The Ideal Digital Currency Needs a Reserve Backed System

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This is part 2 of a seven parts series by Dr Ken Alabi, who has a Doctorate in Engineering from Stony Brook, a masters in Computer Aided Engineering from the University of Strathclyde, and is an IT professional, programmer, and a published researcher with over twenty publications in various fields of technology.

Needless to say, all statements and views expressed below are solely those of the author. You might wish to read the introduction and part 1 of the series before continuing.

This is a continuation from the prior article positing that digital currencies need a more practical monetary system besides a fixed supply method if they expect to grow to reasonable size and be the basis of a thriving economic system. It turns out that we believe that most digital currencies also need a reserve backing for their networks; if only at the outset.

The reason for this is because the value of currency and money really is based on confidence by those who hold and transact in the assets. As a means of exchange, modern money is virtually worthless on its own face value. This is true of paper or fiat currencies, and also true for digital currencies. Their value lies in the consensus agreed upon implicitly by those who accept the currency for transactions. For example, one dollar is only able to buy some item, say 1 loaf of bread because the owner of the loaf of bread accepts that as the value for bread in dollars, and expects that they would be able to at any time turn around and exchange that one dollar for other goods or service that is on par in value with the 1 loaf of bread. Why and how that value settled at one dollar and not, say 100 dollars is determined from a history of the currency and market forces of demand, supply, and costs of production. Let’s consider that history.

History of the Dollar Value

During its creation, inserted into Article 1 of the US Constitution, is a clause known as the Commerce clause, that required the debt of the nation and effectively the dollar be backed by gold and silver. Later on, the Gold Standard Act of 1900 effectively pegged the dollar solely to gold, specifying that the dollar be equivalent to twenty-five and eight-tenths grains (about 1.67 g at the time) of gold of some specified purity level. This guaranteed the dollar could be convertible at any time to a specific amount of gold. Effectively, the dollar was thus backed by one ounce of gold to $20.67. Much of the currencies in Europe were also backed by gold during that period.

The Gold Reserve Act of 1933 modified the rate to $35 per ounce of gold. Following that period, other currencies began to be valued in terms of the US dollar, and thus remained effectively pegged to gold. However, inflation put a strain on this arbitrary peg, and eventually in 1971 following the oil crisis, President Nixon canceled the convertibility of the dollar to gold, and allowed the dollar to determine its own equilibrium value.

The dollar is currently effectively backed by faith in the United States government and its history and obligation to the currency. Other countries, and commodities markets, such as the price of oil, have basically continued to peg their values to the dollar. Deposits in dollars, for amounts less than $250,000 have also been backed by the United States government via the Federal Deposit Insurance Fund – a reserve, such that users know that the amounts they have in the system at any point is secure to that extent in terms of the value they put into it to buy it (which is the goods or services they exchanged for it). That FDIC reference above provides an interesting perspective on the intention of the reserve and would make a good short read separately. It would be imperative not to throw away some of the desirable aspects of an old system while trying to replace it with a better, and technologically more advanced one.

Excerpts from the text setting up the FDIC

The history described above serves the purpose of demonstrating that at the outset, for users to gain confidence in a currency, they initially need to know that if they buy the currency; which they effectively do by exchanging their goods or services for it; they can expect to retrieve roughly that value back at any time. The value they can retrieve back represents a floor on the value of their goods or services. Later, once the currency is established, the currency could set its own rate based on its strength and what its users determine is its exchange value.

Bitcoin seems to have bypassed this path. However, it continues to experience volatility that is not conducive to every day commerce. The argument from a digital currency enthusiast would be that pegging digital currencies to any fiat money, which is typically inflated, simply removes one of the key drivers behind the creation of the digital currency in the first place and would effectively stymie their appreciation. However, this is not a peg of the digital currency to the fiat money but a separate reserve that serves as a floor initially for holders of the new digital currency. The reserve does not imply that users must exchange back their digital currency for the reserved value. They could and likely will continue to exchange at the market rate same as is currently done for digital currencies.

Current Attempts by Digital Currencies at Creating a Reserve System

Some recent work in digital currencies has recognized the need for reserves for crypto-currencies. One such effort is that done by Tethers. Tethers creates new cryptocurrency and pegs its value 1-to-1 to the dollar. However, this arrangement completely negates one of the key advantages of a cryptocurrency – the fact that gains in the ecosystem is not inflated away. Consider a system in which economic activity is taking place, denominated in some currency, or set of currencies. Economic activity eventually leads to the creation of value, and thus the overall value of all circulating currencies should increase. And holders of the currencies that engage in that economic activity would see that increased value in the value of the currencies they hold.

Economic activity as a driver of wealth creation should lead to
increases in value for the underlying currency used in creating that value

What happens with fiat currencies, instead is that the increasing value of the ecosystem is inflated away by printing more money, and the value of the currency does not increase. The trend between GDP growth and the Consumer Price Index, CPI, in the US going back about two decades, is shown below, and illustrates this well. The GDP is seen increases almost annually while the currency has slight decreasing annual CPI.

