Thursday, April 29, 2021

Is DeFi unregulatable?

 Government's can't regulate DeFi, can they? It's too wild and uncontrollable.

DeFi, or decentralized finance, is the set of anarchic financial tools built on top of the Ethereum blockchain. These tools mimic what you'd see in the real world. MakerDAO is a decentralized bank, Compound and Aave are decentralized lending marketplaces (like Lending Tree), and Uniswap is an exchange, like the NASDAQ, except on a blockchain.

Unlike regular financial institutions, none of these Ethereum-based institutions operates with a license, registration, or a permit.

MakerDAO, for instance, recently financed some real world mortgages by issuing U.S. dollar deposits. So it seems to be operating as a commercial bank. However, MakerDAO hasn't secured a banking license from any of the world's biggest banking regulator, say OSFI, the FCA, OCC or any of the 50-some U.S. state financial departments.

Because DeFi is so new, it operates in a grey zone. On the one hand we can argue that the collection of smart contracts and governance mechanisms that comprises MakerDAO probably ought to do the bankerly thing and apply for a banking license. On the other hand there doesn't seem to be an express written rule about smart contracts on Ethereum requiring licensing.

But lets say that a bank regulator made an explicit announcement that MakerDAO and other DeFi tools acting as banks all had to get a license. Could MakerDAO get away without complying?

Because tools like MakerDAO are built on blockchains, and blockchains are too wild to be controlled, the theory is that there is no way for a regulator to exert sufficient pressure on the tool owners to instigate change. MakerDAO's owners will just laugh and keep doing what they've been doing. So would Aave, Uniswap and Curve. Smart contracts are just bits of unstoppable code, after all. They can't be punished for non-compliance. 

So DeFi is not only unregulated, goes the theory. It is unregulatable.

I think regulating DeFi would be fairly easy. U.S. regulators just announce "thou art now regulated and must comply with the following set of rules" and that'd be sufficient. Pretty soon, the biggest DeFi tools would fall into line.

Much of a regulator's leverage is exerted indirectly, via users. Even if the operators/administrators of major DeFi tools are against the idea of falling into line, their users will drag them towards it. 

Right now, the status of most DeFi tools is undefined. Users aren't doing anything illegal by interacting with them. They aren't doing anything legal, either. So people just shrug and use them. But regulation would change that status. Suddenly, tools and their users would be placed squarely in the illegal category, albeit with a pathway to legality.

U.S.-based financial institutions make up the largest group of financial tool users. And financial institutions generally prefer to avoid doing unlawful things, say like connecting to illegal financial tools. Retail customers, a less important customer group, are less picky. Some will do illegal things. But they mostly prefer to be on the side of the law.
That means any decentralized financial tool that wants to continue capturing the two biggest pools of money —institutional capital and licit retail funds—will have to make it legal for these users to connect to them. The proper licenses will have to be secured, regulatory-compliant smart contracts created, and a mechanism devised for users to port over. The biggest DeFi tools will choose to conform... if they want to stay the biggest.  

Sure, plenty of DeFi tools won't bother complying with regulation. But these tools will only end up appealing to an underground clientele, and that's always going to be a smaller market than the pool of licit users.

Network effects will be on the side of regulators. Read on...

There will always be DeFi users (traders, borrowers, liquidity providers, token issuers etc) who are indifferent between lawful DeFi tools or illegal tools. They just want to use the best ones. These agnostics will probably end up using the regulated tools by default. That's because the biggest pool of capital is always going to be licit capital that sticks to lawful trading venues. And so regulated DeFi tools will end up with the best liquidity, tightest spreads, and lowest fees. Hobbyists and criminals will put up with the low liquidity of unregulated DeFi, but everyone else's go-to choice will always be regulated DeFi.

This network effect operates in the same way as the U.S. government's decision to impose Daylight Savings Time. You may hate DST or you may be indifferent, you may not understand it or you may have forgotten about it. But come March 14 and November 7 you unfailingly move your clocks forward or backwards. Using a different clock than everyone else is just too much of a burden. Likewise, if the government announced a DST equivalent for DeFi, much of the space would get dragged, perhaps kicking and screaming, into a state of being standardized, or regulated. Remaining out-of-standard is too costly.

