By Craig Calcaterra and Wulf Kaal
Abstract
Chapter 8 discusses the role of finance in the evolution of decentralized systems. In the 2020s, the market for DeFi has started to take off but fully decentralized DeFi solutions still have a long way to go. Because the decentralized economy is still missing the major institutions that society relies on to conduct profitable business, especially a secure and meaningful system for evaluating reputation for anonymous supranational partners, and an effective and dynamic governance system, it will not be able to fully proliferate until these systems have established themselves. Once these core decentralized infrastructure products become available, the decentralized economy becomes viable. Key indicators include cryptocurrency being used in authentic transactions such as insurance and equities in broad segments of industry and the tokenization of commodities and properties in a mainstream environment.
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Chapter 8. Finance
“Finance is not merely about making money. It’s about achieving our deep goals and protecting the fruits of our labor. It’s about stewardship and, therefore, about achieving the good society.” — Robert J. Shiller
Decentralized finance (deFi) has been the goal of blockchains since their inception with Bitcoin. The goal of Web3 is to provide intuitive UIs for complex financial tools, unleashing the economic potential of humanity — similar to how Web 2.0 tapped into the power of decentralized information. The major financial tools that the Web3 crowd is currently working on include payment, investment, trading, lending, and insurance via P2P technology. Ethereum is leading the way in 2020 due to their support of innovative smart contracts, with approximately 3% of their ether tokens (market cap 26 billion USD) locked in deFi smart contracts.
The obvious concern with Web3 enabled deFi is that the average customer will not be protected without a centralized bureaucracy to maintain order. Since the decentralized economy is currently lacking in many of the civil institutions that we enjoy in the larger economy, the average person should not invest anything in the crypto economy. In this chapter we discuss what is emerging and what is missing and what can be done to include more people in the decentralized economy.
Bitcoin transactions proved digital payment could be decentralized. Ethereum proved investment could be decentralized with initial coin offerings (ICOs). These ICOs are analogous to initial public offerings (IPOs), but are open to anyone on the planet who has access to the internet. In other words, ICOs allow anyone to participate in business investment.
The ICO is run by a smart contract which can create any type of business logic. The ICO smart contract creates digital tokens — the coins of the ICO — which represent equity ownership in a DAO. These tokens may be programmed to confer voting power to their owners or any other rights imaginable in the DAO, such as automated profit sharing or control of functions within the company. The ICO smart contract specifies how many tokens can be created and sold, for what price, at what time. Anyone with a public key address in the Ethereum blockchain who satisfies the contract by transferring the required assets at the right time will be given ownership of the DAO equity tokens. ICOs can be programmed with a single line of code with a secure, carefully audited smart contract using ZeppelinOS. The confusion behind legal regulation in various jurisdictions makes it more difficult than that sounds, but in principle, a decentralized process for investing in decentralized companies has been technologically solved.
In the rest of the chapter we explore further financial tools that are needed for the future decentralized economy, including banking, trading marketplaces, insurance and lending, and stablecoins.
Banking and ZKRollups
Blockchain transactions will always be expensive compared with other P2P transactions. Blockchain transactions are required to be stored eternally and redundantly on as many machines as possible to aid decentralization. Other P2P transactions, such as distributed hash table transactions can be forgotten, and stored temporarily on a variable number of computers based on how important or valuable the information is.
Therefore, there is a difference of efficiencies that can be exploited to earn a profit by bundling small transactions in temporary storage. Then, once the bundle becomes valuable enough, make a single permanent transaction on the blockchain which secures all the small transactions at once.
The most obvious application is for currency transactions. This is already done to some degree, opaquely, with centralized companies, such as exchanges. But these have famously lost or stolen many billions of USD. Decentralized exchanges (referred to as DEXs) are possible between separate blockchains with some cryptographically secure tricks starting with atomic swaps, and they’re becoming more complicated with the 0x protocol, MakerDAO’s smart contract, Plasma on Ethereum, Lightning Network on Bitcoin, etc.
The increase in price efficiency is matched by the increase in speed. Decentralized banking helps solve a major problem with blockchains called scaling. If you double the number of participants and transactions, the linear nature of the blockchain makes it slow down by half. To scale up to a global network like the Visa credit card company would make Bitcoin grind to a halt. As of writing, Loopring offers an open source algorithm which creates a relatively decentralized DEX for cross chain transactions starting on Ethereum. It securely bundles transactions using ZK proofs. This makes the scheme trustless, meaning it doesn’t matter whether you trust the bundlers or not, they can’t steal your data. The worst that can happen — if some malicious middleman breaks the protocol — is that your transaction doesn’t go through and you would need to resend it.
The techie term for this cryptographically secure bundling process is a ZKRollup. A ZKRollup starts on the blockchain (Layer 1) and uses ZK proofs to bundle transactions anonymously using more efficient non-blockchain P2P distributed hash table architectures (Layer 2). Then the ZKRollup distills the extremely complicated bundle and makes a simpler transaction on the blockchain (Layer 1). The Layer 2 calculations are fast (more bandwidth and less latency) but insecure and transient. The Layer 1 transaction secures the transactions making them permanent.
Loopring claims to scale from Ethereum’s native 15 transactions per second (TPS) to 160,000 TPS. The Visa network handles 24,000 TPS. However, this is merely the volume of transactions that can happen at this average rate. 160,000 TPS is the bandwidth. The dual concept of latency is the more important measure for user experience.
Latency refers to how long you have to wait for your transaction to finalize after you initially transmit it. These theoretical estimates of 160,000 TPS come with a current theoretical latency of 20 minutes or longer with a claim of theoretical latency of 1 minute later in 2020 if other updates work as promised.
The application that banking most improves, however, is not currency tokens, but reputation tokens. Reputation transactions include voting, resolving a validation pool and distributing the results, the initial minting and staking of the reputation tokens, and the reevaluation of reputation tokens through review. This is done for every single action that is meaningful for generating reputation. The amount of computation that is required is enormous, similar to how a blockchain needs to make hash function calculations for every message sent between every member in the network. In order to maintain consensus in a decentralized network, with no central authority to check in with, a reputational system needs to verify each others’ votes extremely redundantly, which leads to serious overhead costs in computation. It was not possible before the current state of information technology. But banking can make it much more efficient with randomly delegated validation pool judges.
Before such votes are recorded permanently, one or more validation pools could be completely resolved. Since reputation is reviewable, it is more secure from gaming. A few randomly-selected DAO members could be entrusted to check each other to bundle reputation transactions, especially on the non-contentious validation pools, since the results should always be nearly unanimous. On contentious issues, such as debates on protocol development, the voting is loosely coupled, so there is no need to access the blockchain.
If protocols like Loopring’s can be made truly decentralized, through good governance, it solves one of the major technological obstacles that has been hampering Web3. Currently, ZKRollups have only been deployed to bundle currency transactions, but cryptographers have been improving ZK proofs and can now handle much more complicated logic. The goal is to bundle general smart contracts. In the meantime, banking schemes are handling general smart contracts without cryptographically securing them, by using game theoretical incentivization to encourage people to honestly bundle general smart contracts. Incentivization boils down to a reputation mechanism, where at bottom, the bundler stakes money which is slashed if they are proved to be dishonest. Uniswap is an example.
