All risk, no profit? The vague definition of stablecoin creates problems


Sometimes “stablecoins” and variants like “algorithmic stablecoins” work like historical names because they refer to projects that refer to themselves as stablecoins, such as B. Basis Cash, Elastic Set Dollar, Frax and their clones.

The word “stablecoin” can be used as a logical description for “a cryptocurrency with low price volatility” and “stores of value or units of account” or “a new type of cryptocurrency whose value is often tied to another asset … designed to address its inherent volatility to manage cryptocurrency prices ”or a currency that“ can act as a medium for changing money and as a store for the value of money and whose value should remain relatively stable over long periods of time ”.

On the metaphysically more speculative end, some have defined stable coin as “an asset that values ​​itself rather than an asset that is valued by supply and demand”. This contradicts everything we know about how markets work. “

From my point of view, circularity is the core issue. The alleged lack of Bitcoin (BTC) as money and a vague definition originally inspired a multitude of stablecoin projects. The design features of these projects have now been reintroduced into the stablecoin definition.

Haseeb Qureshi – a software developer, author, and famous altruist – defines a stablecoin simply as a fixed price. However, it’s not obvious that anything with a pen should be called stablecoin. Ampleforth has a “pen” and has been classified in the stable coin category. The founding team routinely makes it clear that this is not the case.

So who is right?

Another example of what exactly is “stable” in a stable coin – the pen or its value? Wrapped Bitcoin (wBTC) is perfectly tied to Bitcoin – a wBTC is always a BTC. Is that a stablecoin?

According to the original motives for creating stablecoins, BTC is not a stable medium of exchange, although Bitcoin is the canonical “store of value” good.

Now that the problem is resolved – that no one knows how to define or recognize a stablecoin – the rest of this paper describes a solution. It contains a well-defined description of value as a relational property, namely “value in relation to a unit of measurement”.

Based on this description, I then classify all digital assets comprehensively in two dimensions – Risk of lossor the likelihood of realizing an impairment, and Profit riskor the probability of realizing an increase in value. We can then define stablecoins precisely and logically: assets where both the risk of loss and the risk of profit are zero.

This is:

p (profit) = p (loss) = 0

I call this a risk-defined stablecoin.

It is clear that today’s algorithmic stablecoins have a risk of loss but no risk of profit. So not only are they not stable coins, but they’re also terrible financial assets. In conclusion, I consider whether it makes sense to expand the concept of a risk-defined stable coin to a more general concept that focuses on expected value. With a stable coin of expected value, the probabilities of loss and gain, weighted with the size of loss and gain, are perfectly balanced and set to zero.

I conclude that the complexity and ergodicity of such a concept precludes it as a useful definition of stable coins.

What is worth?

What “value” means is not entirely clear, as evidenced by the ongoing debates about the “true” rate of inflation. We can ask: Worth in terms of what?

That is, we decide to treat the value as a relational property between the measured object and the measured object. It’s like asking the height – do you want it in inches or centimeters? For our purposes, can we define a function that assigns an asset to a set of numeric values ​​in a selected unit? I call it: value.

For example, if the unit chosen is the US dollar and the item is a bag of chips,

ValueUSD (chips) = $ 5.

We could just as easily have written Heightinches (table) = 35in.

Risk of loss, risk of profit

The value of an asset changes over time, so we can expand our value function to reflect the idea of ​​the “value of an asset in relation to a unit at a given point in time” by adding the point in time ( t) at which we are measured values:

ValuetUnit (Asset) = x

We can define risk as the probability that the value function will show an increase or decrease in value at some randomly selected point in time in the future.

In practice, this means that I would realize a loss or a gain if I converted the asset to the unit I chose.

A risk-defined stable coin

We now have enough to come up with a well-defined description for a stablecoin. A stable coin is an asset where both the risk of loss and risk of profit are zero. That means: p (profit) = p (loss) = 0.

This means that if I sell the stablecoin asset in the future, I will not experience any loss or gain in value, measured in the unit I choose.

The Boston Consulting Group’s famous matrix was invented in the 1970s by company founder Bruce Henderson. With some reorganization, we can re-use the Boston Consulting Group’s growth share matrix to classify all digital assets according to their risk of loss and risk of profit. The four categories are still stars, dogs, unknowns, and money cows.

A star investment with no risk of loss but no risk of profit is rare these days, but is plentiful in hindsight, for example if you regret selling Bitcoin in 2010. Stars also exist in the imagination. This was the case with investors in the Bernie Madoff Fund. But such investments quickly turn out to be dogs. Dogs are sure losers – there is no risk of winning, but if you hold them long enough the risk of losing turns into actual loss.

Star investments are most common in hindsight when we can no longer buy them:

Your regular investments are unknown – they can go up or down in value depending on the day. Most digital assets, even Bitcoin, fall into this category. After all, cash cows are investments with minimal risk of loss or profit. You are reliable. We can now take the projects labeled as stablecoins to see which ones really fit.

Let’s add some key digital assets and stablecoins to the profit-loss matrix.

Projects called algorithmic stablecoins are only in the name of stablecoins. Because of their multiple token designs, they have no risk of profit – as the entire new offering is being given out to investors – but holders retain the risk of loss.

Fixed price is not enough. The expected value of owning an asset can be positive or negative, but it is not zero. Another lesson is that it is important to indicate a unit when discussing value. If our unit of measure is the US dollar, then wBTC is not a stable coin. However, if we define value in terms of BTC, then wBTC is the perfect stable coin.

After all, risk assessment is difficult. I received a pushback because I classified Tether (USDT) as a stable coin due to counterparty risk.

These are all valid points.

Except in exceptional circumstances, no stablecoin is truly free from the risk of loss. Perhaps Tether is a cross between a dog and a cow.

It should be clear, however, that certain projects use the term “stablecoin” egregiously in order to place investors at risk of profit while exposing holders to risk of loss. However, since no sane person would keep these assets on their books, it is almost certain that these dogs will go extinct.

A stablecoin with expected value?

Astute readers will have noticed that expected value is not just a function of the probability of loss and gain – the size of the losses and the size of the gains are important as well.

Suppose I have a fair dice. If I roll a six, I win $ 60. If I roll any other number, I lose $ 6. The expected value for rolling the dice 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 stable coin to that of an expected stable coin? In other words, would it be enough if the expected value of holding an asset were zero? With the dice example above, this condition would be met if I only won $ 30 instead of $ 60. Every time I try to convert this “DieCoin” into US dollars, there is a fifth through sixth chance of losing value and a sixth chance of making a profit. But because the gain is so much greater than the loss, these cancel each other out.

I think this could be a smart approach that can be realized through a number of derivative contracts. However, it would lose ownership to allow holders to leave 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 not a few people find an expected value definition convincing.

This article does not contain any investment recommendations or recommendations. Every step of investing and trading involves risk and readers should conduct their own research in making their decision.

The views, thoughts, and opinions expressed here are the sole rights of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Manny Rincon-Cruz acts as a consultant for the Ampleforth project and is co-author of the white paper of the protocol. Manny is a researcher at Stanford University’s Hoover Institution, which he helped found, and currently serves as the Executive Director of the History Working Group.