The Buying Power of Stablecoins

Ingenuism 52

In this latest episode, Robert Hendershott and Yaron Brook discuss crypto currency in terms of transactions, buying power with crypto and the volatility of crypto.

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Crypto Valley Needs Better Stablecoins

Recently we imagined a hypothetical distributed version of AirBNB, the Stay Network, being developed in a crypto ecosystem we call Crypto Valley.  StayCoins are envisioned as the means for both compensating contributions to and transacting on the Stay Network.  Developers, infrastructure providers, etc. would receive StayCoins for their participation in building/running the network and Guests would pay Hosts in StayCoins when using the network.  StayCoins’ value would be set by supply and demand, so given a relatively fixed supply, the price of a StayCoin would rise and fall with demand for StayCoins and would be correlated with the Stay Network’s success.  If everything goes well, a massive value-creating platform emerges – organized and run without the usual Silicon Valley structures (no corporation, VCs, etc.).  Maui beach houses for everyone!

A catch in this vision is that StayCoin values are likely to be very volatile, particularly during the Stay Project’s early years as users/speculators ongoingly assess whether the Stay Network will succeed.  Granted, there are other issues like sophisticated DAOs evolving to handle the Stay Network’s management and governance.  But dealing with crypto volatility is our topic for today.

StayCoin’s early volatility is a double-edged sword.  As we’ve seen in existing cryptocurrencies, volatility can be an attractive feature of speculation and to the extent that speculation supports the Stay Network receiving the initial resources needed for the project’s success, volatility could buttress value creation.  The Stay Network launches as all potential and no reality – so early StayCoin holders likely need a large upside if the project succeeds to offset StayCoins being worthless if it doesn’t.

But StayCoin volatility would likely hamper operating progress – you don’t know your vacation budget when the currency you are using could double (yay!  First class all the way) or half (ack!) while you are planning it.  Volatility may be a feature for speculative investments, but it is a bug for transactions.

Generally, volatility is a major challenge for using most cryptocurrency to buy/sell items.  Bitcoin, for example, currently varies too much relative to the dollar standard to be very useful for transactions.  During the past year Bitcoin’s range (highest price versus lowest price) varied 4-5% during a typical day – that is, if you buy something with Bitcoin, your dollar cost commonly differs by around 5% depending on exactly when you hit the buy button during the day (and occasionally varies over 15%).  Over the course of a typical week, Bitcoin’s price range expands to 13-15% (and in extreme cases is over 50%) – so transaction prices are very different depending on when you buy during a week.  And over a month, Bitcoin’s highest price is typically about a third above its lowest price.  So, if you were purchasing a $350 item using Bitcoin, you would expect to actually pay as little as $300 or as much as $400 depending on when you bought during the month.  And some months are far worse – if you sold (bought) a car for one Bitcoin in June of 2022, you received (paid) somewhere between $18,000 and $32,000 depending on when the transaction happened.  That is not how most people want to buy/sell cars.

The hypothetical Stay Network needs a stable transaction currency, a stablecoin.  Increasingly, we believe that all the most interesting Web3 projects will – and that the lack of a robust model for stablecoins is a major missing element in the developing crypto ecosystem.  There are stablecoins out there – but they are generally flawed.  What can we learn from the failure of Terra/Luna, as well as periodic shakiness in other stablecoins like Tether?  

And having learned these lessons, what stablecoin designs might crypto entrepreneurs want to explore next?  What could effective stablecoins eventually look like in Crypto Valley?

The spectrum of stablecoins

Stablecoins offer steady purchasing power, which in practice means an anchored dollar price, most commonly $1.  There are many ways to do this, but they all fall on a continuum between two extremes:  dollar-backed coins (100% backed by a portfolio of liquid, low-risk dollar investments) like USDC and purely algorithmic coins (tied to a smart contract designed to maintain the reference price) like Terra.

In practice, a stablecoin’s stability depends crucially on two factors:  its design and the underlying business model.  A useful stablecoin has a robust design and good underlying incentives imbedded in its business model.

Dollar-backed stablecoins (e.g., Tether)

A dollar-backed stablecoin maintains it value by holding $1 of liquid, low-risk assets for each coin.  When a new coin is sold, the dollar received is invested and this value provides the anchor for the coin.  Coins are designed to be used for transactions indefinitely, not redeemed.  However, dollar-backed stablecoins can be redeemed - redemption supports price stability.  The most robust design holds cash instruments - say a portfolio of very short-term U.S. Treasury Bills (T-bills).

