In considering local stablecoins, one has to consider international trade inflows and, crucially, how your stablecoin relates to foreign exchange (FX), i.e. how your local stablecoin will be liquid against the US dollar.

This forces local stablecoin mechanism designers to include FX in their considerations, so we at ViFi Labs have long considered The Impossible Trilemma an excellent model to map economies. If you're building for the world, you have to understand how the world works.

When considering international monetary policy agreements, an often spoken about decision-making theory, called the impossible trinity, discusses three primary options that are available to a nation-state.

These are:

1. A Fixed Foreign Exchange Rate: The country sets and maintains a fixed exchange rate with another currency or a basket of currencies.

2. Free Capital Movement: The country allows capital to move freely in and out of its economy without restrictions.

3. Autonomous Monetary Policy: The country maintains control over its monetary policy to manage its own economy, including setting interest rates and controlling inflation.

According to the impossible trilemma, a country can only achieve two of these three goals at the same time. Here's a breakdown of how these pairs play out in the context of global economies.

1. Fixed Exchange Rate and Free Capital Movement

A country may decide to fix its exchange rates with one or more other countries while allowing capital to move freely with others. In this case, independent monetary policy becomes unattainable because interest rate variations would create currency arbitrage, pressuring the fixed rates and leading to potential breakdowns in the currency pegs.

This is the least popular scenario of the 3, where a country maintains a fixed exchange rate with the US dollar while having open capital flows. This means that monetary policy is entirely linked to that of the US, and any attempt to change interest rates, with a view to relieving economic pressure, for instance, would result in currency arbitrage affecting the artificial pegs and causing a break.

Following World War 2, the Bretton-Woods system established currency pegs which held for a number of decades but quickly unravelled under increased capital movement. Over time, formal currency pegs have proven to be untenable at scale so countries on have the levers of an independent monetary policy and free flow of capital. Countries across the Caribbean still maintain formal currency pegs to the US dollar and Nigeria recently lifted this form of control as it inevitably leads to massive parallel market trading.

1. Fixed Exchange Rate + Independent Monetary Policy (No Free Capital Movement)

Alternatively, a country could choose to have fixed exchange rates and an independent monetary policy, but free movement of capital would not be possible in this setup. Once again, fixed exchange rates and unrestricted capital flow cannot be maintained simultaneously.

China had historically pegged its currency, the yuan, to the US dollar. While maintaining control over its monetary policy. It imposed capital controls to restrict the flow of capital in and out of the country, which adversely affected the economy.

1. Free Capital Movement + Independent Monetary Policy (No Fixed Exchange Rate)

A country might instead allow capital to flow freely with all foreign nations while maintaining an independent monetary policy. However, fixed exchange rates and the free flow of capital globally cannot coexist, meaning only one approach can be maintained at a time. Therefore, fixed exchange rates are not feasible if capital moves freely with all countries.

Several countries adopt this model with no fixed exchange rate, but it leaves them very vulnerable to interest rate changes enacted by the US Federal Reserve.

• Trade-offs: Countries must make trade-offs based on their economic priorities, and so must your mechanism design.

• Policy Implications: The trilemma influences economic and financial policies as countries navigate the challenges of globalization and economic stability.

• FX Mechanism Design: In designing a mechanism for FX, aspects such as capital controls, interest rate hikes, and other policy issues will influence FX price actions.

• Price Action Repricing: As protocol designers, issuers must design mechanisms to absorb deflationary and inflationary FX price actions to remain resilient.

Understanding the impossible trilemma is crucial for local stablecoin issuers as they balance these conflicting goals to achieve economic stability and growth.