Money on blockchains

The most basic economic concepts like what is money can sometimes be difficult to get right. A few weeks back I wrote about how Bitcoin is not money. In this post I’m going to continue with a few random thoughts about money, financial liquidity and explore what true money could look like on the blockchain.

Spoiler alert; there’s no revolutionary conclusion in this blog post, just a few random reflections on economic principles and how they might relate to some interesting blockchain projects 😉

Liquidity

The term liquidity, in financial context, is the degree of which a company or person can turn some assets into other assets without affecting their market price too much. If my entire net-worth is made up of cash, then I’m very liquid because I can easily turn $100 worth of cash into $100 worth of groceries. But for example, if my entire net-worth is made up of rare stamp collections, then I’m not very liquid because rare stamps are difficult to turn into other assets.

If a market lacks liquidity it may cause a liquidity crisis, leading to instability and uncertainty because of the limited ability to exchange goods or invest in growth, with the knock-on effect of declining asset valuations. This is what happened during the financial crisis of 2008, when too much value was tied up in unsecured loans. On a basic level what happened was; banks approved unsecured loans for buying houses, which drove up housing prices, allowing others to borrow money against inflated collateral (their houses).

There were many underlying causes for the 2008 crisis, but one of them was indeed the rate of unsecured loans. Other ways to describe unsecured loans are; renting money, making money from nothing or fictitious capital. This is mostly bad. Here’s some food for thought:

Your savings account is essentially an unsecured loan to your bank, for which you are paid a small amount of rent (i.e. interest).

One conclusion that can be drawn from this is; unsecured loans and renting money is not necessarily good.

Quantity theory of money

On the surface, the quantity theory of money is quite simple:

The general price level of goods and services is directly proportional to the amount of money in circulation.

It gets a lot more complex (at least above my head) when you dive into the details, e.g. considering both velocity, short and long term of the economy. But this fundamental principle has been the basis of many refinements over time, by many economists as disparate as Karl Marx and John Keynes. Either way, the fundamentals hold quite true; money should not be printed unless there’s some universal and secure value backing the money.

Goods on blockchains

The reason why Bitcoin or Ether should not be considered money, as mentioned in that previous post, is that it’s not a good store of value. In fact, most cryptocurrencies are very volatile and might sway more than 30% in a day, i.e. not stable when storing the value. Therefore, it’s better to talk about cryptocurrencies purely as a medium of exchange (a subset of money), a digital good, or a digital asset.

A digital good is some form of digital binary, or text, that comes with some utility, or the right to use some useful digital system. For example, Ether is the good that lets you use this global world computer with a clever and ubiquitous accounting system, called the Ethereum blockchain. Ether is a good. You can compare it to other goods like gas or oil, that lets you use other types of systems.

Money on blockchains

So far the big blockchains, like Bitcoin and Ethereum, are lacking digital money or cash (i.e. some token that is a stable store of value). But stability is relative, so what should stable money be stable in relation to? That’s a good question! A decent answer is probably some global unit of account, like the US Dollar or the currency basket of the International Monetary Fund. This would ensure that wherever you are in the world, you can expect the value to remain stable on average.

Then the question becomes, how do you practically create a stable token without a central bank that decides on interest rates to stabilise the economy? One very interesting take on this problem is the Dai token, governed by the MakerDAO project. They just launched on Ethereum’s mainnet after 2.5 years of development and testing. Here’s my own short-ish summary of what Dai is:

Dai is a token backed by collateral of valuable digital goods (like Ether). The role of the central bank is replaced by a decentralised market with incentive mechanisms to provide stability by means of increasing or decreasing the supply of Dai backed by collateral, with help of external price feeds. The decentralised autonomous organisation (DAO) called Maker, is governing the system by deciding what kind of goods that can be collateralised, while also acting as buyer-of-last-resort, if those goods would fail. This means Makers have “skin in the game”, as opposed to only having a mandate without consequence (like central banks).

Conclusion

I’m quite excited to follow projects like MakerDAO, that explore the concept of real money and liquidity on the Ethereum project. It’s currently a fundamental gap in making a truly decentralised economy work. I’m not necessarily sure that MakerDAO, or other projects like Sweetbridge and their Bridgecoin, hold the final solution to these problem. But I find it very fascinating to follow the development of new and decentralised economic systems.

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