Cryptoassets (or ‘cryptocurrencies’) are notoriously volatile. For example, in November 2018, Bitcoin – one of the more stable cryptoassets – lost 43% of its value in just 11 days. This kind of volatility makes it difficult for cryptoassets to function as money: they’re too unstable to be a good store of value, means of exchange or unit of account. But could so-called ‘stablecoins’ solve this problem and finally provide a price-stable cryptoasset?
Bitcoin’s founder(s) aimed to create a new currency and payment system that did not rely on central banks, commercial banks or governments. The platform was designed to be ‘trustless’ and decentralised, so that no individual or company had control over the whole network. But the unpredictable price of Bitcoin and other cryptoassets means that today, hardly any retailers accept them in payment for goods and services. In fact, even the largest manufacture of Bitcoin ‘mining’ hardware prefers to quote its prices in US dollars!
Stablecoins are cryptoassets that attempt to solve this volatility problem. They aim to maintain a stable price against the US dollar or another specified currency. But what are the chances that they can achieve this in the real world? Some stablecoin projects have already failed. Can newer stablecoins learn from their mistakes and actually become stable coins?
The chances of a stablecoin keeping a stable price depends on its design. There are generally two designs of stablecoin: those backed by assets, and those that are unbacked or ‘algorithmic’.
Many asset-backed stablecoins ensure their stability by holding commercial bank deposits to back all the ‘coins’ that have been issued. Consequently, users know they can always redeem a $1 stablecoin for $1 of deposits in a commercial bank. However, some voices in the cryptoasset world criticise these deposit-backed stablecoins for being too centralised, too dependent on the integrity of the issuer, and too reliant on the conventional banking system to work. One asset-backed stablecoin, Tether, has consistently failed to provide an audit of their backing assets, causing a breakdown in confidence and stability. An alternative approach, more in keeping with the original principles of Bitcoin, is to develop ‘algorithmic’ stablecoins, which do not rely on a central authority or trusted issuer…
Algorithmic stablecoins dispense with backing assets and instead rely on mathematical rules to adjust the supply of stablecoins to match the demand for them. Once programmed, the algorithms will create or destroy stablecoins, with aim of automatically stabilising their price against some other currency, typically the US dollar.
But intuitively-simple algorithms can sometimes hide devastating design flaws. To see why, let’s consider one typical model of algorithmic stablecoin, inspired by the proposal for Basis, a stablecoin which never saw the light of day after its founders identified potential conflicts with US securities regulations. The design for Basis, was inspired by Robert Sam’s 2014 proposal for “seigniorage shares”. Although it has never been tested in the real world, understanding its design flaws provides a useful insight for the multiple stablecoin projects under development.
Managing price stability
The Basis algorithm looks at the current price of Basis on cryptoasset markets and tries to adjust the supply of Basis to meet demand at the point where 1 Basis coin can be bought and sold for exactly US$1.
When Basis trades below US$1, the algorithm buys back Basis coins in exchange for ‘Basis bonds’. Each bond promises to repay exactly 1 Basis coin if and when Basis trades above US$1 in the future. Coin-holders buy these bonds at a discount, giving them a profit when the bonds are repaid. The algorithm then destroys the coins that it receives, reducing supply and (hopefully) pushing up the Basis price.
Figure 1: The Basis Algorithm
When Basis trades above US$1 then the algorithm creates new coins. It first uses them to repay any outstanding bond-holders. This will increase the supply of Basis coins and (hopefully) lower the price. But if Basis is still trading above US$1 even after all bonds have been repaid, then the algorithm creates more new coins and distributes them to holders of Basis ‘shares’. These ‘share-holders’ are early investors in the Basis platform who purchased the right to receive newly issued coins, which they can sell on the market at a premium until the price falls back to US$1.
The risk of a downward spiral
The Basis algorithm sounds simple: if demand for Basis coins is greater than supply, it will increase the supply, and if supply is greater than demand, it will reduce the supply. But the algorithm can’t guarantee this by itself – it relies on incentivising coin holders to voluntarily buy the bonds. Are those incentives strong enough?
When Basis falls below $1, investors may want to sell their coins, since it is better to sell at say, $0.95 than at $0.50. To prevent the price falling further below parity, some sellers must be persuaded to swap their coins for Basis bonds instead of selling their coins in the market.
However, the Basis bond is not truly a bond in the textbook sense of the word. It only pays out if the price rises above US$1 within the next 5 years. There is no coupon (regular interest payment) and bonds that aren’t repaid after 5 years are cancelled. Bond holders risk a 100% loss of capital in exchange for a possibly small and uncertain profit. Only investors who have high confidence in the Basis price returning to US$1 will be willing to buy bonds with this balance of risk and reward.
The problem is that the Basis white paper assumes that the algorithm can push up the price by simply reducing the total stock of Basis coins (by swapping them for bonds and destroying the coins). But in reality the price is determined not by the total stock of coins, but by the balance of sellers and buyers in the market. The algorithm needs to reduce the number of sellers, but it is these low-confidence sellers who are least likely to buy Basis bonds. Meanwhile the high-confidence coin-holders, who might be tempted to swap their coins for bonds, are the ones least likely to be sellers in the first place. Consequently Basis bonds are not an effective way to reduce selling pressure on the market.
The end result of a failed algorithmic stablecoin
Whilst algorithmic stablecoins like Basis manage to eliminate the need for trust in a third party, they instead end up being heavily dependent on investor belief and confidence. As long as all users believe that the coin will be stable, their behaviour ensures that it will be stable, but if some users start to lose confidence and sell, the coin risks falling into a downward spiral.
What does this mean for issuers and users of algorithmic stablecoins? If these stablecoins are destined to lose their stability, then over a long-enough time frame, buyers of algorithmic stablecoins will make significant losses. But the initial sellers of these coins – the founders and share-holders – will make significant gains, since they sold something created at no cost (the coins) in exchange for fiat currencies. If the peg fails, then the end result will have been a significant transfer of wealth from the buyers to the issuers.
Keeping one currency stable against another is easier said than done and algorithms that intuitively seem to work can hide devastating design flaws. Time will tell, but it seems unlikely that these algorithmic stablecoins will be replacing national currencies any time soon.
Ben Dyson works in the Bank’s Digital Currencies Team, Notes Directorate
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