Balancing Stable Coins
Stable coins are a fascinating little corner of crypto. The main challenge is to create a coin with a stable value. Thus, any stable coin faces three big questions:
- What does stability even mean?
- How do you measure stability?
- How do you achieve stability?
The main point of this post is to discuss question #3, but before I get into that I want to briefly discuss points #1 and #2.
What Does Stability Mean?
The short and simple answer is that a coin is stable if the value of the coin remains constant over time (or, perhaps it changes at a constant rate). Unfortunately, this simple answer kind of breaks down once you start thinking about it.
One reason it breaks down is that we don’t have a great way of measuring value. For example, one way of measuring value is to use some baseline like, say, a bushel of wheat (or a pound of potatoes). But what happens when someone invents a new technology that makes wheat production more efficient? Does the value of wheat stay put or remain the same?
Karl Marx suggested that we could measure value based on how much time it takes a human being to create something. But this ignores the impact of education, technology, and other factors that might impact how productive a human being is.
Most modern economists pretty much just throw in the towel and admit that you can’t really compare value across large time scales. But if we take a short enough time scale, technology and other productivity factors are pretty constant. Then we define value in terms of a “basket of goods”. This is how they measure inflation of the dollar. For example, the Consumer Price Index is a common measure of how much a basket of consumer goods costs in dollars.
How Do You Measure Stability?
Most cryptocurrency designers bypass the thorny issue of defining stability (for good reason) and just define it in terms of some existing currency, say, the US dollar. Some even adjust for inflation based on something like the CPI. So for the sake of simplicity, let’s just pretend that the US dollar is stable and define stability of a coin in comparison to the dollar.
How does that work? People are buying and selling coins for dollars all the time. This creates a nice way to measure the value of the coin. Simply look at the price of the coin on an exchange relative to the dollar. The problem is that this information may not be available to the blockchain itself.
One common way to get around this is to use something called an “oracle”. An oracle refers to any method of getting information from outside the blockchain into the blockchain. A simple oracle might, for example, ask all holders of a coin to submit what they think is the price of the coin. Then these submissions could be averaged, and that average value could be taken as the canonical measure of a coins value.
Of course, oracles get a lot more sophisticated than that. There are even services that seek to provide agnostic oracle information that isn’t tied to a particular token. However, the oracle problem is a challenging one and not everyone agrees that even the best services, such as ChainLink, are reliable.
How Do Achieve Stability?
Ok, so we have already assumed that we trust the US dollar, so now let us go one step further and imagine that we trust an oracle to tell us the price of a coin in US dollars. Those are some pretty big assumptions, but they are necessary if we want to get to the real topic of this post: how to achieve stability.
The most important thing to understand when trying to achieve stability in the value of a coin is that coins have a supply and a demand. Supply is how many coins are available at a given price, and demand is how many coins people want to hold at any given price.
This relationship is probably the single most important concept in all of economics.
Some coins, like Bitcoin, completely disregard the balance between supply and demand and simply increase (or in some cases, decrease) the supply of coins over time. In fact, one of the reasons that many people like Bitcoin is that there is no central bank that can manipulate the price of the coin.
In general, we can assume that the coin itself has no way to influence demand. It is an external factor that depends on things like how many people want to use the coin (transactional demand), or whether people think it will be useful in the future (speculative demand). In fact, there are ways to try and manipulate demand, but we will hold that discussion for another time.
Since demand is determine externally, if supply is fixed the price of a coin will fluctuate based on demand. If you don’t want the price to fluctuate, you have to change the supply when demand changes (note that a change in demand happens when the whole demand curve shifts, not when you go up and down the curve). I should also point out that in the case of a cryptocurrency, there isn’t really a supply curve at all. Making coins is “free” in some sense, so in principle the supply can be manipulated to meet demand.
The end result of all this, is that you can achieve stability by increasing supply when the price gets high (a sign of high demand) and decreasing supply when the price gets too low (a sign of low demand).
How Do You Increase and Decrease Supply?
So we are designing a hypothetical stable coin, and so far we have decided:
- We are going to define stability in terms of the US dollar,
- We are going to measure stability using an oracle, and
- We are going to increase supply when the oracle tells us that the price is higher than our target, and decrease supply when the oracle tells us that the price is too low.