But liquidity has always been a problem in decentralized exchanges, as meaningful history and reputation are difficult to achieve when there is little to no governance structure, no insurance, no appeals process, and no reputable decentralized news service to help you evaluate the health of any DAO. In particular, people are used to the security that traditional central banks provide, such as fraud protection. Decentralizing these features requires new architectures for decentralized insurance, which we explore in the next section. Once such overhead processes are instituted and more complicated transactions such as bank bundling are instituted, these decentralized exchanges will become more practically (instead of just theoretically) efficient and secure.
Underwriting: insurance and lending
Insurance is essential for every type of business transaction, every type of property, every type of service you engage — every type of economic action is made more efficient when decisions are hedged, so we can be more confident in our investments in the future. We require the trust that the transactions will finalize satisfactorily as planned or that the contract will be made whole by the platform running the marketplace. Decentralized insurance requires networks of policy writers with individual reputations for efficient underwriting of every type of transaction.
Insurance is an essential industry for the modern economy. Like the appeals process of the law, like policing, like the effort to keep track of reputation and maintain the protocols of governance, insurance is an overhead cost that does not directly generate profit. It’s a type of business cost that any efficiency-minded engineer would prefer to eliminate entirely. But inasmuch as we can’t predict the future, insurance is valuable. Insurance improves the efficiency of the economy by investing in the future, to guarantee the system will continue running, despite inevitable unforeseen problems. Insurance mitigates risk. Insurance helps people get over their fear of joining a transaction because of the risk of loss. In physics jargon, insurance is a catalyst, which provides activation energy for a transaction.
It is claimed that insurance has been practiced since the foundation of civilization.[1] Evidence from Mesopotamia suggests Mediterranean sailing merchants used bottomage. An agent would take a loan to fund their voyages, and would promise to return the loan with interest if successful. Bottomage is an extra amount included in the interest. The normal interest rate was limited to 20% if the borrower had collateral (such as the promise to enslave his family for 3 years). Without collateral, the bottomage rate was 100% with an unlimited loan time. Under bottomage, if the shipment was stolen or lost at sea, the lender promised to cancel the loan. The Code of Hammurabi, c. 1754 BC, obliquely refers to this in three laws, #103, 106, 107.
The new tools of information technology give us the opportunity to improve the efficiency and stability of underwriting through transparency and decentralization. But how do we ensure privacy in a decentralized environment? As mentioned above in Chapter 2, zero knowledge proofs allow individuals to retain privacy over their information while revealing some facts. For example, a DAO devoted to health care insurance could give members a synthesized health score from 0 to 100. The protocol for synthesizing your complex health history could be public, but your particular health history would stay private while you reveal only your final health score to the insurance DAO. Even that number could be mixed with other information, such as parts of your property that would be tokenized and insured.
Tokenization
Early underwriting DAOs likely will be for tokenization of commodities and properties. Tokenization is the use of digital tokens to represent the ownership of physical assets. For example, you can create an Ethereum token to represent a barrel of oil. We can then engage a smart contract anonymously where a person can pay money for the token. The smart contract can be trusted to execute precisely as programmed, acting as an automated escrow service to guarantee the money is traded for the token representing the oil.
However, the basic problem of tokenization is to determine whether a token that claims to represent ownership of an asset truly does. Does the oil exist? Does the person selling the token actually own the oil? Does giving you the token mean you can actually make legal claim on the oil? Anyone can mint 100 billion tokens and put a label on them, claiming they represent property on the moon. Tokenization doesn’t mean anything without something to back it up. A token’s meaning must be attested by something substantial. It must be underwritten by someone who is putting their reputation — and ultimately their money — on the line to assert the validity of the token.
Consider the history of financial innovation when gold coins first replaced the barter economy. The use of gold to represent value led to major leaps in economic efficiency. First, you didn’t need to bring your chickens directly to me to trade them for my labor. Second the contract was much clearer — it was complete when money changed hands. Third it allowed a separation of the business contracts — money traded for chickens was separate from money traded for labor. Fourth, contracts could be fractionalized — you couldn’t trade a fraction of a chicken so easily as you could gold. Later paper money replaced gold coins, so you didn’t need to carry the heavy gold or expertly assay its quality. Around 50 years ago fiat cash replaced gold-backed specie, so you didn’t need the gold at all, and nations gained a new tool for regulating their economies. Then digital money replaced paper cash allowing light-speed transactions over global distances.
Now tokenization allows an increase in efficiency by digitizing commodities and properties for direct sale, while also enabling fractionalization. Further, smart contracts allow us to instantiate any imaginative legal arrangement for partial ownership and rights to properties or assets. For example, transparent public timeshares — for houses or cars or any other physical object — can stipulate any behaviors the owners or renters choose, with self-executing and self-regulating contracts. You can even tokenize your personal space, selling the right to advertise on your social media account or selling your place in line on a carnival ride.
Tokenization will be crucial for IoT applications, which requires decentralized marketplaces as neutral territory for all the various owners within the supply chain, as discussed further below.
Chit fund example
Another important application of underwriting is lending. An important market for decentralized underwriting is microloans and simple insurance in markets with little regulation, as is often the case in developing countries. Similar to how Web 2.0 capitalized on untapped decentralized market information, Web3 will capitalize on untapped economic potential by decentralizing marketplaces, which all will require underwriting. Craig’s students, Mounvi Morthala and Sai Amulya Gandham, are developing transparent, decentralized lending schemes based on chit funds, which are common in India and have been used for centuries to provide a relatively decentralized mechanism for insurance and lending.
Chit funds are only “relatively” decentralized, because they are traditionally run with opaque centralized control from “foremen”, individuals who rely on their informal personal reputation in the community and charge roughly 5% commission for managing the fund. The principles of transparent decentralized underwriting, using the scheme we present below, has the potential to make such chit fund schemes more efficient and secure.
A basic chit fund example is as follows. Suppose 100 people agree to invest $20 in the fund every month for 100 months. Each month an auction takes place, where the members can bid to receive a fraction of the current total chit fund. The lowest bid wins. Once you win an auction, you can’t win another, but you are still required to add your $20 each month until the end.
The idea is that $2000 enters each month for 100 months. For $20 entry you can withdraw almost $2000 in the first few months, if you bid lowest. If you wait longer, the early bids will typically be lower than $2000, so the fund will hold more than $2000 and will continue to grow as fewer people can bid each month. Early withdrawal is like taking a loan that is repaid for 100 months with interest, later withdrawal is like a bank deposit that earns interest.
