Reserve banking

The price of iron from fractional reserve banking

Today saw the collapse of Iron Finance, issuer of a so-called “stablecoin” called IRON which is now worth much less than the dollar it is supposed to be pegged to. This is obviously bad, because the whole point of a stablecoin is to be stable.

Stable coins are important. They are widely used by crypto speculators and day traders as supposedly safe places to park their money between trades, without the hassle and expense of converting to dollars. This demand has made the category competitive, and Iron’s collapse is a big black eye, not just for its creators, but for other tokens that take a similar approach – commonly referred to as coins. stable “algorithmic”.

David Z. Morris is the chief ideas columnist for CoinDesk.

Algorithmic stablecoins are at least one of three varieties. Fiat backed stablecoins such as Circle’s USDC are fully backed by traditional currency. A second category is crypto stable coins, such as MakerDAO’s DAI. Dai is oversized to increase stability in the event of a crypto crash (which creates some problems in itself).

(Tether, somewhat the most widely used stablecoin, is in a messy category on its own.)

Finally, algorithmic stablecoins use less of an individual medium and a complex web of automated transactions and issuances to maintain a fixed price. The details of these systems are spectacularly obscure.

Iron Finance’s stablecoin (IRON) was 75% backed by USDC, which is fully dollar-backed. The remaining 25% of the support was provided by TITAN, a “sharing token” or “balancing token” also created by Iron Finance itself. The Titan token was burnt or printed as needed to maintain Iron’s dollar peg. (The Daily Gwei has a more detailed breakdown of the IRON system.)

Other algorithmic coins may be more sophisticated or robust than those built by Iron, but most use a similar multi-token system. You can begin to see the central intractable problem: in very general terms, these projects are fractional reserve banks. Bitcoiners and other “hard money” proponents hate fractional reserve banks like vampires hate garlic because of the risk of exactly the kind of disaster that befell Iron.

Things took a turn for the worse for Iron starting on Wednesday night when the value of the Titan stock token fell from $ 65 to $ 60 – then quickly to what I’ll just call “effectively zero.” The drop was so steep in part because, once Titan fell just a little too low, the incentives behind stablecoin turned perverse, creating an arbitrage opportunity that was ruthlessly exploited. The role of arbitration parallels the fall in the peg of the english pound in the late 1980s, and it will be interesting to find out who made the George Soros’ money in this crypto-replay.

The creators of Iron attempted not only to justify, but apparently to glorify their failure by asserting in a post-mortem that “we have just experienced the first large-scale banking race in the world”. To which I would say two things: a) No, you haven’t, and b) those words don’t mean what you seem to think they mean.

First, the “world’s first large-scale crypto banking race” occurred in 2014, when customers around the world struggled frantically to get a total of 850,000 BTC from Mt. Gox, one of the first bitcoin exchanges. These were worth around $ 425 million back then, or about $ 33 billion at today’s prices. And the customers were right to scramble: Despite soothing assurances from officials, Mt. Gox really didn’t have their money. Most of it was lost in an apparent hack, and in January 2021, only about 23% bitcoins from depositors were recovered.

It’s unclear how much iron holders lost, but the Protocol in its heyday had $ 2 billion in collateral on its books. Even though it’s all gone, compared to Gox, these are beginner numbers.

There is another difference here. Mount. Gox actually had the money at one point and then lost it. But the whole point of Iron and other algorithmic coins is that the money isn’t really there in the first place: regardless of Titan’s intricate engraving or printing rules, Iron was always a dollar-denominated token backed only 75% by anything that looked like it. dollars. This is ultimately why a slight fluctuation in price led to sales of death spiral panic: everyone wanted out before bottom of the barrel was in sight.

So just like with Mt. Gox – and despite what Iron Finance maintains in its aw-shucks-no-apologies – this bank rush did not cause the collapse of the system. Here is a fantastic quote on the subject from banking economist George Kaufman:

“The fable is that a rush can bring down a solvent bank. What a rush does is, it causes an insolvent bank to be recognized as insolvent.

Kaufman was not talking about Mt. Gox or Iron, but about Enron, a company that was basically a really big bottom-up leverage scam. Through his masterful (and perverse) manipulation of the rules of fairness and accounting, Enron has spent more than a decade supporting its stock price by essentially printing its own currency, in the form of varieties of stocks in it. itself and in its subsidiaries.

He used that money, in various obscure maneuvers, to buy parts of himself from other parts of himself, and then count those sales as reported income on Wall Street. This is how Enron’s income and shares have managed to grow at an impressive and steady rate. It was all wrong, and eventually it became clear to the public.

Are all algorithmic stablecoins subject to the same risk? Can you print your own money and then move it around in a sophisticated enough way that somehow it becomes worth 25% of a real dollar? I remain ready to be convinced. But until that happens, my personal guess is that algorithmic stablecoins are essentially magic beans. Mark Cuban Now wants them to be regulated, but in the meantime, you can protect yourself from another “classic bank run” by simply staying out of the way.

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