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This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
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Stability of value is one of the most important functions of money so it can fulfill its purpose as a unit of account and a reliable store of value. Since Bitcoin and other protocol tokens traditionally do not come with a built-in stability mechanism, stable tokens were explicitly designed to bridge this gap. They represent a store of value, a medium of exchange, and a unit of account that have a stable value against another currency, commodity, or index.
Disclaimer: Certain details described in the following chapter might be out of date at the time of reading this book. This chapter has, therefore, been structured to paint a broad picture of the complexities regarding the mechanism design of stable tokens, independent of the current developments of specific stable token projects.
From a monetary policy point of view, Bitcoin does not entirely live up to the value proposition stated in its own whitepaper. While it introduced a groundbreaking consensus algorithm, which is the basis for P2P value exchange, it currently cannot serve as electronic cash in the sense of a practical medium of exchange. This is why many refer to it as “electronic gold” instead of “electronic cash.” It came with a rudimentary monetary policy that simply regulates and limits the amount of tokens minted in the Bitcoin network over time. The Bitcoin protocol does not provide a sophisticated economic algorithm that regulates price stability. As a result, Bitcoin and other protocol tokens designed with a similar monetary policy are subject to price volatility and are impractical for day-to-day payments, at least in countries with relatively stable inflation rates. At the time of writing this book, they mostly attract speculators and long-term investors.
Short-term stability of value is one of the most important functions of money so it can serve as a unit of account within an economic system. Stability is a basic requirement for meaningful economic planning by all actors in an economy. Salaries, investments, and daily expenses such as rent, utility payments, and groceries cannot be reliably denominated or planned for with a medium of exchange that has extremely fluctuating exchange rates. Businesses and individuals are not likely to accept a token as a method of payment if its value can drop significantly within a short period. The same is true for Web3 tokens. In order for a token to serve as a means of payment, store of value, or unit of account, it needs a relatively stable value so that the price paid for goods and services can be reliably planned. Without a stable medium of exchange, no party to a smart contract can rely on the price given.
Just as developing a secure consensus algorithm such as Proof-of-Work required decades of research and development, an equivalent amount of research and development rigor is needed to develop a resilient “monetary policy” in P2P electronic cash protocols. To serve as a daily medium of exchange, the price of a token needs to be resilient to potential economic fallouts or deliberate attacks by outside parties that could massively interfere with the exchange rate. Financial history has shown that protecting currency stability from outside attacks is not easy to achieve. In 1992, for example, George Soros exploited the stability mechanism of the Bank of England, successfully manipulating the foreign exchange price of the British pound in an event now referred to as “Black Wednesday.” This ended up costing the UK more than three billion pounds at the time.
Protocol tokens such as Bitcoin (BTC) or Ether (ETH) are volatile in value for several reasons. The main reason is the static monetary policy defined in their protocols: this means that the token supply policy does not adjust to macroeconomic conditions outside the Bitcoin or Ethereum system. No currency interventions are performed, which is what central banks usually do to keep their national currencies relatively stable against other currencies. But there are also other reasons, typical of emerging technologies and their applications. For one, there is the shifting public perception of value and unstable expectations regarding the real value of Web3 networks and their tokenized applications, which is quite natural in the hype cycle of any new technology. There is also a lack of public understanding of the fundamental dynamics and infrastructural value of blockchain networks and their tokenized applications. Finally, shifting market reactions are also a result of uncertainty about future regulatory interventions.
The lack of price stability mechanisms in the protocol of classic cryptocurrencies such as Bitcoin has led to the emergence of so-called “stablecoins” or “stable tokens.” Traditionally, the crypto community distinguished between the following types of stable tokens: (i) fiat-collateralized or commodity-collateralized stable tokens, (ii) crypto-collateralized stable tokens, and (iii) algorithmic stable tokens. Lately, (iv) central banks have also started looking into tokenizing their currencies, which already come with built-in price stability mechanisms and are generally referred to as “Central Bank Digital Currencies” or “CBDCs.” This classification is a historical one—from the perspective of how the stable token ecosystem has evolved over time—and the concepts have become entangled. State-of-the-art stable tokens have started to implement the best practices of various mechanisms.
The mechanism design of a meaningful and sustainable stable token system needs to take into account the interdependencies of a myriad of DeFi applications that use the stable token, as well as the macroeconomic and regulatory conditions of the real economy, and is therefore not without challenges. Despite their highly experimental nature, stable tokens have become an indispensable building block for a tokenized economy and a growing body of DeFi applications, which will be discussed in more detail in the following chapters.
In this chapter, I will analyze the different classes of stable tokens from this historical perspective to understand the different approaches to building a stable price and exchange rate mechanism. To understand the different types of stable tokens, two concepts key to currency stability need to be discussed: “inflation” and “exchange rates.”
In traditional economics, the term “inflation” refers to the increase in prices for goods and services one has to pay for in the economic system within which a currency is used. Inflation reflects the reduction of the purchasing power of a unit of a currency: one needs more units of the same currency to pay for the same goods or services. The “inflation rate” is the measure of inflation, which is denominated as the percentage change of either a basket of goods and services, usually the consumer price index (CPI), or the employment cost index (ECI). While inflation usually refers to a general increase in all prices, it can also be used to describe the rise of prices in a particular asset class or industry.
The challenge is that indices such as the consumer price index are based on statistics. Their accuracy depends on the goods and services that are included in the basket of goods and services for an “average” household. Since the inflation rate varies for different goods and services, and each person and household has different spending patterns, such statistical measures seldom reflect the reality of most people's spending, and they can also be tampered with for political reasons. An understanding of how inflation is measured and that inflation statistics can be manipulated is just as important as knowing how high the current rate of inflation is.
Price stability is understood as a relative lack of inflation, where a currency retains its purchasing power within an economic system or only slightly loses its purchasing power at a steady and slowly increasing rate. While most economists agree that hyperinflation is too disruptive to economic systems, low to moderate rates of inflation have become widely accepted or are generally considered less harmful. Some economists believe that a low level of inflation might even be useful to conduct more sustainable monetary policy interventions in the long term.
Many people tend to misappropriate the term “inflation” to refer to the disproportionate increase in the total money supply by central banks. While an increase in the money supply can lead to inflation in the long run, inflation also depends on many other factors. To make things more complex, no economic system is completely self-sustaining but rather reliant on imports and exports. Real inflation rates therefore depend on the exchange rate between a domestic currency and the currencies of countries from which goods and services are typically imported. The same is true for blockchain networks. Stability is, therefore, always a relative term, since fiat currencies, cryptocurrencies, and commodities have a fluctuating exchange rate against each other. A central bank can try to keep the currency it governs stable against the local consumer price index, but in a global economy of imports and exports, such stability endeavors will only be able to affect locally sourced goods and services. To keep prices stable for imported goods or to maintain employment for exporting industries, currency intervention is needed. Currency intervention by central banks and other governmental authorities, however, might have destabilizing effects on other parts of the economy.
The terms “inflation” and “stability” are always relative to the economic system a currency is being used in. While a national currency could become unstable by losing its purchasing power domestically due to high inflation rates, it could—at the same time—have much higher purchasing power in another country with relatively higher inflation rates. In the reality of free global trade, inflation refers to the rate of exchange of a currency in purchasing power, and a currency is not necessarily inflationary or deflationary just because the supply of a currency “goes up” or “goes down.” Unfortunately, these concepts are often oversimplified in the crypto space.