Over the last week, Balaji Srinivasan, Timothy Lee and Joe Weisenthal have mused publicly about a DollarCoin (DLC), aka a cryptocurrency pegged to the dollar that would eliminate the pesky BTC-USD volatility.
Summary: I don't think it is possible to do in practice unless the Fed backs it.
First I will state my bias upfront that the BTC-USD volatility is primarily a factor of market adoption (not something inherent to the currency) and will decrease over time. But let's say we wanted to make a DLC and let's walk through the four proposals I have seen so far about how it could be done.
Let's assume away the problem of having a benchmark DLC-BTC exchange rate that applies across the world (even though that is a separate and large problem of its own).
Also, let's keep in mind that volatility in DLC is much more problematic than in BTC. In BTC, with its mostly fixed money supply, volatility has been generally on the way up. With most versions of DLC, it is easy to keep it from rising, but harder to keep it from falling and that does not make for an appealing asset to hold -- no upside in any case, but some non-zero downside if the system fails.
Take 1: Adjust the mining difficulty based on supply and demand.
In other words, when there is a lot of demand for DLC and price in USD goes up, allow bigger block rewards (increase the rate of money supply increase) to bring the price back down. When there is less demand for DLC decrease the issuance of new DLC to reduce the new supply of DLC.
This will not work because it only affects the rate of increase of DLC. So if you had a serious demand shock, the price would still fall below $1.
Take 2: Issue or redeem DLC based on supply and demand
Have a mechanism to decrease money supply when needed by issuing or redeeming/destroying DLC based on market demand.
This would keep the exchange rate more or less stable, but would still destroy the wealth in your DLC wallet so has no real advantages. In other words, instead of 10 DLCs worth $0.80, your wallet would drop to 8 DLCs worth $1. Same outcome but more convoluted and introduces some other problems.
Take 3: A private company willing to redeem DLC for USD at a 1:1 rate.
Update: This is Timothy Lee's idea. Will add his clarification in italics.
Theoretically this would work, practically it won't.
First of all, this would require a huge balance sheet to be tied up if all DLCs were backed up 1:1 with USD and I don't see what benefit the DLC-backer would receive in return that is large enough to compensate for that.
Timothy Lee comment: Would take deposits in USD, issue DLCs, invest the USD in safe assets and 'bank' could collect the interest as compensation.
Second, it has all the problems of centralization that have destroyed most previous private currencies, including counterparty risk and regulatory risk.
So, best case scenario your DLCs are worth $1. Worst case scenario something goes wrong (regulation, fraud, incompetence) and they are not.
Take 4: A network of (banks) using colored coins to represent USD
I think this is what Balaji was hinting at today. It is the closest idea to being viable, but I think it just obfuscates the counterparty risk.
Even if a network of banks agreed that they would use colored coins to represent USD for transactions between them, there would still need to be transaction confirmation in their systems (that they actually have the USD available to back up their commitments). So the costs would be higher, it would have to be centralized and there would be counterparty risk. In other words, what happens if Citi was on the hook for $1B of colored coins, redeemable in USD, and failed overnight?
And it remains vulnerable to regulatory pressure in a way the BTC itself is not. Would a US sanctions regime not be enforced in this DLC network? It would have to be. And the same for any other country, which means that fungibility would go out the window too.
Take 5: FedCoin
Let's say the Federal Reserve set up a DLC and said it would always redeem DLC 1:1 with USD. It is the most credible party in the world to make the redemption promise as it can always 'print' more USD.
It would also make a public commitment that if the DLC:USD exchange rate started rising that it would issue more DLCs until the benchmark rate was down to 1:1. Because their redemption guarantee is credible, the floor would be stable so they could over-issue at first and keep the price from rising as well.
I don't see any technical reason why this couldn't work. It won't happen any time soon, but if cryptocurrencies become everything people hope they will be, it will happen someday. The USD won't be the first go to for it, but would it shock me if in 5 years, say, the Swiss do it? Not at all.
This is approximately my default 'optimistic case' outcome for the cryptocurrency landscape in 10-15 years: Several national cryptocurrencies that have the full backing of their respective central banks and all the transaction benefits of native digital currencies plus 1 or 2 serious transnational currencies 'winners' (aka BTC) that have predictable money supply/issuance.