Dollar-backed stablecoins are analogous to a money-market ETF.  Exchange traded funds (ETFs) hold a portfolio of assets financed by selling claims on the portfolio that trade on a secondary exchange.  The S&P500 ETF, SPY, holds the individual components of the S&P500 – and SPY trades like an individual stock.  SPY closely tracks the S&P500 index because arbitrage traders compete to step in to buy SPY (and short or sell the individual S&P500 stocks) when SPY lags the index and to sell SPY (and buy the individual S&P stocks) when SPY gets ahead of the index.  

All successful ETFs have a value proposition - and SPY offers investors convenience, the ability to buy and sell U.S. Large Cap stocks quickly and easily.  Similarly, dollar-backed stablecoins also offer convenience, the ability to change volatile cryptocurrency into “cash” (and back into crypto) without leaving the crypto ecosystem

Like an ETF, stablecoins trade on a secondary market.  The price is anchored by the underlying pool of assets via arbitrageurs, qualified institutions who are able to swap dollars for coins and vice-versa.  If the coin value falls below $1, these arbitrageurs buy coins for, say, $0.99 in the market and exchange them for $1 in cash drawn from the backing pool of assets.  If the coin trades up to $1.01, they do the opposite, holding the price stable around $1. 

The dollar-backed design is extremely robust when the underlying portfolio is very low risk and high liquidity, e.g., T-Bills.  T-Bills trade in an extremely deep, liquid market (daily volume in the T-Bill market is roughly equivalent to Bitcoin’s entire market cap), making the arbitrage mechanism virtually indestructible – the dollar-backed design is very robust.

At least in theory – true stability also requires a stable business model behind the stablecoin.  ETF sponsors cover expenses and generate profits in a variety of ways.  Equity ETFs generally make money by charging a management fee on the underlying portfolio and/or collecting stock lending fees.  Money-market ETFs generally charge a modest expense fee – for example the iShares short treasury ETF (SGOV) charges 0.12% per year.  Any ETF (or ETF-like product, including stablecoins) needs a revenue stream to support the business model.

Dollar-backed stablecoins typically pay most expenses (and generate profits) from what is called the float – the T-bill portfolio pays interest, which the protocol sponsor keeps to cover costs and create profit.  This business model can work but has destabilizing incentives.

In a near zero-interest rate world, the stablecoin float is small and may not even cover costs (money-market ETFs have the same problem – if interest rates are close to zero, the EFT has a negative yield after expenses).  In a sufficiently positive-interest rate world, though, the dollar-backed stablecoin business model makes economic sense.  But the business model can still be shaky.

Today short-term T-bills earn over 2%.  If your protocol has 10b dollar-backed stablecoins in circulation, the float pays you 0.02*10b = $200m per year.  Let’s suppose that covers cost of providing the protocol (and that these costs are fixed) with $100m in profit left over.

The dollar-backed stablecoin business model rewards growth to take advantage of scale economies – growth makes a stablecoin more profitable.  If adoption of your stablecoin doubles to 20b coins, now the float pays $400m and your annual profit has tripled to $300m.  Very nice! 

Of course, last year your T-bills paid 0.05% so your 10b stablecoin business created spread income of only 0.0005*10b = $5m per year with costs of $100m.  Not good.  But you could have created a larger spread by shifting away from T-bills into higher yield investments like commercial paper (short term corporate debt) that paid 1% so that you could cover your costs.  High grade commercial paper is just a little less liquid and a little riskier than T-bills.  No harm, no foul.

In fact, if you were running a stablecoin in 2021, you almost certainly did make this shift (or you created another significant revenue stream).  You had to cover the protocol’s costs.  And while you’re at it, why not throw a little something in for yourself?  You deserve it.  Your stablecoin isn’t a charity.

In fact, why not throw a little something in for coin holders?  Give them additional coins (”interest”) over time as the value of the portfolio backing the stable coin grows.  It’s only fair and this sweetener will help spur coin adoption, which is important to your business model because of scale economies.

You may see where this is going – the dollar-backed stable coin protocol’s sponsors have an incentive to reach for a little more yield, to cover costs, to pay themselves, and to stimulate growth.  It always makes sense to sacrifice just a little more liquidity/safety to get a little higher return on the investment portfolio.  Until it doesn’t.

