Stablecoins As Pegged Currencies: Standard Models

If we view stablecoins as traditional pegged currencies many tools from finance can be employed.  In particular the description of pretty much every (non-algorithmic) stablecoin looks like a currency board.  Very roughly this is an arrangement where some entity -- usually the Central Bank -- targets an exchange rate, promises to exchange unlimited amounts at that rate, and maintains a pile of foreign currency equal in size to the local money supply.

Mundell-Fleming

The standard model for exchange rate regimes is Mundell-Fleming.  This is, roughly, where the whole "impossible trinity" trilemma thing comes from.  Stablecoins are odd in that they purport to offer a fixed exchange rate with free flow of capital and monetary policy, such as it is, consists of targeting a positive balance of payments within this framework:

The higher the stablecoin rate the less net demand there is for USD: fewer people want to convert out to USD, and more people want to convert in to stable.  If you want to target inflows you pick a rate somewhere above where the lines cross.  Now with our interest rate in hand we can apply the Mundell-Fleming:

This is completely standard theory: the overall economy clears when the demand for money matches the demand for investment (this is a simplistic take, sure).  Recall here we have a balance of payments target met via deposit rates.  Normally this framework is used to analyse government policies.  But here we have only a simple monetary policy to consider.  We can observe in the market that rates are going up and inflows are maintained.  Let's look at the new equilibrium:

There are two new possible equilibrium points.  The upper-left one corresponds to increased demand for money (stablecoin) and a shrinking economy.  That is what naturally happens when rates go up.  Most of economic policy is concerned with how to stimulate the economy into the upper-right equilibrium.  Normally that is done through government spending and/or the creation of base money.

Now it is a bit clearer why this process generates such wild gyrations in crypto prices: there is no government and there is no policy process so there is no way to steer where on the upper green line we land.  Every day we can see base money creation -- backed or otherwise -- and we can see quite high deposit rates.  The higher the jumps in rates needed to maintain the balance of payments the wilder this will get.

One could even argue, cynically, that an exchange or stablecoin issuer buying in the market with freshly-minted unbacked tokens was stimulating things in the precisely the orthodox manner!

Limits

How long can this go on?  Well, as long as the positive balance of payments target is hit basically forever.  So let's revisit that first chart and consider what happens when rates are both extremely high and rising:

The crypto economy is small compared to the rest of the world.  And there is only some fraction of world capital that is going to get converted into stablecoins at any price.  Exxon isn't going to liquidate their capital base for crypto even at 200% deposit rates.  Note that employing a government-backed fiat-linked CBDC is not a conversion into stable as the CB guarantees the peg in fiat.

Rapidly rising rates, dramatically increased volatility, and things that look like traditional Keynesian stimulus are signs we are on the orange part of the curve.

That curve stops somewhere -- there is some point where, at any rate, the balance of payments surplus cannot be maintained.  Historically this happens around when the population riots because the punishing rates have decimated the real economy.  Crypto is a purely financial economy and a balance of payments crisis won't lead to empty supermarket shelves.  It will, however, lead to runs on stable reserves, exchanges and other entities nobody expects to blow up.

Debt Service

So rather than considering the degree of pain that is politically acceptable let's look at the impact of rising rates on the balance of payments demand.  Total stable outstanding is something like $100B.  Let's say the average borrowing rate is 5-10%.  That's $5B-$10B per year in debt service.

What about Italy?  The Italian government has something like EUR50B per year in debt service payments.  Stablecoin net debt service is already on the order of Portugal or Austria.  Except those are compounding at near-0%.  At a 10%+ funding rate the demand on our meagre "monetary policy" to maintain a positive balance of payments in the face of this sort of debt service is going to be quite strong!

If growth and rates continue on their current trajectory the stablecoin space will need more funding in 2023 than Italy.  The math is simple: say the average balance in 2022 is $250B and the average rate is 15%: that's $37.5B.  If 2023 is $400B and 20% that's $80B in debt service.  Simply rolling the $100B outstanding today at 10% would require ~$20B in new funding for 2 years.

One imagines those scenarios -- which will come to pass absent a change in trajectory -- are off the top of the orange line and the game cannot continue.