Web3 technology can greatly improve the efficiency and security of the scheme. First, smart contracts replace the foremen and their 5% commission, eliminating the risk of a foreman absconding with the fund. Officially sanctioned chit funds are run through banks, as in Kerala, India, adding overhead through regulation and audits. Further, if they implement a reputational system, honest participation can be tracked across many different chit funds, as people will earn reputation each time they pay their required monthly fee. The more often they participate honestly, the larger their reputation will grow. Then participation in larger and more complex chit funds can be dependent on reputation, which will incentivize healthy collaboration. It will come as no surprise that one of the major overheads making this scheme less efficient is members defaulting on paying the premia. It’s been estimated that 35% of chit fund subscribers have defaulted at least once recently and 24% have defaulted after winning an auction.[2]
All things being equal, larger groups dilute the risk of individual default. A chit fund with a large number of people with high reputation can pay small premia for insurance. 1 million people investing $1 daily for 50 years allows 50 people per day to immediately begin taking an average payout of roughly $20,000. More investors investing smaller amounts in shorter increments, means more people can withdraw at any point. By monitoring and analyzing the performance of a fund, programs can suggest values that can be withdrawn at any given time. By automatically bidding when the fund rises above expected levels, the fund can be stabilized to give predictable returns — especially if multiple funds are connected.
With no initial reserve backing, this allows people to bootstrap their way to greater financial security and stability, assuming the reputation system is sufficiently strong to guarantee a low percentage of defaults. Further efficiency improving mechanisms are mentioned below, when we discuss a more general architecture for underwriting.
Like other overhead costs (the appeals process, policing, etc.), insurance is cheaper when the system is running well. The more automated the decentralized economy becomes, e.g., with code-is-law smart contracts, the less insurance is required. The purpose of insurance is to decentralize risk. Ideally the risk would be decentralized perfectly and then the need for insuring individual transactions would disappear. Given that no system will ever be perfect, insurance will always be essential. But by implementing the new tools of information technology and the new architectures of P2P distributed computing, we can create more effectively decentralized organizations. Decentralizing risk makes insurance more stable and efficient, which improves the economy.
Decentralized architecture
The following model for the Underwriting DAO[3] consists of a network of underwriters, who roughly correspond to the shareholders of an insurance company. These underwriters each hold a certain number of reputation tokens in the DAO which correspond to their experience and skill as insurance agents. An agent’s reputation tokens are likely to increase over time only if the agent follows sound and successful underwriting practices.
The inductive argument for building a reputation architecture gives us insights on what is necessary to create an Underwriting DAO. How do we create the proper incentives for organizing a group competing to gain money? How do we develop a legislative governance process to continuously improve standards to protect an organization from gaming and corruption and innovate in response to new market threats and opportunities? Can we do this while preventing the competitive forces from naturally centralizing the system?
Again, secure and meaningful reputation is key. Reputation needs to be grounded to be meaningful, so reputation tokens should only be minted when fees (policy premia) enter the group. Reputation should dictate power in the group. So, reputation should determine how the fees are shared, through reputation-weighted salaries. And reputation should be staked in reputation-weighted democratic validation pools to transparently establish consensus within the DAO, to police every member’s contributions, to settle debates on new protocols.
Reputation tokens serve multiple purposes:
Reputation determines membership. Only token holders are allowed to participate in underwriting insurance policies. Policies may be underwritten either singly or jointly by these agents. New business is attracted by token holders’ sales initiative, or else it is attracted by the fame of the DAO — in which case underwriters can be randomly assigned based on reputation weight, or members can bid on the policy, etc.
Reputation-weighted salaries. Tokens serve as claims on the future cash flows generated by the DAO. Insurance premia collected by the DAO are distributed among the token holders in proportion to their token holdings. It is worth emphasizing that the premium from a policy is not considered the revenue solely of the underwriters. Instead, premia are treated as the revenue of the entire DAO and shared among the DAO participants. Thus, the value of the tokens is a function of the expected future cash flows of the DAO.
Underwriting builds reputation. Agents who underwrite policies by staking their reputation tokens are rewarded with a certain number of newly minted reputation tokens (as discussed in Chapters 4 and 6, the amount of reward depends on the current goals of the DAO). Thus, the total number of tokens grows over time. This implies that “passive” agents who hold the tokens purely to receive a share of future premia will find their proportional ownership in the DAO decrease over time. Their income may however still increase if the overall revenues of the DAO grow at a sufficiently increasing pace. Therefore, the effect of the design is to incentivize agents to play an active role by participating in underwriting activities and thereby grow the business, while still allowing passive investors to derive income and speculate on growth.
Reputation collateralized against risk. Underwriters “stake” or “encumber” an appropriate number of tokens against each policy they underwrite. These tokens in effect serve to secure the promises of the underwriters. The number of tokens to be encumbered is based on a preset formula with the objective of ensuring that the value of the encumbered tokens is sufficient to meet any claims that may arise at any point in the life of the policy. Such encumbered tokens continue to remain under the ownership of the respective agents and entitle the owners to receive their share of future premia. In case there is no claim on the policy, the tokens are “freed up” or become “unencumbered” when the policy matures. In case the insured event were to occur during the life of the policy, the agents who underwrote the policy would lose control of their encumbered tokens, which would be sold at auction to meet the claim. If the auction does not result in sufficient currency to meet the claim, sufficient new tokens are minted and sold to satisfy the claim. All current DAO participants (especially the policy writer) as well as outsiders interested in joining the DAO may bid for the tokens in this auction.
To initiate the Underwriting DAO, to prime the pump, the first reputation tokens would be minted and distributed to members who encumbered money in a smart contract analogous to the capital holdings of an insurance company. Once the DAO is running at equilibrium, with numerous policies bringing in regular premia, the reputation tokens will gain measurable value as measured by the market, and the capital reserve holdings can be diminished or eliminated.
We would consider the need to mint more reputation tokens to meet a policy claim to be a breach. Under what circumstances would a breach occur? It would occur only if the market values the encumbered reputation tokens as less than the payout. This would happen under two broad scenarios. First, the DAO might accept a general practice allowing agents to write policies with less than full backing, to attract more profits from premia while sharing the risk. Then the whole DAO shares the risk that their reputation tokens will diminish in value because more tokens are minted. This would necessitate more strict protocols for the types of policies the Underwriting DAO writes, and careful policing of which customers were accepted. In addition, if the DAO’s protocols require all policies to be fully backed, the only reason for a breach would be because the reputation tokens’ initial valuation diminished before the payout. In general, our models suggest this will happen only if there is a dramatic shift in the future prospects of the DAO, such as a sharp decrease in expected future revenues or a sharp increase in expected payments on outstanding policies.
The Underwriting DAO structure can be used by traditional insurance companies as well as niche players specializing in a narrow range of specialty policies. A blockchain-based DAO has the potential to take mutualization of risk to a whole new level of aggregation and efficiency. One may even speculate on the possibility of a non-profit version that insures its members against various specified risks. Possible examples range from device protection for individuals to long-term-care insurance for retirees to health insurance for an entire country.