This is not a new problem and has precipitated the implosion of many financial products and institutions.  You may remember Lehman Brothers (if not, it is a story with valuable lessons).  And the incentive issue is not hypothetical for existing stablecoins.  Tether paid $18.5m in a settlement with New York after being accused of misrepresenting their dollar reserves.  Tether has promised to be publicly audited for five years but hasn’t yet – although they did recently change accounting firms.  We’ll let readers draw their own conclusions about how to interpret that.

Crypto needs to evolve a solution for dollar-backed stablecoins to truly be long-term stable. 

That said, although robust dollar-backed stablecoins would be useful but not that interesting.  They have value today because they are one of the few direct links between the crypto ecosystem and the dollar economy.  In a world where crypto is ubiquitous, shifting between crypto and dollars (or a money market ETF) would be easy and virtually free.  In this world dollar-backed stablecoins are intermediaries with little differentiated value and are unlikely to thrive in the absence of a major business model innovation.  Most likely they become akin to money market funds - low-profit products that exist to support more interesting (and profitable) financial services.

Algorithmic Stablecoins

Algorithmic stablecoins follow a similar arbitrage model as dollar-backed coins but instead of the anchor being the ability to convert into dollars, the anchor is based on a second cryptocurrency.

Consider the Terra-Luna pair, pre-collapse.  Terra is a stablecoin pegged to $1.  Luna is a cryptocurrency with a floating dollar value, determined by supply and demand, that can be converted into Terra (and vice-versa) at $1.  That is, if Luna is trading at $10, a Terra converts into 0.1 Luna.  This maintains the peg:  if Terra falls below $1, arbitrageurs buy Terra for, say, $0.98 in the market and exchange them for $1 worth of Luna; if Terra trades up to $1.02, they buy 0.1 Luna for $1 and swap for 1 Terra, which sells for $1.02.  This trading holds Terra’s price stable around $1.  If the price of Luna rises or falls, the exchange ratio with Terra simply adjusts to maintain the reference price of one Terra = $1 of Luna.

At least in theory.  Hypothetically, because there can be an unlimited number of Luna, you should always be able to support Terra at $1 (worth of Luna).  If Luna falls from $10 to $5, the Terra-Luna exchange rate rises from 0.1 to 0.2.  Luna falling to $2 yields an exchange rate of 0.5.  If Luna falls to $0.25, a Terra gets you four Luna.  At $0.01, you get 100 Luna.  Always $1.

In practice this breaks down because even an unbounded number of Luna is worth zero if the price is zero.  And a price of zero is a stable equilibrium for any currency, crypto or not.  If we all agree a currency is worthless, it is worthless.

This makes algorithmic stablecoins fragile, subject to what are commonly called death spirals where the stablecoin falling below its peg for a sustained period leads to an explosion in the number of anchor coins (remember, below the peg the arbitrage is to buy the “cheap” stablecoin and exchange it for the “expensive” anchor coin).  Without expanding demand for the anchor coin to offset the greatly increased supply, the anchor coin’s price plummets – which generally chills demand for the anchor coin, leading to even lower prices which rapidly approach zero and you have a death spiral that destroys the stablecoin’s anchor – which destroys the stablecoin.

In the Terra-Luna case the problem was compounded by a “savings” offer (the Anchor protocol) that paid 20% annual interest on Terra.  Initially this strongly supports Terra’s price, increasing demand (20% interest!) and reducing Terra’s float (the supply being traded in the open market).  Because most Terra gets “saved” - at its peak 15 billion of the 18 billion Terra coins were locked up in the Anchor protocol – relatively few coins are trading.  When the Terra price falls below $1, it doesn’t take much “buy-Terra and sell-Luna” to bring the price back up.  Terra looks stable.

But this low initial float comes at a cost - paying 20% interest means that the total supply of Terra coins is growing rapidly, setting the stage for a death spiral unless demand for the coin grows proportionally.  The Anchor protocol supercharged Terra-Luna’s initial growth and accelerated its eventual demise.

