The Impossible Triangle has a restrictive effect on the credit currency system of sovereign countries, and it has been proven in practice. Stablecoins also have the impossible triangle and are restricted by it. Therefore, before discussing the design of the next generation of stablecoins, we need to understand the impossible triangle and establish a connection with stablecoins, so as to grasp the key to the design of stablecoins .
What is the Impossible Triangle
The impossible triangle was independently proposed by Mundell and Fleming between 1960 and 1963, and has been repeatedly proved in the practice of international finance since then. The Impossible Triangle means that a sovereign country cannot achieve a fixed exchange rate system, free capital flow and independent monetary policy at the same time.
- A fixed exchange rate system means that the exchange rate between the domestic currency and a certain currency is kept stable, thereby realizing the stability of the currency value of the domestic currency. A fixed exchange rate is conducive to the stability of import and export trade.
- The free flow of capital means that there is no control over capital, and capital can enter and exit the financial market of the country at any time.
- Independent monetary policy means that the central bank of a country can freely decide what monetary policy to implement, freely regulate the issuance of its own currency, and freely determine its own interest rate level.
Why can’t the three elements be achieved at the same time? Simply put, for a sovereign national credit currency, if capital is free to flow, then an implicit condition is that when the rate of return provided by the sovereign national credit currency system is no longer attractive, the restrictions, then the capital will be completely withdrawn. In the case of free flow of capital, a country’s central bank implements an independent monetary policy and considers the situation of issuing more currency and lowering interest rates and reserve requirements. Being thrown out by a large amount, facing depreciation pressure, and if you want to maintain a fixed exchange rate system, you must have a large number of reserve assets to absorb the selling pressure. Fixed exchange rate system.
The Impossible Triangle of Stablecoins
Many researchers and scholars have their own explanations on the impossible triangle of stablecoins, but there is no consensus statement. This article will discuss the impossible triangle of stablecoins based on their own judgments based on previous research.
This paper argues that the impossible triangle of stablecoins includes stability, decentralization and capital efficiency .
- What is decentralization?
In the context of stablecoins, the meaning of decentralization includes two, the decentralization of transactions and the decentralization of assets .
The decentralization of transactions means that transactions are not restricted, and any entity cannot block transactions in the system. The lower the degree of restriction of transactions, the higher the degree of decentralization of transactions. The decentralization of assets means that reserve assets cannot be controlled by specific entities and cannot be misappropriated. The lower the degree of control of reserve assets by specific entities, the higher the degree of decentralization of assets .
The degree of decentralization of transactions has been quite high at this stage. Many stablecoin projects will rely on the public chain to achieve decentralization of transactions, and the highly developed exchanges make the degree of capital flow close to complete free flow. In fact, In the scope of digital currency, the free flow of capital in and out of the world has reached unprecedented heights .
The decentralization of assets is difficult to achieve. The reserve assets of USDT and USDC are completely controlled by the project party. Even with transparent asset publicity and third-party auditing, the risk of misappropriation of assets by the project party cannot be ruled out . Even for projects that control liquidity by agreement, there is a precedent for the project party to misappropriate reserve assets without authorization. When Luna crashed, LFG kept a large amount of high-value reserve assets of UST, such as BTC, AVAX, etc. It is not transparent whether these assets were used to rescue the market. Decentralized solutions for assets remain a puzzle.
- What is capital efficiency
Capital efficiency itself includes many factors. The growth rate of the system itself is a part, the smaller transaction cost is also a part, and the rate of return of some agreements related to the system is also a part. But these can be discussed as independent monetary policy, why, because capital efficiency as the constraint of impossible triangle actually means whether the system itself can regulate capital efficiency independently . It can be seen from the Luna crash that independent high yields cannot be maintained while achieving stability and decentralization at the same time, because once expectations change, capital can be withdrawn freely, and the selling pressure is very serious. Therefore, if To achieve stability and decentralization, capital efficiency is unsustainable.
