Pete Ryan
Since the debut of Bitcoin in 2009, two things have become clear. One is that cryptocurrencies are wildly unstable. There’s even a website called bitcoinrollercoaster.com. The other is that digital currencies are coming, like it or not.
Stablecoins represent an effort to ameliorate the volatility associated with cryptocurrencies such as Bitcoin, Ethereum, and Dogecoin by turning cryptos into proxies for the fiat currencies issued by official central banks. But in the pursuit of maintaining stability, the issuer has to manage the price impact of demand shocks, suggests research by Stockholm School of Economics’ Adrien d’Avernas, HEC Paris’s Vincent Maurin, and Chicago Booth’s Quentin Vandeweyer.
Stablecoins such as Tether, USD Coin, Binance, and TerraUSD became popular quickly, surging from $3 billion issued worldwide in 2019 to $125 billion in 2023. But values also fell in the 2022 crypto bear market, tarnishing the reputation of stablecoins. When TerraUSD prices crashed that May, investors were wiped out. Cryptocurrency exchange FTX had been working on creating a stablecoin before the exchange failed and its founder Sam Bankman-Fried was convicted of fraud and conspiracy.
The researchers sought to better understand the dynamics of algorithmic stablecoins, or those that are entirely digital, with no tangible collateral as backing. The fundamental aim of an algorithmic coin, the study explains, is to maintain a price equal to 1 (one coin equals $1, say). For that to happen, the issuer has to make sure that supply and demand stay balanced.
If demand rises, the issuer can address that cheaply and easily by issuing more stablecoins. The bigger challenge is falling demand, in which case the issuer needs to buy back coins. To do so, it offers digital tokens that can be exchanged for stablecoins at designated times in the future, once the price recovers. For an example, say demand weakens and the price falls to 90 cents. Buybacks return the coin’s value to $1, and the sellers receive tokens. Demand then strengthens and pushes the coin’s value to $1.10, and the token holders cash in their reserve assets for newly minted coins that push the price back to $1.
In this way, these two intangible assets—a stablecoin and its associated token—may look like levers on a perpetual machine, Vandeweyer says. If the market functioned perfectly as designed, an issuer could work both levers in order to keep prices stable.
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Stephen Colbert Was Wrong on BitcoinThe model is somewhat similar to that of a central bank, which absorbs bonds and offers reserves to help maintain prices. Coordinated confidence in the system’s ability to stay pegged to $1 is crucial to its success. “If everyone believes that they are in a stable equilibrium, then you’re going to behave as though it is stable,” says Vandeweyer. If investors lose confidence in the system, that is a self-fulfilling prophecy, and the stablecoin’s price falls to zero.
But confidence alone cannot keep a price stable, the researchers write. Mathematically speaking, the issuer has to be able to overcome a large drop in demand, and the key to that is the equity token’s value, which reflects the issuer’s anticipated profitability. (The tokens are much like shares of stock, whose price reflects anticipated corporate profits.) Say there are 1 million stablecoins trading, and the equity tokens have a market capitalization of $500,000. If the coin’s price fell from $1 to 40 cents—maybe due to the actions of a competitor, regulator, or short-seller—the value of an equity token would likely also fall. The issuer could create more equity tokens to buy back coins, but it might not be able to create enough to save its skin. If the value of the additional tokens were to fall to zero, it would be impossible for the issuer to repurchase enough stablecoins to maintain a $1 peg.
This, the researchers posit, is consistent with what happened during the TerraUSD collapse, which took with it about $45 billion in value. In its wake, only a few smaller algorithmic stablecoins remain.
Some stablecoins are partially or entirely collateralized, the researchers say, which mitigates the risk of a large demand shock but doesn’t solve all problems. For instance, sharp price movements could hit both collateral and coin value at the same time, says Vandeweyer. Such is the case with USD Coin in that it was partially backed by debt securities issued by Silicon Valley Bank, which failed in March 2023.
A necessary condition for eliminating this risk, they write, is to fully collateralize a stablecoin, as some regulators including the Securities and Exchange Commission have proposed. If $1 million stablecoins were trading, the issuer would keep $1 million in cash as reserves. But for there to be any profit potential for the issuers, the stablecoins would need to be more valuable than their cash counterparts—which can happen, for example if traded by people in countries that have poorly managed currencies and where it is difficult to get access to US dollars.
Adrien d’Avernas, Vincent Maurin, and Quentin Vandeweyer, “Can Stablecoins Be Stable?” Working paper, August 2023.
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