Research Summary: On the Economic Design of Stablecoins

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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Thanks Twan, really great writeup. Would love to hear your thoughts on the below in regards to the users of CBDCs

  • Have you seen any literature/insight on what goes into the consumer choice of which stablecoin to use? Of course there are some specific points of differentiation (ex. why someone would use a crypto-backed stablecoin vs. a Fiat-backed one)

  • The authors state that fiat-backed stablecoins appear to be the only way to ensure long-run stability - with the eventual introduction of CBDCs what might be the use cases / demand for fiat-backed stablecoins that are not CBDCs?

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Thanks for appreciating the work put into the summary. To your questions:

The first one sounds more like a topic that belongs to business or marketing, not economics. The resources that may be helpful to gain “insights” are no more likely to show in academic papers than industry reports or user studies.

The second one is asking for a prediction of the future. So far my favorite author on this topic is Nassim Taleb. If you know what he advocates, then you probably can understand that I think in a world dominated by unpredicted black swans, it is risky to assume CDBCs would take over. Needless to say what role stablecoins would play at that time.

Hope this helps :slightly_smiling_face:

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@Twan and @Astrid_CH do you see any connections between your two recent summaries (Wildcat Stablecoins discussion post and this one)? There’s also a bit of anxiety in the market right now about a Chinese real estate company called Evergrande, which has liabilities of about $300B and seems to be on the brink of failure. The company has issued many low-quality bonds, which are similar to the ones said to be backing some the larger stablecoins. Is this the sort of volatility trigger that could trigger a death spiral (or more legislation from regulators)?

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Evergrande is concerning to investors for many reasons. Analysts also have diverging opinions on how things may turn out. Yet I would say that the threat is different from the threat of a death spiral.

Death spiral happens when the market loses confidence in the promise from the institution, and starts panic selling. Panic selling is something that happens during the death spiral, but it can also happen somewhere else, such as a market crash, which could also lead to panic selling.

One of the main concerns with Evergrande’s impact on crypto is that investors that lost money may need to sell coins to raise funds. If bulk selling happens, prices may drop very quickly because of the surplus in supply. Price drops could also lead to problems with leveraging, hitting the market even harder.

In this case, the price drop from panic selling is only part of the process. Other factors play significant roles too.

So far issuers of some stablecoins have assured that they are not backed by the bond. However, if a stablecoin backs itself with bad bonds, and loses the value of the reserve due to that, then yes, it could enter a death spiral. That would be very relevant to this paper.

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Twan, this is a great research summary!

Stablecoin design and mechanisms is a constant work-in-progress, and having writing such as this provides such valuable insight and clarity over the topic.

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Why thank you. There is plenty of interesting work in the forum. I hope you stay around and find more summaries that you would enjoy.
If you’re particularly interested in stablecoins, you can check out Discussion Post: Taming Wildcat Stablecoins by @Astrid_CH.

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Thank you so much for pointing out the Taming Wildcat Stablecoins discussion post. @Twan can you tell us a little bit about how some of the regulations being considered in the US (such as Taiwan) might affect the design of future stablecoins? And how might that shape decentralized finance?

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Regulations in Taiwan and the US are quite different, and they are going to change as the market is still in an early stage of development. But if cryptocurrency continues to go mainstream, the government is likely to set up regulations that protect general investors against large risks.

I’d also like to follow up with your question on the similarities between the Taming Wildcat Stablecoins post and this one.

I think that post might be a more general overview of how stablecoins could develop over time, and this post is about a specific type of tail risk.

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Thank you for sharing that discussion post, which was also very insightful!

I’m curious, you write in your conclusion, “fiat-backed stablecoins may be the only way to ensure long-run stability”. Can you expand on your thoughts pertaining to how crypto-backed and algorithmic stablecoins can be a long-run solution with significant risk mitigation against a death spiral scenario? Or if you don’t ever see these types of stablecoins being a viable option, why that is so? You write that stablecoins backed by high quality assets perform better under stressed market conditions, and I would love to hear more about what you determine as the criteria for high quality.

