The recent USDC depegging has brought to mind several questions about the viability and stability of stablecoins- and for good reason. Nine months ago, the supposedly stable UST stablecoin also underwent a crisis- and subsequently crashed after failing to restore the peg.
The causes of both crises are complex, but their general outlines are still relatively straightforward.
Because of this, many have drawn relatively straightforward conclusions from both crises- a seasoned investor dismissed the Terra and Luna ecosystem as a “pure ponzi scheme”, saying that anyone who disagreed was “on max copium”.
And the USDC depeg and subsequent recovery has become fodder for many crypto enthusiasts to simply claim that fiat is the problem.
Like most simplistic views, there is some validity in these conclusions. But they are by far only the tip of the iceberg. There is plenty more detail to go into, and far more that can be gleaned than just surface level dismissals of one system or the other.
So today, that will be our quest- to learn more not just from the crypto winter of the past few months, but also of fiat, and how both its failures and its successes can inform better cryptocurrency design and tokenomics.
Why did the Terra ecosystem fail, and why did USDC survive?
The simple answer to this question is that USDC was better managed and better designed- but why?
Many have pointed to the Anchor Protocol on the Terra ecosystem as the key factor for both Terra’s popularity and subsequent downfall. After all, who would turn down a 20 per cent yield in a world where fiat banks are offering less than 5 per cent? Instead of letting money sit in the bank vault and get slowly eaten by inflation, why not put it in Anchor, and earn yields that outstrip the bank’s interest rates while the token itself increases in value?
The common story is that when Anchor announced that it would reduce these rates to more sustainable levels, investors decided to move their capital elsewhere- and this triggered a mass exodus of investment that eventually led to a death spiral and the effective end of the Terra ecosystem.
But looking more closely at this explanation raises a few questions- Terra was not, by any stretch, the only stablecoin that was usable in yield farming. Even coins like USDC can be used in yield farming. So if we explain Terra’s downfall by suggesting that Anchor was to blame, why have other stablecoins not depegged for the same reason?
What this implies is that the Anchor protocol was not exactly the underlying cause for collapse- instead, it was a trigger factor.
Yet, Anchor’s centrality to the collapse cannot be denied- Anchor’s high interest rate had been central in attracting capital into the ecosystem, and the lowering of this interest rate to more sustainable levels also precipitated the exodus.
But what made the Terra ecosystem special was also its Luna Token- which was meant to fully collateralise all the UST in the system.
The Luna token was created and burnt through the system’s seigniorage system, and was expected to appreciate in value- another feature that brought in further investment.
But USDC had no such mechanism- the project remained relatively modest: it formed a way to bridge the Web2 and Web3 worlds with a common currency, and its main selling point was something intrinsic to blockchain technology rather than something devised purely for the Web3 world- a token that could be used to bridge the gap between both.
Yield farming with USDC is possible, but it is not a direct policy of Circle to either control the interest rates of these yield platforms or to either encourage or discourage investment in such platforms.
This yields an interesting observation- Terraform Labs and the Luna Foundation Guard were trying to achieve three things- allowing for the free flow of capital in and out of the ecosystem, a fixed exchange rate, and the ability to set interest rates.
On the other hand, Circle allowed interest rates to float freely, while it focused on enabling the free flow of capital and guaranteeing a fixed exchange rate.
For those with some background in macroeconomic policymaking, the lightbulbs might be turning on right now- but for the uninitiated, these three goals are actually not simultaneously achievable.
The economic trilemma- and its implications
In the early 1960s, the Keynesian model of macroeconomic policy was extended to include the role of capital flows by two economists, J. Marcus Fleming and Robert Mundell- the result was the realisation that central banks faced an important trilemma and implied tradeoff when it comes to interest rate policy, exchange rate policy, and capital controls.
Blockchain enthusiasts are already familiar with the blockchain trilemma- where blockchains are caught between choosing two of the following three qualities in their blockchains: security, scalability, and decentralisation.
The proposition works thusly: blockchains that choose decentralisation and scalability will be prone to attacks, since new actors can quickly come in and carry out 51 per cent attacks, overpowering the hashing power of other miners and allowing them to carry out fraudulent transactions .
At the same time, increasing security by controlling who can use the blockchain or become a validator, say through proof of work, erodes decentralisation.
Alternatively, blockchains that focus on security and decentralisation, such as bitcoin, will have low block sizes and therefore, face scalability issues.
Any blockchain can easily achieve two, but never shall the trio be united.
In the same vein, macroeconomic posits that any economy will face a similar tradeoff- central banks must choose two of the three: free capital flows, a fixed exchange rate, and a sovereign monetary policy (that is to say, the ability to choose interest rates by controlling the supply of loanable funds).
As such, there are also three possibilities for central banks to choose from:
1. Choosing free capital flows and a fixed exchange rate
Under this paradigm, a central bank wants to ensure that it has a fixed exchange rate, while maintaining free capital flows- this would mean that the central bank provides a ratio at which it is prepared to buy or sell an unlimited amount of foreign exchange in return for its domestic currency.
A central bank that chooses this option will eventually also have to allow its domestic interest rates to float according to the peg, since otherwise there would be capital inflow to take advantage of a higher exchange rate, or capital outflow to take advantage of higher exchange rates elsewhere.
The UK, under the Exchange Rate Mechanism, was one such system, where Britain maintained a lack of capital controls, while forcing the pound onto a fixed exchange rate with the other European currencies.
