Currency creation in decentralized finance: a dynamic model of stable currency and cryptocurrency shadow banking

The rise of stablecoins is to meet the demand for safe assets in decentralized finance. Stablecoin issuers deploy various strategies to convert risky reserve assets into tokens with stable value. In order to solve the problems of the feasibility of stablecoins, regulations and large-scale platform-led initiatives, we established a dynamic model of the best stablecoin management and described an unstable trap. The system is binary: stability can last for a long time, but once the stablecoin breaks under a negative impact, volatility will persist. Since it allows the issuer and stablecoin users to effectively share the risk, depreciation will trigger an inevitable vicious circle. The Institute of Financial Technology, Renmin University of China compiled the core part of the research.


More than ten years ago, Bitcoin heralded a new era of digital payments and decentralized finance. Cryptocurrency challenges bank-centric payment systems that provide round-the-clock settlement, anonymity, low-cost international remittances, and programmable currencies through smart contracts (Brunnermeier, James, Landau, 2019; Duffie, 2019). However, the huge volatility exhibited by the first generation of cryptocurrencies limited their utility as a means of payment. The purpose of a stable currency is to maintain a stable price against a reference currency or a basket of currencies by promising to hold legal currency or other assets, while the assets held by the stable currency can be redeemed.

This article provides a continuous-time stablecoin dynamic model that rationalizes a series of rich strategies commonly used in practice (Bullmann, Klemm, Pinna, 2019), such as open market operations, dynamic requirements for user collateral, transaction fees or subsidies, Target price banding, re-pegging, and the issuance of “secondary units” (or governance tokens) as equity in stablecoin issuers. Our model demonstrates a new instability mechanism and is suitable for the evaluation of regulatory recommendations. It can also be applied to analyze the incentive mechanism behind stablecoin programs led by large platforms (such as Facebook).

The creation of stablecoins is similar to the creation of money in shadow banking, that is, the creation of safe assets without supervision to meet the transaction needs of agents. The issuer converts risky assets, that is, cryptocurrency in practice, into a one-to-one stable currency, which can be exchanged one-to-one with legal currency. Issuers usually require stablecoin users to provide collateral and stipulate margin requirements. If the value of the user’s collateral drops sharply, the issuer will use its own reserves (invested in risky assets) to support the value of the stablecoin.

However, the creation of stablecoins differs from traditional shadow banks in one key aspect. Issuers can devalue stablecoins to avoid liquidation, while shadow banks must perform debt contracts or they will go bankrupt. The devaluation option allows stablecoin issuers to avoid costly liquidation, but it induces an amplification mechanism, resulting in a bimodal distribution. In the state of high reserves, the issuer maintains a fixed exchange rate, so the demand for stablecoins is strong and the transaction volume is large. Through open market operations and transaction fees, the issuer gains revenue and further increases its reserves. In a state of low reserves, the issuer provides users with load risks through depreciation, which will inhibit the demand for stablecoins, thereby reducing the issuer’s income. Therefore, the issuer can only slowly rebuild its reserves and fall into the trap of instability. Therefore, a fixed exchange rate can last for a long time, but once a depreciation occurs, the recovery is slow.

Our paper discusses key issues regarding the credibility and sustainability of fixed exchange rates. Unlike the speculative attacks and coordination failures on undercollateralized stablecoins in the research of Routledge and Zetlin Jones (2021), we describe a new risk amplification mechanism and show that consistent with the evidence, even if it is overcollateralized Stablecoins will also lose money when the issuer’s reserves drop to a certain level. When the issuer’s reserves fall below a critical threshold, even over-collateralized stablecoins will be bankrupt. The reason for the depreciation is that the issuer balances the balance between maintaining a stable value to stimulate demand and sharing the risk with users to avoid liquidation. We are concerned about fully collateralized stablecoins because recent regulatory recommendations and bank runs have made people doubt the viability of under-collateralized stablecoins.

The reserve management of stablecoin issuers is reminiscent of dynamic corporate cash management, but unlike companies, stablecoin issuers can depreciate their liabilities (unpaid stablecoins). It is similar to a country monetizing its debt through inflation. Stablecoins are similar to contingent convertible bonds (CoCos), which automatically allocate risk between equity investors and debt holders. But unlike CoCos, risk sharing is accomplished through devaluation, rather than converting stablecoins into the issuer’s equity, and devaluation is determined by the issuer without a predetermined trigger event.

After the tech giant Facebook and its partners announced their own stablecoin Libra (now “Diem”) in June 2019, stablecoins became the subject of intense debate. Using its existing customer network, global technology or financial companies can quickly expand the influence of their stablecoins. In order to understand the advantages of a well-established network in the stablecoin field, we compared platforms with different degrees of network effects. A stronger network effect is indeed related to a lower frequency of depreciation, because a stronger network effect allows the platform to accumulate fee income faster when the reserves are exhausted, and through higher continuation value, incentivize the platform to maintain greater Equity level to buffer risks.

