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title="Permalink to Demystifying Currency Creation and Backing">Demystifying Currency Creation and Backing</a>
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<time class="published" datetime="2020-04-18T00:00:00+03:00">
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Sat 18 April 2020
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<time class="modified" datetime="2020-04-21T00:00:00+03:00">
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Tue 21 April 2020
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By <a class="url fn" href="./author/will-ruddick.html">Will Ruddick</a>
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<p>Once upon a time a goat herder counted his herd and found 100 goats (some old and some young). That was a nice surprise. He estimated a market price of about $100 for a goat once they were mature. Then he went to the blockchain via an easy-to-use interface on his flip phone and created 10,000 goat tokens. He used them to pay trusted carpenters to build a barn where he could keep more animals.</p>
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<p>By the 3rd month of construction he spent all 10,000 tokens and earned another 2,500 tokens by selling a quarter of the mature goats. (He can only sell the goats slowly to maintain his herd). He now has 75 goats left plus another 15 goats that were just born.</p>
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<p>This cycle of spending and redeeming goat tokens could go on and on for years. The Canadian Tire company did something similar with paper vouchers and these coupons for car tires are still in use after 30+ years.</p>
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<p>This kind of community-level credit creation can be a lifesaver when national currency is in short supply. Using goats themselves as a currency is actually a useful strategy, "We enable smallholder rural, off-grid farming communities to meet their farming and household needs using livestock as currency" - <a class="reference external" href="https://uptrade.org/">Uptrade.</a>.</p>
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<p><strong>Let’s look at how it works, and how to to address the risks.</strong></p>
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<p>In a community, a group can come together and decide on the assets they will use to back their community currency collectively, e.g. goats + grapes + corn. Then they can issue a credit to everyone in the group - this is sometimes called a mutual credit. A municipality may create credits this same way and back them with public transport usage and acceptance for taxes.</p>
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<p>but
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<strong>Who is keeping track of how many goats there are and are ready to sell?</strong></p>
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<p>What if some of the goats are killed by a lion or die from a disease and the goat herd is decimated? In fact, the goat herder never had 100 mature goats to begin with - the goat tokens were a promise against future (mature) goat production. If the backing of goats becomes unstable then a lot of people could be left with goat tokens they can't redeem. What if there is a run on the 'bank' and everyone wants goats at once? We’ll get to how to solve this in a moment.**</p>
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<p>but <strong>What if the goat herder wanted to allow other people to make those goat tokens?</strong> The reason this might be attractive to the goat herder is that if someone were to ADD a goat to his herd and breed with the other goats then over time it would produce more goats. What is that worth? Since the goat herder is the one establishing the value at 100 tokens = 1 goat, adding a goat to the goat reserve should create $100 dollars more of goat tokens (100 goat tokens).</p>
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<p>and
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<strong>What if the goat herder wants to trade with the cereals shop in town?</strong>
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Well, let’s say the cereals shop owner doesn't want goats at all. Would she accept these tokens? If she could spend the tokens on other things she needed like labor and cereal distributors then perhaps she could accept 'some', but anyone accepting them would need at some point to have some trust in the goat token issuer.</p>
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<p>so
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<strong>Reserves to de-risk</strong>
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Seeing this problem of lack of trust in his goat tokens, the herder decides to put up some collateral in national currency (it could be any common reserve token if one exists for that region). The goat herder feels so strongly that he will accept back the tokens for goats that in order to build confidence in people he takes $1,000 dollars it up into a contract on a blockchain (using his feature phone). That means anyone who has goat tokens can trade their tokens for national currency without any middleman. Plus, if anyone adds to the reserve of dollars they can create more goat tokens.</p>
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<p>Now the goat herder has promises of goats as backing for his tokens as well as some collateral in national dollars. If he ends up with all the tokens again by selling goats he can simply cash out those vouchers to get back his reserve. Doing this on a public blockchain means that anyone can see the backing for his tokens now in dollars (or any reserve token such as xDAI). That helps with the tracking problem and the backing problem - both good for trust.</p>
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<p>and
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What if the goat herder wants to trade with the cereals shop in town?
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Well, let’s say the cereals shop owner doesn't want goats at all. Would she accept these tokens? If she could spend the tokens on other things she needed like labor and cereal distributors then perhaps she could accept 'some', but anyone accepting them would need at some point to have some trust in the goat token issuer.</p>
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<p>so
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<strong>Reserves to de-risk</strong>
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Seeing this problem of lack of trust in his goat tokens, the herder decides to put up some collateral in national currency (it could be any common reserve token if one exists for that region). The goat herder feels so strongly that he will accept back the tokens for goats that in order to build confidence in people he takes $1,000 dollars it up into a contract on a blockchain (using his feature phone). That means anyone who has goat tokens can trade their tokens for national currency without any middleman. Plus, if anyone adds to the reserve of dollars they can create more goat tokens.</p>
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<p>Now the goat herder has promises of goats as backing for his tokens as well as some collateral in national dollars. If he ends up with all the tokens again by selling goats he can simply cash out those vouchers to get back his reserve. Doing this on a public blockchain means that anyone can see the backing for his tokens now in dollars (or any reserve token such as xDAI). That helps with the tracking problem and the backing problem - both good for trust.**</p>
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<p><strong>Target reserve ratio (TRR)</strong>
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The Target Reserve Ratio is the point at which the contract on the blockchain will give $1 of reserve dollars for 1 goat token. When the herder creates his reserve of dollars on the blockchain he fixes a Target Reserve Ratio. The higher the TRR, the more stable the price of the token will be. Let's say he chooses 10% for his TRR. This would mean that when there are $1,000 dollars in reserve and a total supply of 10,000 goat tokens, the value of those tokens will be 1 token = $1 dollar. Another term for the contract that shows the relationship between the value of dollars and the value of goat tokens is the bonding curve.</p>
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<p><strong>Shares of an asset</strong>
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Using this bonding curve means that as reserve is added (+) the value of the goat tokens will go up compared to the dollar reserve.
