Hayek and Stablecoins
“I don’t believe we shall ever have a good money again before we take the thing out of the hands of government. That is, we can’t take them violently out of the hands of government. All we can do is by some sly roundabout way introduce something that they can’t stop.”
— Friedrich August von Hayek, Austrian economist, and 1974 Nobel Prize winner.
Bitcoin proponents love Hayek, because they share the same anti-establishment ethos. They often quote Hayek’s work as the theoretical foundation for why Bitcoin will become a widely adopted currency. But Hayek’s original vision looks less like Bitcoin, and more like…
In one of Hayek’s most prominent books, the Denationalization of Money, he argues there is no reason why governments should have a monopoly on the money supply. Instead, money should be like any other consumer goods, subject to a competitive market that battles to serve the best interest of its users.
Hayek encouraged private institutions to issue their own money to compete with governments, and described his own, hypothetical version of private money, the “Ducat.”
Here’s how Hayek explained the Ducat’s ideal design:
1) The issuing institution (e.g., a reputed local bank) would make the Ducat available to the public by selling it against government money, while promising to keep the price of the Ducat stable. It would only have one legal obligation: if at any point in time a Ducat holder wanted to redeem his Ducat, he would be permitted to go to the issuer and exchange them for fiat at a fixed rate.
2) This legal obligation was only intended to serve as a price floor, and would be insufficient to stabilize the price by itself. So how would the issuer fulfill its promise of keeping the price stable? Smart monetary policy, of course. If the market price of the the Ducat fell below the promised purchasing power, the issuer could use its fiat reserve, which it raised during the initial public sale, to buy Ducat in the market. Similarly, when the Ducat rose above the desired purchasing power, the issuer could print Ducat and sell it in the market.
You may wonder what the issuer’s economic incentives are to start a business like this. Hayek didn’t really explain this, but there are two reasons that we’re seeing play out with Stablecoins.
First, the issuer can profit as a market-maker when the price of the Ducat deviates from intended purchasing power — buy low, sell high. Second, the issue can invest its fiat reserves in appreciating assets.
If you know how Stablecoins work, you can immediately see the parallels.
In the case of Stablecoins like the Dai, the “issuing institution” is a combination of a smart contract and community of self-interested market-makers. The public may, at a price predetermined by the smart contract, create Dais by depositing Ether into the smart contract, and redeem Dais by withdrawing Ether from the smart contract. This creation/redemption mechanism, enforced by code, is akin to the “legal obligation” of the Ducat issuer. Furthermore, when the market price of Dai deviated from the price to which it was intended to be pegged, market-makers would be incentivized to buy low and sell high, thus pushing its market price back to its target rate.
Now if you are like Preston Byrne, the biggest skeptic of Stablecoins on Twitter, you probably think this is sheer market manipulation.
While I respect Preston for calling bullshit whenever he sees it, he’s dead wrong on this one, and it’s irresponsible to spread the false message that market-makers are market-manipulators.
Market manipulation is rent-seeking. Market-making is a positive-sum activity where the market-maker and its counterparty both benefit. Hayek clearly didn’t hate market-making, either. He’s the one who proposed the Ducat!
With stablecoins, counterparties work with market-makers to obtain the liquidity they need. Market-makers open positions at an attractive price in the market, and may close the position immediately by using the smart contract’s creation/redemption mechanism, thereby making a risk-free profit in exchange for providing liquidity.
The creation/redemption mechanism isn’t unproven crypto voodoo science, either. It has been tried and tested in the legacy financial industry for decades.
Exchange Traded Funds, or ETFs, are the most important example. Surely, there are times when the Dai deviates from the intended price, as you can see in the price chart above. But so do ETFs. On August 24, the Black Monday of 2016, ETFs diverged from the indices they were intended to track, by THOUSANDS of basis points, for almost ONE hour. The reason is simple. Market turmoil generally drives up the demand for market-makers, and that day there just weren’t enough market-makers. In the long run, however, well-designed ETFs track their indices very well.
Where Stablecoins and the ducat Can Fail
One thing Stablecoin skeptics are right about — which many Stablecoin teams haven’t made an effort to emphasize in their marketing materials — is that the Stablecoin will fail if the Ethers deposited into the smart contract to create new Stablecoins fall in price substantially.
I won’t get into the mathematical details here, but intuitively this should make sense. If the assets that are used to back your currency are worthless, then your currency will likely also be worthless. Hayek was fully of aware of this problem as well with the Ducat:
Once these [fiat] currencies had, as the result of further inflation, substantially depreciated relative to the Ducat, the bank would have to be prepared, in order to maintain the value of the Ducat, to buy back substantial amounts of Ducats at the prevailing higher rate of exchange.
This is why Hayek thinks that the issuing institution should carefully invest the fiat collateral in appreciating assets. Similarly, Stablecoin devs appear to be working on multi-collateral system (as opposed to a single collateral that is Ether) in order to diversify away the price risk of Ethers.
Here’s what’s really interesting about Stablecoins. It’s not the fact that they are capable of tracking the price of a stable asset like USD. It’s the fact that with the creation/redemption mechanism you can track the price of ANY liquid real-world asset on the blockchain. In fact, why would you ever want to track the biggest shitcoin on Earth that is the USD?
Why not track a stable basket of commodities that is resistant to inflation? The #1 problem with fiat money is inflation, and inflating money supply is equivalent to robbing from the the average citizen for the self-interest of the elite.
If Hayek were still alive today, I think he would be very pleased to see that his vision could finally be realized. In the Denationalization of Money, he was worried that governments may not let private institutions issue their own stable money.
If we can put that on a blockchain, then no one can stop it.