The stablecoin program sponsored by a company with a global customer network has attracted the attention of regulators because it not only has the potential to be widely adopted, but also has concerns about monopoly power. In our model, two mutually cancelling forces determine the share of economic surplus captured by the platform. With a strong network effect, the platform can obtain more rent from users through fees or risk sharing, but it is also more eager to stimulate the demand for tokens by reducing fees and stabilizing tokens, because individual users have not integrated the active network Internalization of externalities. In a state of balance, these two forces balance each other. Therefore, the distribution of benefits between stablecoin issuers and users is quite insensitive to the degree of network effects.

The massive transaction data brought by the payment system provides a powerful impetus for the digital platform to develop its own stable currency. According to Parlour (2020), we use data modeling as a by-product of trading. When the currency speed remains unchanged, the value of the stablecoin held by the user determines the transaction volume and the speed of data accumulation. Data can help the platform improve its productivity, thereby gaining access to the traffic utility that users obtain from tokens. Data can help the platform improve productivity, thereby gaining access to the traffic utility that users obtain from token holdings. A feedback loop has emerged: transactions generate more data, which improves the platform and leads to stronger token demand and more transactions. Therefore, the data grows exponentially over time. The platform strikes a balance between data acquisition and reserve accumulation.

Crypto shadow banking in decentralized finance

Blockchain technology supports the point-to-point transfer of assets on distributed ledgers, which may eliminate the need for transactions through intermediaries. Decentralization avoids considerable intermediary costs (Philippon, 2015). According to the blockchain protocol, decentralization can enhance the resilience of operations by eliminating single points of failure, while also achieving scalability (John, Rivera, Saleh, 2020). Decentralized finance (“DeFi”) provides alternatives to traditional financial services based on blockchain, such as banks, brokers, and exchanges (Lehar, Parlour, 2021). It is also based on smart contracts (executed through the coding of programmable currencies), a concept independent of the blockchain (Halaburda, 2018).

This emerging financial architecture requires blockchain-based currencies. A viable payment method should maintain a stable value at least during the settlement period (that is, the time required to generate a decentralized consensus on the transaction (Chiu, Koeppl, 2017). However, most cryptocurrencies are highly volatile. They are The value of platform-specific currencies is unsupported and fluctuates with the dynamics of supply and demand native to the hosting platform (Cong, Li, Wang, 2019).

The stablecoin is advertised as a copy of the legal currency based on the blockchain. The total market value exceeds 100 billion U.S. dollars. In May 2021 alone, $766 billion worth of stablecoins were transferred. The issuer can be a corporate entity or a consortium. For example, a consortium led by Facebook or the developers of Diem. It can also be an Internet protocol (such as MakerDAO, the publisher of Dai), whose rules can be updated based on the consensus of users. Stablecoins are backed by the issuer’s reserve asset portfolio, and the stability of value is maintained by the issuer’s open market operations, that is, trading reserves for stablecoins and satisfying redemption requests (Bullmann, Klemm, Pinna, 2019). The distributed ledger records the ownership and transfer of stablecoins, but the verification reserve still relies on traditional auditing (Calle, Zalles, 2019).

Stablecoins are the link between decentralized finance and the real economy. The volatility of the first generation of cryptocurrencies, such as Bitcoin and Ethereum, limited their applications in the real world. The stable currency is designed to have a stable exchange rate relative to the reference legal currency, and it is possible to mediate the transactions of goods, services and real assets based on the blockchain. Stablecoins are also important to the cryptocurrency community. Traders’ activities involve a lot of rebalancing between stablecoins and more volatile cryptocurrencies. Cryptocurrency has become an emerging asset class with a total market value of approximately US$1.5 trillion (of which Bitcoin is approximately US$700 billion). It is estimated that 50% to 60% of Bitcoin transaction volume is for USDT, the stable currency issued by Tether (JP Morgan Global Research, 2021)

Currency creation in decentralized finance: a dynamic model of stable currency and cryptocurrency shadow banking

Figure one

Cryptocurrency shadow banking. This illustrates the two structures of stablecoins. As shown in Figure 1, in Panel A, a platform issues stablecoins backed by its reserves. The excess reserves, or equity status, belong to the governance token holders who have control rights (ie, control over platform policies). When reserves are invested in risky assets, potential losses are absorbed by equity positions. As long as the stablecoin is over-collateralized, its value will not be affected. In Group B, stablecoins are supported by both the user’s collateral and the platform’s reserves. When the value of the collateral drops and users cannot meet the margin requirements, the platform will liquidate the collateral and use the proceeds (and its own reserves) to buy back stablecoins on the secondary market.

Although stablecoins are important, there is no clear legal and regulatory framework. Unlike depository institutions, stablecoin issuers have no obligation to maintain redemptions at face value. Given that reserves are often invested in risky assets, many people worry that a major stablecoin will “break the pot” and cause financial turmoil (Massad, 2021). This concern was inspired by a relatively recent event in which money market funds switched from a stable net asset value to a floating net asset value during the 2007-2008 global financial crisis. In fact, the creation of stablecoins is essentially a new form of shadow banking, that is, an unregulated security transformation.

