A Framework for Decentralized Stablecoin Monetary Policy and Fiscal Policy Governance
Good governance is one of the most defining features of a healthy ecosystem (political, economic, social) in the long-run. As ecosystem participants come and go, they must abide by the set of rules and ideals perpetuated through the governance structure. In the blockchain world, decentralized governance is vital yet tricky to get right. A proper incentive structure must be put in place, with the ability to change in a measured manner. To achieve this, many blockchain ecosystems choose to start out more centralized, but move toward greater decentralization over time. This piece addresses some of the unique monetary policy and fiscal policy governance challenges specific to decentralized price-stable cryptocurrencies, and puts forth some ideas for how these core components of a stablecoin ecosystem can become automated, removing the need for human input.
Who Controls the Money?
There’s a saying:
“Cash is king”
Which really means:
“Whomever controls the cash is king”
In order to determine whether a stablecoin ecosystem is decentralized, look at who controls the money or collateral, and whether this responsibility has been put on a path to becoming more decentralized through governance. Monetary and fiscal policy are arguably the most powerful levers of a stablecoin ecosystem, balancing the stabilizing force of collateralization and the growth impetus of fiscal spending. Control over monetary and fiscal decisions is likely to be more centralized at inception, as ownership of the governance process is more concentrated. Centralized power at an early stage can be justified by the need for having fault-proof ownership in order to speed development, carry out expeditious system upgrades, and allow time for knowledge transmission of critical monetary and fiscal matters. The nature of the vesting or transition should reflect the intent of the protocol to automate or open these decisions to a broader network. The transition toward decentralization could be gradual as the founding entity likely has specialized knowledge about managing a decentralized ecosystem that must be conferred upon new, vested participants.
Any fiscal or monetary decision could be subject to a governance vote, where X% of validators or miners agree on a certain outcome for the network. This is a traditional approach to governance that has been applied to blockchains, and it can be effective. However, users and investors must place their faith in the people rather than the math running the network, resulting in a lower level of determinism for the protocol’s future state and a departure from the more programmatic origins of the decentralized movement. Voting is subject to gaming if insiders collude or control a majority of tokens and vote in their self-interest, however a more automated approach to decision making is subject to unforeseen risks in system modeling. It’s best to keep automation simple at first, and to gradually transition from one governance implementation to another as more information about system behavior is known. The focus for the remainder of this piece is to provide a programmatic governance framework for stablecoin monetary policy and fiscal policy decisions.
Monetary Policy Governance
Provisioning the Reserve — Ratio Between Endogenous and Exogenous Assets
To maintain the value of a stablecoin during a contraction or shock, a countercyclical stability mechanism is required. Dual-token stablecoin regimes where one token is the stablecoin and one token is the collateral coin are the most promising design to achieve decentralized stability. They rely on some form of endogenous stability (i.e. internally generated revenue streams such as seigniorage, transaction fees, or mining rewards) whose value reflects demand for participation in the stablecoin economy. And most decentralized stablecoins implicitly or explicitly rely on some form of exogenous stability such as the underlying pegged asset. These two forms of stability comprise the reserve that backs the stablecoin, with the total collateral ratio always >= 100% of the stablecoin money supply.
If the exogenous reserve ratio always remains at 100% of the stablecoin economy size, then no endogenous reserves are needed. But this type of stablecoin can be subject to centralization and censorship risk. However, the value of a fully endogenous reserve can be subject to a downward recursive spiral during severe declines in stablecoin demand, and these types of stablecoins have failed in the past. Thus, a hybrid approach is advocated here. As the exogenous reserve ratio moves away from 100%, there arises a decision point on what level of exogenous reserves are appropriate to guarantee stability.
The underlying asset the stablecoin is pegged to is the highest value exogenous righting mechanism that can be employed to contract the economy at the peg price, or to supplement the value of endogenous reserves. For most stablecoins, cash or cash-like instruments are the underlying asset for the peg, and one which they may have plentiful access to as their economy grows, through the power of seigniorage. Other exogenous assets, including cryptocurrencies can be used to achieve a greater level of decentralization, though proper portfolio management practices should be observed to minimize volatility and downside risk. For the purpose of this analysis, it is assumed that the change in value of each type of reserve asset is not due to portfolio management decisions, but other causes such as market behavior or changes in expectations.
