24 Jan, 23
What is Crypto Seigniorage? Fundamentals and Purpose
This article will explore the fundamentals and purpose of crypto seigniorage and its stablecoins, including how they allow for the existence of decentralised monetary policies.
Supply and demand dynamics have been a factor contributing to the volatility of the cryptocurrency market since the establishment of Bitcoin in 2009. These influences have a direct impact on the price of tokens, regardless of their nature. As a result, stablecoins which are supposed to retain a set price, typically of US$ 1, are at risk of depegging. This is not a problem only specific to the blockchain industry, traditional markets face similar issues with currencies; however, the solution to these problems has been monetary policies dictated by countries’ central banks.
Taking inspiration from the utility of monetary policies on metering supply and demand, Robert Sams, in his 2014 paper entitled “A Note on Cryptocurrency Stabilisation: Seigniorage Shares”, proposed a new type of stablecoin that is algorithmically governed by a smart contract that expands and contracts the token’s circulating supply.
Fundamentals of Crypto Seigniorage
Crypto seigniorage refers to the creation of stablecoins on the blockchain that utilise complex mathematical formulas to ensure price stability. Unlike algorithmic stablecoins which seek to retain their value through being backed by a basket of other tokens, seigniorage tokens have flexible monetary policies based on algorithms that increase and decrease their supply so as to maintain the token’s price. In traditional finance, seigniorage refers to the practice of central banks issuing and buying back debt for the betterment of the economy. With this category of stablecoins leveraging the ideals of seigniorage, it also inherited its name.
Unlike traditional currency creation, which is controlled by central banks, the process of crypto seigniorage is decentralised and open to anyone with the necessary computational power. This decentralisation allows for a greater degree of transparency and security in the currency creation process, as transactions are recorded on a permissionless blockchain that is accessible to all users. Additionally, the decentralised nature of crypto seigniorage can also provide a level of immunity to inflation, as the supply of new digital currency is limited by the computational power of the network.
How Crypto Seigniorage Works
Seigniorage stablecoins do not have reserves held in smart contracts, but instead rely on seigniorage shares to alter the token’s circulating supply. Dependent on supply and demand, these stablecoins will leverage advanced mathematical equations to deploy monetary policies that protect the token’s value.
As such, tokens that deploy a seigniorage approach buy or sell seigniorage shares depending on the price. For instance, if the price of a stablecoin rises above US$ 1, it becomes clear that there is more demand than supply for the token. Subsequently, the algorithm underlying the stablecoin will sell seigniorage shares to generate more tokens, increasing the supply to the extent that it equates to the demand, resulting in the token’s price returning to US$ 1. Conversely, if the stablecoin falls below US$ 1 whereby demand is below the supply, the algorithm will buy seigniorage shares to reduce the supply such that the stablecoin once again becomes worth US$ 1. Notably, the profits obtained from purchasing and selling the shares when protecting the stablecoin’s price are referred to as “seigniorage”. In mimicking a central bank, these types of stablecoins will use the seigniorage profits to purchase the shares when necessary, resulting in a sustainable cycle of stability.
The Purpose of Crypto Seigniorage
Seigniorage has a long history in traditional, centralised markets, where it refers to the process of governments creating new currency by issuing debt. This practice has been used for centuries to fund government spending, and it is one of the primary ways that central banks control the money supply and achieve the goals of fiscal policies. The purpose of seigniorage in traditional markets is to provide a steady flow of new currency to meet the demands of the economy, whilst concurrently allowing governments to invest value into the economy without having to increase taxes.
Crypto seigniorage can play a role in providing stability to stablecoins in a decentralised capacity by focusing on leveraging the token’s supply as opposed to relying on other market participants arbitraging price depegs. Stablecoins are a type of cryptocurrency that is pegged to the value of a fiat currency, commodity, or other assets, and they are designed to maintain a stable value despite market fluctuations. By using crypto seigniorage to create a new digital currency, stablecoin issuers can ensure that there is a sufficient supply of the stablecoin to meet demand without diverging from its intended value. This can help to prevent various forms of price manipulation and attacks that can lead to volatility in the value of the stablecoin.
Decentralised Monetary Policies
Decentralised monetary policies refer to the use of distributed systems and blockchains to manage the supply of money and achieve stability in the purchasing power of money. A key feature of decentralised monetary policies is the use of rules and algorithms rather than human discretion to dictate the supply of money. In a commodity money regime, such as a gold standard, the supply of money is determined by the cost of extracting a new supply of the commodity. This has the advantage of being a monetary policy driven by rules, but it also has the downside of fixing the supply function to an arbitrary process that may not serve the goal of stabilising the purchasing power of money well. In his paper, Sams articulates that with respect to Bitcoin, the supply function is not influenced by the value of Bitcoin at all; instead, the rate of increase in the supply of BTC is determined by the mining difficulty and its supply is capped at 21 million coins.
Seigniorage stablecoins represent a new approach, where coins and shares work together in a decentralised system to achieve the functionality of a fiat money central bank without involving entities and ideologies that oppose that of the cryptocurrency industry, namely banks and centralisation. The essence of a central bank’s operations is the use of its balance sheet to adjust the supply of money. By purchasing assets with newly created money, the central bank can expand the money supply without limit. However, its ability to shrink the money supply is constrained by the value of the assets it holds. Seigniorage shares act as the assets side of a central bank’s balance sheet, and the market capitalization of shares at any point in time fixes the upper limit on how much the coin supply can be reduced. Accordingly, through the use of seigniorage stablecoins, smart contracts can allow for the execution of non-human-led decentralised monetary policies to achieve stability in a novel way.
Ultimately, despite its battle-tested nature in the centralised, banking industry, seigniorage-based stablecoins have not successfully spread throughout the cryptocurrency space. Notwithstanding, a non-collateralised stablecoin can have significant benefits on the DeFi ecosystems as users will no longer need to rely on centralised issuers like Circle and Tether to maintain their stablecoins’ reserves. For this reason, DeFi will be able to have a trustless, decentralised stablecoin that is not at risk of bank runs like Terra’s UST. Clearly, further research and experimentation relating to on-chain seigniorage are needed before this category of stablecoins is capable of becoming an industry-wide standard.
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