10 Sep 2018
Bitcoin and its relatives are far too volatile to be a stable form of value – one of the chief characteristics of money.
So in a bid to combat this flaw, there’s a new beast in crypto-land - stablecoins.
“The central bank’s backing of gold was never one-for-one.”
A “stablecoin” supposedly solves the problem of volatility by pegging price to an established currency such as the US dollar - inheriting the stability of its pegged currency. Real world currencies like the Hong Kong dollar have such a peg.
So how is this done? The mechanism can be understood with (boring old) traditional banking concepts such as those used by central banks to manage a gold standard.
The simplest form of price pegging is achieved by offering two-way convertibility between the stablecoin and the pegged currency and letting arbitrage establish value equivalence. This is how central banks used to maintain gold convertibility.
There are a couple of ways to maintain this convertibility. First is to back each stablecoin one-for-one with the pegged currency - the common method used for ‘stable’ cryptocurrencies such as Tether. The difficulty with this model is how to offer convertibility and be profitable.
Another way to handle convertibility is to issue the stablecoin to buy income-producing assets and hold only a ‘fractional’ reserve of the pegged currency. The gold standard existed in part because the public worried that the value of central bank money would be too volatile without the link to gold. But the central bank’s backing of gold was never one-for-one.
The danger with this fractional reserve method comes when everyone wants to convert their stablecoin back to the pegged currency at once – the equivalent of a bank run which occurs when the number of customers wanting to take back their deposits exceeds what the bank has available.
A bank run doesn’t mean a bank is insolvent rather it doesn’t have enough cash on hand – a liquidity crisis.
Banks have always had to deal with the problem of bank runs and central banks had to deal with them during the period of the gold standard.
To manage this central banks use their official interest rates to discourage withdrawals. With the gold standard, conversions of central bank money meant gold outflows, these flows threatened reserves of gold, so the central bank would respond by raising its discount rate.
Interestingly, some stablecoins come with a supposedly new way of maintaining the price peg, where there is no reserve or convertibility. Instead, algorithms promise to remove the need for convertibility:
“As demand for an algorithmic stablecoin increases, supply also has to increase to make sure there's not an appreciation in the value of the stablecoin. At the same time, as the value decreases, there needs to be a mechanism by which supply can be reduced again to try and bring the price of the stablecoin back to the peg. That's really the class of stablecoins that are much more challenging to design. They're really unproven at this point.”
- Garrick Hileman, Head of Research at Blockchain
It should be easy to add to the existing supply stablecoins, more problematic is how to remove stablecoins from the market, even temporarily.
One idea is to auction discount stablecoin bonds that are bought with (and hence retire) stablecoins and repay with more new stablecoins later. This is not a new concept - discount rates have always been an essential part of maintaining a currency peg. The discount means that future stablecoin commitments pile up and higher discounts make it harder to restrict the supply – the ‘death spiral’.
As history has shown – from the UK’s withdrawal of the pound sterling from the European Exchange Rate Mechanism, to recent emerging market currency falls - maintaining a peg (or even the value of a currency) by interest rates alone is far from easy.
The question is even though the theory of a stablecoin is very neat, would it actually work in the real world?
James Culham is Director, Institutional Portfolio Management at ANZ
The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.
10 Sep 2018
30 Jan 2018