The Cryptoeconomics of Seigniorage Shares Stablecoins: Basis and Carbon
The topic of stablecoins has occasioned a flurry of discussion and activity in late 2017 and early 2018, not unsurprising given the potential of stablecoins to allow the expansion of the crypto community in a number of important ways. This articles considers two developing stablecoin projects that fall within the seigniorage shares category of stablecoins, exploring the particulars of their constructions, their relative positioning within the market, and significant challenges each is likely to confront.
Seigniorage style stablecoins are an algorithmically governed approach to expanding and contracting a stablecoin’s money supply. They are inspired by a 2014 paper written by Robert Sams, and represent one of the three primary approaches to stablecoin development. This article examines two developing stablecoins projects, each broadly inspired by this model, and considers both the particulars of their construction and their relative positioning within the context of the broader market.
The topic of stablecoins has occasioned a flurry of discussion and activity in late 2017 and early 2018. The challenges and opportunities stablecoins represent are frequently described in enthusiastic terms such as the “Holy Grail of cryptocurrency,” given the perceived potential to expand the scale and impacts of the crypto community if a stable, scalable cryptocurrency could be developed. An effective stablecoin could represent the emergence of a cryptocurrency able to fill all three recognized monetary roles, of unit of account, store of value, and medium of exchange, in a way that more volatile cryptocurrencies cannot. Additional expectations that the emergence of effective, trustworthy stablecoins will prove central to the development of a host of core elements of the overall distributed ecosystem, whether prediction markets, lending facilities, and insurance vehicles, in addition to a variety of other dApps, only reinforces this sense of anticipation and possibility.
As frequently described, emerging stablecoins generally fall into one of three categories.
- Collateralized off-chain: One genre is that of a tokenized claim on a portion of a centralized holding, such as Tether, TrueUSD, or even the GOLDX Token HelloGold intends to issue. These are generally simple, easy to understand vehicles, that nevertheless are often criticized by crypto maximalists for the centralized nature of the underlying asset, and the single point of failure represented by a storage facility such as a bank account or a Brinks vault.
- Collateralized on-chain: The second genre of stablecoin, that of a collateralized on-chain vehicle such as MakerDao’s DAI, or Sweetbridge’s BRC token, are decentralized vehicles operating on-chain. Such stablecoins function only as a result of sizeable economic inefficiencies represented by the low lending ratios against the underlying cryptocurrencies used to collateralize such stablecoins.
- Seigniorage shares: The third broad category, that of seigniorage shares, named after an October 2014 Robert Sams article, describes stablecoins with flexible money supplies governed by algorithms that programmatically buy and sell a stablecoin’s tokens in order to maintain the token price near the intended peg. While stablecoins of this genre are effectively untested in practice, their promise has aroused considerable interest and serious entrants are beginning to enter the space.
This article begins to examine stablecoins in general and seigniorage style stablecoins in particular as part of a larger study of stablecoins that began with a previous discussion of Sweetbridge’s highly ambitious project to create a stablecoin as part of a larger cryptocurrency lending service itself serving even larger global supply chain and trade finance objectives. This article focuses on two recent entrants into the seigniorage style shares space, and considers their underlying cryptoeconomic design and particularly the stabilisation mechanisms intended to govern their operations, as well as the teams and outlooks behind each project. In addition, the focus on the distinct economic incentives each team has built into its operations provides additional insights into competing approaches to establishing rentier positions in what many consider to be a stablecoin arena with virtually unlimited upside for whichever coin or coins emerge as long-term winners. While this article does not attempt to predict who those winners are likely to be, it does consider potential long-term scenarios in the stablecoin space.
