Stablecoins and the Story of Money

Stablecoins are a class of cryptocurrencies which are price-stable — this means that it is pegged to another unit of value. Being the largest global reserve currency, pegging to the USD is often used as a proxy measure for stability. The largest cryptocurrencies, Bitcoin and Ethereum, have seen meteoric rises in value since their inception. Price-stable cryptocurrencies have extremely far-reaching benefits across the entire cryptocurrency ecosystem, so much that it is even dubbed the "Holy Grail of Cryptocurrencies". There is a huge market for a censorship-resistant and decentralized currency which is price-stable.

Firstly, hyper-volatile prices are problematic for time-based contracts. If someone was to make a bet for 1 BTC that an event will happen in a year, he is exposed to the risk of the event not happening and the risk that BTC will drop in value. This makes it difficult to calculate risk, and hence calculate odds on these types of financial contracts. Furthermore, all real-world trade is predicated on time-based contracts — payment and delivery of goods and services are almost always asynchronous. Being exposed to large price-volatility makes it extremely difficult to execute many types of commerce. Secondly, there exist a large number of crypto-traders who need a fiat-stable position to be able to hedge against a volatile position. This is the market that Tether is going for, and is already a multi-billion dollar market even in the early days of crypto. Lastly, stable coins are possibly the best definition for a new, sound, form of money and the natural evolution over fiat currencies. To understand this point, we must first understand the history of money and its purpose in society.

The Story of Money

Money is extremely complex and severely misunderstood, but at its core, it is a technology which solves a single problem — the double coincidence of wants. In a barter economy, if party A and party B both have items which are objectively equally valuable, they may still not be able to trade with each other because one party does not want the specific item the other party desires. Hence, money exists as a medium of exchange — a way for multiple parties to trade regardless of the specific desires of each individual.

Consequently, using a common medium of exchange creates price discovery in a market. By having a single currency, suppliers are able to put a numerical value on how much the item they produce is worth. Having explicit prices is much better than a barter economy — it creates orders of magnitude more efficiency in trade, every market participant can precisely indicate how much they value everything.

Lastly, the last use of money is as a store of value. Instead of having to store physical goods, some of which may not be durable, people can now keep pieces of metal which will not decay over time. Money allows people to abstract away the value of goods and services into a representative form of value, whether it is a large piece of rock or a metal coin.

It is extremely clear that money, is a fundamental step forward for society to exchange value and interact with each other more effectively. Money has evolved over time, from extremely primitive forms like shells to stones, then precious metals, then pieces of paper and now bits on the Internet. In each iteration of money, we have made progress in its utility — paper-money is much easier to trade than large Rai stones. We must see money as a social technology built to solve problems — and this can and should be improved upon.

However, the more money one amasses, the more purchasing ability he has, and hence the more power he has in a market. This dynamic creates the last, and not universally accepted use of money — as a form of power which extends beyond purchasing power, and includes things like social influence and political power. Naturally, this gives rise to power struggles on many levels, the most significant being political power struggles. By pushing for the US Dollar to become the global reserve currency during the Bretton Woods Conference, the United States snatched up an inordinate amount of power. Although the US has managed the USD sufficiently well without any major currency crises, it is obvious that this kind of power should not be concentrated in such few hands. Bitcoin and cryptocurrencies created an opportunity for money to become decentralized — clearly the next step for the evolution of money the technology.

Philosophy of Sound Money

Since it is obvious that a decentralized international currency is desirable, what should this currency look like? There exists a philosophical divide between two camps regarding what sound money is. The crypto-anarchists who love Bitcoin propose one main argument: "governments rob us of what we own by printing more money at their own discretion". Bitcoin solves this problem by being a decentralized fixed-supply currency, which is unseizable on two fronts — you have custody of your own money (unlike banks), and your money cannot be inflated away (no one can create more Bitcoin and reduce the value of your holdings). To this group of people, Bitcoin and other decentralized fixed-supply currencies are sound money. On the other side of the Bitcoin camp, there exist another group of people who believe that inflationary currencies are not inherently evil, but instead what is damaging is poorly managed, corrupt, and irrational amounts of inflation — factors which led to the extreme devaluation of various currencies in the past.

