Federal Reserve vs. Carbon: An Overview

Introduction

Stablecoins, like Carbon, are cryptocurrencies designed to maintain a stable value peg to an existing currency. In most cases, that existing currency is the U.S. dollar, the most dominant global reserve currency. To achieve price stability, other stablecoins rely on some form of collateral backing: such as 100% fiat reserves like Tether or cryptocurrency collateral like MakerDAO. Carbon’s stability mechanism, however, much like most of the world’s government central banks, is based on managing an elastic supply of currency units. In this blog post, we will discuss how the U.S. Federal Reserve conducts monetary policy, why and how Carbon plans to maintain its peg to the dollar, and the potential benefits of stablecoins now and in the future.

The reasons why Carbon, at least at first, will be pegged to the dollar were mentioned in our white paper and will be covered again later in this blog. In the future, Carbon intends to maintain a stable value relative to a basket of goods, but, for now, the “purchasing power” of a Carbon — the true measure of the relative value of a currency — will be subject to the actions of the Federal Reserve. Thus, how the Fed conducts monetary policy is important to understand.

Federal Reserve Monetary Policy

Monetary policy can be broadly defined as the actions undertaken by a nation’s central bank to manage the supply of money and credit in the economy. The Federal Reserve was established by the United States Congress in 1913 as an independent central bank to ensure three things: maximum employment and stable prices (together known as the “dual mandate”), as well as so-called moderate long-term interest rates. It has a few tools at its disposal to manage the supply of money in pursuit of these macroeconomic goals but, contrary to popular belief, one of those tools is not “setting interest rates.” Rather, the Federal Reserve can only influence the money supply by setting a target for the federal funds rate — the rate at which commercial banks (who are responsible for most of the “money” creation in the economy) lend to one another to satisfy the reserve requirements of their accounts at the Federal Reserve. The Fed then uses the following tools to affect the market for those funds:

  1. Open market operations: the buying and selling of U.S. treasury bonds on the open market to directly increase or decrease the amount of liquidity held by commercial banks.
  2. The discount rate: the rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility‍ — ‌the discount window.
  3. Reserve requirement levels: the percentage of certain deposit liabilities that a depository institution must hold in reserve i.e. not lend out.

A fourth — interest paid on excess reserves — is a new, post-Crisis addition to the Fed’s toolbox that can be thought of as a way of influencing the demand for excess reserves (reserves being the “base money” that is lent out, multiplied, and filtered through the economy), whereas the three tools above are to do with the supply of reserves.

Equally important to how the Fed conducts monetary policy (the tools listed above) and why it chooses to do so (to maximize employment, achieve stable prices, and promote moderate long-term interest rates) is when it will choose to use those tools for its goals. Simply, the Fed has two directions to set the target interest rate: up or down. When the economy is “overheating” — i.e. unemployment is too low and inflation is picking up — the Fed will institute contractionary monetary policy to raise interest rates and make money more scarce, thus slowing economic growth and minimizing the risk of rampant inflation and production. When the economy is in a recession, the Fed will institute expansionary monetary policy to lower interest rates, making money more abundant in the hopes of spurring economic growth.

What does this have to do with Carbon? As mentioned above, the “purchasing power” of Carbon will, at first, be subject to the actions of the Federal Reserve and thus it is beneficial to know broadly how it works. But, aside from that, it also helps explain how Carbon will maintain its peg to the dollar. Much like the Federal Reserve implementing expansionary and contractionary monetary policy when needed, Carbon’s protocol incorporates an elastic supply policy to adjust the quantity of the coin with market demand in order to keep the value pegged to $1. The difference, however, is that while the Federal Reserve’s decisions are done behind closed doors with quarterly press conferences (and lag times of three weeks for meeting Minutes and five years for full transcripts), Carbon is fully decentralized and transparent.

Decentralized Elasticity

Much like a currency board — an alternative to central banks used by (mostly) developing nations to maintain a fixed exchange rate with another country — Carbon’s monetary policy has one goal: to maintain the peg to the dollar. To achieve distributed consensus on Carbon’s exchange rate, Carbon utilizes a decentralized schelling point scheme.

When the price is below $1 and contractionary monetary policy is called for, market participants have the chance to remove their coins from circulation in exchange for more coins in the future. When it is above $1 and expansionary monetary policy is called for, coins are distributed to Carbon holders pro rata to create downward price pressure via inflation.

The Dollar Peg and the Future of Carbon

Pegging a stablecoin such as Carbon to the dollar has one main benefit: the dollar’s widespread use creates network effects that keep its value stable, especially when compared to most other currencies in the world. In fact, nearly 65% of all physical dollars — nearly $580 billion — are used outside the United States. According to the IMF, 8 countries have adopted the dollar as their own currency, 20% of its 189 member countries use the dollar as an exchange rate anchor, and as of Q4 2017, the dollar made up ~63% of foreign exchange reserves held by the world’s central banks — more than 3x the next most widely held currency, the euro.

Carbon is a combination of the benefits of cryptocurrencies — peer-to-peer exchange of value without a centralized authority — with the stability of the most dominant government fiat currency.

Of course, many in the budding cryptocurrency community view government fiat of any kind as prone to failure due to inherent reliance on centralized authority. This argument and the pursuit of “sound money” is what drives so-called “bitcoin maximalists” (and, before them, those who pushed for a return to the gold standard). Indeed, such a viewpoint is not far-fetched. The specter of rising U.S. government debt and geopolitical instability could disrupt the dollar’s preeminence as a stable reserve currency.

Carbon’s goal is to be the common denominator of the future, a stable asset that anyone anywhere can trust, beyond the machinations of any country or group of individuals. We believe that in a fully tokenized economy, if Carbon achieves widespread adoption, we will eventually have the opportunity to create a new denominator tied specifically to tokenized assets. But today, the dollar is the standard.

Whereas the Federal Reserve uses the Department of Commerce’s Personal Consumption Expenditure index for its symmetric 2% inflation target, Carbon could develop its own basket of goods to track that would better maintain the value of the currency in the long term. As the internet continues to make the world’s 7.6 billion people more interconnected socially and economically, the potential for a stable cryptocurrency to reach the scale of the dollar, in the long term, is real and exciting.

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