Stablecoin Model #3: Seigniorage Shares

The final approach is the seigniorage shares approach, which algorithmically expands and contracts the supply of the price-stable currency much like a central bank does with fiat currencies. These stablecoins are not actually “backed” by anything other than the expectation that they will retain a certain value.

In this model, some initial allocation of stablecoin tokens is created. They are pegged to some asset such as USD. As total demand for the stablecoin increases or decreases, the supply automatically changes in response. While different projects use different methods to expand and contract the stablecoin supply, the most commonly used is the “bonds and shares” method that’s being implemented by Basecoin and others.

As the network grows, so too does demand for the stablecoins. Given fixed supply, an increase in demand will cause the price to increase. In the seigniorage shares model, however, increased demand causes the system to issue new stablecoins, thus increasing supply, and ultimately lowering price to the target level. This works conversely, using “bonds” to remove coins from circulation (more details below).

The major challenge of seigniorage shares is figuring out how to increase and decrease the monetary supply in a way that is both decentralized, resilient, and un-gameable. Expanding the money supply is easy: print money! Contracting the money supply, on the other hand, is not. Who loses money? Is it forced, or voluntary? If voluntary, what motivation does the person have to part ways with her stablecoin?

When the supply must contract, the system issues bonds with a par value of $1 that are sold at some discount to incentivize holders to remove stablecoins from circulation. Users purchase bonds (which may pay out at some future date) using stablecoins, thus removing some stablecoins from the supply. This creates a mechanism to decrease supply in the event that the price of the stablecoin falls below the target range. At some point in the future, if demand increases such that the system needs to increase the money supply, it first pays out bond holders (in the order that the bonds were purchased). If all of the bond holders have been paid out, then the software pays those who own shares (the equity token of the system). Shares represent a claim on future stablecoin distributions as demand increases. Shares can be thought of much like equity in that both shareholders and equity holders can value their asset as a function of expected dividends of holding the asset. Additionally, in most seigniorage shares implementations, shareholders are offered voting rights.

With the seigniorage shares model, supply never actually contracts with finality. Instead, each contraction involves the promise of a future increase in total supply. We’ve provided a basic overview of these mechanics, with some example estimates, at this link. Basecoin attempts to solve the contraction problem by allowing bonds to expire after five years. These instruments are not actually bonds– they are binary options with an indefinite payout date. This means that buyers will likely demand higher interest rates to account for this risk. One issue this creates is that a rapid decrease in demand can lead to a death spiral in the price of bonds. As the system begins printing new bonds in order to take stablecoins out of the supply, the bond queue becomes increasingly large. This increases the time to payout and decreases the likelihood that each bond is paid. As such, the newly printed bonds must be sold for a cheaper price in order to account for the additional risk. As bond prices fall, the number of stablecoins taken out of circulation for each bond sold also falls. This causes the system to have to print more bonds in order to shrink the supply sufficiently. This creates a recursive feedback loop that could make large-scale supply contraction near impossible unless other measures are put in place to prevent it.

Some projects like Carbon modify the seigniorage shares model. In Carbon, users can elect to freeze portions of their funds to manage contraction and growth cycles. Some projects issue bonds, but simply pay out new stablecoins to all users, pro rata, when all bonds have been paid and supply must increase still. Each approach to the seigniorage shares model has its own set of challenges.

The seigniorage shares model is the most exciting, most experimental, and most “crypto-native”  approach to creating a trustless decentralized stablecoin. There are many economists who believe it cannot work. Indeed, it’s fundamentally predicated on perpetual growth of the stablecoin system.

This fluctuating supply concept, while foreign at first, is rooted in a well known theory of economics: the Quantity Theory of Money. It’s also the method used by the Federal Reserve to maintain the stability of the US dollar. The crypto projects adopting the seigniorage shares model are attempting to do what the Federal Reserve does in a decentralized, algorithmic way.