Basis: A Twist on Seigniorage Shares
Like its many stablecoin peers, Basis has embarked upon its quest for the Holy Grail by seeking to differentiate itself by virtue of its novel approach and innovative ideas. From a rhetorical standpoint, Basis strongly succeeds, with an intelligent, readable and compellingly argued whitepaper that makes an appealing, if nevertheless ultimately unproven, case for the theoretical strength of its approach. Ambitiously describing itself as the ‘stable cryptocurrency with an algorithmic central bank’, Basis believes its specific approach to protocol-governed expansions and contractions of its monetary supply will allow it to emerge as a leading entrant in the field. The decision to refer to its own protocol-governed monetary policy as akin to ‘an algorithmic central bank’ is also a carefully chosen metaphor, indicative, as shall become clear, of a larger destiny Basis boldly suggests awaits it. Finally, while the protocol-governed nature of Basis’ adjustments to its money supply justifies including Basis in the ‘seigniorage shares’ group of stablecoins, Basis argues such classification is misplaced, by virtue of its monetary mechanisms’ specific features. While a seemingly trifling semantic distinction, this claim can actually be considered a window into a core feature of Basis’ functioning.
Basis’ Three-Token Economy
By most accounts, the principle challenge for seigniorage shares lies in maintaining market confidence that the algorithmic operations of the stablecoin will continue to hold the trading price of the token around the designated peg. Theoretical discussions of seigniorage share systems describe how stablecoins maintain their close relationship to their peg due to buyers of shares stepping up into price declines, eager to arbitrage short-terms fluctuations in price through the promise of re-selling their newly purchased shares once the token returns to and moves past its peg. Such a system is premised upon the persistence of widespread beliefs that the stablecoin will, in fact, return to its peg. More broadly, some consider stablecoins of this type to be dependent upon continually expanding cryptocurrency markets which, it is argued, should serve to provide a steadily increasing pool of buyers for stablecoins. In a case where this confidence is lost, attempts to move the price back upward towards the peg by selling shares for coins fall flat, as buyers simply do not appear.
Importantly, a wholesale loss of confidence in the general crypto markets is not required to undermine a particular stablecoin’s operations and effectively seal its fate as a failed effort; simple lack of additional buyer interest, caused by either a newer, more appealing stablecoin’s appearance, a shift in market sentiment towards stablecoins such that one genre of stablecoins such as asset-backed stablecoins falls out of favor, or general market conditions that leave few buyers for stablecoins, can have the same effect of leaving a stablecoin without buyers willing to fulfill the price stabilization role. The worst case result is an actual ‘death spiral,’ where increasing amounts of shares must be sold to purchase and retire more coins, further lowering the price while massively increasing the outstanding shares. As the amount of unredeemed shares increases with this dilution, potential buyers are discouraged even as the stablecoin crashes to zero.
Within the context of this challenge, there are three components of the Basis ecosystem that together govern the system’s functioning:
- Basis tokens represent the core stablecoin of the system, tradeable tokens that are intended to retain a value close to the designated peg.
- Bond tokens, or simply bonds, are created during declines in the Basis token price, are purchased with Basis tokens in order to reduce token supply and increase the token price, and are redeemed upon the Basis tokens returning to and trading above par, at which point the algorithm would be interested in increasing the money supply in order to lower the price. Bond tokens are not tradeable, and after purchase must be held until redemption or expiration.
- Share tokens represent a fixed supply token called Basis shares. When all outstanding bonds have been redeemed and the Basis token continues to trade over par, additional Basis tokens are issued to share token holders. These shares are not redeemed upon issuance of additional Basis tokens and can theoretically receive unlimited tokens as or if demand increases. These are not intended to be tradeable on public exchanges.
These three elements of the Basis ecosystem are significant in that they both guide the system’s functioning and represent a novel attempt to address the fundamental challenge facing all stablecoins of the seigniorage shares genre. This is because, whereas seigniorage share protocols generally issue ‘shares’ redeemable for coins as prices drop below the designated peg, Basis has introduced a minor yet important modification by instead offering to sell Basis ‘bonds’. Basis considers itself different from the seigniorage shares group by virtue of this distinction that it considers a novel and critical component of its stabilisation and monetary policy techniques. Upon closer inspection this distinction is at the core of several innovations that might ultimately insulate Basis from many of the challenges facing other members of the seigniorage shares group.
