Money Creation in Decentralized Finance: A Dynamic Model of Stablecoin and Crypto Shadow Banking

Stablecoins are at the center of debate surrounding decentralized finance. We develop a dynamic model to analyze the instability mechanism of stablecoins, the complex incentives of stablecoin issuers, and regulatory proposals. The model rationalizes a variety of stablecoin management strategies commonly observed in practice and characterizes an instability trap: Stability can last for a long time, but once debasement happens following negative shocks to the issuer’s reserves, price volatility persists. Capital requirement improves price stability but still fails to eliminate debasement. Restricting the riskiness of reserve assets can surprisingly destabilize price. Finally, we show that data privacy regulation has an unintended benefit of reducing the price volatility of stablecoins issued by data-driven platforms (e.g., Facebook)