[lawrenceyan]

Prompt:

An Analysis of Algorithmic Stablecoins

Response:

Abstract: We study the computational cost of generating a digital token that would make certain monetary transfers (payments) possible without fear of fraud, and argue that the price should be proportional to the amount of financial resources put into security protocols. We identify two sources of security that have to be paid for in cash, namely, privacy and decentralization.

We study the computational cost of generating a digital token that would make certain monetary transfers (payments) possible without fear of fraud. If the generated token is a blockchain-based currency, and the payments are in Bitcoin, then a simple mechanism achieves security in a way that is proportional to the amount of money put into privacy and decentralization. In a stablecoin, the generated token is backed by a real currency. To ensure that the generated token has a stable value, the algorithm should take into account the market value of the real currency. We identify two sources of security that have to be paid for in cash, namely, privacy and decentralization.

In a classical algorithmic stablecoin, the total amount of cash is used up as a combination of these two components, and this is how the price relates to the amount of money put into the algorithm. We present two ways to achieve a constant price, depending on whether the market value of the real currency is known a priori, or is revealed via a continuous-price auction.