In particular, Basis believes it has developed three mechanisms that collectively address this fundamental challenge facing all seigniorage shares. The first solution, mentioned above, is to sell what it terms Basis ‘bonds,’ rather than shares. This allows it to place an expiration date upon each bond–Basis has determined this shall be a five-year period based upon what it describes as extensive research–after which unredeemed bonds will simply expire. Basis believes this will limit the possibility of the bond queue becoming so large that it leaves potential new buyers skeptical that the entirety of outstanding bonds could ever be redeemed. This would obviously deter new buyers, effectively undermining the core logic of the algorithmically-governed modulations of the money supply. The second is that Basis will redeem bondholders on a first-in-first-out (FIFO) basis. This approach is intended to encourage potential buyers to act early in the face of a Basis coin decline, in order to be closer to the front of the bond queue when redemptions begin, rather than wait in hopes of timing the absolute bottom of a decline. The ultimate intention of this method is to prevent self-perpetuating cyclical declines in the token price. Finally, should this FIFO method not prove sufficient to incentivize buyers who might insist in sitting on their hands as prices decline, Basis bonds have a price floor of $0.10, a level below which bonds simply will not be sold, an effort to ensure against the worst-case scenario of massive dilution that would come from retiring coins with bonds sold for pennies on the dollar. Collectively, these mechanisms represent the core innovations of the Basis approach, and their effectiveness will likely be critical in the project’s fate.
Basis Team and Backers
Basis, née Basecoin, emerged in 2017, founded by three Princeton computer science graduates, Nader Al-Naji, Lawrence Diao, and Josh Chen. Following their graduation from Princeton, the three have worked in various tech, finance, and research firms. While Basecoin is reported to have found early-stage investment and support from a handful of leading venture capital firms during 2017, the project changed its name to Basis early in 2018, around the same time it completed a ~$133 million investment round with an extended group of top venture firms.
Investors in this most recent round purchased not Basis stablecoins, but the underlying Basis Shares. As such, if or when Basis coins are trading above their peg, and assuming all outstanding bonds have been redeemed, new Basis coins will be issued to Basis shareholders, who are then free to sell them into the market. Should Basis’ market cap increase to some approximation of Tether’s early May 2018 valuation of $2+ billion, that entire amount in Basis coins will need to be issued. These will be issued to Basis shareholders who will in turn be free to resell them into the market in what could become a lucrative position as a supporter of what Basis founders and backers believe could assume a central role in the expansion of the crypto space into the world of traditional economies.
Basis: Beyond the Dollar
Basis also makes intriguingly bold claims about its ability to establish for itself not merely a central role in the crypto ecosystem, but to transcend the crypto universe and play a broader role in national, regional, and even global economies. Basis outlines two ways it could assume such a role. While its initial peg is, as with most stablecoins, to the U.S. Dollar (USD), Basis anticipates moving beyond a simple USD peg. This could take a number of different forms. One would be that unique instances of Basis could be established for individual national currencies, such as the Swiss Franc or Japanese Yen, or regional currencies, such as the Euro or CFA Franc used in parts of Africa.
While the above merely illustrates Basis’s ability to peg to currencies other than the USD, Basis also has a ‘post-fiat’ vision where Basis itself could become the monetary foundation of economies. Outlining a scenario where transactional volume and value of Basis begin to surpass that of the USD or other local currencies, (an admittedly unlikely scenario given the role of USD denominated bonds in serving as ballast for the global financial system and of government bonds generally in serving as foundations for the valuation of fiat currencies) goods might ultimately begin to be priced in Basis tokens as well as local currencies. Were such a scenario somehow to materialize, Basis could shift its peg from the USD to a basket of goods priced in Basis, effectively replicating the process whereby the Federal Reserve Bank evaluates the Consumer Price Index (CPI) to inform policy in the United States. Regional instances of Basis, pegged to regional CPI baskets, could potentially form a unique global underpinning to an integrated, highly liquid global economy interconnected by an accessible crypto ecosystem. The above-noted rhetorical strategy of referring to its ‘algorithmic central bank’ clearly appears, in light of such aspirations, to intentionally suggest Basis’ suitability for the challenges of such a demanding role.
Prospects and Challenges for Basis
Without question, Basis is an innovative attempt to develop a thoughtful solution to a problem widely perceived as one of the most pressing challenges in crypto. That said, a number of questions, both regarding stablecoins more generally as well as Basis in particular, are difficult to avoid when evaluating Basis. Considering these questions is worthwhile, for these issues will likely retain a central place in the relative fortunes of both stablecoins in general and Basis in particular going forward.
