Crypto today is borderline euphoric. As it should be, considering that many of its leading voices are printing money, having made investments in 2010 that have paid off at a rate of 65,000,000% as of earlier this morning. These same voices call to you now to join them in this revolution of personal investment and wealth generation driven by technology. This is the core underlying cause of the ICO mania.
I have been around “blockchain” for some time. Early enough to remember the prosperity gospel surrounding the first useless ICO craze in late 2013 and early 2014, where the celebrated cryptocoin projects were those that few if any of you have heard of today: such as Protoshares, Bitshares, MaidSafe, or others.
Today’s prosperity gospel features revamped, slicker, prettier, younger versions of those projects. Like Tezos (Ethereum 2: Electric Boogaloo), Eos (Also Ethereum 2: Electric Boogaloo), Cardano (also Ethereum 2: Electric Boogaloo), DFinity (again, Ethereum 2: Electric Boogaloo), Augur (Truthcoin 2: Electric Boogaloo), Gnosis (Augur 2: Electric Boogaloo), Filecoin (StorJ 2: Electric Boogaloo), and…
The latest of these is a proposed cryptocurrency called Basecoin (Bitshares 2: Electric Boogaloo) which, we learn, has received investment from a smattering of reputable traditional VC firms (including Andreessen Horowitz and Bain Capital Ventures) as well as the top crypto-only outfits (Pantera, DCG and Polychain).
The product? To create what Coindesk calls
“the crypto holy grail: a stable token.”
This is an exceedingly bad idea.
The concept is so profoundly ill-conceived that I’d venture to say the “Stablecoin” is the closest thing the crypto world has for an answer to the Hitchiker’s Guide to the Galaxy’s Ravenous Bugblatter Beast from Traal, a creature known not only for being extremely vicious and hungry, but also for being denser than a neutron star. Which, for those of us not versed in stellar physics, is very dense indeed. In that series of books, the Traalbeast is regarded as the single dumbest creature in the entire universe, a failure of evolution so complete and irredeemable that it “believes if you can’t see it, it can’t see you.”
It’s thus with this pernicious idea of the stable coin: a free-floating digital commodity devoid of intrinsic value that doesn’t assume the market prices it, but rather that it prices for the market, and which only works by devouring new investment money at every available opportunity. This is far from the first time such a scheme has been attempted; the BitsharesX cryptocurrency, abandoned two years ago by its founder (Eos’ Dan Larimer) to work on other, more lucrative projects, claimed to possess a working asset peg that operates through a similar mechanism to that Basecoin proposes.
Bitshares’ stablecoin, “BitUSD,” has not been wildly successful; it manages to hold its peg but only on extremely thin trading which could quite easily be maintained through market manipulation.
Note, in 2014 Bitshares’ “BitUSD” dollar peg fell flat on its face less than 100 hours from launch, with the result that the core developers were forced to shut the thing off. I liveblogged it at the time so you can see for yourself how it all went down.
Basecoin claims to solve the problem of wildly fluctuating cryptocurrency prices through the issuance of a cryptocurrency for which “tokens can be robustly pegged to arbitrary assets or baskets of goods while remaining completely decentralized.” This is achieved, the paper states in its abstract, by the fact that “1 Basecoin can be pegged to always trade for 1 USD. In the future, Basecoin could potentially even eclipse the dollar and be updated to a peg to the CPI or basket of goods.”
(Interjecting, I once had a sit-down chat with A16Z. I have no idea how on Earth this startup got away with hyperbole like this. Guess I had the wrong approach.)
Continuing, Basecoin claims that it can “algorithmically adjust…the supply of Basecoin tokens in reponse to changes in, for example, the Basecoin-USD exchange rate… implementing a monetary policy similar to that executed by central banks around the world”.
First, this is not how central banks manage the money supply. Something akin to a price-first approach (really a spending-first approach) to managing the money supply is known as Nominal GDP Targeting (NGDPT) and is currently in vogue among fringe libertarian groups like the Adam Smith Institute, which means we should probably expect it to be official policy of the Bank of England at some point in the next 10 years. Just not today.
But of course, Basecoin isn’t actually creating a monetary supply, which central banks will into existence and then use to buy assets, primarily debt securities. Basecoin works by creating an investable asset which the “central bank” (i.e. the algorithm, because it’s nothing like a central bank) issues to holders of the tokens which those token holders then sell to new entrants into the scheme.
Buying assets to create money vs. selling assets to obtain money. There’s a big difference.
We need to talk about how a peg does and doesn’t work
Currently there are very efficient ways to peg the price of something to something else, let’s say (to keep it simple) $1. The first of these would be to execute a trust deed (cost: $0) saying that some entity, e.g. a bank, holds a set sum of money, say $1 billion, on trust absolutely for the holders of a token, which let’s call Dollarcoin for present purposes. If the token is redeemable at par from that bank (qua Trustee and not as depository), then the token ought to trade at close to $1, with perhaps a slight discount depending on the insolvency risk to which a Dollarcoin holder is exposed (although there are well-worn methods to keep the underlying dollars insolvency-remote, i.e. insulated from the risk of a collapse of that bank).
