Stablecoin as Hayek’s Private Money
In a previous article, I describe how money has value. The value of money is based on value-trust: the person accepting any form of money places trust in the value of that money and that trust is not misplaced because it is based on all the trust that other people have placed in that money before. In this article, I will deal with the question of decentralization and how private money (stablecoins) can gain value.
In any transaction, there are two sides: the spend-side and the accept-side. For any transaction to have occurred, the two sides implicitly agreed on the value of currency exchanged (value of money used). This implicit agreement is not obvious because explicitly what the two sides agreed to was the price of the commodity being bought, expressed in units of money exchanged (e.g., $1.31 for a bunch of bananas). When we buy something, our immediate attention is to the price of that something; it never occurs to us that the money we use has its own price expressed in its purchasing power with respect to a basket of commodity types.
When I buy something, I am the spend-side and I agree that the thing I buy is worth at least the amount of money I pay for it. The other side of the buy transaction, the seller (or accept-side because it’s the side accepting the money used) agrees that the amount of money being paid is at least worth the thing she is giving up possession of. The accept-side places trust in the money being used as payment. This trust is not readily apparent because it is taken for granted. It becomes apparent only when the network effect of trust for money has started to break down (say in a hyperinflation).
It’s hard to think about this because the value of money is a frame of reference; in fact, it is like a multi-dimensional frame of reference in which each dimension is any commodity that a currency can be exchanged with. While here on earth the best frame of reference is the firm land we stand on (“terra firma”), out there in space this terra firma we stand on does not look firm at all and it’s anything but a frame of reference. However, while here on earth, it is much easier for us to use the earth as frame of reference for GPS and we take this for granted; in a similar manner, we never talk of the price of money with respect to a basket of commodities. It is much more useful in the practical sense to think of the price of a single commodity in units of money. In the early stages of hyperinflation, people blame groceries for raising the price of produce, it is only during later stages that people finally realize that it’s the value of money that has decreased, rather than grocery owners gouging the people. Likewise, having evolved on earth and used earth as our only frame of reference, we used to think that the center of the universe was earth and that the sun revolved around the earth; we now know it is the other way around.
Money Constructs or Various Answers to ‘What is Money?’
While money can be considered as a “frame of reference”, this insight only works in only one construct of money. My views about money are borne of the money-as-commodity construct.
In literature one can find several other constructs of money:
Money-as-legal-tender: for me, this is the worst construct. It considers money as something only the government (central bank) can declare valid. In most explanations from adherents, this construct also declares that only the government can determine the value of money. It rejects any possibility for private money (like bitUSD or DAI) to be stable. Adherents go all out to prove that MakerDAO’s DAI has never been stable. The only way for a currency like USD to be accepted anywhere is to have a powerful military like the US does now. I have debated privately with people who believe this construct and, as much as I can see where they’re coming from, they and I continue our disparate ways.
Modern monetary theory (MMT) is a variant of money-as-legal-tender. In essence, MMT is saying that a central bank can issue money without worrying about inflation because people will ascribe value in each unit of money according to what the central bank declares.
Money-as-debt: paper money started out as certificates of deposit of gold in a bank. In this construct, a certificate issued and then circulated as money is an “IOU” payable in gold or another valuable commodity held by the bank. Stretching this idea construct to the current complex, centralized structure of banks where there is a central bank, money issued by the central bank is nothing but an “IOU” by that central bank. This is the construct responsible for the 1–1 backing imposed by most stablecoin source companies on themselves (USDT, USDS, USDC, etc). If money issued is debt, then the issuer better be able to pay that debt or else the issuer should not be allowed to be in business.
This construct is responsible for people asking whether Facebook should pay interest to future holders of Libra. It is also the construct behind this article that talks about interest rates.
Money-as-commodity: this is where I am coming from. Money is something that comes out naturally, spontaneously among a group of people wanting to trade with each other. Money retains its value because of the network effect of trust that people grant it. Without this network effect of trust, money has no value. Once money has gained this network effect of trust, its value fluctuates according to demand and supply, just like a commodity. But it’s a special kind of commodity because its issuer has an unlimited supply. According to this construct, the stability of money depends on how the issuer manages its quantity (quantity theory of money). The success of the private issuer is measured by how it can keep the value of its money fairly constant, even in the face of economic storms. Having an unlimited supply of money does not mean that a private issuer is eternally profitable because it can issue money as much as it can. Rather, the issuer stays in business as long as users trust its money; once it over-issues its stablecoin (too much quantity in circulation), its value degrades until finally trust is lost. When trust is lost, the quantity theory of money does not hold anymore and the currency in question quickly becomes worthless.
Bitcoin is valuable because of the network effect of trust by people in it, but its quantity is not adjustable so its value directly depends only on demand.
Private Money and Decentralization
All stablecoins in existence today are private currencies issued by way of decentralized networks or blockchains. This does not mean that stablecoins are ipso facto decentralized. For every private money issued, there is a single source who control the quantity; this is precisely what makes every stablecoin a centralized business.
To achieve decentralization, we can design a game-theoretic system that can determine the right quantity in an interval of time (say a week) and control the quantity accordingly in a kind of feedback mechanism, but it’s difficult to start off with this mechanism right off the bat without value-trust being built first. MakerDAO was able to achieve this with their DAI, but only within the confines of exchanges. Reserve.org is using seignorage shares to do something similar.
