The Future of Stablecoin: Will History Repeat Itself?
Block Crafters & Korbit Joint Research
Haebin Lee @ Block Crafters
Young Lee @ Block Crafters
Michelle Cha @ Korbit
Back When Private Banks Could Print Money
Stablecoin, a cryptocurrency that eliminates its price volatility first came to public attention with the launch of ‘Tether’ in 2015 — which was quickly accepted as a ‘key currency’ in cryptocurrency exchanges. Just as any other cryptocurrency, stablecoin has evolved from its original model over time. There are mainly three types of stablecoin: stablecoin pegged to fiat currency, stablecoin pegged to cryptocurrency, and algorithmic stablecoin. As this year remarks the third year since the first introduction of stablecoin, we would like to ask a crucial, yet difficult question to answer: Is the value of stablecoin truly sustainable? Can we trust the value of stablecoin? Discussion regarding stablecoin is reminiscence to the past when private banks had a right to print money, which suggests that the idea of ‘printing private money’ is nothing new. About 200 years ago, the Free Banking Era (1836–1864) in the United States was the era of massive power shift from central to private. During this era, private banks were allowed to issue currency, which was deemed as the exclusive right of central banks for a long time. Against expectations, the era ended as a failure in less than 30 years. This report aims to project the future of stablecoin in retrospect to the past failure of the free banking era.
Where ‘Wildcat Banking’ Prevailed
The first perspective to explain the free banking era failure focuses on ‘WildcatBanking’ stemming from a lack of robust governance . The term ‘wildcat banking’ refers to fraudulent free banks abusing the 1 regulatory loophole. Free banks could print money according to the face value of their collateral, not its depreciated market value. For example, in order to print 1000 dollars some banks would collateralize 500 dollars’ worth of depreciated bonds with a face value of 1000 dollars. After the issuance, wildcat banks would pocket this difference and close the bank without any prior notice. Many economists later contended that such practice caused damage to noteholders, a loss of trust toward the private banks, and eventually the failure of the free banking era. Such malpractice stemmed from a lack of supervisory authority to oversee the governance of free banks. In this context, the age of cryptocurrency may be no different from the free banking era. It is evident that cryptocurrency industry currently lacks regulations to prevent fraud, moral hazard, and unwarned bankruptcy of stablecoin issuers — even more so than the past. The industry must give proper attention and hold high standards to stablecoin issuers’ internal governance.
Once Collateral Fell, So Did the Currency
Declining collateral value is another suggested reason for the free banking era failure. Upon economic turbulence, the total value of collateral — which was in most cases, state bond — may fall below the par value of total outstanding notes. As banknotes were callable upon request, all noteholders would rush to a bank to redeem their banknotes for specie , which caused multiple free banks to go bankrupt. According to the paper published by Rolnick and Weber in 1984, 76 out of 96 free banks’ bankruptcies in four states (New York, Indiana, Wisconsin, Minnesota) during the free banking era have coincided with state bonds’ price fall. In this paper, they concluded that falling prices of collateral was the primary trigger for free banking era failure.
Can stablecoin be free from the risk of collateral price falling? In this context, stablecoin pegged to another cryptocurrency requires special cautions. Once collateral cryptocurrency exhibits drastic price volatility, stablecoin pegged to cryptocurrency will lose its purpose of existence — which suggests a higher chance of repeating the past failure.
In Currency We ‘Trust’
For a currency to be accepted as a ‘true currency,’ it is crucial to secure the trust of society. Economist such as Simmel, Hayek, and Cohen argued that currency can function solely based on social belief without governmental power. How would these economists evaluate today’s stablecoin? Will the social trust towards stablecoin be viewed as sustainable? Furthermore, if a stablecoin is issued and controlled by some lines of codes, can we trust it? We want to answer these questions first by defining social trust in two perspectives: the faith toward governing algorithm of stablecoin, and the trust toward its social acceptance as a public currency.
The first type of social trust, the one toward governing algorithm of stablecoin, is a reflection of the belief towards the algorithm’s capability to systematically stabilize the price of the coin in all situations. Once a stablecoin diverges from its basis price point, the algorithm should work immediately to converge the price back to baseline by adjusting circulation volume. If poorly-designed governing algorithm fails to promptly return to its basis price point, stablecoin will lose its price stability it’s trust. The second type of trust, the social acceptance of stablecoin as public currency, determines the level of social tolerance to price falling below the basis price point. Low level of trust can easily stir panic sell with a slight price decline, which quickly leads to the loss of currency’s value. We have already witnessed several modern-day examples of such a phenomenon. For instance, Zimbabwe has suffered from inflation due to economic policy failure and foreign capital outflow. Zimbabwe government’s repeated act of issuing new currency increased the circulation volume drastically. This accelerated inflation and raised questions toward the intentions and reasoning behind issuing currency, leading to the loss of Zimbabwean dollar’s social trust. By the end of 2008, the annual hyperinflation rate of Zimbabwe even reached 89.7 × 10 % . It entailed catastrophic side effect on all economic activities in Zimbabwe and due to the loss of social acceptance, Zimbabwean dollars were replaced with foreign currency.
Stablecoin Should Not Repeat History
There are three things stablecoin must secure in order not to repeat the history of failure: a sound internal governance structure of issuers, stability of collateral value, and social trust toward its governing algorithm and social acceptance. Stablecoins such as Gemini Dollar and Paxos Standard which are regulated under the NYDFS (New York Department of Financial Services) represent the very beginning of improved standard for issuers’ governance structure. Stability of collateral value raises a red flag to stablecoin pegged to cryptocurrency, which calls for additional systematic safety net to mitigate and hedge such risk. Securing social trust entails more complex discussion. The level of social trust toward algorithmic stablecoin and social acceptance varies between cryptocurrency users and general public. Building social trust to the general public means cryptocurrency being widely used in our daily life. It is a challenge.This is, however, the end-picture the entire industry currently aims for and hopefully it is a goal that can be achieved one day.
Despite the controversy, stablecoin may be a crucial stepping-stone for the crypto industry to grow stable. It is important to note that failure of stablecoin will only result in more chaos. The value of genuinely sustainable stablecoin will be much higher than mere a dollar on its note.
Reference
- Sanches, D., 2016, “The Free-Banking Era: A Lesson for Today?” Economic Insights, Federal Reserve Bank of Philadelphia Research Department,Third Quarter 2016, pp.9–15.
- Rolnick, A. J. & Weber, W. E., 1984, “The causes of free bank failures : A detailed examination,” Journal of Monetary Economics, Elsevier, vol. 14(3), pp. 267–291.
