"Algorithm Stabilizing Coin" is a pseudo-proposition

The stable currency is very hot.

"The Holy Grail of blockchain application", "the right to print money in the world of encryption", "free currency without human control", from the project side to the exchange and even to the traditional financial field, everyone wants to do, everyone is talking .

When it comes to stable coins, three modes are generally introduced: the legal currency custody mode, the digital asset mortgage mode, and the unsecured algorithm stabilization currency.

Among them, the algorithm stable currency can be described as the largest and most mysterious imagination space.

After all, using computer code to control the issuance of currency in an economy without the control of any central organization, with the attributes of artificial intelligence, is a very attractive story, especially for encrypted punks.

However, from the strict monetary theory, the algorithm stabilizes the currency as a false proposition . Any currency issuance mechanism is a trade-off between established rules and discretion . Just relying on an auto-running algorithm is like facing a robot with basic chat functions, which can be a daily conversation, but in the face of more complex needs and sudden situations, it is still far from the complete system.

What is the algorithm stable currency

Unlike the 1:1 generated counter currency (100% US dollar reserve) and the digital asset pledge loan stable currency (excess digital asset reserve), the algorithm stabilizes the currency to pursue unsecured issuance.

Without asset endorsement, how to protect the value of its issuing currency? The algorithm stabilizes the currency name and simulates the central bank's open market operations—increasing supply when the price of the stable currency is higher than $1. The supply is recovered when the price of the stable currency is less than $1.

There are usually two approaches. The first (in the case of Basis) is the introduction of "bonds" and Seigniorage Shares in the system.

When the price of the stable currency is less than 1 US dollar, the system will issue bonds that can be purchased in stable currency, and the bond can receive more stable coins in the future. Trying to push the price back to around $1 by withdrawing the supply of stable currency in the market.

When the price of the stable currency is higher than 1 US dollar, the system will issue more stable coins to the holders of the bonds, increase the supply of stable coins in the market, and flatten the price to about 1 US dollar.

Another approach (using Ampleforth as an example) is simpler and more rude. When the price of a stable currency is higher than $1, more stable currency will be cast to the user's address.

When the price of the stable currency is less than 1 US dollar, some stable coins will be evaporated automatically. If the price of the stable currency falls to $0.5, then all the addresses that own the stable currency will be cut in half, and the price will be more expensive until the price of the stable currency returns to $1.

It sounds quite economical and can't stand the scrutiny.

When the price of the stable currency is higher than 1 US dollar, it means that the market is optimistic, the stable currency is at a premium, and the increase in supply can naturally lower the price. However, when the price of the stable currency is less than 1 US dollar, it indicates that confidence in the stable currency has begun to shake at this time. Even with the issuance of bonds, it promises to issue more stable coins in the future, and people have no incentive to buy and hold, but will further sell stable coins. This will increase the deviation between the actual value of the stable currency and the anchor value in the market, thus making the system tend to be further unstable.

The way of evaporation is a vicious circle of wages and firefighting. Not only can it not lock the stable currency in circulation, but people will worry that the stable currency value in their hands will shrink, and then panic sells. The result is that the value is directly zero.

Behind the stable coin design: rules are still discretionary

Defects in existing projects may not be enough to represent a model failure, but using algorithms as placeholders for mechanisms masks the core of monetary policy design, that is, compliance or discretion. ( Rules vs Discretion )

In fact, using algorithms to control the circulation of money is nothing new.

As early as 1960, the famous Nobel laureate in economics, Friedman, proposed to replace the Fed with a computer, increasing the fixed amount of money each year. This was later called the K percentage criterion, which is to increase the K-percentage of money every year. Try to achieve stable prices and low unemployment, and solve the problems caused by currency overshoot.

Friedman conceived to replace the autonomy of the central bank with absolute rules, because in his view, the volatility of economic activity comes from the uncertainty of the central bank's monetary policy.

The K percentage rule is a sketch of monetary policy. The rules are still discretionary . These two claims became the focus of the academic debate in the 1960s and 1980s. One party believed that the money market should not be influenced by a central authority's policy and business cycle, but should be based on established rules. The other side advocates more flexibility, such as countercyclical policies (tightening during boom times, expansion during recessions), and emergency relief in the face of unforeseen black swan events.

Although Friedman’s idea of ​​replacing a central bank with a computer has not been implemented in any country, the world of cryptocurrencies gives opportunities for similar mechanisms.

If Bitcoin is a fixed deflation mechanism that mimics gold, the recently-recognized privacy coin, Grin, is a K-percentage criterion that issues money at a fixed rate each year.

However, at least from the available data, this linear growth of monetary policy does not bring stable value, neither Bitcoin nor Grin can achieve the expected trading media function.

