Stablecoin price dynamics under a peg-stabilising mechanism

Abstract

Stablecoins are created in various public or private blockchains, and their growing uses include payments, settlements, lending, and even as safe assets in periods of turmoil. They are designed to maintain credible price stability similar to that of a currency pegged to another currency (e.g. the US dollar) operated under a currency board monetary system. To study the peg-stabilising mechanism for stablecoin prices and associated dynamics, this paper uses the analogy of a currency board and the theory of the quasi-bounded target zone model based on the standard flexible-price monetary framework. The solution to the model equation illustrates that the price is more stable in a narrower trading bandwidth and less sensitive to changes in the fundamental variable (i.e. demand for stablecoins) with a stronger stabilising force in the fundamental dynamics. The empirical results using the stablecoin Tether demonstrate that the model can describe Tether’s price dynamics. The mean reversion in the Tether price dynamics representing the stabilising force is positively related to market liquidity in the stablecoin market and volatility in the price of Bitcoin, suggesting that the increased market liquidity and safe haven characteristic of Tether stabilise its price. Tether’s blockchain migration with a larger investor base enhanced the peg-stabilising mechanism. This paper also discusses the implications for prudential treatment of stablecoins, including trading bandwidths, market liquidity condition, and the quality of backing reserves.