Cryptocurrencies were supposed to destroy the traditional monetary system.
Ten years on, where are we?
Bitcoin has been wildly successful, but as
a financial game--not as a medium of exchange. It's a fun (and
potentially profitable) way to gamble on what Keynes once
described as what "average opinion expects the average opinion to
be." But no one really uses it to pay for stuff. It's nature as a
gambling token makes it too awkward to serve as a true substitute for
banknotes and credit cards.
A number of stablecoins have emerged over the last five or six years.
Like bitcoin, stablecoins exist on a blockchain. But unlike bitcoin, these
tokens have a mechanism for ensuring their stability. Stablecoin owners can
convert tokens at par into underlying dollar balances maintained in the
issuer's account at a regular bank. So stablecoin entrepreneur have basically
built a new blockchain layer on top of the existing financial stack. This is
interesting, but not very subversive. It's not that different from what
PayPal does, or a mobile money operator like M-Pesa.
Which gets us to MakerDAO.
MakerDAO is the name of the decentralized organization that manages the Dai
stablecoin. Dai is unique because like bitcoin (and unlike other types of
stablecoins), it has no connection whatsoever to the traditional financial
system. So Dai has all the rebelliousness of bitcoin. But unlike bitcoin it
isn't a gyrating Keynesian beauty contest. Which means that it has a much
better chance of becoming a generally-accepted medium of exchange than
bitcoin.
This post is for monetary economists and others who would like to know how
MakerDAO works, without necessarily getting into the specifics. Since
cryptocurrency jargon, like all jargon, is complicated, I'm going to explain
it by comparing it to something we can all recognize, a bank.
The Dai system is in many ways like a regular bank, say Citibank. Citibank
create 'stablecoins', specifically deposits, out of unstable assets like
personal promises, property claims, flows of future business profits, etc.
The process of creating Citibank deposits begins with a loan. Jim pledges his
house that is appraised to be worth $1 million to the bank, and the bank
creates $500,000 digital Citibank dollars for Jim. He spends the $500,000
into the economy, which ends up being held by Terry, who is most comfortable
investing in safe assets like Citibank deposits. Thus Jim's unstable house
has been transformed into Terry's stable deposit.
The creation of Dai tokens works the same way. Jim pledges $1 million in
assets to the Dai system, and in return he gets $500,000 Dai. After Jim
spends those stablecoins into circulation, they end up with Terry, who wants
to hold a stable cryptocurrency.
One difference between Dai and Citibank emerges pretty quick. To get his
hands on Citibank dollars, Jim pledges his house as collateral (or some real
world instrument, like business inventory or a boat or equity shares). But
with Dai, Jim can only pledge assets that exist in blockchain space. Because
Dai exists on a particular blockchain--Ethereum--the key pledgeable asset for
a Dai loan is Ethereum's native token, ether, a volatile cryptocurrency.
What ensures that Terry's Dai tokens will be worth the same as a Federal
Reserve dollar? First, lets revisit why a Citibank dollar is always worth a
Federal Reserve dollar.
Citibank maintains a network of ATM machines and tellers that will redeem
Terry's deposits at par with paper currency. Since he knows that he can
always cash them in 1:1 at a Citibank outlet, Terry needn't ever sell his
Citibank dollars at a discount on the open market.
Unlike Citibank, Dai doesn't maintain a network of dollar-filled ATMs. There
is simply no way to redeem or cash out of Dai, as there is with other
stablecoins. To provide a cash-out mechanism would contradict the whole point
of a fully decentralized stablecoin. Dai is trying to recreate a virtual
version of the dollar, but entirely within the world of blockchains. It can't
rely on out-of-blockchain dollars to secure the system.
So how is the price of Dai kept at $1?
Let's go back to our Citibank illustration. Imagine that Citibank were to
announce that henceforth all its deposits are inconvertible. Its network of
ATM machines is to be shut down and cash can no longer be withdrawn at the
teller. If Terry can no longer return his Citibank deposits to the bank at
par, will their value collapse? Or will the 1:1 exchange rate somehow hold?
The short answer is that the exchange rate will hold... to a degree. Remember
that Jim is still obligated to repay $500,000 to Citibank. Even if Terry can
no longer directly bring his $500,000 worth of Citibank dollars to Citibank
for redemption into Federal Reserve dollars, he can do so indirectly, by
offering to sell them to Jim for Federal Reserve dollars, who in turn is
obligated to bring deposits to the bank to clear up his loan.
Say that Jim's debt is due and he has decided to take up Terry on his offer.
The price that Jim decides to pay Terry for his deposits depends on how many
other buyers he must compete with. On any given day, a number of Citibank
borrowers will have to purchase Citibank deposits in order to settle their
existing debt to Citibank. If they are all anxious to settle their debts, Jim
may have to offer Terry as much as $1.05 or $1.06 for his deposits. Again,
with ATMs and tellers no longer providing 1:1 convertibility, it is possible
for these odd exchange rates between Citibank dollars and Fed dollars to
emerge.
