Research Summary: On the Economic Design of Stablecoins

[jmcgirk]

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.

[Astrid_CH]

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.

[Twan]

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.

[Remixbeky]

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.

[Twan]

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.

[jmcgirk]

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

[Twan]

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.

[Freakytainment]

I find this topic interesting, was reading through when I found this

@Twan

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

but I really don’t really understand what you mean by “stress” in the context which leads to death spirals even in a normal active market. Would be happy if you can explain that sir.

[Twan]

Unexpected or unfavorable volatility. Sometimes inflicted by a suddenly lost of confidence in the market. Sometimes made severe by unregulated over-leveraging. Normal active markets can crash too.
(I’m not a he/him btw)

[Freakytainment]

Thanks for the clarification. And I’d note that

[Samuel94]

A stablecoin is a digital currency that is pegged to a “stable” reserve asset like the U.S. dollar or gold. Stablecoins are designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin. Stablecoin are usually pegged to U.S dollar or gold. The combination of traditional asset with digital asset has proven to be wildly popular idea. https://www.coinbase.com/learn/crypto-basics/what-is-a-stablecoin
Stablecoins are important because they are free from the volatility of non-pegged cryptocurrencies. They have also be recognized to be accessible to anyone on internet, 24/7, fast cheap and secure to transmit. In a third world country with fiat-currency devalution, stablecoin can serve as means to protect fiat currency against devaluation. For instance, Naira, Nigerian currency has serial history of being devalued against dollars, a Nigeria can thus save his or her Naira against such devaluation by purchasing stablecoin.
Based on the economic designs, stablecoin maybe backed themselves or other cryptocurrencies or backed by fiat currency or they are CBDCs. As a result, while the technology behind stablecoins has the potential to drastically lower the cost of payments and increase interoperability and competition in financial services, in the absence of robust economic design, stablecoins may either never deliver on their potential or turn into a threat to financial stability. It has been contended that poor economic design of stablecoin can lead to death spiral or high capital inefficient. For instance, events in early May, when the algorithmic stablecoin TerraUSD crashed and the largest stablecoin (Tether) temporarily lost its peg, show that stablecoins may not be so stable after all.

To mitigate some of this risk the stablecoin design must be made to reserve risk profile. One problem of stablecoin is the inability to trade close to par with their pegged asset. When the price trades above the pegged asset, it can restore the peg by issuing newcoins, but when the price trades below par, it needs to liquidate reserve assets and buy back coins. However, where the reserve assets have dropped in value after coins have minted, the issuer cannot buy coins and defend the peg. Further the design must insure against volatility by ensuring that the value of the reserve and the reference asset move in perfect level. Just a quick question @Twan can legal and regulatory approach mitigate stablecoin economic risk and if yes, how ?

[Humphery]

@Twan I hope this finds you well

Regarding stablecoins, Terra’s UST has certainly given everyone a great shock. The best strategy to minimize or eliminate risk is to have the stablecoin backed by off-chain assets. With stablecoins, there should be little to no risk. The new Stablecoin Transparency Act calls for doing just that. By year’s end, this measure should become legal, which is good news for the cryptocurrency market.

[Humphery]

@Twan Stablecoins can be broadly divided into two categories.

1. Algorithmic Stablecoins

2. Conventional Stablecoins

Maker Dai is probably the most prosperous algorithmic stablecoin. People stake their Ethereum on a Dao in exchange for loans of Dai Stablecoins. If they don’t repay their loan on time or if the value of their Ethereum drops too low, buyers will step in and buy it at a discount. This approach appears to be used by the majority of algorithmic stablecoins. As long as the DAO is functioning properly and the coin backing it up (Ether) has value, this method is effective.
There are far more successful “traditional Stablecoins”. These include:
• USDT
• USDC
• BUSD
• TUSD
These tokens all function in a similar manner. The tokens are created by an institution, which guarantees that they are backed by dollars, bonds, and other reliable assets in a bank account. These organizations must also provide a way for you to exchange your coins for USD directly. The institution issuing them determines how reliable this method is. Some assert that they are completely backed up, but my suspicion is that most are only sufficiently backed up to handle a sizable number of people cashing them in. This approach is effective, and the institution stands by it.
ways to reduce risks;

There is really only one effective way to reduce risk: diversification. Invest a portion of your funds in various stablecoins. Instead, possess a range of them. You won’t suffer a catastrophe if USDT or USDC collapse.

