Basecoin: An Overview and Some Thoughts
Amongst numerous other headwinds (regulation and exchange hacks, to name a couple), one marked roadblock that has stifled the adoption of cryptocurrencies — for pretty much their entire history — has been their extreme price volatility. For a currency to function properly, it needs to be capable of functioning as an effective 1) store of value, 2) medium of exchange, and 3) unit of account. Price volatility seen in cryptocurrencies as of late is completely incompatible with all three of these functions.
In response, a new class of cryptocurrencies called stable coins has emerged, claiming to offer coins with stabilized values and therefore the ability to perform the three functions above. Perhaps the most popular of these stable coins has been Basecoin, a “price-stable cryptocurrency with an algorithmic central bank.” Its whitepaper, published in January, describes it as a completely decentralized cryptocurrency whose tokens are pegged to an arbitrary asset or basket of goods. By algorithmically expanding and contracting the supply of coins, Basecoin claims that it can stabilize the exchange rate of the coin vis-à-vis the asset or goods basket, hence the price stability.
How Does Basecoin Intend to Achieve Price Stability?
Basecoin’s founding team is very strong on the tech side (all three are Princeton CS graduates) — but a bit weaker on the monetary economics side. Their algorithm relies on three classes of tokens:
Basecoins, the tokens of the system intended to function as currency;
Base Bonds (which seem to resemble a binary call option more than a bond), which feature a 5 year expiration period and are auctioned off to contract the money supply (we’ll use “money supply” and “coin supply” interchangeably here), redeemable when the algorithm determines that a supply-expansion is in order; and
Base Shares, which have fixed-supply and pay out dividends after all Base bonds have been paid off.
To contract the money supply, the blockchain issues and sells Base bonds to take Basecoin out of supply. These bonds pay out one Basecoin at expiration and generally sell for less than one Basecoin, which the whitepaper claims will incentivize holders to lock up their Basecoins for a period of time. This continuous “open auction system” allows holders to specify orders (i.e., 100 Base bonds at 0.9 Basecoins per bond). When the money supply needs to be contracted, orders with the highest bids will be prioritized (with the lowest bids having their bids partially fulfilled), and fulfillment continues until a certain amount of supply has been sufficiently eliminated. The protocol sets a floor for the price of the bonds (0.10 Basecoins in the whitepaper).
To expand the money supply, the blockchain creates N new coins and pays out bondholders in first-in-first-out order (kind of like how pyramid schemes pay their investors; bonds are typically paid out pro rata, or proportionally) distributing any remaining new coins to shareholders (prioritizing debt-holders over shareholders, as is typical). An example of how this might work in practice:
Will the Basecoin Protocol Actually Work?
This is a very interesting concept, no doubt. However, a decent amount of problems arise. First, people will only buy these bonds in the if they expect the currency that they’re denominated in to retain its value — and for Basecoin to retain its value, people need to buy these bonds in the first place. Basecoin doesn’t say how it will handle currency risk for investors and holders; one can imagine the following scenario in a currency area based on Basecoin:
1)Basecoin sinks below its 1 USD peg to, say, 0.75 USD. Protocol calls for a decrease in the money supply.
2)The blockchain issues new Base bonds in an attempt to take Basecoin out of circulation.
3)Investors, fearing further devaluation, demand extremely high yields on these new bonds, and bids approach the floor set by the protocol. Assuming interest rates are influenced by the yield on these bonds (a fact that is interestingly mentioned nowhere in the whitepaper, even though these Base bonds are basically presented as virtual Treasury bonds), borrowing costs would skyrocket in the currency area. Basecoin mentions 0.10 USD as a floor price on these bonds, which would effectively mean an interest rate of 90 percent (the Blockchain is “borrowing” 10 cents and returning a full dollar) — imagine if the risk-free Treasury rate was 90 percent!
4)Severely higher borrowing costs mean severely stunted growth — investor’s confidence in the currency area declines further, demand for Basecoin contracts even more, and continuous devaluation results. There is no mechanism in the algorithm to prevent such a loss of trust; no matter how much supply is contracted, the loss of faith in Basecoin could lead to a “devaluation spiral,” which would likely be associated with high inflation as well. If truly decentralized, there would be no central bank to step in and take necessary measures outside the scope of the protocol.
Second, Basecoin’s whitepaper demonstrates a lack of understanding of how monetary policy actually operates; for starters, the Federal Reserve doesn’t target inflation and maximum employment by just simply manipulating the money supply (just because you give people more money doesn’t mean they’ll spend it). With expansionary policy, for instance, the Fed doesn’t purchase government securities in some nod to the Quantity Theory of Money. Instead, through reverse repurchasing agreements (also called reverse repos, they usually involve government bonds) with commercial banks, the involved banks’ deposits with the Fed rise in value, giving them more money to lend. In turn, banks are forced to lower interest rates to attract borrowers of their new cash supply. Lower borrowing costs ripple throughout the economy and households and businesses spend and invest more, which catalyzes more aggregate demand, pushes up inflation, and lowers unemployment. Basecoin’s whitepaper seems to assume that central bank policy relies solely on the Quantity Theory of Money (it doesn’t).