But our design is not complete because there are a number of different ways to manipulate supply, and they all have different advantages and disadvantages. I want to discuss five methods: collateral, rebasing, shares, bonds, and fees.
The basic idea of collateral is to issue new coins in exchange for holding some kind of external assets (say, US dollars) as collateral in a vault. When coin prices are too high, issue more coins (and require less collateral) and when coin prices are too low, offer a better price for people to reclaim their collateral. Some of the most common stable coins today are based on some form of collateral, like MakerDAO.
Rebasing is one of the simplest ways to adjust supply. The basic idea is that to increase supply, you simply add coins to every coin wallet proportional to the number of coins in the wallet. To decrease supply, you remove coins from every wallet proportionally.
Rebasing is comparable to the redenomination of fiat currency. One of the first discussions of coin rebasing can be found in the paper Hayek Money. Ampleforth is an example of an existing coin that maintains stability using rebasing.
The obvious problem with rebasing is that while it stabilizes coin value (which can make it easier to, say, write long term contracts denominated in the coin), the value of a wallet can fluctuate wildly. This might be fun for speculators, but it can be problematic for people who just want a medium of exchange.
Also, if demand is decreasing, people will know that supply will be taken from their wallets so they will try not to hold on to coins. This can result in further decreases in demand, which can then force more negative rebasing…which can lead to a downward spiral in wallet value.
Shares are kind of like rebasing, but instead of providing extra supply to all wallet holders, you provide the extra supply only to the holders of a separate token (i.e., the shares). The simplest way to do this would simply be to drop more coins on holders of shares, like giving dividends to the holders of corporate stock. Thus, issuing shares can be compared to issuing corporate equity.
By dropping new supply on shareholders instead of on all wallets, the value of the coins and the wallets can be preserved, while allowing investors to speculate on future demand by purchasing shares.
One of the first papers to discuss shares, namely Seignorage Shares, had a slightly more sophisticated method of using shares. They allowed share holders to swap their shares for coins if the price got too high (thus increasing the supply of coins), and then allowed coin holders to swap their coins for shares if the price got too low (thus decreasing the supply of coins). Unfortunately, if demand decreases for an extended period of time the value of shares can fall to zero and then the share mechanism can break down.
The idea behind bonds a bond is that you can remove coins from supply by selling something that looks more like debt than equity. That is, in exchange for coins today, you give someone a promise to pay them a certain number of coins tomorrow. A famous (but defunct) coin that used bonds was Basis.
Crypto bonds are comparable to government or corporate debt. In fact, one of the main tools that modern central banks use to manipulate the supply of currency is to buy and sell bonds. For example, when the US Federal Reserve wants to put more cash into circulation they buy outstanding US Treasury Bonds. When they want to take cash out of circulation, the sell them.
However, as with shares, the bond mechanism can break down if demand for the coin decreases for too long. The problem is that in order to get people to buy bonds you have to promise to give them more coins in the future than they give up today. Thus, if you keep issuing bonds, eventually the supply will start to increase as you pay out the coins promised to bond holders.
The final method of manipulating supply is to charge fees for transactions, and supplement or destroy part of the transaction fee (i.e., giving more or less than the amount paid to the miners who verify the transaction). One coin that makes use of fees to manipulate supply is a Korean coin called Terra.
One of the advantages of fees is that unlike the other methods discussed, modest, long term, decreases in demand do not necessarily trigger a death spiral in coin demand. Destroying a small portion of the coins in every transaction can be sustainable over a long period of time without putting negative pressure on the price of coins, bonds, or shares.
However, if the fees are too high, it can be a major disincentive for users of the coin to make transactions, which will eventually lead to less adoption. Thus, there is probably a limit on the fees that can be imposed while still remaining viable.
At the end of the day, pretty much every method of adjusting supply has some advantages and disadvantages. And every method has trouble with decreases in demand that are both rapid and sustained. A sophisticated coin might take advantage of multiple methods. For example, rapid increases in supply might be handled through shares. Rapid decreases could be handled with rebasing or buying bonds/shares. Sustained increases might be managed using bond sales/payouts, while gradual decreases might be managed using fees.