To say that Bitcoin and cryptocurrencies have been extremely volatile would be an understatement. So much so that it’s been the butt of jokes lately.
But why has Bitcoin been so volatile?
One answer deals with the fact that prices are a function of the supply and demand of goods. The money supply of Bitcoin increases at a fixed rate every 10 minutes until it reaches the limit of 21 million BTC. Because the total supply of Bitcoin is fixed by an algorithm, changes in the demand of Bitcoin cause the price of Bitcoin to fluctuate accordingly, and the money supply can’t expand or contract to compensate for the changes in demand and keep the price stable.
The price volatility of cryptocurrencies has thus created a huge demand for stablecoins. In fact, Tether already has a market cap of $1.3 billion. 
Pegs and Stablecoins
A currency peg is a method of stabilizing a currency by fixing its exchange rate to another currency. Currency pegs enable countries to create a stable trading environment without wild fluctuations in the exchange rate.
Stablecoins, such as Basecoin, are cryptocurrencies that peg to the USD or other assets. The money supply of stablecoins is algorithmically expanded and contracted to maintain the peg. If the price of a stablecoin increases relative to the USD, then the money supply of the stablecoin expands. Likewise, if the price of a stablecoin decreases relative to the USD, then the money supply of the stablecoin contracts.
To maintain a peg, a country needs to accumulate large reserves of foreign currency. This is because if the country needs to appreciate its own currency to maintain the peg, then it can buy its own currency on the market using its reserves of foreign currency. The country can also raise interest rates and contract the money supply to attract foreign demand for its currency, thereby causing appreciation. Similarly, if a country needs to depreciate its own currency to maintain the peg, then it can sell its own currency on the market, lower interest rates, and expand the money supply.
Pegs are commonly used throughout history. For instance, from 1944 to 1971 most of the developed world was under the Bretton Woods system. To maintain stability in the international economic system after World War II, the USD was pegged to gold and other countries pegged their currencies to the USD as a global reserve currency. Over the course of 25 years, other countries exchanged their USD foreign reserves for gold, slowly draining Fort Knox of gold. This led Nixon to terminate convertibility of USD to gold, and the USD has remained a free-floating fiat currency ever since.
One common concern for stablecoins, or any pegged currency, is the possibility of a Soros attack. A Soros attack is when a malicious actor tries to break a peg. This is a reference to when George Soros made over $1 billion in a single day in 1992 shorting the British pound to break the Bank of England’s peg to the German Deutsche Mark.
We’ll come back to the details on how Soros broke the Bank of England and how this concern affects stablecoins, but first we need to know what the impossible trilemma is.
The Impossible Trilemma
According to the impossible trilemma, it is impossible to achieve all three of the following goals at the same time.
- Free capital flow (i.e. no capital controls). Capital mobility lets a nation’s citizens diversify their holdings by investing abroad. It also encourages foreign investors to bring their resources and expertise into the country.
- A fixed foreign exchange rate (i.e. a peg). A volatile exchange rate, at times driven by speculation, can be a source of broader economic volatility. Moreover, a stable rate makes it easier for households and businesses to engage in the world economy and plan for the future.
- A sovereign monetary policy. The central bank can increase the money supply and reduce interest rates when the economy is depressed, and reduce the money supply and raise interest rates when the economy is overheated.
A central bank can only achieve two of the three goals simultaneously. Attempts to achieve all three have caused financial crises such as the 1997 Asian financial crisis.
In the 1990s, short-term interest rates of East Asian countries were higher than those in the United States. Free capital flow and pegs to the USD encouraged foreign investors to invest enormous amounts of money in Asian countries without the risk of exchange rate fluctuation. While the Asian countries trade balance was favorable, the investments fueled an overheated economy. But when the trade balance reversed, investors quickly pulled their money, triggering the financial crisis. Eventually countries such as Thailand ran out of USD reserves and were forced to let their currencies float and devalue. 
That said, what does choosing two of the three goals look like in practice?
Option A is to have free capital flow and fixed exchange rate. In the Eurozone, the nations are bound together by a single currency, the euro. French companies doing business in Germany face no exchange rate risk. There is free flow of capital throughout the Eurozone. But the participating nations have given up the ability to conduct their own independent monetary policies. This makes it more difficult for the countries to alleviate an overheated or depressed economy.
Option B is to have free capital flow and sovereign monetary policy. The United States uses monetary policy to maintain price stability and full employment. There also exists free flow of capital in and out of the country. But for the exchange rate — it is what the market determines.
Option C is to have fixed exchange rate and sovereign monetary policy. China uses monetary policy to promote domestic economic goals while managing the exchange rate to promote export-oriented industries. To do so, the government controls the flow of capital in and out of the country — both how much money Chinese citizens can take out of the country and how much foreign firms can invest in China.
What does this mean for stablecoins?
Stablecoins, by definition, are currencies with fixed exchange rates. So the two remaining options are to either choose free capital flow or sovereign monetary policy.
Option C, which chooses sovereign monetary policy but gives up free capital flow, seems unlikely. The purpose of a decentralized digital currency is to allow transactions to take place among trustless parties without the need for an intermediary. Implementing capital controls would require a central decision maker (or algorithm) to determine when the stablecoin can’t be exchanged for other currencies, which contradicts the whole purpose of using cryptocurrencies. 
So this leaves us with Option A: choose free capital flow and give up sovereign monetary policy. Not doing so is the reason why the Bank of England was broken. As mentioned earlier, one way for governments to appreciate their currency is to take their reserves of foreign currency and buy up their own currency on the open market. The British government spent about £27 billion of its foreign reserves buying up pounds to no avail (other investors had learned about Soros’s trade by then and were also shorting the pound). The only option left was for the British government to raise interest rates to attract people to buy pounds. But the British economy was in a recession at the time, and raising interest rates during a recession would further contract the money supply and be disastrous for the economy, not to mention political suicide. So the Bank of England broke the peg and let the British pound sterling float with the German Deutsche Mark. 
If a stablecoin ever becomes the de facto currency for all transactions in the economy, it is inevitable that there will be periods of recession. Since the stablecoin has relinquished its duty of monetary policy, it isn’t able to pursue inflationary policies such as buying bonds and lowering interest rates when the economy is depressed. And if someone attempts a Soros attack during the recession, the stablecoin’s algorithmic central bank would automatically contract the money supply to counter the attacker and thereby worsen the recession.
Thus, stablecoins are subject to the impossible trilemma and, in achieving their stability, make a conscious choice to give up monetary policy. This is politically popular in the short-term, but without the ability to use monetary policy to alleviate an overheated or depressed economy, it would be difficult for stablecoins to become a world currency in the long-term.
 Tether is a cryptocurrency where you pay one USD for one Tether and burn one Tether to get back one USD. But this is the same as using USD — just on the blockchain.
 Trade balance is the difference between the monetary value of a country’s exports and imports over a certain period. A depreciated currency causes trade balance to be positive and favorable; an appreciated currency causes trade balance to be negative and unfavorable.
 Note that capital controls would obviate a Soros attack by preventing Soros from exchanging British pound sterling for German Deutsche Mark.
 Governments have raised interest rates during recessions before. One big reason why the Great Depression was so bad was because countries raised interest rates to maintain their pegs to the gold standard, which further contracted the money supply.