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The USDi Return for May is Not an Estimate!
This is just a brief note to clarify something about the construction of USDi, about which I’ve gotten a number of calls. Before I do, let me also tell you to be on the lookout for my blog next week, when I’ll tell you what I think about Probable-Next-Fed-Chairman Kevin Warsh. (In the behavioral economics world we call that a ‘precommitment’ strategy that has the effect of forcing me into doing it. It’s overdue anyway.)
In May, the USDi token (freely mintable at https://usdicoin.com/coin/ ) will return 12.59% annualized. That’s not an estimate, and it isn’t a typo. As I type this, USDi is in the midst of a month wherein its price is increasing at a 5.65% annualized pace. Its current price at the moment when I am writing this is 1.034237. At the end of April, its price will be 1.035424. At the end of May, its price will be 1.046286. The movement from the end-of-April price to the end-of-May price is 1.049% for the month, which annualizes to 12.59%.
Note that I am not saying its price ‘may be’ or ‘will be approximately.’ While the price you see if you buy USDi on Uniswap or another liquidity pool may not be exactly that, those are precisely the prices you can buy or sell at on our website if you do it at exactly the end/beginning of the months in question. (To be fair, I’ll also note there is a small fee to mint or burn. These are listed on the minting page under the header ‘What are the transaction fees,’ and they range from a low of 0% if you mint over $5mm, to a high of 0.05% – but at least a dollar – if you mint less than $100,000. So, your return will more likely be 0.99% for the month, or 11.88% annualized. Still pretty good).
This is an important nuance. USDi is not a tokenized money market fund, or some other tokenized fund, where the buyer gets a small share of the fund’s performance. If it was, then USDi would be a security and you couldn’t buy it at all in the U.S. unless we filed a Form D and performed AML and KYC on you. That wouldn’t be a very useful crypto tool. So we made USDi an indexed currency, similar to the Unidad de Fomento in Chile, that depends only on the value of the Non-Seasonally-Adjusted CPI index, mechanically. It accretes just like a TIPS bond, except that it does it every block, not just every day. I walked through the particulars last year in How to Calculate USDi’s Current Value.
Now, a TIPS bond – even a short-dated TIPS bond – also experiences changes in price. So while the principal of the October 2026 TIPS, and every other TIPS, will accrete 1.049% for the month of May…those bonds will also experience price changes. In particular, it is extremely likely that they (at least the short-dated ones) will decline in price over the course of the month since each successive buyer will have the right to less and less of that sweet accretion. Either way, you don’t know what you’ll have in a month if you buy a TIPS bond. But USDi has no maturity date. It is not a bond whose price declines when interest rates rise. It is inflation-indexed cash, or (if you prefer) analogous to an inflation-linked CD where the bank is paying you 12.59% for the month, but which you can cash out at any time with no penalty.
This remarkable return – which is likely to remain pretty attractive in June if the inflation swaps market is right about where NSA CPI will print when we get that data next month – is due to the spike in gasoline prices last month, which passed through fairly directly to the CPI.
The next logical question is ‘where does that return come from?’ I am going to skip that answer for now because when I talk about the underlying investment dynamics people tend to get confused and think that the underlying investment dynamics determines how USDi behaves. It doesn’t. Furthermore, the answer to that question does involve a fund that is a privately-placed security and which (therefore) it’s awkward to discuss on a public forum.
But mainly, I don’t want to confuse you. USDi this month is earning 5.65% annualized, and it will earn 12.59% annualized next month. The first estimate concerns June, and an estimate based on the inflation swap market suggests USDi will earn around 9% annualized in June. When we get the CPI in a few weeks, that return will crystallize and we will know June’s return absolutely.
I repeated this point about five times because it seems to me people are being very cautious about buying USDi at the very time that people should be agog over the known future returns and grabbing it. I understand why a big hedge fund might not want to buy $50mm of USDi without ever having experimented before. It is more confusing to me why folks aren’t buying $5k or $10k to try it out and see how it works. Don’t get me wrong, the flows are positive. They’re just…very timid. So just in case the concern is that ‘maybe this return won’t really happen after all,’ I wanted to be clear (here comes #6) that May’s return is baked in the cake. Go get some cake.