A related third problem is that we’re not entirely sure that the Quantity Theory of Money holds in the long-run, let alone the short-run (the whitepaper acknowledges its limitations in the short-run, and sees incentives to speculators as the cure). In their 2013 paper “Is Quantity Theory Still Alive?” Pedro Teles and Harald Uhlig of the European Central Bank show that for countries with moderate inflation, “the raw relationship between money growth and inflation is tenuous at best or even nonexistent.” They do find an improved fit when including other factors such as variations in output growth and the opportunity cost of money, as well as yields, but still note that after 1990, countries “cluster around fairly similar inflation rates, with considerable dispersion in money growth rates.” Ultimately, while concluding that the theory is still alive, the authors note that “whether it should be used as a guide to long-term monetary policy is more debatable,” and that “central banks in low inflation countries need to pay attention to considerably more variables [other than money supply] in order to keep inflation in check.” Whatever one’s conclusions, the fact that maintaining price stability is infinitely more complicated than laid out in Basecoin’s whitepaper seems pretty straightforward.
Fourth, while decentralization is a nice ideal to strive for, its application to the world of monetary policy is completely misplaced. Not many people are particularly enthusiastic about the idea of technocratic central bankers, but without them, the U.S. and other countries would have been significantly less able to respond to financial and economic crises. It’s inevitable: at some point, a problem will emerge that conventional wisdom and theory cannot fully handle. For instance, how would an algorithm have responded to the crisis and subsequent recession of a decade ago? That crisis tested the limits of what we knew about monetary policy and forced policymakers (like Ben Bernanke, who unlike an algorithm had extensive experience with monetary history and the Great Depression) to carefully craft out mostly untested and creative solutions. If a crisis were to hit today, policy makers would quickly run into the zero lower bound problem, something that even experts are not entirely sure how to deal with. Whatever their faults, do we really trust a body of technocrats who have studied monetary policy their entire lives less than a pre-determined algorithm?
Monetary policy doesn’t stay the same over time. Over the course of the twentieth century, we saw monetary regimes around the world constantly evolve in response to economic challenges, refinement of theory, ideological shifts, and social and political pressures, to name a few factors. Monetary policy has been as much art as science, and its history is one of constantly moving forward (and sometimes backward). This isn’t even to mention the diversity of monetary regimes coexisting at the same points in time.
Fifth, Basecoin’s exchange-rate targeting model resembles the classical gold standard in structure — restrict credit when the exchange rate is too low, expand credit when the exchange rate is too high — so Basecoin should expect to run into similar problems. An interesting gold-standard parallel is Basecoin’s reliance on speculators to restore the peg quickly before the protocol even needs to (and solving what they see as the short-run problem for Quantity Theory):
“If a speculator sees that the price is too low and he believes it’s eventually going to correct because of a reaction from the protocol, he is incentivized to buy coins in anticipation of the protocol’s actions to capitalize on the current, temporary drop in prices.”
Note the similarities in UC Berkeley monetary expert Barry Eichengreen’s account of the pre-war gold standard:
“When currency fluctuations did occur, investors reacted in stabilizing ways. Say the exchange rate fell…funds would flow in from abroad in anticipation of the profits that would be reaped by investors in domestic assets once the central bank took steps to strengthen the exchange rate….capital flowed in quickly and in significant quantities…the exchange rate strengthened of its own accord, minimizing the need for central bank intervention.”
This worked well for a time, because the franchise and political rights in general had not been extended to a significant portion of the population. Monetary policy makers had small regard for workers and the unemployment rate, because those who felt the brunt of those effects had little political say about it. However, as political rights were extended and unionization grew over the course of the early twentieth century, the seeds of the gold standard’s destruction were sewn. Investors lost confidence in central bank’s commitment to exchange rate stability, and so failed to provide the stabilizing influence described above (and actually served more as a destabilizing influence). Eichengreen has comprehensively demonstrated how the widespread extension of democratic rights was incompatible with the way the classical gold standard operated, partially explaining its collapse shortly after its interwar reconstruction. Assuming Basecoin intends to serve as a currency for areas with democratic political systems, it would likely run into this challenge — a challenge that policy makers were never really able to solve, opting instead to construct a completely different monetary order after World War II.
It’s unrealistic to think that such a factor could be incorporated into an algorithm. Tradeoffs, such as exchange rate-targeting vs. unemployment targeting and price stability vs. credit expansion, aren’t constant parameters. They change over time, forever shifting due to social, cultural, political, psychological, and ideological factors. Let’s imagine an algorithm based on the Taylor Rule:
Here, we do account for unemployment (reflected through the output gap); however, we assign a “weight” of 1/2 to unemployment and a “weight” of 3/2 to inflation. There’s a mathematical reason for this, certainly, but it brings up a broader question: do we think that a given society will always place the same respective priorities on price stability and unemployment? This is not a rhetorical question; the answer is “no.” Much of central bank policy is captured in that Taylor Rule formula by the r̃ term. That term refers to the autonomous policy decisions made by human central bankers, who draw on experience, research, historical insights, and expert-intuition. No algorithm can capture this autonomous element of monetary policy.