Algorithm stable currency is not a clever imitation

The algorithm's claim to stabilize the currency is also to follow the rules rather than discretion. Compared to Grin and Bitcoin, the improvement is based on a responsive policy rather than a single fixed rule. For example, adjusting the supply of money according to the market price of the currency, in turn affecting the expected price of the currency.

Money supply determines the price of money. This view comes from the Fisher equation (MV = PY), which is the product of the amount of money and the velocity of circulation in an economy = total commodity × price level. When the circulation speed and the total amount of commodities are relatively constant, the currency issuance determines the price level. It is further derived that as long as the circulation of the currency is controlled, the price level can be determined.

It should be noted that the theory of the quantity of money based on Fisher's equation has an important premise that the velocity of money circulation is constant .

However, this is not true in the highly liquid cryptocurrency market. Once the stable currency enters the market, the circulation speed is not controlled by the currency issuer. In addition, the amount of money in Fisher's equation represents only high-energy currencies. High-energy currencies have the ability to multiply or shrink the total money supply. For stable currencies, high-energy currencies are monetary entities that exist on the blockchain, but do not include shadow currencies issued based on the stable currency, such as balances on exchange books, various chain or under-chain derivatives.

For the stable currency project of the Ampleforth class, it is not only technically impossible to evaporate the stable coin supply that has flowed on the market or “mapped”, but also a drumming flower game full of run-flat risks.

The root cause is not to control the supply of money, but to control the price of money. Money supply is only the result of economic activity, not monetary policy. It is only paying attention to the supply of money.

In addition to the money supply, what other variables will affect the price stability of the currency? Interest rates are one of the important factors. The algorithmic stabilization currency with coinage and bonds essentially simulates a market for loanable funds – the money market + the bond market.

The use of interest rates to control inflation levels in the economy is not a myth. The Taylor rule , which the economists are familiar with, is regarded as a policy reference by many national monetary authorities.

To put it simply, this rule adjusts the benchmark interest rate based on the difference between the current GDP and the potential GDP level and the difference between the current inflation level and the expected inflation rate, thereby helping a country to achieve economic output growth and price stability.

So, why the rules that are widely used and adopted in the traditional world are not feasible in the blockchain and cryptocurrency?

The algorithm central bank buying and selling bonds is very different from the traditional central bank's open market operations.

First, the Fed sells and repurchases the US dollar relative to the national debt, rather than the so-called "central bank bonds." Behind the national debt is the income support of taxation. The central bank bond is nominally a promise to issue money in the future. It is difficult to generate income sources without stable islands of commercial and trade.

Second, the reason why bonds can promise to pay more than the market value in the future is because the liquidity of bonds is lower than the currency. Bonds have different repayment terms and cash flows managed according to maturity. Under the coinage model, the liquidity of the bond and the stable currency itself is the same, and there is no deadline, first come first served.

These two points mean that the so-called "bonds" of the algorithmic stable currency are actually just futures.

In addition, the coinage tax is premised on the fact that the currency is the only legal currency in the economy to pay taxes, and neither foreign currency nor private currency can participate. The starting point of cryptocurrency is to increase competition between currencies and not to restrict the issuance and circulation of private money.

Therefore, when the market goes down unilaterally, people can freely sell the algorithmic stable currency in the depreciation to other cryptocurrencies or legal currencies, and this should be used as a back-end bond to recover stable currency, which will form a more liquid futures market. , causing a spiral collapse.

Only the mortgage stable currency has long-term value

At present, in the market of cryptocurrency, only stable coins with collateral have a long-lasting value.

Why do you say that? Because the currency issuer, whether it is a string of code or DAO, is not linked to real-life identities and rights, it is impossible to create a credit currency without guarantee. So who will identify individuals and institutions that have the ability to borrow and repay, who will liquidate assets and emergency assistance when others default?

Even if the algorithm stabilizes the currency to introduce part of the assets as collateral, in terms of the issuance mechanism, there must be appropriate rules for the parties to have stable expectations, and they must be able to adapt to specific circumstances. To achieve this, artificial judgment and governance under the chain are inevitable.

In addition, the introduction of data analysis in monetary policy has been widely adopted in the traditional banking system. Central banks and commercial banks in various countries collect feedback and prediction models through indicators to help select the most appropriate tools among different monetary policies.

Formulating an economy's monetary policy is no less than driving a high-speed car in intricate terrain. Even with the most advanced autonomous driving system, police and protective personnel are required to participate in the machine when they are stupid. It is far from enough to emphasize the magical stable currency algorithm on the blockchain with incomplete infrastructure and lack of identity data. It is tantamount to training the autopilot model in Excel.

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Author: Pan Chao, MakerDAO economist and head of China