Stable value: killer enabler for Smart Contracts

Traditional crypto currencies (bitcoin/ether etc.) are incredibly useful; but for long term personal or business dealings, they suffer from high degrees of value fluctuation (often called volatility) which makes working out future costs of things in a fixed amount of crypto hard. E.g. To paint my house next month, I agree to pay you 10 bitcoin on completion.

Agreeing to get paid in a specified amount of bitcoin 1 year, 1 month, 1 day or even 1 hour from now involves at least one (or both) parties taking a bet on the future value of bitcoin, in addition to whatever risk might be associated with the reason for the payment in the first place. To the avid bitcoiner, that may look like a good bet. To the average man on the street/business; they just want to know whether they can pay their rent with it when they get it.

This brings us neatly to the concept of value stability. Value stability, over a long time period, is NOT the same as price stability. Let’s say I really like cheeseburgers. I want to be able to buy one cheeseburger a month for the next five years; so I create cheeseburger coin. This coin has the magical property of always being equivalent to exactly one cheeseburger at my favourite cheeseburger stall.

Let’s say over this same 5-year period, that cheeseburger has gone up in price, due to inflation, from £1.50 to £2.50. The property that both I and Barry (the guy who owns the cheeseburger stall) want is for that cheeseburger coin to be worth the price of one cheeseburger, regardless of when the coin it is used. I.e. 1 cheeseburger coin is worth £1.50 today and £2.50 in five years time, allowing me to always get a 1:1 cheeseburger:cheeseburger coin exchange rate, and Barry to always be able to sell the coin at the price a cheeseburger is sold for at the time of use, allowing him to pay for his inputs and make his profit.

This, essentially, represents both the time value of “normal” (fiat) money: e.g. £1 in one year is worth less than £1 now (assuming positive inflation), and an economic concept called Purchasing Power Parity (PPP): what equivalent money do I need to purchase a specific good (e.g. a cheeseburger) given some sort of variation (time/geography etc).

Smart contracts

Smart contracts are a broad, often accused to be a badly named, concept. In this instance, I am restricting a smart contract to include code on block chain that has an ability to control assets (e.g. ether), with defined rules as to how it administers those assets.

This still covers a huge number of scenarios; but let’s go with a simple escrow service example, with a binary outcome (either done or not done) that can be determined by code alone (i.e. no arbitration/opinion input needed).

Let’s say I really, really want to become famous. To achieve this, I create a smart contract that says; here is a 10 second video of me looking amazing, if you are the first person to get 10 million people to look at my video of me looking amazing by posting it on your youtube channel, I will pay you $10k (not a real offer, please don’t).

Before anyone seriously embarks on this, they will want to know the money is there. They have no reason to trust me, but there is real work involved and an opportunity cost in doing this vs doing something else. Smart contracts can solve this problem: by putting the funds into a smart contract, anyone can go and see, on the public block chain, both that the funds are available, and also, how they can earn/win some/all of the funds.

However, there is a problem: to put the funds into the smart contract, I need to fund the contract in crypto assets. Now comes the uncertainty of value. I go out to my favourite exchange and buy $10,000 worth of ether; I take that ether and place it in the smart contract. Now, not only am I hoping that ether doesn’t crash, so is everyone who is considering taking on the project. This is a contract that may take some time to complete, so I am hoping that not only is someone willing to take a punt on getting my face in front of 10 million people, they are also hoping that by the time they do it, that ether was worth it in REAL (i.e. cheeseburger) terms — i.e. if I would charge $10k for this service today, and it takes 2 years to complete, I want $10k + inflation (at least) by the time I manage to finish the work.

Enter: stable coins. Crypto currencies that aim to maintain a constant, stable, absolute value. My personal favourite so far of these is MakerDAO. In my next blog post, I will do a bit of a dive into the mechanics (as they are super cool), but here is a quick and dirty (read: not 100% accurate, but short) summary:

MakerDAO is split into two coins, a stable coin (DAI) and a volatile coin (MKR). The value of the DAI is benchmarked against SDR (Special Drawing Rights — basket of global goods and currencies; like the cheeseburger coin, but broader) making the DAI global inflation linked (maintaining the real world value of the DAI for both time value of money and purchasing power parity). The MKR stands behind the value of the DAI, and makes sure that the DAI maintains that benchmark in value, absorbing losses instead of the DAI, but also rewarding excess gains to the holders of the MKR.

Thus, the DAI value stays constant (in PPP terms), and MKR jumps around like a willowy gazelle being pursued by a leopard.

It is this value stability that is fundamentally critical to the wider adoption of smart contracts; removing value uncertainty, and radically broadening the real world applicability of crypto currencies in general. Now I can fund my make-me-famous smart contract with DAI, and everyone interested only has to ask one question: is it worth trying to get 10 million people to view this ugly mug for a measly $10k + inflation?

With thanks to Vitalik Buterin and the ethereum team for creating an incredible platform that enables smart contracts written directly in the block chain; and to Rune Christensen and the MakerDAO team for their work so far in creating a strong contender for a universal stable crypto currency.