What are the stability risks of different types of Stablecoins and how can they be simulated? It includes an introduction to stablecoins, what the major risk factors are, and how to create a simulation. This talk was originally given at DeFi Summit May 2, 2020 by Dr. Markus Franke from cLabs (celo.org).

1. May 2020
Dr. Markus Franke
Markus@c-labs.co
Simulating the Risk of
Stablecoins

2. Agenda
Research Questions
● What are the stability risks of different types of Stablecoins?
● How can they be simulated?
Agenda
● Introduction: Stablecoins
● Types of Stablecoins
● Major Risk Factors
● Simulation

3. Agenda
Research Questions
● What are the stability risks of different types of Stablecoins?
● How can they be simulated?
Agenda
● Introduction: Stablecoins
● Types of Stablecoins
● Major Risk Factors
● Simulation

4. Introduction: Why Stablecoins?
Source: skew. BTC ATM Implied Volatility 2020

5. Introduction: Why Stablecoins?
Source: Coinbase, own calculations

6. Introduction: Core Differentiations of Stablecoins
Source: Adapted from “Investigating the Impact of Global Stablecoins”, G7 Working Groupon Stablecoins, October 2019,
https://www.bis.org/cpmi/publ/d187.pdf
User Interface
○ Wallets
○ Exchanges
○ Resellers
○ Agents
○ Service Providers
Issue & Stability Mechanism
○ Issuer (Decentralised
Protocol, CB, …)
○ Governance
○ Entities (Banks, …)
○ Technology (Smart
Contracts)
○ Underlying
○ Stability Mechanism
Transfer Mechanism
○ DLT
○ Permissionless vs.
permissioned
○ Public vs. Private
○ Non-hierarchical vs.
Hierarchical
○ Open source vs. closed
source

7. Agenda
Research Questions
● What are the stability risks of different types of Stablecoins?
● How can they be simulated?
Agenda
● Introduction: Stablecoins
● Types of Stablecoins
● Major Risk Factors
● Simulation

8. Types of Stablecoins
Type Collateral Example Governance Transparency Stability Risks
Fiat /
Commodity
Collateralized
Fiat / Commodities,
Off-chain
Centralized,
regulated
Opaque, requires
audits on
collateral and
counterparty
Central entity
storing
collateral
Counterparty,
Liquidity,
Demand
Crypto
Collateralized
Crypto, On-chain Decentralized Transparent Crypto
collateral
Crypto,
Demand
Seigniorage
Share
Seigniorage Coin,
On-chain
Decentralized Transparent Seigniorage
asset
Crypto,
Demand
Algorithmic /
Crypto
Collateralized
Seigniorage
Share Hybrid
Seigniorage-style
protocol with
crypto-reserve,
On-chain
Decentralized Transparent Seigniorage
asset
Crypto,
Demand

9. Agenda
Research Questions
● What are the stability risks of different types of Stablecoins?
● How can they be simulated?
Agenda
● Introduction: Stablecoins
● Types of Stablecoins
● Major Risk Factors
● Simulation

10. Supply = Demand!?
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

11. Demand is Random
𝜇=20%
𝜇=10%
𝜇=-10%
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

12. And the Cryptomarket is Random
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org
𝜇=10%
𝜇=0%
𝜇=-20%
𝜇=20%

13. Analyzing Algorithmic Stablecoins
● Empirical vs. theoretical studies
● Scenario analysis vs. forecasting
● Historical vs. simulated studies
● Scenario generator: Geometric Brownian Motion vs Ornstein-Uhlenbeck
● Distribution: normal vs. heavy-tailed

14. Using a Geometric Brownian Motion
multivariate GBM
(correlated diffusions)
idiosyncratic
jumps
market-wide
jumps
Multivariate geometric brownian motion with
jumps
● Idiosyncratic jumps for individual assets
● Market-wide jumps for all assets

15. Geometric Brownian Motion (𝜇=0, 𝜎=0.75)
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

16. Geometric Brownian Motion (𝜇=0.5, 𝜎=0.75)
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

17. Geometric Ornstein-Uhlenbeck Process
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

18. Geometric Ornstein-Uhlenbeck Process (w. Jumps)
Source: “An Analysis of the Stability Characteristics of Celo”, cLabs Team, Celo.org

19. Analyzing Algorithmic Stablecoins
● Scenario analysis vs. forecasting
● Empirical vs. theoretical studies
● Historical vs. simulated studies
● Scenario generator: Geometric Brownian Motion vs Ornstein-Uhlenbeck
● Distribution: normal vs. heavy-tailed

20. Thanks, we value your time
May 2020
Dr. Markus Franke
Markus@c-labs.co
chat.celo.org
twitter.com/CeloOrg

21. Stability Mechanisms: Fiat / Commodity Collateralized
Type of Stablecoin Stability, Transparency and
Governance
Examples
● Backed by off-chain assets (e.g.
fiat, commodities
● Collateral typically in bank, safe...
● Creation: sending fiat to
centralized party
● Contraction: destroying when the
centralized party returns fiat to
token holder
● IOU token
● Stability depends on value of
collateral, liquidity,
counterparty risk
● Requires audits on collateral
and counterparty
● Very direct arbitrage
opportunities
● Redemption process depends
on liquidity, pricing of
fiat-backed stablecoins should
factor in risks

22. Stability Mechanisms: Crypto Collateralized
Type of Stablecoin Stability, Transparency and
Governance
Examples
● Backed by on-chain assets
● Typically via loan instruments
(users can borrow stablecoins by
locking up other cryptocurrency
holdings as collateral).
● Decentralised
● Collateral held by smart
contract
● On-chain liquidation process
● Transparency: any user can
audit the code or query the
amount of collateral being
held
● Collateral can be traded and
settled 24/7
● Crypto collateral is volatile
● Supply of stablecoin does not
necessarily match demand

23. Stability Mechanisms: Seigniorage Style / Algorithmic
Type of Stablecoin Stability, Transparency and
Governance
Examples
● Seigniorage-style stablecoins
algorithmically expand or contract
the supply of the stable token in
order to match demand
● Elastic supply of stable asset
● Volatility is shifted to
non-stable (seigniorage) asset
● Value of seigniorage asset
determines stability
● Decentralised and
transparent, typically
open-source
● Expansion and contraction
mechanism critical for elastic
supply