Lastly, if given the perfect scenario, what are your thoughts on the ideal economic design of a stablecoin?

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IMAO crypto-backed and algorithmic stablecoins are less reliable because of the nature of that type of asset.

Because the crypto doesn’t pay dividends, the only price gain comes from the expected value in the future.

This easily leads to a vicious cycle when a death spiral happens, because the cause of that is exactly a significant drop of the expected value in the future.

Ideally, a stablecoin should be collateralized by fiat or highly liquid assets. The reserve should also be higher than 1:1 to buffer other financial risks.

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I keep thinking about the discussion we had about the digital eNaira and how struggling governments might use CBDCs to enforce spending controls or prevent withdrawals during a bank run. Smart Contract Summit 2021: Central Bank Digital Currency (CBDCs) & Blockchain Panel. Do you think stablecoins based on hard currencies might be used as a ‘safer’ substitute for a CBDC in some cases? Perhaps instead of using Bitcoin or pegging a currency to the dollar.

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If it is a legal tender, rather than a means to store value in the digital world, then instead of issuing stablecoins backed by the dollar, they might as well just used the dollar.

But what are the safety issues on CBDCs are you referring to?

As for Bitcoin, I think the country that adopts that as their legal tender usually have different goals than what expectations we have from more traditional options.

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Of possible interest to readers of this is Zeke Faux’ investigation into Tether’s financials in today’s Bloomberg. He starts by pointing out Yellen’s concern about the company’s rapidly expanding issue (now $69B worth, making it a potential economic risk)

I’m starting to see where some of crypto sector’s antagonism towards traditional journalism comes from. It’s a hit piece, filled with nasty allusions to people’s former careers as child actors or cartoonists (specifically Inspector Gadget).

Faux began canvassing Wall Street traders to see if they’d noticed Tether buying anything.

His best source is a former banker in Puerto Rico who claims he held 98% of tether’s assets. It’s definitely been informed by reading the Wildcat Stablecoins piece.

Faux discusses Bitfinex’s rescue, a crisis provoked when Polish Prosecutors seized a partner’s assets, and the company walked back its claims about always having a 1:1 ratio of traditional currency to tethers. He then finds a Bahaman company (Deltec Bank & Trust) that admits working with Tether (created by the former Inspector Gadget creator). Deltec’s chairman has a much more positive view of Tether, he says the reserves existed when he investigated the company in 2018.

Faux says he obtained (but won’t say from where or from whom) a document detailing Tether’s assets and says that they include billions of short-term loans. These do not include Evergrande though he does make a parallel to them and says it’s unusual for a money market to rely on them given the risk. Tether has also apparently loaned billions to Celsius Network (another crypto-related quasi bank). Celcius’s CEO says its ‘commercial paper is low-risk’ and borrows from Tether at 5% interest.

To me, this reads as if it’s pretending to be a damning indictment of Tether, in that it takes that tone and struts that way (look at the cover!), but every legitimate person in crypto Faux speaks to seems to back Tether’s claims about their reserves. Sam Bankman-Fried said he’d bought billions of Tethers because of traditional banks’ reluctance to deal with crypto companies. Celsius’ leaders seem confident in Tether which lending them money, Deltec investigated Tether and came away happy. Other than the Bitfinex liquidity issue caused by the Polish authorities, which required Tether begin using short-term loans, it seems like Tether does have assets, although Faux claims the reliance on short-term loans is potentially more risky than a traditional money market account.

Would love to hear everyone’s thoughts on the article.

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What I see from this article is a company that tumbling in setbacks and still survives well by settling risks of legal actions and redeem shortages. I can feel the author tried to accentuate the founder’s potential untrustworthiness by presenting something implying financial crime and fraud, but as @jmcgirk said, “every legitimate person in crypto Faux speaks to seems to back Tether’s claims about their reserves”.