[19charles54]

Are the Economic Designs of Existing Stablecoins Reliable?

This is a good question.

This question can also be asked of regular fiat systems. The banking system in the United States, for instance, is a fractional reserve system. Only a fraction of bank deposits is backed by actual cash. In a fiat bank run, a bank would go into a death spiral a lot faster because of its lower reserves compared to the supposedly higher reserves of some stablecoins. However, in the case of the United States, banks have various mechanism set up by the government to mitigate this risk, like the Federal Deposit Insurance Corporation (FDIC).

The question is, do stablecoins have similar mechanisms to mitigate risk? Apparently, not. Stablecoins don’t have anything equivalent to the FDIC in the crytoworld.

A stabilizing mechanism like the FDIC would be the holy grail of stability. Short of that, stablecoins would need an economic design capable of keeping the value of the reserve in lock step with its reference asset perfectly. And that’s not going to happen.

In a decentralized system, is that even possible?

What is economic design?

Economic design refers to the way that certain currencies interact with one another. Since they’re so widely used in nearly every industry, they’re not always easy to figure out. Secondary markets and other third-party sources can help you learn more about economic designs of existing stablecoins.

But it’s one thing to understand the design and another thing to implement it in practice. If there isn’t enough liquidity in the system to handle a withdrawal request or a trade transaction, then the economic design fails.

So how does a stablecoin mitigates this risk of snapping its financial bungee cord and plunging to its death? There are several strategies that stablecoin vendors offer for stabilizing their tokens: fiat-collateralization, crypto-collateralization, and non-collateralized algorithms or a combination of these approaches.

So, which is better? For now, the best strategy is fiat-based collateralization. The drawback is that you’re sacrificing decentralization for stability. Eventually we will probably see a day when we can combine the benefits of both worlds together, but that day is not here yet.

Currently, most vendors peg their tokens to the US dollar.

Since the dollar is the dominant global reserve currency it makes sense to peg a stablecoin to the usd. but is that sustainable, especially, when the US economy is struggling, and when there have been growing talks between Russia and China and others of using another fiat currency to replace it. So far, the United States and the usd has kept the wolves at bay.

But for how long? If there’s another fiat currency that ends up replacing the usd as the reserve currency in the future, then the ramifications will be dire for most cryptocurrencies that are pegged to the dollar because they’d no longer be as valuable as they used to be. Their value would have depreciated over time because of the shift in relative value between the new fiat currency and the pegged cryptocurrency.

So even the fiat-collateralization has potential risk because of international politics which are very volatile and unpredictable sometimes. In the real world. there are no real fixes, only tradeoffs.

[Idara_Effiong]

Although stablecoins are not widely used outside of the crypto industry at the moment, they have the potential for much broader applications. In June 2019, Facebook proposed creating “a simple global currency” or stablecoin called Libra, which would be pegged to a basket of fiat currencies, including the dollar and the euro. That proposal drew harsh criticism, both for its sponsor and for its design. Central bankers were concerned that it would jeopardize sovereign currencies and monetary policies. Diem has since been renamed and redesigned as a set of stablecoins, each tied to a different fiat currency.

It is not operational in part because Facebook promised in congressional hearings that it would not launch the concept unless regulators approved it, which they have not done. Other stablecoin issuers did not seek permission, and their tokens have grown enormously, prompting regulators to consider taking action.

Finance and technology are evolving in tandem. Today, technology is not only transforming finance but also money, with the introduction of a number of challenges to traditional sovereign currencies, ranging from Bitcoin to Libra. Among these, the development of new technology-based “stablecoins” holds significant promise for embedding a digital monetary instrument in distributed systems and transaction frameworks. However, as with all payment technologies and asset-backed structures, adequate regulation is required.

