Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking
Charles A. Dice Center Working Paper No. 2020-30
78 Pages Posted: 30 Dec 2020 Last revised: 8 Apr 2022
Date Written: April 2, 2022
Stablecoins are at the center of debate surrounding decentralized finance. We develop a dynamic model to analyze the instability mechanism of stablecoins, the complex incentives of stablecoin issuers, and regulatory proposals. The model rationalizes a variety of stablecoin management strategies commonly observed in practice, and we characterize an instability trap: Stability can last for a long time, but once debasement happens, price volatility persists. Capital requirement improves price stability but fails to eliminate debasement. Restricting the riskiness of reserve assets can surprisingly destabilize price. Finally, data privacy regulation has an unintended benefit of reducing price volatility of stablecoins issued by data-driven platforms.
Keywords: Stablecoin, platforms, regulation, decentralized finance, financial instability
JEL Classification: E41, E42, E51, E52, F31, G12, G18, G21, G31, G32, G35, L14, L86
Suggested Citation: Suggested Citation