Are Stable Coins Stable?: Usman W. Chohan, Mba, PHD

Are Stable
Coins Stable?1
29th March, 2020 2
Usman W. Chohan, MBA, PhD 3

Discussion Paper Series: Notes on the 21st Century

Abstract: Stable coins attempt to resolve the problem of wide

volatility in dollar-denominated prices that characterize most
cryptoinstruments, by “pegging”their value to fixed amounts of
traditional monetary instruments. This discussion paper considers
the challenges faced by “stable coin” cryptocurrencies, at
different levels of collateralization, through comparison with
pegged currencies, which follow a similar dynamic in terms of
maintaining support for a given monetary value. Thepaper suggests
that the novelty of cryptocurrencies should not detract from
observing what are fundamental difficulties in constructing pegs
to traditional currencies.
1
This paper formed the basis of the Crypto Research Report’s first
podcast:
https://cryptoresearchnewsletter.substack.com/p/introducing-the-academic
-blockchain?fbclid=IwAR1NwuB6BoiSoi1pN1IU6pE26lvLkzESGZ-r91J_StMV7wbOUez
t9zhRZcU
2
Originally published on SSRN on January 24th, 2019
3
Critical
Blockchain Research Initiative (CBRI)
Electronic copy available at: https://ssrn.com/abstract=3326823

1


2

Are Stable Coins Stable?

Cryptocurrencies have generally been characterized by wide
fluctuations in their dollar-denominated prices. This volatility
has proven dissuasive to users as a unit of account and store of
value, and to a portion of traditional investors attempting to
grapple with what is already a complex domain and novel asset
class. However, anew breed of cryptocurrencies, termed “stable
coins,” have emerged in the recent past with an approach to
mitigate this volatility through a sustained peg (or in
cryptocurrency jargon, a “tether”) with traditional instruments
such as the US dollar or a basket of currencies.In addition,
tethers can be constructed against other assets such as oil and
gold; and perhaps even more interestingly, a peg between
cryptocurrencies themselves. The pegging itself can be conducted
using deliberate issuance of coin, deliberate transactions with
other assets, or through an algorithm that maintains the pegged
relationship using pre-programmed code, buying and selling as
required.
Do such concepts resolve the problem of volatility without raising

new concerns in turn? Pondering this question, the purpose of
this discussion paper is to consider the challenges faced by
“stable coin” cryptocurrencies through comparison with pegged
currencies, which follow a similar dynamic (depending on their
level of collateralization) in terms of maintaining support for a
given monetary-value peg.The paper suggests that the novelty of
cryptocurrencies should not detract from observing what are
fundamental difficulties in constructing pegs (or tethers)
totraditional currencies.In what has culminated in a substantial
public interest in cryptocurrencies and aburst of research into
the promise of blockchain technology at the global level, it is
also worth noting that these novel and alternative assets face a
series of problems that traditional asset classes too have
grappled with. Tethering (pegging) the value of stable coins, at
different levels of collateralization,is but one such example
that has borne out many a times in traditional currencies.
The most prominent names among the stable coins are

Tether,
Basis,
Digix,
and
Sagacoin
,but newer names continue to enter the space
as of this writing. Their value is generally rigidly tied to a
specific currency such as the dollar or euro, or in turn pegged

3

to a basket of national currencies.4 Pegging appears

prima facie

to be a useful solution to the volatility problem, which would
allow for greater adoption of cryptocurrencies across societies.
The value of stable coins is “stable” on a dollar-denominated
basis, which makes them more viable as units of account or stores
of value. This would also seem to remove some of the speculative
aspect underlying the prices of cryptoinstruments. However, a
closer inspection of the challenges to using tethered crypto
instruments leaves some of the optimism directed towards them to
dissipate, irrespective of the level of collateralization of the
coin, which can be seen conceptually by segmenting the problem
into fully collateralized, partially collateralized, and
uncollateralized cryptoinstruments.
As of this writing, the most prominent stable coin is