By decentralizing risk, insurers as well as consumers can enjoy the benefits of transparency, efficiency, and greater stability. An underwriting DAO not only has the potential to lower capital requirements for insurance, but also to broaden and deepen the market for such capital as any individual or corporate entity can participate in the DAO. The particular design outlined above facilitates the entry of new players to the insurance market. Such participants could buy tokens when they come up for auction, and then use these tokens to participate in underwriting, or else just hold the tokens as a passive investment. Decentralization empowers knowledge at the edge. Individuals with more fine-grained information about their neighbors and community can make better underwriting decisions than a centralized hierarchy can. This diversification decentralizes the market, making it more liquid, more efficient, and more profitable.
The design allows for collaboration among DAO underwriters as well as between underwriters and consumers. The need to trust is minimized by appropriately designed economic incentives, which allows pseudonymous participation, thanks to the greater value of meaningful, auditable reputation. The governance rules of the DAO can be set up so as to ensure that minority token holders are appropriately protected. The rules can ensure that the proportion of policies written by an agent in the long run is commensurate with the proportion of the agent’s token holdings.
Bad business decisions by one underwriter need not impact the other underwriters or the DAO. If a certain underwriter makes the mistake of underestimating the risk of the insured event, the losses will be suffered purely by the underwriter as long as the value of the staked or encumbered tokens covers the claim. Policing this quantity of encumbered tokens is the responsibility of the entire DAO. All members of the DAO are incentivized to develop successful protocols through good governance in order to protect the value of their reputation, which is continually revalued each time a claim occurs and the market determines the price of a reputation token. As far as consumers are concerned, potential claims are fully backed or secured by the entire DAO.
In the case of traditional insurance companies, whether the company is solvent and can meet its obligations depends on the safety and soundness of its investments; whereas in the case of a DAO, this depends only on the safety and soundness of the DAO itself. The advantage of a blockchain-based system is that the latter information would be transparently auditable by everyone.
In this decentralized system, the tokens essentially substitute for reputation. Even if the underwriters of a particular policy were to breach the contract, the auction of the encumbered tokens and the sale of additional tokens as needed, ensures that the policy holder’s claim is fully met. Thus, what we are referring to as a breach on a particular insurance contract does not necessarily imply any losses for the consumer as long as the entire DAO is more valuable than the individual customer’s claim. A breach leads to no losses for other members of the DAO, as long as the encumbered tokens match the payout of the claim.
The structure of incentives embedded in this design has the potential to substantially lower capital requirements and the related need for capital regulation in the insurance industry. We note that the burden of maintaining sufficient liquidity in order to meet claims is not on the DAO, but rather is distributed amongst the individual underwriters that make up the DAO. Each underwriter would of course need to maintain sufficient liquidity and economic capital in order to be able to reclaim tokens as and when claims occur. However, it is possible under certain conditions that the total amount of capital that these agents will collectively hold is lower under this design than if the burden of meeting the liability were to be on a traditional insurance firm which has more centralized risk.
This result is based on the premise that the amount of capital each underwriter will hold will be based on the risk of the underwriter’s overall portfolio. The overall portfolio of an individual underwriter, especially a non-traditional one, may benefit from the addition of underwriting due to diversification, as attested to some extent by the existence of insurance-linked securities such as catastrophe bonds.
As a result, the sum of the incremental VaRs (Value at Risk amounts) of the individual underwriters may be less than the VaR of an insurance firm that has underwritten the same contracts. More importantly, how much capital an underwriter holds is a matter of their personal risk preference. An underwriter who is willing to tolerate fluctuations in their token holdings need only provide for expected losses. The key point is this: from the viewpoint of consumers and regulators, the encumbered tokens (which as we know derive their value from the DAO’s future cash flows) essentially serve as a substitute for capital. Financial distress or bankruptcy of an individual underwriter does not have to affect either consumers or the DAO. As mentioned previously, in case of a breach on a particular contract, the policy holder’s claim can still be met by an auction of the encumbered tokens. Additional resources if required can be raised by minting new tokens. Barring highly adverse market conditions, the availability of “capital on tap” protects the DAO from default and bankruptcy. Thus, the design has the potential to greatly simplify capital regulation.
In sum, the larger the network of Underwriting DAO members, the more distributed and decentralized the risk can be spread, making the system more efficient and stable. This makes the economy more predictable, efficient, and prosperous.
Trading markets
“From the time I first understood economic principles, I was always concerned also that any system be operated on an efficient basis, which meant decentralization because knowledge is not concentrated anywhere. It’s based on motivation, and so these are […] the cautious case for capitalism, that the market system is efficient.”
–Kenneth Arrow, Interview with the Federal Reserve Bank of Minneapolis
December 1, 1995.[4]
General principles
Decentralization and bureaucratic transparency are essential to the efficient operation of marketplaces.
The liquidity of a market depends on how quickly its assets can be sold and how much prices change when they are sold. A market’s depth is how much can be bought and sold at any given moment. A market can only remain liquid under various conditions if it is also deep. The efficiency of price discovery characterizes a market’s liquidity. Liquid markets are more efficient and stable. Business on a liquid market is less risky and more profitable.
All things being equal, larger, decentralized, transparent markets are more efficient. The larger the market, the deeper it is, and the more liquid it becomes. Second, the more autonomous the members of the market are, the more they will have divergent interests and desires, which improves the market’s liquidity. Concentration of power (especially monopolies or trusts) decreases liquidity; decentralization of power improves liquidity. Another obvious disadvantage of a centralized market is the overhead that a central authority charges; in a decentralized market the members police themselves. Third, the more transparent the statistics of the market’s transactions is, the better it is for price discovery, which improves the market’s liquidity. The more liquid a market is, the more transparent it is, the more open it is, the closer it becomes to what is technically called “perfect”.
Therefore, markets become more efficient, more profitable, and less risky when they achieve greater power decentralization, greater transparency, and more open membership. The foundational values of Web3 are the basic principles that improve an economy.
However, greater transparency is at odds with more open membership, because larger networks are only achieved when privacy is ensured. Privacy and power over your own personal information need to be prime values for development, but this is generally achieved at the expense of transparency and efficient price discovery. Further, anonymity is a threat to many market schemes, such as the chit fund example discussed above. Reputation and sophisticated ZK proof protocols can help to address this problem. Pseudonymous wallets held by private keys can encumber reputation tokens in such a way that they are staked and can be automatically slashed if violations are provably committed. Statistics on transactions can be revealed with ZK proofs without revealing information from the individual transactions.
Web3 has achieved the technology required to build liquid decentralized markets, with smart contracts and cryptography. The basic idea is to have a network engaging smart contracts with offers to sell at different prices and buy at different prices. Whenever there are two smart contracts that cross (buyer offering higher than the seller is offering) then the next block producer combines the contracts and completes them in the block, and collects the difference. Those differences are the reward for maintaining the network, shared with everyone owning reputation tokens. These smart contracts can be active as long as required before a coincidence of wants is found. The owners can put limits on their validity, so they self-destruct after a short, set time, then update the contract as they observe the market.
