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Disclosure Regarding Author's Motivations
At the time of writing, the author has no nancial interest in either Nushares/Nubits
or Bitshares/BitUSD. The author may help develop a competing product in this
space at a future point in time. The author's aim in this document is to encour-
age improvements in Nushares/Nubits design that would render a competing
product unnecessary. This document does not disclose all of the author's rec-
ommendations for design improvements. If Nushares/Nubits makes acceptable
progress in implementing the author's recommendations, the author will most
likely disclose a more complete set of recommondations in the future.
Introduction
Cryptocurrencies such as Bitcoin, Nxt, and Peercoin suer from extreme
price uctuations that limit their usefulness for electronic payments. The Nubits
network attempts to create a USD-denominated cryptocurrency that eliminates
these uctuations. Ideally, a pegged cryptocurrency such as Nubits could retain
decentralization, payment irreversibility, and low fees common to other cryp-
tocurrencies, while simulatenously oering its users price stability comparable
to conventional payments systems. Such a currency would be better suited to
the electronic payments needs of average people than existing cryptocurrencies.
However, many individuals in the cryptocurrency community remain sceptical
of pegged cryptocurrencies, likening them to ponzi schemes.
Such scepticism is warranted. In the real world, countries using pegged ex-
change rates often issue debt in excess of their future capacity for repayment.
Under a xed exchange rate regime, excess debt issuance inevitably leads to a
bank-run scenario where investors sell o currency of the heavily indebted coun-
try in exchange for currency issued by a country in a stronger scal position. If
the indebted country cannot generate enough foreign exchange to satisfy the de-
mands of all these investors simultaneously, it is forced to devalue its exchange
rate. In essence, this process of excess debt issuance followed by inevitable
devaluation is indistinguishable from a ponzi scheme. Likewise, a pegged cryp-
tocurrency that issues USD liabilities in excess of its capacity to generate USD
for repayment will also face inevitable devaluation. This scenario seems espe-
cially likely in the context of cryptocurrencies because their future USD values
are so uncertain. However, as I argue in this document, this problem is not
unsolvable.
Some countries do succeed in sustaining xed exchange rates for a prolonged
period. Hong Kong, for example, has maintained a stable peg of the Hong Kong
dollar to the US dollar from 1984 to the present. The longevity of Hong Kong's
exchange rate peg reects the unusual level of scal prudence exhibited by Hong
Kong's government. Collectively, Hong Kong residents have accumulated a mas-
sive stock of foreign assets that greatly exceeds Hong Kong's outstanding liabil-
ities. When necessary, Hong Kong can sell these assets for USD and use USD
revenue from these asset sales to repurchase its outstanding debt. As we can
see from this example, a country exercising a sucient level of scal prudence
can maintain a xed exchange rate for a prolonged period, perhaps indenately.
A pegged cryptocurrency that manages the issuance of USD-denominated cur-
rency with a similar level of prudence might also enjoy a long lifespan.
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In sum, the sustainability of pegged cryptocurrencies depends on whether
they incorporate credible policies for managing outstanding debt. To be credi-
ble, pegged cryptocurrencies need to commit to both a xed exchange rate AND
a constant and conservative ratio of network equity to debt issuance. To assess
the credibility of a particular pegged cryptocurrency, investors should ask the
following three questions:
1) Can participants in the system intervene to sustain a xed exchange rate?
2) Can participants in the system intervene to maintain a constant and
conservative ratio of network equity to network debt? Below I refer to this as
the reserve ratio.
3) Even if participants could perform these interventions are they likely to
do so in practice? Do participants in the system have incentives that encourage
them to do both (1) and (2).
If the answers to all three of these questions are yes, then the system should
allow for a sustainable peg. On the other hand, if one or more of these conditions
is not satised, then the system will be prone to excess issuance of debt and
eventual collapse in a bank-run scenario.
To work towards evaluating Nubits, let's begin with a review of the mone-
tary tools available in the Nubits system. We will see that the existing Nubits
system lacks the tools to do both (1) and (2) simultaneously, but could acco-
modate both goals through a minor, albeit contraversial, modication. We will
then consider incentives for shareholders to use these tools to vote for prudent
monetary policies. I will argue that incentives for shareholders are well-alligned
with prudent monetary policy as long as the reserve ratio remains conservative,
that is, (2) is likely to imply (3). However, if network indebtedness is allowed to
increase beyond a certain point, shareholders may become unwilling to vote for
monetary policies that reduce the debt stock. We can think of this as a reputa-
tional issue. Suppose that you are a gambling rm and you oer relatively small
bets. For the gambling rm, it can be worthwhile to repay small bets honestly
to preserve a strong reputation. If the gambling rm loses a very large bet, on
the other hand, it may make more sense to repudiate the gambling debt, close
down the rm, and run o with the money. Similarly, nushares holders may be
willing to spend resources to preserve the system's reputation as long as it is
not too costly. If the system becomes too deeply in debt, shareholders may balk
at the large expenditures necessary to stabilize the system.
