Understanding the Relationship Between Monetary Velocity, Seigniorage, and Stability
1. Monetary Velocity Definition and Understanding
Monetary velocity is an important concept for understanding stablecoin economies. It is broadly defined as total transaction value (GDP) divided by the monetary base per unit of time. The monetary base of a stablecoin is equal to its market cap, and the total transaction value represents the gross value of stablecoin that was transferred from one economic agent to another over a certain period of time.
For example, if the stablecoin market cap is constant at $100, and the stablecoin is used in $1,000 worth of transactions over the course of a year, then the stablecoin’s monetary velocity would be 10. Below we see the quarterly velocity of the U.S. dollar over the years, using two common measures of money supply, M1 and M2.
Monetary velocity is an important output to measure because it captures how economic participants are using the money in circulation. Put simply, velocity of money and demand for money are inversely related, as velocity is a byproduct of how a currency is being used. If velocity is very low, then one would deduce that most participants have a bias to hold on to their money. Conversely, if velocity is very high, then one would assume that most participants would rather spend their money than hold it.
Among fiat currencies, the Venezuelan bolivar has very high velocity because Venezuelan citizens want to spend their money quickly before hyperinflation erodes the present purchasing power, rather than invest in endeavors which increase productivity in the long-run. On the other hand, the euro has a very low velocity as the economy suffers from persistently below target inflation, gradually stagnating activity, and structural headwinds. In such an environment, the eurozone would benefit from targeted fiscal stimulus to boost aggregate demand. This would help shift the static piles of money from central bank and private bank balance sheets into circulation to facilitate lending and production.
From these examples we can see how velocity is one metric, albeit neither a perfect nor always easily observable one, that shows how well a currency is functioning within an economic system. Neither extremely high nor low velocity is desirable for a healthy functioning economy and currency, and the proper balance lies somewhere in between. Thus a reasonably low monetary velocity can signal that a currency is functioning as intended, both as a medium of exchange and as a store of value, which helps to maintain the currency’s value all else equal (note: the unit of account function is solved by pegging). A currency which maintains its value forms the backbone of a well functioning economy where agents can engage in contracts. As such, we view monetary velocity as one gauge of a stablecoin’s usefulness as a currency in the blockchain economy.
2. Monetary Velocity has Important Implications for Seigniorage
In simple terms, seigniorage is the profit a government receives from printing money. For a government such as the U.S., which operates the de-facto global reserve currency, printing money is extremely profitable. The U.S. and other governments manage their seigniorage profits generally by provisioning a foreign currency reserve and by capitalizing initiatives which benefit the welfare of the nation.
Over the past few decades of the modern era, governments and central banks have had a monopoly on seigniorage and were trusted by their constituents to exercise that power responsibly. Many governments successfully earned this trust, while many others failed. A government which mismanages its seigniorage is likely to erode the full faith and credit it was bestowed, resulting in currency depreciation and rising inflation, both which devalue its monetary base relative to other currencies.
Seigniorage is a powerful tool that must be calibrated and exercised appropriately. Governments know that the more useful and stable their currency, the more seigniorage they can steer from their currency reserve toward productive uses such as funding the country’s military or subsidizing the economy. Given that a useful and stable currency should have a reasonably low velocity, we can begin to understand the relationship between velocity and seigniorage. Lower monetary velocity enables greater seigniorage to be used for productive purposes, all else equal.
3. Applying the Concepts of Seigniorage and Velocity to Cryptocurrencies and Stablecoins
With the emergence of blockchain technology, anyone can provably secure and transfer value without a trusted government or third-party intermediary. Unfortunately, the lack of focus on adoption and cryptocurrency monetary policy, or ‘tokenomics’, has led to a value implosion for many otherwise promising projects and use cases. Even stablecoin monetary velocity is stubbornly high as most are only used for cryptocurrency trading. Cryptocurrency monetary policy matters greatly in this brave new world.
Each cryptocurrency that users and investors choose to purchase is essentially benefitting from the same power of seigniorage as governments. If I give you my fiat currency or my cryptocurrency in exchange for your token, my money now forms your reserves and I trust you to utilize those resources wisely, most likely in the service of adoption or stability. The value of your token or currency is the ultimate arbiter on whether you are successful or not, assuming the value is linked to the project’s underlying utility and adoption. If you were to put all the money you received for your token into a bank account and used it to back the value of your token, you would even be on your way to creating a centralized stablecoin if that was your intent, but development and adoption might suffer.
While most government currencies operate without the full backing of reserves, credible government pegged currencies have a full reserve. Since stablecoins are pegged currencies, they too should adhere to the proven practice of backing the peg with a reserve comprised of off-chain or on-chain assets and resources to ensure the long-run viability and stability of the stablecoin. Utilizing seigniorage wisely, and maintaining a reserve that can appropriately contract the economy in extremely adverse scenarios is of utmost importance. More efficient use of seigniorage for productive purposes, such as adoption, results in a greater share remaining for stability.
