The Stable Coin — A Cryptocurrencies Philosopher’s Stone

Stable coins are a very sought after goal of the current cryptocurrencies ecosystem. A16z podcast has claimed it to be one of the two main challenges of cryptocurrencies’ core tech, together with identity providers. Existing solutions today include Basecoin, MakerDAO and Tether. The reason they are so important is the high volatility in current cryptocurrencies, which is probably due to speculators in the market and the uncertainty of their future value. This creates huge fluctuations in the value of the currencies that prevents them from becoming what they were originally meant to be — a medium of exchange, and also what they were later predicted to be — a store of value. A merchant can’t work with a currency that can change 30–40% on the day. If he receives a payment from a customer and by the time he needs to pay his suppliers the payment’s worth is reduced 30–40%, assuming his profit margins are not that high, he’s in a world of trouble. Thus, if you could come up with a coin that is pegged to a more stable asset such as the USD or gold, it could be a great solution for these problems.

What decides an exchange rate between two commodities are the laws of supply and demand. It’s easiest to imagine as two cities with interconnecting roads. Some of these roads might go through other cities — this is the case of imports, for example. US Dollar is exchanged to Chinese Yuan to buy Chinese products and bring them back to the US. But at the end the summation of all the traffic going in and out from one city to the other determines the exchange rate. If many people want to go from a New York suburb into New york, but not so many want to go from New York to a certain suburb of it, then we would say that from economics perspective you need to pay a surplus for using the road into the city, but not the other way around. And if you could take a detour and get into the city faster and easier, people will use this road and close the existing Arbitrage.

Now, to peg two commodities together would be like saying two cities are the same city. That would mean that magically, exactly the same amount of people want to go from one city to the other, and at all times there is no excess of people wishing to go from NY to Boston than the other way around, or vice versa. This is highly improbable. So, what Stable coins aim to achieve is to manipulate traffic in a way that keeps this behavior at all times.

While the Quantity theory of money holds, meaning that by increasing and contracting the amount of a certain currency you can control the exchange rate between the currency and some other asset, the expansion and contraction of the currency is actually meaningless for the coin holders. If a currency’s exchange rate drops to 0.5$, and by devaluing their currency x2, you will raise the exchange rate with the US Dollar by x2, their net value stays reducted, following the real exchange rate before the currency manipulation. So nominally you can manipulate a coin to be worth 1 USD at all times, but as the real relation between the coin and USD is determined by supply and demand, which coin architects do not control, coin holders will bear the costs of all monetary acrobatics imposed by the architects.

BaseCoin -

BaseCoin are running an inflationary monetary policy with their coin. In the two cities fable, say at some point more people want to go from NY to Boston. BaseCoin administrators will tell them — sure, you can go to Boston now — but what you can also do is wait 5 years, and then you can go to Boston very fast and as many times as you want. If Boston and NY are overall balanced in the traffic between them, this might work, but 5 years later you will need to fulfill all these promises, so you will need to have much better highways between the cities so everyone will be satisfied and there will not be a confidence crisis in the currency. Who will finance these highways ? It’s basically the coin holders, as their currency will be worth less and less over time.

In more detail, BaseCoin’s Bond mechanism promises that over time smaller amounts of BaseCoin will be traded for future larger amounts of BaseCoin, so in the long term more and more coins will be printed, and the more instability exists in the exchange of BaseCoin and its pegged item — currently the USD — the more inflationary pressures on the currency.

Their ‘protection mechanisms’ against a currency crisis are actually mechanisms for currency default that mark the point of no return for the currency. Not issuing bonds at a lower rate than 0.1$ doesn’t mean prices will not go down there, but only that in the event of prices going down there the coin will immediately default and become worthless.

On a technical note, the thing missing the most in Basecoin’s white paper and FAQ is a proof that Base Bonds Queue’s length doesn’t go to infinity. The fact they have them expiring at 5 years does not mean the queue length will not go to infinity, it could just become denser and denser. Assume Basecoin spends more time trying to contract rather than expand, then you’re sure to have bonds expiring eventually and bond holders not getting their money. The analogue of the bond queue to the US Government debt is almost funny. The US Government debt can and should be paid by paying back tax revenues to bond holders, not by devaluing the dollar. This is the original purpose of bonds — To finance wars not by immediate taxation but by issuing bonds that will be paid with future taxes. What happened since the financial crisis though, with Quantitative easing is that indeed the US Government pays its bonds partly by devaluing the currency. This is not a model to follow, but Basecoin could become a nice demonstration of the Fed’s mischievous policy.

For the second part of my discussion of the Stable coins ecosphere.