In this report, we will analyse the optimal price stability strategies of cryptocurrencies and the monetary policy alternatives. The central argument is that price stability via reserve management and direct quantity targeting is basically inefficient and costly, whereas state-dependent liquidity provision based on a previously announced schedule is a more efficient solution. Although contributing to the recent discussion on the meltdown in cryptocurrency markets triggered by a bank run on #UST, we take a more general look at the optimal price management mechanisms. As such, we provide a monetary policy framework which is easily implementable and facilitates the adoption of cryptocurrencies.
Let’s start with some technical observations on the 1-to-1 pegging strategies behind stablecoins.
First and foremost, the opportunity cost of maintaining the peg is too high. You can defend an absolute peg between a stablecoin and any fiat currency only if you have enough collateral to do so. This introduces the first difficulty: you need a massive amount of liquid financial assets to be locked in the reserves in order to mitigate a possible bank run in the future. The opportunity cost of keeping such large volumes (which must grow at the monetary base’s growth rate) is too high. This amounts to billions of dollars being readily available for exchange rate management which cannot be invested in other assets or even kept in an account where they would take more than a few seconds to liquidate. Nevertheless, for the sake of the argument, let us assume that someone is willing to invest several billions into financing a fiat-pegged stablecoin.
The collateral assets in the reserves could come in two different forms: either as traditional assets, e.g. central bank money, treasury bills, and commercial papers, or as decentralised assets, i.e. crypto assets like Bitcoin. However, there are risks related to both the reserve management approaches.
- The reserves can be fueled with traditional assets, which are dollar-denominated. Fiat-backed stablecoins are prone to two different types of failure: first, this is not a sustainable decentralisation in the long run. Your reserves would be open for confiscation or legal seizures motivated by any imaginable political strategy of central authorities. Second, and more importantly, you would be creating bank money out of a centrally owned asset in your reserves, namely dollars. A decentralised cryptocurrency should not work like this: the structure would not be different from running a commercial bank within the traditional banking system and as such, it would still be under the influence of a central authority.
- Alternatively, you can keep decentralised assets in your reserves: a basket of cryptocurrencies or the gold standard of cryptocurrencies, Bitcoin. Such crypto-backed currencies are immune to the possible legal seizures or being a digital copycat of traditional banks. However, they carry a significant price risk in the reserves, which can be used for manipulation by speculative traders. To be more precise, we are concerned with the risks related to the quantity management framework via selling (or buying) reserves in the event of downward (or upward) pressure on the peg. Large scale open market operations would have price effects on the reserve currencies themselves because of the relatively small market size and the possibility of coordinated sell-offs. This is fundamentally what happened with the Terra ecosystem last week. Note that, the crucial problem with backing a cryptocurrency with another crypto is that they are both subject to the same aggregate risks: this is not a proper stability strategy at all.
Our discussion above shows that the direct quantity management framework is not what is expected from a decentralised cryptocurrency. It is inefficient at its best. The trade-off can be summarised with the famous open economy trilemma adopted to stablecoins in Figure 1. A stable peg can be maintained only by over-collateralizing or centralising the reserves, which are too costly to maintain. Similarly, algorithmic solutions like TerraUSD are subject to the same devaluation risk, if they are not backed by enough reserves. Then, what is the solution? Do not peg!
Figure 1: Stablecoin trilemma. Source: Chaudhary and Viswanath-Natraj (2022).
So far, the criticism has been on the 1-to-1 pegs with fiat currencies and that they are either too costly or unsustainable. This shall not be interpreted as disbelief in exchange rate management. Price stability is obviously an important issue, if not the most important one in the public eyes. The main concerns about cryptocurrencies are price volatility and uncertainty about their value. Cryptocurrency developers must solve this problem to become prominent and acceptable to a larger population. Therefore, the focus must be on reducing price volatility by using the least amount of resources for this purpose. Here are two propositions in this direction.
Targeting High-Frequency Price Volatility
Just like any other financial asset, a cryptocurrency should be valued by the market forces. However, young markets — such as cryptocurrencies — do not work flawlessly. There are serious mismatches in the timing of supply and demand, arising from market frictions. They cause significant short and medium-term volatility in the prices. There can be many approaches to reducing the exchange rate volatility, but reducing it to zero through 1:1 pegs is not optimal, as we have discussed above. On the other hand, there is room for monetary policy design to reduce short term fluctuations in the price of a currency that arise due to market frictions.
Intervention with Schedules
Rule-based monetary policy has its advantages in implementing efficient price management of a currency with parsimonious reserves. Although direct quantity targeting is effective in determining the exchange price of a cryptocurrency in terms of dollars, it leads to excessive reserve build-up or erosion. A more efficient way to manage the exchange rates is shown to be announcing an intervention schedule rather than directly injecting or withdrawing liquidity from the markets. As argued by Basu and Varoudakis (2013), by declaring an intervention schedule one can change the expected demand curve of the currency and implement the desired exchange rate without any quantity intervention. The crucial aspects of such a mechanism are to design the intervention schedule with appropriate incentives and to sustain the credibility of the operating body.
Price stability is not trivial with cryptocurrencies. Nonetheless, the flexible structure of distributed ledger systems opens a wide range of possibilities to overcome this problem. With some imagination, cryptocurrency developers can envision creative liquidity protocols to tackle price volatility.