Research Summary: On the Economic Design of Stablecoins

TLDR:

  • Without reliable economic design, under stressful conditions stablecoins are at risk of entering a death spiral when they are unable to defend their peg and win back market confidence.

  • This is especially severe if the stablecoins are only backed by themselves or other cryptocurrencies.

  • While fiat-backed stablecoins with appropriate capital buffers have low volatility, only CBDCs have zero risk.

Core Research Question

  • Are the economic designs of existing stablecoins reliable? What are effective ways to avoid economic risks?

Citation

Background

  • When well designed, the technology behind stablecoins may lower the cost of payments and increase interoperability. This is because they are able to trade on par with a reference asset (usually the US dollar).

  • Stablecoins differ from each other by the following qualities:

    • economic design

    • quality of the backing asset

    • stability assumptions

    • legal protections for coin holders

  • The economic design of stablecoins has two critical dimensions:

    • The volatility of the reserve assets against the reference asset

    • The degree of risk exposure to a death spiral

  • Lack of robust economic design can undermine a stablecoin’s usefulness. In the worst cases, it can even turn into a threat to financial stability.

  • High-quality, liquid assets perform better in stressed market conditions, making it easier for stablecoins to maintain their redeemability. This is especially true when combined with capital buffers.

  • The volatility of stablecoins refers to how much reserve is needed to support the peg at any point in time.

  • The current economic risks of stablecoins:

    • Given the size of their issuing amounts, it is unclear how many stablecoins would be redeemable at par in a crisis (the top five USD stablecoins account for $110B of worth)

    • Stablecoins that rely on investment tokens to back them suffer from this problem even more severely.

    • If expectations change these stablecoins would enter a death spiral, making them worthless.

    • Decentralized stablecoins rely on algorithms by design. They have a big challenge maintaining stability against a real dollar.

Summary

1 Introduction

  • As seen in the previous section (Background).

2 Key Design Choice: The Reserve Risk Profile

  • The key challenge stablecoins face is to ensure they trade close to par with their reference asset.
    • When a stablecoin’s price trades above par, it can restore the peg by issuing new coins.
  • When the price trades below par, it needs to liquidate reserve assets and buy back coins.
  • However, if the reserve assets have dropped in value after coins have been minted, the issuer cannot buy coins back and defend the peg.

2.1 Volatility against the reference asset

  • At one extreme, the value of the reserve and the reference asset move in perfect synchrony. This kind of reserve has zero risks, and is only true for CDBCs, as the banks control both the digital assets and its reference assets.

  • Though fiat-backed stablecoins have low volatility, they still need appropriate capital buffers to offset potential losses coming from credit risks, market risks, liquidity risks, and operational risks.

  • At the other extreme, stablecoins are backed by non-fiat-like assets, such as risky types of commercial paper or cryptocurrencies. Their required amount of reserve assets for buying back a given amount of stablecoin supply will fluctuate dramatically over time. In this case, over-collateralization is expensive and cannot protect coin holders from extreme events.

2.2 Self-fulfilling prophecies and stablecoin death spirals

  • Death spirals are likely to occur whenever the value of a stablecoin’s reserve is tied to the future success of the stablecoin itself. This is true for stablecoins reserved by their investment coins

    • They can fail even when initially over collateralized.

    • Stress is sufficient to cause loss of confidence and more redemptions, which can then lead to death spirals even in a healthy market.

  • During a death spiral, a stablecoin backed by its investment coins needs to be shut down. The reserve’s value will fall to zero easily and cannot be recovered.

  • Features that are intended to stave off death spirals

    • Solution group 1
      • Partially winding down the stablecoin as the likelihood of a death spiral increases.
      • This is effective while the stablecoin is fully backed, and there will be no need to sell its investment coins.
    • Solution group 2
      • Stopping a run after it materializes.
      • Has not been tested in the context of stablecoins, but likely to make matters worse based on historical evidence on bank runs in the United States.
  • The risk of death spirals is inherently tied to the first design choice, which is the volatility of the reserve assets to the reference asset.

3 Conclusion

  • Decentralized stablecoins are either exposed to death spirals or capitally inefficient due to a lack of reliable on-chain, fiat-pegged assets.

  • Decentralized protocols rely on centralized stablecoins as part of their reserve, and/or over-collateralization to maintain their market price at par. This shows that fiat-backed stablecoins may be the only way to ensure long-run stability.

Method

The paper first goes through the natures of stablecoins and arrives at its conclusion by logical reasoning and comparison with historical events in a particular case. Some explanations are supported by diagrams which can be found in the next section.