Terry isn't the only Citibank depositor. There may be many other depositors
who are anxious to sell Citibank deposits that day. If Jim is one of the only
buyers, he may be able to convince Terry to accept 93 or 92 cents for each
Citibank dollar.
So under inconvertibility, the price of Citibank deposits relative to Federal
Reserve dollars depends on the short term demand for deposits and desire to
settle debts to Citibank. If there is a large demand to settle debts on
Wednesday, and few sellers of Citibank deposits, then the price can spike
well above $1. But if everyone wants to sell on Thursday, and no debtors want
to settle, it could collapse to well below $1.
The soft Citibank peg I'm describing is exactly how Dai functions. You
can actually see below how relaxed Dai's peg is below. Sometimes Dai trades
far below $1, sometimes it trades above:
This flexibility is not so much a bug, but a feature. It's the same sort of
behaviour that Citibank's inconvertible deposits would exhibit.
Returning to our Citibank analogy, there are limits to how far the price of
Citibank deposits can stray from $1. When the price of Citibank deposits
falls too low, say to 90 cents, then existing Citibank borrowers will smell a
deal. They can buy cheap Citibank deposits, cancel their loans (and thus
unencumbering their housing collateral), and then proceed to another bank
(say Wells Fargo) in order to re-open the same loan (using the same
collateral). The whole process of closing and re-opening the loan will result
in a 10% profit. The pace of Citibank debt cancellation will increase as a
result, thus shrinking the supply of Citibank deposits and bringing its price
back up towards $1.
Conversely, when the price of Citibank deposits gets too high, say $1.10,
then borrowers will be eager to mortgage their homes with Citibank (and not
another bank). After all, they can mortgage a $1 million home with either
Citibank or Wells Fargo and get $500,000 in deposits. But Citibank deposits
are worth $1.10 which means that a Citibank borrower gets 10% more bang for
buck. A splurge in new Citibank loans will increase the supply of Citibank
deposits and drive the premium back down to $1.
In addition to these automatic forces that push Citibank deposits towards $1,
Citibank can use monetary policy, specifically interest rate changes, to keep
the exchange rate between their dollars and Federal Reserve dollars close to
$1.
Say that there are is a glut of Citibank depositors who want to get rid of
their deposits, and their desire to sell has temporarily pushed Citibank
dollars down to 95 cents. By increasing the interest rate on existing loans,
Citibank makes it more onerous for those who have Citibank debt to meet their
interest payments. These borrowers will start to buy up Citibank deposits in
order to cancel their burden. This wave of buying will counterbalance the
glut of depositors who want to sell, pushing the price of Citibank dollars
back up to $1.
Citibank can also set monetary policy using the rate it pays to depositors.
Say that a horde of debtors have lined up to repurchase and cancel their
debts to Citibank, pushing the price of Citibank deposits up to $1.05. By
lowering the interest rate it pays depositors, Citibank reduces the incentive
that people have to hold Citibank deposits. Depositors will flock to sell,
thus pushing the purchasing power of Citibank deposits back down to $1.
MakerDAO manipulates a rate called the stability fee to a level that
is consistent with $1 Dai. The stability fee is the rate that Dai borrowers
must pay. MakerDAO is in the midst of implementing the Dai Savings Rate.
This savings rate provides Dai holders with a reward, much like how Citibank
depositors are paid interest.
Does Dai monetary policy work? The price of Dai recently fell to a large 3-4%
discount to the dollar. In response, MakerDAO jacked up the stability fee. I documented
what happened in this series of tweets:
Dai is still trading below $1.
But the stability fee increases do seem to be reducing the supply of Dai,
which is down by almost 10 million since April 10: (https://t.co/k13yNtrENe). This should
eventually nudge the price back up to $1. Milton Friedman's long &
variable lags? pic.twitter.com/k3ycJPHa47
— JP Koning (@jp_koning) May
2, 2019
This effort seems to have successfully brought Dai back to $1.
Under times of stress, how can these systems continue to ensure that the
value of their deposits/tokens stays close to $1?
Each inconvertible Citibank deposit is twinned with a lender who will
eventually have to repurchase it. Say that Jim and a few other debtors go
bust and can no longer pay back their loan. Now there are a bunch of orphaned
deposits. This spells disaster for the peg. There won't be enough debtors to
repurchase Citibank deposits from Terry and the remaining depositors. And as
a result, the price of Citibank deposits will slide far below $1.
But Citibank has a tool to prevent this. Remember that Jim provided collateral
in order to get his loan. When Jim can no longer pay his loan, the bank can
seize Jim's collateral--his house, inventory, boat, or whatnot--and sell it
to repurchase Citibank deposits. All the orphaned deposits can be withdrawn,
driving the exchange rate back up towards $1.
The same goes for Dai. But rather than seizing debtor's houses, MakerDAO
takes control of the cryptocurrency collateral that Dai debtors have
provided.
Another feature that helps keep Citibank inconvertible deposits near par is
the fact that Citibank can always wind down its operations and go out of
business. If so, all debtors must settle their debts, which means buying up
Citibank deposits and thus cancelling out what is due to Citibank depositors.