- Overcollateralization is not a loss of capital efficiency
A common misunderstanding before is that over-collateralization is a loss of capital efficiency. The direction of efforts to improve capital efficiency is to reduce the mortgage rate. This is a misunderstanding. Whether over-collateralization has nothing to do with capital efficiency, over-collateralization only reflects unreasonable credit expansion, and reflects the reasonable conversion value of a new credit form at a specific stage, rather than the loss of capital efficiency.
From a long-term perspective, in the period of crazy credit expansion, people will only feel that the excess mortgage rate is so dazzling, and thus pursue higher leverage, but when the cycle reverses, it will eventually usher in a collapse. It is difficult to separate the process of credit enhancement from capital efficiency, because a new form of credit is sought after in a short period of time, and when it expands rapidly outside the system, the income from the entry of capital outside the system will exceed the internal rate of return. It is difficult to tell whether high returns are driven by capital inflows, credit inflation, or by returns within the system. The only solution is to over-collateralize new forms of credit to avoid uncontrolled credit inflation . Rapid credit inflation is bad in the long run and leads to a rapid redistribution of wealth in the short run. Over-collateralization actually reduces credit risk and is an inevitable choice for new forms of credit.
- what is stability
Stability means that the digital currency maintains a fixed exchange rate with the currency of the sovereign state. Stability can be divided into long-term and short-term. Short-term stability can naturally be achieved through reserve assets to offset selling pressure, but reserve assets will always be exhausted. To achieve long-term stability, it must be restricted, and trade-offs between the other two elements must be made. At this stage, stability depends on sufficient reserve assets.
The form of credit is not static. The last stage of the algorithmic stablecoin attempt was to create a new form of credit, but it is impossible to create a new form of credit out of thin air. The new form of credit needs to rely on the old form of credit. , gradually transformed.
Next-Generation Stablecoin Design
The problem to be considered in the design of the next-generation stablecoin is how to choose between the impossible triangles and how to carry out credit expansion on the margin. In response to this problem, this paper proposes a retail model of credit expansion to solve the marginal problem of credit expansion. , proposed the dynamic balance of the impossible triangle, made choices according to the situation, and proposed a monetary policy regulation framework to regulate currency issuance.
There are also some research institutions and scholars who have proposed alternative design ideas, but they are all specific to specific issues such as the selection of reserve assets, the selection of mortgage rates, and the construction of stability mechanisms. Less, and these are the most critical to a stablecoin project in the long run. Therefore, this paper proposes three improvements for the next-generation stablecoin design from these perspectives.
The stable currency discussed in this article is a digital currency with the goal of stability, and does not specifically refer to a stable currency or stable currency that uses a certain asset as a reserve asset .
This paper believes that there are three points to pay attention to in the design of the next-generation stablecoin: in the selection of the impossible triangle, dynamically balance the impossible triangle, adjust your choice according to market conditions, and make flexible responses; in terms of credit expansion, A retail model should be adopted; in terms of monetary policy, native tokens should partially absorb seigniorage and build a liquid market .
Impossible Triangle of Dynamic Balance
For a stablecoin project, the constraints of the impossible triangle are not rigid, that is, the three factors are not rigid constraints of either one or the other. Each factor can choose a different strength. A more reasonable expression of the impossible triangle is the three It is not possible to achieve high strength at the same time. Stablecoins can choose different degrees for the three elements at the same time point, or adjust the strength of the three elements according to different development stages.
At the same time point, different degrees, each element is not rigid
For stability, in fact, stability itself is not enough to summarize all choices. Stability itself is also divided into strengths and weaknesses. Through the choice of mortgage rate, the choice of reserve assets, and the frictional cost control of cashing, a stablecoin project presents different fluctuations rate and acceptance capacity, choosing a stronger stability is bound to weaken the other two factors.
