Friday, July 17, 2015


The whippersnappers who work in the cryptocurrency domain are moving incredibly fast.

As I've been saying for a while, assets like bitcoin (or stocks) are unlikely to become popular as exchange media; they're just too damn volatile relative to incumbent fiat currencies. There's a new game in town though: stablecoin. These tokens are similar to bitcoin, but instead of bobbing wildly they have a fixed exchange rate to some other asset, say the U.S. dollar or gold.

Now this is a promising idea. If a crypto-asset can perfectly mimic a U.S. dollar deposit's purchasing power and risk profile, and do so at less cost than a bank, then the monopoly that banks currently maintain in the realm of electronic payments is in trouble. Rather than owning a Bank of America deposit, consumers may prefer to hold an equivalent stablecoin that performs all the same functions while saving on storage and transaction fees. To compete, banks will either have to bribe customers with higher interest rates on deposits, thus putting a crimp in their earnings, or go extinct.

Let's look at these stablecoin options more closely.

Type A: One foot in the legacy banking sector, one foot out

The unifying principle behind each type of stablecoin is the presence of some sort of backing, or security. Bitcoin, by way of comparison, is not backed. Stablecoin backing is typically achieved in two ways. With type A stablecoin, an organization creates a distributed ledger of tokens while maintaining a 1:1 reserve of dollars at a traditional bank. Owners of the tokens can cash out whenever they want into bank dollars at the stipulated rate, thus ensuring that the peg to the dollar holds. Until then, the tokens can be used as a stable medium of exchange. Examples of this are Tether and Ripple U.S dollar IOUs.

Could stablecoin be a bank killer?

We can think of a bank as enjoying stock and flow benefits from its deposit base. The existence of a stock of deposits provides it with a cost of funding advantage while the flow of those deposits from person to person generates fees.

Type A stablecoin pose no threat to the stock benefits that banks enjoy. After all, each stablecoin is always backed by an equivalent bank deposit held in reserve. If people want more stablecoin, the deposit base will have to grow, and that makes traditional bankers happy.

The flow benefits, however, are where the fireworks start. At the outset, people who receive stablecoin--through lack of familiarity--will probably choose to quickly cash out into good old fashioned deposits. But if stablecoin provides an extra range of services relative to deposits, rather than "kicking" back into the bank deposit layer, more people may choose to keep their liquid capital in the overlying stablecoin layer. Merchants will have more incentives to accept stablecoin, only adding to the snowball effect. Once all transactions are routed through the stablecoin layer, underlying deposits will have become entirely inert. While banks will continue to harvest the same stock benefits that they did before, they'll have effectively yielded up all the flow benefits to the upstarts.

So while Type A stablecoin doesn't kill banks, it certainly knocks them down a few wrungs.

By constructing a new layer on top of the deposit layer, stablecoin pioneers would be cribbing off the same playbook that bankers have been using since the profession emerged. Centuries ago, the first bank deposit layer was built on top of an original base money layer. Base money consisted then of gold and silver coin, but in more recent times it morphed into central bank banknotes and deposits. Because bank deposits inherited the price stability of base money (thanks to the promise to redeem in base money), and were highly convenient, bankers succeeded in driving transactions out of the base coinage layer and into the deposit layer. That's why gold and silver rarely appeared in circulation in the 19th century, being confined mostly to vaults. Perhaps one day stablecoin innovators will succeed in confining bank deposits to the "vault" in favour of mass stablecoin circulation. If this sort of displacement hadn't already been done before, I'd be more skeptical.*

Type B: Both feet out of the banking sector

More ambitious are type B stablecoin, which try to liberate themselves entirely from the traditional banking layer. Rather than using old-fashioned bank deposits as backing, a pre-existing issue of distributed digital tokens is used to secure the stablecoin's value.

As an example, take bitShares, a brand of bitcoin-like unbacked tokens. These tokens are every bit as volatile as bitcoin, up 10% one day and down 10% the next. Here's a chart. So far nothing new here, there are literally hundreds of bitcoin look-alikes.

