From Nixon to Nakamoto

10 min readOct 8, 2018

Algorithmic Stability and the Role of Automated Monetary Policy in the Decentralized Economy

A Brief History of Money

Money can be analyzed using three key functions: as a medium of exchange, a unit of account and a store of value.

The Histories of Herodotus teach us that the Lydians were “the first of men, so far as we know, who struck and used coin of gold or silver”. The Lydian “stater”, created from a mixture of gold and silver known as electrum, is largely considered to be the first currency ever created. The key feature that distinguishes the stater from other forms of money was the fact that it was issued by a central authority. The markings of a lion’s head, the symbol of Lydian royalty on the coins make the stater the first “official” currency of any government, designated for widespread use within the Kingdom of Lydia.

This was to be the model from which all subsequent iterations of standardized coinage are based, from the drachma in Ancient Greece to the florin in Renaissance Italy.

Marco Polo’s return from his travels in China would be Europe’s first introduction to paper money, initially adopted by merchants in the form of promissory notes (a standard of deferred payment is sometimes considered to be the fourth function of money). Beginning with Sweden in the 17th century, it became common practice for European central banks to issue banknotes, as paper money became the most common form of legal tender.

As will be discussed in more detail later, it is important to note that up until the 20th century, the predominant global monetary system was the gold standard, which dictates that money can be converted to gold.

The introduction of currency, the move to paper money and the eventual move away from gold lead us to the current state of affairs: a world in which more than 90% of the entire globe’s currency is digital.

Decentralization

Satoshi Nakamoto’s publication of a paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” in 2008 would prove to be a symbolic event in the context of the economic and financial history of the world. What ultimately differentiates Bitcoin from the aforementioned forms of money is the lack of a centralized authority. This is a fundamental pillar of blockchain technology- summarized concisely by R3’s CTO Gendal Brown:

“A distributed ledger* is a system that allows parties who don’t fully trust each other to come to consensus about the existence, nature and evolution of a set of shared facts without having to rely on a fully trusted centralized third party.”

One of the most common definitions of blockchain technology is the following, provided by IBM’s Chief Technology Leader, Ed Corno:

“A shared, replicated, permissioned ledger with consensus, provenance, immutability, and finality.”

Consensus: agreement on a shared set of facts
Provenance: authentication of ownership
Immutability: information cannot be altered or removed
Finality: once confirmed, the transaction will not be reversed or revoked

Looking back at the basic functions of money, cryptocurrencies are an effective medium of exchange due to the above properties, yet they fall short of being considered good units of account or a reliable store of value.

Over the course of 2017, the cryptocurrency space saw arguably the largest bull run in the history of financial markets, growing from below $20B to over $600B before the end of the year. Despite this incredible growth in value, only a minuscule fraction of the world’s largest retailers accept Bitcoin, let alone other forms of cryptocurrency.

This is because the largest impediment to the mainstream adoption of digital currencies as an everyday means of payment for businesses is volatility.

Although Bitcoin recently ended the month of September having traded within a relatively meagre range of 1'500 USD (the lowest volatility since July 2017), the value of other digital currencies still fluctuates significantly in comparison. Just recently, on September 26th, Ripple (XRP), the 3rd largest cryptocurrency by market cap rose by nearly 60% in the space of just 12 hours.

Whilst this is good news for traders, the price movements experienced are enough to dissuade the vast majority of merchants. The risk is simply too great- why would retailers accept a form of payment for goods and services which may be worth significantly less the following day?

The Potential of Stablecoins

Described as the “Holy Grail” of cryptocurrency, stablecoins are the latest trend in the space and aim to solve precisely this problem. Stablecoins are defined by 1confirmation founder Nick Tomaino as cryptocurrencies with “price stable characteristics”. Whilst most would associate stablecoins with being backed by reserves of a “real” asset such as Gold or the U.S. Dollar, non-collateralized, or algorithmically stable coins are the latest generation of this emerging class of digital assets.

In order to differentiate between collateralized and non-collateralized stablecoins, we should start by looking at the most renown (and controversial) example: Tether (USDT).

Released in late 2014 by the founders of BitFinex, one of the largest exchanges in the world, Tether is the largest stablecoin in terms of market capitalization. The premises are relatively straightforward, every Tether token is backed at a 1:1 ratio by the U.S. Dollar. Essentially, it operates under the assumption that for every USDT token in circulation, Tether Holdings has the equivalent quantity in its reserves.

Today, that equivalent amount is nearly $3 billion, and Tether is ranked as the 8th largest cryptocurrency by market cap (at the time of writing). Its appeal is evident- in the event of cryptocurrency prices rapidly falling, traders can simply convert their holdings into USDT and avoid major losses.

The problem? Despite repeated claims from Tether that any tokens in circulation are fully backed by U.S. dollars, they have never been successfully audited by a major public accounting firm. Numerous other “fiat collateralized” stablecoins have emerged such as TrueUSD (a more compliant version of Tether), and the Winkelvii’s very own “Gemini dollar”, regulated by the New York State of Department of Financial Services.

Although the name “fiat-collateralized” would indicate that reserves of a particular currency would be necessary, this same concept can be applied to any physical good: there are numerous projects that involve pegging stablecoins to assets such as gold, oil or even diamonds. The major impediment to fiat-collateralized stablecoins is that they are ultimately considered centralized- a trusted custodian is needed to ensure the storage and security of the underlying asset being tokenized.

