Astute readers will recognize that an interest bearing asset of limited supply may trade higher or lower than the underlying asset depending upon other opportunities to earn interest on the same asset. With an high interest rate paid on an asset pegged to a dollar many people will bid up the limited supply of Steem Dollars until they are no longer valued at $1. In economics there is a principle known as the Impossible Trinity4 which states that it is impossible to have all three of the following at the same time:

 

  1. A stable exchange rate

 

  1. Free capital movement

 

  1. An independent monetary policy

 

If Steem feed producers aim to have an independent monetary policy allowing it to create and destroy Steem Dollars while simultaneously having full control over the interest rate then they will encounter problems. The Impossible Trinity says that Steem Dollars either need to restrict capital movement, have an unstable exchange rate with the dollar, or have limited control over the interest rate.

 

The primary concern of Steem feed producers is to maintain a stable one-to-one conversion between SBD and the U.S. Dollar (USD). Any time SBD is consistently trading above $1.00 USD interest payments must be stopped. In a market where 0% interest on debt still demands a premium, it is safe to say the market is willing to extend more credit than the debt the community is willing to take on. If this happens a SBD will be valued at more than $1.00 and there is little the community can do without charging negative interest rates.

 

If the debt-to-equity ratio is under 10% and SBD is trading for less than $1.00 then the interest rate should be increased. This will encourage more people to hold their SBD and support the price.

 

If SBD trades for less than $1.00 USD and the debt-to-equity ratio is over 10% then the feeds should be adjusted upward give more STEEM per SBD. This will increase demand for SBD while also reducing the debt-to-equity ratio and returning SBD to parity with USD.

 

Assuming the value of STEEM is growing faster than Steem is creating new SBD, the debt-to-equity ratio should remain under the target ratio and the interest offered benefits everyone. If the value of the network is flat or falling, then any interest offered will only make the debt-to-equity ratio worse.

 

In effect, feed producers are entrusted with the responsibility of setting monetary policy for the purpose of maintaining a stable peg to the USD. Abuse of this power can harm the value of STEEM so VESTS holders are wise to vote for witnesses that can be counted on to adjust the price feed and interest rates according to the rules outlined above.

 

If the debt-to-equity ratio gets dangerously high and market participants choose to avoid conversion requests, then the feed should be adjusted to increase the rate at which STEEM paid for converting SBD.

 

Changes to the interest rate policy and/or any premiums/discounts on the STEEM/SBD conversion rate should be a slow and measured response to long-term average deviations rather than attempting to respond to short-term market conditions. The blockchain is paying liquidity providers for their service in absorbing short-term demands.

 

It is our belief that these rules will give market participants confidence that they are unlikely lose money by holding SBD purchased at a price of $1.00. We fully expect there to be a narrow trading range between $0.99 and $1.01 for SBD under most market conditions.

 

Source: Pages 13 and 14 of The Steem Whitepaper