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:
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.