The asset(s) which comprises the endogenous reserve is often volatile and its value as a proportion to money supply may fluctuate within a wide range based on economic cycles or growth expectations. In extreme cases, the endogenous reserves enter a recursive spiral, declining in value when they are needed most. To compensate for this, discount the endogenous reserve’s value by the appropriate scaling terms, to more accurately capture its true stabilizing capacity. First, rather than using the market value of endogenous reserves, let’s define the effective endogenous reserve value, denoted here as ‘epsilon’, which compensates for endogenous reserve downside volatility by subtracting off the value at risk (e.g. rolling 3-month 1% VaR). Second, discount the endogenous reserve by the exogenous reserve ratio, to adjust for the reality that a lower starting exogenous ratio means endogenous reserves will bear more of the burden for stabilizing the economy. An exponential factor helps to further discount the value of endogenous assets as they are not direct substitutes for exogenous assets. This factor also accelerates the provisioning of exogenous reserves in the event of a shock, a useful level of redundancy. These adjustments yield the following equation for the percentage of seigniorage which should be allocated to exogenous reserves based on the effective endogenous reserve value and the exogenous reserve ratio:
The graphs below show how the decentralized, programmatic reserve provisioning equation works. The first graph shows the output of the above equation. Seigniorage is available for fiscal spending only after protocol stability funds (miners and the exogenous reserve) are appropriately provisioned. Note that miner or validator rewards are not in scope for this writeup. Only after compensating miners and validators for the fixed and variable costs of maintaining the blockchain do monetary and fiscal decisions come into play.
The second graph shows how the exogenous reserve ratio evolves over time, as an output of the seigniorage allocation function and economic cycles. Note that the endogenous reserves are modeled to exhibit very high volatility, with their value being dependent on stablecoin demand and the use of seigniorage.
The third graph below shows the remaining amount of seigniorage available for fiscal spending. Given that fiscal spending can be volatile, a simple smoothing algorithm can be put in place to make fiscal expenditures more consistent over time. Fiscal policy is discussed in greater detail later in the piece.
Use of Reserves During Interventions (Exogenous vs Endogenous)
Both endogenous and exogenous reserves operate in conjunction to absorb changes in stablecoin demand. The reserves are scarce resources which must be managed appropriately in this service.
Endogenous reserves are an important instrument for achieving stability and adoption in a decentralized manner, representing a first line of defense for maintaining the stablecoin peg. Exogenous reserves represent a second (more senior) stability defense because they are theoretically less cyclically correlated with stablecoin economic cycles and price changes. The further away the exogenous reserve ratio is from 100%, the greater the potential risk that endogenous collateral sales will have diminishing marginal impact. But who decides when to use the endogenous reserves, the exogenous reserves, or both to maintain the stablecoin peg price during a contraction?
The countercyclical mechanism which provides endogenous reserves with greater stabilizing power during contractions is different for each stablecoin. During a recession or contraction in stablecoin demand, the endogenous reserve’s price declines, volatility increases, and demand diminishes…a dangerous trifecta, where multiple forces are working in tandem to erode the endogenous asset’s stabilizing power. At some inflection point the endogenous asset’s price enters a death spiral and never recovers. The death spiral is only averted by two powers, i) demand floor (uncertain), and ii) exogenous assets (certain). This is the reason why decentralized stablecoins often maintain an exogenous reserve, because it is certain to break the price spiral of the endogenous reserve, more so than any other mechanism of the protocol.
Assuming the reserve is properly provisioned (as described in the earlier section), the decision on when to use each type of collateral should come down optimizing system resources. Therefore, endogenous reserves are the first line of defense, as long as they are ‘pulling their weight’. This framework, if executed properly, would make it prohibitively expensive for attackers to break the peg. The more that endogenous reserves are used to contract the economy, i) the higher the exogenous reserve ratio becomes before it needs to be used as a last line of defense, and ii) the economy operates with greater independence from exogenous assets, which is the eventual goal. The formula for determining the level of exogenous reserves to sell, based on the endogenous reserve ratio (NRR) is defined here:
The threshold for determining whether to use endogenous or exogenous reserves is if the rate of endogenous reserve burn is greater than or less than the rate of stablecoin money supply contraction. If the rate of endogenous reserve burn is less than the rate of money supply contraction, then continue using endogenous reserves to contract the economy until a 100% exogenous reserve ratio is achieved, at which point the system can switch over to exogenous reserves. If the rate of endogenous reserve burn is greater than the rate of money supply contraction, then exogenous reserves can be used to help contract the economy. But this doesn’t mean use only exogenous reserve, because you would run into some of the same problems of capacity described earlier. Rather, the equation above demonstrates how exogenous reserves should be used to supplement endogenous reserves on a sliding scale. The ‘x’ exponent is an input that can be pre-set or programmatically set for spending exogenous reserves at a faster or slower rate than the model suggests, and can incorporate other inputs such as the starting or current exogenous reserve ratio.
