Stablecoins and their Macroeconomics

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    By Amee Mehta
    Mar 18th, 2020
    The world of today is a result of many digital revolutions. We’ve been through so many advancements that it won’t be wrong to say that we’ve seen a change in the way the world functions. From the rise of e-commerce to the concept of remote work, the entire global economy has seen massive disruptions. Blockchain-based currencies, or cryptocurrencies, are one such change that occurred during the 80s and caught momentum since. Incepted in the 1980s, the concept got implemented through open-source software, Bitcoin, in 2009. Bitcoins are digital assets that can be used as a medium of exchange. If you know your economics, you know that one of the basic functions of normal currency is that it is a medium of exchange. If you have followed the subject of cryptocurrency in the past, you may have seen many discussions (with a pinch of salt) pop up about the rising times of cryptocurrency back in 2017. And if you are not someone who invested in it, you may have also laughed at the sudden fall of it back in 2018-2019.

    Why did such fluctuations suddenly take place?

    Well, this has to do with the volatility of cryptocurrency. Cryptocurrency is extremely volatile. Why is it so? Again, basic economics says that prices are actually a function of demand and supply. Hence, when there is a free-flow of this demand and supply, prices will fluctuate. The price of cryptocurrency is generally fixed by using an algorithm which is quite sensitive to the changes in money supply changes. This is the reason why the prices of Bitcoin fluctuates so rapidly. So, what is the way out of this? Stablecoins - a remedy? Stablecoins come as a way to bring stability in the fluctuations that cryptocurrency faces. Stablecoins are used as a means of pegging. Now, you might ask, what is pegging? Pegging is fixing the exchange rate of one currency with the exchange rate of another. It is also called the fixed exchange rate. The reason why pegging was introduced in the first place is to bring stability in the currency value. Hence the dangers of fluctuations in currency are minimized if it is pegged with a more stable currency. Now, how can countries use pegging? After pegging their currency with another fixed currency, the country tries to maintain its peg. If they have to appreciate the value of their currency, they can buy their currency on the market using the foreign reserves or raise the rates of interest. They can depreciate the value by selling their own currency or lowering the interest rate.

