Liquidity and Token Economics

How can token mechanics bolster the preservation and regeneration of ecological principal?

In financial markets, liquidity is the capacity for a financial asset (such as a stock or bond) to be turned into cash. High liquidity means this process can happen quickly (such as with the stock of publicly owned companies), and low liquidity means this process happens slowly (such as with a majority stake in a privately held enterprise).

In the crypto space, it is an unquestioned assumption that more liquidity is always better. Suggesting that there are instances where we’ve have enough, or even too much liquidity, is taboo.

It is a first principle of economics that the medium of exchange and store of value functions are inversely related. Blockchain will not alter this economic fundamental.

Too much liquidity can destroy value, or at least curtail value creation. To take a classic example, when purchasing refineries, Standard Oil would offer to pay in stock or cash. People who took the cash (optimizing for liquidity) later regretted it, as the Standard Oil stock appreciated a hundred-fold. And in these instances, Standard Oil then had less credit to reinvest in their operations, slowing their growth.

Global markets are already extraordinarily liquid. That said, prudent investors understand that they pay for liquidity, and avoid this fee when possible. Private equity and venture capital are extremely illiquid, as are a majority of the investments in big university endowments and sovereign wealth funds.

The Cost of Liquidity

Liquidity has a number of downsides. In liquid investment, the investor is paying for the option of an exit. In illiquid investments, the investor is being paid to forgo that option.

For the purposes of this essay, we can think of “investments” as projects reliant on a stable productive capital base that yields an ongoing return (such as an endowment, with principal and yield). We can think of “speculation” as projects where the market value of the underlying asset is of primary concern, and where liquidating the underlying asset enables financial gain. By these definitions, Warren Buffett would be the epitome of an investor.

Liquidity also takes a toll on the economy as a whole. Increased liquidity results in increased volatility. Shocks propagate through the system with more speed and violence. This can be seen very clearly in the boom-bust cycles of the crypto markets, which dramatically exaggerate swings that are already occurring in the general economy. Too much liquidity has also been a driver in the economic shocks of the past decade, including the subprime mortgage crisis and the Eurozone crisis (Adam Tooze). When wealth is locked up in illiquid assets, there’s a solid floor that prevents market prices from dropping too far. Every successfully executed sell order drives a market down further, so liquidity accelerates a crash, while illiquidity tempers it.

Turning our mind to the sphere of natural capital assets, liquidity’s price becomes clear. The vast majority of any natural capital asset must be treated as principal if yields are to be sustained. Aside from shifting mosaic applications such as coppice and swidden, every time a forest is clear cut, its regenerative ability is substantially curtailed. Each time the trees grow back, there’s less biomass of a lower quality. In contrast, when natural capital assets are respected, they can sustain ample carrying capacity indefinitely.

Decreasing Volatility in Crypto

Coming back around to crypto, I’d postulate Cosmos Network’s (Interchain Foundation) most enduring contribution to the space at large is the economics of their Proof-of-Stake model. As I mentioned earlier, crypto assets are generally treated as speculative, resulting in high volatility and low utility. Cosmos may be able to reverse this trend; the economics of staking Atoms rather than simply hoarding and then selling them is quite compelling. Cosmos is a month or so into a very strong launch, and we’re very excited to see how these dynamics continue to develop.

Thinking about the potential in cryptocurrency design:

What can token accounting enable or enhance compared to a cash accounting system?

Natural capital is massively undervalued in the current economy. This is generally because it is “off the books.” In the extractive economy, this could actually be a good thing; if it were on the books, it might be slated for liquidation. And this brings us back around to liquidity.

Reverse Mining

In the beginning, Regen Network was inspired by the concept of “reverse mining.” Whereas Bitcoins are “mined” — like gold — through an extractive process resulting in environmental degradation (through the production of ASICs and consumption of mammoth gigawatt hours of electricity). Regeneration looks to build the capacity of living systems. To get literal, whereas of previous generation at Walkers Quarry operated a sand quarry in Barbados, denuding the land and exporting natural capital, the current generation has been restoring this land, now Walkers Reserve — planting trees, building ponds, increasing biodiversity. What would that process look like in the crypto space?

Capital Formation

There are a number of examples of financial capital getting tied up to enable the creation of new capital. One example would be in a growing private corporation with a new issuance of stock. The total number of shares expands, and investors contribute cash in return for shares. This cash becomes illiquid to the investor, as it is utilized in business operations. This could be considered a transformative or metabolic process — cash to shares, with a concurrent increase in ableness of the company. Another is MakerDAO and DAI. New DAI con be created by posting collateral into a MKR contract.

Token Creation

In our token design at Regen Network, we’ve been considering a number of options for the process of token creation. What if new staking tokens in the Regen ecosystem were created upon the successful completion of an Ecological Contract (smart contracts tied to an increase in ecological health)? These tokens could be bonded to the outcomes; as long as the outcome was retained, these tokens could be staked and could yield fees (some of which would cover the auditing of the former contract on an ongoing basis). If the outcome was reversed, these token would be burnt, decreasing the total number of staking tokens in the system. This would align the interest within our system to create enduring ecological regeneration (locking up ecological capital in low-liquidity arrangements that optimize for sustainable yield), and create incentives towards these ends.

There would need to be some experimentation on how to assess the level of new staking token creation (likely tied to the economic size of the ecological contract in question), and determine in what ratio.

Iteration

In a few decades, we’ll look back at these days of the Wild West of token design. One of the amazing things about these times is that the nascent world of token design has enabled economies that operate on an entirely different set of rules than the mainstream economy. We have access to points of leverage that are simply inaccessible to entrepreneurs and startups via conventional means.

At the same time, this means that we’ll also look back on this era and maybe feel some embarrassment as to our naïveté. This is a time for experimentation, learning, and iteration. In what settings is Proof-of-Stake an effective method of securing a blockchain, and what dynamics does it result in? How can mutual credit be deployed in a blockchain? When is it useful, and what can it enable? These are some of the questions we’re asking, and we’ll be closely watching what communities like those of Cosmos and Holochain Design are learning so that we can integrate these gleanings into our own architecture.

We don’t assume that we’ll get it right the first time. Rather, we’re aiming high, looking to bring innovation to the token design space in a way that furthers ecological accounting and aids regeneration. During the next few years, we’ll be experimenting with many ideas, documenting our learning, and retooling our system as we go. Shortly, we will be releasing our economics technical paper, which will outline all of this in more detail.