Icewater
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Icewater

Stablecoin Bankruptcy

Recently, Vitalik asked an interesting question: can a stablecoin “safely” wind down to zero users?

He makes the following useful point:

In principle, if demand decreases extremely slowly, the volcoin’s expected future fees and hence its market cap could still be large relative to the stablecoin, and so the system would continue to be stable at every step of its decline. But this kind of successful slowly-decreasing managed decline is very unlikely. What’s more likely is a rapid drop in interest followed by a bang.

Vitalik is right, a stablecoin can wind down if the system declines gradually, but it can also experience a death spiral if the decline is too sudden. No currency can be completely risk-free, so the challenge for a stablecoin is to design a coin that does two things:

  1. Reduce the risk of a sudden collapse; and
  2. Assign losses appropriately if a collapse happens (i.e., create an orderly “bankruptcy” process).

Reducing the Risk of Collapse

Just because a collapse is possible doesn’t mean we can’t do anything to make it more or less likely. Here is an overview of things you can do to reduce the likelihood of collapse:

  • Issue coins conservatively. Each stablecoin is a liability of the system. If you issue a lot of coins without a lot of revenue, you won’t be able to withstand a run
  • Partially collateralize. All issued coins should be backed by either external collateral or future revenue. Having at least some collateral makes the system more robust to sudden shocks. You can collateralize by allowing people to mint tokens with an over-collateralized vault, or by simply exchanging equity for collateral in good times.
  • Create a stable revenue base. For any algorithmic stablecoin, at least some liabilities will be backed by expected future revenue. If your revenue base is volatile, your coin is more likely to be volatile. If possible, differentiate between “stable” revenue and “speculative” revenue, and use the stable revenue number as a basis for determining the limit on how many coins to issue.
  • Stabilize with debt, not equity. The main difference is that payments on debt are more secure (because debt gets paid before equity gets paid) and predictable (because they usually have a fixed rate of return). Since debt has a more stable value than equity, it is a better tool for stabilizing a currency.
  • Create a bankruptcy protocol. By having a transparent bankruptcy protocol, you can increase stability of the stablecoin by making it clear that stablecoin holders are senior to debt and equity holders.

Orderly Bankruptcy

You may have seen a diagram like this explaining the a concept of “seniority” in a bankruptcy scenario:

https://ieefa.org/articles/ieefa-primer-cleanup-costs-supersede-most-other-liabilities-oil-and-gas-bankruptcies

The basic principle is that some stakeholders have priority over others in a bankrupcty scenario. Those at the bottom (i.e., equity holders) take on more risk because they are lowest priority, but they are compensated by having a higher upside. It is important to distinguish between who is taking a risk and who is not taking a risk.

Some of these categories may not apply for a smart contract (i.e., administrative costs), but the following could be relevant:

  1. Secured debt. For example, a vault that has a claim on a particular piece of collateral.
  2. Stablecoins. The second priority should be to pay holders of the actual stablecoin.
  3. Unsecured debt. These are tokens or staking or anything else that pays out interest at a fixed rate. Debt holders are typically compensated for taking on some risk by receiving interest payments, so they should be subordinated to holders of the actual stablecoin.
  4. Equity. This is the token that gets paid a variable rate after the debt gets paid.

There are a number of ways to ensure that this order gets followed. For example, the protocol could detect a “bankruptcy” condition and stop allowing people to trade debt and equity for stablecoins. Then allow people to trade stablecoins directly for collateral. After some delay, you can allow people to trade unsecured debt for collateral.

By instituting a bankruptcy protocol in your stablecoin, you can assign risk to the right parties and, as mentioned previously, actually reduce the risk of a run. In some cases, the bankruptcy protocol might be triggered temporarily to give debt holders a haircut if some sustainability threshold is exceeded. In many cases, a person or company can come out of bankruptcy intact. It might be possible for a stablecoin to do so as well if the process is sufficiently well designed.

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Redbeard

Redbeard

Patent Attorney, Crypto Enthusiast, Father of two daughters