The unique idea is to turn volatile water into stable wine by requiring that a varying amount of bitShares be used to back a second type of token, bitUSD. A bitUSD is a digital token that promises to provide its owner with a U.S. dollar-equivalent return. As long as each bitUSD is secured by, say, $3 worth of bitShares, the owner of one bitUSD will be able to cash out (into one U.S. dollar worth of bitShares) whenever they want and the peg to the U.S. dollar will hold.**

My understanding is that bitUSD, which debuted last year, is coming close to consistently hitting its peg. If bitUSD were to catch on as an alternative transactions layer, banks would lose not only their flow benefits but also stock benefits. After all, a bitUSD-branded stablecoin is not linked to an underlying deposit. We're talking complete devastation of the banking industry.

The system has some warts, however. If the market price of bitShares starts to fall, the scheme requires that more collateral in the form of bitShares be stumped up by the issuer of a bitUSD. This makes sense, it protects the peg. But what if the value of bitShares falls so much that the total market capitalization of bitShares is insufficient to back the total issue of bitUSD? At that point, bitUSD "breaks the buck." A bitUSD will be only worth something like 60 cents, or 30 cents, or 0 cents. Breaking the buck is what a U.S. money market mutual fund is said to do when it can't guarantee its one-to-one peg with the U.S. dollar.   

I'm skeptical of type B stablecoin for this very reason. Cryptocoin like bitcoin and bitShares are plagued by the zero problem; a price of nothing is just as good as a price of $100. They thus make awful backing assets, and any stablecoin that uses them as security has effectively yoked itself to the mast of the Titanic. A breaking of the buck isn't just probable, it is inevitable. Stability is an illusion. Maybe I'd get a bit more bullish on type B stablecoin if there emerged a brand that used digital backing assets not subject to the zero problem.

Anyways, keep your eye on these developments. Like I say, the young whippersnappers who are working on these projects aren't slowing down.

*In principle, type A stablecoin ideas are very similar to m-Pesa and Paypal. Both of these services construct new banking layers, but keep one leg back in the the existing banking infrastructure by ensuring that each Paypal or m-Pesa deposit is fully backed by deposits held at an underlying brick & mortar bank. See Izabella Kaminska, for instance, on m-Pesa.
 ** For those who like central bank analogies, this is an example of indirect convertibility, whereby a central bank sets market price of its liabilities in terms of, say, a bundle of goods, but only offers redemption in varying amounts of gold. See Woolsey and Yeager.  
*** Another working examples of Type B stablecoin is NuBits. Conceptual versions include Robert Sam's Seignorage Shares, the eDollar, and Vitalik Buterin's Schellingcoin.


  1. I realize some may see the ability to keep them in their own wallet a benefit, but anyone with a bank account would likely prefer a bank maintain it anyway, so banks seem like the natural purveyors of stablecoin in these instances, just like prepaid cards. It really seems ideal for interbank exchange if they could trust it. It would be interesting if storage could be handled by smart cards though one would need a reader to use it online or have a separate online wallet or the smart card could talk to the online wallet when used offline.

    1. Yes, if stablecoins become popular with the public, I don't see why banks wouldn't just issue their own versions.

  2. No, the new smart card technology provides hardware secure card to card exchanges. The exchanges always report volatility honestly, and the card network is secure from human tampering. Hence volatility is an endogenous, managed variable; the pricing between currencies always the Black-Scholes strike price. Thus all currencies are stable up to the transaction costs, but card to card exchanges are nearly free.

    You might want to talk about popular currencies. But any currency set up in the network is stable. A currency may be created on the spot for a night of poker between friends, one may be created to count chickens among the chicken association, create one on the spot for tax collection, or create them for value points and consumer discounts, like frequent flyer miles. But they are always guaranteed to be volatility weighted to maximum likelihood, and thus always stable.

    1. Sorry, I'm not following what you're saying.

  3. bitshares look just like shares in a bank. More volatile than the underlying assets, because the deposits are less volatile

    But why doesn't the bitshares bank hold assets like mortgages? It could be exactly like a bank, except it uses a different type of cheque. It's like a bank, where your Interac card disappears, leaving only the password.

    Damned if I can see the difference.

    1. > But why doesn't the bitshares bank hold assets like mortgages?
      Because mortgages reference exogenous assets which cannot be owned by computers. The legal system does not permit computers to own houses and computers cannot preempt this. BitUSD and bitcoins are the opposite: they can be owned by computers and the legal system cannot preempt this.

