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.
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Disclaimer: Certain details described in the following chapter might be out of date at the time of reading this book.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.
History of Stable Tokens
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.”
Inflation & 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.
Blockchain networks can be considered a new type of economic actor on a global scale, with their own internal currencies as well as an entire ecosystem of economic services that build on these electronic infrastructural networks. This new type of non-state actor is an addition to the global interplay of currency, exchange rate, and inflation, and generally adds to existing complexities, both in foreign exchange markets in particular and in the financial landscape in general.
Fiat-Collateralized & Commodity-Collateralized Stable Tokens
A simple way to achieve a token with a stable value is to back the token with a reserve of assets from the real economy that have relatively stable prices. Fiat currencies or commodities, such as gold, offer a relatively stable and familiar alternative to volatile digital currencies. Their value is directly tied to assets that users trust.
- Fiat-collateralized stable tokens are backed by reserves of fiat currency, such as the U.S. Dollar, Euro, or another national currency. The issuer of the stable token holds an equivalent amount of fiat currency in reserve. “Tether,” “TrueUSD,” and “USDC” were early examples of stable tokens that were backed by the U.S. Dollar, meaning that for every token issued, there is an actual U.S. Dollar held in reserve. This type of backing gives users confidence that the token will retain its value, as it is tied directly to a recognized and widely accepted currency. The simplicity of fiat-collateralized stable tokens makes them attractive for both users and developers and is reminiscent of representative currencies. They are easy to understand and offer a clear link to traditional financial systems. One of the primary risks is centralization, as the reserves are typically held by a centralized entity, such as a bank or financial institution. This creates a potential point of failure, as the stability of the token depends on the trustworthiness and solvency of the financial institution issuing the tokens and managing the fiat reserves. Users must trust that the issuer maintains sufficient reserves and that regular audits are conducted to verify the backing. While USD tokens are pegged to the value of the U.S. Dollar, they are not necessarily backed only by cash reserves. The array of reserves backing the value of an asset-collateralized stable token can also contain other securities, such as short-dated government bonds. The same is true for stable tokens pegged to other fiat currencies, such as the Euro (e.g., EURS, EUROC), or stable tokens pegged to other currencies, such as the Singapore Dollar in the case of “StraitsX Singapore Dollar” (XSGD).
- Commodity-collateralized stable tokens are similarly designed. The value of the token is backed by commodities such as gold, silver, or diamonds. For example, a gold-backed stable token might be issued with a promise that each token represents a specific quantity of gold stored in a vault managed by the financial institution issuing the token. “Digix Gold” was an early example of a token that was backed by gold. Today, many alternatives exist. Commodity-collateralized stable tokens can appeal to those who prefer to hold assets with a historical track record of value preservation. They provide an alternative to fiat currencies, particularly in times of economic instability when investors seek out safe-haven assets. However, as with fiat-backed tokens, there is a risk of centralized control over the reserves, which may undermine the decentralized ethos that many blockchain networks strive to uphold.
In both fiat-collateralized and commodity-collateralized systems, the tokens must maintain a 1:1 peg to the underlying asset. If the value of the reserves changes or if doubts arise about the solvency of the entity managing the reserves, the token could lose its peg, leading to instability. For this reason, it is crucial for such stable tokens to maintain transparency and offer mechanisms for regular audits and verification of the assets held in reserve. However, another challenge remains. In global asset markets, absolute price stability in relation to other currencies can never exist. To diversify the risk of exchange rate volatility of single currencies or single commodities, the concept of backing a stable token with a basket of commodities, a basket of fiat currencies, or an index such as the Consumer Price Index (CPI) emerged over time. Despite the centralization risk, fiat- and commodity-collateralized stable tokens have gained widespread adoption in decentralized finance (DeFi) due to their ability to bridge the gap between traditional and digital economies.