The decentralized market is the most efficient mechanism for price discovery. Price discovery determines the price of an asset but also the ideal quantity the economy needs and the ideal levels and types of services the economy needs. The market finds the right equilibrium between all the industries and companies to determine how much of each work and good is required to keep civilization running efficiently.
The basic financial markets
The basic financial assets are currencies (foreign exchange, or Forex), commodities, equities, securities, and derivatives.
We discussed decentralized Forex above with DEXs (peer-to-peer decentralized cryptocurrency exchanges), such as the 0x protocol, MakerDAO’s smart contract, Plasma on Ethereum, and the Lightning Network on Bitcoin. Many other protocols are competing to take part in the crypto economy. DEXs epitomize market decentralization because they allow users to interact and trade anonymously in a secure environment without the need for third party intermediation.
In a DEX, proprietary trading intermediaries, such as market makers and centralized third-party operators, cannot inject themselves in a transaction. As a result, conflicts and counterparty risks are ab-sent in a DEX. Moreover, the fee structure in a DEX is different from a centralized cryptocurrency exchange, which typically charges a percent of the total value of the transaction. Instead, on a DEX, the users pay a fee as gas (Ethereum’s fee for motivating the network’s nodes to add your transaction), more akin to a per-trade fee, which is a fraction of the percentage charged per transaction on centralized cryptocurrency exchanges. Because a DEX does not centralize authority over users’ assets, users can sign and start trading anonymously, that is, without identity verification. Centralized cryptocurrency exchanges struggle keeping up with know-your-customer and anti-money laundering rules. Nevertheless, most DEXs have been struggling with liquidity and price discovery.
Orders on a DEX are matched and settled through the operational rules provided by the code. Unlike central order books on centralized exchanges and the settlement back office that facilitates the finalization of a trade, on a DEX, the code facilitates the peer-to-peer exchange without the involvement of any intermediary.
Despite many of the benefits that derive from its decentralized exchange model, DEXs may not be able to ensure market integrity. Just like centralized cryptocurrency exchanges provide certain traders with benefits that may provide them with advantages at the expense of other traders, the code that creates a DEX may also allow the asymmetric distribution of trading information based on user status.[5] The code may also create new risks to market integrity because of its automation and lack of a human backstop in compliance, back office, and settlement. Wash trading, frontrunning, and insider trading are risks to market integrity that can materialize on a DEX, among other price-manipulation practices. Again, regulation and governance are crucial to the future of the decentralized economy.
The next assets to consider are commodities. To make decentralized commodities markets, the key is tokenization. This was explained above, where we argued underwriting is necessary to give tokenized commodities and properties meaning and value. Tokenization is technologically achievable on Ethereum with standard ERC-20 and ERC-721 tokens. But such tokens don’t hold value without secure reputation and transparent history.
The next assets to analyze are equities. An equity is a token of ownership in a company, such as a stock. ICOs, as introduced by Ethereum, prove we have the technological tools to cheaply create and sell decentralized stocks in a company, called ERC-20[6] tokens. These tokens can give their owners more practical powers than traditional stocks. Due to their smart contract functionality, any imaginable business transaction can be programmed, with the token being used as proof of ownership.
The ICO market peaked from March 2018 to June 2018. The percentage of ICOs in relation to total fundraising of blockchain startups dropped from 80% to around 35% in August 2018 and only marginally recovered between September 2018 and February 2019 at around 40% to 50% before dropping to 20% in March 2019. From March 2017 to June 2018, ICOs were the overwhelmingly dominant fundraising tool for the blockchain industry. The demise of the ICO market turned the overall trend away from ICO funding to traditional venture funding in the blockchain industry.
The emergence of the ICO market changed the market for venture funding. In the traditional venture capital model, venture capital funds invest significant amounts of money in the hope of finding the next unicorn start-up. This investment process is subject to long, complex, and time intensive processes leading up to a late liquidity event in the form of an IPO or acquisition. By contrast, ICOs provide liquidity to investors much faster and allow venture capital funds to capitalize on existing profits early. Venture capital funds who invest in crypto start-ups gain access to much earlier liquidity via ICOs by converting their cryptocurrency profits into Bitcoin or Ether through any of the cryptocurrency exchanges and can thereafter transfer into fiat currencies via online services such as Coins-Bank or Coinbase. During the ICO boom years, the venture capital market in the decentralized technology sector ground to a halt. In the aftermath of the ICO boom and collapse, traditional venture funding has become, again, the predominant model for funding blockchain startups.
Market decentralization via ICOs and other decentralized funding methods has significant disruptive effects on finance. ICOs provide lower barriers to entry for a more diverse body of investors and thus increase the diversity and the heterogeneity of start-up funding. Through borderless online sales, ICOs are directly marketed to a worldwide potential pool of investors, bypassing the typical legal, jurisdictional, and business hurdles in traditional venture capital financing. Moreover, ICOs benefit from limited accreditation standards, as well as from multiple global cryptocurrency exchanges that provide continuous access to trading. ICO promoters and their developers are not forced to sacrifice their equity in the project in exchange for the funds they raised.
The next type of financial market to consider is securities, which are other financial instruments that make some guarantee to pay off money in the future, such as bonds or annuities. Smart contracting allows us to create decentralized transparently auditable securities with extremely complex business logic.
The final type of asset is a derivative. They are called this because they are second-order contracts, such as options, which give people the right to buy (a “call”) or sell (a “put”) another financial asset in the future. By managing risk, futures stabilize the market, improving its liquidity and efficiency. Traditional markets hold perhaps US$1 quadrillion in derivatives. Therefore, this is a rather important target for deFi development. There is a great multiplicity of possible traditional futures contracts that use complicated business logic, so it would seem to be the ideal application for self-executing smart contracts. However, there is not much liquidity in decentralized derivative exchanges. At three years old, and functional for much less than that, the Augur DAO is one of the older decentralized options. There are other protocols, such as Opyn on the Uniswap DEX.
At the time of writing, the market for decentralized options is extremely shallow — especially considering how turbulent the other decentralized financial asset markets are. The problem, again, is reputation. In order to guarantee liquidity, someone who wishes to sell a call option is required to actually own the asset, since there is unlimited potential for growth. In other words, the inability to trust the platform or the anonymous users requires these decentralized derivatives to be capitalized at least 100%, which would be impossibly onerous in traditional markets. We will discuss this problem again, below, as a major flaw in today’s stable coins, and again suggest the solution demands more sophisticated reputation and history.
Regulation
The anarchist and libertarian philosophy that informs most Web3 developers’ public pronouncements has led to an antiregulation fervor that is damaging the potential for widespread adoption of decentralized P2P tools.
Securities commissions in every major market (such as the SEC in the US, the ECMS in the EU, and the CSRC in the PRC) were ostensibly created to protect investors from patterns of bad business that naturally arise when creating and trading equities and other assets. However, these centralized bureaucracies are slow to update their regulations, which means these regulations often hurt the very people they were designed to help. The average citizen is not capable of benefitting from the power of many financial derivatives, for example, because safeguards from the SEC require million-dollar outlays. But the SEC provides many systems which improve the market and protect basic consumers, which the crypto economy is currently lacking.