Does Crypto Expand the Money Supply?
We live in interesting times, and let’s face it: mostly, in a good way. It doesn’t have to stay that way, naturally, and it won’t stay that way naturally.
This has always been the weak spot in any system that insists on centralized management of certain functions. Of course, that’s the fundamental flaw and conceit of socialism: it relies on the active intercession of omniscient beings to order activities better than the masses of private actors can. Usually, “better” means “less volatile” to the policymakers who set up the committees of omniscient beings (personally, I would say “better” means “less fragile,” which is the opposite of “less volatile”).
The best argument for using the collective wisdom of the anointed few is to prevent the tragedy of the commons, where individuals making private decisions can impact the use of public goods. And that brings us to money.
I think it is a fascinating question whether ‘money’ is a public good, which should be regulated and controlled. Or is a particular currency, such as the US Dollar, the public good which should be regulated and controlled? The argument the Federal Reserve would make is that, absent the control of the Federal Open Market Committee, the money supply would grow or shrink in dangerous and random ways. Or at least, that would be the argument they would make, if they cared about the stock of money any more.
There is no plausible argument in my mind that “interest rates”, which is what the Fed now works to control, is a public good that is better managed by the Smart Guys. So, weirdly, the Fed now manages something which they don’t have any knowledge about that should supersede private market actors (rates), but does not purport to manage something they could plausibly argue is a common good that no one directly controls (money).
** Separate question: are the Cognoscenti at the Fed any good at it? Chairman Powell said yesterday that the Fed is likely to stop running down its balance sheet soon. With the balance sheet still at 22% of GDP, compared with the pre-GFC normal of about 6% – see chart – “Until the job is done” has apparently become “until it’s time for my smoke break, and then you’re on your own.” What’s the matter with kids today?
So the answer to this ‘separate question’, as inflation remains at the highest level of this millennium and is now headed higher, is “of course they’re not. Why are we even asking that question?”
I actually want to go slightly further. The Fed no longer tries to control the money supply, which at least they might have an argument for doing, in preference to managing interest rates against the market-clearing actions of private actors. But over time (and accompanied by the whining and moaning of central bankers), the concept of money has gotten squishier and squishier. One of the reasons that central bankers want to control crypto is that they fear the power of money loose in the wild (ironically, given that they stopped worrying about money a long time ago), untamed by the Anointed Stewards of Money.
The question is, does crypto expand the money supply? For the purposes of this question, let’s ignore the official definitions of money, M1, M2, M3, etc and just focus on ‘spendable balances.’
If you give me a dollar, in exchange for something that feels like a dollar and that you can spend (say, a stablecoin like USDC), have we increased the money supply? The answer depends on what I do with that dollar. If it is deployed to a vault, then obviously the number of ‘dollarish’ units in circulation haven’t changed. You have minted $1000 USDC, but there are now $1000 USD that are sequestered in a vault and not spendable. The amount of spendable money hasn’t changed. If instead that $1000 goes to buy a Treasury bill from the government, then it is going to the government to spend. Normally, buying Treasuries doesn’t change the amount of spendable dollars, because in buying a Tbill I am deferring my decision to spend (instead, I hold securities) and delegating that decision to spend to the government. I exchange my future spending for the government’s current spending, and in the future that transaction is reversed when the Tbill matures. Some people think that means that Treasury issuance increases inflation because it increases money, but it doesn’t. The Treasury bill is just a token representing my deferral of spending into the future.
But if I was able to buy that Tbill because I issued a USDC token, which you can spend, and then gave the fiat money I received from you to the government in exchange for a Tbill, then I have doubled the number of spendable dollars in circulation: $1000 in the form of USDC, and $1000 in the form of dollars sent to the Treasury which will be spent. Essentially, what has happened is zero-reserve banking. If I were a bank and you deposited $1000, I could lend out only, say, $900 of that (“fractional reserve banking) and in principle the Fed can control that multiplier by changing the reserve requirement.[1] But now you’ve deposited $1000 and I am lending 100% of that to the government. Stablecoin manufacturers in this way are basically banks issuing their own currencies. Now, a lot of that money is going abroad, but it looks like money to me.