Put another way, there is a way to turn 1 dollarcoin into a $1 here. Easy-peasy, no questions asked, with ancient technology like paper and pens or SQL tables. The downside of course is that you need to 100% cash collateralize the system, which is (from a cost of capital perspective) rather expensive. This is the reason why fractional reserve banking exists.
Convertibility, no parity
Here is where we find the official pegs of the Zimbabwean Dollar or the Venezuelan bolívar, which vastly overstate the value of the domestic national currency vis-à-vis their US dollar price on the free market. More successful examples include the European ERM, although that too fell apart when George Soros took advantage of it to kick England’s ass in 1992.
These situations are an object lesson in why you don’t try to peg currencies: because you are unable to hold the peg any longer than you can afford to subsidize your differences of opinion with the market. Once you run out of firepower, the peg breaks, and ceases to have any useful meaning except perhaps to assuage the egos of delusional tyrants who insist on its continued maintenance.
But you need to study politics, economics and history to learn things like this, which I understand are not computer science and are therefore unpopular.
No convertibility, parity?
Alternatively, we could make something like Tether, which is sort of like Dollarcoin above but with one important qualification. Tether says its tokens, which are listed on a corporate affiliate’s exchange (Bitfinex), are backed 1:1 by USD in an account at an as-yet-unnamed bank, probably somewhere in Asia. Tether does not say that there is any contractual mechanism to convert these tokens into USD. The tokens trade at close to $1 despite the fact there is no way for most people to actually turn them into dollars, due in large part to banking issues a certain exchange has had lately. It is thus very much unlike Dollarcoin.
Put another way, there is not a way to turn 1 Tether into 1 dollar, yet somehow the thing trades at a dollar on the exchange run by its corporate parent. Sketchy, but I can trade that into Bitcoin, so what the hell. Party on.
No convertibility, no parity
This is where stablecoins go.
The third way might be called “the Bitshares way” (or the “Basecoin way” thanks to the fact that Bitshares really isn’t much of an actively developed project anymore). This approach involves having a bunch of cryptocurrency and then manipulating either (a) the supply of the cryptocurrency or (b) the supply of pools of collateral which “back” it in order to artificially support its price on off-chain markets.
This is why Basecoin (hereinafter “$BASE” or “BASE”) is not really one cryptocurrency. In fact, it is three cryptocurrencies in one.
But before we get to that, here’s a helpful chart I made for you, using fancy legal graphics software, summarizing what we’ve covered so far:
Down the rabbit hole: how Basecoin is supposed to work, in English
True to form, there’s a 19-page white paper running to 10,000 words and published with LaTeX, so it’s formatted like hot death and the font is too small. Fortunately, I can deal with it in about five hundred words.
To spare myself unnecessary typing, I will simply screen shot the white paper:
There’s a coin. Called BaseCoin. It should be worth, arguendo, $1 on the market at all times.
The decentralized protocol, which has no way of independently verifying what is going on in the outside world, relies on a third party’s computer to tell the protocol what 1 BASE is trading for on Kraken/Polo/whatever (also a third party) and to modify its new coin issuance by relying totally on that third party data feed. In other words, it’s not decentralized at all.
If the price of 1 BASE is above $1, the blockchain prints new $BASE to holders of “BASE Shares” (mother of god), a standalone cryptocurrency which is issued in the genesis block and held by early adopters, which then distributes new Basecoins to them as a “dividend.” Holders of “BASE Shares” are free to either hold onto their Dividend-Basecoins (thus not bringing the price down) or sell them into the market, pushing out the supply curve and bringing down 1 BASE’s price. This process continues until the price of 1 BASE drops to $1.
If the price of 1 BASE is below $1, the blockchain prints “BASE Bonds,” which aren’t really “bonds” at all but rather are BASE call option/future hybrid critters (feel free to amend the white paper, team Basecoin. No charge). If 1 BASE costs $0.80, for example, and the peg is $1.00, the “BASE Bondholder” spends $0.80 with a promise that once the peg is hit again the “bond” (again, really an option contract of sorts, and not a bond) will convert at 0.8:1. This is also supposed to be a standalone cryptocurrency of its own.
Oh, and “BASE Bond” holders are paid not pro rata and pari passu, which is what would happen with a class of bondholders who hold real bonds (which I used to draft for a living), but rather on a first-in first-out basis, like payments are made in a pyramid scheme. Which of course is all the more incentive for BASE Bondholders to “evangelize” after they buy.
As a result of all this we are told, again in CoinDesk, that
“…the basecoin protocol can be pegged to the value of any asset or basket of assets, dynamically adjusting its market price through the creative use of a combination of tokens… ‘(we aim to prove) this actually works and that the peg stays put no matter what'”.
