What The Mississippi Bubble Can Teach us About Basis - Part 2 of 2

Michael Ippolito | August 1, 2018

This post is a follow-up to What Long Term Capital Management Can Teach us About Basis - Part 1 of 2

Earlier this week we examined the issues with Basis' central algorithmic 'smart bank' by looking at LTCM's mistakes from the late 90's.

Here's the one sentence summary: LTCM placed too much faith in an algorithm that didn't have the amount of data it needed to make accurate predictions about deviations in fair value.

This article will examine the second, and arguably more crucial, issue that underlies Basis' ability to function as a stablecoin. Namely, the idea that not enough people will believe that base coins are 'real money' to prevent a virtual bank run.

Basis, like fiat currency, is not collateralized with an underlying asset. That means in order for it to function, people need to buy the fact it truly can act as a unit of account and medium of exchange.

It's pretty difficult to overstate just how difficult of a problem this really is. History has provided us with some sharp lessons about individuals who've tried to make that shift before people are fully bought in. One such example is John Law 's system of finance that would (after an initial brief period of success) bring 18th century France to the brink of economic catastrophe.

 

John Law's Big Idea

John Law is something of a controversial historical figure. Born the son of a successful Scottish goldsmith and heir to Lauriston Castle, Law displayed a deep affinity for two areas from an early age: gambling, and finance. An unfortunate side effect of the former was a habit of heavy drinking and debauchery, which led to a number of escapades and regrettable behaviors.

Law's proclivity for gambling and drinking culminated in the duel and subsequent murder of his neighbor, who had voiced objections concerning Law's unseemly mistress. Law was tried for dueling and sentenced to prison, but escaped to nearby Amsterdam before his incarceration.

At the time of Law's arrival, Amsterdam was the world capital of financial innovation. The Dutch had recently made improvements to the Italian system of public debt and reformed their currency by creating (arguably) the world's first central bank, the Wisselbank. Also known as the Amsterdam Exchange Bank, the Wisselbank solved the problem of coinage debasement by successfully issuing a reliable form of bank money.

Perhaps most importantly of all was the creation of the world's first joint-stock company, the Dutch East India Company (popularly known as the VOC). So popular were shares in the VOC, which by this point in time were producing healthy dividends thanks to a profitable monopoly on trade routes to Southeast Asia, that a robust secondary market formed to support trade.

Law was fascinated by this precursor to the modern stock market. The principal idea that excited him was the successful issuance of the central bank's currency in conjunction with the popularity of the VOC shares.

It wasn't long before an idea that combined the properties of a monopoly trading company with a public bank issuing paper notes began to take shape in Law's head. The idea was a simple one, but one that would nonetheless have profound implications for both France and eventually the rest of the world: was it possible to replace raw material currency with paper currency via a nationalized bank?

 

The World's First Stock Market Bubble

France turned out to be the testing grounds for what would become known as 'Law's System.' Why did France, of all places, consent to be the guinea pig for the financial experimentation of a known gambler and alcoholic (among other things)? The same reason many countries result to financial alchemy: desperation.

The wars led by Louis XIV in the late 17th century had left France deeply in the red. A review of the crown's existing debts in 1711 led to a partial default, exacerbating the already dire financial situation.

It was John Law who came to France's rescue with a bold new proposition: a central bank that issued paper notes in exchange for deposits of gold and silver. Law's argument was that an infusion of currency into the French monetary system would boost trading activities and provide a much needed stimulus for the economy.

The limited amount of gold and silver in post-war France was providing a ceiling for economic activity, argued Law, and the best way to remove the ceiling would be to issue more currency.

The Duke of Orleans, regent for Louis XV, granted his proposal. Law took direction of the Banque Generale in 1716, French's first central bank. In 1717, it was mandated that the bank's paper notes would be used in all tax payments. And so Law accomplished the first portion of his grand design: a central bank that maintained control over the monetary supply.

In order to achieve the second portion (the trade monopoly), Law exerted his considerable political influence to gain a monopoly on all trade with French-owned Louisiana in the newly formed United States. The company, dubbed "The Company of the West" (popularly known as the Mississippi Company) was formed in 1717 and granted exclusive trade rights for a period of 25 years.