If a cryptocurrency were to have very low velocity and high adoption growth, it could more effectively utilize a greater share of seigniorage to fund necessary expenditures with less offsetting impact on the ratio of reserves backing the economy. Now we can begin to close the loop on seigniorage, growth, and monetary velocity. Available seigniorage is a function of monetary velocity and growth. Higher adoption growth and slower monetary velocity unlocks greater levels of sustainable seigniorage, which is money that can be spent to promote the welfare of constituents. This is true for governments and cryptocurrencies.
4. Bringing it Together: How Velocity, Growth, Seigniorage, Reserves and Stability Relate to the Terra Economy
The concept of seigniorage can be adapted to fit the Terra economy. Terra’s objective is to return the benefits of adoption and growth back to users of the protocol, thus the primary use of seigniorage is discounts on purchases made with Terra through whitelisted dApps, offered on a sustainable basis. If we were to assume a constant annualized velocity ‘V’, and vary the weekly money supply growth ‘g’ and seigniorage discount rates ‘S’, we can visualize how the long-run steady state reserves ‘%Rn’ evolve. The velocity matrix below demonstrates the trade-offs between growth, discounts, reserves, and velocity over a long-run time frame. Generally speaking, higher growth ‘g’ and lower velocity ‘V’ leads to a higher sustainable seigniorage discount rate ‘S’ that the Terra protocol can programmatically offer users who pay for goods with Terra through whitelisted dApps.
For example, annualized velocity of ‘V’ = 26, a weekly money supply growth rate ‘g’=2% and a generalized discount rate ‘S’ = 2% yields a long-run reserve ratio of ‘%Rn’ = 50% over n=104 weeks assuming an initial reserve ratio ‘%R0’=50%. Slowing the velocity to ‘V’ = 13, and using the same values for ‘g’, ‘S’, ’n’, and ‘%R0’ yields a long-run reserve ratio of ‘%Rn’ = 72%. Since ‘%Rn’ in both examples is below 100%, another form of stability must be used to supplement the reserves since Terra is a pegged currency. For the Terra economy, the Luna token represents the on-chain stability mechanism. Luna is also used for network validation and governance. As the Terra economy grows and becomes more diversified, and as the Luna token strengthens as an on-chain automatic stabilizer, Luna’s role as a primary reserve asset will increase, subsequently reducing the economy’s reliance on other assets in the ecosystem. More analysis on Luna’s role in stabilizing the Terra economy is forthcoming in a future blog post.
5. Slowing Velocity is an Important Step for the Maturation of the Blockchain Economy
Simply holding a currency can be a valuable contribution to the economy because this activity slows velocity. By holding on to a currency for a period of time, you are signaling that you value it (‘putting your money where your mouth is’ so to speak). You believe that the currency will maintain its purchasing power over a certain period of time, and can use the currency for other purposes than current expenditures. As more people hold a currency, longer-term contracts between agents can begin to take shape. Savings, credit, insurance, and mortgages are all examples of this behavior. For participants in the blockchain space, OTC smart contracts can be used as digital representations of these financial products. A plethora of blockchain use cases are enabled once velocity is slowed and stability achieved, with each helping to further maintain a reasonably low monetary velocity.
The blockchain ecosystem as a whole would benefit greatly from a focus on ‘tokenomics’ and understanding the impact of velocity. A few authors have proposed models to incorporate velocity and other measures to quantify a token’s value or have proposed ways for cryptocurrencies to manage velocity. Further analysis of these topics by the cryptocurrency community will bring greater understanding and provide promising projects with the tools needed to fulfill their mission.
6. What Does This All Mean for Stability Under Adverse Scenarios
Lower velocity and higher adoption can enable greater levels of sustainable seigniorage to be utilized without cannibalizing stability reserves. But what if growth shifts downward or perhaps contracts significantly? How can a system be designed to maintain stability in an adverse scenario or shock?
Previously, we established that seigniorage can be sustainably allocated for productive uses, and that a secondary on-chain stability token can provide supplemental stabilizing capacity for any token, not just stablecoins. An on-chain stabilizing mechanism can compliment a reserve of real assets, and both can be operated in a decentralized and programmatic fashion. To the extent that an asset or token comprising the reserve is volatile, correlated, or exhibits tracking error, then its stabilizing capacity should be appropriately discounted. Bivariate dependence and volatility among reserve assets can shift in calm versus stressed regimes, which also must be accounted for. Central banks utilize increasingly sophisticated portfolio modeling and reserve diversification strategies to meet policy objectives, the foremost of which are liquidity, safety, and then return. Stablecoins can learn from and utilize these same practices, though would benefit from taking a more conservative approach to asset allocation than a number of central banks.
The ultimate intent of a properly designed and provisioned stablecoin stability reserve is to fully contract the monetary base at the pegged exchange rate, if necessary. Since stablecoins require the highest level of stabilizing capacity of any asset, robust modeling and conservative thinking will allow stablecoins to depart from their current centralized format toward a more decentralized format, which is necessary to power the growth of the global blockchain economy.