Which it won’t, just like BitShares didn’t when the BitUSD market didn’t consist entirely of wash trades. But anyway, as part of proving their concept, there will presumably in the near future be a public-facing ICO where “Base Shares” will be sold and hey, better get in fast because Tim Draper was behind Tezos, and OMG A16Z INVESTED IN BASECOIN and everyone knows that A16Z is the only firm in town hotter than Draper’s.
It’ll work fine while we’re all going “to the moon.” On the way down, however, there will be insufficient new “bond collateral” entering the scheme to bring the price back up and the only way you can achieve stability is by way of massive buys on the part of insiders. Which speculators will trade against, as they did when they broke the Bank of England in 1992, and when they broke Paycoin in 2014. They will break Basecoin.
The rest of the paper is a lot of citation-needed, freshman-dorm-room economics. I mean, come on:
Conceptually, the Bond Queue is similar to the US national debt. Just like how the Basecoin system issues Base Bonds that go into the Bond Queue, the Fed issues Treasury bonds that add to the national debt.
When the national debt is too large, faith in Treasury bonds drops, resulting in higher borrowing costs that, if left unpaid, eventually manifest as future inflation, higher future taxes, or future default. By capping the size of the Bond Queue and defaulting on bonds that are too old, the Basecoin system disallows this tax on future stability. Instead, its fixed bond expiration transparently taxes the present. We propose a 5-year bond expiration that we have shown by rigorous analysis and simulation to result in a robust system with sufficiently high bond prices even in the face of wild price swings.
Except it’s nothing like that at all. Government bonds are obligations of governments. They function as money-substitutes while they remain outstanding, but they have nothing to do with the price of money itself – or money’s issuers, for that matter, who are independent central banks.
Central banks purchase bonds to create money in a process known as open market operations. They do not issue their own bonds in an effort to stabilize the currency they issue (in which the bond is denominated) as pegged to some second asset.
When the white paper’s authors speak of Fed “open market operations” as being the Fed creating bonds, or conflate monetary and fiscal policy, they betray an ignorance of finance requiring at least a two-year postgraduate master’s and several years’ work experience to cure. This lack of practical knowledge has led them to make assumptions so obviously faulty that the operating thesis of the entire project is undermined.
Due to the Basecoin team’s failure to ascertain the difference between the Treasury Department and the Federal Reserve System, the structure their “white paper” puts forward – which can be summarised as “I create a coin, which will always revert to a market price of $1 per coin regardless of quantity demanded, backed by bonds which I issue, which are denominated in the coins I just created, and redeemed for coins I will later create” – is recursive, or the financial equivalent of a perpetual motion machine.
The money to keep the machine going must come from somewhere, and in this case that somewhere is a new investor willing to subsidize profit-taking by earlier participants in the scheme by committing risk capital of his own. When he stops investing, Basecoin loses its ability to hold the peg.
How’s that for “rigorous analysis.”
one day, Basecoin might become so widely used as a medium of exchange that it actually starts to displace the USD in transaction volume.
Please. Figure out what a government bond is, first. Then we can have a little chat about scalability.
All the above, mind you, is absent any securities law analysis, on which I could write chapter and verse. But that’s a conversation for another day.
If this level of overwrought garbage is what one needs to get past a top VC’s investment committee these days, I weep for entrepreneurship.
Anyway. I’m at roughly 2,000 words, which is about 1,000 more than I set out to write an hour ago. So I’ll wrap up. It seems to me on this very cursory review that Basecoin depends on
- Printing free money and giving it to crypto-investors who are inclined to hold it and thus restrict supply;
- providing financial incentives to subsequent investors to introduce money into the scheme and subsidize the price of the scheme if the price of a coin should fall below a certain level (say, $1);
- with a not-at-all-decentralized reliance on price indicators provided by unsupervised, unregulated third-party markets already widely suspected of serious shenanigans;
- with the primary benefits accruing to early buyers in an unregulated ICO;
- which is completely dependent upon, and immediately falls apart without, new buyers for $BASE.
Similarly, a cascading margin call situation could lead to failure to hold the peg in such a way as to require a lot of new money and a very convoluted two-step investment process to recapture it. This, in a business where most users can’t even manage their private keys.
I leave it to you, dear reader, to provide a name for a scheme such as this.
When dealing with crypto-assets, which are crazy enough already, trying to build for “stability” in relation some to third, highly liquid, mass-adopted asset like 1 USD is folly: even if this approach to setting prices of goods (what we want the goods to be priced, rather than the price of things being what purchasers are willing to pay for them) had ever worked in the 6,000 years of recorded history preceding us (it hasn’t), these things only work as long as the humans are playing along.
I don’t care how complex your algo is. If nobody’s buying, your network’s up a creek without a paddle. Today it’s within the realm of possibility that adoption is going to hockey stick like the price of Bitcoin. Perhaps it will. Maybe it’ll take awhile. Maybe some folks will go to jail along the way. Who knows. But I suspect that, before too long, we will relearn the lessons of the past, and that the laws of economics have not been suspended.
Postscript, 2 January 2018
It gets worse.