Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking
75 Pages Posted: 31 Aug 2021
Date Written: 2021
Stablecoins rise to meet the demand for safe assets in decentralized finance. Stablecoin issuers transform risky reserve assets into tokens of stable values, deploying a variety of tactics. To address the questions on the viability of stablecoins, regulations, and the initiatives led by large platforms, we develop a dynamic model of optimal stablecoin management and characterize an instability trap. The system is bimodal: stability can last for a long time, but once stablecoins break the buck following negative shocks, volatility persists. Debasement triggers a vicious cycle but is unavoidable as it allows efficient risk sharing between the issuer and stablecoin users.
Keywords: stablecoin, instability, regulation, debasement, big data, payment, collateral, shadow banking
JEL Classification: E410, E420, E510, E520, F310, G120, G180, G210, G310, G320, G350, L140, L860
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