General Misconceptions About Stablecoins
Over the past few months I’ve found myself repeating the same conversations over and over again so I thought I’d write down a few things I found myself repeating.
1) Fixed supply tokens will eventually stabilize and then be useful for micropayments
It is impossible to predict the future (especially in crypto) with any degree of accuracy but this seems incredibly unlikely and is unsupportable by any historical data. Generally the demand for anything that has a limited supply depends mainly on speculation on future demand. There are no assets where the supply has been both as fixed and as liquid as crypto currencies. Even gold will be extracted at higher rates if the price is high and used at higher rates for industrial or cosmetic uses if the price is low. These alternative uses can be viewed as reservoirs for supply, pulling it out when demand is low and leaching it back in when demand is high. Fixed supply crypto is used solely for capital purposes (no natural reservoirs), the markets are unregulated and global, and the supply is in no way reactive to demand.
At the very least fixed supply crypto should be highly reactive to future expectations of growth. If we expect instability going forward we place a premium on liquid capital. If we expect rapid growth we place a premium on assets that will capture that (capital investments).
2) Stablecoins are risky and unprecedented
There are few great innovations that didn’t have both those traits.
There are three style of stablecoins (although many more nuanced designs exhibit hybrid traits). We believe all three will have a role in the future of space. It’s worth breaking this down a little to explore the different types of stablecoins as well as their precedents and risks.
Fiat collateralized (Tether)
These are basically cashiers cheques and only as good as the trust of the issuer. This style of note is actually how paper money worked for most of history (bullion backed notes).
Asset collateralized (Makerdao)
These are somewhat similar to notes issued from banks in the 1800’s. The note is only as good as the assets backing it. With these, in crypto, you need to trust the issuer less but trust the markets more. There is no proven route for elegantly handling blackswan events. Most strategies dictate rapid fluctuations in supply which would depend heavily on market liquidity. From a capital standpoint, these are incredibly expensive as they typically lock up otherwise productive capital. They are also fairly dependent on the investment decision of the designers/managers. However these systems are incredible useful however for providing decentralized margin. Many banks evolved into asset backed (often through the forms of loans).
Uncollateralized (Basecoin)
These are by far the riskiest approach but also have the highest potential reward. These systems seek to build a decentralized central bank. These require trust only in the protocol, leaving users less exposed to either centralized issuing entities or the underlying assets of crypto collateralized. Getting these systems to scale however is a daunting task that will require some degree of collateralization. These systems closest parallel is central banks.
3) Stablecoins are a winner take all space
Long term, there is an argument to be made for this (liquidity + network effects). In the short term this is highly unlikely due to regulatory uncertainty and the fact that there isn’t a single clear go to market strategy. From a regulatory standpoint different stablecoins are guaranteed to take different stances and make different bets which will align them closely with specific market segments. There will definitely be a white collar coin that pursues every degree of potentially relevant licensing and there will definitely be groups that take a more blasé approach to regulation. Due to the underdeveloped nature of the market (trading pairs and hedging are the only two use cases we have really seen), I expect a high degree of diversity in the go-to-market strategies, further allowing projects to distinguish themselves and carve out niches.
Stablecoins also have a much higher degree of interoperability with each other than with fiat, meaning that in the short term at least higher market penetration of any helps all. (Fiat backed tokens are considered an on/off ramp by uncollateralized/cyrpto-collateralized groups).
4) Stablecoins are easy.
This criticism is one of the most nuanced that we received. Generally people who held this belief actually understand most of the stabilization mechanism for most of the stablecoins very well. From a code standpoint, implementing these systems, while not trivial, is patently easier than implementing an interoperability layer or a sharding system. Better yet most designs are almost certainly guaranteed to work at scale. Network effects are powerful things.
If everyone in America woke up tomorrow speaking German, Mandarin, or French, America would continue to function. There would not be huge differences between all three cases. Designing our own language, while time consuming, also isn’t terribly hard. However these facts have very little to do with the actual challenge of getting America to adopt a new language.
Stablecoins are a similar problem. It is very, very easy to design a stablecoin (if you have had any exposure to economics and know a thing or two about cs). Over the 9 months we’ve been working on this we iterated through 10+ models before we incorporated (it seemed wrong to take investor money without evidence of the optimality of our model). Every single one of these would have worked at scale. However getting to scale means surviving a host of Soros attacks and black swan events. Stablecoins are the perfect short (infinite downside potential, minimal upside). So why did we choose the model we chose? What makes it better?
I have become very familiar with the operations of the federal reserve (as anyone working in this space should be). Something that has been discussed heavily both within our team and between me and some close advisors is the question of levers. The federal reserve has a broad variety of mechanisms at its disposal to maintain the alignment of supply and demand. Obviously any stablecoin will need to use a variety of different mechanisms to maintain stability as it scales. The key question becomes which should go where and who should control what.
Going back to the language analogy, how do you design something to do something that’s never been done before? How do you design a vehicle for exploring an uncharted areas on a map? How do you maximize your chances of success? The key is maximizing flexibility through layering. Only the most fundamental aspects of the stability mechanism should be in the protocol layer. The priority of the protocol layer should be simplicity and incentives. We want to motivate behavior of all other actors to benefit the system. We strongly believe that things like bonds markets or reserves should not be baked into the protocol. Both of these can be run externally. Creating a bonds market on top of a pool of Carbon Credits is trivially easy. Reserves, both in terms of gamability and suitability to economic context, should be both dynamic and discretionary. Protocol dictated reserves drastically increase predictability and, therefore, gamability of the system.
There is a massive amount of risk associated with setting up a protocol dictated reserve. Most dynamic governance structures lead to the problems with over leveraging. We see this with Keynesian economics on average running deficits. The best historical example is the free banking era where markets routinely drove banks to over leverage and then go belly up. Stakeholders are usually short sighted and counting on them not being short sighted seems naive.
On the flip side, reserve based systems that do not have a governance system are probably the most gamable actors in the space, especially if the rebasement is protocol driven and therefore also predictable. Ultimately most projects that emphasize a protocol level crypto reserve offer the worst of both worlds: the black swan performance of crypto collateralized and the death spiral potential of uncollateralized.
We focused on maximizing the simplicity, fairness (no rent seeking), and elegance of the protocol to make it easier for stability to both reactive to evolving markets and to be everyone’s problem. Carbon Credits give actors a stake in the system. Most projects in the crypto space will succeed or fail due to their ability to appropriately align incentives through stake and we believe the minimalism and flexibility of the protocol have set us up to make stabilization truly collaborative.
Stablecoins will likely be foundational to the future economy. Some tokenized anti-volatile currency will almost certainly achieve network effect. The path to this point is murky and convoluted and many projects will get bogged down by the baggage they tied to their protocol as a means of inspiring false confidence.