    2. What Peter said. You need to be able to hold the backing asset on the blockchain, which you can't do with existing mortgages and whatnot.

    3. an aside, from the Nick Rowe archives:

  4. What does it mean for a machine to own an asset? Surely, some person must own the machine and therefore the underlying asset, at least indirectly.

    Is there some legal stuff going on here that I am unaware of? If so, it seems critical and I'm surprised it's been left out of your discussion.

    1. In this context, it means that the machine acts as an autonomous economic unit, on its own behalf, rather than on the behalf of the owner of the machine. It has its own economic goals. It could be that these goals are identical with those of the owner of the machines, but once it's running, the owner can only influence it indirectly, by economic incentives.

      And in order for this to work, the machine must be able to assert property rights over the assets. It means it is incompatible with the current legal system, because this assumes that people are the only carrier of rights. Even separate legal entities such as corporations must have humans in executive functions. A machine-executive is not allowed.

      For an example, I recommend Mike Hearn's lecture:

    2. I'm not familiar with the legal issues. In this case, does a machine own the assets that uphold a bitUSD's value? It could be that it holds assets on behalf of the person who has submitted the collateral to back each bitUSD, sort of like a trust, ETF, or mutual fund.

      As for the problem you have with the zero problem (here):

      "In the case of Bitcoin, this epsilon backing comes from the intrinsic value in a P2P global value transfer system."

      The point you're making is circular. That a medium of exchange has value because it is a medium of exchange doesn't resolve anything. To have intrinsic value, it needs to have some value apart from being a medium of exchange.

    3. JP,

      I do not believe my argument to be circular. It may depend on how you define "medium of exchange." If you think of MOE as simply an bookentry object, or its physical equivalent (paper note), then you are correct.

      But Bitcoin is more than a bookentry object; it is a communication system. It has intrinsic value the same way that a telephone connecting two people has intrinsic value (true, Robinson Crusoe attaches no value to an unconnected telephone, but so what?).

      Even if bitcoin itself is no longer valued as a payment instrument, it can still have use in communication. This is the intrinsic value I am talking about.

    4. Peter,

      Thanks for the link. The lecture was interesting, but did not really answer my questions. The notion of a machine "owning itself" sounds ridiculous. In part, he is confusing the notion of a machine "operating itself." Ownership and control are conceptually distinct.

      The creator of these machines must be incentivized in some manner and invariably, this will mean having ownership rights defined over the stream of profits generated by the robot.

      Near the end he talks a bit about a public funding model...a system of voluntary taxation to fund a public good...but he is talking pie in the sky here. Even in the cases where this could happen, the legal system would (I presume) endow the public with the liability associated with the robot.

      So when you replied to Nick to say that bitcoin can be owned by a machine and the legal system cannot prevent this, I am inclined to disagree on both counts. If I build a robot to act as an assassin, believe me, the FBI will exert great effort to track down and prosecute the owner. It's not impossible to do, not even if all transactions are governed by BTC.

      Still, I have to give all of this some more thought. It's all very interesting!

    5. JP probably thinks that if utility depends only on the network effect, it means it can disappear altogheter. I think that while technically true, practically irrelevant. The same could be said about other goods subject to the network effect, like the internet: if everyone stopped using it, then IP addresses will have no value. But to argue that in order to prevent this, there needs to be an additional source of utility is a non-sequitur, because this additional feature could very well turn out to be a burden, and cause the collapse of the network effect.

    6. For the purposes of our debate, we can define "ownership" as infrastructure for enforcing economic exchange. Control is somewhat different, it does not require ownership or legitimacy. This ownership infrastructure is a prerequisite for trade. A machine must be able to enter into a contract and have the infrastructure enforce it afterwards. Otherwise it cannot act as an economic unit.

      However, ince the infrastructure is available, and the machine starts entering into contracts, it is its own economic unit independent of the creator of the machine. It can allow others to invest in it and pay dividends, it can hire people or machines, it can itself invest into other economic units. It should not confuse us that it behaves deterministically, or that its incentives are aligned with those of its creator, or that the statist law does not recognise this. You can attack the machine claiming that you are enforcing property rights, but this does not necessarily make it so, anyone can attack anyone irrespective of whether there is infrastructure for this or not.