Results

The authors include an appendix and Figure.5 to discuss why algorithmic stablecoins find it hard to defend their peg in a crisis by reducing stablecoin supply.

  • Suppose the current price of the stablecoin is p < $1, and there is S amount of excess coins in circulation
  • The protocol needs to raise $(1+p)S/2 funds to burn S coins (Because the average price is (1+p)/2, and the quantity is S)
  • The additional coins to be issued is Q, with P as the price of the investment token, P’ as the price of investment token of the Qth coin is sold, and (P+P’)Q/2 = (1+p)S/2
  • During a death spiral, the amount of new investment tokens needed to be minted and coins to be burned rises dramatically. The cost of defending the peg quickly becomes infinitive.

Implications and Follow-ups

  • Adequate reserve assets (high quality, liquid, embedded within a legal framework) opens stablecoins to an upgradable path for CBDCs.
  • By building the peg with their investment coins, algorithm stablecoins are extremely volatile.

Applicability

  • To better understand the economic risks associated with various types of stablecoins and make better design choices for future tokens.
  • Stablecoin owners need to take caution in the implications of economic designs for different stablecoins
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@Twan thank you so much for contributing a fascinating summary. A couple of quick questions: Do you know of any recent examples of stablecoins failing to maintain their peg and entering the death spiral? Are there ways that stablecoin projects can mitigate the risk by conducting audits?

I’m also curious whether there is a point at which a stablecoin has so much money behind it that it becomes “too big to fail.” It also seems interesting to consider what might happen if more countries like El Salvador adopt Bitcoin as legal tender. Seems like it would blur the difference between CBDCs and crypto-backed assets a bit.

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That’s interesting to think if stablecoins become “too big to fail.”
[Fitch Ratings (2021). Stablecoins Could Pose New Short-Term Credit Market Risks. Retrieve from https://www.fitchratings.com/research/fund-asset-managers/stablecoins-could-pose-new-short-term-credit-market-risks-01-07-2021] In a recent report, Fitch Ratings seems to regard the reserve of Tether as a high-risk asset allocation. “A sudden mass redemption of USDT could affect the stability of short-term credit markets if it occurred during a period of wider selling pressure in the CP market, particularly if associated with wider redemptions of other stablecoins that hold reserves in similar assets.” (Fitch Ratings, 2021) However, it also points out that “We believe authorities are unlikely to intervene to save stablecoins in the event of a disruptive event, partly owing to moral hazard”. (Fitch Ratings, 2021) From this perspective, they don’t think stablecoins reach the quality of “too big to fail” so far. Maybe stablecoins need more capital and breakthrough moral concerns by some approach such as FIDF to reach it?

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Thanks, James. Here’s my take on your questions.

  • For a real example, Tether is at the center of attention. Let’s hope the stablecoin stays stable

  • Grant Thornton LLP issues attestations each month for USDC. You can find the reports here: Centre | USD Coin

  • As cryptocurrencies are decentralized, it is less destructive than traditional institutes

  • Preferably, legal tenders should have a stable price. Yet this quality is not essential to payment instruments

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I think there will not be an international trend for countries to adopt Bitcoin as legal tender as El Salvador in the recent cryptocurrencies development phase. If they do so, it will be hard to adjust the exchange rate and currency supply. This may cause a severe problem on loan liquidity, then affect the economic activities in the country. So I think most countries may prefer to preserve their currency sovereignty rather than use this kind of non-sovereign, decentralized cryptocurrencies, which may also be influenced by unknown third parties. However, if there come more countries to do so, the power of the USD may be weakened. I also wonder what will happen in other aspects.

On the other hand, as I know, many people are expecting to see a whole new financial system can be built, and this is prospective to begin from the cryptocurrencies-world. I think this is an interesting issue too.

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It seems that exchange rates and currency supply are less pressing problems in their country, which is why they adopted USD in the first place. President Bukele of El Salvador says he believes this will encourage investors with cryptocurrency to spend more of it in his country, but I wonder if people holding Bitcoin are looking to spend them at all.

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Thank you for contributing. Interesting and clarifying read!

I am curious. What is the reason that over-collateralization still occurs in the status quo if it is such an expensive option? And, why have protocols utilizing this option not switched over to fiat-backed stable coins if this is the most stable option?

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Thanks, shoule. Although over-collateralization could further ensure stability, switching to fiat-backed stablecoins could be financially devastating and thus is not an available option for everyone.

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