Crypto-Collateralized Stable Tokens
Crypto-collateralized stable tokens are backed by cryptocurrencies rather than fiat currencies or physical commodities. They allow users to store their Web3-native digital assets, such as Ether (ETH) or Bitcoin (BTC), in a smart contract as collateral and issue the stable token in exchange. The volatility of the collateral asset is offset by over-collateralization. The digital collateral can be provided by anyone who would like to participate in the system. The stability mechanism is encoded into the token contract and is designed to incentivize the behavior of market participants in the form of arbitrage opportunities to buy or sell the stable token in question to maintain stability. The assets are managed entirely on-chain and are audited by a publicly verifiable infrastructure—a blockchain network—instead of a third party that would need to hold physical collateral assets in secure vaults and conduct regular analog audits. This guarantees a level of transparency that is difficult to achieve with fiat- or commodity-collateralized models. Since all transactions, collateral deposits, and liquidation events are recorded by all nodes in a public blockchain network, any user can independently confirm the system's solvency in real time. In other words, anyone can check if the necessary collateral is in place to back the issued stable tokens.
Unlike fiat- or commodity-backed stable tokens, which usually only require a 1:1 backing ratio, crypto-collateralized stable tokens typically require more than 100 percent of the token's value in collateral, as cryptocurrencies have higher levels of exchange rate volatility. For example, a user may need to deposit 150 USD worth of ETH to issue 100 USD worth of a stable token. This over-collateralization acts as a buffer against the inherent price volatility of ETH. If the price of the collateral drops, the system has mechanisms in place to automatically liquidate the collateral to protect the value of the stable token. While over-collateralization helps mitigate this risk, it does not eliminate it entirely. In times of extreme volatility, if the value of the underlying crypto assets collapses, the stability mechanism can be compromised despite the over-collateralization. The risk of forced liquidation increases, leading to potential losses for users providing collateral assets to secure the system. In times of market stress, rapid price declines in the collateral can lead to cascading liquidations, destabilizing the entire system. The reliance on over-collateralization also ties up market liquidity of the collateral asset and reduces the overall efficiency of the system. This is why some crypto-collateralized stable tokens, such as DAI, eventually transitioned to accepting a basket of different crypto collateral, including fiat-pegged stable tokens that are, by design, less volatile.
“BitUSD” was the project that introduced this stable token model back in 2014. It inspired many other projects, such as “MakerDAO” (DAI), which was the most dominant crypto-collateralized stable token on the market for a long time. Other tokens of this kind—such as “Liquity” (LUSD), “Reflexer” (RAI), “Decentralized USD” (USDD), or “Dark Dollar” (DUSD)—have been less widely adopted. In addition to the decentralized nature of collateral management, the governance of this type of stable token protocol was also often decentralized, with various levels of success. The idea behind this was that the stability and integrity of the system should be collectively managed, reducing reliance on centralized entities. MakerDAO, for example, was created as the governing entity of DAI, where token holders of MakerDAO could participate in key decision-making processes or the monetary policy of DAI, both long term and short term, such as adjusting collateralization ratios or determining which assets can be used as collateral. Read more about the mechanism design and governance of DAI in a chapter dedicated to the use case of DAI and MakerDAO in the third part of this book.
Algorithmic Stable Tokens
Algorithmic stable tokens are the most controversial form of stable tokens. In their purest form, they were not collateralized at all and did not withstand the test of time. Similar to DAI and other crypto-collateralized stable tokens, they are pegged to a fiat currency, and the stability mechanism is controlled by the algorithmic supply and demand policies baked into the token contract. Unlike DAI and other crypto-collateralized stable tokens, they were under-collateralized or not collateralized at all, relying solely on adaptive algorithmic mechanisms to manage their supply and maintain price stability.
Like DAI, the stability mechanism of a purely algorithmic token is designed to reduce price volatility by offering economic incentives in the form of arbitrage opportunities to market participants, who collectively regulate the stable token price. The peg could be anything from a fiat currency to a basket of goods and services or a suitable economic indicator. Elastic supply mechanisms are designed to either stimulate expansion or contraction of the token supply, similar to how central banks control the supply of fiat currencies. If the demand for stable tokens rises or falls, the algorithm automatically adjusts to maintain a stable price. If the price is too high, the mechanism increases supply. If the price is too low, tokens need to be “frozen” in some manner. The question of how to increase and decrease token supply in an attack-resistant and resilient way has not been conclusively resolved. Different algorithmic methods can be used for expansion and contraction: (i) rebase mechanisms, (ii) seigniorage mechanisms, and (iii) fractional-reserve mechanisms.
