Basecoin — Money out of thin air?

By Manish Agarwal and Setu Saurabh

With the tokens going through a phase of extreme volatility, speculators and traders are shifting between fiat and tokens to book profits as well as to better time the markets. However, moving to fiat is not always easy and favorable — 1) all exchanges do not support direct fiat conversion (to avoid regulations); 2) transaction costs are higher and; 3) there are tax implications (in certain jurisdictions). While it might seem counter intuitive to the extreme proponents of the crypto world, there have been attempts to provide stability of fiat currencies in the crypto world — most popular so far being Bitshares and Tether — Basecoin being the latest addition.

Fiat pegged tokens

Bitshares and Tether — the two flawed attempts

While there have been many attempts — Bitshares and Tether have been able to garner highest interest and volumes among pegged tokens. However, the two have very stark approaches.

Tether is pegged to 1 USD, and the issuing body (Bitfinex), stores equivalent amount in USD as reserves (at least they claim to be storing). Interestingly, the centralized agency (Bitfinex) has no obligation to redeem it for USD —we wonder if it can get more opaque than this?

Bitshares on the other hand does not have a centralized body storing reserves — but wait, there is no actual external collateral or reserve. Collateral or reserves are created out of thin air, where the token of the Bitshares protocol acts as a collateral (200%) — which basically means that in case the value of Bitshares fall, higher number of BitShares will be required as collateral. It works till BitShares trade above 0. But the question is why should anyone value Bitshares as there is no utility? It seems to be a forced belief and one can not force beliefs.

In comes the Basecoin

Basecoin is the latest addition to the list of pegged crypto currencies — we went through the whitepaper of Basecoin released in Oct-17.

Going through the paper, the first thought that came to our mind was - this is very complex with a lot of engineering on paper — but with very little details on implementation. The whitepaper claims that robustness has been tested, but does not provide any details — we believe it will be better if the company comes out with a technical whitepaper — to give more credibility to the whitepaper.

While different to Tether, the underlying logic is very similar to that of Bitshares, where the peg is maintained through value ascribed to the tokens created in the system itself — which means without a tangible backing. While Bitshares adjusts the number of Bitshares tokens, acting as collateral to peg BitUSD (or other assets), Basecoin aims to vary supply of Basecoin tokens in the system itself. Basecoin team very loosely refers to this activity as mimicking the central banker, however, unlike the central banker it will be distributing the tokens to the token holders without getting anything in return — basically creating and distributing new money, with nothing backing it.

The Mechanics — three token system

The fundamental mechanism is based on regulating supply of Basecoin token in the economy. With increasing demand, price of Basecoin token should increase, which is brought back to USD 1, by increasing supply of Basecoin. On the flip side, when the demand decreases (price of Basecoin falls below USD 1), supply of Basecoin token is reduced. This management of supply in the system, will be achieved through a Three Token System

The Three Token System: Basecoin uses an interesting mechanism of three token system — where in addition to Basecoin, there are two additional tokens of Baseshare and Basebond — which help manage supply of Basecoin to keep the peg at USD 1.

1) Basebond: The new bonds will be created and issued through open auctions, at a price less than 1 Basecoin. This will be redeemed at a future date for 1 Basecoin, within 5 years, post which it will be deemed to be expired

2) Baseshare: Baseshare will be issued only at the Genesis block and hence supply is fixed.

Basecoin — The three token system

Contracting supply of Basecoin: To reduce the supply of Basecoin in the system, new Basebonds are issued in exchange for existing Basecoin, which reduces the supply of Basecoin in the system. The Basebonds will be issued at a price less than 1 Basecoin, with a promise of redemption at 1 Basecoin in future.

Expanding supply of Basecoin: To increase supply, new Basecoin tokens are created by the protocol. The new Basecoin tokens are first issued to existing Basebond holders in exchange for their Basebond in the ratio of 1:1. Redemption is done on FIFO basis, with older Basebond holders having higher preference. However, Basebonds also have an expiration time of 5 years — which means that in case Basebonds remain in the system for more than 5 years, they will not have any value and will be deemed to have expired. This is done, as per the whitepaper, to keep a check on the queue of Basebonds. A very long queue, could lead to sharp drop in interest in new Basebond being issued.

In a scenario, when there is no longer any Basebond in the system, new Basecoin is distributed among existing Baseshare holders — something similar to dividend distribution.

In the expansionary phase, there does not seem to be an issue — who does not like free tokens — the system will keep issuing new Basecoin tokens to the Baseshare holders. Price reaction will also depend on the action of the Baseshare holders, whether they decide to hold the Basecoin or sell it in the secondary market.

A vicious cycle to 0 valuation?

In the contraction mode, it could be vicious cycle, driving down Basebonds valuation to 0. Basebond valuation will depend on expectation in recovery of Basecoin demand and the quantity of Basebond already issued in the system. When the Basecoin will trade below 1 USD, demand sentiment is anyways weak. In such a scenario, Basecoin holders could consider exchanging Basecoin in secondary market rather than exchanging with Basebonds. As more Basebonds are issued, sentiment for Basebond should turn further bearish, given that the newly issued Basebond will be further behind in the queue.

Basecoin white paper claims to have used Geometric Brownian Movement, block bootstrapping etc. and claims that the artificial floor (which they have set at 0.1 Basecoin) is never hit.

Is this money created out of thin air?

Basecoin is similar to Bitshares where the collateral’s value (Basebond) is dependent on the value of the token (Basecoin), the very token for which it acts as collateral. This is like A is dependent on B whose value is dependent on A. So, if one goes down, it could spirally go down to 0. With no tangible collateral or any form of energy being spent on creating the new tokens, this basically seems to be an attempt to create money out of thin air. It will work well, if everyone suddenly starts believing in it, but will fall flat on the way down.

Are price feeds reliable and robust ?

The entire pegging mechanism depends on the current price feeds, which is a major point of vulnerability. The whitepaper aims to get this through 1) centralized exchanges; 2) a group of feed providers — which in our view is no different from centralized exchange; 3) a decentralized mechanism, which the whitepaper claims can only be gamed if bad actors hold 50% tokens — to us, it seems it can be gamed with 25% bad actors.

Should you or should you not?

We find Basecoin a complex implementation with largely similar pitfalls, as that of older tokens. Everything should go well if a faith is built, however it is difficult and takes time — till then it will require a lot of insider support. The whitepaper claims to have done exhaustive tests for robustness — we would like to have more clarity on those.