Furthermore, while most stablecoins pose a limited risk to financial and monetary stability, the introduction of global stablecoins raises much larger issues and concerns. In the future, authorities must have the tools, skills, and technology to recognize the evolution or creation of stablecoins, particularly global stablecoins, and to build appropriate regulatory and supervisory frameworks. Technology has the potential not only to improve supervision but also to provide new tools for enforcing regulations. Stablecoins and other forms of decentralized finance not only present regulatory and supervisory challenges but also opportunities for directly embedding supervisory and monitoring frameworks into systems during the creation and authorization process.

This has the potential to improve the achievement of regulatory and supervisory objectives through technology that was originally designed to make the role of regulation unnecessary. However, it remains unclear whether central bank infrastructures, such as CBDCs or retail fast payment systems, with a role for private sector services built on top, could provide many of these same opportunities more effectively. However, backing a stablecoin with assets that have low volatility in comparison to the reference asset is insufficient. Reserve assets must be of high quality and liquid, and they must be embedded in a legal framework that protects coin holders from credit risk, market risk, operational risk, and the issuer’s insolvency or bankruptcy. Stablecoins can provide not only efficient payment rails, increased competition in financial services, and new use cases when these conditions are met, but also a simple upgrade path to central bank digital currencies (CBDCs).

@Twan Thank you so much for contributing such an interesting summary.

[Amazingdez]

Thanks @Twan this is a very interesting summary, I learned alot… I think For a coin to enter the death spiral it has to be depreciating drastically, lacking investment/sponsorship and must have failed to mitigate the risks involved…

However, I think a stablecoin will eventually reach a point where there is so much capital backing it that it will be nearly hard to enter the death spiral.
Imagine third-world nations accepting Bitcoin as currency! Amazing, right!?.

[Gift82822546]

@Twan thanks for this interesting summary but I have just this two questions to ask ….
Are the economic designs behind the current stable coins valid?

What are the best strategies for minimizing economic risks?

[Cashkid18]

Nice work @Twan
The summary is really an interesting one especially for the crypto industry.
Stablecoins are digital currencies that are intended to trade on an equal footing with a benchmark asset, usually the US dollar.
Stablecoins all have the same basic goal of maintaining stability versus their reference assets, but they range greatly in terms of their economic structure, backing quality, and stability. suppositions and legal safeguards for coin owners.
Every stablecoin’s economic architecture is supported by two key factors: (1) the reserve asset volatility relative to the reference asset, which determines the stablecoin’s risk profile for coin holders; and (2) the stablecoin’s level of death spiral risk exposure.
Fiat-backed stablecoins must be subject to a framework that safeguards coin holders from credit risk, market risk, operational risk, and the insolvency or bankruptcy of the issuer in order to address these risks. To do this, they must rely on reserves of high-quality, liquid assets. Although decentralized stable currency designs do away with the need to rely on an intermediary, they are either highly capital inefficient or vulnerable to death spirals since they must be heavily over-collateralized to make up for the absence of an intermediary.
They are either highly capital inefficient or vulnerable to death spirals since they must be heavily over-collateralized to make up for the absence of a middleman. While these compromises might be acceptable for some bitcoin use cases,They are probably going to restrict growth without a breakthrough in decentralized stablecoin architecture.
the viability of these coins as a widely used payment method.

[Raphking]

@Twan thank you for this wonderful summary.
I learned that there are two dimensions of risk. First, “whether the value of the reserve assets relative to the reference asset (e.g. USD) is volatile, to begin with”. Second, whether the reserve assets are susceptible to a death spiral.
I would like to know if a coin like terraUSD crashed due to one of the above reasons and if the recent stablecoin is adopting an adequate approach to mitigate economic risks.

[Desotech]

From your question “Are the economic designs of existing Stablecoins relaible” I will confidently say it’s quit reliable due to its numerous features.
Stablecoin been a digital token whose value is pegged to the dollar(Or another Currency or asset). They serve to grease the wheels of the crypto industry, enabling investors to easily transfer value between different crypto exchanges and crypto currencies without converting back and forth into dollars.
The features of this Stablecoins are:

• Security and instant processing of payment
• Stable prices, as the volatility factors is
  numbed due to stablecoin being fiat or crypto
  reserve backed.
• Liberty to make private payments
• No associated taxation
• it’s a decentralized digital Currency.