Worse are the vaporware crypto issuers who simply create supply out of thin air. If people accept bitcoin as money, rather than as a speculative chip to trade around, then I have created money with no reserves whatsoever, and no limit on how much ‘money’ I can so create.
If this is true, then the irony is that crypto – which was inspired originally by the desire to remove money from the ministrations of the Very Smart Bankers who could ruin money by creating too much of it – could be the very tool that creates the inflation its originators wanted to protect against. In that kind of world, I really don’t understand the use of a nominally-anchored stablecoin. If the overall money supply growth is unbounded and now essentially uncontrollable (once the size of the crypto world gets sufficiently big), then holding something that is pegged to the sinking ship seems counterintuitive to me.
While I didn’t start this article with the intention of pointing out that our USDi coin is a raft rather than an anchor (like stablecoins), it does seem to be relevant here to mention that you can now mint USDi directly from our website: https://usdicoin.com/coin . And, while the increase of USDi will contribute to the overall money supply – at least it has a built-in defense!
[1] …but it doesn’t really work like that any more. The Fed still has a dial to turn that limits how much lending can happen on a given depository base but it isn’t as clean as it was when there was a simple reserve requirement. This is well beyond the point of this article.
USELESS Coin vs Very Useful Coin
It is rare, in the investment world, for an investment to honestly and fully disclaim its basic nature in a way that finishes the story and requires no further analysis from us before making an investment decision. I have found such an investment. It is a cryptocurrency/meme coin called, appropriately, USELESS. https://coinmarketcap.com/currencies/theuselesscoin/ If you were to buy all of the USELESS in existence, it would cost you (as of this writing) about $272 million dollars. This seems to me to be a lot of money to pay for something useless, but what do I know?
Now, it should be noted that there are lots of useless coins. DOGE coin. Fartcoin. I could go on and on. But the difference here is that as far as I can tell, USELESS is being completely honest. It is not usable as a payment rail. It is not redeemable for anything, at any time, and therefore it is guaranteed to one day be worth zero. It doesn’t even come printed on a nice certificate so that the scripophiles can frame it and put it on the wall.
To be fair, as I said it isn’t the only such memecoin that is useless. It is merely the only one that turns that uselessness into a dare. It is a game, of seeing who eventually gets the ‘pride of place’ as top-ticking it, paying the highest price for something that is useless and that never pretended otherwise. (People who bought Enron stock were buying something that turned out to be worth zero, but they didn’t know it at the time. USELESS buyers are fully aware and cannot possibly claim otherwise.)
And actually, ironically, that unlocks the reason this coin exists. It reminds me of a fantasy baseball auction. For those of you who don’t play fantasy sports, there are generally two varieties: the ‘draft’ kind, where people take turns drafting players, and the ‘auction’ kind, where someone offers a player and a price they will pay for that player, from a limited budget allotment. The other participants in the draft all take turns bidding until someone wins the player, and then the process is repeated until every fantasy team is full. Done correctly, a bidder doesn’t merely bid for the players he or she wants but also bids up the price of a player he or she does not want, in order to force someone else to pay more than that player is worth. This part of the auction is a game, trying hard to make someone else pay top dollar – which requires you to figure out what everyone else’s top price is – while not getting stuck with the now-overvalued hot potato.
I think that’s what USELESS is. It’s a game of trying to push the price higher and higher, until someone is stuck with the honor of having paid the highest price for an utterly worthless unit. It’s a game; it’s only a game; and it is just as much of an “investment” as is the forty-two dollars you paid to select Juan Soto for your fantasy team.
Now, as you all know by now I have been at least partially converted and no longer think that all crypto is useless. The absolute opposite of USELESS is the enormous utility of our inflation-linked stablecoin, USDi. And yes, I’ve written about it before. And yes, I will write about it again. Because it’s as useful as it gets. There is no such thing as inflation-linked cash in traditional finance space. I am not aware of any bank that offers an inflation-linked savings account. And this is not a little thing. This is a big, big thing.