While the novel idea of bonds expiring in the event that they remain unexercised after five years is appealing in terms of the argument for controlling the size and length of the bond queue, this could also have unintended impacts. One potential problem is that while the theoretical aspect of ‘refreshing’ the bond queue by culling the oldest members might have a positive impact on market confidence, the reality is that such a default could instead have systemically destructive repercussions in reducing investor confidence if it broadly calls into question future bond redemptions across other redemption dates. Perhaps more relevant is the concern that, long before defaults actually occur, Basis would have to spend four plus years trading below par while bonds linger unredeemed. Confidence in Basis’ prospects would likely already have been destroyed in such a scenario, leaving an actual default as an anticlimactic formality.
Other questions can be asked of the framework Basis employs in referring to its “bonds.” Bonds, as widely understood in the context of financial markets, are fixed-income investment products where investors loan money to a company or government for a defined period with scheduled repayments occurring until redemption. Bonds are generally understood as low-risk investments, with defaults rare, although not unheard of. Basis bonds, with no interest payments, no fixed redemption period, yet possessing a fixed expiry date as well as the risk of total loss of capital should the bond expire unredeemed, could be argued to bear a closer resemblance to common understandings of equity options than actual bonds. Such products are widely understood as having a meaningfully different place in the universe of financial products than bonds. While potentially merely another issue of semantics, the distinction between the terms could be crucial in shaping perceptions of the Basis ‘bonds.’ These altered perceptions could potentially have a material impact on the performance of Basis coins.
Another important question that will only really become answerable when Basis tokens begin to trade actively, and in challenging conditions, is whether the introduction of FIFO methodology will prove sufficient to entice Basis bond buyers to act early once a price decline begins. One might wonder whether the addition of the bond price floor suggests there are concerns that prices could decline dramatically. Seen differently, however, the existence of a price floor may simply be a clever tactic to ensure that any potential dip buyers hover, in the worst case, in the low teens rather than just above zero. Whether this will prove to have a practical impact will only be clear with time.
Having just raised $133 million from buyers of Basis shares, Basis presumably has a strong treasury that, in the worst case, could be employed to stabilize its own market while a broader audience develops. However, while $133 million does appear to be a substantial amount even if portions are dedicated to product development, in a scenario where Basis saw its market valuation or trading volume expand rapidly towards that of Tether, for instance, such an amount would quickly become utterly insignificant as a useful market stabilization reserve. Only time will tell whether this reserve will be needed for market stabilization efforts, and if it will be able to be effectively deployed in such a role should the need arise, but this could easily become a critical issue.
Finally, while Basis boldly proclaims its algorithm can function as a central bank does in terms of actively managing money supply, this claim raises many obvious questions. For instance, while Basis claims it can effectively respond to the diverse inputs and circumstances that inform central bank decisions, its own whitepaper substantially subsequently retreats from this assertion in acknowledging the difficulty that responding to the Fed’s Dual Mandate would represent. The result is to acknowledge that while an algorithmic stablecoin might be able to ‘piggyback’ on the efforts of central banks to stabilize a currency–an already vastly complex process that requires central banks to monitor inputs ranging from currency reserves, economic conditions, and government policies both past and present, and to interpret them in light of evolving circumstances and the actions of both markets and other central banks, to cite just a few of the challenges–such a stablecoin would face a considerably more difficult, if not outright impossible task of responding to conditions such as rising unemployment, natural disasters, resource shocks, or government policy changes that central bank policy makers continually confront. The answer provided in the Basis whitepaper, that the unemployment component of the Fed’s dual mandate could be addressed by incorporating the price of an hour of labor into the core CPI data informing the Basis algorithm, is interesting, but not altogether inspiring or convincing that it would prove up to the complexity of this challenge were such a tactic ever needed. What it does do is illustrate the challenges behind central bank decision making. In describing its own plans, Basis refers to many of the standard criticisms of central banks, such as opacity of decision making and inclination to inflate money supplies, yet many will be skeptical of proposals to algorithmically replace those efforts in a sustainable and confidence-inspiring fashion.
