Could a crisis of confidence cause a death spiral in the system?

The Basis mechanism is designed to be resistant to death spirals and positive feedback loops. Our stability analysis, which we plan to make public, explores this question from many angles. Here, we discuss what we find to be one of the most common misconceptions around the way we believe the Basis system would work in a crisis of confidence.

When the bond queue becomes very long, it takes longer for new bond tokens to be redeemed. This would tend to depress bond prices, as it would cause people to become less willing to buy bonds. Some claim that during a crisis of confidence, depressed bond prices would cause the system to create more and more bonds at lower and lower prices in a positive feedback loop. However, we have two features in the Basis system designed to halt this loop: A bond price floor and a bond expiration.

The protocol is designed such that when a crisis of confidence occurs, once bond prices drop below a threshold that we call the bond price floor, the protocol would simply stop creating new bonds. When this happens, we would expect Basis price to dip below $1 for a period of time because demand has dropped but bonds are no longer being created. However, having a bond expiration means that old bonds gradually expire. When old bonds expire, the bond queue gets shorter. At some point, and usually quite rapidly, we would expect the shorter bond queue to cause bond prices to rise above the floor again, helping to restore Basis price back to $1.

Note that the intended restorative effect of bond expiration is continuous. To see this, suppose that the protocol has not issued bonds for a whole week. Assuming a 5 year expiration, this means that all of the bonds that are currently in the queue will expire in 4 years and 51 weeks at most. A buyer of a bond when the queue is in this state will have a full week, after 4 years and 51 weeks have passed, where all the bonds have expired and all of the Basis expansion is paid to that buyer. Because of this, the payout of a bond recovers over time, and should become more and more attractive as more time passes. In fact, this “expiration window” effect could allow bond prices to start recovering even on the next reconciliation, just after bond prices have dropped below the floor.

How does this compare to existing monetary systems? What’s interesting is that existing monetary systems that rely on fiscal debt don’t have an expiration on that debt. Rather, when they reach a situation in which they have to run a fiscal deficit for a prolonged period of time, they finance that deficit by issuing more debt, effectively kicking the can down the road. The issue with this is that when a large enough crisis of confidence eventually does occur, people suddenly lose faith in the government’s ability to pay everyone back. When this happens, the currency effectively dies and people are forced to switch to a new one. This is not only a catastrophic outcome for the citizens of countries in which this happens, it is also one of the chief ways governments and monetary systems fail (see this interesting survey post on how currencies fail and how long they typically live).

Basis’ approach of having an expiration on bonds is intended to allow the system to “default” transparently by de-pegging temporarily, and then re-pegging as bonds expire (or as Basis demand returns), rather than staying pegged for a while and then catastrophically failing. This is a key property because we believe the Basis system, as designed, could avoid catastrophic failure mode, potentially preventing the tremendous costs borne by people in an economy that is forced to switch to a new currency.

What’s also interesting is that there is actually a trade-off in setting the expiration. Having a shorter expiration would make bond prices lower because bonds would be more likely to expire worthless, which in turn would make the system more likely to de-peg during a crisis of confidence. But, at the same time, a lower expiration would allow the system to recover from de-pegs faster because bonds would expire from the queue more quickly. For example, if the expiration were set to 1 month, the system would likely de-peg frequently—but it would also be expected to re-peg fairly quickly after every de-peg. On the other hand, if the expiration were set to infinity, it would stay pegged for as long as possible, but it would also mean that a crisis of confidence would likely completely kill the system (similar to what has happened to monetary systems historically).

For this reason, the expiration of bonds in the Basis system is one of the deepest and most interesting design choices, and something that we think makes Basis a material improvement over existing monetary systems. The reason we talk about a 5-year expiration in our white paper is because we believe 5 years was a “sweet spot” based on our experiments using historic economic data. As future research, we are looking into having a dynamic expiration on bonds.

How would Basis behave when the bond price floor is reached, and Basis is trading at below $1? Well, the system is designed not to issue any new Basis until the price recovers. In this way it would be like a fixed-supply currency (e.g. Bitcoin), except that to the extent speculators are willing to purchase bonds again as the queue starts to clear, the Basis supply could be further contracted to help the price recover to par. As a result, we expect Basis would effectively be a more deflationary version of Bitcoin when de-pegged.

We do not believe any monetary system can remain stable under all possible circumstances, and Basis is no exception. However, looking at Basis as compared to the currencies that underlie most developing countries, and even developed ones, we believe Basis improves upon the status quo. Furthermore, given the fact that Basis is designed to behave like a more deflationary version of Bitcoin when de-pegged, and the fact that it could gracefully re-peg in the face of crises of confidence, we think, makes it fairly robust, and possibly more robust, in comparison to any monetary mechanism that has existed up to today.