A Central, not Centralized, Bank of Crypto for a Physical Ecosystem

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Governance Without the Fed

A plot of land devoted to crypto presents an incredibly exciting sandbox from technological, sociological, governmental, and economic standpoints. Something of this magnitude will require a novel financial system to function, ideally a layer of abstraction away from any existing currency peg which allows it to self-regulate and grow separate from the economic influences of the jurisdiction it resides in. Its success will be determined by its ability to capture the benefits of debt financing, which has been the single most impactful driver of large-scale human innovation. In other words, any new society that is looking to build with crypto will have its development severely hampered if there is no way to leverage debt for growth. But issuing debt, which in the past only central banks have been able to do, seems at odds with the core ethos of crypto.

For example, our current system where the Federal Reserve (Fed) issues dollars at will is nontransparent and likely conflicting with the interests of the public it was designed to serve. This is the result of a completely unidirectional relationship — decisions by the Fed affect banks, who pass those costs on to consumers. By comparison, the public has no direct channel to affect rates going the other way. The ecosystem envisioned in this paper is underpinned by blockchain and democratizes monetary policy, putting it into the hands of the citizens. When the people control the inflation rate, they are balancing their own money’s strength against the growth of the society they live in.

The Reserve

Everything starts with a Reserve, at its core a staking mechanism by which people who want to participate in the ecosystem can obtain local currency, tentatively called LCC. LCC, in turn, must be used as the ecosystem’s main currency. Enforcing LCC adoption, like requiring merchants to accept it and workers to be paid in it, is paramount in it taking firm root. The funds in the Reserve would collateralize the LCC, akin to how gold backed the US Dollar. The Reserve itself is a smart contract or set of smart contracts that accepts ETH (or some other cryptocurrency, but ETH is used in the rest of the paper as the example) in return for LCC at a fixed ratio. The ratio can be arbitrary, so we are using 1 ETH:100 LCC for ease of calculation.

A robust decentralized Reserve needs two characteristics: incentive to deposit and sufficient collateral to support withdrawals. The former is achieved through a fixed interest system that assures appreciation of deposits into the Reserve, and the latter maintained through a withdrawal fee which defines the exchange rate from LCC back to ETH. How this mimics inflation and deflation will be explored in the “Collateralizing Withdrawals” section. Both policies are tied together using a voting protocol that mandates locking in ETH to participate. By requiring users to put skin in the game in this manner, it encourages people who are going to use it as a medium of exchange to own it while discouraging speculative purchasing or scalping.

Incentivized Deposits

Upon depositing ETH, the Reserve exchanges it for LCC at the fixed conversion rate and starts paying out interest 1% per annum. Economically speaking, this is a more attractive alternative to holding ETH because it turns it into a revenue producing asset. The table below illustrates this in action.

Figure 1: Flowchart for how ETH becomes LCC
Figure 2: Payout schedule on ETH kept static in the Reserve

In the above example, the user deposited 1,000 ETH into the Reserve. She receives 1% annual percentage yield (APY) for as long as the ETH is parked there. The APY far exceeds anything an average person could get in a savings account today. This is because while the Fed has an interest rate of up to 3%, banks typically charge between 3.5 and 5% for loans. Savings accounts need to give a lower rate of return than the arbitrage between those as a result. By removing the banks’ markup and decentralizing the Fed, return rates for Reserve contributors can far exceed returns that any institution can presently offer.

Each new deposit into the Reserve serves as a “Reserve block (RB)” and begins generating interest immediately after being converted to LCC. It also records the original depositing ETH address and the time of deposit.

Figure 3: Reserve Blocks in practice. The smart contract can keep track of original depositors for interest payout purposes, and interest accrued for withdrawal purposes.

Collateralizing Withdrawals

Deposits are incredibly important for capitalizing the Reserve, but would be impossible to secure in the first place without some capability to redeem them later. Users maintaining ownership rights over their original assets remains key to the Reserve’s longevity and the health of the ecosystem it supports.

To maintain withdrawal ability, there needs to be parity between LCC and ETH. In other words, when ETH leaves the Reserve, a commensurate amount of LCC would need to exit circulation as well. But the LCC generated by APY on reserve currency means that circulating LCC would increase relative to Reserve funding by a compounding rate of 1%. Over time, this would lead to people purchasing LCC through Over the Counter (OTC) channels at a discount and draining the Reserve, leaving LCC holders with a currency backed by nothing. To solve this, a withdrawal fee equal to the interest accrued by that Reserve block needs to be implemented:

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This way, any resultant LCC inflation only stays in circulation while the RB it is tied to stays in the Reserve, avoiding the situation where the collateral can be siphoned off over time:

Figure 4: A worst-case scenario if withdrawals ignored the interest that deposits generate. LCC accumulates over time while ETH remains static. The withdrawal fee is the solution to ensuring there is sufficient backing in the Reserve for LCC to derive its value from.

