For those who are in crypto would know about the UST depegging issue by now.
I am not going into crypto-speak to explain the issue. I think it has been well covered by many other experts.
I am coming in with an economics perspective to relate real word currencies to stablecoins.
In economics, there’s this concept called the Impossible Trinity.
There are three components.
Fixed exchange rate (peg to a currency or a basket of currencies)
Free capital flows (allow capital to move in and out of a country)
Independent monetary policy (set interest rate)
A country can only choose to do two of the three things.
In US, they allow free capital flows and the Fed sets the interest rate. Hence it has to allow the value of USD to be determined by market forces.
In China, the government sets interest rate and the Renminbi exchange rate is managed against a basket of currencies. She cannot allow free capital flows as a result.
In Singapore, the Monetary Authority of Singapore manages the SGD exchange rate against a basket of currencies. There’s free capital flow and hence she cannot set her interest rate.
I believe this Impossible Trinity concept has to apply to stablecoins because they work like currencies.
USDT and USDC are popular stablecoins that are pegged to the USD. They have USD reserves (or close equivalents) backing every stablecoin created.
There’s free capital flows as users can buy and sell these stablecoins as and when they like. Thus, they cannot set the interest rate and have to allow market forces to determine the rates.
UST on the other hand is an algorithmic stablecoin without any reserves. We can still consider UST being pegged to the USD as it does it indirectly via its sister crypto, LUNA token – 1 UST = US$1 worth of LUNA.
UST allows free capital flow and it originally promised a fixed interest rate of 20% under its Anchor Protocol program. This is a violation of the Impossible Trinity because UST tried to do all three things at the same time – something has to give way eventually.
The plan was to reduce the interest rate but I think it wasn’t done fast enough and hence the peg buckled, causing UST devaluation. My view is to allow the interest rate to float freely to improve the stability of UST.
Does it mean USDT and USDC are safer? Not necessarily. Both have drifted away from the USD pegs in the past before and it doesn’t mean it will not happen again.
Even countries who pegged their currencies have ran into problems in the past. Some examples were:
Black Wednesday: pound sterling couldn’t maintain within the European Exchange Rate Mechanism (ERM) limits and devalued after abandoning it
Malaysian Ringgit was pegged to the USD between 1995 and 1997 but Malaysia was forced off the peg when the Asian Financial Crisis worsened
Basically bad things can happen even to a real world currency, what can we say about a stablecoin. Moreover, the crypto market is still learning and improving. There are a lot of unknown unknowns.
I see risks but I also see meaningful development in crypto which can turn into a viable economic option for the masses in the future.
The best way to understand it is to dip your toes in it. But manage the risks – put in an amount you are okay to risk losing and always diversify into different cryptos and platforms. You never know what will happen next.
