An economist’s take on Basis/Basecoin
I like the idea of a cryptocurrency with monetary policy, but have the following misgivings:
tl;dr
(1) It is quite simple to game their algorithm
(2) Their “bonds” violate basic common sense
(3) Higher volatility results in less income for “shareholders”
Pre-amble
It was announced recently that Basis (aka Basecoin) closed a $133 million round of funding. That seems like a lot to me for a project without a working prototype, but by crypto standards, this is par for the course.
For those who don’t know, Basis is an “algorithmic central bank” that expands/contracts their currency supply in order to maintain a stable exchange rate. If you want to learn more about how it’s supposed to work, the project has a fairly coherent white paper.
I wish the team luck and I hope they succeed. A stable cryptocurrency that people can actually use for commerce is badly needed in the ecosystem. Basis has the potential to unlock a lot of value for both users and investors.
However, I have a lot of misgivings about their proposed monetary policy to keep the currency stable. I cannot in good conscience let these misgivings go unstated when both investors and users have this much money on the line. Just as cryptographers weigh-in on projects as they gain prominence, I think that economists should do the same, especially for stablecoins.
Misgiving #1
Basis’ proposed monetary policy algorithm is quite simple for speculators to game. In fact, any monetary policy algorithm can be gamed, but that’s a discussion for another time. Let’s focus on Basis.
When demand for base coin exceeds current supply, the monetary policy algorithm creates new currency to keep the price stable. New currency is given to holders of “base shares”. If an investor holds 10% of all base shares and the algorithm creates 100 new units of currency, then she will earn 10 base coin.
This same investor can game the system by artificially pumping up demand for base coin. Suppose she went and purchased 100 base coin on an exchange. The monetary policy algorithm, sensing this increase in demand, will send an additional 100 base coin to share holders. Our investor will receive 10%, or 10 base coins. Now she can sell all 110 of her base coins, earning an extra 10% from where she started.
These extra 10 base coins given to the manipulative investor are not free but represent a cost born by the entire platform. It is not difficult to imagine how such a system could completely fall apart.
Misgiving #2
Base “bonds” violate basic common sense. When the supply of base coin exceeds demand and the price decreases, the monetary policy algorithm decides to contract the money supply. It does this by selling to investors “bonds” that are promises to pay back 1 base coin in the future when demand increases.
The problem with these bonds is that if they are not paid back within a certain time frame (e.g. 5 years), they automatically default. That is, the monetary policy algorithm will never make good on its IOU to the bond holder.
If that sounds weird, it should. Imagine your friend wants to borrow your car. You agree, but tell him that you need to have it back before 5:00pm. He says sure, but under one condition: if he doesn’t return the car before 5pm, then he gets to keep it. No matter how trustworthy and responsible your friend is, you would never agree to this deal! He has all the wrong incentives. Plus, what happens if he gets stuck in traffic and doesn’t make it back until 5:15pm? Does he get to keep the car?
I don’t understand how an automatic default in base bonds will be a good thing. True, borrowers default all the time. If a company defaults, that’s bad for its creditors. But if the central bank refuses to make payments in a currency it controls, that is catastrophic for the financial system. Imagine what would happen to the USD if the Treasury voided its bond obligations?
Misgiving #3
Volatility in base coin demand results in less income for holders of “base shares”. As stated previously, when new base coin is created, it is sent to the owners of base shares. On the surface, it seems quite easy to calculate base shares’ income if we know how fast the platform is growing. If we start with 100 base coin in circulation and we end with 105 base coin, then shareholders made 5 base coin.
This analysis completely breaks apart when you factor in volatility. What if initially demand for base coin took a hit and the algorithm removed 20 coins from circulation by issuing base bonds. (It should be noted here that all outstanding bonds must be repaid before any income is given to share holders.) We now have 80 base coin instead of 100. For the sake of example, let’s assume the price of each base bond was 0.8 base coin. The algorithm thus sold 25 base bonds, each redeemable for 1 base coin. You may already see where this is going…
After its initial contraction, demand for base coin rebounds over 30% and the algorithm repays all the base bonds. Now we have 105 base coin in circulation, just like before. However, shareholders haven’t been paid anything. Their income is zero!
Higher demand volatility means bonds will have to be issued more frequently. Because bonds must be paid off with interest, more bonds means less money for shareholders. Its entirely possible that Basis could grow to a $1 trillion platform yet shareholders get nothing.
Shareholders are long-growth but short-volatility. Given the turbulent history of crypto markets, this is a bad investment strategy.
Conclusion
The notion of a cryptocurrency with monetary policy makes a lot of sense in theory, but Basis’ proposed implementation has a lot of non-trivial shortcomings.
With that said, Basis is very well-funded and the team seems reasonably intelligent. The project still has a good shot at becoming a success. Hopefully they will find ways to address these flaws and have a rethink about some of the design choices before they go live.