The charge of every securities commission in every major nation is to protect the average small investor from predatory groups, by ensuring transparency and good accounting and business practices. As such they have a duty, both professional and moral, to do everything in their power to prevent Web3 technologies which are used for rent-seeking, insider trading, and outright digital theft. Bitcoin.com has estimated that more than US$3 billion worth of cryptocurrency was stolen in 2018 alone.[7] Much of this was never retrieved because the regulatory agencies are not up to date on the new technology.
At the same time any project that matches or exceeds traditional standards for transparency in accounting and good business practices should be encouraged. Truly decentralized projects which surpass traditional regulatory standards have the potential for improving our economy and revitalizing our society. Any nation that stifles innovation that improves the status of its citizens and increases their opportunities doesn’t deserve the mandate of governance it is given by its people. If it doesn’t update to match the challenge of these new technologies and architectures, the SEC will no longer be deserving of its charge.
Standards for transparency and external audits of equities should be natural additions to the decentralized economy, and Web3 developers should welcome them. Open source protections for consumers gives individuals more power, making them more autonomous, making the network more decentralized.
It is, however, not possible to create a centralized organization, such as the SEC, for regulating the decentralized economy. Submitting to such regulatory power would place the supranational decentralized market under competing jurisdictions which naturally have contradictory regulations. Submitting to centralized regulatory control limits the network to members from a single jurisdiction, which would limit the network effect, making the market less liquid, less efficient, and less profitable.
Dynamic standards under decentralized control is necessary. Both the SEC and Web3 need to change. Again, effective decentralized governance and a genuine bureaucratic transparency are crucial.
Stablecoins
“All money is a matter of belief.” –Adam Smith
What is a stablecoin? What makes them crucial for the decentralized economy? How are they built? What is missing?
A stablecoin is a cryptocurrency token from a blockchain which is designed to maintain its value, instead of rising and falling under temporary market changes. Stablecoins distinguish themselves from other digital money, like bitcoin and ether, whose value fluctuates strongly in response to changes in market demand, switching between the need for cash or investments.
Stability is an obsession in this book. Stable motion, liquidity, is the most efficient state of the economy. A liquid market rapidly matches the “coincidences of wants” necessary to form business deals, so people can cooperate and trade to meet their needs and desires. Stability is necessary to make good predictions so that your investments in the future are more successful.
A currency which maintains a stable store of value is more efficient for an economy than one which does not. The US dollar (similar to every other national fiat currency) is managed by the US Federal Reserve in order to maintain a steady and predictable value in the long run. Since 2002, their stated target is 2% annual inflation. The value of a dollar is determined by comparing what a basket of goods costs, year to year, in many different locations. The “basket of goods” are typically commodities, such as oil or minerals or grains, which have a relatively constant supply and demand.
Bitcoin and other cryptocurrencies are extremely volatile compared with almost every form of national fiat currency. This is natural, since the value of cryptocurrencies is almost entirely due to speculation on their future usefulness in the currently non-existent decentralized economy. If bitcoin ever does become widely adopted and used, however, its price will likely not completely stabilize. The total quantity of Bitcoin is capped at 21 million tokens. This means, like gold, its value will change depending on the market demand. The demand will change whenever the trends change for people’s economic behavior. More use of the currency, through more transactions, and more savings, generally increase the demand for the currency, which raises its value, due to its scarcity.
Currency with price volatility on the order of gold, is not a good choice for a currency. Without stablecoins, typical consumers should never hold their checking account in the currency. No one should ever make a long-term contract for any essential service in bitcoin. Neither the renter nor the landlord should sign a contract if its value might halve or double in any given month. Renegotiating contracts each time the value of a currency changes is inefficient, and continually punishes one of the parties. The economy should not be founded on gambling, so any future decentralized economy requires stable cryptocurrencies.
Since their inception in 2014 with Tether, stable cryptocurrencies have primarily been used as a cash equivalent for cryptocurrency portfolios. They are used as a safe harbor to weather the volatility in digital assets. By 2019, stable cryptocurrencies grew substantially in popularity as an answer to the high volatility associated with the cryptocurrency markets. Depending on their design, they can offer additional features, such as transparency, privacy, and increased decentralization. Stable cryptocurrencies can also offer lower fees and faster transaction speeds, making them rather useful for international transactions and everyday payments.
However, today’s cryptocurrencies are still in their infancy, and offer very few of these features. The largest stablecoin platform is Tether (USDT) which pegs its value to the US dollar. As of June, 2020, Tether holds 85% of the 10 billion USD market share of stablecoins.
In 2014, Robert Sams introduced the first attempt at creating a stability mechanism for cryptocurrencies.[8] In 2020, the leading notable stable cryptocurrency startups and their respective approaches include: Tether, Coinbase, MakerDAO’s DAI, and many, many others. They all naturally have flaws, but give useful tools for today’s crypto speculators. We criticize their design and identify areas for improvement in this section.
Basic Design
Design architectures fall into two broad categories, e.g. collateralized and uncollateralized mechanisms. Both are subject to downsides. Collateralized projects use either fiat currencies or cryptocurrencies as reserve backing. The function of the collateral is as follows.
Imagine a stablecoin DAO which mints a cryptocurrency token and pegs its value to the USD. The idea is that the token can be sold in a public exchange, and the value is kept at 1 token for $1. Whenever the price of the token goes up, the smart-contract-automated mechanism mints more of the tokens and sells them on the exchange. This brings the price down to $1. Whenever the price drops below $1, the algorithm buys tokens on the exchange and deletes (“burns”) them, which raises their price back to $1, according to the Quantity Theory of Money.
Fundamental to this scheme is that the DAO needs to hold a reserve of foreign assets, collateral, such as fiat currencies (dollars, euros, yen, …) or cryptocurrencies (bitcoin, ether, …). This collateral is sold when the price is low, and is bought with the newly minted tokens when the price of the tokens is high. When running properly, this mechanism actually makes money while maintaining the stablecoin’s stability.
Unfortunately, fiat currency collateralization is expensive and inefficient, and no stablecoin can currently compete with traditional currencies and services. The basic problem is that the reserve is expensive to maintain. Because of the threat of the Soros attack, all of the major cryptocurrency platforms have publicly committed to maintaining reserves which back their coins 100%. If there are $1 billion worth of coins in the public, they promise to maintain a reserve equivalent to $1 billion US in some bank. To see why this is necessary let’s discuss the basic idea behind the Soros attack[9] simplified as follows.
Imagine the Bank of England institutes a policy of maintaining a peg of one British pound artificially high, equal to $2. But the market sees the true value as $1 per pound. The Bank of England maintains a reserve of foreign currency worth $10 billion to keep the peg at $2 to 1 pound. Under these conditions George Soros would arbitrage the system as follows:
Take out a loan for $10 billion in pounds.
Sell $10 billion of the pounds at $1.99 per pound. So that the bank of England pays George almost $10 billion to maintain the peg at $2.