      The creator can, at the beginning, own all the shares of the machine, and then the machine can gradually buy him out as it's earning money. He may not even know that the buyer of the shares is the machine.

      With respect to public goods, check out "Dominant Assurance Contracts" described by Alex Tabarrok. This is now possible with cryptocurrencies.

    7. "It may depend on how you define "medium of exchange." If you think of MOE as simply an bookentry object, or its physical equivalent (paper note), then you are correct."

      The definition I'm using for medium of exchange is anything that people accept in trade because they anticipate being able to pass it on. Banknotes and gold have non-monetary properties (ie. value apart from their role as media of exchange) while the bitUSD is anchored by its peg. Bitcoin, on the other hand, has no non-monetary properties, it a pure medium of exchange. And like any other Ponzi asset, a price of $0 is as good as a price of $10,000.

    8. You realize, of course, that the $0 equilibrium exists *only* if the object in question has *strictly zero* intrinsic worth?

      So, if there were people out there that sort of liked the idea of holding and trading bitcoin, just for its own sake, just to screw the man, or whatever, that this minuscule amount of backing would *theoretically* eliminate the zero-price equilibrium?

      It is the fragility of this theoretical result that leads me to question the empirical relevance of the zero price problem.

    9. Yes, I realize that. See here, for instance.

      There are probably people out there who held units in Bernie Madoff's investment scheme even after it was exposed because they wanted to consume some sort of affinity they felt they had with the man. So *theoretically* an investment with Madoff wasn't worthless.

    10. Yes, that's correct. And that's all one needs to get rid of the "zero price problem." In other words, it isn't a practical problem. The result is a theoretical proposition and hinges critically on an assumption that likely does not hold for any asset.

    11. More relevant than the question of low price is the question of low liquidity. The more interesting economic issue with Zimbabwe dollars and Madoff's shares isn't that they decreased in value, but that they lost almost all liquidity. I remember writing about it in a comment on this site some time ago. For example, I presume that the Zimbabwean dollar was delisted from forex markets, and Madoff's shares can't be traded on the official exchanges anymore. And here a mechanism focusing on propping up the price may not help at all.

    12. "...that likely does not hold for any asset."

      That can't be, since then the price of a financial asset would never fall to zero. But we know from observation that many assets (stocks, bonds, deposits, etc) have become worthless. Just look at all the altcoins that have run into the zero problem. [link]

    13. JP, that proves exactly what I said: the altcoins that failed don't have a zero price, they have zero (or close to zero) liquidity: they have been delisted from all the exchanges.

  5. Peter,

    "The creator can, at the beginning, own all the shares of the machine, and then the machine can gradually buy him out as it's earning money. He may not even know that the buyer of the shares is the machine."

    Suppose the creator begins by owning the machine outright, like a slave. The machine may earn profits, but it is the creator who is entitled to those profits, even if the machine is programmed to spend the money in particular ways. Using the profits to buy shares from the creator makes no sense -- the creator already owns that money. Why would the creator consent to something like that? A slave has no way to buy its freedom. Of course, the creator could "free" the machine (as a slaveholder frees a slave). But then, I wonder what the legal status of the machine might be in this case? Is it really possible to say that legally, no one (or group) owns the machine and that machine owns itself? Should we be speaking to lawyers about this?

    1. Now we're talking about technicalities. The creator may decide to sell just like a slave owner in the past decided to sell. He may, for example, need to make payments and decides to dispose of the shares. The machine has some cash flow irrespective of how dividends are paid, or could borrow money to buy him off, or other machines can buy it outright. Just like a company nowadays can do a share buyback, or be subject to a takeover.

      Philosophically, for comparison, we could ask why parents allow their children to become independent individuals, why employment contracts leave space for private activities or why teachers allow their students to go out and use what they learned. At least one of the reasons is that even strictly economically, they may make better use of scarce resources that way.

      You shouldn't be talking to lawyers. Our legal system does not recognise this. I am talking about ownership from economic, not legalistic, perspective.

  6. The zero problem, as you put it, may be a non problem if the currency has developed a sufficient network effect. Unless thwarted by law, any spike towards zero would rather quickly be offset by demand from the bottom feeders in the market.

    If the mass of users find a better solution, then the value or price of the currency will tend to zero, but as a result of people leaving it for a better alternative. Is there a problem with that?