To understand algorithmic stable token design in detail, one needs a foundational understanding of macroeconomics (particularly monetary policy), financial markets, mathematics, and the technological building blocks of DeFi products and their interactions. Investors need to understand the level of risk involved when putting money into such highly experimental tokens. Critics of algorithmic stable tokens argued that token holders risked losing all their investments when the mechanisms inevitably crashed, leading to a “bank run” effect—since there is no collateral to back the system—which is what eventually happened.
The challenge with these stable tokens is that they require a certain degree of demand; otherwise, the mechanism collapses. The mechanism is also designed on the assumption that all token holders are self-motivated, independent investors who are both interested in and have the time to invest and profit from the arbitrage opportunities the protocol provides. It is the age-old myth of the profit-maximizing individual market participant who makes only rational economic decisions without mental shortcuts, based on full information and with unlimited time at their disposal. Unfortunately, this type of assumption is not based on any hard evidence from financial market history in general or crypto markets in particular. This flawed assumption has led to many mechanism design failures in the area of stable tokens and DAOs since the early days of alternative cryptocurrencies.
Financial markets, in general, are known for their hype cycles, which are very often driven by herd behavior rather than rational economic and evidence-based thinking. Such herd behavior is often unrelated to the actual underlying asset values, at least in the short term. Only a select few market actors—those who are financially savvy and have industry know-how—can protect their downside and potentially win in this poker game of arbitrage opportunities. The rest of the financially less literate investors might believe they are playing the same game, when in fact, they are engaging in a game of roulette rather than poker, as they lack the knowledge to protect their downside. For the mass of retail investors, crypto assets, like stock market assets, are often just a game of pure chance, which led to the collapse of this type of stable token faster than expected.
Stable Token Building Blocks
The above-mentioned categories of stable token mechanisms have developed over time but often no longer exist in their pure form. Many mixed stable token mechanisms have emerged over the past years that do not adhere to these classical categorizations but instead incorporate the best practices from different stable token experiments. The following properties are essential to understanding the benefits and pitfalls of different stability mechanisms:
- Peg: The main purpose of a stable token is to maintain price stability against a target value—the peg. The peg might be hard or soft or allow fluctuation within a certain base range. A stable token can never be stable against all global currencies or all assets but only in a relative sense—in relation to one currency, a basket of currencies, one asset class, a basket of assets, or a macroeconomic indicator such as the consumer price index. In a globalized economy with over 200 different national currencies, in addition to commodities, stocks, bonds, and a growing range of crypto asset classes, all of which have fluctuating values against each other, “stability” is a relative term.
- Collateral asset: The collateral assets do not necessarily need to be identical to the assets against which the target price is pegged. The target price of a stable token, for example, could be pegged to USD, while an equivalent in ETH or gold could be held in reserve as collateral. It is important to understand what asset or mix of assets will be held in reserve as collateral and whether the assets are on-chain (crypto-native assets such as BTC, ETH, etc.), off-chain (real-world assets held in a vault), or if there is no collateral at all.
- Collateralization level: If a collateral asset exists, one needs to determine the collateralization level, i.e., the percentage of assets in proportion to the peg that must be held in reserve. To maintain price stability against the pegged target, one can use full collateralization (1:1), over-collateralization, or under-collateralization. A sustainable collateralization level will depend on the price volatility of the collateral asset in proportion to the pegged asset, currency, index, or basket. As previously mentioned, non-collateralization has not proven to be sustainable, at least at the time of writing this book.
- Stability mechanism: The mechanism can be designed to be static, meaning it does not change over time. In this case, the mechanism is hard-coded into the smart contract. The mechanism can also be dynamic, as would be the case with algorithmic stable tokens that adapt to market conditions. In this case, the parameters are designed to adjust within a predetermined range and could also be modified through human intervention via a governance process involving eligible network stakeholders. AI tools could be used at the heart of the smart contracts steering the stability mechanisms to make them more comprehensive and adaptive to the complex interaction patterns of internal and external economic events influencing the stability of the peg.
- Crisis resistance & risk management: To evaluate the sustainability of the stability mechanism, one must understand the conditions under which the mechanisms can maintain the envisioned stability and under what conditions they might fail in an unforeseen crisis. Given the complexities of a growing DeFi ecosystem, crisis resistance is one of the most critical factors. It raises many questions around individual and institutional risk management as well as governance concerns, such as: (i) Who controls the stable token system? and (ii) Who can intervene if unexpected situations arise to prevent maximum collateral damage?
