Stablecoins have been a hot topic for a while now. There's been a lot of clamor and excitement about the concept of a price-stable cryptocurrency, i.e a cryptocurrency that behaves like an actual currency.
Investors certainly seem to think there's a need. Basis, a non-collateralized stablecoin that uses an algorithmic 'smart bank' to govern monetary policy, has raised $133 million from a hodge-podge of big name investors, including Bain Capital Ventures, GV, Stanley Druckenmiller, Lightspeed, Andreesen Horowitz, and the list goes on.
The question is, what is the incentive for investors to pour real US dollars into an asset that's end goal is to be a digital IOU for a US dollar? If there's no appreciation in the value of the asset, how do these investors (and Basis as a company) expect to make any money?
It turns out there is a very well thought out revenue model, and it's a bit of a doozy.
A Quick Overview of Seignorage Shares
Stablecoins fall into one of three categories: fiat-collateralized, crypto-collateralized, and non-collateralized. This article will be analyzing the non-collateralized seignorage shares approach to stablecoin creation (you can read a more general overview of stablecoins here).
Here's the basic premise for the seignorage shares model: rather than collateralizing the coin with an underlying asset (i.e USD) coins are simply pegged to the underlying asset (again, in the case of Basis, the USD).
The difference is that with coins like Basis, base coin holders can't trade in their coins for US dollars.
The value of the coins depend on the expectation that people will treat them like money. The system relies on an algorithmic 'smart bank' to expand and contract the monetary supply to maintain the peg.
So, for instance, if there is a sudden increase in demand that drives the price of the coin above $1, the 'smart bank' will issue more coins into the system to dilute their value.
Conversely, if there is excess supply that drives the value of the the coin below $1, the 'smart bank' will issue bonds at a discount, redeemable for the equivalent of $1 at some designated point in the future. I.e, I buy a bond for .8 base coins with the expectation that the 'smart bank' will issue me 1 base coin in 6 months.
Seems simple enough, right? Maybe. First, let's discuss how these systems generate capital for their managers and investors.
How Stablecoins Make Money
Not all coins are created equal in the seignorage shares approach. In Basis' model, there are three different types of assets.
1. Base shares
2. Base coins
3. Base bonds
Base shares are a sort of equity representation in the system. Here's how it works. A certain allocation of base coins are issued and pegged to the US dollar. As demand for the coins increase, the value of the base coins rise above a dollar.
To maintain the peg, the 'smart bank' increases the supply of coins, driving the value of the base coins back to par. The question is, who gets these coins?
You guessed it - the base share owners. Now, if it turns out there are outstanding bonds, the bond owners will be paid first. If not, the coins are allocated to the base share owners.
Base shares are similar to equity in that the owner can value their shares as a function of the amount of future dividends that they expect to be paid out.
Additionally, in many seignorage shares models, shareholders get a right to vote. That means they have direct influence over the system's monetary policy.
Now you might be starting to see why the VC's are so eager to throw money at stablecoin projects. The total monetary base of the US dollar is around $4 trillion.
The total global monetary base clocks in at around $84 trillion.
If a stablecoin were able to capture even a very small percentage of that pie, it would still be quite a mouthful.
One percent of the US monetary base is around $40 billion. A 10% equity investment in a project like that would produce very handsome dividends indeed.
Seems like these guys have it figured out right?
It may not be that simple. Actually, there's a pretty massive problem that has already been pointed out with the seignorage shares model.
The Pretty Massive Problem
The issue with seignorage shares revolves around the requirement that the monetary supply keeps expanding. Basically, the system needs to keep adding participants who will increase the demand for more coins.
To illustrate why that is, let's return to our quick description of how the bond system works.
Say you decide to purchase a base bond. You purchase the bond for .8 base coins at a face value of 1 base coin, to be paid out 6 months in the future.
What does a transaction like this require? That there will be an increase in future supply. In simpler terms, if I buy a bond today I'm doing so under the expectation that there will be an increase in demand sufficient to increase supply while still maintaining the dollar peg.
In even simpler terms, the system requires the subsidization of future investors to function.
The seignorage shares model only really requires one premise to function: demand needs to continue increasing. So let's examine what would happen if it doesn't.
If there is a sudden decrease in demand, we know that the 'smart bank' will begin to print new bonds.
However, as the line of bond-holders grows longer and longer, it becomes less likely that some of these bonds may ever be paid out (base bonds expire after 5 years and the owners of the oldest bonds get paid first).
The result of this would be that the market value of the bonds would fall, as investors require a higher risk premium for fear of a default. The falling market price of bonds would then force the 'smart bank' to print even MORE bonds to take supply out of the system.
What I am describing here is a death spiral. And it's not even an unlikely one - it's one that inevitably will happen when there are no more participants to be added to the ecosystem.
The Bright Side - Why Stablecoins Might Make Sense
Yes, there are problems with the seignorage shares model, but they speak more to the complexity of what these projects are trying to achieve than anything else.
The success of most start ups depends on the founder's determination, vision, the right product-market-fit, raising capital, and a whole lot of luck.
Basis' success hinges on all of that plus their ability to design a monetary policy that will function in a brand new ecosystem. Hardly a project for the faint of heart.
It's also not fair to point out a potential problem (albeit a big one) as though Basis hasn't given any thought to it.
Basis has an entire page dedicated to explaining the countermeasures in place to prevent such a spiral, which include bond expiration dates and a bond price floor.
Although, I do feel the need to point out the fact that price floors of any kind have been known to produce disastrous results.
If seignorage shares projects like Basis have one flaw, it may be that they're too early. I've already written about how I think the best stablecoin solution (for now) is one that's collateralized by the US dollar.
Why? Money is predicated on belief, and people already firmly believe that the US dollar is money.
Having a coin collateralized with USD will not only be the simplest solution, but it may experience the fastest rates of adoption because people believe that it's money.
So what's the conclusion here? I think Basis ultimately Basis is on the right track, but I'm not convinced that A) people are ready it and B) they've got the kinks worked out.
There are just so many things that can go wrong, just look at how many financial missteps regulatory bodies have had in the US over the past 50 years.
Will investors in Basis be alright? Probably. It's unlikely that the system will run out of new participants to subsidize growth before they have a chance to liquidate their positions.
It will probably require many iterations of stablecoins before we get a project that really works. And they'll all need to contend with the oracle problem at some point. But as of now stablecoins are one of the most fascinating areas of work in the blockchain space, and (most crucially) one that will probably see some of the fastest rates of adoption.