Trend between US GDP and CPI going back about three decades.
Sources: US Bureau of Economic Analysis (BEA) – Gross Domestic Product.
Federal Reserve Economic Data (FRED) – Consumer Price Index: Purchasing Power of the Consumer Dollar

Consequently, tethering a cryptocurrency to fiat currency while it might instill confidence in the value of the new currency, would also strip away the ability of the cryptocurrency to set an independent monetary path free of the supply policies of the fiat system.

Another cryptocurrency that addresses the idea of a Reserve system, but in a different way is Bancor. In the Bancor formulation, a new token is created that sets up a reserve system where the token sort of plays the role in the ETH ecosystem that the USD does to other national currencies, or that gold initially did for the dollar.

Description of the Bancor Protocol from the website

While the reserve idea in Bancor for new digital currencies is fundamentally reasonable, pegging of new currencies to a brand new one such as Bancor or even other slightly older digital currencies will likely not create much confidence of the type advocated here. The point of the reserve is to peg a new digital currency to a more established one that users have confidence in; and not just those already using cryptocurrencies. In addition, a predetermined reserve price known to the user before purchasing the new currency, and without the exotic price discovery schemes, is currently advocated here as it would be more deterministic and clearer to those new to cryptocurrencies – which is the vast majority of people.

An Ideal Reserve System for CryptoCurrencies

The ideal reserve system for cryptocurrencies would allow the new currency to gain in value on its own based on the economic activity underlying the currency, its demand, as well as its monetary supply strategy. The reserve would simply provide a base initially backing any fiat currency exchanged initially for the currency. Essentially, a similar law as the first law of matter should govern an initial exchange of a fiat currency for a cryptocurrency – value should not be created or destroyed simply by changing it from one type of currency to another. If $100 is exchanged for an equivalent amount in a crypto-currency, then the holder of the new cryptocurrency now has the ability to proceed and spend an equivalent of that $100 in the ecosystem. The initial exchanged amount can be placed in a reserve essentially providing liquidity backing a potential return to fiat currency, if needed. Without that, the newly minted cryptocurrency would have caused an equivalent of $200 to be available for spending within the ecosystem.

The challenge in this formulation arises when the new currency begins to grow in value; which it will if it begins to be utilized in transactions that drive economic activity, and its supply is not inflationary. When the currency begins to gain in value, subsequent minted value would be backed by higher and higher fiat values. This would mean that the reserve value is either no longer on par with the initial reserve rate set, or methods need to be devised to ensure that the reserve itself is growing at pace with the value of the cryptocurrency; which is not impossible if a portion of the growth in the ecosystem is also returned to the reserve. However, keeping the reserve exchange rate fixed is a simpler formulation and would still be a significantly better scenario than the current status quo.

Operating a Reserve System with a Decentralized System

Setting up a reserve system for a centralized cryptocurrency or one where the minting is centrally controlled is fairly straightforward. Setting one up for a completely decentralized blockchain system would be much more challenging. For instance, who would be responsible for verifying the reserve? A reserve system could be fully decentralized, semi-centralized or fully centralized. New processing nodes or master-nodes of a blockchain system may be required to deposit an equivalent amount in reserve for every currency they mint in new blocks they create. Each node may then need to submit an audited review of their reserves on a periodic basis. This formulation would be more easily operable with a network that is based on proof of stake for processing nodes. There is no doubt that much of the verification operations on the reserve side would occur outside of the blockchain, but the tools and techniques to implement such a system exists today.

Finally, it should be pointed out that just as the dollar disengaged itself from its reserve asset years after it was fully established and had gained near universal buy in, a reserve backed cryptocurrency would also gradually shed its need to be backed by a prior currency. This will occur naturally as the value of the cryptocurrency begins to gain comparatively in value, and as its share of use in the economy increases. It is possible that within a decade or less, the growth in value of the cryptocurrency, and its controlled monetary supply, and preference for transactions denominated in it would have seen it grow as a share of the overall economy sufficiently to gradually phase away the fall back exchange rate, and with it the reserve requirement.

Conclusions

In this second article in the series pointing out improvements to digital currencies, or attempting to envision the ideal digital currency, we describe a system of reserves that would see this ideal digital currency with the following attributes:

  1. Perfectly liquid against original fiat currency in its domain right from the outset. Members of the digital currency’s economic ecosystem have confidence that the digital currency they hold can be exchanged back to local fiat currency on demand.

  2. Reserve procedure is transparent and automated and programmed into the blockchain logic.

  3. The reserve price by nature of the limited supply will slowly become lower than the market price as the digital currency appreciates against its reserve currency.

  4. The reserve price is programmed to appreciate year on year, up to a number of years at which point the reserve is no longer needed, and the digital currency no longer provides a fallback conversion rate to the older currency.

 

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