Monetary Policy in Nubits
The Nubits system represents network ownershup claims and voting rights
using two distinct classes of assets. The rst asset type, called Nushares, rep-
resents ownership of equity and voting rights in the Nubits network. Nushares
owners are residual claimants of all network value net of network liabilities.
Through a voting procedure, nushares owners also control the issuance and re-
tirement of currency issued within the network. In addition, shareholders use a
voting procedure to manage network assets held in trust outside of the network
itself. The second asset, called Nubits, represents USD-denominated debt obli-
gations of the network. Nubits earn interest at a variable rate voted upon by the
holders of nushares. Holders of nushares promise to use monetary interventions
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to maintain an exchange rate peg at 1 Nubit = 1 USD. As long as this peg
holds, holders of Nubits are able to recover any USD owing to them through
the sale of Nubits on external markets.
The success of the Nubits network depends rstly on its ability to sustain the
exchange rate peg. To achieve this, nushares holders vote on monetary intevern-
tions and carry out interventions supported by a majority of shareholders. The
primary forms of monetary intervention in the nubits system are open market
operations and interest rate adjustments. To conduct open market operations,
Nushares holders vote to allocate new issues of Nushares or Nubits to an agent
called a custodian. The custodian uses these resources to control the amount
of Nubits and Nushares circulating on the open market. Specically, when the
price of Nubits rises above 1 USD, the custodian sells Nubits for Nushares, USD,
and/or other assets. These sales release new issues of Nubits into circulation,
increasing Nubits supply. The expansion of the Nubits supply depresses the
market price of Nubits causing it to fall back to 1 USD. Conversely, when the
price of Nubits falls below 1 USD, custodians repurchase outstanding Nubits
through the sale of USD, Nushares, and other assets. These repurchases with-
draw Nubits from circulation, reducing Nubits supply. The decrease in supply
increases the market price of Nubits until it recovers to 1 USD. To supplement
open market operations, shareholders also vote on periodic interest rate adjust-
ments that aect demand for Nubits. Increases in the Nubits interest rate make
investments in Nubits more attractive and can be used to prevent a fall in price
below 1 USD. For example, if there is zero demand for Nubits at a 1 USD price
point with a 0% interest rate, Nushares holders can increase the interest rate
to ensure that an adequate supply of Nubits circulates in the market. Likewise,
decreases in the Nubits interest rate can be used to prevent a rise in price above
1 USD. For example, if issuance of Nubits is perceived as exessive, Nushares
holders could respond to pressure for appreciation by decreasing the interest
rate. A decrease in the interest rate checks upward price movements but does
not involve an increase in Nubits supply. If interest rates are allowed to take on
negative values, this type of intervention becomes quite powerful.
The success of the Nubits network also depends critically on controlling
the volume of Nubits issuance. Does this objective stand in conict with the
exchange rate peg. Or is it possible to achieve both aims using the set of
monetary tools at Nubits' disposal? The answer depends critically on whether
negative interest rates are allowed. To understand this, let's see how monetary
interventions can be used to address four possible situations the network may
encounter, as shown in the Table below.
Nubits Issuance not excessive Nubits Issuance excessive
Price 1 USD Issue Nubits and repurchase Nushares Lower the interest rate.
Price 1 USD Raise the interest rate. Issue Nushares and repurchase Nubits
Let's consider each case in the table. If Nubits trade above 1 USD, the central
bank can choose between two possible interventions to correct this. Firstly,
shareholders can vote to issue new Nubits and sell them for Nushares. This
process reduces the market price of Nubits, but also increases the supply of
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Nubits in circulation. If the supply of Nubits on the market is already excessive,
then the release of additional Nubits would be undesirable. In this case, the
central bank can reduce prices by lowering the interest rate oered on Nubits.
A reduction or increase in the interest rate has no immediate eect on supply,
but does aect the Nubits price. The eectiveness of this approach depends on
the ability of the central bank to impose negative interest rates. If Nubits are
allowed to earn negative interest rates, this mechanism can reduce the market
price of Nubits to any level desired. On the other hand, if interest rates are
bounded at zero, the central bank can encounter a situation where the price
remains above 1 USD even at a 0 interest rate. In this situation, the central
bank must either a) allow nubits to appreciate above 1 USD or b) print more
nubits and allow excessive quantities of Nubits to circulate on the market.