- Who issues the stable token? To understand the politics behind a stability mechanism, one must examine the type of issuer, how the issuer is institutionalized (private institution, governmental institution, or DAO), and what legal liabilities the issuer might face. If the issuer is a private institution or a DAO, the question of which national legislation applies to them is crucial. When the issuer is institutionalized as a DAO, it is also necessary to assess how decentralized the DAO is, who can participate in decision-making, and what the power structures are to understand potential vested interests.
Stable tokens have complex interaction patterns with a growing range of financial tools in the DeFi, CeFi, and increasingly, TradFi ecosystems. Flawed assumptions about the effects of different building blocks of a stable token system when integrated with other stable token systems or financial applications can lead to massive collateral damage for individuals and institutions alike.
Impossible Trinity
Stable tokens always face the “impossible trinity” that conventional fiat currencies are also confronted with. This trilemma was first mentioned by economists Fleming and Mundell in the 1960s and describes the impossibility for fiat currencies to ensure a fixed exchange rate, free capital flows, and an independent monetary policy all at the same time. In the context of stable tokens, the free flow of capital is a given due to the nature of blockchain networks and tokenization. Exchange rate stability is the goal, so autonomous monetary policy seems to become the trade-off. Additionally, a new trade-off emerges between the following goals: (a) exchange rate stability, (b) decentralization and autonomy, and (c) capital efficiency. These three objectives of stable token designs often conflict with each other and need to be delicately balanced when designing a stable token system.
- Exchange rate stability toward a target range or a peg is the ultimate goal and the whole raison d’être of a stable token. The best level of stability, at least so far, has been achieved with fiat- or commodity-backed stable tokens, but they are the least “decentralized” type of stable token. Meanwhile, undercollateralized algorithmic solutions were hyped as being the most decentralized, but they are highly volatile and, in many cases, have completely collapsed.
- Decentralization and autonomy: The concept of “decentralization” in the context of stable token systems would require autonomous monetary policy and for a stable token not to rely on a centralized service provider managing all collateral assets. The monetary policy of an asset-pegged and asset-backed stable token, such as USDT or USDC—both pegged to the USD—depends entirely on the monetary policy of the US Federal Reserve and grants no autonomy whatsoever to the issuers of the stable token. The monetary policy of a crypto-collateralized stable token such as RAI can be considered partially autonomous because it is crypto-collateralized with ETH only, not requiring it to hold any real-world assets and currencies in reserve. However, it depends on the monetary policy of Ethereum and the US Federal Reserve since it floats around the USD but is backed by ETH. Algorithmic stable tokens with no collateral have full autonomy, but they are also less sustainable, at least at the time of writing this book.
- Capital efficiency is a general financial term that has been adapted to the context of stable tokens. It refers to the amount of capital required to create one unit of stable tokens. Capital efficiency is related to collateralization levels, which usually trade off with decentralization efforts. In the case of crypto-collateralized stable tokens, price stability can only be achieved with over-collateralization due to the volatile nature of crypto asset prices, which in turn reduces overall capital efficiency. Crypto-collateralized stable tokens could achieve higher levels of capital efficiency by leveraging the collateral assets for quick loan or arbitrage opportunities, but this opens a can of worms in terms of systemic risks. Algorithmic stable tokens, in turn, are extremely capital efficient, as they do not require much (or any) collateral. However, at the time of writing, they have yet to prove that they can maintain price stability in the medium and long term, which is the ultimate goal of a stable token.
Economists argue that decentralized stable tokens with more independent monetary policies from nation-states and their central banks will never have stable exchange rates comparable to conventional currencies. However, if one considers a crypto token not as a competitor to a conventional currency but rather as a new, alternative asset, the outlook might be different. It is also important to point out that stable tokens may not be the only solution to token price volatility. Insurance or financial derivatives could provide alternatives, or at least complementary methods, for mitigating price volatility. Hedging is another investment strategy that can be used to reduce financial risk by balancing positions in the market to protect against price volatilities. A combination of DeFi applications could be used to create such peer-to-peer derivative and hedging solutions. Such solutions, however, are only practical for financially savvy institutions and individuals, but not for the end consumer who would use a stable token for day-to-day spending. They might become viable inclusive instruments for less tech- and finance-savvy users if they could leverage AI tools to make them more comprehensible and usable in the future.