The chart below shows a hypothetical efficient frontier made up of a lot of different asset classes; this frontier might look a little different from what you’re familiar with because the x-axis and y-axis are in real terms whereas most of us learned finance in nominal terms where you had a Treasury bill as the risk-free asset. But we don’t care about nominal returns (if we did, we’d own stocks in the most hyper-inflating country we can find) – we care about real returns. In the nominal world, Tbills or money market funds exist with sub-zero real returns most of the time. More importantly, they have significant risk in after-inflation terms. As a result, in real space we are confined to the blue curve as our efficient frontier (the curve shows the lowest-risk portfolio that achieves a given expected real return. Remember these numbers are all hypothetical but the point I am making doesn’t depend on the numbers).
But USDi is, as I said, super useful. It is the origin security, the zero-real-risk, zero-real-return point. And that means that it improves every portfolio in real terms, with the possible exception of very-high-risk portfolios.
Now, most of these securities don’t yet exist in the defi world. There really aren’t any tokenized commodities yet, except in the narrow edge case of gold and one or two other single spot commodities – and no tokenized commodity indices yet, and commodity indices have additional sources of return beyond the spot commodity return. No tokenized TIPS, and few tokenized equities. Someday, the defi world will have these things. But what it does have right now, which is really useful and a good enough reason to visit the crypto world, is the low-risk security: USDi. How useful is that?
[N.b.: USDi was originally launched in a manner only available to accredited investors. However, because of growing regulatory clarity about its status as a stablecoin or currency rather than as a security, we have re-launched USDi so that the mint/burn functions are available to all. The coin’s address on mainnet is 0xAf1157149ff040DAd186a0142a796d901bEF1cf1. We will be adding functionality to allow minting or burning via user tools on our website, but in the meantime users can make a public call to the blockchain to mint or burn versus USDC. Reach out via the https://USDiCoin.com website if you want more information.]
The Road to Crypto Conversion
While this isn’t exactly the conversion of Saul on the road to Damascus, I came to a realization recently that subtly changes the way I look at the potential for large cryptocurrencies, such as Bitcoin.
Historically, my attitude has been dismissive about the value of bitcoin itself. While I recognize the amazing reach of blockchain technology and the genius of using asymmetric key cryptography to secure the public record of private transactions, I’ve always thought that bitcoin didn’t really achieve the promised goal, which was to be a better money than fiat dollars. After all, bitcoin is not backed by anything more than the dollar is – nothing. Its value is based on scarcity, and scarcity by itself is not a source of value (if it was, my toenail clippings would be immensely valuable). So in my 2016 book What’s Wrong with Money? I wrote in a chapter on bitcoin:
“But is bitcoin money? Calling it a virtual currency, or a digital currency, or a crypto-currency doesn’t make it money. At some level, it is of course money in the same sense as cigarettes are to prison inmates. It serves as a medium of exchange, a store of value, and a unit of account – but only within the special community that already accepts bitcoin as credible…It is not yet broadly a credible currency. It doesn’t have universal value because not everyone believes that everyone else will accept bitcoin.”
Even in that chapter I recognized that bitcoin may someday be money-like. And I underwent a partial conversion and even worked for a while on a paper with my co-authors Kari Walstad and Scott Wald to define a measure (“Crypto Trust Index”) that would objectively measure how much like money the cryptocurrency world was becoming. [That paper ended up being overtaken by real-world developments, as stablecoins fully backed by fiat balances are obviously crypto money by identity, rendering the question moot.]
But in my mind bitcoin, eth, etc aren’t money but speculative vehicles – they are distinctly separate from USDC, USDi, and other fully-backed coins. It may be that they belong in a portfolio with stables and/or securities, but since bitcoin has no intrinsic value I have always held the view that I don’t want to own it as it can go to zero in a nonce.[1]
Recently, as I said, I’ve had a mild conversion as a result of two realizations.