Consider a scenario where this might occur. Suppose that a sudden crash
in bitcoin prices causes investors to rush to buy nubits as a safe haven. An
uncontrolled ow of money into Nubits would cause pressure for appreciation.
In response the central bank drops the interest rate to 0, but even then Nubits
continue appreciationg. Responding to this problem by issuing more Nubits is
unwise. To understand why, consider what may occur in the future when this
money leaves the system. A monetary outow from Nubits will cause pressure
for depreciation and require the central bank to respond by selling Nushares,
USD, and other assets for Nubits. An outow that is either too large in mag-
nitude or too rapid for the network to accomodate could exchaust the central
bank's capacity to repay. To see this more vividly, consider the situation of a
central bank repurchasing nubits and selling nushares. If the central bank is
required to sell a large volume of Nushares over a short time frame, liquidity on
the Nushares market could dry up and the USD price of Nushares could plum-
met. This would encourage futher monetary outows from Nubits and require
the central bank to issue sell even larger quantities of Nushares, potentially
leading to a devaluation. How serious this problem is depends on the reserve
ratio. If the market cap of Nushares is much higher, say 20 fold, than the mar-
ket cap of Nubits, then even a relatively small issuance of Nushares would be
sucient to repurchase all outstanding Nubits. In this case, central bank inter-
ventions could be relatively easily absorbed by the nushares market and would
not precipitate violent price movements. On the other hand, if the market cap
of Nushares is only a bit higher, say 2 fold, than the market cap of Nubits, then
a massive issuance of Nushares would be necessary to repurchase all outstand-
ing Nubits. In this case, central bank intervention could easily destabilize the
Nushares market.
Should we be scared of negative interest rates? No, not at all. If we examine
the above table, we can see that negative interest rates are only necessary when
demand for Nubits is so high that their price rises above 1 USD, interest rates
are 0, AND an excessive supply of Nubits is circulating. This is an extreme
bubble scenario for Nubits. A scenario where Nubits are simply too popular.
Negative interest rates are the central bank's means of deating a Nubits bubble
before it gets out of hand. Left unchecked, such a bubble would pose a threat
to Nubits' future. A collapse of the bubble would mean that investors would
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rush to all sell Nubits simultaneously. To avoid a collapse in the Nubits price,
the central bank would need to repurchase these Nubits using new issues of
Nushares equity or other assets (see the bottom right corner of the table). The
collapse of a large bubble could exhaust the resources of the central bank, force
a devaluation of Nubits, and cause the price of Nushares to go to zero. This
would essentially mean the dissolution of the Nubits system.
Now let's briey consider the case where Nubits trade below 1 USD. Again,
the central bank can choose between two interventions to address this. If the
current voluime of Nubits in circulation is very low, then the central bank will
not want to support the Nubits price through a decrease in supply. Such a
decrease would lead to withdrawal of Nubits from circulation and make Nubits
less useful for online txns. Instead, the central bank should choose to increase
the Nubits interest rate. An interest rate increase strengthens Nubits competive
position relative to conventional payment systems. As long as Nubits issuance is
not excessive, interest rate increases provide a scally prudent means of encour-
aging Nubits adoption. On the other hand if the supply of Nubits is excessive,
repurchases of nubits through sales of nushares are the appropriate policy re-
sponse.
To summarize, we have considered the twin goals of maintaining a pegged
exchange rate and a stable ratio of value in Nushares equity to Nubits debt.
We have seen that both of these goals are feasible if interest rates on Nubits
are allowed to take on negaive values. If the system does not allow for nega-
tive interest rates, then the central bank cannot achieve both objectives in all
circumstances. Failure to allow for negative interest rates would leave Nubits
with no eective tools for preventing a bubble. Correction of such a bubble
could cause Nubits to collapse. This situation directly parallels the current
predicament of the USD. The issuance of USD has increased massively since
the nancial crisis, without any accompanying rise in ination. Some obervers
argue that this is a bubble and predict rapid ination in the future when the
bubble pops. If the US sought to maintain a peg with another currency, the
popping of the USD bubble (if it exists) would cause investors to ee USD and
likely force the US to devalue. The only away of avoiding this risk is preventing
the bubble from forming in the rst place. For Nubits, negative interest rates
are the only credible means of doing this.
Shareholder Incentives
What about the third condition? Will shareholders actually vote so as to
maintain a constant exchange rate and a constant ratio of debt to equity? This
issue should be a serious cause for concern. For governments, the collapse of xed
exchange rates often stems from an incentive problem. It is always tempting for
governments to live beyond their means. This makes it exceptionaly dicult for
governments to reduce debt levels even when it is necessary to do so to sustain
an exchange rate peg.