Law wasted little time in issuing his first tranche of shares, priced at 500 livres each. During this time, Law successfully acquired other trading privileges, such as the right to collect all revenue from tobacco and eventually the right of first refusal to all trade activities outside of Europe.

To finance these activities, Law began to issue more shares. On June of 1719, the Mississippi Company issued another 50,000 shares priced at 550 livres apiece. Less than a month later, a third tranche of shares were issued at 1,000 livres apiece.

Law's system was unknowingly (or perhaps knowingly) predicated on one basic concept: more and more people needed to keep buying shares of the Mississippi Company. The more shares they bought, the more they needed to borrow paper currency from the bank, and the more gold and silver they needed to deposit in exchange. As long as there continued to be a market for the shares, there would continue to be demand for Law's paper currency.

For a while, this system worked. By December of 1719, Mississippi share prices had run up to over 10,000 livres.

 

Hitting the Floor

Law's System couldn't last forever. Eventually, partially due to shaky reported profits from Louisiana trade, Mississippi share prices began to trend lower. Sensing an impending crisis in confidence, Law began to institute measures to prop up the price.

The Banque Generale (or Banque Royale as it was now known) opened a bureau that guaranteed to buy shares and sell them at a floor price of 9,000 livres. Law also created options that cost 1,000 livres entitling the owner to buy a share for 10,000 livres over the next 6 months.

These worked for about a month. The skyrocketing price of the shares pushed inflation in Paris into double digit numbers, prompting deflationary fears of Law's paper currency. This prompted investors to redeem their banknotes for the gold and silver they had deposited in the central bank.

Fearing a run, Law acted swiftly: bank notes were made legal tender, the production and export of gold and silver was banned, and in February it became illegal for a private citizen to possess more than 500 livres of metal coin.

And just like that, the link was broken. The bank notes, the French realized, were nothing more than pieces of paper. Their value was arbitrary, based not on an inherent measure of value but the whims of Law and the crown.

The final nail in the coffin was the abandonment of Law's 9,000 guaranteed share buyback price. Shares slid to $4,200 in under a week, and the system was broken. By June of 1720, the crown was forced to reintroduce the use of gold and silver back into domestic transactions.

 

The Connection to Basis

So what does Basis have to do with the failure of Law's System?

Simple: they both rely on a currency that people did (or will not) believe in.

Law's System ultimately collapsed because the French people lost faith that paper bank notes were truly a currency. When investors wanted to take profits from Mississippi Company investments, they sought to do so in gold and silver. When shares of the Mississippi Company began to tank? They wanted to redeem then for gold and silver.

Why? Because while John Law could issue all the paper currency he wanted, he couldn't ultimately convince anyone it had any inherent value and the absolutist economic tactics he used to prop up the price of Mississippi Company shares (i.e price floors) are notoriously ineffective.

And the same, I believe, will be true for Basis.

It's likely Basis will see some success in the beginning. There's a massive need for stablecoins in the blockchain ecosystem. They are a good answer to the volatility problem, and they're a decent on-ramp for fiat money. Plus, if collateralized with an asset like the USD, they could provide a meaningful injection of liquidity.

The problems will begin once a meaningful amount of money has been invested in Basis' ecosystem and demand for the coin slows down. We've written before about how a slowdown of demand or new users could result in a death spiral. Problematically, their solution has been focused on absolutist policies such as bond expiration dates and price floors - remind you of anyone you know?

In the end, Basis can't really win because there aren't enough people in the world ready to believe that this is a real currency. The US was able to successfully abandon the gold standard in favor of paper currency because enough people readily believed in its status as money. By 1971 when Nixon made the announcement, most people had never transacted with gold. Most had likely never even seen a gold bar in person.

And that's just not the case with Basis. In the end, investors will abandon the system to take their profits in fiat currency. Users, who are incentivized to participate by profiting from the bonds and shares system, will do the same once they smell blood in the water.

In the end, I doubt it will be an improper line of code or a competitor or even government regulation that spells the end for basis. Rather, their fatal flaw lies in the hubris of thinking they could change people's mind about money.

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Michael Ippolito

Co-Founder of BlockWorks Group