Do Monetary Authorities Dream of Algorithmic Central Banks?

I see things you fiat people wouldn’t believe. Wages and salaries in Bitcoins and stablecoins, savings are free from sanctions and inflation. The whole economy is digitalized. All those moments are yet to come, and that’s our aim.

It is not Roy Batty monologue.

Nah, it is not that I think that all the problems of an already-established economy will be solved with a mass adoption of cryptocurrencies. For at least it has nothing to do with existing disparity in earnings, live conditions, and which is more — the access to knowledge. Yeap it is the Internet that shrinks the gap, but I believe there’s greater inequality we will face shortly, and it is rooted in the concept of knowledge we owed to Renaissance.

As we see so many attempts from the bottom — I mean from so-called retail investors — to approach the promised land of crypto-singularity (seems like I’m strongly gone into poetry when choosing appropriate language), this time I would like to see is there any chance that governmental institutions like central banks show any cue to become modernized, digitalized, algorithmized and whatever. And so, to start I come along the history of central banks and then analyze the very recent attempt to put the whole idea into digital rails.

Why do we need a central bank?

It can be claimed that the main instrument for maintaining financial stability is the central bank’s role as the lender of last resort in the banking system.

The “lender of last resort” concept means an institution that provides banks with emergency liquidity when they cannot attract it on market grounds or when other lenders refuse to lend. And it can be done only if the central bank has a monopoly for the emission of money.

The theoretical foundation of the function of the lender of last resort laid the classic works of Henry Thornton (1760–1815) and Walter Bedzhgot (1826–1877) in the XIX century. Originally the lending of the last instance was thought as the temporary provision liquidity to banks in a critical situation. A quite similar situation occurs during periods of liquidity crises and banking panics, during which banks had an extraordinary need for liquidity to meet suddenly increasing demand from customers, depositors, and lenders for cash.

This classic concept of the lender of last resort, which emerged in the XIX century, involves the fulfillment of several conditions:

• The lender of last resort is not trying to prevent a financial crisis, it only minimizes its negative consequences, i.e. seeks to stop the spread of the crisis in the banking sector;
• Lender of the last instance executes in the conditions of the financial crisis threatening the stability of the banking sector, not in a normal market situation;
• Lender of last resort maintains an equal approach to all banks, i.e. It provides liquidity to the banking sector as a whole, rather than to individual banks;

And so on. I’m not a historian of this process, but it seems some debates are still active and maybe even more elaborated positions may occur up to now. For this article, let’s consider the two most common actions used by central banks to manage the economy:

• Expand the money supply, in case the prices going down to bring them back (deflation is no better than inflation).
• Contract the money supply, in case the prices going up to lower them and bring to the average level (that’s inflation).

Why it happens I think is a common wisdom, however, if you like to revise this part of high school economics, please, read about the quantity theory of money.

And so what?

It seems like it is far from all these god damned cryptos and whatsoever. But it’s not that really.

The price volatility of Bitcoin and other cryptocurrencies is one of the most significant barriers to adoption that cryptocurrencies face today. In the last article, I cover the stablecoins topic and this my opus is a kind of successor. While I was researching the stablecoins market for my current project, I stumbled upon Basis project. As I always thought about the fundamental mechanism for self-regulation of crypto, I found it extremely interesting and so decided to consider it in detail.

I hope you remember that stablecoin is a particular type of cryptocurrency pegged to some real-world asset (USD, EUR, gold, coal and so on). It is designed with a particular purpose — to deal with volatility and put it under control. But you know, not every stablecoin is pegged to a traditional asset. Or at least it has no idea to be pegged to which one, that’s why it claims itself non-collateralized. This is the case of Basis. Yeah, baby.

Interlude

Well if you read the beginning of this article carefully, you noticed that I was talking about any attempt from central banks to become modernized, digital.. forget it. They are nitty barrels of superstitions and old economists thoughts. And you know why?

“The ideas of economists and political philosophers, both when they are right and when they are wrong are more powerful than is commonly understood. Indeed, the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually slaves of some defunct economist.” J.M. Keynes

That’s it; I lied to you. No way I would tell you all these fake news that central banks are willing to modernize. Not that they are corrupted or something, they have a huge responsibility that obliges them to be conservative. That’s why I will just switch to the first (at least that I know) attempt to build something resembling a central bank, but with some nuances.