Both MakerDAO and Reserve.org peg the value of their respective stablecoins to USD. It makes sense to do this because currently USD is the most stable and universally accepted currency. What if the USD itself loses its value? Then both stablecoins (in fact all USD-pegged stablecoins) would lose their values also, if they kept the peg. Clearly, these stablecoins would have to disconnect from USD and start measuring their own respective CPIs (purchasing power with respect to a basket of commodities). At this stage, as Vitalik Buterin has observed, even a well-designed system becomes centralized because measuring the CPI is an off-chain centralized activity.
I think the question should be: is decentralization absolutely necessary for private money? As with many money matter issues, this question has been asked and answered before. Hayek has a very reasonable answer. Hayek proposed an economic system in which there are several competing currencies. Although each currency is issued by a centralized business entity, the whole economic system is decentralized because there is not a single currency. There is no single point of failure.
If we examine the current plurality of stablecoins, the situation right now where we have several competing currencies is exactly what Hayek envisioned. He could not have imagined it to happen this way because, before the coming of age of cryptocurrencies, what has transpired seemed politically impossible. Hayek could only do thought experiments and so right now we are all living in Hayek’s head. He expounded on the benefits and there are several huge benefits to mankind, including the systemic avoidance of depressions and maybe even recessions.
One question I have encountered is whether competition would lead to dominance of a few or even a single currency. Just like in any industry, when the dust settles, there will be only a few money issuers left standing. And just like any industry there will be consolidation in which a money issuer is absorbed by another. Are we going to end up in the same too-big-to-fail situation like the largest banks are in now?
Let’s talk about how consolidation can occur first. It will be similar to corporate consolidations in that two “currencies” will consolidate, except that while in the normal corporate world the two currencies consists of two distinct shares of stock, in the case of money issuers the two currencies are the currencies issued that will be merged. Just as in the case of corporations, the relative values of the stocks are declared prior to merging, the consolidation of two money issuers would also declare the relative values of their currencies prior to merging. Just as shares of stock of one side are all converted to the shares of stock of the other side in the corporate merger case, in the money issuers case all units of one currency are converted to the other. During the merging process, the negotiation between the two corporations is driven by their respective managers; it is no different during the merging process of two money issuers. However, while in corporate mergers it will be the interest of shareholders that is paramount, in the case of money issuers it is the interest of users that will be paramount. Why so? Let’s say of the two currencies merging, the first is stronger than the second. The primary incentive for the first money issuer to merge is increased market share and if users of the second currency are not happy with the declared exchange rate, they could instead exchange their holdings with a third currency. How can the issuer of the third currency offer users of the second currency a better deal? The issuer of the third currency has an unlimited supply of that third currency and it’s the market share that counts more than money issued. The second currency will become worthless after the merger. It is therefore most likely that the third issuer will not even get a chance to offer a better deal because the first issuer will have already offered users of the second currency the best deal possible. Therefore, mergers will naturally benefit users of a weak currency.
With regards to “too big to fail”, this has so far happened only among financial institutions in the current fiat money regime in which there is a single source of money (the central bank). In the brave new world of stablecoins, there is no justification for saving a big issuer of money from a catastrophe of its own making. Regulations still have to be legislated and so private money issuers are currently not beholden to government. By the same token, the government has no obligation to save a money issuer in trouble. There is no “moral hazard” in this nascent field and it will be foolish for any government to assume the “responsibility” for saving any money issuer in trouble. There can be no “lender of last resort” in a system made up of diverse parallel currencies and it is not necessary because a money issuer in trouble can merge with another.
Value-Trust Transference and How to Issue Your Own Money
In the beginning, a money issuer, in introducing its stablecoin, has to gain the trust of users. This trust is most important on the accept-side because a stablecoin that cannot be accepted as payment cannot become a currency. By far the most common way to get started is to peg the value of the new currency to another that has already attained value-trust. This other currency can be an established stablecoin. For example, stablecoin X can be pegged to a value-trusted stablecoin Y such that a fairly constant value relationship 1 X = 1 Y is maintained. Once X circulates among a large number of users, we say it has attained value-trust and it can then be disassociated from the value of Y and managed on its own with respect to a basket of commodities. It is not necessary to keep the peg, especially if Y deteriorates in value. This process of maintaining 1 X = 1 Y within a small band in order to gain users is called value-trust transference. Nobody trusts X in the beginning and a lot of users already trust Y, but if Y is redeemable from X, then users can also trust X as if it were Y.
I expect this marketing strategy to be used again and again as new entrants into the business emerge. Value-trust transference is very easy to understand for users and its simplicity belies a rigid discipline in the new entrant not to release any X without accepting a corresponding amount of Y. However, almost no initial capital is needed to keep the peg because all the new entrant is doing is selling X and accepting Y. Given that the only source of X is the new issuer, every X released can be backed by a Y in this manner. Therefore, as long as this disciplined backing is kept, there can be no “bank run” for the new entrant. This is a business that is very easy to get into and that’s the way it should be.
Historically, value-trust transference has occurred a number of times. Paper money came into being as certificates of gold deposited in early banks. There was existing value trust in gold and this value trust was “transferred” to paper money. The gold standard limited the quantity of USD that can be issued and at the time its value was disassociated from gold by then President Nixon in 1971, it had already attained world-wide value-trust.
The author is the founder and CEO of Rock Stable Token Inc, purveyors of ROKS, the stablecoin with its own payment system.