Some Thoughts on Fedcoin – a Fed backed cryptocurrency.

Since the invention of Bitcoin some have given significant thought to cryptocurrencies issued by central banks or governments. Recently the idea of Fedcoin stimulated a lot of discussion after David Andolfatto from the Federal Reserve Bank of St. Louis presented the idea at P2P Financial Systems 2015. David also discussed the idea in a post. As a concept the idea is intriguing, but a flurry of questions about details have quickly been raised. Among those are issuance, distribution, peg to the dollar, miner rewards, restriction on users and miners, monetary policy and others. I will attempt to address these issues as I see them.

Why Fedcoin?

Think of it as digital cash, just like Bitcoin but without the volatility. It would be a payment system where you can send dollars to anyone else with a Fedcoin wallet in seconds for a very low fee.

Issuance.

In my opinion the Fed should premine all the currency that they want to issue on a blockchain, or maybe even more to have extra in case it becomes a runaway hit. A premine happens where all (or part of) the cryptocurrency is issued in the first block, the genesis block. Then the Fed would just exchange the fedcoin for a dollar each. This would mean no block rewards to miners – I will address that in a moment.

Peg to the Dollar.

Fedcoin would need to be pegged to the dollar. How would that be accomplished? The lower bound is simple – the Fed would offer to exchange any fedcoin for dollars. The upper bound is a bit trickier. Some have suggested that the rate of issuance, that is the block reward, could be adjusted whenever the exchange rate goes above a dollar. In practice this would be difficult as it would require the majority of the miners to update their software in a timely fashion. Of course it would be possible to build software that allows the Fed to set the block reward in a central manner, but that approach invites a host of other problems. Others have suggested that the Fed could then start another blockchain with more currency (both total number and rate of issuance). But this is not an elegant solution, unless there is a way to combine the two chains so that tokens from one can be used on the other and vice versa.

This is why I would argue for a premine. The Fed can just sell as many fedcoins as there is demand for, at a fixed dollar to fedcoin rate. This way no one would pay more than a dollar for a fedcoin, as one could always buy it directly from the Fed. Also the premine can be for an arbitrarily large number as the Fed would get dollars back for the cryptocurrency, so no additional money is created – it just shapeshifts.

Miners’ Rewards.

Bitcoin rewards miners with newly issued currency – this is to attract miners that help secure the network. The rewards are dispensed in a special transaction in each block called the coinbase transaction. Miners secure the network to protect the value that the network offers. In Bitcoin, miners do not want to manipulate the reward amount because that would devalue the currency and lower the amount of trust in the network. Bitcoin basically backs itself. A Fedcoin would be backed by the Fed. As a result, if miners colluded to increase the reward they are not hurting the network at all. The token’s value would be still a dollar, regardless of the reward amount (remember the Fed would buy your fedcoins at a dollar each). And it is easy to see that miners would readily accept a change in protocol that increases the reward. This is why I don’t think block rewards are wise at this point in a network like Fedcoin.

In this scenario miners would need to be paid strictly by transaction fees. As a result, the fees would need to add up to a large enough amount. Perhaps a percentage of the transaction amount. For example twenty five cents for each hundred coins with a max cap at let’s say ten coins. These are just details. The Fed can always support miners by moving its coins around, thereby guaranteeing a minimum total transaction fees in each block.

Restrictions.

Should there be restrictions on the Fedcoin system or should it be open, just like Bitcoin? We believe the system should be open. I think there is enough evidence that open systems have an advantage over closed systems. One of the biggest is permissionless innovation. In an open system third parties will create a plethora of value added services when and where there is demand for said services.

Monetary Policy.

I think this is a non-issue. Questions have been raised about how the Fed would conduct monetary policy with Fedcoin. The currency would be a digital dollar, same as cash and therefore would have no impact on monetary policy. Of course it could be used to affect monetary policy. The Fed could set interest rates and pay interest on fedcoin holdings. What is noteworthy is that negative interest rates are also possible.

Should the Fed be a Privileged User?

Some commentators suggest that the Fed should have special powers in this system. I disagree. JP Koning suggests: One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin.” If that were the case we would be back to a centralized system, controlled by one entity. Why bother with the blockchain then? Just implement a Paypal-style system. Sina Motamedi argues for the Fed to set and adjust the block mining reward at its discretion”. I don’t think that would be practical – an update to block rewards would have to be processed by at least half of the miners to be effective. Unless the process is somehow automated, miners may simply not pay attention to the changes all the time. Which in turn takes the Fed’s ability to adjust the rewards. And again if one user controls the system, then we have a centralized system and we needn’t bother with a blockchain. So in my opinion the Fed should not have superuser privileges.

The Federal Reserve is Interested in Crypto.

The Fed has been looking at cryptocurrencies for a while. To see the extent, type bitcoin in the search box on the https://fedpaymentsimprovement.org website. Most recently the Fed mentioned blockchain based payment systems in a white paper: Strategies for Improving the U.S. Payment System (pg 39 footnote, pg 42).

Acknowledgements:

The author would like to thank the following colleagues for feedback: Carla Miller and Paul Jones. Additionally, thanks go to Carla Miller for her editing work.

 

References:

Andolfatto, David. Fedcoin: On the Desirability of a Government Cryptocurrency.” Web Log post. http://andolfatto.blogspot.co.uk/2015/02/fedcoin-on-desirability-of-government.html, February 3, 2015

Koning, JP. Fedcoin.” Web log post. http://jpkoning.blogspot.ca/2014/10/fedcoin.html October 19, 2014

Motamedi, Sina. Will bitcoins ever become money? A path to decentralized central banking.” Web Log post. http://tannutuva.org/blog/2014/7/21/will-bitcoins-ever-become-money-a-path-to-decentralized-central-banking, July 21, 2014

 

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