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.