In the same way, decentralization is the same. The higher the degree of decentralization of assets, the less flexible the adjustment of assets, the higher the degree of transaction decentralization, the freer the flow of capital, and the more difficult it is to control the loss of assets from inside to outside. , and the more difficult it is to control the influx of assets from outside to inside, the other two factors will be affected.
The stronger the independence of capital efficiency, that is, the more independent the monetary policy is, the more the rate of return within the system needs to be controlled, which requires a more closed system under stable conditions and a more floating exchange rate under an open system.
In short, the three elements are not rigid, and the relative strength of the three can be adjusted to achieve a balance .
However, realizing that the three elements are not rigid, the choice is actually more flexible, which is reflected in RMB and FRAX. RMB liberalizes the CA account (current account, trade in goods and services, etc.). Free flow, but strictly control the KA account (capital financial account), although RMB is a fixed exchange rate system, it also has a floating mechanism, and the target price will be adjusted according to the situation, and independent monetary policy is not completely independent, the Fed’s rate hike cycle is also will be taken into account.
Although the range of choices is more and more flexible, how to adjust according to external conditions is a more critical issue. In this paper, the dynamic rules are given to guide the dynamic balance of the impossible triangle.
For the choice of dynamic balance, the basic principle is to obey the big cycle of traditional finance and its own development strategy, but it should be more aggressive in the expansion period, because the entire digital currency market will also have a large external absorption. There are three macro options: strengthening internal absorption, optimizing internal growth, and speculative products .
- Strengthen external absorption: high interest rate (capital efficiency), anchoring (stability), restricting free flow of capital (locking positions, etc.)
- Optimizing internal growth: low interest rates (capital efficiency), anchoring (stability), liberalization of free capital flows
- Eligible speculative products: high interest rate (capital efficiency), floating (stable), liberalized free flow of capital
Credit expansion using a credit retail model
For a stablecoin project, credit expansion is independent of the impossible triangular choice problem, and is more important than the impossible triangular choice. Credit expansion is a model system of how stablecoins issue additional currency at the micro level and how to improve their credit level. This paper proposes to use the credit retail model for credit expansion, which has flexibility on the margin.
In the traditional credit currency system of sovereign countries, credit expansion relies on the entire expansion system of the central bank and commercial banks, which is microscopically dense bank outlets and a large number of salesmen. For the previous generation of algorithmic stablecoins, it wants to expand credit through a complete set of smart contracts and the front-end operation and promotion of the Internet. This article proposes that there is a problem with stablecoins relying entirely on smart contracts, and it still needs a retail model. At the micro level, some people still need to be operated . People have subjective initiative. More importantly, everyone has assets dedicated to them. Strong information, this part forms the basis for credit expansion.
Credit expansion has marginal problems
Interest rates should vary on the margin and have a certain range, otherwise there will be a series of problems, and when algorithmic stablecoins rely on smart contracts or some specific agreements for credit expansion, the entry threshold and mortgage rate for everyone are all the same. it’s the same. There is an adverse selection problem here. When a person is considering borrowing or mortgaging assets to obtain stablecoins, if he feels that the mortgage rate is not suitable, then he will choose the project he thinks is better, and the most likely choice is He believes that he is taking advantage of the project . Therefore, if the margins are treated equally, the users who choose to come to this project will be worse than expected, and the entire project will face a serious adverse selection problem, that is, the probability of default is higher than expected. That’s why adjustments are made for individuals at the margins. This has also been repeatedly verified in both traditional finance and decentralized finance. To solve this problem, it is necessary to introduce a credit retail model.
credit retail model
This model requires a complete credit system on the chain. The overall credit expansion depends on the credit issuance of the salesman at the micro level. The salesperson works for himself and plays a certain role in guaranteeing the credit. The salesperson can freely form an organization and follow the The historical performance is superimposed on its own mortgage on the stablecoin project to determine its own level and quota, and the project party is only responsible for ensuring payment clearing and credit settlement and maintaining a fixed income market. The salesman forms the initial credit through historical performance and collateral, obtains the amount and interest rate range, and then the salesman lends according to the loan demand in the market, and the lender needs to provide credit records and mortgage some assets . In this way, the money is distributed at the micro level to achieve credit expansion.