The first realization is that even in the traditional securities world, we sometimes invest in things which have no intrinsic value in many states of the world. For example, we buy out-of-the-money options, or equity in a firm that is highly leveraged so that if the business goes under, the equity-holders get nothing. I am not sure this is a good excuse to buy bitcoin, though, since even if a far out-of-the-money option is unlikely to ever have intrinsic value there are at least future states of the world in which it could have intrinsic value. Similarly, that penny stock might end up being worth something if business booms. So we could think about bitcoin as being an option that may go to zero or may go up a lot. The problem with this, and the reason this reasoning alone is not compelling to me, is twofold. First, those far out-of-the-money options and long shots tend to have low prices, not high prices, and bitcoin certainly does not seem to have a low price. Second, there is no state of the world in which bitcoin will ever have an intrinsic value. Therefore, it doesn’t make a lot of sense to think of it as a real option, but at best as a speculation with an option-like payout (low in many states of the world, but massive in a few states). Put another way, while the value of that penny stock or out-of-the-money option can go to zero for some clearly-defined reasons, bitcoin can go to zero for any reason or no reason and it wouldn’t be wrong.
The second realization, though, relates to scarcity. Yes, scarcity alone cannot be the basis for value (see: my toenails). For scarcity to matter, there needs to be exogenous demand. And that demand need not be rational. If someone wants to hold bitcoin, not caring that it has no intrinsic value (or erroneously believing that it has some), then scarcity matters. The realization is that scarcity goes from not mattering at all, to mattering a great deal, as soon as there is any demand. To be sure, if that demand goes away, then scarcity again ceases to matter.
(By the way, it is entirely possible and even likely that someone else has pointed this out.)
So the case for speculating in bitcoin (no, I won’t call it investing) is that since the total supply is independent of price, the supply curve is vertical and moving to the right at an ever-slower rate. As this happens, it takes less and less increase in demand to push price higher.
It also takes less and less decrease in demand to push price lower. Since there is no slope to the supply curve, it means that oscillations in demand are responsible for all of the oscillations in bitcoin’s price. And we can say more about the volatility dynamics. Early in bitcoin’s development – when demand was very low, supply was relatively high compared to demand, and the price was as a result very low – we were operating at the far left end of the demand curve where demand was relatively more elastic and therefore there was a lot of volatility. As bitcoin matures, and demand catches up to the existing supply, we should expect price volatility to decline. And this is, in fact, what has happened (chart below, source: Bloomberg, shows rolling 100-week historical volatility (about two years, but I like round numbers today), now at the low-low level of 43% (about 3x equity market volatility).
The fun part comes later, when the supply curve shifts get slower and slower as the bitcoin halving converges to zero and the bitcoin supply gets closer and closer to its absolute maximum. At that point (and here is where the uberbulls get really excited), if there is a steady secular increase in demand, price just goes up without bound.
Don’t get too excited, uberbulls, because we aren’t there yet. When we are starting to get close to that point I would expect that we will also see volatility start to go up again. If historical volatility continues to decline, it means (a) we aren’t close enough to that point that the vertical singularity is nigh, and/or (b) people are losing interest in or diversifying away from bitcoin so that the steady increase in demand is not manifesting and interest is fluctuating less and less. So, I am waiting for that volatility to begin to expand at higher prices.
In any case, I am much more likely to invest in tokenized real world assets than I am Bitcoin or Ethereum. I am not a speculator at heart. Heck, I’m a bond guy which means I worry more about return of my principal than return on my principal. But if you are already long bitcoin, I will no longer sneer at you, because I recognize at last that one way or the other I will may be driving your car someday – either because it was repossessed and I bought it at auction, or because I am your chauffer.
Did You Know? Want to buy USDi, the inflation-linked stable coin, but don’t own any crypto you can exchange for it? You can actually use the coin as an on-ramp. Accredited investors need merely complete onboarding with USDi Partners and then can invest fiat dollars and receive USDi coins.
[1] Pun intended.
What Makes a Stable Coin Stable?