The fundamental problem with Bitcoin as sound money is that perfect value-retention (fixed supply) comes at the cost of usability. Fixed supply currencies will always be volatile, because the world is dynamic and demand for that currency changes over time. This inherent volatility renders Bitcoin complete unusable across a large set of financial transactions. The unpredictability of price of a currency is a huge barrier in commerce, and may be undermine any claims that Bitcoin will ever become sound money. If there are expectations that the price of Bitcoin will rise in the future, people are hesitant to spend. If there are expectations that the price of Bitcoin will fall in the future, people will not accept it as payment. Although there is validity in the argument of value-retention, I believe that the drawbacks of a fixed-supply currency are too great to ever enable money-like utility.

The State of Stablecoins in 2018

The importance of a price-stable cryptocurrency cannot be understated. Today, these stablecoins reduce the friction between fiat and crypto, allowing traders to easily jump in and out of positions without having to perform bank transfers. In the medium term, stablecoins will be used as the base currency for all on-chain financial contracts and applications, such as loans, gambling sites, prediction markets, and so on. In the long term, some stablecoins aspire to become a new form of money to replace the USD — a brand new monetary system that is used across the globe without any political bearings. How close are we to that pipe dream?

The short answer is: far. Out of all the projects today, the only one which has seen significant use is Tether, with over $2B in daily transaction volume. Although it is still the early days, we have seen a variety of projects use different models to achieve price-stability. There are three main categories of stablecoins: fiat-collateralized, crypto-collateralized, and non-collateralized. This blog post does an excellent job outlining the different approaches. However, the blog post glosses over some extremely important details and specifics.

Instead of comparing the pros and cons of each stability model, this blog post will provide criticism of specific projects in this space today.

1. Tether and TrustToken

By backing their tokens 1:1 with USD in the bank, these projects are super simple and are able to maintain the peg quite well. However, they will never work in the long-term for a variety of reasons. Firstly, it is against the ethos of decentralization to have the keys of a monetary system be held in 3 people's hands. This is even worse than governments, where power is completely monopolized by the creators of these projects, and creates perverse incentives which could harm the system. Secondly, this operation will never be able to scale. As the market capitalization for Tether and TrustToken gets larger, they will have to store more and more USD in banks. At a certain point (billions), it becomes impossible for banks to hold so much cash on their balance sheets, and Tether/TrustToken cannot grow beyond that. This means that Tether and TrustToken will only be effective in the short-term, if effective at all.

2. MakerDAO's Dai

MakerDAO is an interesting, but fairly complex project which uses other cryptocurrencies as collateral for their stablecoin Dai. Aside from the fact that it is difficult for the layman to understand the MakerDAO system, it does have some fundamental flaws which are difficult to overcome. Firstly, because the Dai is collateralized by other cryptocurrencies, it is vulnerable to extrogenous factors, such as a sudden devaluation of the collateral. To overcome this, MakerDAO says that they will soon be able to collateralize their Dai with a basket of diversified, uncorrelated cryptocurrencies so that the likelihood of the entire collateral collapsing is low. Let us take a look at the correlations of cryptocurrencies:

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Using data from here, it seems possible to build a fairly diversified portfolio of cryptocurrencies. However, this is severely misleading and is a misconception that MakerDAO has spread. Although 1-year correlations are fairly uncorrelated, all correlations go to 1 during a market crash. This means that it is, in fact, much more likely for the Dai's collateral to devalue severely with a crash of a single cryptocurrency like ETH or BTC.

Secondly, to accommodate for these market crashes, the Dai has to be over-collateralized. This means that there has to be more cryptocurrency in the system than circulating Dai, currently by 150%. Much like Tether and TrustToken, this creates an artificial cap on how big the Dai system can grow to. Today, for the market capitalization of Dai to be $10B, there must be at least $15B worth of ETH in the Maker collateral vault. That is currently almost 30% of the current ETH supply! This is an inefficient use of capital, but it is the cost of creating a buffer for possible devaluations of the collateral.

