There are no shortcuts for stablecoins
Son of the great anarcho-capitalist theorist David Friedman and grandson of legendary Nobel prize winner Milton Friedman, Patri Friedman wrote a tweet thread quoting Vitalik Buterin, creator of Ethereum, on the need to create a stablecoin.
Gazing at BTC’s volatility and thinking of examples of current uses, I understand why Vitalik Buterin says it is important to create a “StableCoin”. People should be able to store value without being exposed to all this risk.
Patri and Vitalik’s concern is fair. After all, how can anyone use Bitcoin (or any other crypto) as a store of value if it is subject to falls of more than 50% in short time frames as seen in the last two months? A large company or investor could hedge the future contracts that have now emerged from the CME and CBOE, but hardly a Brazilian average citizen would be able to do such operation due to its operational complexity. He goes on arguing that if the only way to use Bitcoin is being a speculator, a club of gamblers would be created rather than the new global financial system.
Several ingenious strategies were created in order to come up with a stablecoin.
The first, which motivated Vitalik’s 2014 article, was the IBC proposal, the “Improved Bitcoin”. The idea is simple: price is a function of the, among other things, monetary supply of the currency. Since Bitcoin has a fixed monetary supply, its value changes with other variables out of control. Therefore, if we code a change in the monetary supply counterbalancing its price variation, this may diminish its volatility, similar to what central banks do around the world. However this leads to some problems:
1- How to measure the price in a decentralized way?
Just as Bitcoin and other cryptocurrencies need to reach consensus, a similar system could be created to find the currency value consensus. However, there would be many difficulties in encouraging honest participants and punishing the dishonest. Could there be any benefit to a group of participants wanting to increase or decrease the monetary base beyond the “natural” system? How to reduce this incentive and effectively punish it?
2- It is easy to issue new tokens and increase the monetary supply, but how to decrease it in a decentralized way?
It is possible to create an inflationary effect that each coin holder earns a more percentage of coins, but to decrease the monetary base one would have to subtract a value. Imagine having $10.00 in your wallet to buy a movie ticket, and when you get there, you only have $ 9.00. This would be quite frustrating and an incentive not to use currency.
3- The famous Black Swan
Black Swan is a term popularized by Nassim Taleb which indicates an impossible shock to predict. A very complicated system that tries to control its natural volatility may have problems that cannot be predicted, generating devastating effects. For example: the IBC can be relatively stable for a long time and suddenly break down. The complexity of this system will exist for value is subjective and price depends on the wants of a large set of participants in the economic system. In such a system, this complex information takes some time to be effectively reflected in prices, leading to being overestimated or underestimated. Depending on the response of the system participants, it may trigger a destructive resonance, just as in Tacoma bridge.
There are several systems cited by Vitalik where there are two coins: a Stable and a Volatile. Stable has a value set at $ 1 and Volatile can float. At any time, the Volatile currency may be exchanged for the Stable currency. From there there are multiple forms, such as a use of the Stable token as a mandatory collateral for the use of the Volatile currency, with a “margin call” if the price rises well above a certain margin, and/or an exchange rate fixed at $ 1 between the Stable and the Volatile tokens, and/or also an interest rate control where the Stable token is a debt contract, where there are someone with negative Stable token for each positive Stable token.
In addition to the Black Swan problems that may arise, there are also two other fundamental problems: (i) how to guarantee the $ 1 value of the currency Stable in a decentralized way? and (ii) why have all this work to create a cryptocurrency that depends on its core of a fiat currency ?
It is common knowledge that a good portfolio should have a level of diversification. “Do not put all eggs in one basket.” The Modern Theory of Portfolios, by Harry Markowitz in the 1950s, creates a mathematical formula for finding the optimal portfolio, where we would have the greatest return and the lesser risk of a set of assets. With a diversification of inversely correlated assets, it would be possible to bring volatility theoretically to zero, while maintaining the weighted average of returns. The big problem is that all decentralized, stable and limited monetary supply cryptocurrencies are also extremely volatile, especially those with low liquidity, and their (un)correlation is not stable.
The correlation of the daily returns of the last 2 years between, for example, BTC and ETH, Dash, LTC and ZEC is low, around 0.3, but if we calculate in periods of 60 days we will see a completely different behavior. As we can see in the charts below, the LTC spent almost the entire year 2017 with a high correlation with the BTC, greater than 0.75. Ethereum presented moments of antagonism to Bitcoin, with correlation reaching -0.5, and other moments where it was reached in a similar way, reaching 0.8. In the case of the Dash, we see that at the turn of 2016/17 the cryptocurrency also turned from negative correlation to highly positive correlation.
The last graph shows the correlation of 70 periods of 4h to 5 cryptocurrencies in relation to the BTC between November 2017 and February 2018. When there was a huge rally, all were uncorrected with Bitcoin, but when the BTC fell, they fell all together and maintained a high correlation for a few days. Therefore, a portfolio of cryptocurrencies is not stable enough.
