The Problem with Stable Coins

Price volatility is a big problem in the crypto world. Widespread adoption is unlikely without a good monetary rule that reduces volatility. But, as Barry Eichengreen notes in a recent Project Syndicate article, stable coins like Tether, Sagacoin, and Basis have their own issues.

To illustrate the problem, Eichengreen offers three scenarios. In the first scenario, a cryptocurrency issuer maintains 100 percent dollar backing for coins in circulation. This is similar to how a currency board works. Since such an arrangement requires the issuer attract and hold dollars in order to expand the supply of coins, the cryptocurrency will not be subject to a speculative attack. However, this also means the issuer cannot invest those dollars since it must hold all of them to back the cryptocurrency.

Unable to earn interest on the float, a cryptocurrency issuer would find it challenging to profit while holding 100 percent dollar reserves. It would also struggle to offer a competitive return and, hence, attract customers. Why would one exchange a widely used dollar for an illiquid cryptocurrency, which is harder to use and does not offer a competitive interest rate?

In the second scenario, an issuer holds less than 100 percent of its circulation in reserves. Business profitability is greater than in the 100 percent scenario, but at the expense of an increase in the risk of a run. If coin holders lose faith in the issuer’s commitment to exchange the coins for the dollar at a certain rate, or believe others will lose faith, a run on the cryptocurrency might force the issuer to break its peg—a well-known problem to any central banker trying to maintain a peg.

Finally, in the third scenario, the issuer issues a cryptocurrency and a crypto bond. If the price of the cryptocurrency falls (rises), then the issuer will sell (buy) bonds denominated in its currency to equilibrate the price of the currency. Note that the issuer is doing something similar to open market operations — not by selling assets, but by issuing bonds that pay interest. In this case, the project becomes sustainable only if the demand for the cryptocurrency grows fast enough for the issuer to roll over or pay off its debt. Doubts about the likelihood that the issuer will grow can have, in turn, a negative effect on the price of the bond, making the situation more difficult for the issuer.

Eichengreen’s points are well-taken and focus on the challenges of issuing a stable cryptocurrency. At least some of Eichengreen’s points rest on the fact that the demand to use cryptocurrencies is unlikely to rise. His reason seems to be that cryptocurrencies are less liquid than the dollar (and more difficult to use for most people).

There is, however, a potential advantage of using a cryptocurrency: the reduction in the transaction cost of making digital payments. Bitcoin’s innovation was to make peer-to-peer electronic transactions feasible. By eliminating intermediaries, cryptocurrencies have the potential to reduce transaction costs relative to legacy payment systems. That would create a source of demand from consumers and, hence, a business opportunity for crypto issuers.

Eichengreen raises important issues. But the potential to lower transactions costs is a reason to be optimistic about the future stable coins.

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