Now the reserve is depleted, the Bank of England cannot defend its artificial peg, so the market drops to its genuine valuation of the pound at $1.
Now that the peg is broken, George repurchases the pounds at $1 which is half what he was paid for them, so he only pays $5 billion.
George repays the loan and pockets the $5 billion difference.
The lesson of the Soros attack, is that if the value of a cryptocurrency is pegged at a value higher than its true market value, the difference must be backed 100% by a foreign reserve of collateral holdings. Otherwise financiers can make money breaking the stablecoin’s peg.
As an indictment of the stablecoin developers’ faith in their own product, every major stablecoin publicly claims their tokens are backed at least 100%. This means they think their coins’ fundamental value is $0. We don’t entirely agree. But given the instability of the cryptocurrency market, and the lack of fundamental features such as decentralized governance, we don’t entirely disagree.
The maintenance of a 100% reserve is too expensive to be efficient, and signals the need for more sophisticated mechanisms. All of the value in the reserve which backs the cryptocurrency needs to be liquid, otherwise arbitrage opportunities, such as the Soros attack, are possible — especially with an algorithmic stable coin. Whatever value is held liquid in the reserve, costs its users due to the loss of opportunity to invest the money. The price tag of fiat-backed tokens is, at a minimum, the interest rate of the pegged fiat currency and the cost to maintain the platform. As long as the market is so unstable, platforms can profit from the buy low, sell high mechanism mentioned above.
Cryptocurrency-backed tokens are even more expensive than fiat backed tokens, because the stability is achieved with much more unstable cryptocurrencies. Any cryptocurrency-backed token must be backed with much more than 100% of the current value of the cryptocurrency in case the basket of other crypto currencies’ value drops. For example, in MakerDAO, if a token is backed by ether, and the value of ether drops by half at any moment, then the automated scheme will punish anyone who has not backed their tokens by more than 200%. Given how unstable the market is, users need to back their tokens by even more, or risk automated punishment.
Hot money
On the contrary, we argue that a 100% reserve is not always necessary, as is the case with any currency which has an intrinsic worth. At minimum, e.g., a national currency has the intrinsic worth represented by the confidence gained from the ability to pay taxes. But the amount of value represented by the currency also contributes to its intrinsic worth. For example, the amount of money invested in company shares, annuities, insurance, and property all contribute to the value that is authentically determining the total value the currency intrinsically represents.
A cryptocurrency can be measured to have intrinsic worth if there are similar authentic business transactions that rely on its tokens. Authentic transactions are distinguished from hot money. Hot money is money which is being used on second-order investments, such as speculating on the market. It is hot, because it can immediately exit the system, for example if it is exchanged for a foreign currency. It’s easier to distinguish between authentic and hot money transactions for typical cryptocurrency transactions than traditional business, since transparency makes them more easily auditable.
Soros was not able to break the Bank of England because it wasn’t fully backed with foreign reserves, but because the British pound was being pegged at a value that was inauthentic. In fact no nation holds anything near to a 100% reserve for the obvious reason that it would be too expensive to have a large liquid reserve. The US foreign reserve, e.g., is less than 2% of its money. Holding any liquid reserve is a loss of opportunity cost that is a type of economic friction its users must subsidize, explicitly in transaction taxes which transparently pay for maintenance of the peg, or implicitly in holding taxes which bearers of the currency pay, usually through inflation.
Therefore, determining the fraction of a currency that is hot money is necessary for efficient defense of its stability. A currency that overestimates this hot money ratio will cost more to use. A currency that underestimates the ratio will be insecure. The tension between these two values of efficiency and security motivates a careful estimate of the hot money ratio. This means a sophisticated decentralized governance system is crucial for any efficient stablecoin.
Today, we estimate that a majority of all cryptocurrency is used for speculation. It’s virtually all hot money. Worse, these open source platforms can be cloned and replaced by competitors within minutes. So their fundamental value is questionable.[10] Therefore, it needs to be backed fully or risk collapse. We need a robust decentralized economy before a stablecoin can reduce its collateralization. We need an efficient and useful stablecoin before we can build a robust decentralized economy. This is another of the many chicken-and-egg problems that hamper the adoption of new systems.
Stablecoin design choices
Here we briefly discuss how to build a stablecoin.[11] The quantity theory of money dictates how you can stabilize the value of a token by minting new tokens to drop the price and burning tokens to raise the price. Theoretically, all things being equal (which is never accurate in practice), if the economy has twice as many tokens available, prices should be twice as high. If there are half as many tokens in an imagined mirror economy, the price of goods would be half as much.
Reserves and bonds can be used to burn tokens and raise the price. The bond mechanism is to mint and sell bonds at auction for the stable coin; the stable coins earned through the sale are then burned raising the price of the stable coin; then the bonds are redeemed for newly minted stable coins at some later date. The reserve mechanism is the same as described above with the Soros attack. Reserves should be used to defend the peg against hot money short-term fluctuations. Bonds should only be used when the larger economy is experiencing longer-term changes, when one of the Four Horsemen visits.
To maintain the network’s operation, the price should be borne by transaction fees. To stabilize the value due to inefficiencies in the economy (spoilage, overhead, other frictions/corruption), holding taxes should be used. Holding taxes means the currency’s inflation rate. I.e., if you hold the money for a year, the inflation rate tells you how much value you lose. Inflation is controlled by dictating how the peg of value changes.
Finally, if the economy has a fundamental change, the currency should be repegged. A fundamental change may include a black swan event that makes the market reevaluate the value of the economy. Trying to maintain a peg at an artificial level prevents new members from adopting the currency and punishes members as they need to pay to maintain the artificial valuation. Maintaining the artificial valuation is the most likely way to induce a death spiral which collapses a currency.
Most importantly, good governance principles are crucial for every aspect of instituting any long-term stablecoin due to inevitable changes in the market and the fundamental obstacle represented by the Folk Theorems of Game Theory. How does the stablecoin DAO determine when and how to adjust the parameters of the stability algorithm to react to market changes? How do we know whether a change in price is due to hot money or more fundamental factors? What type of assets should be maintained in the reserves. To address these problems, we need decentralized central banking systems. The long-term governance of the DAO requires the best expertise to keep the currency stable. To find the best people to make governance decisions, requires a secure and meaningful reputation system to filter that talent. Secure means the reputation provides the right incentives and defenses to police the system and prevent gaming. Meaningful means the reputation pays the members properly for their expertise.
Summary
In the 2020s, the market for DeFi has started to take off but fully decentralized DeFi solutions still have a long way to go. The fundamentals go both ways, predicting deFi’s current failure and eventual success.
First, the decentralized economy is missing the major institutions that our society relies on to conduct profitable business, especially a secure and meaningful system for evaluating reputation for anonymous supranational partners, and an effective and dynamic governance system that we can trust will guarantee justice and predictable continual improvement.
