Let a Thousand Stablecoins Bloom
what the free banking era tells us about room for competition in the stablecoins
Back when a dollar represented a claim on a fixed amount of gold, there were numerous state-chartered banks in the United States that issued their own notes.
Since redeeming notes for gold required taking them to the issuing bank physically, they traded at a discount as they got farther away, so a $1 bill issued in Kansas might be worth only $0.95 in New York.
Banks generally accepted deposits of other bank’s bills, the discount taking into account the need to sort out bills, ship them to their counterpart, and receive remuneration in gold. Notes from banks judged untrustworthy were likely to face steep discounts or not be accepted at all.To learn more about this, read Chapter 4 of Selgin’s Money, Free and Unfree.
Just as deposits at each bank might command different interest rates based on the risk/return profile of the bank’s lending business, so might the value of their notes fluctuate slightly based on the ease of redemption.
There are a wide variety of stablecoins, or cryptodollars, being issued. They differ in the trust assumptions involved, the risk exposure of their backing, the yield holders can earn on deposits and the cost to borrow, and the volatility of their price.
This is a good thing. Users have a wide variety of options to choose from, depending on which risks they judge more concerning and which returns they find most attractive in light of this.
If you’re an institution looking to earn crypto yields but may want to redeem to fiat in size, you may prefer USDC.
If you’re concerned about censorship and centralization, you’ll choose a coin with issuance governed on chain with decentralized debt or PCV backing.
I believe there is room for a wide variety of risk differentiated stablecoin models. Below I describe some elements of design that could influence a stablecoin’s success in the long term and observations about trends.
- demand to hold one stablecoin over another is strongly influenced by yield. Without a way for holders to earn that doesn’t rely on token inflation, it’s hard to see a long term answer to why someone would wish to hold the coin over another alternative.
- opportunities to generate yield have a wide variety of risk characteristics. Lending a stablecoin against ETH overcollateralized is much less risky than lending against a DeFi small cap and will carry a lower yield. If each lending market has a unique risk profile, each stablecoin also has a unique risk profile based on the composition of its backing.
- users have an appetite for a wide risk spectrum, especially as the “real world” starts to use decentralized financial applications.
- lots of room in the exchange design space. How much of each stablecoin should exist in liquidity pairs with each other coin? Are isolated pairs or multicoin pools best from risk and efficiency perspective, or is there a new and better structure waiting in our future? Uniswap V3 but you can express ticks with arbitrary number of other stablecoins using the same capital. Uniswap 3D.
- debt-backed stablecoins need negative rates. Sometimes, demand for a debt-backed stablecoin like DAI is very high, forcing price above the peg. This commonly occurs during a supply contraction. When crypto prices are dropping rapidly, leveraged borrowers will seek to repay loans all around the same time, and few participants will take new loans, so the price rises above peg. Reliance on centralized stablecoin backstops is undesirable and has scaling limits. Using a perpetuals-style funding rate is my preferred solution. When the price is above peg, “longs pay shorts” — holders of the stablecoin experience negative rates, incentivizing them to sell while the coin is above peg and allowing the supply to smoothly contract as borrowers buy and close their loans. Participants are also incentivized to open new borrows to earn funding rate payments. If the price is below peg, “shorts pay longs” — borrowers need to pay more to holders, so whoever holds the coin earns a savings rate. Please read more about what informed this view here.
- each lending market could support its own native stablecoin. A flexible currency supply would benefit any lending market by smoothing rate volatility and generally lowering costs for borrowers
- alternative denominations like RAI have promise, but for now most on chain borrow demand (the source of yield) is dollar-denominated. Remains to be seen what the demand side thinks about alternative denominations