Fortunately, the days of the Basis algorithm displacing the roles of central bankers in the management of money supplies are likely far off, thus some of the potentially most challenging aspects of developing an algorithm controlled stablecoin need not be immediately tackled. In the interim, Basis is undoubtedly a substantial addition to the stablecoin field that represents an innovative effort to address important challenges in the crypto space. While Basis’ prospects are not inseparable from those of the sector as a whole, Basis does appear to be a thoughtful new addition that has meaningful prospects of fulfilling some of the much-heralded prospects of stablecoins even as it pushes on the extant limits of the crypto protocols and methodological approaches. Before Basis can focus on its long-term future, however, it will face substantial competition from a host of competing stablecoins, including Carbon, another entrant into the seigniorage shares category.
Carbon: Textbook Seigniorage Shares
Carbon is another seigniorage shares style stablecoin that emerged early in 2018, with plans for protocol-governed expansion and contraction of the money supply via the issuance of additional tokens as the price moves above the peg, and the withdrawal of tokens as the price moves below the peg. Like Basis and other entrants into this genre, this approach is an attempt to modulate the volatility in fixed-supply cryptocurrencies such as Bitcoin that frequently exhibit wide price swings as demand fluctuates, through algorithmic mechanisms to increase and contract supply in response to the ebbs and flows of demand surges. While Carbon’s whitepaper does not compare positively with the thoughtful, well-informed and well-argued nature of the Basis whitepaper, Carbon’s approach is to accentuate its cleverly developed and likely highly competitive commercial position.
Carbon will trade on the Hedera Hashgraph, a blockchain-alternative permissioned hashgraph intended to achieve hundreds of thousands of transactions per second, in addition to having asynchronous Byzantine Fault Tolerance and leaving it as a highly secure, rapid, and affordable host blockchain for what Carbon’s backers believe could become an important element of the larger cryptocurrency space.
Carbon’s Two-Token Economy
Carbon also employs a two-token ecosystem:
- CUSD is the Carbon stablecoin, and is intended to trade in a narrow band around Carbon’s designated price peg of the US Dollar (USD).
- Carbon Credit is the free-floating coin, and is sold for CUSD when the CUSD price moves below $1. New Carbon Credits are issued via a Reverse Dutch Auction mechanism, with Credits priced and paid in CUSD. Payment for Carbon Credits is in CUSD, which serves to reduce the outstanding supply of CUSD, theoretically helping the price move back towards the $1 peg. When or if the CUSD price moves above the price peg, signalling strong demand for CUSD, additional CUSD tokens are issued to Carbon Credit holders who are free to sell them into the marketplace, pushing the CUSD price back towards its peg.
Carbon is unique in that it allows for secondary trading of Carbon shares issued as part of the contraction of money supply, potentially allowing a share bought at $0.90 to be resold at $0.98, rather than waiting for redemption at par in a similar fashion to other stablecoins of the genre such as Basis.
Carbon uses a decentralized Schelling Point oracle scheme to achieve consensus on Carbon’s exchange rate with its US Dollar peg. Exchange rates are established every 24 hours. Network nodes post collateral to submit their estimate of the Carbon-USD exchange rate. Users falling outside of the 25% – 75% range will lose a portion of their collateral, with those falling within the central range acquiring portions of this lost collateral.
Carbon’s Team and Backers
Carbon is led by Connor Lin, Gavin Mai, Miles Albert and Sam Trautwein, along with advisor Michael Karnjanaprakorn. The four studied at Columbia, Stanford, and the University of Southern California, and have held positions with organizations such as Uber, Consensys, and Hedera Hashgraph. On its website the company also lists a number of funds as investors, a group that includes relatively well-known names in the industry. There is little info regarding the nature of their support for or investments in Carbon.
Cryptoeconomics of Carbon v. Basis
Much of the framing of Carbon’s project, as presented in the whitepaper, concerns strategic efforts to situate Carbon in relation to the most prominent new entrant into the seigniorage shares category, Basis. As noted, Basis raised $133 million in early 2018 from a variety of prominent venture firms, and has generally received considerable attention. Interestingly, despite the substantial support Basis has generated, both monetarily but also symbolically given the nature of the firms that participated in its sale, in some ways Carbon can be considered a highly competitive project that may present a strong commercial competitor to Basis.