One potential complication with this approach is the seeming dichotomy between long staking periods, which undoubtedly are better for consistency and long-term security of the Reserve than short staking periods, and interest accrued, which makes it more costly to withdraw an RB that has been staked for a longer time. In order to make sure users who stake for longer periods aren’t punished in this manner, withdrawal fees should be averaged across all existing RBs as illustrated below. This has the effect of making it relatively less expensive to withdraw from RBs that have been staked for longer, thus rewarding users operating on a lower time preference.

Figure 5: By normalizing withdrawal fee across all current deposits, longer depositing periods are rewarded.

Voting & Incentives

Incentive for deposits and control for withdrawals are solved, but the consumer currency framework is still rather rigid in that it cannot grow much larger than the total value stored in the Reserve. For meaningful growth to occur, inflation is necessary. The job that a central bank typically handles is instead decided democratically by users who have skin in the game via Reserve deposits.

They Vote to adjust the withdrawal fee. A lower fee means there is residual LCC left in the ecosystem after each withdrawal, even after full redemption for ETH. Likewise, a higher fee means the cost is greater than the accrued interest, so more LCC is leaving the ecosystem than was created by the original deposit. The percentage is denoted as distance from the default 100% of accrued interest. Therefore a fee of 10% means it costs 110% of accrued interest plus principal on LCC to convert back to ETH, so all withdrawals remove some LCC from circulation. Likewise, -10% means it costs 90% of accrued interest.

This methodology allows the people with the highest stakes in the ecosystem’s continuation to make the decisions. The act of Voting is simply staking ETH deposits into the Reserve for a set period. Vote strength is determined by the quantity of ETH staked and the amount of time it is staked for, as the graph below illustrates. Each Vote made creates a time-locked Reserve block (TLRB), which cannot be redeemed early but continues to generate interest for the Voter.

Figure 6: Highly simplified example for how a consensus of -10% withdrawal fee would be reached. Additionally, as TLRBs exit their lockup period, they can be reallocated to new votes. In this way, withdrawal fee is dynamically set to reflect the immediate preferences of the users.

When there needs to be wealth created, Voters can come together to enact inflationary behavior. But when purchasing power within the ecosystem becomes too low, they can mobilize for deflation. By assigning time as a real cost and withdrawal fee as a real outcome to Voting, users are incentivized to interact with the system. Moreover, buyers are more likely to be people who want to interact with the system in the first place. This Proof-of-Time-Staked protocol is effective because it forces Voters to stand by the effects of their decisions.

Vote strength is designed to reach a maximum after a certain number of years to prevent Voters from leveraging trivial amounts to have outsized effects on the withdrawal fee.

Figure 7: Vote strength is designed to hit a maximum after 10 years. Not only does this limit the ability for trolls or attackers to stake for unreasonable periods, but it also causes people to actively engage with governance.

In the interest of attracting Reserve contributors, Voting should be cheaper than withdrawing. As a TLRB comes due, one of three things can happen to it: it can be withdrawn for ETH at the current withdrawal rate, it can be used to Vote again, or it can remain floating in the Reserve. The original owner of the TLRB is given the first right of refusal to choose any of these actions for up to the entirety of the block. Assuming they possess the requisite LCC, they may choose to withdraw some and Vote with the remainder. If they don’t or they are unable to do these things, the block becomes open again. Any LCC holder can withdraw from it at the current withdrawal rate, but in order to gain access to its voting power they only need to pay the equivalent LCC to what the block originally produced (which does not include accrued interest).

Figure 8: When the withdrawal fee is positive, voting is less expensive than withdrawing. This contributes to the negative feedback loops that should keep withdrawal fees from becoming too low or too high, as described in “Security Considerations.”

Both increases and decreases in the withdrawal fee are negative feedback loops, which will keep the system stable over time. Inflation brought about by a low withdrawal fee begets greater incentive to turn LCC into ETH. More users would try to exit by redeeming their LCC at the Reserve, but the withdrawal rate is capped by however many TLRBs have come due. If the backup is too significant, LCC holders may turn to selling OTC. A larger secondary market for LCC would cause more people to deposit into the Reserve to generate interest of their own, who would subsequently Vote for increasing the withdrawal fee to protect their new LCC from further inflation. When the pendulum swings towards deflation, it becomes more expensive to withdraw so instead people will choose to Vote for a lower fee to withdraw with in the future.