Indexed or backed currency
This is the simplest and best known model. There are a few out there, but the most famous, without any doubt, is the USDT, the famous Tether. Just as the former banknotes used to guarantee a sum of gold stored in banks, the company of the same name guarantees that it has saved 1 dollar for each existing USDT.
It’s great if you want a way to send dollars out of the country quickly with few fees but not so good if you do not want to rely on third parties. The trust starts to become crucial especially when the Tether company needs to secure $ 2.3 billion in its reserve, has had security problems, has cut relations with the firm that audited the company and can still be closed due to regulatory
problems. If confidence in the company breaks down, the currency can quickly break as well.
The gold case
In 2015, after the re-election of Brazilian President Dilma, I worked as an investment analyst and had read a bit about classical liberalism and the Austrian school of economics. I wanted to diversify my investments with dollar and gold, because I already knew that Brazil would drown in an unprecedented crisis.
Commenting with my co-workers, they said “Are you nuts? Gold is very volatile!”*. It really was. Between 2012 and 2015, gold lost almost 50% of its value. Adjusting for inflation, gold went from almost $ 2.2 thousand to $ 800 in less than a year and a half in the 1980s. But how could the world have a currency almost as volatile as Bitcoin and survived for so long? That is the question that can unravel the mystery of how cryptocurrencies can stabilize their price.
The figure below, which shows the prices of gold since 1910 with due proportions, is very similar to that of a cryptocurrency.
However, before 1971 the dollar was not a fiduciary currency, or fiat, it backed by gold. Look how the gold price stayed around $ 35.31 for over 16 years:
This analysis is not 100% correct because, obviously, the price of gold would be equal to the price of the dollar, since the dollar was backed by gold by law. In order to have a fairer analysis, we have to insert one more variable: inflation. Reminding the friends of the Austrian school that, in this case, I am referring to the generalized price increase indicator of the United States economy. That is, let’s see how much gold could buy, on average, through the ages. The higher the value, the more products you could buy on the market with the same amount of gold. The ideal stable currency would be one approaching a horizontal line.
The first chart seems even well behaved in comparison to the one adjusted by inflation. It does not seem so stable, but let’s look at what happened in the meantime.
Unfortunately, it is not easy to find data from the nineteenth century, but from the data available we can see that gold had great periods of price stability: the period after World War I until the Great Depression and the period after World War II to the end of the gold standard. Basically whenever there was no war with world proportions (remember that the Vietnam War lasted from
1955 to 1975) or the government intervening very strongly in economic policy. And I am not even willing to discuss whether the crisis of 1929 was generated by the government or not, but the next chart is enough to grasp the idea that the end of gold standard had forever changed its volatility patterns.
The Brazilian Real Plan
Now that you know the case of a stable asset that has lost control, let’s move to the case of the currency that was out of control and became stable: the Brazilian currency.
There was not exactly only one event that could be pointed out as the beginning of Brazilian hyperinflation. There were a sum of several events until we reached the absurd annual inflation rate of 4,922.60% in June 1994. There was already high inflation in 1964 before the military coup, 92% when the military seized power. The national-developmentalism policies of the military “a la Dilma**” also did not help, leading to a 242% inflation. From then on, the various economic plans only worsened the situation until the Real Plan was developed in 1994.
The big challenge of the new plan was how to insert a new currency for the seventh time in 10 years effectively? The solution found was politically difficult, but necessary: a financial reform (decrease government expenditure and increase revenues); creation of the URV (Real Value Unit), fictitious currency introduced gradually so Brazilians could familiarize; and the launch of the real currency from the URV, initially backed by the US dollar.
The real was gradually replacing the older currency in the Brazilian economy after privatizations, economic openings, deindexation of the economy, among other things, and was backed by the dollar until it earned the trust of its citizens. It was rather fast but none of this was achieved without a great coordinated and centralized effort.
Some of the major advantages of cryptocurrencies are: (i) decentralization, which makes us not to have to rely on a centralized entity; and (ii) monetary policy written in code, which protects us from inflation. However, all the stablecoin attempts that exist today (i) have enormous risks of breaking, (ii) are centralized or (iii) are extremely complex in relation to their monetary policy. That is, they are the exact opposite of the reason for Bitcoin to exist.
On the other hand, gold shows us that the difference between economic stability and volatility lies greatly in indexing the prices of the economy in relation to the asset. When all prices were measured indirectly in gold (in dollars, which was equivalent to a quantity of gold), there was little price volatility. So, by analogy, we will have our stable cryptocurrency as soon as it is frequently used in the economy and we look at the cost of goods in Bitcoins, instead of looking at the cost of Bitcoin in reais or dollars. The Real Plan shows us that there is no use in putting the cart before the horse. Six currencies were created previously, but what it really needed was time for people to gain confidence and get used to the new currency and, of course, a rational policy with a nice downsizing of the state.
But it should always be remembered that in the end there will remain only one of two: astronomical returns or a stablecoin.
*Brazil’s interest rate at the time was 14%.
- *Dilma was the president of Brazil from 2011 until her impeachment and removal from office on 31 August 2016. She was a communist guerrilla against the military dictatorship and, when president, made a very similar interventionist economic policy.