Regulated tools would probably stop interacting altogether with illegal tools. DeFi, currently an open playground, would further balkanize into underground DeFi and legit DeFi. Choosing underground DeFi would be an increasingly costly choice, since one risks being forever cut-off from legit DeFi.

So DeFi, or at least a big part of it, can probably be regulated. However, there will always be an unregulatable anarchic edge. Good luck stopping an Ethereum-based ponzi scheme, for instance. These are blockchains, after all. And they are open to everyone.

Wednesday, April 21, 2021

Why did Dogecoin take off but Feathercoin didn't?

Dogecoin makes us all shake our heads. Introduced in December 2013 as a joke, Dogecoin is now worth over $50 billion, more than Ford Motor Co. Meanwhile Feathercoin, a more serious cryptocurrency that debuted in April 2013 (and initially worth more than Dogecoin), is currently valued at a tiny $10 million.

How are we supposed to understand the strange thing that is Dogecoin?

Let's start by exploring what these odd instruments are. While Dogecoin and Feathercoin seem like an entirely new phenomenon, I'd suggest that they're both really just an updated version of a fairly old financial instrument. You may remember those chain letters your parents used to get in the mail. "Send $5 to each person on the list, then copy it (adding your name to the bottom) and send to their friends," the letter would say. "Then wait for the money to flow in."

Old fashioned chain letters were simple ranked lists that propagated through the post. Propagation occurred in a decentralized manner. There was no "schemer" administering the whole thing. Each player was responsible for abiding by the letter's rules.

Dogecoin (along with Feathercoin) is an updated version of your parent's decentralized chain letter. To begin with, the deployment mechanism is different. Doge propagates over the internet, not the post. Secondly, Dogecoin software ensures honesty. By contrast, old fashioned chain letters – reliant as they were on pen, paper and photocopy machine – were dogged by cheaters who snuck their name to the top of the list.

Rather than have people manually append their names to the list, Dogecoin software creates all the entries in at the outset. And instead of being hierarchical, all spots in the Dogecoin list are equal, or fungible. (All of this goes for Feathercoin, too.)

But other than that, the core concept of a chain letter remains the same: those who already have a spot in the decentralized list are paid off by late-comers.

Sophisticated markets have sprung up to serve those who want to buy & sell these modern honest and fungible chain letters. PayPal, Robinhood, and newly-public Coinbase all let users buy Dogecoin. And so Dogecoin has been effectively fused into the regular financial system.

This degree of mass adoption never happened with your parent's chain letters. Prior to the emergence of cryptocurrencies, chain letter list entries weren't fungible. And so secondary markets never developed. Lacking any sort of integration into regular finance, the chain letters of the 1980s and 90s never went beyond being a sketchy underground phenomenon.


Fans of honest & fungible chain letters (or HFCLs) like to explain them by adopting the complicated rhetoric of monetary economics. Feathercoin says it is for "feather lite payments." More famously, Bitcoin has been variously marketed as a "coin", a store of value, digital gold, or a form of electronic cash destined to "replace fiat currency." This has given the cryptocurrency sector a certain gravitas.

But as Joe Weisenthal points out, Dogecoin doesn't have any of these pretensions. It's just a fun token with a Shiba Inu dog as a mascot. And so all of the rhetoric that traditionally gets attached to cryptocurrency is conveniently stripped away. We get to see Dogecoin and Bitcoin for what they truly are, HFCLs.

Dogecoin's cuddly Shiba Inu has proven be a great tool for propagation, better even than bitcoin's marketing strategy of co-opting the stodgy lingo of monetary economists. In the chart below, I compare the market capitalization of the first 2,690 days of Dogecoin and Bitcoin respectively.

After 2,690 days, Dogecoin's market cap has hit $52 billion. This outranks bitcoin's market cap of $7 billion when it was 2,690 days old. Bitcoin didn't breach the $52 billion level until day 3137, more than a full year (447 days) after Dogecoin did. 

Think of market capitalization – the number of list entries multiplied by their current market value – as a measure of an HFCL's success. But take that number with a grain of salt. If all existing list entry owners actually did try to sell at once, an HFCL's value would fall to zero.