Second, in the opposite direction, these decentralized networks have grown past the tipping point and are now immortal. The only way a centralized nation can control a decentralized network within their borders is to ban it completely, like the PRC has for many blockchains. But that will pose no threat to their existence. Like the nomadic Apaches, or filesharing apps like BitTorrent, attacking them will only make the decentralized economy stronger. In countries where it is allowed, it will thrive, making them more economically efficient and competitive under global capitalism. Though the People’s Republic of China has banned its people from using current cryptocurrencies, they have been developing several stable coins for years. The global social media giant, Facebook, has been developing its own stable coin, Libra. If successful, such initiatives could link the crypto economy with establishment institutions.
The comparison of new P2P projects with older projects, like BitTorrent, is instructive. BitTorrent has been the subject of intense legal scrutiny and regulation[12], yet it still exists because of its decentralized nature. However, these older P2P projects did not receive anything close to the level of accredited academic support that the newer blockchain projects are receiving. The technology is improving quickly, as is public and scientific understanding. In 2018, most voices that made it to major media outlets proclaimed deFi will vanish, that “crypto is the mother or father of all scams and bubbles.”[13] In 2020 there are more peer-reviewed articles published each day with improvements from accredited scientists, than there are stories criticizing the technology. Academics have begun to take the technology seriously as a new tool for improving peoples’ lives.
Ethereum has the most deFi investment. It is growing, but at the moment, it is still insignificant. Only 3% of ether tokens (market cap 26 billion USD) are locked in deFi smart contracts. The intrinsic value of cryptocurrencies will only become significant once tokenization of commodities and other authentic uses of the money are achieved.
When will deFi take off? When the economy becomes viable — when cryptocurrency is used in authentic transactions such as insurance and equities in broad segments of industry and tokenization of commodities and properties is instituted. This will happen when people can trust the systems, which will only happen when decentralized reputation and governance are achieved. The technological problems are tantalizingly close to being solved, but so far, the inability to trust each other due to the requirements of anonymity is crippling the deFi market. So traditional markets have a fundamental advantage. Decentralized markets are overcollateralized. To make a decentralized financial transaction, such as a loan, or buy an insurance policy or a derivative instrument, someone needs to completely back the product with 100% collateral. In the case of secondary layers, you need more, such as MakerDAO’s scheme which requires much more than 200% collateralization. This would be an unthinkable obstacle to liquidity in traditional markets. It is only being used in the crypto space because of a lack of decentralized alternatives.
However, once secure and meaningful reputation is incorporated into the Web3 environment, this imbalance will be reversed. Since reputation tokens are more meaningful than identity, and much easier to valuate, even less collateralization will be required than traditional protocols, and the decentralized economy will gain the upper hand over traditional centralized institutions. Locking your reputation tokens instead of your assets would be a strong leap in efficiency, giving a powerful economic advantage over traditional finance. This can only be achieved with a coherent system which securely tracks the value of a reputation token.
Not until the problems with decentralized governance are addressed will the decentralized economy be stable enough to invest fully, for the long term. These problems need to be solved before the decentralized economy can realize its full potential for efficiency. Once they are solved, however, the crypto economy is ready to explosively grow. The technical tools have been built. The legal and business dimensions just need to be arranged to ensure security and fairness through the proper incentives.
But even with all this, there is still another basic component missing — one more institutional overhead system that gives business the catalyst it needs. How can the average person participate in the decentralized economy? How can they know what is a good network to participate in? How can they know what to invest in? We need trustworthy open source decentralized institutions for recording and parsing history, for investigating and reporting the news, for guiding our attention to the future.
Bibliography
Formating example:
Evans, Dave (Apr. 2011). The Internet of Things: How the Next Evolution of the Internet is Changing Everything. CISCO White Paper, https://www.cisco.com/c/dam/en_us/about/ac79/docs/innov/IoT_IBSG_0411FINAL.pdf (accessed June 1, 2020).
Wikipedia. Last Universal Common Ancestor, https://en.wikipedia.org/wiki/Last_universal_common_ancestor (accessed June 1, 2020).
[1] Charles Farley Trenerry, The Origin and Early History of Insurance: Including the Contract of Bottomry, P.S. King and Son, Ltd., p 6. (1926)
[2] Preethi Rao, Sharan Buteau, “Modelling credit and savings behaviour of chit fund participants”, Gates Open Research, 2: 26 (2018).
[3] Craig Calcaterra, Wulf A. Kaal, Vadhindran K. Rao, “Decentralized Underwriting”, May 30, 2019. Available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3396542 (Retrieved 6/30/20)
https://www.minneapolisfed.org/article/1995/interview-with-kenneth-arrow (Retrieved 6/23/20).
[5] Barbara Underwood, “Virtual Markets: Integrity Report”, Office of the New York State Attorney General, (Sept. 18, 2018) https://virtualmarkets.ag.ny.gov/ (accessed June 1, 2020).
[6] Ethereum has a primitive governance system for coordinating updates its codebase. One element is their public ERC proposals. ERC stands for Ethereum Request for Comment, and 20 is the proposal identifier.
[7] https://news.bitcoin.com/9-million-day-lost-cryptocurrency-scams/ (Retrieved July 20, 2020.)
[8] Robert Sams, A Note on Cryptocurrency Stabilisation: Seigniorage Shares, BRAVE NEWCOIN (Apr. 28, 2015),
[9] The Soros Attack is named after investor George Soros because of his role in Black Wednesday, which occurred September 16, 1992. Soros believed the British pound sterling was overvalued based partly on low interest rates and high inflation and so built a large short position and initiated the attack described in this section. The British government failed to maintain its peg and was forced to withdraw from the European Exchange Rate Mechanism. The British government lost over £3.3 billion sterling, while Soros profited more than £1 billion.
Matthew Tempest, “Treasury papers reveal cost of Black Wednesday”, The Guardian, London, UK (9 February 2005)
[10] On the other hand, a major source of stability of a decentralized organization comes from the autonomy of its members. This makes it extremely unlikely for them to all do one thing and exit en masse. This means the more decentralized the platform is, and the larger and older the platform is, the more intrinsic worth it will have, and the less it will be hot money. No stable coin should be backed 100%. And a well-designed stablecoin should anticipate the future when it is used for more authentic economic activity, and can drop the reserve to well below 100%.
[11] A deeper analysis can be found in Craig Calcaterra, Wulf A. Kaal, & Vadhindran K. Rao, “Stable Cryptocurrencies: First Order Principles”, Stanford Journal of Blockchain Law & Policy, Vol. 3, №1, (2020)
[12] More than 200,000 lawsuits were filed in the U.S. over the use of the decentralized protocol from 2010 to 2011. “BitTorrent: Copyright lawyers’ favourite target reaches 200,000 lawsuits”, The Guardian, (August 9, 2011).
[13] CNBC quoting a New York University professor in a hearing with the U.S. Senate Committee on Banking, Housing and Community Affairs. (October 11, 2018) https://www.cnbc.com/2018/10/11/roubini-bitcoin-is-mother-of-all-scams.html (Retrieved July 28, 2020)
