Sometimes “stablecoins” and variants such as “algorithmic stablecoins” function as historical names, as they refer to projects that call themselves stablecoins, such as Basis Cash, Elastic Set Dollar, Frax and their clones.
The word “stablecoin” can be used as logical Description for ‘a cryptocurrency designed to have low price volatility’ and ‘has value stores or units of account’, or ‘a new type of cryptocurrency whose value is often tied to another asset … designed to address the inherent volatility of cryptocurrency prices, “or a currencies that can “act as a means of payment and a means of storing monetary value, and its value must remain relatively stable over a longer time horizon.”
On the more metaphysically speculative end, some have determined a stablecoin as “an asset that prizes itself, rather than an asset that is priced by supply and demand. This goes against everything we know about how markets work. “
Circularity is the key question, as I see it. Bitcoin’s alleged shortcoming (BTC) because money and a vague definition originally inspired many stablecoin projects. The design features of these projects are now included in the stablecoin definition.
Haseeb Qureshi – a software engineer, author and renowned altruist – simply defines a stablecoin as a price tag. Still, it’s not clear that anything with a pin should be called stablecoin. Ampleforth has a “peg” and has been placed in the stablecoin category. The founding team routinely clarifies that it is no such thing.
So, who is right?
Another example of what exactly is ‘stable’ in a stablecoin – the peg or its value? Wrapped Bitcoin (wBTC) is perfectly linked to Bitcoin – one wBTC will always be one BTC. Is that a stablecoin?
According to the original motivations for creating stablecoins, BTC is not a stable medium of exchange, even though Bitcoin is the canonical “store of value“Business asset.
Once the problem has been clarified – that no one knows how to define or recognize a stablecoin – the rest of this essay outlines a solution. It provides a well-defined description of value as a relational property, namely ‘value in terms of a measure’.
Using this description, I then comprehensively classify all digital assets according to two dimensions: risk of loss, or the chance of realizing an impairment, and risk of profit, or the chance to realize an increase in value. We can then precisely and logically define stablecoins: assets where the risk of loss and risk of gain are both zero.
p (profit) = p (loss) = 0
I call this a risk-defined stablecoin.
Obviously, the current algorithmic stablecoins have a risk of loss, but no risk of gain. So not only are they not stablecoins, but they are also terrible financial assets. I conclude by considering whether it makes sense to extend the concept of a risk-defined stablecoin to a more general concept in which expected value is central; a stablecoin of expected value is one where the probability of loss and gain weighted by the magnitude of loss and gain is perfectly offset and net zero.
I conclude that the complexity and ergodicity of such a concept precludes it as a useful stablecoin definition.
What is Value?
What “value” means is not entirely clear, as evidenced by ongoing debates about “true” inflation. We can ask: Value in terms of what?
That is, we decide to treat value as a relational property between the object being measured and the thing taking the measurement. It’s like asking for height – do you want it in inches or centimeters? For our purposes, can we define a function that maps an asset to a set of numeric values in a chosen unit? I call it value.
For example, if the unit chosen is US dollar and the item is a bag of chips,
Value USD (chips) = $ 5.
We might as well have Heightinches (table) = 35in.
Risk of loss, risk of gain
The value of an asset changes over time, so we can extend our Value function to reflect the idea of ’the value of an asset, in terms of a unit, at a particular point in time’ through time ( t) add on which we measure value:
ValuetUnit (asset) = x
We can define risk as the probability that, at any time in the future, the Value function will show a decrease or increase in value.
Specifically, this means that if I convert the asset into the unit of my choice, I would realize a loss or gain.
A risk-defined stablecoin
We now have enough to make a well-defined description for a stablecoin. A stablecoin is an asset where the risk of loss and the risk of gain are both nil. That is: p (profit) = p (loss) = 0.
This means that if I sell the stablecoin asset in the future, I will not experience any loss or increase in value, as measured in my chosen unit.
