Cycles: A Revolution in Monetary Policy using Blockchain Technology

A groundbreaking protocol named Cycles has been announced, bringing in a new era of innovation in blockchain technology. Developed with concepts introduced by Informal Systems, known as CoFi, Cycles proposes a departure from the traditional DeFi models that have dominated the blockchain space since 2020. While DeFi has largely focused on refining mechanism designs, Cycles aims to reimagine monetary policy and the foundational structures of financial transactions. This innovative approach seeks to address the inherent flaws and inefficiencies in our current financial system. By reducing liquidity requirements, simplifying compliance and accounting, and increasing transparency, Cycles presents a solution that could safeguard small and medium sized enterprises against liquidity-induced bankruptcies, promising a more resilient and equitable financial ecosystem.

Cycles: What is it?

At its core, Cycles is inspired by the principles of CoFi, which aims to deepen our understanding of networks of obligations and to foster robust commercial economies through improved liquidity management. Drawing on a seminal paper, Cycles builds upon the success of Slovenia’s Obligation Clearing program and the Sardex mutual credit system in Sardinia, demonstrating the profound impact of obligation clearing and mutual credit on liquidity efficiency. By rethinking monetary policy, we can see incredible improvements in how money functions:

• Reduced liquidity needs: Up to 50% less liquidity could be required by businesses, saving them from unnecessary burdens and preventing bankruptcies. [1]
• Simplify accounting: Automate processes for payroll, accounts receivable, payment processing, and tax collection. [2]
• Increased transparency and collaboration: Blockchain technology offers us the ability to increase transparency, collaborate on open source software, and offer neutral banking services to a global audience.

Obligation Clearing

At the core of Cycles lies obligation clearing, a method for settling debts without traditional financial intermediaries. Imagine a network where suppliers and customers can directly exchange goods and services, with debts automatically cleared through a series of connected transactions. This eliminates the need for cash and reduces dependence on banks, fostering a more efficient and self-reliant financial ecosystem.

Obligation clearing has been shown to have great liquidity saving capability in times of crisis. 683 million Euro (1.89% of Slovenia’s GDP, the red line) was cleared as obligations in 2012. There is clear counter-cyclical behavior, as the usage of obligation clearing increased after the 2008 financial crisis. [1]

A real world example of a system that would benefit from obligation clearing is Trade Credit — a crucial form of financing in B2B transactions, where upfront delivery of goods are given to the customer on credit. Payments are usually required within 30–90 days, with 0% interest during the payment period. It’s estimated that there’s over $5 trillion dollars in trade credit transacted globally each year. [3] This is a huge opportunity that is ripe for disruption.

Let’s describe some of the liquidity issues that businesses often face, that can be resolved using obligation clearing [1]:

• Circular liquidity issues — a situation where individual payments can only be settled in a specific order. This situation is resolvable by reordering the payment queue.
• Gridlock liquidity issues — a situation in which several payments cannot be settled individually but can be settled simultaneously. This situation is resolvable with multilateral off-set.
• Deadlock liquidity issues — a situation where the individual payments can be made only by adding liquidity to at least one of the system participants.

Through strategic debt dischargement, these obligations can be fulfilled. All participants must consent to the settlement of their debts within the protocol, thereby enabling the discovery and resolution of these cycles of obligations.

Mutual Credit

Cycles leverages the power of Mutual Credit, a system where participants agree to extend credit to each other within a closed network. Entities within the system are allocated credit based on predetermined criteria, such as a percentage of their annual turnover. These transactions are done on credit with 0% interest. The research paper showed that with just a 2% injection of liquidity to each entity in the network, along with obligation clearing, the liquidity requirements can be reduced by up to 50%, an incredible achievement. [1]

A Mutual Credit protocol such as Cycles might work like so:

• Each entity that opts into the protocol agrees to some predetermined credit line in a community currency, such as 2% of your annual turnover rate in settled obligations.
• All obligations are posted to the protocol, to help discover the loops of payments.
• The payments graph can be mapped using algorithms and equations from the field of Graph Theory. [4]

Spanning Tree Visualization of the Sardex Mutual Credit System. Color coded by business sector, with node sizes proportional to the number of invoices issued. The larger businesses are strongly connected, and serve as anchor points for loops of obligations to be cleared, reducing liquidity needs. [1]

With enough businesses, obligations, and liquidity, you can end up settling very complex loops of obligations that our traditional financial system could never solve. For example:

• If you are owed $10,000 by your employer on May 1st, that obligation can be on chain. You can use that as collateral to borrow against, as long as a counterparty trusts that the employer will fill that obligation on May 1st.
• Not only that, you could settle a debt you have in BTC, if within the loop there is someone who would exchange BTC for USD.

As you can see, liquidity can become much more flexible. Businesses with inventory or assets that typically would be considered illiquid, can find a match in the loop that can help settle their debts, preventing them from missing payments.

Blockchain: The Missing Piece

Although obligation clearing and mutual credit are not new concepts, their integration with blockchain technology underpins the innovative potential of Cycles. Blockchain’s attributes of neutrality, global accessibility, open-source development, and increasing adoption provide a fertile ground for reimagining financial transactions. We can build new financial systems in parallel to our existing one, giving us a lifeboat to escape on if the US debt continues to spiral out of control.

Creating New Financial Infrastructure with Cycles

The advent of blockchain technology offers a unique experimental playground for monetary policy innovation. Cycles aims to leverage this opportunity to establish novel economic systems at both local and global levels. The envisioned infrastructure can fundamentally transform:

• Payment processing and debt management — can be automated, easily tracked, and quickly settled.
• Transparency — with transparent on-chain debts and obligations, businesses with strong loops can be more easily discovered and trusted.
• Liquidity requirements — lowered through the use of on-chain obligations and mutual credit.
• Accounting practices — with open source software, we can one day automate all accounting, even paying your taxes.
• Self-custodied assets — remove banks as middle-men, allowing businesses to directly deal with each other, decreasing delays, and reducing liquidity needed.
• Access for everyone — we can create a global banking system that can be accessed by anyone, leapfrogging the awful banking infrastructure of some poorer countries.
• Secure and fast identity verification — using crypto wallets, on-chain reputation and self-custodied assets, we can quickly verify identities and understand who we are doing business with. Rather than the broken Know Your Customer (KYC) processes that banks enact today, which are extremely slow, and still allow billions of dollars of money to be laundered.

All of these improvements could easily lower the costs to do banking, accounting, and business. It honestly won’t be hard to improve, because the systems we work with today are inefficient, antiquated, and broken. Not to mention the millions of hours of human time we could save from accounting and compliance, which could be put towards more creative human endeavors.

Of course, there will be resistance from the banks and governments, as the inefficiencies in the system allow the banks to make money on fees while they custody your assets. It’ll be a hard battle to take down the old guard of banking, but eventually the better system will prevail.

Conclusion

Cycles represents a visionary step forward in the realm of cryptocurrency and blockchain technology. DeFi has shown we can build incredible mechanisms that allow for executing trades, taking loans, and creating stablecoins, all in a permissionless, self-custodied manner. Cycles now promises to lay the groundwork for us to rethink obligations, liquidity, monetary policy, and the very way we do business with payroll, accounting, tax collection, debt, and credit.

Sources

[1] Liquidity-Saving through Obligation-Clearing and Mutual Credit: An Effective Monetary Innovation for SMEs in Times of Crisis — Tomaz Fleischman, Paolo Dini, Giuseppe Littera

[2] CoFi FAQ — Informal Systems

[3] Reconceiving the global trade finance ecosystem -McKinsey

[4] Announcement Tweet — Ethan Buchman