Basis—the “stable” cryptocurrency with $133 million invested—explained

Last week, we learned that an impressive slate of Silicon Valley investors was pouring $133 million into Basis, a company that aims to create a cryptocurrency with a stable value against the dollar.

It’s easy to see why investors would be excited about a project like this. If successful, it would provide all the benefits of conventional cryptocurrencies without the volatility that plagues bitcoin and its competitors today. Demand for such a cryptocurrency could easily outstrip demand for conventional cryptocurrency, since volatility is one of their big weaknesses.

But there’s no guarantee that the Basis project will succeed. Lots of people have tried to create stablecoins in the past, with generally poor results.

Today’s most widely used stable cryptocurrency, called Tether, claims to back each unit of its currency with a dollar of hard currency reserves. However, the company has a poor transparency record, causing critics to wonder if Tether might not actually have reserves backing all of the cryptocurrency in circulation as it claims.

Basis is taking a different, more ambitious approach to the stablecoin problem. Basis coins won’t be directly backed by dollars or any other asset. Instead, the Basis blockchain will attempt to adjust the supply of Basis coins over time to maintain a peg to the dollar, much as foreign central banks expand and contract their own money supplies to maintain a stable currency value.

The Basis network doesn’t exist yet—the 10-person team expects to launch it in the coming months. All we have now is a white paper describing the team’s plans. And that white paper does not give us a whole lot of confidence that the team has figured out how to succeed where previous projects have failed.

The Basis stablecoin may manage to track the dollar in value for a certain period of time—especially if it’s backed by a $133 million warchest. But if confidence starts to falter, the whole project could collapse.

What it takes to create a stablecoin

The simplest way to create a cryptocurrency with a stable value—in dollar terms—is to directly back it with dollars. The big downside to this approach is that some organization needs to have custody of the dollars. That runs counter to the decentralist philosophy of most cryptocurrency projects. There’s a danger that the intermediary could prove to be untrustworthy, refusing to redeem coins and running off with customer funds instead. Centralization also makes it easier for governments to regulate cryptocurrencies or shut them down altogether.

So in recent years, cryptocurrency enthusiasts have been searching for a way to build a cryptocurrency with a stable value without relying on a centralized entity to hold conventional funds as backing.

To do that, a decentralized cryptocurrency needs to solve three problems in order to maintain a stable value against the dollar (or any other reference asset):

1. A decentralized way for the network to know the current exchange rate between dollars and the cryptocurrency.
2. A way for the network to push the value of the cryptocurrency down when it rises above $1.
3. A way for the network to push the value of the cryptocurrency up when it falls below $1.

The first problem seems solvable. Like a number of other stablecoin projects, Basis plans to use an on-chain consensus mechanism to establish an official exchange rate between Basis and dollars at any given point in time. Anyone will be able to vote on the current exchange rate. The system will choose the median value of these votes as the official exchange rate. A system of financial rewards and punishments—the details of which are still under development—will dissuade people from trying to game the system.

The second problem—preventing excessive appreciation of coin values—is easy to solve. If the value of the stablecoin rises too much, the system can create additional coins and introduce them into circulation.

The third problem is the hard one: how to prop up the value of the coin if it falls below $1. If the coin were backed by conventional dollars, this could be done by using dollar reserves to buy up coins. But there’s no way to store dollars directly in a blockchain. So a decentralized stablecoin system needs some other asset it can sell to prop up the coin’s value.

Possible fixes

As this great article by Haseeb Qureshi explains, there are basically two options here. One is to have the coins backed by another existing cryptocurrency, such as bitcoins or Ethereum’s ether. The system might hold $1 of ether in reserve for every unit of the stablecoin that’s put into circulation. If the price of the stablecoin falls below par, the system can use the ether to buy up coins until the price gets back to $1.

The problem, of course, is that ether itself doesn’t have a stable value. If ether’s value falls, the system will become insolvent. So in practice, systems like this tend to require users to deposit more than $1 worth of backing assets for every $1 of stablecoin that gets issued. Still, this scheme will break if the backing asset is too volatile. For example, if the system requires a $2 ether deposit for every $1 of stablecoins issued, then the system could become insolvent if ether’s value falls by more than 50 percent.

The other option uses an approach first outlined by Robert Sams in a scheme called Seigniorage Shares. Seigniorage is the profit that a central bank makes when it issues new units of currency. The basic idea of Seigniorage Shares is that, during periods of falling demand, the system props up the value of the stablecoin by essentially selling future seigniorage profits—that is, the value of coins that will be created during later expansions of the money supply.

The scheme outlined in the Sams white paper uses two different types of token on the same blockchain, called coins and shares, respectively. Coins are designed to have a stable value over time. Shares, which fluctuate in value, entitle the owner to a share of the system’s future seigniorage profits.

When the price of a coin rises above $1, the system responds by creating new coins and using them to buy shares, pushing the value of coins back down to $1. This works like a stock buyback, pushing the value of the remaining shares up. If demand for coins is rising over time, then the value of shares will grow over time, making them an attractive investment opportunity.

If the price of a coin falls below $1, the system performs the opposite operation, issuing new shares and selling them for coins. That takes coins out of circulation and props up the value of the remaining coins—while simultaneously pushing down the value of shares.

This system should work as long as the market expects the total demand for coins to rise in the future. If the market expects coin demand to rise over the long run, it will see shares as a profitable investment opportunity and so there will be a robust market for shares the system can use to prop up coins’ value during temporary downturns.

But this system could fail catastrophically if markets start to expect a long-term decline in demand for coins. In that case, we would expect the value of shares to fall over time. Attempts to prop up coin values by selling shares would simply cause share prices to fall faster, leading to panic-selling and a further downward spiral. As shares get cheaper, the system would have to create more and more shares to keep coins at $1, potentially leading to share hyperinflation and ultimately to the collapse of the system.

It’s not obvious how Basis improves on previous systems

Sams never created a working network based on his Seigniorage Shares paper. But his ideas have inspired others, including the founders of Basis. Like Seigniorage Shares, the Basis team plans to prop up the value of its stablecoin during periods of declining demand by selling the rights to coins that are created later.

However, Basis makes a couple of important modifications to the basic Seigniorage Shares system.

First, instead of doing share buybacks during expansionary periods, the system pays dividends to shareholders. While the mechanics of this are a bit different, the result should be roughly the same—shareholders get enriched as the money supply expands.

The more consequential change is the addition of a third asset class called bonds. When the value of Basis coins falls, the system creates new bonds and sells them for Basis coins. Each bond has a face value of one Basis coin (and hence $1), but investors can acquire them at a market-determined discount.

Then, during a subsequent expansion, the system pays back these bondholders before paying anything out to shareholders. Bondholders get their money back in a first-in-first-out order, with the oldest bond being repaid first.

In effect, buying a bond amounts to making a bet that the demand for coins will rebound in a timely fashion. The less confident the market is that this will happen, the steeper the discount—a bond might sell for 0.8, 0.5, or even 0.2 Basis coins—and the greater the potential profit.

The Basis team members say that they’ve done Monte Carlo simulations that show this scheme is more robust than the basic Seigniorage Shares scheme.

With Seigniorage Shares, “there is no incentive for people to buy shares early in the drop rather than later in the drop,” the Basis white paper argues. “Shares bought earlier pay off the same as shares bought later. This means that if people suspect an upcoming drop in coin demand, share price will immediately crash.”