Lastly, any collateralized currency, like the Dai, is not particularly interesting from a money perspective. The Dai is unable to become an independent monetary system that can stand on its own legs without relying on other assets. Because of the way collateral works in the Dai system, the Dai economy can really never grow to anything larger than a small % of the crypto-economy.

3. Basecoin, Fragments, Carbon Money

These projects are non-collateralized stablecoins, which solves my issues with MakerDAO and Tether. However, they too, have their own kind of problems.

Although it is unfair to consider these three projects as homogenous, they operate under the same premise: expand and contract the money supply to control price, as stated in the Quantity Theory of Money. When the coin is trading above $1.00, print new coins and distribute them out. Conversely, when the coin is trading below $1.00, contract the money supply by destroying some coins — this is done through schemes such as Base Bonds, Fragment Bonds or Carbon Credits. The theory is that when you increase the money supply, this newly minted coins will get auctioned off into the free market and create downward price pressure. When you contract the money supply, each circulating coin is more scarce, and this should in theory bid up the price.

I believe that this model of stability is fundamentally flawed — there are many issues with religiously following the Quantity Theory of Money. The theory may hold true in the long-run, but there is no concrete evidence that it applies in the short-run as well. This is an example of how fragile the system is in the short-run: when the demand for Basecoin increases, people are willing to buy the coin above par value, let's say at $1.05. To push the price back down, the Basecoin 'algorithmic central bank' prints 10,000 new Basecoins and distributes it to the bond holders and the share holders. When the bond holders and share holders sell off these coins, the desired downward price pressure will be produced. But what happens when these bond and shareholders just hoard these newly minted coins instead of selling them? When there is no selling, prices will not change. Hence, the system sees that price is still not going down and algorithmically decides to increase the supply even more. All this while, the bond holders and share holders continue to sit still, pocketing all the newly created supply while the price still does not go down.

This scenario can happen in the short-run because the system is reliant on humans to actively sell off the newly created supply. There will always be a lag between changes in supply and correction of price, making the system less robust and reactive to price fluctuations. This also holds true for monetary contractions, but even worse. First, it takes time for people to actually buy up these bonds. Once they do, the money supply is effectively contracted. However, as before, the price of the coin does not magically get pushed back up to par value by adjusting the supply. The system still requires people to buy up these coins — and if there is a negative outlook on the future of the system, no one will.

The problem with a system that relies on macroeconomic theory is that there are no guarantees that it would work at all in the short-run. There are many variations of the expansion and contraction of the money supply, but they all suffer from the same fate in that they will likely break in the short-run. Steps to overcome this include back-up plans like a Reserve or a Bond-fund, but that too can be broken or drained relatively simply. Ideally, there must exist a stablecoin solution that is able to instantly adjust price back to par value and provide some sort of provable guarantees of price-stability. Such a stablecoin will be exponentially more robust and resilient than Basecoin, Fragments, and Carbon.

Concluding Thoughts

An examination of the existing stablecoin projects in early 2018 indicate that there is still a long way to go to build a new type of money. It is clear that any collateralized stablecoin will not be able to scale and suffers problems of custody and insolvency. To solve these problems, we must create an independent monetary system like Basecoin, but with a better and simpler model of stability. The Quantity Theory of Money does not hold true in the short-run and stablecoin systems which adopt this model can easily fall into an irrecoverable death spiral.

Stablecoins are much larger and more significant than just enabling specific financial contracts or for traders to trade — it is the next step for the evolution of money. This new money will be algorithmically controlled, free of political bearings and serve its use as the most advanced medium of exchange and unit of account we have in human history. So we must get it right.

In the later parts of his life, John Nash wrote and spoke about the possibility of an "ideal money". This would be a global money standard which would have value similar to that of standard measures, like the metric system. Of course, creating such a standard is virtually impossible from a political standpoint.

Cryptocurrencies have provided us with a way to create a decentralized currency — what is left to solve is price-stability.