Nor is this the first time that Dogecoin has moved ahead of its older HFCL cousin. As the chart above shows, Doge's market capitalization outranked bitcoin through much of its early life. It also took the lead around days 1,300 and 1,600.


Bitcoin fans aren't pleased. Dogecoin is a bit like your embarrassing younger sibling, the one that you want to hide in the closet because he/she reveals a little too much of the family's foibles. Cryptocurrency is supposed to be about monetary revolution, not fun dogs.

Bitcoiners have adopted various mental blocks to avoid being associated with coins like Dogecoin and Feathercoin. This involves publicly tarring any coin that isn't Bitcoin as a memecoin or a shitcoin. Not only are Dogecoin and Feathercoin categorically different from Bitcoin, they claim, but the category that they belong to is an inferior one.

I'll grant there are some differences, but none as deep as bitcoiners might prefer. Yes, Bitcoin is a bit older than Doge and Feathercoin. And they all have very different marketing techniques i.e. fun vs serious. And one of them, Dogecoin, has been (pound for pound) a bit more successful. But apart from that, they're all the same thing. They are all HFCLs.


Whenever experts warn against chain letters, the point they always bring up is that chains cannot be sustained indefinitely. For everyone to make money, a chain letter must grow exponentially. But at some point the math stops working. There won't be enough people left on earth to feed the chain letter.

Does cryptocurrency have to end in tears? 

I'm not so sure. Yes, HFCLs require a constant stream of new players to buy in so that earlier players can exit at a profit. At some high enough market capitalization, there simply won't be enough buyers on earth to pay off ensuing waves of sellers. The HFCL collapses.

It doesn't have to collapse to zero, though. After a 90% or 95% fall the HFCL's price will start to stabilize. The peak-collapse-trough-mania-peak-collapse-trough-mania cycle begins anew.

Feathercoin offers a good template. Feathercoin and Dogecoin were both part of a huge influx of new HFCLs in 2012 and 2013. This crop included Peercoin, Terracoin, Novacoin, Litecoin, Sexcoin, Worldcoin, Ixcoin, and hundreds of others. You can see some of them on the list in the tweet at top of this post. Funny enough, I wrote about the 2012-13 cryptocurrency wave on my blog: see here and here. (Wow, hard to believe I've been doing this for so long.)

Below is a chart of Feathercoin's market capitalization over the last eight years. It has generally moved around between a trough of $100k-$1m and a peak of $10m-$100m. (Note that I am using a log scale axis.) Buy Feathercoin early and hold till its peak and you've effectively turned $100 into $10,000. It is this whiff of huge gains that tempts people into playing HFCLs. Buy too late, however, and your $100 becomes $1.

Of the 2012-13 crop of HFCLs, many of them look like Feathercoin. They haven't grown, but they still exist. Dogecoin is different (and so is Bitcoin). It shares the same general peak-to-trough pattern as Feathercoin. But its peaks and troughs have been steadily rising. 

What I think is happening here is that there is a huge pent up demand to play HFCLs. They are a fun way to potentially make huge amounts of money. But this demand eventually gets focused on a few lucky chains. After all, the market doesn't need 200 HFCLs when two or three large one will do. 

How does the market settle on two or three? I suspect it probably comes down to luck. Finicky things like mascots, logos, influencers, and catchy names probably play a role too. In Bitcoin's case, being first is a huge benefit. And so most HFCLs sort of putter around like Feathercoin. They don't die. But they don't expand either. 

I suspect that Dogecoin and Bitcoin will eventually follow the same pattern as Feathercoin. Growth will peter out. Peaks will start to roughly align with previous peaks. Troughs will form at the same level as previous troughs. And in-between these peaks and troughs, huge fortunes will continue to be made and lost.

Monday, April 12, 2021

The Biden stimulus and the big jump in cash

Since mid-March, the stock of U.S. banknotes has surged by $45 billion. That's a 2.1% increase in just 30-days.  

