When a dollar is not a dollar

This article was originally published Economic power Newsletter

One of the things banks do is allow you to take real money and deposit it in your account with them. You pay them a $ 100 bill and the bank credits your account 100. They let you come back and get your $ 100 back whenever you want. You can wait a week or a year or five minutes. When you show up and ask for your $ 100, they will pay you বিল 100 bill (or five $ 20 bill or ten $ 10 bill, you get points). In short, when you deposit that hundred-dollar bill, the bank creates a 100 liability. To better off that liability, they keep some $ 100 bills in hand when you show up.

Now, banks just don’t hold on Everyone The money that people deposit is lent to some borrowers, or used to buy certain kinds of assets. Thus, the bank makes money when it issues liabilities because its dollar liabilities outweigh the physically contained dollars. Since banks are issuing dollar-defined liabilities, they need some way to make sure your dollar value is one dollar. Banks do this by retaining a few dollars in reserves. When you show up to get your $ 100, they have a $ 100 bill waiting for you. It may not be like the $ 100 bill you left there, but it’s a $ 100 bill and a $ 100 bill is fungus and so it’s good for you.

The dollars held by the bank are only a fraction of the deposit liabilities they issue. On any given day, there are a number of people who make new deposits and a number of people who withdraw. Sometimes the deposit is more than the withdrawal and sometimes the withdrawal is more than the deposit. Sometimes these extra deposits or withdrawals are predictable. Other times, they don’t. To deal with this kind of thing, banks will keep some buffer of dollars to cover unexpected extra withdrawals. Until everyone comes to pay their dues at once, that’s fine. Of course, if everyone shows up, some people will be able to get their dollars and some people won’t. Most of the time this is not a problem. You promise people that your দায় 1 liability is worth $ 1 and you make sure it’s true by holding on to some real, physical dollars.

Forget all about saying an alternative to it. I can issue dollar liabilities and I don’t need any dollars. I can only promise that my dollar liability is worth one dollar. If someone comes to me with that liability and says “I want my dollars,” I can say, “You have one. It’s as good as a dollar. You have my word.”

This is clearly different from how a traditional bank works. Banks hold real dollars and give them to people who want to redeem their digital dollars for real dollars. But banks need a lot of overhead. You need building and bank vaults and bank tellers. Who needs all that?

Instead, you can just go with my plan and just issue dollar liabilities and save no dollars and no money to pay the bank tellers and no worries about the bank vault. You can only make one promise.

You may say that my plan sounds silly, but you haven’t heard the whole thing. Instead of having a bank, I’m going to issue my dollar liability in a blockchain and everyone likes blockchain, so my plan seems a little better now.

Now that I’ve got your attention, you’re probably wondering how I’m going to stop it. I’ll just use supply and demand. I issue this liability and I tell everyone it’s worth a dollar, but I issue it in blockchain and these blockchains have decentralized exchange. This means that my obligation will be to trade in a secondary market. But since I understand supply and demand, that’s fine. I determine supply and those who use blockchain determine demand. That way, when my liability is above 1, I will increase the supply. When the price is below $ 1, I will reduce the supply. My knowledge of supply and demand is therefore what is needed here. Fool’s bank.

But wait, you wonder, how can I increase or decrease the supply? Increasing supply can be easy. I can figure out a way to send it to some digital wallet at random. After all, it’s a blockchain (I mentioned it’s a blockchain, isn’t it?) Of course, reducing supplies would be hard to do because I can’t simply remove my dollar obligations from a random digital wallet.

Don’t worry, I have a plan. I have studied financial policy for years. When the Fed seeks to increase or decrease the money supply, it conducts open market activities. When I want to increase supply, I can buy something from people. When I want to reduce supply, I can sell something to people. However, unlike the Fed, I can’t really force dealers to trade with me.

I have to be creative. Here’s my idea: I can issue a second liability. However, unlike other liabilities, it will have a free-floating value. To motivate people to do what I want to do, I will create an arbitration opportunity to encourage trade. When my dollar liability is traded above one dollar, people can trade ড X flexible value liability for a new unit of my dollar liability. Since the dollar liability is traded above one dollar, it is a risk-free gain for the trader. When my dollar liability is traded below one dollar, I will allow people to sell me X units of dollar liability for a flexible price liability of $ X. For example, if my dollar liability value is $ 0.90, they can give me that liability and I will give them a flexible value liability of $ 1. Risk-free gain of $ 0.10.

This arbitration opportunity allows me to reduce the supply of my dollar liabilities when my dollar liability trades at a discount and increases the supply when my dollar liability trades at a premium. For a given level of demand, these changes in supply will ensure that the value of my dollar liability is actually equal to 1.

I have thus created a dollar obligation that requires a zero dollar reserve, using the basic principles of supply and demand, and has a market-based monetary policy to keep everything working.

Unfortunately, my plan does not consider a few factors. I have created two resources from thin air, and these resources are self-reference. One of my worthless assets is used to make arbitrary profits with my other worthless assets. As long as everyone is willing to play the game and benefit from the arbitration, it works. But suppose someone decides to deviate from the game. This can affect expectations. For example, suppose someone starts shortening both resources. This lowers the value of both assets. If people think that prices will continue to fall, then this will reduce demand. In terms of my dollar obligations, this is fine as long as supply is declining faster than demand. If so, the price will be higher. But remember, when the supply of dollar liability decreases, I am increasing the supply of flexible price liability. So flexible price liability has increasing demand and increasing supply. The price falls because of these two.

Regardless of whether dollar liabilities are rising or falling, it must be that flexible liabilities are falling (and the value of dollar liabilities is falling faster than any fall). If my flexible price liability price is expected to fall faster than the dollar liability price, then the arbitrage opportunity no longer works. I don’t want to trade সম্প 0.90 on one asset if I expect this other asset to be reduced by 20 percent. Thus, I have an incentive to sell dollar liability for some other asset, which further lowers the price. As a result, the value of both my worthless assets goes to zero.

So anyway, a few weeks ago TerraUSD broke its peg from the stablecoin dollar and the flexible price of the protocol broke with the LUNA token, and now you know why.

Joshua R. Hendrickson


Joshua R. Hendrickson is an associate professor of economics at the University of Mississippi. His research interests include financial theory, history and policy. He has published articles in leading scholarly journals, including the Journal of Money, Credit and Banking, the Journal of Economic Behavior and Organization, the Journal of Macroeconomics, Economic Inquiry, and the Southern Economic Journal.

Hendrickson earned his PhD. In Economics from Wayne State University. He earned a BA and MA degrees in economics from the University of Toledo.

Receive notifications of new articles from Joshua R. Hendrickson and AIER.

Leave a Reply

Your email address will not be published.