    Pegging - Case Studies

    Pegging is not a new concept. It has been used before and has been successful too. However, a faulty implementation can result in losses as well. A few cases of pegging are: 1. The Gold Standard Many countries followed the Gold Standard from the late 1800s to the early 1900s before the World Wars. In this standard, currency was pegged against a fixed amount of gold. So, the central banks allowed people to exchange gold for a certain amount of money. Plus, banks were required to have gold reserves so that they could exchange currency with gold as well. Due to this system, the exchange rate remained fixed. 2. The Bretton Woods System The Bretton Woods System came as a repercussion of the Second World War. It was clear that World War II had taken place due to economic fluctuations. The Gold Standard lacked fluidity and so, it was necessary to add some flexibility in the money management system. For this reason, the Bretton Woods System was introduced. After the Second World War, the USA could boast of having the most gold reserves and so it was decided that all currencies should be pegged to the US Dollars while the US Dollars would be pegged to gold. While more flexible from the previous setting, the dollar also got devalued and eventually, Nixon had to transform USD into a free-flowing fiat currency. 3. Soros Attack A concern regarding pegged currency popped up with the Soros Attack. George Soros took advantage of the weak position of the United Kingdom in the European Exchange Rate Mechanism and shorted more than $10 billion in pounds. When the UK finally withdrew from the European Exchange Rate Mechanism, there was a devaluation of the pound leading to a profit of Soros. At that time, the Bank of England had pegged the currency to the German Deutsche Mark. Kinds of Stablecoins Stablecoins are a way in which cryptocurrencies are pegged. From the case studies, it is clear that there are several ways in which pegging can be done. Stablecoins are of three kinds. They are: Fiat Collateralized: Fiat Collateralized stablecoins works on a simple equation - or ratio. An amount of fiat is locked up against a collateral. Against this collateral, coins are issued let’s say at a 1:1 ratio. Of course, other products like gold or oil can be used instead of fiat currency. Tether is a company which is fiat-collateralized against the US Dollars. While successful, there are certain problems in this settlement. Since the US Dollars is centralized money, Tether makes cryptocurrency centralized which defeats the purpose of the decentralized nature of cryptocurrency. Crypto Collateralized: Crypto Collateralized works on a similar principle as Fiat collateralized. However, the catch is: the cryptocurrency will be collateralized against another cryptocurrency. Now, we know that cryptocurrencies are extremely unstable. So, how can you achieve stability by collateralizing one cryptocurrency with another? In such a situation, you have to engage in overcollaterization. It won’t work in the 1:1 ratio - the collateralization ratio has to be heavily skewed. Hence, you may have to deposit $400 worth of ether and against that, you will get $200 worth of stablecoins. Dai works on the crypto-collateralized principle. Non-Collateralized: Non-Collateralization can be a movement against fiat-currency or the use of fiat-currency as collateral to achieve stability. In non-collateralization, coins are not backed up by anything. It works on the principle of seigniorage. It means that if one can create a smart contract that acts as a central bank and hence, issues currency -this currency can be traded at a rate of $1. However, due to price fluctuations, the price can increase as well and the same currency can be traded at $2 or higher. The Macroeconomics Of StableCoins - The Unachievable Trinity As you can see, there are several policies that can be used to bring about the stability of the cryptocurrency. However, as per economics, there are three goals that cannot be achieved all at once. These goals are: - Pegging or a fixed exchange rate - Lack of capital controls or free capital movements - An independent monetary policy Pegging: Pegging is opposition against a volatile currency exchange rate. By stabilizing the exchange rate, it is possible for businesses to contribute to the economy as a whole. Free capital movements: With free capital, the citizens or business of an economy can diversify their capital or holdings by investing in economic components abroad. Similarly, foreign investors can inject capital into the country as well. An independent monetary policy: Here, the central bank takes the role of a controller of the economy. During recessive states, the interest rate can be reduced and money supply can be boosted while during inflationary trends, interest rates can be raised and money supplies reduced. Since it is impossible to put all three in motion, let’s look at how things would fare if two of these goals are used: If fixed exchange rate and free capital is used, we can see a situation as Eurozone where Euro is fixed as a currency. The countries in Europe can freely trade without facing any exchange rate issues and free capital can be moved from one place to another. However, the central bank cannot intervene during inflation or depression. The use of free capital flow and an independent monetary policy puts us face to face with the US economy. Here, there is a free flow of capital and there is an independent monetary policy for employment and price stability. However, the exchange rate is determined by market forces. Capital flow is also free domestically and internationally. However, exchange rates are subject to market changes. In China, the exchange rate is fixed and managed so as to promote exports. There is also An independent monetary policy to promote exports. However, capital movement is restricted by the government and hence, there is no free-flow of capital goods. The future for Stablecoins Now, the question arises, how can these goals be applied to stablecoins? Stablecoins, by definition, means that it is pegged or has a fixed exchange rate. So, now the question is - should we also simultaneously put Free capital flow or an independent monetary policy. The independent would result in the centralization of the cryptocurrency which defeats the entire purpose. Hence, the only way to go is with the free capital flow. In the Soros example, one way that the British government wanted to counter the shorting of the British pound was by buying pounds using the foreign reserve but it was not helping. Raising the interest could have been the next step but the UK was in recession and hence, people would not be buying pounds even if the interest rates were raised. Hence, the Bank of England broke the peg and let the British pound sterling float along with the German Deutsche Mark.If cryptocurrency becomes a de-facto currency, there will be times of recession. With the lack of central monetary policy, there cannot be any way to tackle an inflated or depressed economy. Breaking the peg is also not an option since stablecoins, by their very nature, are a fixed exchange rate. Hence, it will be hard for stablecoins to stay afloat as a world currency in the future.