To summarize, if the dNRR is negative, then sell exogenous reserves. The greater the NRR decline, the more exogenous reserves can be sold to subsidize its stabilizing capacity of the endogenous reserves. Though there are a variety of scenarios and special situations that can’t be captured in a simple formula alone, this represents an effective framework for solving a complex problem. If the stablecoin economy switches back to expansion, then the reserve would be automatically rebalanced at a measured pace using the algorithm from the previous section.
Below are the results of a stablecoin intervention simulation using endogenous and exogenous reserves. The scenario is very adverse, which is necessary to ensure the protocol can fully contract the economy at the stablecoin peg price.
Fiscal Policy Governance
Fiscal policy is the engine for allocating system resources, the same way that governments steer resources to stimulate growth and benefit the welfare of constituents. Fiscal resources are any form of protocol income, and can be comprised of seigniorage, other revenues, taxes, transaction fees, etc. The fiscal governance logic in this section engages only after the monetary reserve is adequately provisioned, given stability is the elemental requirement.
The goals of a programmatic decentralized fiscal policy are to promote the efficient allocation of fiscal resources while eliminating the need for voting or human input. Again, problems with subjecting such consequential decisions as fiscal spending to a governance vote arises from the inherent risk of centralization in governance token distribution and reliance on humans rather than algorithms. There are an array of situations where bad actors can attempt to bankrupt the fiscal reserve, so a variety of additional precautions can be put in place, which all work to make long-term commitment to the protocol a pre-condition for fiscal disbursement. A vote to ‘whitelist’ or ‘blacklist’ entities within the fiscal regime based on streamlined transparency mandates is a valid enhancement. These mandates can also be implemented as boundaries which automatically trigger upon suspicious activity, restricting fiscal disbursement. A ‘stability-as-a-service’ scheme is another method for doing this programmatically. Further discussion of these and other approaches to safeguard the fiscal resources is saved for another writeup.
A programmatic framework works well for a federated fiscal spending model where various decentralized service providers (firms) with unique value propositions compete with each other to receive an optimal allocation of capital. Resources can be allocated more efficiently in this manner, meaning the marginal propensity to consume and the fiscal expenditure multiplier is higher in the stablecoin world than for fiat governments. As mentioned earlier, fiscal spending can be smoothed by a simple algorithm to ensure fiscal resources are available even during periods with little or no protocol income.
The following formula demonstrates how the weight (w) of fiscal resources that each firm in the economy receives is based on the normalized transaction volume multiplier momentum (T) and the normalized money supply holding ratio (M), with (gamma) as the programmatic lever abstractly related to the concept of interest which is used to divvy resources based on the state of the economy and the usage of money.
A breakdown of the (T) variable, shows the inputs are i) the firm’s relative total transaction volume, ii) the fiscal expenditure multiplier (i.e. spending efficiency) represented by transaction volume (TV) divided by fiscal spending (F), and iii) the multiplier momentum. In this example, (TV) is a proxy for GDP. The multiplier momentum component re-scales the expenditure multipliers each epoch to more evenly balance the contributions of early cycle and late cycle firms. Weighted moving averages of (TV) and (F) are helpful to smooth fluctuations over time, as both can sometimes be volatile.
The money supply portion of the equation takes into account the monetary velocity for each firm relative to the broader stablecoin economy’s velocity, rewarding firms with lower velocity because of their outsized contributions to seigniorage. Rewarding a longer holding period helps to stabilize the distribution of funds across time and to raise the rewards for firms with lower velocity. Normalizing holding rewards by (TV) enforces honest behavior by eliminating gains from manipulation. Moving averages are also useful for the money supply component, as they work to maintain more consistent rewards by smoothing fluctuations over time and enforcing long-term commitment.
Below is a simulation of a 2-firm economy, showing the effect of including transaction volume (TV) and money supply (MS) holding as inputs for determining fiscal allocations. Firm 1 has half the transaction volume of Firm 2, so (TV1) = (1/2) *( TV2). But Firm 1 holds money for 4 weeks (Velocity1 = 13) and Firm 2 holds for 2 weeks (Velocity2 = 26). Therefore Firm 1 generates a greater proportion of seigniorage (1-V1/(V1+V2)). Some randomness is applied to the (TV) input in the model. The model gamma value of 0.5, midway between 0 and 1, is a reasonable choice for this simulation, but a lower gamma is useful to steer economic activity toward areas where rents are extracted via transaction fees, unless the protocol also extracts rents on money holding through demurrage.