Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking

Fisher College of Business Working Paper No. 2020-03-030

Charles A. Dice Center Working Paper No. 2020-30

78 Pages Posted: 30 Dec 2020 Last revised: 27 Dec 2021

See all articles by Ye Li

Ye Li

Ohio State University (OSU)

Simon Mayer

University of Chicago - Booth School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: December 22, 2021

Abstract

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 characterizes an instability trap: Stability can last for a long time, but once debasement happens following negative shocks to the issuer's reserves, price volatility persists. Capital requirement improves price stability but still fails to eliminate debasement. Restricting the riskiness of reserve assets can surprisingly destabilize price. Finally, we show that data privacy regulation has an unintended benefit of reducing the price volatility of stablecoins issued by data-driven platforms (e.g., Facebook).

Keywords: stablecoin, reserve management, regulation, instability, debasement, data privacy, payment system, collateral, open market operations, governance token, q-theory

JEL Classification: E41, E42, E51, E52, F31, G12, G18, G21, G31, G32, G35, L14, L86

Suggested Citation

Li, Ye and Mayer, Simon, Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking (December 22, 2021). Fisher College of Business Working Paper No. 2020-03-030, Charles A. Dice Center Working Paper No. 2020-30, Available at SSRN: https://ssrn.com/abstract=3757083 or http://dx.doi.org/10.2139/ssrn.3757083

Ye Li (Contact Author)

Ohio State University (OSU) ( email )

Blankenship Hall-2010
901 Woody Hayes Drive
Columbus, OH OH 43210
United States

Simon Mayer

University of Chicago - Booth School of Business ( email )

5807 S Woodlawn Ave
Chicago, IL 60637
United States

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