A16z: Justifying the name of the stablecoin

Original: https://a16zcrypto.com/stablecoins-defense/

This column originally appeared on the Financial Times website on Monday 8 August 2022 and in the paper's print edition on Tuesday 9 August 2022 with the headline "Defending stability Coins (In defense of stablecoins).

Crypto critics are using the collapse of the dollar-pegged virtual currency Terra as a leverage to attack stablecoins and the crypto industry as a whole.

However, getting lost in the conversation is the root cause of confusion. A better understanding of what went wrong—and why—can help protect consumers while preserving innovation.

First a terminology clarification. A stablecoin is a cryptocurrency that is nominally "pegged" to a stable asset such as the U.S. dollar. The recent surge is often blamed on so-called "algorithmic stablecoins," which are often programmed to automatically incentivize the creation and destruction of tokens to maintain a price peg.

It is wrong to attack them. Leaving aside that TerraUSD should not be considered a "stablecoin," the real problem here has little to do with computer code, but with a concept as old as finance itself: collateralization, or the use of assets to back value.

This is a key point that policymakers around the world will need to consider when drafting legislation to prevent future Terra-like collapses. If lawmakers believe that algorithms are to blame, they may create regulations that backfire and stifle innovation. Poorly designed laws can disrupt markets, encourage regulatory arbitrage, and reduce the influence of Western democracies in the emerging, decentralized internet economy, web3.

The promise of decentralized finance (DeFi) depends in large part on blockchain's breakthrough ability to execute transparent, algorithmic contracts with instant finality.

The vast majority of “decentralized” stablecoins backed by blockchain assets like bitcoin and ethereum have done well amid recent market volatility, able to handle extreme price swings and unprecedented redemptions. In general, algorithms are not an issue with modern stablecoins. Instead, basically all the risk now comes from their collateral design.

The riskiest stablecoins are obvious: they are significantly under-collateralized (less than $1 of collateral is needed to mint a $1 of stablecoin), and they rely on “endogenous” collateral (collateral created by the issuer, such as Governance tokens that give holders voting rights in blockchain rules and procedures).

Endogenous collateral creates dangerous, explosive growth: users can mint more stablecoins as the issuer’s governance token appreciates in value. That sounds fine until you consider the flip side: when prices fall — as is virtually guaranteed during a bank run — a cascade of collateral liquidations to satisfy redemptions triggers a death spiral. Take TerraUSD as an example.

To prevent a similar collapse, regulation is necessary, but overly strict rules are not. The truth is, enforcement actions under existing securities laws and anti-fraud regulations could have curbed the proliferation of nearly all failed stablecoins to date.

Even so, additional, targeted regulation could be beneficial. While it’s difficult to pinpoint exactly where regulators should establish collateral requirements, it’s clear that without guardrails, stablecoin issuers could once again be taking unreasonable risks.

Tailored rulemaking can support the crypto ecosystem and protect consumers. Massive changes — such as a complete ban on the use of algorithms and digital assets as collateral — would place a huge burden on the burgeoning DeFi industry, disrupt the digital asset market, and hinder web3 innovation.

This is because stablecoins can indeed remain stable if their collateral is properly managed. For “centralized” stablecoins backed by real-world assets, reserves may be less liquid and less transparent, so collateral should include less volatile assets such as cash, treasuries, and bonds. Regulators could establish parameters and require regular audits regarding these types of collateral.

There are trade-offs for “decentralized” stablecoins that use almost exclusively blockchain assets like Bitcoin or Ethereum as collateral. Digital assets, while often volatile, are also highly liquid and can be managed transparently and algorithmically. Liquidity can be achieved almost instantaneously, enabling a more efficient system. Therefore, decentralized stablecoins may end up being more resilient than centralized stablecoins.

Algorithmic stablecoins present a unique opportunity to make a variety of assets productive and drive global digital commerce. Putting guardrails around their collateral can help unlock that potential.