Tether
, which
is purportedly a fully collateralized coin, although the claim
has been disputed.First, for a fully collateralized coin, i.e.
one whose value is fully pegged to a traditional currency on a
1-to-1 basis, the coin issuer must hold reserves in excess(or at
least equal to) the value of circulating coins, which raises
expenses in terms of5 See discussion in Chohan 2018lElectronic
copy available at: https://ssrn.com/abstract=33268233raising
capital, as well as issues with respect to their scalability.
Tether
is an example of one such cryptocurrency which claims to
have coins in reserve greater than those in circulation. However,
a lack of transparency regarding Tether’s mechanism has led this
to be disputed.7Second, for a partially collateralized coin, the
problems of bank runs emerge, as they would in pegs of
traditional currencies which are at risk.
A partial collateralization implies a fractional reserve pegging

mechanism, as is found in traditional currencies(particularly
those of emerging markets), where pegging at only a portion of
the reserve heightens the risk of coin holders selling whenever
the durability of the pegis in question. This in turn depends on
the actual reserves held by the coin issuer.Due to a lack of
transparency among coin issuers (such as Tether), there are risks
ofbank run behaviour, further combustible due to the mercurial
attitudes of a segment of investors towards cryptocurrencies. In
a crisis event, the coin issuer shall be forced to purchase its
4
Alternatively, as mentioned earlier, the pegging can be conducted against
a basket of cryptocurrencies or against other assets such as oil or
gold.


4

issuance using its dollar reserves to prevent the coin’s price

from precipitous falls. This could be done in a manual or
algorithmic fashion. The durability of the peg, already a tough
proposition given the trust deficit faced by cryptocurrencies
issuers, is therefore a key determinant in such conditions.
Third, for uncollateralized coins, the need for transparency and

bridging the trust deficit is even greater. A coin issuer that is
uncollateralized and pegged would require not just coin issuance
but some time of additional instrument, such as a fixed income
issuance (“crypto-bonds,” so to speak5), with the interest repaid
in coins. At falling price levels for the coin, the issuer would
be forced to buy the coins through the emission of additional
crypto-bonds,and these bonds would need to be emitted at below
par value (at a discount), so as to attract fixed-income
investors with the potential of a price rise, in addition to the
coin-bearing interest. Coin-bearing interest would be premised on
future earned income through issuances. For this to occur, the
issuer would require ever larger fixed-income emissions (a high
growth trajectory), which in turn would depend on investor
interest in such an asset.
Without future issuances, current interest liabilities will not be

met, and so greater discounts or higher coin interest rates would
need to be applied, exacerbating the problem over time. This
would destroy the issuer’s ability to maintain the peg. In sum,
irrespective of the level of collateralization, stable coin
issuers will face substantial challenges, relating to credibility
of their pegs and resources to assure the viability of the peg,
that are often present in currencies (particularly in emerging
markets) where pegs have at times not been sustainable. At full
collateralization,substantial reserves will need to be held,
which would also need the assurance of transparency, which in
current cases has been left wanting. At partial
collateralization, the tether (peg) will be susceptible to
traditional bank-run behaviour. At no collateralization, coin
5
The term crypto-bonds is used distinctively from the recent trend of
mainstream institutions to issue bond that are denoted on a blockchain.
One example of this is the Chinese issuance of “cryptobonds,” and
another is the World Bank commissioning the Commonwealth Bank of
Australia to build a bond that is underwritten with some blockchain
element. These are not examples of the sense in which a crypto-bond is
used here, as a fixed income instrument that provides an additional
justification for investors in uncollateralized stablecoins.


5

issuers would need to emit fixed-income instruments which would

be even more susceptible to bank-run behaviour.
As of this writing, the precipitous decline in cryptocurrencies, and

the marked volatility of the larger (and unpegged)
cryptocurrencies would suggest that investor appetite for such
risk is far lower than in the period 2015-2017. While volatility
is an issue that is
prima facie
dealt with through tethers, the
viability of such a tether - or to put it another way: the
stability of the stable coin - remains an open question,
irrespective of the level of collateralization, and particularly
more so for lower levels of collateralized cryptocurrencies.
For this reason, the most common usage of stablecoins is as

intermediate instruments that help investors to hedge bets and
smoothen their transactions on crypto-exchanges. This is a
utility function that is quite limited to the specific
exchange-oriented investor that facilitates their transaction
requirements in the absence of larger capital markets and deeper
pools of capital on the exchanges.
In the long-run, stablecoins may become a redundant technology

because of the intermediary function they serve. Stablecoins are
in fact a “translation device” between traditional finance and
cryptocurrencies. However, if and when cryptocurrencies receive
widespread adoption, they will form a natural comparative
relationship with traditional asset classes. In that case, having
stablecoins to peg cryptoinstruments will be an unnecessary
feature. This is ultimately the goal that cryptoanarchists and
casual investors alike would yearn for: wider and deeper capital
markets for cryptocurrencies where devices of pegging and
comparison no longer pose a need.


6

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Usman W. Chohan, MBA, PhD 3

Discussion Paper Series: ​Notes on the 21st​ ​ Century

Abstract: ​Stable coins attempt to resolve the problem of wide

Electronic copy available at: https://ssrn.com/abstract=3326823

Electronic copy available at: https://ssrn.com/abstract=3326823