Theoretical Fedcoin, Meet Operational NuBits

Blockchain, cryptocurrency ,Fedcoin, FinTech, NuBit
Teetertotter by M. Rehemtulla, modified, CC BY 2.0, original available on https://en.wikipedia.org/wiki/Seesaw#/media/File:Teetertotter.jpgwikicommons

Blockchain, cryptocurrency ,Fedcoin, FinTech, NuBit

In a recent blog post, St. Louis Fed Vice President David Andolfatto suggests that central banks “consider offering digital money services (possibly even a cryptocurrency) at the retail and wholesale level.”  His reasoning is straightforward.  Bitcoin, he observes, offers a host of benefits, most of which relate to its role as a payment device.  It enables individuals to transfer funds more cheaply than traditional payment mechanisms.  But it also has shortcomings, the chief of which, Andolfatto claims, is its short-run price volatility.

As an alternative, Andolfatto points to “Fedcoin” — a central bank-issued cryptocurrency proposed earlier by J.P.  Koning.  In theory, Fedcoin would employ the same blockchain ledger technology as bitcoin to transfer funds between accounts.  However, as Koning explains, “One user — the Fed — would get special authority to create and destroy ledger entries, or Fedcoin.”  To what end? According to Koning, “The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types — paper money and electronic reserves — and Fedcoin at a rate of 1:1.”  Hence, Fedcoin would offer the payment system advantages of bitcoin — the ability to transfer funds cheaply — without its excessive purchasing power instability.

In an earlier post on the topic, Andolfatto goes even further by claiming that “the Fed is in the unique position to credibly fix the exchange rate between Fedcoin and the USD.”  And, lest one think his claim applies exclusively to Fedcoin, he clarifies that “the Fed has a comparative advantage over some private enterprise” issuing a distinct cryptocurrency “backed by USD at a fixed exchange rate.”

Although Andolfatto is right to claim that the Fed — or any central bank for that matter — has a comparative advantage in issuing substitutes that are accepted at par with its other liabilities, it is certainly not in a unique position to issue a digital, P2P (peer-to-peer or person-to-person) cryptocurrency that is accepted at par.  There are all sorts of par-valued, dollar-denominated private digital monies.  In the US, private banks issue electronic balances that exchange at par with the dollar.  There are also P2P monies that trade at par.  The notes and coins issued by a currency board are P2P (in the sense of person-to-person and that they need not be cleared by a central authority).  And, since an orthodox currency board holds sufficient reserves by definition, it will maintain par acceptance.  Private banks in Scotland and Northern Ireland issue circulating notes that exchange at par with the British pound.  Clearly, private providers are capable of supplying either a digital or P2P money that trades at par with an established official currency.

In fact, there is even today at least one dollar-based, privately-provided digital, peer-to-peer cryptocurrency.  Billed as the world’s first stable digital currency, NuBits (an altcoin governed by the Nu protocol) has only deviated from its $1 par value by $0.025 or more on fourteen days — and only twice for two consecutive days — since it was launched on September 23, 2014.  In other words, NuBits are remarkably stable in terms of the dollar.  Figure 1 tells the whole story:

NuBit

How does the Nu protocol maintain a fixed exchange rate between its NuBits and the dollar?  In brief, its owners (“NuShareholders”) vote to adjust the supply of NuBits in circulation to equal current demand for NuBits at exactly $1.  Those interested in all the details should consult the original white paper and discussion forum.  I sketch out the basics below.

The Nu protocol relies on the premise that demand for NuBits will tend to grow over time.  For a fixed-supply cryptocurrency, like bitcoin after it reaches the 21-million-coin cap, an increase in demand increases its price and market capitalization (i.e., price times quantity of coins).  The increase in the market capitalization, or network value, of a fixed-supply cryptocurrency accrues to coinholders as their coins appreciate.  For NuBits, in contrast, an increase in demand only increases the market capitalization — not the price.  The increase in the market capitalization, or network value, of NuBits accrues to NuShareholders, who (through custodial grants) create and sell new NuBits for $1.  Revenues generated through the sell of these newly created NuBits are used to cover operating expenses and pay dividends to NuShareholders.  Hence, NuShareholders are residual claimants on the network value of NuBits and, as such, have an incentive to maximize the value of the NuBits network.