I deed noticed that there is systemic risk exists within these crypto entities, such as the Crypto Capital Corp. incident. But does this affect the traditional financial system that may induce a huge crisis within the global scope? If so, the requirements of stable arrangement in a recent report by BIS may have grounds. This is also what I discussed in the Taming Wildcat post. But if not, as the Faux’ article said, wildcats notes “once fueled frontier cities’ economies”. Sometimes we just need a thing that really fosters a prosperous future. Even though its risk is larger than traditional tools, the benefits may be larger. In the crypto world, stablecoins indeed play this role on a large scale.

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Thanks for sharing Bloomberg’s investigation. I say it’s great supporting material and vivid illustration of some of the topics discussed in this paper.

In general, it seems that these coins are fine to use in most cases, not even when the institutions start issuing more money than their corresponding reserves. After all, it was only after the Federal paper money came out that notes issued by wildcats were replaced.

I wouldn’t trust everything I own with any stablecoin, but I say they are pretty useful to keep on a typical day. It’s going to zero only after a black swan event happens.

Tether holders might not be able to pull out all the money immediately upon loss of confidence, too. So if I were to defend from the issuer’s perspective of not holding enough reserve, I might start with that it’s unlikely for all stablecoins holders to ask to redeem within a very short period.

To deviate a bit -

  1. It seems a little odd to me though that the reporter said that stablecoins are used to do anonymous transactions because all transactions are visible on Etherscan. Anyone can look up by typing the wallet address.

  2. After reading the investigation, I looked up Coinbase’s page for USD Coin again. It’s 1/3 months into October, and Coinbase hasn’t issued their attestation for September yet, which is a little odd.

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Since they are called stable coins, users often think they do not face volatility. While stablecoins are pegged 1:1 to their underlying asset, they are also faced with volatility, albeit low volatility. However, there are times that volatility could occur with stable coins. While some of the most popular stablecoins are backed by the USD, they can also be backed by non-fiat-like assets. Therefore in a case where the underlying asset backing the stable coin is threatened, the coin itself is at risk of volatility.

A typical example of a threat to the economic prowess of the asset backing a stable coin is the debt ceiling extension the United States had to go through recently. If the debt ceiling was not raised, the USA would default on its debts and it could lead to catastrophic effects on the USD. In such cases, the users of stable coins can not be protected from the volatility that would result from such an event.

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Thanks for sharing your insights. I find them interesting, and would like to share mine as well:

  1. I won’t say the threat of a death spiral is high volatility. Volatility is a statistical measure of the dispersion of returns for a given security or market index. Death spirals are tail risks that are consequential and cannot be accurately represented by the characteristics of a distribution that does not take into account unexpected crises.

  2. Although both can be catastrophic, death spirals are not the same as hyperinflation (if that’s what you’re talking about). Hyperinflation happens when the demand for goods skyrockets or there is a large surge in the money supply. Death spirals are more like bank runs, which is when the underlying asset still keeps its value, but the reserve can no longer pay back to the coin owners.

Since I’m commenting anyway, I’d also like to follow up with USDC. Coinbase hasn’t been updating their monthly attestation for September for USD Coin, and we’ve arrived at the end of October! Let’s wait and see if this turns into anything.

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I looked up the attestations - you’re absolutely right, as of this Financial Times article (6 days old), we’re still waiting for September’s attestation from Circle and Coinbase about USDC. The share price of COIN has spiked considerably in the last few days so it’s possible they have. The article claims USDC was fully backed by US dollars until March 2020 and Coinbase says it’s been true up until August 2021. Circle is apparently (per this article in the Straits Business Times preparing for a NASDAQ listing, so there will definitely be a lot more scrutiny on the company and its reserves… should be an interesting year in crypto

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Just checked again. Circle has their attestations uploaded alright.

Highlights:

  • 4 billion more USDC in circulation. This makes 31.7 billion, 15% more than the previous update
  • Reserve is now 100% backed by cash. On the last attestation, it was 92% cash.
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