The temptation to print too much debt is not unique to government. It is
also present in Nubits and indeed in any form of banking. There are several
factors at work here. Firstly, income from sales of Nubits generates 'seignor-
age revenue' for Nushares holders. In the short-run, more sales of nubits mean
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more seignorage revenue that can potentially be returned to Nushares holders.
Secondly, Nushares holders earn income from txn fees charged on Nubits trans-
fers. A conservative reserve ratio implies that txn fee income is divided across
a very large pool of capital invested in Nushares. A precairously low reserve
ratio, on the other hand, means that fees are divided across a murch smaller
pool of capital, implying a dramatically higher rate of return for shareholders.
Higher returns also mean more risk. However, the risks associated with in-
creasing leveerage do not fall exclusively on shareholders. Since a total system
collapse would wipe out both types of asset holders, some of the risk associated
with increased leverage is always transferred to holders of nubits. This problem
remains managable as long as indebtedness is low, but can lead to destructive
voting behavior when indebtedness reaches an unacceptably high level.
To understand this last point, let's consider rogue shareholders who are
considering gambling with USD reserve assets. The Nubits network controls
10 USD in USD reserve assets and 10 USD worth of intangible capital. The
outstanding issuance of Nubits is 1 USD, so the residual value of Nushares
would be 19 USD. Now suppose that USD reserve assets can be bet at a casino
in secret via a 50-50 coin-toss. If the bet pays o, Nushares holders can divide
a 10 USD prot amongst themselves and Nubits holders will be none the wiser.
If the bet does not pay o, Nushares holders will lose their reserve and have to
disclose their loss to Nubits holders. This disclosure will cause all the intangible
capital in Nushares to evaporate and cause both Nubits holders and Nushares
holders to lose their entire investment. We can see here that Nushares holders
should not take a fair bet. If they win they gain only 10 USD, but if they
lose they lose 19 USD. In essence, the value of intangible capital in the network
greatly exceeds anything the shareholders could expropriate from Nubits holders
by gambling. Now suppose we increase issuance of Nubits to 15 USD without
any corresponding increase in intangible assets or reserve assets. Nushares are
residual claimants on assets net of liabilities, so issuance of 14 additional USD
of Nubits liabilities will decrease the market cap of Nushares by 14 USD. Thus,
the new gures would be: market cap of Nushares is 5 USD, reserve assets are
10 USD, and market cap of Nubits is 15 USD. Here Nushares holders should
take the bet. If they win, then they get 10 USD. If they lose, they lose 5 USD.
What if sales of Nubits went into reserves instead? This actually doesn't help
matters. In this case we would have: market cap of Nushares is 10 USD, reserve
assets are 24 USD, and market cap of Nubits is 15 USD. Again, Nushares holders
would expect to benet by gambling with the reserves.
The key point here is that shareholder incentives always encourage excessive
risk-taking, but that these problems remain modest as long as the value of
debt issued is low relative to equity. When debt issuance is relatively low,
shareholders own claims to the vast majority of intangible capital associated
with the network. With a conservative and constant reserve ratio, shareholders
can be expected to vote for prudently to avoid losses of their intangible capital.
As Nubits issuance increases, however, claims on the network's intangible capital
are sold o to Nubits holders. As shareholder ownership of intangible capital
declines, they face an increasing temptation to gamble with network assets and
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become less concerned about a possible collapse of the network.
Excessive risk-taking by shareholders has implications for voting on mone-
tary policy decisions. When shareholders vote for an increase in the interest rate
to sustain the peg, they are essentially betting that a favorable shock will occur
and allow for a future recovery. Gains from a recovery accrue entirely to share-
holders, wheras losses from a collapse are divided amongst both Nushares and
Nubits holders. On the other hand, when Nushares holders vote to repurchase
Nubits through issuance of Nushares, they absorb outstanding losses in order
to enhance the stability and intangible capital of the Nubits system. As long as
shareholders own the vast majority of the network's intangible capital, they can
be expected to voluntarily repurchase Nubits to protect the system's reputa-
tion. As the reserve ratio increses, however, an increasing fraction of intangible
capital is transferred to holders of Nubits. At some point, rational Nushares
holders will see the benits of preserving intangible capital through repurchases
primarily accruing to debt holders. At this point, the Nubits monetary pol-
icy system becomes unsustainable. Instead of prudently retiring excess Nubits
from circulation, shareholders will vote to use interest rates as the primary tool
to support Nubits prices. In essence, they will behave much like operators of
a Ponzi scheme. The medicine for this problem is simply to ensure that the
Nubits reserve ratio is always maintained at a conservative level and that any
deterioration in the reserve ratio is immediately addressed through shareholder
action. The sooner shareholders act the more likely they are to make prudent
decisions.
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