The advantage of the retail model is that it can take advantage of people’s information on the margin, and build a credit expansion system through Web3. If DID is developed and perfected, users can take part of the information as collateral. This process is actually external absorption, because Currency creates incremental value in this process. Liquidity is not distributed to arbitrageurs, but to those who really have borrowing needs, and these needs are commercial credit. When commercial credit is continuously realized, the entire system will have Internal growth drivers .
Building a Monetary Policy Control Framework
Native Token Design
In previous projects, most of the stable projects that issued native tokens had to take all the seigniorage. The motivation was the expectation of currency issuance to motivate people to buy native tokens, which in turn supported stablecoins. But this form of credit has proven to be fragile, and taking full seigniorage is unreasonable in that it should not be controlled by a few entities, nor should it incentivize a few to buy native tokens in bulk .
The formation of the entire credit system is not achieved by a team, it depends on all participants in the system, and the unreasonable distribution of native tokens will lead to unbalanced benefits from system expansion. It is a failure of the incentive system to rapidly accumulate large amounts of wealth. Income should be distributed evenly, and rules should be clarified to slow down the distribution of wealth, which is suitable for the development of the entire system. Therefore, this paper proposes that native tokens should absorb part of the seigniorage.
Therefore, it is necessary to issue native tokens as part of the reserve assets to absorb part of the seigniorage, and with the expansion of credit to increase the proportion, the proportion of native assets as reserve assets reflects the degree to which this form of credit is accepted by the public. The native token design should follow the following points.
- The native token only takes part of the seigniorage, a small proportion. At this stage, it is necessary to choose stability and decentralization.
- When the income in the system increases, it gradually changes to use the future income of the native token as a reserve asset to support the issuance of currency, and the proportion gradually increases.
- Choose the cycle flexibly, and increase the proportion of native tokens appropriately when accelerating expansion.
The volume and price control of monetary policy
Quantity refers to the money supply, while price refers to the rate of return. The level of income of the entire system directly reflects the marginal liquidity price. **Direct control of money supply is the most direct monetary policy. The previous generation of monetary policy control mechanisms, such as rebase, are marginally consistent, and there is no so-called precise delivery. However, if the credit retail model is used to put money in, the money will be put directly on the margin through the direct adjustment of the salesperson’s quota.
Compared with direct regulation of money supply, price regulation is more precise, which requires a perfect liquidity trading market to form a rate of return, and the project party itself has a regulated interest rate as the benchmark interest rate to influence the entire market. For projects that use the retail credit model for expansion, the benchmark rate can use the mortgage rate.
In the regulation of valence, the countercyclical regulation mechanism can be used to guide the regulation of valence .
- During the accelerated expansion period, the demand for money is large, the money is issued more, and the interest rate (mortgage rate) is increased.
- Accelerated recession, low demand for money, less money issued, lower interest rates (mortgage rates)
Through counter-cyclical adjustment, the fluctuation of the project can be reduced, but the specific operation should be selected according to the cycle law and strategy.
Stablecoin projects are constrained by the impossible triangle in the long run, so it is necessary to have a clear understanding of the impossible triangle and perform dynamic balance according to dynamic rules.
If credit expansion is completely realized by contracts, there will be an adverse selection problem, and there will be no change in the margin. Therefore, the credit retail model is adopted, and the external commercial credit is captured and credit expansion is realized by relying on the lending of salesmen.
The complete acceptance of the credit form of native tokens is a long-term process. Therefore, native tokens can only absorb part of the seigniorage. In terms of volume and price regulation, according to the credit retail model, one is to directly adjust the share of salespeople to regulate the money supply. , one is to adjust the liquidity price through the adjustment of the mortgage rate, thereby affecting the liquidity market.
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