NuShareholders stand ready to create and sell NuBits anytime demand increases because it generates the revenue used to pay their dividends.  In other words, we can be pretty confident there will be sell side liquidity in the market for NuBits.  Any buyer will be able to find a seller at $1.  But how and why would NuShareholders produce buy side liquidity?  Or, to state the matter another way, how and why do they contract the supply of NuBits in circulation when demand decreases?

NuShareholders have several mechanisms to decrease the supply (or effective supply) of NuBits in circulation when demand decreases, thereby offsetting a reduction in price.  Originally, NuShareholders would simply vote to pay interest to NuBit owners who agree to “park” a balance of NuBits for a period of time.  When a user agrees to park a balance of NuBits, the balance is marked as parked on the blockchain and cannot be spent for the agreed upon park period.  When the agreed park period expires, control of the balance is returned to the owner along with the interest earned.  Park rates vary by duration and are adjusted regularly by NuShareholders to ensure that enough NuBits are effectively (if only temporarily) removed from circulation when needed.

Recent updates offer additional mechanisms to reduce the supply of NuBits.  NuShareholders can vote to increase the transaction fee, which, rather than being distributed to participants (as is the case with bitcoin and most other cryptocurrencies), is permanently destroyed.  They might also vote to convert some NuBits to NuShares.  This process, known as “NuBits burning,” is described as follows:

In the event of parking rates being offered for a prolonged period of time, NuShareholders can vote to create new NuShares that are sold through auction.  The proceeds from this auction would then be used to purchase NBT on the open market, at which point the purchased NBT would be destroyed permanently by the custodian.  The net result would be a dilution of equity value for all NuShareholders in order to reduce the outstanding supply of NBT in circulation.  This price support mechanism allows NuShareholders to reduce the supply of NBT to match periods of contracting demand. 

With these mechanisms, NuShareholders are able to manage the supply of NuBits in circulation to maintain par acceptance with the dollar.

Why would NuShareholders incur the costs to maintain par acceptance in the face of a negative, transitory shock to the demand for NuBits?  Essentially, NuShareholders believe that, as Nu protocol developer Jordan Lee states in the original white paper, “Temporarily losing peg will harm the value of the network.”  They are surely right.  After all, there are a lot of alternative cryptocurrencies available.  The unique feature of NuBits is that it has a fixed exchange rate with the dollar.  Abandoning that commitment would render NuBits no better than the competition.  To boost the network value — and maximize their dividends — NuShareholders must protect the fixed exchange rate.

Is the Nu protocol the answer to all our monetary economic prayers?  Absolutely not.  First, it would not seem to meet the robustness standards of a “real monetary rule,” as outlined by George Selgin.  Unlike the automatic (if crude) supply protocol of bitcoin and most other cryptocurrencies, the NuBits supply protocol depends on voting NuShareholders.  Second, it can — by definition — be no more stable than the dollar.  Widespread adoption of NuBits would provide no refuge from the Fed’s monetary mismanagement.

Nonetheless, one might appreciate that the Nu protocol offers the advantages of transferring funds with blockchain ledger technology, like bitcoin, without the disadvantages of bitcoin’s short-run price volatility.  Although the Fed has a comparative advantage in issuing substitutes that are accepted at par with its other liabilities, it is far less likely, as Andolfatto acknowledges, to offer a permissionless, privacy-protecting cryptocurrency.  The Nu protocol provides a pseudonymous cryptocurrency that trades at par with the dollar.  In other words, it is already doing precisely what advocates of FedCoin hope a central bank-issued cryptocurrency would do.

  • Sentinelrv

    Hi, I'm from the Nu Network. About this here…

    "Second, it can — by definition — be no more stable than the dollar. Widespread adoption of NuBits would provide no refuge from the Fed’s monetary mismanagement."

    Once our decentralized exchange (https://bcexchange.org/) is finished getting built and released, Nu will begin to introduce more pegged currencies other than its current USD peg. Among those that have already been planned for release are the Euro, Yuan and the SDR. That last one should excite some people. We feel the SDR has a much better chance of competing as a digital currency, and the Nu Network is in a great position to start offering it first. For those interested, here are some linked discussion threads where these plans were formalized and voted on by NuShareholders…

    https://discuss.nubits.com/t/on-currency-baskets/2819
    https://discuss.nubits.com/t/passed-motion-to-introduce-new-nubits-products/2834

  • Samuli Pahalahti

    Bitshares has also market pegged assets. Some of those are issued by network (and controlled by Bitshares), some are privatized (anybody can issue and control them).