The early growth of Bitcoin and the cryptocurrency space was originally stimulated by the mistrust of centralized control of monetary policy and financial institutions. While Bitcoin is a fiat currency, in the sense that it is not ‘backed’ by anything and has value only because other people believe it has value, the rules for the expansion of the total float of Bitcoin are mechanical and so the unit benefits from being isolated from the whim of flesh-and-blood central bankers. Milton Friedman once said in an interview with the Cato Institute that “We don’t need a Fed…I have, for many years, been in favor of replacing the Fed with a computer [which would, each year] print out a specified number of paper dollars…Same number, month after month, week after week, year after year.”[1] And, with Bitcoin, that is exactly what you have. Management of Bitcoin is decentralized, automatic, and the rules are stable.
Unfortunately, ‘fiat’ cryptocurrencies are anything but stable. Moreover, since their value depends entirely on the trust[2] of other actors in the economic system that these currencies will have value, it is entirely possible that any of them could crash just like any fiat currency sometimes crashes when confidence in the currency issuer vanishes. There is no intrinsic value to a fiat currency – digital, or analog – which means that they are stable only when looked at in a self-referential frame. A US Dollar has a stable value of $1 but is volatile from the viewpoint of a Mexican-peso-based observer. I will return to this observation presently.
Because these fiat cryptos are unstable when looked at by a participant in the analog world, the concept of ‘stablecoin’ was developed. In Coinbase’s summary ‘What is a stablecoin?’, the first two bullet points are:
- Stablecoins are a type of cryptocurrency whose value is pegged to another asset, such as a fiat currency or gold, to maintain a stable price.
- They strive to provide an alternative to the high volatility of popular cryptocurrencies, making them potentially more suitable for common transactions.[3]
Why is a stable price important? The answer goes back to the question of whether Bitcoin and similar cryptos are money, or assets. In the conventional definition of money, such a label only applies to units that provide a medium of exchange, store of value, and unit of account. First-generation cryptos certainly serve as a medium of exchange but are sketchy on the ‘store of value’ and ‘unit of account’ dimensions. Nothing natively is priced in BTC, so it is not a good unit of account, and the high volatility creates a high barrier to any argument about being a store of value. Cryptos are most assuredly financial assets. It is hard to argue that they are money.
Enter the stablecoin. By pegging the value to an existing currency, a stablecoin ‘borrows’ the characteristics of that currency as a store of value and unit of account. It’s true by mathematical association: if USDC is equal to one US dollar, and the US dollar is money, then (as long as it’s accepted a medium of exchange) USDC is money because it has equal ‘store of value’ and ‘unit of account’ dimensions.[4] A stablecoin maintains its stability by means of holding reserves and being fully convertible on demand into the underlying currency.[5]
But Stable with Respect to What?
Stability, though, depends on the frame of reference. Consider a stablecoin linked to the US Dollar, which always can be minted or burned at $1 (ignoring fees). Consider a second stablecoin linked to the Japanese Yen, which always can be minted or burned at ¥1. Which one is stable?
Figure 1 – US Dollar Frame – US Dollar is stable
Figure 2 – Japanese Yen Frame – Japanese Yen is stable
The answer, of course, depends on your frame of reference. From the standpoint of someone in Japan, who is buying goods and services with Yen, a stablecoin like USDC that is linked to the dollar is most assuredly not stable in any useful sense of the word. Conversely, a US dollar investor would not find a Yen stablecoin to be stable. This, then, is an important element of defining a stablecoin: something which matches the volatility and behavior of the basis of the frame you are in, is stable with respect to you. This raises an interesting question when it comes to stablecoin regulation. A coin could very easily be regulated as a stablecoin in one jurisdiction, and not be regulated as such in a different jurisdiction – even between regulatory jurisdictions that are congruent in their treatment of most assets.
What passes for stability, in short, depends on the transactional frame – literally, the underlying currency in which transactions happen – of the observer.
Stable with Respect to When?