This system, however, did not last, as the British government faced an attack on the Pound, led by George Soros, later known as the 1992 Sterling Crisis. After burning through billions of their reserves trying to maintain the exchange rate, the government caved and suspended its membership in the Exchange Rate Mechanism, allowing the Pound to float and devalue in order to obtain some sovereignty over their monetary policy.
2. Choosing free capital flows and a sovereign monetary policy.
If a country maintains free capital flows and sets its own interest rates, it will inevitably lose control over its exchange rate, as capital flows in or out of the country in response to exchange rates.
In practice, central banks may set their interest rates in order to attract or deter capital flows into the country, and to influence domestic consumption, often as part of counter-cyclical fiscal policy.
In the absence of capital controls, investors are free to either buy or sell any amount of currency on the open market, resulting in changes in the exchange rates- if a central bank wishes not to allow for great fluctuations in the exchange rates, it must either respond according to market sentiment with exchange rate or money supply policies, which undermines its monetary sovereignty, or it can impose capital controls in order to limit the amount of its currency being or bought on the open market.
3. Choosing a sovereign monetary policy and a fixed exchange rate
An economy that chooses to set a fixed exchange rate and set its own interest rates will find itself unable to carry out fiscal policy decisions- an expansionary fiscal policy will increase the money supply and therefore exert a downward pressure on the interest rate.
In response, capital will flow out of the country, and the currency peg will come under pressure. Since under a fixed exchange rate absent capital controls, the central bank must offer to buy back its own currency without limit as to the amount, the central bank will eventually run out of reserves unless capital flows are restricted.
As such, any economy that wishes to set its own interest rates and have a fixed exchange rate must inevitably set capital controls to prevent changes to the exchange rate or interest rates from affecting each other.
During the Bretton Woods System, most economies chose this option, limiting the amount of foreign currency that could be exchanged, and imposing taxes on dealings with financial assets.
It should also be noted that when the three goals of free capital flows, sovereign monetary policy, and fixed exchange rates are pursued together, crisis is almost always inevitably the result- the Asian Financial Crisis was one such occasion.
Southeast Asian countries mostly had a fixed exchange rate, and were promoting the free movement of capital, while making their own independent monetary policy. This resulted in an initial inflow of capital, as investors could rest assured that exchange rate risk was non-existent. But when trade balances began shifting, investors quickly began to withdraw their money, and the house of cards collapsed, and countries like Thailand were forced to float their currencies.
Cryptocurrency ecosystems are not all that different- every token is like a domestic currency, which is valued only as the market values it, and can be exchanged either through CeFi or DeFi protocols for other tokens (or in fiat terms, foreign exchange).
The key difference in cryptocurrencies is that quite often, the central bank is either the protocol itself, or the company that controls the protocol.
The future of token design
The limitations that the economic trilemma places on cryptocurrencies is also relatively clear if one knows where to look and what to compare.
The Bitcoin ecosystem, for example, is one where there is free capital flow and a sovereign monetary policy: Money supply is limited by the block reward, which stipulates that there will never be more than 21 million BTC in existence. The rate of this increase is also automatic- a new block, with its block reward, is created about once every 10 minutes, and the block reward halves every 210 thousand blocks. There is also basically no limit as to how many people enter the ecosystem, buy and transact in BTC, or change BTC into other cryptocurrencies in exchanges.
Stablecoins like USDC, on the other hand, have free capital flow and a fixed exchange rate- guaranteed through their collateral. Companies like Circle are essentially prepared to sell USDC at a peg of 1USDC to 1USD to anyone willing to buy, and are willing to buy USDC back from their users at the advertised peg as well. As a result of this system, they do not, or more precisely, are not able to control the money supply and interest rates of USDC.
What this implies is that moving forward, should anyone attempt to create a new token, the question of what they wish to prioritise within the system is something that should be answered almost from the start- since it must be put into the protocol itself.
That being said, the policy trilemma has a significant caveat, owing to several developments in monetary economics over the past few decades.
Firstly, there is the issue of a banded floating exchange rate- countries like China do not exactly have a fixed exchange rate. Instead, the central bank allows the currency to float within a certain range, and only intervenes when exchange rates start to deviate from this range. This will usually mean monitoring exchange rates throughout the day, and authorising massive buybacks or selloffs depending on market sentiment.
In exchange, there is some flexibility in terms of the central bank’s ability to set its own monetary policy and the government for its own fiscal policy, since barring any black swan event there will likely not be any major shifts that will require intervention.
For cryptocurrencies, this might provide some valuable wiggle room to play with- instead of setting a fixed exchange rate, the value of a crypto might be allowed to remain at a range that is deemed healthy.
There may also be something to be gained by developing a crypto that is able to shift freely between the several options that are presented for a currency. Different external events may result in different needs at different times, and a death spiral can completely wipe out years of hard work building the chain and the community.
Implementing a mechanism for capital controls may be one way to stem the fallout from external events, before contagion causes a cascading effect.
As we can see, there are plenty of possibilities when it comes to cryptocurrency design- but this model can offer some insight into what is possible for a sustainable cryptocurrency, and what is likely a recipe for disaster.
Given the strong ethos of decentralisation that the crypto world has, there is not likely to be any cryptocurrency that will be designed with capital controls and enforcement of these controls in mind- but it is food for thought nonetheless.
Cryptocurrencies, at the end of the day, are still currencies and are based in economies- and as such, it may be worth the time to take a closer look at economics and what it has to say about macroeconomic problems like the policy trilemma.
The free hand of the market is not something that should be underestimated- and central banks and crypto companies alike are equally subject to its whims and fancies.