    When Bitshares 2.0 was launched two months ago the rules were changed so that the peg is always at least the value it's pegged to (exept for privatized where the owner can decide otherwise). This floor has been held, but usually the price has been swinging too much up because lack of liquidity.

    To promote liquidity we have a proposal to create market maker incentivization feature. I'm not a trader of economist so it's hard to evaluate how this would really work, so it would be interesting to hear your comments on it: https://github.com/cryptonomex/graphene/issues/475

    Can be discussed also here: https://bitsharestalk.org/index.php/topic,20482.0

  • Blok Zinciri

    Pegging a failing fiat currency does not make any sense . Seriously …

    • http://vikingvista.blogspot.com/ vikingvista

      Nu shareholders have the power and incentive to devalue Nu coins to any degree necessary to maintain the peg. As long as the peg is maintained by the Nu shareholders, the Nu coin benefits from the same police powers used to force use of the failing state currency. Only when the state currency stops being used does the Nu coin stop being used.

      In other words, the peg to a failing state currency works, and is profitable for Nu shareholders.

      On the other hand, if the public is simply not interested in a Nu coin, for whatever reason, the Nu shares dilute to zero value.

  • MasterOfDisaster

    As someone who is following the development of Nu for some time, I want to express my deep admiration about how sharply you spotted important functions of Nu and how they have been refined over time!

    It was a pleasure reading a scientific article about Nu and NuBits!

    I know that understanding how Nu and NuBits (NBT) works can be hard, although the basic function is as simple as: adjust supply to demand.

    Allow me to outline my understanding of important differences of Nu and their initial product NBT to something like FedCoin.

    1)

    FedCoin as I understand it would be backed by US government. That has important benefits, e.g. if it would be allowed to pay taxes in FedCoin it would boost adoption immensely. But FedCoin would inherit the same weaknesses as the USD has.
    It would be quite hard to replace FedCoin with something completely different as FedCoin would be limited to the interests and reach of the backing government.

    FedCoin would be a digital USD.

    Nu is a different animal. It's a corporation which creates pegged currencies. NBT is the first pegged currency – the first product of Nu – and I think it was a clever move to start with a peg to something as widely used as USD.

    It has already been mentioned that other pegged currencies are on the road map of Nu products – currencies pegged to Euro, Yuan or SDR (XDR).

    WIth NBT it could be shown that this system basically works. NBT are here and stable for roughly 15 months now.

    After the successful introduction of new products it will be very easy to convert between different pegged currencies. And it t will be easy to abandon a specific pegged currency if there are severe problems with the currency it's pegged to.

    Nu is not limited to NBT the way FedCoin would be limited to USD.

    2)
    FedCoin can help tracking payment activities that can't be tracked with cash. The FedCoin blockchain as public legder with pseudonymous transaction details can be used to gather personal information if it's possible to discover to whom addresses belong.

    Nu is aware of the need for privacy. While not being part of the protocol yet – there might already be consensus that at some point privacy functions need to be incorporated in the protocol, though – privacy can be created by converting NBT to crypto coins which offer privacy functions – popular examples are Dash or Monero. Users lose the (value) stability temporarily, but that might be just the price that has to be paid at the moment.

    3)
    FedCoin would be the digital counterpart of USD and would be controlled by a single government

    Nu wants to generate revenue and is not bound to the limits of a single government. Nu doesn't need to follow the intererests of a single governement and in fact it can't.
    Ownership of Nu is decentralized. NuShares (NSR) holders are spread across the globe.

    It's likely that the majority of NSR is in the hands of inhabitants of developed countires, but it's almost as likely that these developed countries have different governments with different interests.
    While their governments try to create a monetary policy which benefits that country, Nu creates monetary policy to the benefit of Nu.
    It will be close to impossible (without buying a majority of NSR) to adjust the monetary policy to benefit say the USA at the expense of other countries as long as there are enough NSR holders from other countries owning NSR.

    4) No difference, but a gimmick:
    Today it's already possible to pay with NBT at each place that accepts BTC (or some other crypto currency) with an Android app called NuDroid (https://play.google.com/store/apps/details?id=com.matthewmitchell.nubits_android_wallet&hl=en). You can keep (USD) stable NBT and they get instantly converted to e.g. BTC via https://shapeshift.io.

    5) Outlook
    Nu with SDR might become something like a world currency if the success story of Nu goes on for some more years and adoption increases.

    There's a lot more at Nu than the eye can see at first glimpse ;)