Central Bank Digital Currency
While the crypto community has experimented with a wide array of privately or collectively issued stable token solutions, central banks have started to look into tokenizing their own fiat currencies to be settled over some kind of distributed ledger infrastructure—generally referred to as Central Bank Digital Currency (CBDC). CBDCs are a new form of electronic money that is directly issued by the respective central bank without the need for private banks in the middle, as the wallet application could manage all banking functions. Tokenized fiat money issued by central banks already comes with a built-in stability mechanism, provided in collaboration with the fiscal and monetary policy of a national government. It would be part of the base money supply of a nation, along with other forms of money: cash and other cash equivalents, short-term deposits, and long-term deposits. “Synthetic CBDCs” (sCBDCs) are a possible variation of this concept and refer to tokens that are issued by private institutions and fully backed with central bank reserves.
In a CBDC scenario, every citizen would have their own CBDC wallet, meaning that central banks would compete with commercial banks over customer deposits. In the long run, CBDCs could eliminate the need for classic bank accounts, replacing them with government-developed crypto wallets. This would mean that account holders interact directly with the central bank instead of with a private bank. Such a shift could significantly reduce the cost of managing local and international payment systems, which are currently quite high due to the global interplay of private banks and cross-border transactions. However, cutting out commercial banks and cross-border payment systems could destabilize the credit system (notably the fractional reserve system) and foreign exchange markets, leading to significant systemic impacts.
Some economists believe that CBDCs could be a method to achieve a full-reserve banking system, challenging the practice of fractional-reserve banking and eliminating the need for deposit guarantees. Issuing central bank money directly to the public could also provide a new channel for monetary policy execution. This would allow for more direct control of the money supply and more granular financial stimulus packages, such as government subsidies that can only be conditionally spent with real-time auditing and compliance mechanisms. Issuing new CBDC supply could complement or substitute indirect financial stimulus tools, such as adjusting interest rates or engaging in quantitative easing.
On the downside, there are serious threats, particularly concerning privacy, as CBDCs could be used to introduce a financial surveillance state. Unlike cash-based systems, CBDCs are not anonymous at all. While the lack of anonymity already exists in the context of electronic bank money, which makes up most of the total money supply and financial transactions today, governments currently do not have direct and immediate access to their citizens’ spending logs—at least not without a judicial warrant. CBDCs would make money prone to permissioned spending, enabling more refined fiscal policymaking. Subsidies or tax breaks could be granted for conditional spending, allowing for greater control than with current systems. However, for individuals and organizations, CBDCs could lead to a loss of autonomy over spending decisions if governments begin to micromanage and monitor financial behavior.
Challenges & Outlook
Only a small percentage of stable token systems have survived since their launch, especially among the group of more experimental projects. No clear best practices have been established yet—other than fiat-pegged stable tokens and potential CBDCs, which are both centralized solutions and do not live up to the claim of P2P money. An increasingly complex web of composable DeFi solutions creates additional systemic risks and spillover effects that need to be taken into account when designing sustainable P2P stable token systems. While these challenges can be resolved with more refined mechanism design, it also requires much more research and development. Unfortunately, research and development is often replaced by real-life trial and error—where the founding team launches a stable token project based on often untested assumptions. As a result, it is often the less experienced investors who risk losing a lot of money on stable token systems that have not been sufficiently researched.
- Adoption: Current adoption of stable tokens shows that fiat-collateralized tokens are leading the field in terms of market capitalization. Crypto-collateralized solutions such as DAI, SKY, or RAI seem to be the most promising alternatives. Algorithmic stable token projects without collateral claimed to offer full decentralization and automation but failed in their risk management. The combination of best practices from various stable token models might prove to be the most resilient token design in the long run.
- Oracle problem: If the stable token is pegged to the value of an asset, the system also needs a decentralized way to receive data about the exchange rate between the stable token and the asset it is pegged to, as well as the actual location of that asset. However, existing oracle solutions are yet to be fully decentralized; otherwise, the reliance on centralized oracle services remains.
- Network effects: It is expected that once economies develop around the stable token and certain network effects materialize, the peg might start to matter less, and the network effects of the actual economy that has evolved around that stable token will matter more. This could be the case when businesses are willing to accept a stable token because it is also accepted by other businesses.