Thoughts
Applications in Developing Markets
Perhaps the most promising application for Basecoin resides in the world of developing markets. For all its flaws, Basecoin’s whitepaper addresses the very real problems faced by citizens in less developed nations: rapid inflation, volatile national currencies, and hard-currency shortages. For citizens in countries like Venezuela, stable coins such as Basecoin might offer a welcome escape from their increasingly worthless bolívar, which has effectively lost its ability to function as a 1) store of value, 2) medium of exchange, and 3) unit of account. Additionally, such a coin might help capital-starved businesses and households skirt U.S.-imposed sanctions and obtain greater access to funding on international markets (without effective safeguards, this could also allow those associated with the Maduro regime to access funding, though).
Basecoin’s value proposition for developing countries stands in contrast to the old-fashioned process of dollarization, which has occurred both with and without local government endorsement. According to Basecoin, virtual currencies can be more attractive than dollarization (or euro-ization, etc.) because one day, obtaining something like Basecoin may be “easier and safer than obtaining paper bills, especially in remote regions” (they also claim that “virtual currencies could actually become more stable” than currencies like the dollar, but we’ll leave that comment alone).
Within the developing market context, Basecoin envisions a paper currency-backed coin that is “governed by a credible, pre-defined rule, an algorithm that can be monitored…or even a ‘smart rule’ that might reflect changing macroeconomic conditions.” As we noted before, it is pretty unrealistic to think that a pre-defined algorithm is capable of performing the functions that we now assign to technocratic, human-powered institutions like the Federal Reserve.
However, this doesn’t mean Basecoin and other stable coins have nothing to offer. If Basecoin were to think a little more realistically and shed its goal to “displace the USD in transaction volume,” it might stand a chance to offer a useful, well-desired financial instrument in the developing world. A 2016 McKinsey Global Institute (MGI) report on digital finance and emerging markets found that the digitizing of finance in the developing world should result in “higher growth, greater innovation, and more inclusion,” and that “the digital infrastructure needed already exists and is being further improved…billions of people across emerging economies possess the mobile handset that can connect directly into the national payments system…they are just waiting for governments and businesses to wire up the infrastructure and create the products they need.”
Many players such as fintech firms and large international banks are tackling this issue; Basecoin could offer a creative alternative to solutions that rely on local currencies and the transfer of international currencies like the dollar. Basecoin can certainly make a difference, though it is not going to supplant the international monetary order.
Making Room for Centralization
In order to succeed, Basecoin and other stable coins will need to compromise and permit some degree of centralization. As made clear above, a monetary system cannot operate purely through an algorithm and the incentives created by that algorithm. Pure decentralization should not be the unwavering goal; rather, it is an ideal to strive for within the bounds of practicality.
A centralized component can take many forms, and finding the “best” of these forms is beyond the scope of this article. But we can speculate. Perhaps developed states like the U.S. could “sponsor” a stable coin as part of their international development and poverty alleviation efforts. For instance, the U.S. Treasury could commit a certain amount of USD to collateralize a coin for a developing region— this would effectively render the coin backed by USD and the U.S. government, instilling confidence and promoting its exchange rate stability against the USD. A committee of experts could be established to ensure that monetary policy surrounding the coin is sound. This would ease the difficulties associated with the international transfer of dollars, as well as mitigate currency risk for international lenders and local debtors. Those in developing regions would gain alternatives to unstable national currencies, greater access to credit, and many of the other potential benefits explored in the MGI report above. Governments don’t have to be the only option; perhaps large philanthropic organizations could collaborate and commit their capital to collateralizing a coin and managing its implementation and governance.
Some type of blockchain voting system could even be held that allows Basecoin holders to vote on a committee of experts to oversee monetary policy. Basecoin’s whitepaper already explores a voting system to determine how exchange rates are measured; perhaps intermittent elections would provide the “human” aspect needed to make monetary systems work, while still preserving the ideal of decentralization by allowing those involved with the system to hold their monetary authorities democratically accountable. Myron Schole, a legend in the world of financial economics, is already getting involved in the cryptocurrency world. If Basecoin’s value proposition is good enough (“we’re going to help those in impoverished regions gain greater access to credit” is better than “we’re going to replace the dollar as the anchor of international finance”), then many experts who have been averse to cryptocurrencies might be willing to come off of the sideline. And they would still be held accountable by Basecoin holders.
As someone more adept at economics than tech, I’d love to hear any constructive input, as well as your general thoughts. Feel free to DM me through twitter @DonovanBerry6— I don’t tweet from this account, but I’ll see your DMs there.