starspirit, do I understand this correctly: the proposed way to balance supply and demand to create a peg equilibrium is to allow a negative yield? (as well as a positive yield)
Doesn't that mean that if you hold bitUSD while there is negative yield you are essentially getting charged a negative interest rate? Won't this be a hard sell for the general public?
Well, that's a good question monsterer, that I've been debating with myself for a while, and have not reached an absolutely firm view on yet - i.e. is the possibility of negative yield needed at all? Here's some food for thought...
The yield is determined by the free market as the level that equates a pegged currency at parity with its real equivalent for the marginal buyer and seller. So
by definition, it
must be acceptable to all the current holders of the pegged currency.
Forcing any other yield on the market creates a situation where either supply falls (forcing a higher than natural rate), or demand falls (forcing a lower than natural rate), either of which means that the quantity on issue and in use would be less than if the free market had determined the rate. That's the advantage of flexible yield - in that in maximises and stabilises the quantity on issue as yields can adjust for supply or demand shocks.
Now why would the free market choose a negative yield? Its important to note that this is likely to be very rare. But it is a far more likely situation in the current global environment of suppressed interest rates.
The yield on a pegged currency is normally going to move with external interest rates due to arbitrage. But it would move around that depending on relative supply and demand. For example, it could be higher if issuers/shorts are positively motivated (e.g. crypto bull markets) or lag if they are negatively motivated (e.g. crypto bear markets). In any case, the current environment of zero to negative external rates (after fees) in some currencies like USD or EUR could well lead to a free-market yield in the pegged currency that might calibrate at zero or below.
While bond markets can reflect negative yields very easily by trading above par, negative rates in an at-call market require an actual payment from longs. Cash holders will seek to avoid this if they can. That's exactly why some economists have been recently calling to ban cash, and force people into deposits where they cannot avoid such charges (a proposal I'm against BTW).
Although negative rates are theoretically possible, it's a profound question as to whether negative interest rates on a pegged currency should be allowed or not, even if that's where the free market would calibrate. On the one hand, if external interest rates can go negative after fees, why not for the pegged currency? But its possible for example that even if rates were positive, the mere possibility that they might be allowed to go negative, could be seen as a controversial or negative feature by the market, reducing demand at all times. Like I said, I can see both sides of an argument here.
If we decided we did
not want to cross the zero bound, it would not "break" this or any other pegging system. It could still operate. The result of forcing the rate to remain at zero when the natural rate is negative, would be to:
i) reduce the supply of the pegged currency, perhaps dramatically or completely in some extreme situations where shorts demand compensation to participate, and
ii) the peg would break and a large premium develop.
This may not be the end of the world if these situations are rare, but its bound to be an issue of debate also.
Sorry for the long post - but its a complex issue, and not one that is black and white.