The Boston Consulting Group’s famous matrix was invented in the 1970s by the company’s founder, Bruce Henderson. With some realignment, we can reuse the Boston Consulting Group growth stock matrix to classify all digital assets based on their risk of loss and risk of gain. The four categories are still stars, dogs, strangers and dairy cows.
A star investment, with no risk of loss but risk of gain, is rare today, but in hindsight abundant, such as when one regrets the sale of Bitcoin in 2010. Stars also exist in the imagination. That was the case with the investors in Bernie Madoff’s fund. But those kinds of investments quickly turn out to be dogs. Dogs are definitely losers – there is no risk of gain, but if you keep them long enough, the risk of loss becomes a real loss.
Star investments are most abundant in hindsight when we can no longer buy them:
I would be * billionaire * right now if I hadn’t sold the 55,000 bitcoins I mined on my laptop in 2009-2010 too early (usually before 2012). That’s unfortunate, but again, with the early bitcoiners, we set in motion something greater than personal gain.
– Martti Malmi (@marttimalmi) December 18, 2020
Your regular investments are unknown – you can rise or fall in value depending on the day. Most digital assets, even Bitcoin, fall into this category. Finally, cash cows are investments with minimal risk of loss or gain. They are reliable. We can now take those projects listed as stablecoins to see which ones really fit.
Let’s put some important digital assets and stablecoins in the profit-loss matrix.
Projects called algorithmic stablecoins are stablecoins by name only. Due to their multi-token design, they are not at risk of a profit – as all new supply is given to investors – but holders remain at risk of loss.
Price coupling is not enough. The expected value of holding an asset can be positive or negative, but it is not zero. Another lesson is that it is important to specify a unit when discussing value. If our unit of measure is US dollar, then wBTC is not a stablecoin. But if we define value in terms of BTC, then wBTC is the perfect stablecoin.
Finally, risk assessment is difficult. I received pushback about Tether rating (USDT) as stablecoin, given the counterparty risk.
These are all valid points.
Except in exceptional circumstances, no stablecoin is truly free from risk of loss. Maybe Tether is a cross between a dog and a cow.
Nonetheless, it should be understood that certain projects make the term “stablecoin” blatantly applicable in an attempt to put investors at risk of profit while saddling holders with risk of loss. However, since no sane person would have these assets on their books, it is almost certain that these dogs will become extinct.
A stablecoin with expected value?
Astute readers will have found that the expected value is not just a function of the probability of loss and gain – the magnitude of losses and the magnitude of gains are just as important.
For example, suppose I have a fair die. If I roll a six, I win $ 60. If I roll another number, I lose $ 6. The expected value of the roll of the die is:
EV (dice) = $ 60 ∗ p (profit) – $ 6 ∗ p (loss) = $ 60 ∗ (1/6) – $ 6 ∗ (5/6) = $ 5
But can we extend the concept of a risk-defined stablecoin to that of an expected value stablecoin? In other words, would it be enough if the expected value of holding an asset is zero? Using the above dice example, this condition would have been met if I only won $ 30 instead of $ 60. So every time I try to convert this “DieCoin” into US dollars, there is a five-sixth chance that I will realize a loss in value, and a sixth chance that I will realize a profit. But because the profit is so much greater than the loss, they are offset.
I think this could be a smart approach that can be realized through a series of derivative contracts. However, it would lose the trait that holders can exit their position with minimal impact on their portfolios.
This should remind us that definitions are ultimately artifacts of a community of speakers. And I find it doubtful that more than a few people will find an expected value definition convincing.
This article does not contain investment advice or recommendations. Every investment and trade move carries risks, and readers should do their own research when making a decision.
The views, thoughts and opinions expressed here are the sole ones of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
Manny Rincon-Cruz serves as an advisor to the Ampleforth project and is co-author of the protocol whitepaper. Manny is a researcher at the Hoover Institution at Stanford University, where he helped launch and currently serves as the Executive Director of the History Working Group.