Safeguarding Stablecoins From Black Swan Events

Investors seeking cryptocurrencies that remain stable in price pursue stablecoins. At present, bitcoin’s volatility discourages merchants from accepting them for payment. Stablecoins solve this problem, as they are often pegged against the US dollar, basket of fiat currencies, or even the consumer price index. Thus, a merchant paid $5000 in bitcoin can immediately trade it in for a stablecoin to protect themselves from loss. In essence, they serve as a hedge against general cryptocurrency volatility.

As a result,  the stablecoin Tether (USDT), which is pegged to the US dollar, has the second highest trading volume outside of Bitcoin. Tether enables short-term crypto traders to forego the need for transferring funds into a bank account (saving significant time in the process). Investors can thus feel confident that their investment’s value will be preserved

Handling Black Swan Events

In The Black Swan: The Impact of The Highly Improbable, author Nassim Taleb notes that financial forecasters tend to underestimate both the frequency and effects of rare events. So how might how stablecoins react when faced with a sudden market crash? Will they hold up or collapse and drag the entire cryptocurrency industry down with them? In The Strengths & Weaknesses of Stablecoins, the MakerDao stablecoin team suggests that the answer lies in whether they exist as IOUs, Seignorage Shares, or On-Chain Collagorization.

In its most fundamental form, traditional stablecoins like Tether can be considered an IOU. That is, a bank or other centralized entity will redeem a stablecoin at a pegged 1:1 ratio. The underlying assumption here (among investors) is that the centralized entity will always have enough reserve, to cover all IOUs (recall recent investor concerns about whether Tether had enough fiat reserves to cover all Tether tokens in circulation).

However, what happens when a black swan event occurs? What consequences follow if investors begin to have little confidence in the stablecoin? Or if the coin starts to collapse in a financial crisis? The bank runs that preceded the 1929 Depression give us a pretty good idea (reminder, the FDIC does not back cryptocurrencies). A good starting point to answer this complicated question is Wired’s Why Tether’s Collapse Would Be Bad for Cryptocurrencies. Ultimately, this IOU model leaves investors heavily at risk.

A crowd of depositors outside the American Union Bank in New York, having failed to withdraw their savings before the bank collapsed, 30th June 1931. (Photo by FPG/Hulton Archive/Getty Images)

In contrast, seigniorage share stablecoins rely upon keeping the price stable by matching supply with demand. Thus, as demand rises, a stablecoin can meet this demand by issuing new coins. If demand drops, the stablecoin supply must contract. Consequently, these stablecoins “use a bond issuance system to incentivize users to “turn in” their coins for a bond that might provide a return of stablecoins issued in the future” (Medium).

However, operating in this way is predicated on the belief that the coin will soon appreciate in value again (which may not be the case). More importantly, if a black swan event hits, no collateral exists to back up the stablecoin. In effect, this arrangement is even riskier than the IOU model. The stablecoins Carbon and Basis use this model.

With on-chain collateralization, an on-chain system issues coins “relative to the value of the underlying collateral. As explained in the article above,

This process is similar to an escrow. Since the collateral backs the stablecoin, coin stability links to the total value of the underlying assets. If those assets, collectively as a portfolio, are stable, the ability for the portfolio to quickly change in value reduces, further increasing stability.

In a black swan event, these coins “generally rely on allowing flexibility in the price of the underlying asset, or exchanging the stablecoin for collateral. In both instances, the damage is minimized by the speed that the system can act (Medium).”  However, any loans are automatically liquidated if these collateralized cryptocurrencies experience significant depreciation. The MakerDao and Dai coin are the most prominent examples that use this model.

A Closer Look

Do crypto-collateralized coins offer any protection against a future cryptocurrency death spiral? MakerDAO argues that its Dai token relies upon “a diverse array of supporting assets.” Though that only assumes that those assets won’t fall as well (which remains highly likely given their positive covariance).

Consider what might happen to MakerDA in such an event. As one Reddit observer notes,

when ETH prices go down, MakerDAO starts liquidating ETH collateral in anticipation so the value of Ether backing Dai doesn’t go below 1:1. In mild price downturns this is fine. But black swan crashes happen fast and they don’t give you time to recover. In market meltdowns, selling ETH to liquidate Dai would actually contribute to driving the price down faster. MakerDAO has a contingency plan for this. The community of MakerDAO MKR token holders will bailout Dai as a buyer of last resort. Not to underestimate the MakerDAO community, but I really doubt any such community can stand against a torrent of sell-orders in a market crash.

Nonetheless, Dai stablecoin supporters will argue that such a scenario fails to take into account that their stablecoin is supposed to be multi-collateral and not solely dependent upon ETH (which may not be realized at present). They also note that Dai investors also overcollateralize (giving $150 of ETH for $100 of Dai).

An Alternative Route

The truth is, no coin – or even monetary system – will easily survive a worldwide black swan event (say, a limited nuclear war). While MakerDAO holders are currently able to bail out their Dai if its collateral crashes, that won’t be the case if such a model goes large scale. So, what might a plausible future where fiat still plays a viable role?

Colton Robtoy suggests that stablecoins could be offered by a bank upon receipt of physical fiat from a consumer. The bank would credit the consumer via a smartphone digital eWallet – perhaps by 2025. He also posits that the Federal Reserve might start offering stablecoins upon receipt of a USD Bank Transfer by 2040 (whose to say that vested interests don’t have staying power).

However, my guess is that cryptocurrency investors won’t be willing to tie themselves so tightly to fiat in the near future. Unless a black swan event does occur, jolting investors back toward that direction is some new semblance.

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  • Craig

    At BitBay.market our dynamic peg has the most resistant stability protocol against Black swan event.


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