This jump surprised me (ht to David Beckworth, who brought it to my attention). That's because cash demand patterns are typically quite predictable. We always see a seasonal Christmas/New Year's rush for cash. After Christmas vacation is finished the stock of cash always falls as notes and coins are returned to banks. For the rest of the year the stock of notes slowly rises. During crisis (i.e. Y2K, 9/11, the 2008 credit crisis, and the coronavirus panic) the demand for cash spikes.

But there shouldn't be a cash surge in the middle of a quiet March.

To see how odd this spring's jump in the stock of cash is, I've plotted banknote data from the period beginning November 2020 to now and compared it to equivalent November-to-October periods from 2013-2019. (I've omitted 2020 due to coronavirus-induced oddities). To better facilitate comparison, I've set the opening banknote balance for each period to 1.

The large increase in cash beginning in mid-March 2021 goes far beyond the range set between 2013 and 2019. (Also, take a look at the strange out-of-season pattern in January. We'll get into that further down.)

Here's what I think is happening. On March 13 the Biden stimulus checks started to arrive. For the next few months around 150,000 Americans are expected to receive individual payments of $1400. Those with a child dependent will receive an additional $1400. According to the Congressional Budget Office, the total amount of stimulus is budgeted at $411 billion. By now most of this amount has already been sent out, either in the form of direct deposit, a paper check, or a plastic prepaid debit card.

We'd expect Americans to withdraw a chunk of the $411 billion in stimulus in the form of cash. After all, many people still like to use cash for payments. And many businesses still operate on a cash-only basis. As the chart shows, that's exactly what has happened.

Because banknote patterns are stable, we can use data from previous years to get a pretty good idea about what the stock of cash would be absent stimulus checks. Using weekly data from 2013 to 2019 to infer 2021 numbers, I estimate that there would normally be around $2.067 trillion in banknotes outstanding by mid-April. But this number is clocking in at $2.101 trillion. So thanks to the Biden stimulus, there appears to be $34 billion in extra notes that wouldn't otherwise be there. This averages out to $100 per American.

There are a lot of assumptions in this estimate. I'm assuming that the Biden checks are the only factor explaining the difference between the actual stock of banknotes and an imputed "no stimulus" stock. But this assumption could be wrong.

Cash being withdrawn into circulation is a sign that the stimulus is working. As Claudia Sahm writes here, one goal of a stimulus is to kick-start a self-reinforcing spending loop. My spending on goods & services at your businesses encourages you to spend on goods & services, which gets the next person to do the same. The big jump in cash-in-circulation shows that people are indeed spending their $1400 stimulus rather than saving it in their bank accounts. Put differently, if we didn't see any increase in cash-in-circulation we'd be worried that the $1400 stimulus was being hoarded, not spent.

By the way, we can also see the effects of Trump's earlier stimulus on cash demand in the above chart. The Consolidated Appropriations Act, signed into law in late December 2020, entitled all American adults to a one-time $600 plus $600 per child dependent. The CBO set the total cost of Trump's stimulus checks at $164 billion. This round of checks began to arrive in bank accounts on December 30 and continued into January.

But here things get a bit more complicated. The $600 stimulus payments began to be distributed around New Year, thus overlapping with the traditional unwinding of the big Christmas/New Year splurge in cash. This year the Christmas/New Year effect may have been muted given that many families avoided vacationing and travel due to COVID-19. But in any case, the two effects have counterbalanced each other. The traditional post-New Year's slump in the banknote stock didn't occur this January. Instead, banknotes-in-circulation slowly grew thanks to the stimulus check effect.

The chart shows that by late February 2021 the stock of banknotes had returned to its 2013-2019 average. This suggests that all of the extra Trump stimulus that had been withdrawn as cash had been spent at shops, only to be redeposited at banks, and then the Federal Reserve.

I suspect that the same thing will likely happen with the Biden stimulus. By June, the big bulge in cash will have shrunk. Having been spent, the notes will be sent back by retailers to their bank via Brinks trucks, and then on to the Fed.

One would hope that not all of it disappears. As I suggested earlier, stimulus is supposed to set off a multiplier effect. When this effect has played out, prices and/or output should all have risen by a bit. This means that the ending stock of cash should be a bit higher than before. After all, if the economy has improved, then we all need to hold a bit more cash in our pockets to support our new spending habits.