is hoping is that the price of bitcoin and ethereum will not move so drastically that the peg breaks.
→ Blow-up risk: a sufficiently violent collateral move breaks the peg and the holder loses money on a so-called stablecoin.
Common mistakes
Believing the stability is free
Naval's whole point is that people think today they are not paying for it, that they are getting these free crypto stable dollars or getting the stability aspect for free. Unpriced risk is still held risk.
Solving fraud risk with regulation and calling it done
Moving to a regulated, trusted issuer removes fraud risk and installs censorship risk. If a government instruction can freeze the balance, you have reproduced a bank account with extra steps.
Trusting a peg because it has held so far
A collateralised peg holds until the collateral moves drastically enough. Extrapolating stability from an untested period is precisely the failure mode blow-up risk describes.
Assuming a coin carries only one of the three
Naval's formulation is that they are either taking on fraud risk or censorship risk or blow-up risk or some combination of them. Stopping at the first identified risk understates the exposure.
Is it for you?
Best for
Anyone parking meaningful value in pegged crypto assets who needs to know what they are actually exposed to.
Not ideal for
Long-term holders of volatile crypto with no need to sit in a dollar-denominated asset at all.
From the transcript
“there's no free lunch so what does that cost and all i was saying is that the three main categories of stable coins today they…”
“so for every tether they issue you they claim to have a dollar somewhere but what if they don't and you just don't know so…”
“there's censorship risk where if the government says hey we don't like this character seize their bank account coinbase can turn off your usdc account…”
“but they're not they're either taking on fraud risk or censorship risk or blow up risk or some combination of them”
From the episode
#473: Naval Ravikant on Happiness, Reducing Anxiety, Crypto Stablecoins, and Crypto Strategy