Carbon’s approach to issuing new coins in service of expanding the money supply is commercially appealing, particularly when compared to the approach Basis has taken towards the same question. Basis, for instance, once outstanding bonds have been redeemed, will issue new tokens to the holders of Basis shares. These shareholders are insiders and the venture capital firms who invested ~$133 million in Basis in spring 2018. By investing in Basis coins, those firms are betting that Basis will experience sustained strong demand and that hundreds of millions in new tokens, or more, will be issued to Basis shareholders. The scale of the opportunity can be appreciated when one imagines the quantity of new tokens that would be required were Basis to begin to rival Tether’s $2b+ billion valuation.
Carbon, by contrast, promises to issue all new tokens exclusively to the holders of Carbon Credits, which appear to be primarily acquired through public markets. Rather than issuing its new coins exclusively to venture capital firms and other insiders holding Basis shares that were acquired in private sales, Carbon Credits are exclusively available to those who purchased them in the marketplace at a moment when the Carbon token was trading below its peg and in need of support. In effect, Carbon is seeking to ensure additional support in the marketplace, potentially at the expense of Basis, by structuring its Carbon Credits so that they offer higher upside and more appealing terms for a potential buyer attempting to decide between purchasing a Carbon Credit and a Basis ‘bond’.
Carbon increases the demand for its Carbon Credit through a second element of the Credit’s structure related to the question of redemptions. For example, and assuming that stablecoins such as Carbon and Basis exhibit generally high correlations–a not unreasonable expectation given the traditionally high correlations between crypto assets–in a situation where both stablecoins declined to $0.80, a buyer of Basis bonds would be wagering that underlying Basis coins would return to $1.00, whereupon the bond holder would realize a 25% return when his bond was redeemed. The Basis bond holder, however, would have no additional upside prospects beyond the 25% return, for even if Basis continued to trade above $1.00, any new coins issued would go to the holders of Basis shares. While 25% is a strong return in any market, a potential buyer of a Carbon Credit in the same instance would, for the same $0.80 initial outlay, gain exposure to potentially far greater return. This is because, were Carbon to return to its peg, then remain above it while new coins were issued, some portions of any newly issued coins would go to the Carbon Credit holder. Should Carbon proceed to grow to a multi billion market cap, the Carbon Credit buyer in this example would realize a substantially larger return than the Basis bond purchaser who would have had their bond redeemed at par. The mechanisms are somewhat different, given that the Carbon Credit is not redeemed but rather receives open-ended allocations of new coins, and the exact return to the Carbon Credit buyer would also be a function of the overall number of outstanding Carbon Credits, but the potential for a far larger return clearly exists.
What will be fascinating to observe will be the interplay between these assets over time. Basis and its Basis bond program, by virtue of its substantial support from prominent venture investors, appears to have a more pedigreed group of backers who could potentially form the nucleus of a strongly positive public narrative that may emerge. Carbon and its Carbon Credit system, however, would appear to offer more substantial investment return potential, in a situation where all other contexts appear to be equal. The question of relative degrees of market confidence in the enduring potential of these two assets will likely emerge as critical to their respective fortunes. The likely competition between these two assets could also potentially develop as a sort of indicator of the state of the crypto markets, particularly the question of whether ‘popular’ or ‘institutionally-supported’ approaches are finding larger degrees of support.
Carbon, by virtue of not having an immediately apparent rentier position making a claim on the issuance of new tokens, is specifically seeking to capture market support by offering all upside to Carbon Credit holders (the functional equivalent of Basis bond holders in terms of having claims on the issuance of new tokens). This is, loosely, the stablecoin equivalent of forking a blockchain in order to remove a founders’ allocation, and how it unfolds in this context bears watching.
Beyond this direct challenge to Basis by virtue of Carbon Credits’ structure, Carbon has developed a second mechanism designed to present a competitive challenge to Basis. This second challenge revolves around the question of liquidity and is another potentially significant aspect of the competition that appears likely to emerge between these two stablecoins. Specifically, while the purchaser of a Basis bond can only redeem the bond at par–so a buyer at $0.80 must hold if or until the bond is redeemed at $1.00–Carbon Credits will be continuously tradeable on secondary markets. This means that the purchaser of a Carbon Credit at $0.80 will be theoretically able to resell their Credit at $0.90 –assuming liquidity exists– if a scenario arose that left the holder doubting the potential of the Credit to return to $1.00. All other conditions being equal–a not insignificant caveat–the Carbon Credit would appear to be a considerably more appealing asset in terms of allowing a potential purchaser a wider range of options than a bond with a single redemption scenario.