The meaning of stability also fluctuates with the time horizon of the observer. Fixed-income investors are very familiar with the concept of Macaulay duration, which is the future horizon at which the value of a bond holding is completely insensitive to parallel shifts in the yield curve, because the change in the value of reinvested coupons (which goes up with higher interest rates) exactly offsets the change in the value of the remaining cash flows (which go down with higher interest rates). What is the riskiness of a bond with a 7-year duration? Or more to the point of this discussion – which is riskier, a 1-month Treasury bill, or a 7-year zero coupon bond?[6]
As it turns out, it depends on the applicable horizon of the observer.
Suppose an investor pursues one of two strategies: in the first strategy, he or she buys a 1-month Treasury bill, initially at 5%, and then rolls the proceeds every month for 7 years. Alternatively, he or she could buy a 7-year zero coupon bond yielding 5%. Using a simple two-factor model with no drift, I generated 250 iterations of T-bill paths and yield curve shapes, to produce hypothetical monthly time series of returns for the two strategies. For example, here is one such random path (Figure 3):
Figure 3 – Illustrative single random path of cumulative returns for two strategies
The a priori expected return is approximately the same for both strategies; sometimes the T-bill roll strategy ends up ahead and sometimes the buy-and-hold strategy wins. With similar expected returns, a rational investor would therefore choose the one which has the lowest risk. But the riskiness or stability of the returns depends very much on the observer’s time horizon. Each of the following three charts is drawn from the same 250 Monte Carlo iterations, but the cumulative return is sampled at a different horizon. In Figure 4, the cumulative returns are sampled at the 1-month horizon. In Figure 5, the sampling is at the 3-year horizon. In Figure 6, the sampling is at the 7-year horizon. For each figure, the cumulative return for the T-bill strategy is shown on the x-axis and the cumulative return for the zero-coupon-bond buy-and-hold strategy is on the y-axis.
Figure 4 – 1-month T-Bill strategy is riskless at a 1-month horizon
Figure 5 – Both strategies are relatively risky at a 3-year horizon
Figure 6 – The 7-year zero-coupon-bond is riskless (in nominal terms) at a 7-year horizon
Although this conclusion is trivial and inevitable to fixed-income investors, the reason for our observation here is to point out that what is considered ‘stable’ not only depends on one’s functional currency but also on one’s holding period horizon.
Is the Nominal Frame the Most Important Frame?
The prior points are likely obvious to most investors. If you are investing with the intention of spending the proceeds in US Dollars, then a USD frame is most relevant. If you are investing for a known future nominal payout (for example, a life insurance company hedging scheduled annuity flows), then an investment that matures to a given value at the time when the money is needed is the most-relevant frame. However, investors sometimes lose track of one of the most important frames, and that is the “real” frame where values track the price level.
While a $1 bill is ‘stable’ in nominal terms – it will always be worth $1 – it is very unstable in purchasing-power terms.
Figure 7 – A dollar is inherently unstable in the main consumer frame
The framework where we ignore the value of the dollar, in preference for the fixed price of the dollar at $1, is the “nominal” framework. When inflation is low and stable, this frame is a useful shorthand in much the same way that when traveling abroad a tourist in the year 2000 might translate Mexican Peso prices into US Dollar prices by dividing by 10 even though the exact exchange rate differs from 10:1. In the short term, such a shortcut framework makes up for in convenience what it surrenders in precision. But in the long term, what starts out as mild imprecision becomes wildly inaccurate as the Peso exchange rate has gone from 10:1 to 20:1.
Similarly, while the nominal frame is the default for short-term comparisons it is clearly not the most important one to a consumer. Someone who is negotiating a salary at a new job, who knows he or she made $40,000 per year in 2004, would be ill-suited to use that figure as the starting point. The frame that matters over time is the real, or inflation-adjusted, frame. In the chart above, if we plotted the purchasing power of an inflation-adjusted 1983 dollar, it would be a flat line at $1.[7] On the other hand, if we plotted the nominal value of that same inflation-adjusted 1983 dollar, it would show a mostly steady increase from $1 to $3.15 over the same time period.
As before, the frame matters. A dollar that is stable in nominal space is very unstable in purchasing-power space. A unit that is stable in purchasing-power space looks unstable in nominal space.
