What does a sound currency need: Why is it difficult for decentralized systems to achieve true stability?

Author: Zeus

Compiler: Block unicorn

Preface

Currency is the foundation of economic activity, yet we rarely explore the qualities that make currency effective. As digital currencies challenge traditional concepts of money, we need to reassess which characteristics enable currency to fulfill its fundamental functions in the modern economy.

History shows that the definition of currency lies not merely in its technical characteristics, but in its ability to evolve through different stages of development. True currency must undergo a challenging evolutionary path, which most emerging currencies fail to complete.

Complete Currency Lifecycle

To become a fully functional currency, an asset must successfully complete four stages of development:

1. Value Attraction

First, currency must attract capital and attention. Whether through precious metals, government backing, or potential appreciation, all successful currencies begin by enticing people to hold them. This initial allure lays the groundwork for subsequent development.

Without this stage, currency cannot amass the critical mass required for widespread adoption. Many digital currencies excel at this stage, leveraging speculation and network effects to establish initial adoption and liquidity.

2. Scale Development

Second, currency must achieve sufficient scale and liquidity to support meaningful economic activity. It needs enough market depth to avoid excessive volatility from trades; it also requires adequate distribution to ensure that finding counterparties is not overly difficult.

Scale brings credibility, network effects, and the necessary liquidity for broader application. Major cryptocurrencies like Bitcoin have successfully navigated this stage, reaching market capitalizations in the trillions of dollars.

3. Stability Mechanism

Third, currency must develop stability mechanisms that make it reliable in commerce and contracts. Stability does not mean fixed value; rather, it refers to predictability and resilience under market pressures. This requires both technical mechanisms and institutional support.

Many emerging currencies fail at this stage. True stability requires a system that can function normally under various market conditions without collapsing or needing external intervention. This means that currency must possess inherent coping mechanisms to address both excess demand and shortfalls.

4. Economic Utility

Finally, currency must be genuinely practical in ordinary economic activities beyond speculation. It must serve as a reliable unit of account, medium of exchange, and store of value across various economic environments.

True practicality means supporting all financial functions necessary for the modern economy: efficient payments, reliable contracts, reasonable lending markets, and stable planning cycles. This means currency becomes mundane and practical, rather than merely exciting and novel.

Coordination Issues

People often overlook that later stages require addressing fundamental coordination issues that become more challenging as the system scales.

Consider the basic functions of currency, such as providing a last resort function, implementing emergency stabilization measures, or intervening during crises. These functions are essentially public goods. They require entities to prioritize system stability over their immediate self-interests—taking personal risks for the collective good.

In purely self-interest-driven decentralized systems, these critical functions lack structural support. The system may operate well under normal conditions, but it can collapse when stability is crucial.

We repeatedly see this vulnerability in the cryptocurrency market:

During the crash in March 2020, exchanges like BitMEX had to suspend trading to prevent a cascading liquidation that threatened the entire ecosystem with a complete collapse.

On "Black Thursday," MakerDAO required emergency governance responses and community bailouts due to insufficient collateral.

LUNA initially weathered market pressures through large-scale interventions from well-capitalized participants, but it ultimately collapsed when its scale grew beyond what these supporters could stabilize.

These examples reveal a profound truth: although cryptocurrencies theoretically advocate for trustless systems, their survival in crises repeatedly relies on the discretionary interventions of participants with implicit trust.

As the system scales, this coordination problem becomes exponentially more difficult. Issues that may be resolved through informal coordination at smaller scales become impossible once the system exceeds certain thresholds.

Capital Formation Requirements

Beyond stability, a healthy currency must support capital formation—the lending process that drives economic productivity. This is another fundamental limitation faced by existing cryptocurrencies.

The use of crypto assets as collateral is increasing, but they are rarely used as pricing assets for debt. Few are willing to borrow against Bitcoin (BTC) or Ethereum (ETH) due to the uncertainty they present, creating unmanageable risks for both borrowers and lenders.

A fully functional currency must provide a stable unit of account for agreements over time. Whether for borrowers building homes, financing businesses, or developing infrastructure, they need reasonable certainty about the future value of their debts.

Designing a Complete Currency System

The limitations of existing cryptocurrencies are not temporary issues but fundamental design constraints. Assets like Bitcoin and Ethereum are primarily designed for the first two stages of development—value attraction and scale development.

Their fixed or highly constrained supply models create strong incentives for early adoption and speculation. This design excels at initiating value and achieving initial scale, but it becomes a burden when stability and practicality are needed for broader adoption.

Without mechanisms to adapt to changing economic conditions, provide last resort functions, or stabilize during crises, these systems remain fundamentally incomplete as currency systems. They operate well as ownership ledgers but struggle to become fully functional currencies.

Complete Framework for Healthy Currency

Based on these observations, we can define what is needed for a well-structured currency:

• Adaptive supply mechanism: A healthy currency must be able to expand when demand exceeds supply and contract when supply exceeds demand, creating natural stabilizing pressure.

• Last resort function: A healthy currency needs built-in mechanisms to provide liquidity, stability, and intervention under market pressure without requiring external coordination.

• Productive reserve utilization: A healthy currency should utilize its accumulated value for productive purposes rather than letting it sit idle or dissipate, creating sustainable value for the system.

• Lending market foundation: A healthy currency must provide the stability needed for the development of functional lending markets, allowing for capital formation without excessive risk.

• Transparent health indicators: A healthy currency should provide clear indicators of system health, enabling participants to make informed decisions based on fundamental strengths rather than merely market sentiment.

The historical development of traditional currency systems is not coincidental—these characteristics evolved because they are essential for currency to function under diverse economic conditions.

Bridging the Gap

This analysis does not deny the achievements of cryptocurrencies. Bitcoin and other cryptocurrencies have made extraordinary strides by successfully completing the first two stages of development—demonstrating that it is possible to initiate a non-sovereign currency system through market incentives.

Their success has provided crucial strategies for the initial stages of currency evolution. The core insight is that a complete currency system must consider its ultimate mature state in its design while still addressing the early stages of evolution.

Currency technology needs to balance mechanisms for initial growth and speculation while providing pathways for stability and practicality once sufficient scale is achieved. They must combine the launch capabilities that have made cryptocurrencies successful with the adaptive mechanisms currently lacking.

Conclusion: The Path to Healthy Currency

The evolution of currency is not merely a technical issue but a matter of addressing the coordination problems that increase with scale. A healthy currency must be designed to operate throughout its entire lifecycle—from initial adoption to mature application—equipped with mechanisms to adapt to changing conditions without continuous external intervention.

This does not mean reverting to fully centralized systems but rather designing a well-structured system that incorporates the mechanisms necessary for currency operation. This means creating currency that is effective not only under optimal conditions but also across various economic scenarios.

As we continue to develop digital currencies, these insights provide a framework for assessing their potential. We should not focus solely on technical characteristics or short-term price appreciation but consider whether a currency possesses the complete structural elements necessary to perform quality currency functions throughout its entire evolution.

The future of currency does not belong to those with the most advanced technology or the strongest initial growth but to those systems that fully understand the actual mechanisms of currency operation at the time of design.