Reserve assets are often risky. Panel A in Figure 1 illustrates the creation of stablecoins characterized by overcollateralization. The issuer’s excess reserves (equity) cushion the fluctuations in the value of the reserves. Equity is called a governance token (or “secondary unit”), with the right to vote (ie, control) on protocol changes, and to pay for the cash flow generated by the transaction fees charged to stablecoin users. Governance tokens can be issued to supplement reserves, just as traditional companies can raise cash by issuing equity.

A stablecoin issuer basically makes a leveraged bet on the value of reserve assets. Issuers can increase their leverage by issuing new stablecoins to fund the purchase of reserve assets, just as banks use newly issued deposits to fund their loans and securities transactions (ie, internal currency creation). Unlike banks, which promise to redeem deposits at face value, stablecoin issuers can devalue stablecoins.

Panel B of Figure 1 shows a more complex structure, similar to the structure used by MakerDAO. Users use their cryptocurrency and other assets as collateral for newly created stablecoins, but they must meet the impairment (margin requirements). Users can transfer stablecoins and then circulate them in the market, but they must maintain margin requirements. If the value of the collateral drops and the user cannot maintain the margin, she will throw the collateral to the stablecoin issuer, and the issuer will liquidate the collateral and use the money to buy back (and process) the stablecoin created for this user. If the liquidation of the collateral does not generate sufficient income, the reserve fund of the stablecoin issuer will be used to supplement the cost of repurchasing the stablecoin.

The structure of Group B in Figure 1 is very common in traditional shadow banking. A bank set up the structure of Group B in Figure 1 which is very common in traditional shadow banking: the bank sets up a channel (special purpose institution) to convert venture capital into debt and equity, and at the same time, provides guarantees to debt investors. When this channel appears, the bank will internalize losses (Acharya, Schnabl, and Suarez, 2013). Stablecoins are like the debt (priority) part of the channel. The issuers and users of stablecoins in Group B in Figure 1 correspond to banks and users, respectively. The issuers and users of stablecoins in Figure 1 correspond to banks and channels, respectively. Stablecoin issuers promise to buy back stablecoins with their reserves, which is similar to a bank guarantee.

In the language of traditional shadow banking, the difference between the two structures in Figure 1 is that from group A to group B, the issuer of the stable currency transfers the risk to the entity (ie, user) off the balance sheet, so that the stable currency is It will be supported by both the user’s collateral and the issuer’s reserves. Compared with the simple structure of Group A in Figure 1, this double mortgage does not necessarily enhance stability, because both the user’s collateral and the issuer’s reserve assets may be risky and their values ​​are highly correlated, especially when both are When it is encrypted currency.


The first generation of cryptocurrencies, such as Bitcoin and Ethereum, were built to serve as a medium of exchange, but price fluctuations impaired this function. With the rapid development of decentralized finance, various stablecoin programs have emerged to meet people’s demand for stable payment methods based on blockchain. Stablecoins are issued by private entities, who promise to maintain price stability by holding mortgage assets and redeem them with assets held by stablecoins. However, since these issuers maximize their own returns, rather than maximize their overall welfare, conflicts of interest between issuers and stablecoin users will naturally arise, thereby providing room for improved welfare supervision. In addition, mature Internet companies (such as Facebook) plan to launch their own stablecoins. Behind these measures, the incentive mechanism is more complicated, especially considering that operating a payment system allows the platform to collect transaction data and profit from it.

Although regulators and practitioners have paid great attention, so far, there has not been a unified framework to solve these problems. In this article, we filled this gap and established a dynamic model of optimal stablecoin management. The characteristic of achieving equilibrium in the model is to run two systems: when the issuer’s reserve is high enough, the price of the stablecoin is fixed; when the reserve fund is below a critical value, the price of the stablecoin will follow the issuer’s The reserve fund changes so that the issuer can share the risk with the stablecoin users, thereby avoiding expensive liquidation.

The distribution of the state is bimodal. Above the depreciation threshold, the issuer credibly maintains a fixed token price, which induces a strong demand for tokens, enabling the issuer to collect fee income and further increase reserve holdings quantity. When a negative shock consumes the issuer’s reserves below the devaluation threshold, this virtuous circle becomes a vicious circle. As the price of tokens became unstable and users’ demand for tokens declined, the issuer’s fee income and income from the revenue operations of selling tokens on the open market declined, which then slowed down the reconstruction of the reserve, resulting in an unstable trap. This vicious circle can be broken by issuing equity (governance tokens) to supplement reserves. Issuing equity must also expand the supply of tokens to eliminate arbitrage.

Our model provides a framework to evaluate regulatory recommendations. We show that capital requirements have the potential to improve overall welfare, but that a legally binding commitment to perfect price stability can undermine welfare. Our framework can also be applied to analyze the incentives behind stablecoin initiatives led by mature platform companies. We prove that strong network effects can indeed lead to the stability of token value, which makes these platform companies become natural issuers of stablecoins. In addition, the introduction of stablecoins can stimulate transactions, and transaction data can be used to improve the profitability of the platform. However, the increase in data productivity will undermine the stability of stablecoins, as platforms become more eager to stimulate transactions, issuing more stablecoins per unit of reserve.

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Currency creation in decentralized finance: a dynamic model of stable currency and cryptocurrency shadow banking

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