Finally, while Carbon’s seeming strong advantage on a number of commercial points appears to make it a vastly more appealing token, only time will tell whether this rivalry unfolds as might be anticipated. One potentially highly complicating issue is the question of underlying fees. While Basis has made few declarative statements, it will likely operate on the Ethereum blockchain. As noted, Carbon will operate on Hedera Hashgraph. Unlike an open-source, decentralized blockchain, Hedera is a for-profit permissioned hashgraph run by a limited number of nodes. These nodes will collect small processing fees, roughly analogous to Ethereum gas fees, in addition to processing fees accruing to the nodes. Nodes are rewarded for their contributions based upon tokens held in wallets controlled by the node of token holdings, and presumably Hedera insiders–who as noted are related to Carbon’s founders–could easily assume dominant node roles, allowing them to acquire the majority of processing fees. Should Carbon assume a dominant position in the stablecoin ecosystem and develop a multi billion dollar market cap with similar daily trading values, as does Tether, one assumes these fees could become substantial. Noting this relationship is not necessarily to suggest it is somehow improper, but merely to bring it to the light of day in order to help community members make the most informed decisions possible. The reality is that the same rentier position privileging insiders that is easily identifiable in Basis own structure may develop with Carbon as well, albeit through a different and less visible mechanism.
A further potentially complicating point for Carbon concerns the repeated manifesto-like aspect of statements within their whitepaper that transcend the common–and frequently justified–criticisms of United States Federal Reserve and its governing board. While statements such as “One of Carbon’s main value propositions is that code is more predictable and less arbitrary than humans” are essentially standard fare in this context, Carbon appears to undermine its carefully developed competitive position in making other, more outlandish comments. Suggesting that Federal Reserve Board members are themselves a treasonous bunch, having “only limited interest in the well being of your country,” seems not only to go too far, but to potentially represent the sort of comment that might easily alienate exactly the sort of institutions that could potentially become prominent backers of an emerging stablecoin. Given the critical nature of market sentiment towards these stablecoins, deliberately provocative comments such as that above seem curiously indiscreet.
Prospects and Challenges for Carbon
Looking ahead to the challenges likely to be confronted by Carbon as it attempts to establish itself as a leading actor in the stablecoin space, several issues are easily identifiable. The most obvious is undoubtedly the competition with Basis described above. Whether Carbon manages to acquire a popular perception as a stablecoin that distributes its most immediate financial benefits across a wider range of supporters may well be the most central issue in its relative and near-term successes.
Beyond this, a second compelling challenge for Carbon concerns the realities of using a Schelling Point system as a pricing oracle. While reporting on exchange pricing for Carbon should be relatively straightforward and uncontroversial, some users will, by definition, fall outside of the 25% – 75% range and will, as a result, lose a portion of the collateral submitted at the time of posting. Whether this confiscation of collateral that could occur even if a node reported a price that was correct out to several decimal points, yet still falling outside of the 25th – 75th percentile, thus losing a portion of their collateral in a way that might ultimately deter nodes from submitting price estimates will be interesting to observe. Presumably an alternative format could be established should it prove necessary, but the disruption could be significant.
Another important test for Carbon will be to observe how the Carbon Credits perform in practice. Will the potentially large returns they offer buyers be sufficient to arrest any declines in the Carbon stablecoin trading price? Unlike Basis, which has attempted to address the central criticism of seigniorage share style stablecoins by incentivizing buyers to act early via its (still untested) FIFO redemption process, Carbon has made no effort to address this weakness. While the groups controlling the Hedera Hashgraph may be incentivized to ensure Carbon’s survival, no other obvious group of supporters is immediately apparent. For this reason alone many market participants may be eager observers of Carbon’s performance following its first meaningful decline.