You might imagine that this lesson has been learned and won’t haunt future algorithmic stablecoins.  Maybe.  It will certainly be hard to get adoption of an algorithmic stablecoin just by offering high interest for as long as crypto buyers remember the Terra-Luna lesson.  But the incentives to offer rewards to juice adoption and to design coins that lock up current supply at the cost of higher future supply will always be present (as will the incentive to disguise that is what you are doing) – and this will always be destabilizing.

Dollar-backed stablecoins like Tether are fragile because of the incentives built into their business model and not that innovative/interesting.  Algorithmic stablecoins like Terra-Luna are very innovative and interesting but have a very fragile design. 

Crypto Valley needs stablecoins that are both robust and innovative.  What might this look like?

Blended Stablecoins

While crypto’s eventual stablecoin solution will be discovered through a process of experimentation and learning, we think that it lies somewhere between the two extremes of dollar-backed stablecoins and purely algorithmic stablecoins. 

Let’s go back to our Stay Network example.  Imagine that once the Stay Network is up and running (hosts are listing beach houses and guests are searching and booking them), a new cryptocurrency, StayBucks, are created to serve as the network’s robust transaction currency.  StayBucks are an algorithmic stablecoin, analogous to Terra, while StayCoins provide the anchor, analogous to Luna.  But critically, StayBucks have inherent value because they are the currency for getting a Maui beach house on the Stay Network.

Imagine the Stay Network is thriving and StayCoins trade for $20.  Then the conversion ratio between StayCoins and StayBucks is 0.05.  The process that anchors StayBucks to $1 will be familiar at this point – StayBucks is an algorithmic stablecoin.  If the price of StayBucks falls below $1, arbitrageurs buy StayBucks for less than a dollar in the market and exchange them for 0.05 StayCoins, worth $1.  If StayBucks are trading above $1, they do the opposite.

This looks a lot like Terra-Luna - so why wouldn’t StayBucks/Coins inevitably fall into a death spiral?  Because the design is inherently more complex in ways that likely give StayBucks a steady price as long as the Stay Network is thriving.  Blended stablecoins can be both robust and interesting.

StayBucks have inherent value – they can be swapped for a week on the beach.  So, when the price of StayBucks falls below $1 buying support doesn’t just come from arbitrageurs – it can also come from vacationers who suddenly see properties as being on sale. 

Additionally, StayBucks steadily flow to Hosts who sell them to the next batch of Guests.  Or maybe not immediately if StayBucks are trading at a discount.  Hosts could convert the StayBucks to StayCoins and sell those!  If so, the supply of StayBucks shrinks, increasing the equilibrium price given demand.  Hosts are natural arbitrageurs.  Perhaps they also arbitrage over time – we might find that StayBucks consistently sell at a small discount in the Winter (say $0.99) when travel is relatively light and at a premium during the Summer (say $1.01) when demand is high.  Granted, this works if the exchange rate between StayBucks and StayCoins isn’t symmetric – that is, if the anchor is a small range around $1.  Assuming a range of $0.98-$1.02 and using the example above where StayCoins are at $20, the exchange ratios are 1 StayCoin can be exchanged for 19.802 StayBucks and in the other direction 20.202 StayBucks can be exchanged for 1 StayCoin.

Doesn’t this variability destroy the benefit of having a stablecoin?  Possibly, but we think not.  People regularly make purchases in a foreign currency despite not knowing the exact exchange rate because they trust that variations will be small.  StayBucks with a small (and capped) trading range provide the same reassurance and might be 99% as desirable as a true stablecoin.

Given the slightly-floating anchor design, some Hosts may hold the StayBucks they receive in February (when StayBucks are $0.99) for a few months to sell them for $1.01 when people start planning their summer vacations.  This time arbitrage would help keep the supply of StayBucks in line with demand and support the price staying close to $1 throughout the year.

The Economics of Blended Stablecoins

StayBucks being what gets you the Maui beach house clearly supports StayBuck value - but now it is less obvious what gives StayCoins their value.  However, nothing important has changed – StayCoins are valuable because they are where coinholders benefit from the Stay Network’s success.  More users increase the demand for StayBucks, and that demand flows through to StayCoins.  StayBucks are anchored at $1 so it is StayCoins that appreciate when things go well.

By design StayBucks can’t.  Suppose StayBucks are trading for $1, as designed, and StayCoins are trading for $25.  A StayCoin can be converted into 25 StayBucks (and vice-versa).  Then Stay Network usage soars – with more properties listed, more Guests booking stays, etc. – all with a fixed supply of StayBucks.  This increased activity pushes up demand for StayBucks, driving the price to, say, $1.04.  What happens?