Crypto-collateralized stablecoins offer a decentralized alternative to the above, they instead rely on a cryptocurrency (or basket of cryptocurrencies) as collateral. Notable examples include MakerDAO, Havven and BitShares.

However, as mentioned at the beginning, cryptocurrencies are volatile in nature, and the only way to maintain a stable price is to over-collateralize in order to account for any significant fluctuations in price. Although the concept is interesting, the over-collateralization factor makes them less capital-efficient than stablecoins backed by physical goods, and they are ultimately vulnerable to significant price drops.

The end goal for stablecoins is to ultimately attain price stability independent of any other asset class.

The Illusion of Money

Up until 1971, the world’s most dominant currency, the U.S. Dollar was fixed to an equivalent amount of gold. Known as the Bretton-Woods system, the currencies of the United States, the majority of Western Europe (including France, Great Britain and Germany), Canada, Japan and Australia relied on the “gold standard”, in the interests of exchange rate stability. This was largely based on the fact that since the 1800s, the value of currency largely depended on gold due to its uniquely distinguishable features: scarcity, durability, and divisibility. The currencies of the aforementioned countries were therefore pegged to the U.S. dollar and could exchange their dollars into the equivalent quantity of gold.

This worked well, up until a myriad of European nations, starting with Charles de Gaulle’s France in 1965 started redeeming their dollars for gold, exposing its inflated valuation. This was largely due to rapid economic growth in nations recovering from the Second World War as well as the deficit caused by exorbitant military spending due to the Vietnam War. In short, the dollar had become overvalued in relation to gold- Fort Knox did not contain nearly enough gold to account for the immense foreign debt the U.S. had accumulated.

In order to protect the dollar’s position as the “pillar of monetary stability around the world”, President Nixon essentially severed the ties between the U.S. dollar and gold. To this day, the currency as backed by nothing more than an undeterred faith in the Federal Reserve.

Algorithmic Stability

If the world’s most powerful currency today is backed by “nothing”, why shouldn’t the same logic be applied to stablecoins? This leads us to algorithmic stability, wherein value is derived from supply and demand.

In essence, the role of the Federal Reserve or any other central bank would be performed through a smart contract.

Where exciting and disruptive innovation occurs, money follows. In April of this year, Google Ventures, Andreessen Horowitz and Bain Capital invested $133 million into Basis, a startup with the end goal of creating a “Central Bank on the Blockchain”. They aren’t alone: other exciting projects in the space include Carbon, Reserve and Fragments.

Basis is of particular interest as their model is purely based on the quantity theory of money. In order to protect against deflationary spirals, central banks create more money when prices fall, in short, the capacity the deflate and inflate according to economic conditions. The Basis protocol employs a three-token system, composed of:

Basis tokens
Basis bonds
Basis shares

The first of these is intended to be the stablecoin, the medium of exchange, pegged at $1 (although their whitepaper states that it can be stabilized against essentially any asset class). Supply of Basis tokens is expanded and contracted through a smart contract in order to maintain the peg, aka stability.

Basis bonds are used to counteract the effects of contracting basis tokens. They are auctioned off at a competitive rate as basis tokens are contracted, promising the bond purchaser 1 Basis token in future (sound familiar?), with a 5-year expiration date. The contraction mechanism is described as follows:

“Suppose the system wants to sell 100 bonds.
Suppose that there are three buy orders on the order book: One bid for 80 bonds at 0.8 Basis each, one bid for 80 bonds at 0.6 Basis each, and one bid for 80 bonds at 0.4 Basis each.
The system will compute the clearing price, which is a single price at which all offered bonds would have been bought at. Here, the clearing price is 0.6 Basis.
The system will fill the winning bids at the clearing price: The first user will receive 80 bonds in exchange for 80 * 0.6 = 48 coins, and the second user will receive 20 bonds in exchange for 20 * 0.6 = 12 coins.”

Finally, shares come into play when demand for Basis goes up- so long as all outstanding bonds have been redeemed, shareholders will receive the newly minted Basis tokens, as dividends. The expansion mechanism is described in their white paper as follows:

“Suppose there are 500 bonds in the Bond Queue, 200 of which were created more than 5 years ago. Additionally, suppose there are 1,000 shares in circulation.
Suppose the system needs to create 1,000 new coins.
The system expires the 200 oldest bonds, leaving 300 bonds in the queue. If the system needed to create fewer than 300 coins, it would only redeem the oldest bonds. However, the system needs to create 1,000 coins, so it redeems all 300 bonds.
The system still needs to create 700 more coins. The system distributes these 700 coins evenly across the 1,000 shares. Each share receives 700 / 1,000 = 0.7 coins. If you hold 100 shares for example, you would receive 70 coins during this expansion, which you can then sell for USD.”

Basis is largely considered to be the leading project aiming to create an algorithmically stable coin.

Towards the end of their whitepaper, a “post-USD” world is envisioned, assuming Basis were to one day displace the dollar in transactional volume, where a fully automated monetary policy can provide stability and transparency beyond the capabilities of any central bank.

Not bad if we’re talking about mainstream adoption.

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*Distributed ledger technology and blockchain are not interchangeable terms, for more on the distinction between the two, I recommend checking out this post.