An algorithmic [crypto] central bank

Here and after I will use their Whitepaper for reference.

So, in its essence, Basis implements price stability using the same economic principles relied upon by central banks around the world. Mostly they relied on the quantity theory of money that I had pushed you to do your homework. Oh sorry, it was really rude.

The mastodons of Basis rely on three instruments to establish “stability.” They are:

• Basis token, the core tokens of the platform. They can be pegged to whatsoever stable assets like USD, Gold, your salary or anything else. They are intended to be used as a medium of exchange. The supply is to be expanded and contracted to maintain the peg.
• Bonds tokens, they received that name because they are to be auctioned off by the blockchain when it needs to contract Basis supply. Bonds are not pegged to anything, in particular, they are like traditional bonds promise the holder some Basis tokens in the observed future. They are sold with a discount to Basis tokens (1 Bond < 1 Basis token) unless it doesn’t make sense. The conditions they can be redeemed you better read in the whitepaper.
• Stocks tokens, the supply is stabilized at the beginning of the blockchain. They are either not pegged to anything, but their function is crucial: when demand for Basis goes up, and the blockchain creates new Basis to match demand, shareholders receive these newly-created Basis pro rata so long as all outstanding bond tokens have been redeemed.

What the hell is going on?

You remember that the ultimate aim of central bank is to drive supply up or down right? So, in the case in an expansion, the blockchain counts any outstanding bond tokens and orders them according to when they were created, with the oldest first. The authors call this ordered sequence of bonds the Bond Queue. The blockchain also counts all outstanding share tokens.

Then, the blockchain creates some number of new Basis tokens and distributes them as follows: bond-holders are paid first in FIFO order, then shareholders are paid. Just quite the way it should go on in the regular company in S&P500 or the like. In that sense, the Bond Queue is similar to the US national debt. Just like how the Basis system creates bond tokens that go into the Bond Queue until they are paid, the government offers Treasury bonds that add to the national debt until they are paid.

Contraction works the same way. To lower the amount of Basis tokens, it is necessary to incentivize holders of Basis to lock up their Basis in exchange for future payoffs. It is to be done by having the blockchain create and sell bond tokens. I leave here unaltered scheme presented in the Whitepaper:

• Suppose the system wants to sell 100 bonds.

• Suppose that there are three buy orders on the order book: One bid for 80 15 bonds at 0.8 Basis each, one bid for 80 bonds at 0.6 Basis each, and one bid for 80 bonds at 0.4 Basis each.

• The system will compute the clearing price, which is a single price at which all offered bonds would have been bought at. Here, the clearing price is 0.6 Basis.

• The system will fill the winning bids at the clearing price: The first user will receive 80 bonds in exchange for 80 * 0.6 = 48 coins, and the second user will receive 20 bonds in exchange for 20 * 0.6 = 12 coins.

The protocol sets an artificial floor for the price of bond tokens to ensure that it doesn’t borrow too heavily against the future to contract supply now. We currently set this floor at 0.10 Basis per bond.

Are you retarded?

Yes, that’s all about Basis project. It’s anyway quite interesting as it seems good structured, though I have never thought any kind of pseudo- bonds or stocks can be used that way. However, I like the idea. I would personally include all those indexes and derivatives to make the picture even more bright.

On the other hand, I don’t really like when authors come down to wannabe stories like they did in “A Post-USD World” section. If Basis coin becomes a true mean of exchange (“we can assume that some goods will begin to be sold at prices denominated first in Basis.”), then it lies in a highly competitive lake.

Well, presumably we know nothing the like genius minds do: on Wednesday, April 18, Basis announced it had raised $133 million in a round backed by venture-capital firms including GV (formerly Google Ventures), Bain Capital Ventures, Lightspeed Venture Partners, Andreessen Horowitz, and Sky9 Capital.

So, if you ask me — what about algorithmic central banks? Not quite soon, guys.

The opinion of the author may not coincide with his point of view.

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