Stablecoins & the Crypto Monetary System
Nothing backs this peg. A rule does — and only while it is believed.
No dollar in a reserve account, no over-collateralised crypto. Supply expands and contracts by rule, and a second, volatile token takes the strain. Elegant on paper. This lesson is about what it does under stress.
The problem
Run the rule yourself. Then let doubt in.
Two presses show the mechanism working exactly as designed — and it does work. The next press changes one thing only: how many people want to hold the second token. Everything after that is arithmetic.
The rule, by hand
ILLUSTRATIVE · MODELLED FIGURESThe peg is holding and nothing has happened yet. Press Price above target — mint.
That is the whole design, and there is nothing foolish about it. Above the target the rule mints; below it, the rule burns stablecoin and mints the second token to absorb the value leaving. No reserve account had to be funded, no collateral had to be locked — which is exactly the capital efficiency the model was built for. Notice what it quietly assumes: that somebody wants the newly minted second token at roughly the price it had a moment ago.
Nothing in the code changed. What changed is that fewer people wanted to hold the second token — and the mechanism's own response made that worse. Absorbing value means minting the second token; minting it pushes its price down; a lower price means the next round has to mint far more of it. That is reflexivity: the fix feeds the failure. By the last round the token that is supposed to absorb the shock was worth a fraction of a single round's outflow, and no amount of minting can make a buffer carry more than the market is willing to hold. The failure mode is about liquidity and confidence under stress, not about the rule being badly written.
Illustrative model. Every figure here is invented to show the shape of the mechanism the source describes. It is not any asset's price history, and it is not a forecast.
The definition
Three claims the spiral just made concrete.
Tap each card for what sits underneath it.
Hands on
Three situations. The rule has one answer for each.
No reserve account is involved anywhere below. Pick a situation and read what the rule does there — visit all three to unlock the summary.
Pick each of the three situations above.
The bridge
Four steps, and each one causes the next.
This is the sequence you ran by hand, written out.
That loop has a name: the death spiral — a self-reinforcing downward spiral in which the system can no longer absorb enough value. It is not a thought experiment. In May 2022 TerraUSD (UST) went through it: confidence tipped, the arbitrage mechanism failed, UST lost its peg, the linked token LUNA broke down with it and the system collapsed. Be precise about what went wrong there. The intended strength — capital efficiency, with little capital tied up — was real. What failed was that in a stress phase stability needs genuine liquidity and genuine confidence, and a theoretical mechanism could supply neither. Next we leave the models behind and look at how stablecoins are actually used: Stablecoins in DeFi.
Check yourself
Five questions.
Answers come straight from this lesson. Submitting completes it.