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As tokens are destroyed and reserve is pulled out (-) the value of the remaining goat tokens will go down compared to the dollar reserve.**</p>
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<p><strong>Primary Market</strong>
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The goat herder creates a primary market around his goats by spending and redeeming tokens. He keeps the value of his goat tokens stable by backing them over time with his goats. His token is stable over time for as long as he redeems the tokens and people want the goats. Primary markets are important because they determine the base value of goods and establish a value for the tokens.</p>
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<p><strong>Secondary Market</strong>
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What happens If the value of the goat tokens drops (-) below a dollar because people at the cereals shop are cashing them out for reserve? Then it becomes even more attractive for people who want to buy goats. Anyone who wants goats could also add reserves cheaply in order to claim them for goats later. The issuer (the goat herder) could also add national currency to the reserve (the secondary market on the blockchain) and create more tokens to pay for more labor.</p>
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<p>The primary market forms the basis for value on the secondary market. As the secondary market value goes up (+) more people will cash out the tokens for dollars. The more it drops (-) the more people will cheaply buy tokens to get goats.</p>
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<p><strong>More Currencies, More Resilience</strong>
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Because the herder has added a reserve to his token, it means that his token will automatically have value against other tokens with the same or connected reserves. This means that anyone in the world could accept the herder’s credit (tokens) because they can always see the reserve on the blockchain behind it. They can convert it to the reserve and also put that reserve into their own tokens.</p>
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<p><strong>Risks</strong>
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The inherent risk in trusting any single issuer of a currency is that they will no longer be able to, or just stop, reclaiming the tokens for goats (or goods or services - whatever is backing the currency). (This is akin to a bank run). By adding collateral to a reserve, a secondary market can reduce risk and build trust. It can also enable many credit systems to connect together into larger economies. We’ve seen this build stable markets that allow communities to trade their goods and services with a much wider population.</p>
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<p>The risks of using tokens with on-chain collateral are easily measurable based on the size of the reserve, the trade on the network, and the target reserve ratio. In contrast, the risk of accepting a token that’s only backed by physical goats requires that I both want a goat (or I know others that do) and trust that the promised goats will be around.**</p>
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<p><strong>Takeaway</strong>
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Credit creation can be regulated and de-risked in a whole new way, where anyone could potentially issue their own credit. A network of such credit issuers and users can form a decentralized economy, which is more resilient to crisis. This is what Grassroots Economics is doing with partners like the Red Cross.</p>
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<p>The technology is now open source and we encourage replication and development. You can see more of the impact in Kenya <a class="reference external" href="https://www.grassrootseconomics.org/post/crisis-supply-chains">here with nearly 100K USD trading on the networks monthly</a> trading on the networks monthly. We hope to open this secondary market up for anyone to contribute in the next two months.**</p>
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<p><strong>Timely: How this impacts aid and COVID-19</strong>
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What if instead of goats, a non-profit created a primary market of credit with donor funds to bolster local food security and health? The secondary market on the blockchain allows anyone in the world to add reserve (liquidity) and give more value to these tokens. It’s a way to multiply donor funds and allow locals like the goat herder to buy and sell the goods they need. At a time when international and national markets are collapsing, tools that allow people at the local level to trade needed goods and services without national currency is critical.</p>
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<p><strong>How can I do it?</strong>
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<a class="reference external" href="https://katanapools.com/">https://katanapools.com/</a> is a site where you can use the Bancor protocol to create a goat token or any other and add one or multiple reserves to it on the Ethereum blockchain. More in this Medium article.</p>
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<p>All the code to create and trade these types of tokens is open source. To understand the bonding curves we use,read the open source Bancor Protocol whitepaper: <a class="reference external" href="https://storage.googleapis.com/website-bancor/2018/04/01ba8253-bancor_protocol_whitepaper_en.pdf">https://storage.googleapis.com/website-bancor/2018/04/01ba8253-bancor_protocol_whitepaper_en.pdf</a>.</p>
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<p><strong>How can I support?</strong>
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Turning these open source infrastructures into something anyone in the world can use is our priority. We are racing to address the widespread impact of COVID-19 on people’s income, food security, and health. Funding to bring on more developers and to do more pilots and help communities right now is what we need. Please contact us if you would like to take part.</p>
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