If an investor or consumer had to choose one frame to care about, it would surely be the one in which his or her money represents not just a medium of exchange and a unit of account, but also a store of value. What this means is that a coin that is native currency and inflation-adjusted in the local price level is the most stable of stablecoins. And what that further implies is that what we currently call ‘stablecoins’ are stable only in the narrow context of being fixed at a certain nominal value of domestic currency…and that is suboptimal since all investors and consumers live in a world where prices change.
Tying Frames Together
What is interesting is that each of these frames describes “stability” in a different context. People in one frame see their own side as stable and the other side as volatile – and the exact same thing is true, in reverse, for the other side.
The various frames do traffic with each other. A holder of US Dollars (in the nominal-USD-short-term-stable frame) exchanges those dollars with a person who holds Euros (in the nominal-Euro-short-term-stable frame). We call that an exchange rate. And what ties together the nominal dollar and the inflation-linked dollar is the price index.
Figure 8 – Exchanging dollars with different purchasing power is functionally the same as exchanging currencies with different purchasing power.
In fact, the relationship between the Dollar and the Euro is so much like the relationship between the nominal dollar and the inflation-linked dollar that in 2004 Robert Jarrow and Yildiray Yildirim wrote a paper describing how to value inflation-protected securities and derivatives using a model designed for foreign exchange.[8] And that highlights the fact that an inflation-linked stablecoin isn’t some strange construct but rather an important new product to be added to the cryptocurrency universe. It is just another currency – one that is fixed in time, rather in nominal dollars, that is exchangeable to today’s dollars at the ‘inflation exchange rate’. If a 1983 dollar existed today, it could be exchanged for $3.15 current dollars because the dollar that was frozen in time in 1983 buys more than today’s dollars. That’s just an exchange rate!
Conclusion
It seems that ‘stability’ is not a stable term. Perhaps a more accurate description of the current crop of ‘stablecoins,’ which are exchangeable 1:1 with the base currency, is “fixed coins.” Only an inflation-linked coin would be a “stablecoin” in the true sense of the word, and only because being stable in purchasing-power space is the most important frame.
[1] http://www.cato.org/publications/commentary/milton-rose-friedman-offer-radical-ideas-21st-century
[2] This is not to be confused with the trustless nature of the transaction verification process of the blockchain, where the peer-to-peer nature of the process allows transactors to be certain their counterparty has the amount of bitcoin in question before completing a transaction. Rather, this is a comment on the entire system itself.
[3] https://www.coinbase.com/learn/crypto-basics/what-is-a-stablecoin
[4] Arguing that a coin pegged to gold or other commodities is a stablecoin is a bit of a stretch. Such a coin may be granted intrinsic value by such backing, and it may even be a better store of value in the long run because of such backing, but it is lacking as a unit of account (nothing is priced in gold units) and as a short-term store of value it leaves a lot to be desired.
[5] So-called ‘algorithmic stablecoins’ are mostly stable because of fiat reasons. That is, only because people believe the algorithm can guarantee that the coin is fully backed, will they behave as if they are. My usage of ‘stablecoins’ leaves out algorithmic stablecoins.
[6] I made this a zero-coupon bond to make it easier. A zero-coupon bond has a Macaulay duration equal to its maturity. However, at the 7-year horizon, any bond with a 7-year Macaulay duration has the same risk to a parallel shift of the yield curve: none. The point of this paper, though, is not fixed-income mathematics so take my word for it for the sake of this argument.
[7] Naturally, whether it is truly precisely flat depends on whether the price index we are adjusting with is an accurate representation of changes in purchasing power. Of course, such an index would look different for every person based on his or her consumption patterns so the line would not be truly flat for any person. But it would be much more stable than the non-inflation-adjusted dollar.
[8] Jarrow, Robert A. and Yildirim, Yildiray, Pricing Treasury Inflation Protected Securities and Related Derivatives Using an Hjm Model (February 1, 2011). Journal of Financial and Quantitative Analysis (JFQA), Vol. 38, No. 2, pp. 337-359, June 2003, Available at SSRN: https://ssrn.com/abstract=585828