- Power of nation-states: Nation-states still have coercive powers over their citizens and can undermine global decentralized stable token solutions through legislation. P2P stable tokens face competition from potential CBDCs as alternative payment tokens that regulators can (try to) enforce, either directly (by banning or highly regulating privately issued stable tokens) or through regulatory backdoors. The question is whether CBDCs will render private stable token efforts obsolete or if they will just become one of many stable tokens in this new tokenized economy.
Footnotes
[1] The term debasement goes back to the time of gold and other precious metal coins, when governments reduced the precious metal content of their currencies, which translates to the concept of inflation today.
[2] https://thenetworkstate.com/
[3] According to the Bank of International Settlement (BIS), counterparty credit risk “is the risk that the counterparty to a transaction could default before the final settlement of the transaction in cases where there is a bilateral risk of loss. The bilateral risk of loss is the key concept on which the definition of counterparty credit risk is based […]” https://www.bis.org/basel_framework/chapter/CRE/50.htm#:~:text=Counterparty%20credit%20risk%20(CCR)%20is,at%20the%20time%20of%20default.
[4] EU regulatory framework on crypto assets, crypto assets issuers and crypto asset service providers.
[5] The IMF defines Purchasing Power Parity (PPP) as “the rate at which the currency of one country would have to be converted into that of another country to buy the same amount of goods and services in each country.” It is a useful tool to compare economies of different countries regarding their GDP, individual consumption, to compare the cost of living between places, labor productivity and many more. It is calculated through a basket of consumer goods and services, equipment goods, construction projects, and other indicators.
[6] In economics, gross domestic product (GDP) is the most important indicator to capture economic activity. It measures the value created in financial terms through the production of goods and services in a country during a certain period, usually one year (the total amount spent on final goods and services minus goods and services imported), but does not reflect information about the actual wealth of single individuals, or their purchasing power.
[7] An oracle is data fed into a smart contract that can trigger actions within a smart contract.
[8] Arbitrage refers to an investment strategy where someone can make a profit from price differences across different markets by simultaneously buying and selling that asset across markets.
[9] The term “seigniorage” is used in macroeconomics in the context of the creation of fiat currencies and refers to the difference between the value of money and the production and distribution costs of it. Seigniorage is a form of inflation tax, returning resources to the currency issuer, and can be a source of revenue for a government. It derives from the difference of the cost to produce and distribute money and the value of it.
[10] Terra(LUNA) was an algorithmic stable token system which consisted of two tokens, the stable token TerraUSD (UST) which was pegged to USD, and the governance token Luna (LUNA). The system was designed in a way that Luna token holders could profit from the arbitrage opportunity and exchange 1 USD of LUNA for a UST when the price of UST climbed over 1 USD. LUNA token holders could create UST tokens by burning LUNA. LUNA tokens could also be used for staking, paying blockchain transactions for their proprietary blockchain network (Terra blockchain) or earning interest on DeFi lending protocols. In May 2022, UST lost its peg to USD. A big token holder started selling large amounts of UST, creating a downward spiral in the LUNA price, which soon fell to almost zero after an all time high of more that 100 USD per LUNA, destroying a total market capitalization of over 45 million USD. Even though the Luna Foundation started buying UST and selling BTC to restore the peg, more token holders tried to sell their UST than the rescue mechanisms could handle, which created a new sell pressure on the stable token and ultimately resulted in a bigger de-peg, with collateral effects on other crypto asset prices.
[11] The IMF assumes that “when private capital is allowed to flow freely across borders in search of the best investment opportunities, it can be channeled toward its most productive uses on a global scale. Developing countries, where domestic resources tend to be in short supply, stand to benefit particularly from capital account liberalization, which can lead to increased investment, faster economic growth, and improved standards of living, as well as contribute to the deepening and broadening of domestic financial markets.” This definition does not take into account the potential negative aspects of capital mobility for certain countries in certain contexts. (Source: https://www.imf.org/external/pubs/ft/fandd/1998/06/guitian.htm)
[12] Capital efficiency is a broad financial term for how efficiently a company spends its money to operate and grow. It describes the ratio between the spending of a company on their growing revenue and how much they are receiving in return in the way of profits.