One of the objections against crypto currencies has been their volatility. Bitcoin for instance just rose by about 60% over 2 days only to then fall by about 15% in a matter of hours. Steam just ended bitcoin support citing volatility. This has led a number of teams on the quest to create a so called stable coin: A coin that does not fluctuate in value.

Now that raises some immediate questions. First, an easy question, relative to what is a stable coin stable? Other crypto currencies? The US dollar? The cost of some kind of computer operation? Second, a much harder one, if a coin were to be stable, do supply and demand become meaningless? And is that a good or bad thing? And third, possibly the hardest of them all, how in the world does one create a stable coin?

Here are some potential answers. The most desirable peg for a stable coin would be some kind of purchasing power index. That is a lot easier said than done especially when it comes to computation where cost has been coming down fast (easier for say the Big Mac Index). In the absence of a PPI, the second best would be a global currency basket.

The question about the effects of supply and demand on price though is a tough one. Prematurely stabilizing a coin could destroy the entire incentive effect for building out capacity. Take filecoin as an example. If there is a lot of demand for decentralized storage, one wants the price of filecoin to rise so as to provide an incentive for more storage capacity to be added to the network. Stabilizing such an increase away would effectively be suppressing the entire price signal! I have explained previously that a better approach to keeping speculative (rather than usage based) demand at bay is to have built-in inflation. So a stable coin makes more sense in places where the coin is simply replacing an existing payment mechanism.

As for a mechanism for creating a stable coin. Many of the ones I have looked at propose some kind of buy back mechanism to withdraw coins should the price per coin fall. I happen to believe that none of these account for the ruin problem (meaning you run out of funds for buying back). Given that a new stable coin would start out tiny relative to the size of the financial markets as a whole these could all be attacked (and an attack would make sense if the coin can be shorted). Leaving aside whether this can be done on an existing blockchain or not, I believe that a potentially better mechanism would be to randomly select coins for deletion (for contracting supply) and similarly randomly select coins for duplication (for increasing supply). While this does have wealth effects for individual holders, those should be small, random, and linear with size of holdings, thus minimizing incentive effects.

I am looking forward to feedback on these answers. And here are to more questions for readers:

A. Do you think a stable coin is needed?

B. If yes, what’s your favorite stable coin project (and why)?