Not unrelated to the above is the absolutely critical role of confidence in terms of Carbon’s future prospects. While perceptions are critical for all stablecoins, for if they turn negative the general premise of any seigniorage style stablecoin is undone, this is doubly true for Carbon. This is because if Carbon does retain a high degree of market confidence and develops a broad, stability-inducing user base, its more appealing terms relative to Basis, a primary competitor in the realm of elastic-supply seigniorage-type stablecoins, could allow it to grow and assume a leading role in the more general stablecoin space. If, however, Carbon is seen as less competitive or secure than any of its many peer stablecoins, finding buyers willing or able to serve the critical volatility inducing role could be critical.
The Larger Question of the Stablecoin Project
While both Basis and Carbon face a number of profound challenges on their respective quests, challenges deriving from the particular approaches their founding teams have taken, these do not represent the extent of the issues each will face. Additional risks exist that extend beyond each company’s control, representing a variety of more existential challenges confronting all stablecoins. These may well emerge as the most significant issues that Basis, Carbon and every other stablecoin may confront.
For example, a question of tremendous importance for all members of the seigniorage-style class is the risk of being discredited by peer stablecoins that may not survive. Even if a particular stablecoin’s algorithms prove successful in maintaining prices around a peg, a crisis befalling a fellow stablecoin would likely disgrace the entire sector, potentially leading to a cascading series of collapses as algorithm after algorithm is stress-tested by the market. The reality may well be that any user of a seigniorage style share is not simply betting on the governing protocols and mechanisms of their chosen stablecoin, but of all the others in the genre. Or, more worryingly, all users of such stablecoins may be betting upon the governing protocols and mechanisms of the weakest member of the group, for an ‘accident’ there could easily doom all members of the space. This is a substantial wager.
In the event one genre of stablecoins is discredited by an ‘incident’ befalling one of its members the broader market reaction would also be difficult to predict. Might the market, for instance, flee into a different category of stablecoins–from seigniorage share style coins to collateralized on-chain, for instance–or simply abandon any cryptocurrency with stablecoin in its product description? One might suspect simpler, less complex stablecoins might benefit from such a scenario, at the expense of the more complex constructions of the on-chain allocated and seigniorage style stablecoins, but the details of any situation will likely prove crucial in determining exactly how the market reacts.
An additional challenge could emerge if market sentiment towards stablecoins begins to shift. One potential concern is the incessant representation of stablecoin development efforts as selfless, altruistic efforts to allow the cryptocurrency ecosystem to expand into wider spheres where its impacts can be multiplied. Yet a closer look at many of these projects reveals clear commercial ambitions behind many projects. This tension, between the undisputed right for innovators and entrepreneurs to be rewarded for developing forward-thinking efforts, and the potential for short-term opportunities to assume primacy over long-term impacts, is perpetually at risk of shifts in perception. As one observer recently remarked on Twitter “Your mistake is thinking they are building a stable coin. They are just building a product for which they will charge fees,” suggests the potential for many of these stable coin efforts to be seen in a negative light. A shift towards a sharply negative view could easily end with the unfortunate impact of having even the most promising stablecoin projects be seen in a negative light. Should the market’s sentiment ever shift, the crucial question of confidence in terms of motivating buyers to step up, as discussed above, might be irrevocably destroyed.
Stepping back even further, the idea of any stablecoin emerging ‘victorious’ from the fray is itself premised upon the entire genre obtaining or retaining the relevance many expect it to acquire. While most consider the matter of the enduring role of stablecoins to be so obvious as to not merit consideration, the broader markets could evolve in a range of unanticipated directions. For instance, a major argument for the importance of stablecoins is creating an option for investors to sidestep the volatility of existing cryptocurrencies. In the current crypto setting where crypto-fiat onramps are few, clunky and expensive, such arguments are broadly appealing, but if those onramps improve their functioning and accessibility, and in a world where many expect some form of state-backed digital assets to emerge, the obvious case for the importance of stablecoins may become less clear. In a setting where one could as easily trade out into euros as they could trade into e-dollars, the fate of individual stablecoins, no matter how decentralized, fashionable, or technically sound they might be, could become less than entirely obvious. In such a scenario, the potential market for stablecoins could become significantly smaller.