Security Considerations

In any decentralized system, it is necessary to consider the cost, effects, and motivations of potential attacks. Two categories of these exist: hacks and protocol exploitations. Hacks are the result of technical failures which allow attackers to drain user funds directly. The DAO hack is one such example. These can be mitigated by building the Reserve with a noncustodial architecture, like TLRBs with different expiry months being locked into different smart contracts. Protocol exploitations are unexpected behavior caused from well-funded entities using their resources to push predefined rules to their limits to gain an unfair advantage over those who are using the system within more reasonable bounds. An example of this is the looming specter of the 51% attack in Proof-of-Work (PoW) chains, the FCoin disruptions to the Ethereum network, and EOS RAM pricing during rampant speculation.

To predict where the Reserve may be vulnerable, one must evaluate the points where humans can impose variable influence on the system. For example, the Bitcoin or Ethereum chains are vulnerable to miners coordinating hashpower to decide which blocks to mine. With LCC, the variable influence is in the Voting system. If a user possesses enough resources, they could effectively hijack the withdrawal fee by staking more reserve currency than the rest of the community. Already this should elicit comparisons to a 51% attack in PoW blockchains, and indeed both are rooted in bad actors controlling a majority of voting power. Similarly, the cost for exploiting it increases geometrically with the number of users present, and LCC has an added layer of protection in requiring users to lock their ETH in to vote. Anyone who wants to impact the Reserve in a meaningful way would have the whole cost of the attack locked into TLRBs for the entire duration of it.

In addition to attacks becoming prohibitively expensive, the negative feedback loops discussed above become even more apparent with violent movements, causing them to regress quickly. An outlandishly low withdrawal fee, like one trending towards zero, gives users more reason to buy as many TLRBs that come due with LCC as possible since the interest they earned can be fully converted. LCC’s value would paradoxically increase in the short term because traders outside the ecosystem would be willing to pay a premium to access the cheaper ETH. A greater demand for LCC would lead more people to stake to accrue interest, who would in turn likely vote for a higher withdrawal fee to protect the Reserve and their ability to withdraw at the end of their TLRB’s term.

Very high withdrawal fees would likely prevent some users from leaving because they don’t want to spend more than they earned, or cause others to sell at a loss because they need the ETH. Those who stay, however, would be more likely to stake their LCC to Vote for a lower withdrawal fee, causing the pendulum to swing the other way.

Extremely low withdrawal fees would likely be motivated by an entity that wants to cause runaway inflation. Extremely high fees would likely be set by an entity that wants to freeze users out of converting back into ETH. Neither would have its effects felt for long.

Early Implementation

The largest obstacle is a social one: people need to believe in the value of the Reserve currency for LCC to be worth anything. During the early stages of the LCC ecosystem, this can be trivially accomplished by using opening Out Of The Money (OTM) short positions for ETH as a form of insurance. If its price dips too far, original Reserve contributors can recoup their losses in fiat and a new Reserve currency can be chosen. If it increases in value, everyone is happy about staking their ETH for LCC.

With initial investment into the ecosystem sufficiently de-risked, minimum capital requirements can be considered. The United States aggregate wealth is approximately 5x GDP. The GDP output per citizen is an average of $58,000. Using that as a very rough measure, a $1 billion Reserve amount (aggregate wealth) would sustain $200 million in dynamic economic activity (GDP) per annum, which in turn should support a very healthy ecosystem of around 3,500 people.

Indeed, groups of early investors will likely amass enough LCC to act as secondary “banks” within the ecosystem, lending at rates slightly higher than the inflation, but requiring less collateral than the Reserve. The conflict that happens between traditional banks and the Fed would be avoided here, as the two entities are one in the same with LCC. Moreover, their activity is clearly recorded on-chain so all transactions and terms are completely transparent. A society based around an evolved concept of money deserves an evolved concept of a bank. Not only would they serve as key drivers of internal growth through efficient LCC distribution, but would have in their best interests to create a team focused on bringing more outside users into the Reserve. Nothing catalyzes user growth like potential profits.

There are countless possibilities for LCC usage. In addition to operating as the “local” currency, its unique inflation and interest-accruing nature can be used to create a Universal Basic Income, public infrastructure funding, collateral for transactions requiring different currencies to make, and much more. Undeniably, there are many more details to address and challenges to solve in implementing something of this complexity. But this united monetary framework is scalable to any size, and can even be used to connect users across the world. Stepping towards crypto independence requires radical thinking, and this might be just crazy enough to work.

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