Now you can buy a StayCoin for $25 and convert it into 25 StayBucks, which you sell for $1.04 each - a total of $26 and $1 profit for you.  By doing so, you increased the supply of StayBucks by 25 and reduce the supply of StayCoins by 1.  The price of StayBucks falls with the increased supply and the price of StayCoins rises with decreased supply.  This trade continues until the supply of StayBucks increases enough to push the price back close to $1 – and with each trade the supply of StayCoins shrinks and the price of the remaining StayCoins rises.  The consequence of increased demand for StayBucks is a higher StayCoin price.

As an analogy you might think of StayCoins having similarities to AirBNB stock while StayBucks are like having AirBNB credit.  AirBNB stock has the upside (and downside) while the credit is worth what it is worth.  That doesn’t mean that the credit’s value can’t disappear.  Facing a potential pandemic travel armageddon, AirBNB raised $2b, half debt and half equity, in the first half of April 2020.  The equity piece was valued below the company’s 2017 fundraising round and about one-quarter where the company traded post-IPO eight months later.  Fear of the pandemic’s impact cut AirBNB’s stock price by roughly one-half!  And then AirBNB thriving during the pandemic caused its stock price to quadruple.

Something similar would have happened to StayCoins.  But not StayBucks.  Granted, in addition to tanking the stock, fears that AirBNB would struggle during the pandemic  would make having an AirBNB credit temporarily less attractive too.  So StayBucks likely would have experienced downward pressure, but this pressure would have flowed through to StayCoins.  By design, StayCoins, not StayBucks, capture the upside and downside in the Stay Network.

Given that the demand for home-sharing quickly rebounded, our hypothetical StayBucks stayed stable.  Of course, if the Stay Network stops appealing to travelers, a death spiral ensues.  Demand for Maui beach houses are critical to keeping StayBucks worth a buck.  But it is important to recognize that this basic principle has nothing to do with the blended stablecoin algorithm – organizations of all kinds sometimes fail and both customers and owners suffer if this happens.  AirBNB could have gone bankrupt (the Spring 2020 stock price certainly reflected that fear).  There is a big difference between being subject to creative destruction and having an inevitable death spiral. 

We recognize that the AirBNB stock-credit – StayCoins-Bucks analogy isn’t perfect.  Maybe blended stablecoins the way we’ve described them are either too volatile or fragile to serve their purpose – but if so, we are confident that enough crypto entrepreneurs exploring enough designs will discover a structure that gives Crypto Valley the stablecoin it needs.

The Benefits of Blended Stablecoins

Blended stablecoins could give Crypto Valley a self-contained financial system tied to the ongoing value being created by innovative new projects.  Not just StayCoins but also FriendCoins (a social network), RideCoins (Uber-like), JobCoins (LinkedIn-like), CraftCoins (Esty-like), HomeCoins, GameCoins, DateCoins, and many others.  A cloud of blended stablecoins anchored by their utility to their individual projects, but freely convertible.  Some would thrive (alongside their projects) while others struggle – some would be like the U.S. Dollar while others more resemble the Brazilian Real. 

Maybe this cloud consolidates into a small number of coins.  We previously floated the possibility of Crypto Valley building the Life Network, starting with a large issue of LifeCoins and finishing with a ubiquitous powerful smart personal agent that replaces the plethora of apps currently on your smartphone, adds unheard of capabilities, and completely protects your privacy (to the extent you care).  An agent that was crowd developed/funded and empowers seven billion people to accomplish their goals – and is owned by those same seven billion via the Life DAO.  All using LifeBucks and LifeCoins.

It is a fun fantasy.  But more likely instead of being created in one fell swoop, the hypothetical Life Network evolves over time.  Because there are no companies creating proprietary networks in Crypto Valley the cloud of individual applications and cryptocurrencies could end up evolving into the Life Network.  An intelligent super-app that continually grows and evolves and is available for anyone anywhere to use or to bolt their ideas onto.  With everyone having access to LifeBucks and LifeCoins (perhaps along with a multitude of subcoins) inside the most fertile econsystem of opportunity that humanity has ever seen.

Possible?  Of course.  Plausible?  We will never know unless we try.