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Stablecoin Primer Section 1— Path to stablecoins

Fiat money’s inflation, bitcoin’s volatility bug, and stablecoins’ prowess

Path to stablecoins by diedamla

Functions of fiat money

  1. To calculate: In order to be a part of society and a complex economy, I need to know how to value my productive output and what I can get in return for it. For example, without money, say I am an apple producer, I would need to know the relative price of everything in terms of apples. But what if the thing I want to buy (e.g., pears) has no value in apples simply because their producer does not want apples. Money is a common denominator that allows me to easily evaluate my apple’s relative worth to pears and many other goods and services. We can think of it as an S.I. unit, such as Meters, to measure the worth of things instead of length or weight. As such, this function of money is usually referred to as the unit of account.
  2. To transact: Consider again the scenario where I’m an apple producer looking for pears, but this time I already know that the pear producer does not want my produce. So I go to a tomato producer who wants my apples and exchange my apples for tomatoes, which I intend to exchange for pears. Unfortunately, once again the pear producer rejects my offer because she doesn’t want my tomatoes. With money however, I could go to the tomato producer, exchange my apples for money, and buy pears with that money. A more efficient process thanks to money acting as a medium of exchange for apples, pears, tomatoes, and many other goods and services.
  3. To save: Sometimes our productivity exceeds our current needs and we want to save the “fruits” of our work for later enjoyment. For example, as an apple producer, I may have produced more apples than my needs. So instead of wasting my excess apples by having them rot, I need to exchange them for something that will preserve its value the next week and/or month. Without money, I end up having to go through the burdensome process of knocking on the door of many producers, hoping that one with durable goods would buy my excess apples. With money however, I wouldn’t have to go through the tedious task of finding producers of durable goods specifically looking for apples. I could simply sell my apples to anyone that wants apples and keep the money from this sale in my safe as a store of value.
Expected functions of fiat money by diedamla

Non-scarce fiat money

Gold has a high-stock-to-flow ratio because a lot of gold already exists and its annual production remains relatively stable. Graph source: The Bitcoin Standard, Chapter 3; Stock-to-flow by diedamla

Incentive to print

Inflation = -Scarcity

CPI diagram by diedamla

So what causes consumer prices to inflate?

If money supply grows (blue line), we would expect consumer prices to inflate (orange line). That’s why throughout the accounting history, the orange line and blue line have been closely linked — with a few exceptions. The period from 1995-now is one of these exceptions. During this period, tech advancements in the US made goods and services more accessible and cheaper, meaning the growth in money supply was successfully used in increased production. However, with the recent reports suggesting that CPI is at an historically high level, we may finally be at a point where growth in money supply does not translate to growth in production but in consumer prices. Source
Expected vs. Real functions of fiat money by diedamla

Enters Bitcoin

  • Bitcoin has a finite supply of 21 million units (vs. fiat money has infinite supply)
  • Bitcoin supply grows each time a miner (think a gold miner) discovers a new block on the blockchain
  • Bitcoin supply rate is fixed and decreases over time. Block discovery rate is adjusted every two weeks, and the number of bitcoins generated per block decreases geometrically. This means that every 210,000 blocks (~4 years), number of bitcoins created per block decreases by 50% (rate of increase of blue line decreases)
  • Bitcoin’s supply algorithm is cemented on the blockchain and agreed upon by all node operators. To change bitcoin’s supply schedule requires more than 50% of the decentralized set of node operators to agree — which is algorithmically disincentivized given it would be like shooting themselves on the foot for miners
The more bitcoin is extracted, the harder it becomes to extract new bitcoins. That’s why the rate of increase of new bitcoins (blue line) and thus bitcoin’s monetary inflation decreases (orange line) over time. This decreasing supply schedule is cool because it tries to mimic the rate at which new gold is mined and ensures a high stock-to-flow ratio for bitcoin. Source
Expected functions of bitcoin by diedamla

Bitcoin’s volatility bug

Expected vs. Real functions of bitcoin by diedamla

Path leading to stablecoins

1) Fiat-backed stablecoins, 2) Crypto-backed stablecoins, and 3) Algorithmic stablecoins. While fiat-backed stablecoins rely on a widely used reserve mechanism, algorithmic stablecoins depend on game theoretic coordination of their backers. Types of stablecoins by diedamla
Expected functions of stablecoins by diedamla



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Osman Sarman

Engineer and ex-consultant exploring stablecoins, twitter: @_namsso_