Debtors who can't pay their dues will have their collateral seized and sold,
the proceeds used to pay remaining depositors US$1 for each Citibank deposit.
As long as Citibank has properly appraised the value of the collateral that
has been deposited with it, then it will be able to make everyone whole. The
proximity of a wind-down, the mere chance that this event can always occur,
should be enough to help push the price of Citibank deposits towards $1.
MakerDao also has an equivalent feature called global settlement. Global
settlement occurs when the Dai system is shut down and all Dai holders are
paid out an equivalent of US$1, with debtors to the system getting all that
remains. The odds of global settlement being invoked should help keep the
price of Dai close to $1.
There is a lot of skepticism surrounding stablecoins. Folks like Preston
Byrne, for instance, are convinced like stablecoins are Dai inherently
doomed. And some of them have collapsed. (Just read my old
post on the demise of Nubits.)
I'm more sanguine. As I've illustrated, Dai isn't that strange of a beast.
Apart from the fact that it is inconvertible, a Dai token is very much like a
Citibank deposit. Both Citibank and MakerDAO take unstable assets and turn
them into stable-priced ones.
These sorts of water-into-wine institutions have been a regular feature of
the financial landscape for centuries. Yes, banks have often failed. But they
can also be incredibly durable. Here in Canada, the Bank of Montreal has been
operating since 1819, some 200 years, without going under. And for those who
attribute the Bank of Montreal's longevity to government sponsorship ad
support--nope. Canada only got a central bank in 1935 and a deposit insurance
scheme in the 1960s.
Will the new digital upstarts like Dai be able to unseat the incumbents, as
many of its fans believe?
Relative to convertible Citibank deposits, inconvertible Citibank
deposits really aren't that great of a product. Thanks to Citibank's
convertibility mechanism, regular Citibank deposits are fungible not
only with Federal Reserve dollars but all other brands of bank deposits including
Wells Fargo dollars, Bank of America dollars, JP Morgan Chase deposits, and
more. To be fungible means to be perfectly interchangeable.
Harmonization, or interoperability, is pretty useful. People can walk into a
store and purchase goods with whatever brand of dollar they want. Neither the
buyer nor seller need think twice about which one is being used. But not so
with inconvertible Citibank dollars or Dai. The price of these
"soft-pegged" versions of the dollar will never be quite the same
as other dollars. Any purchase that is made with these exotic dollars would
be a bit like walking into a Taco Bell in New York with euro banknotes or
Canadian dollars.
I mean, the purchase can still go forward, but there is an extra layer of
awkwardness that must be endured. The exchange rate between inconvertible
Citibank dollars and Federal Reserve dollars must be determined, conversion
fees must be incurred, and foreign exchange risk absorbed. Likewise with a
purchase made with Dai. Sure, Dai tokens are relatively stable. But they
aren't fungible with the underlying instrument they are trying to
represent--U.S. dollars--and that hobbles their payments functionality.
The same awkwardness occurs when taking out a loan in inconvertible Citibank
dollars, say to invest in a business or renovate a house. Businesses and
individuals earn income and salary in regular Federal Reserve dollars (and
all the other dollars that are interoperable with Fed dollars), but if their
loans and interest must be repaid in Citibank dollars, they effectively owe
what is a foreign currency.
This undoes one of the most useful features of dollars or yen or pounds,
which is that they can be used as general
medium for short selling, or put differently, a standard
for deferred payment. Standard of deferred payment is "that other
function" of money, the one no one thinks about because it is
overshadowed by the triumvirate of medium-of-exchange, unit-of-account, and
store-of-value.
Briefly, since income is earned in local currency, and income is fairly
predictable--especially salaries--a borrower (i.e. a short seller) has a
pretty good idea ahead of time how much of their future budget they will be
required to pay to cover the bank loan. But when the units borrowed are
different from the units that make up most of one's income, all of that
pleasurable certainty is lost.
But what about decentralization? Doesn't this feature give Dai an advantage
over other types of dollars?
Unlike inconvertible Citibank deposits, which are issued by a centralized
financial institution, Dai tokens are decentralized. What does this mean? The
organization that maintains the system--MakerDAO--doesn't exist in a fixed
physical location. It resides on the Ethereum blockchain, which is maintained
by a crowd of validators that is distributed all across the world. Whereas
the authorities can easily exert pressure on Citibank--they know its
address--MakerDAO's crowd of decentralized nodes cannot be so easily
controlled.
Citibank relies on people in offices to do much of the work of running the
bank. MakerDAO uses smart contracts: automated bits of code that cannot be
tampered with. Governance of the system occurs over the internet, with
MakerDAO shareholders voting on resolutions such as interest rate changes.
MakerDAO shareholders needn't reveal their identities, which means the
authorities can't exert pressure on them as easily they might on Citibank
executives.
A regular bank is obligated to meet a long list of regulatory requirements
including those on how much capital they must hold, customer identification
practices, and more. But since the authorities can't easily get a bead on
MakerDAO stakeholders in order to punish it for infractions, the Dai system
may be able to avoid all sorts of costly regulations. And these cost savings
means that Dai borrowers might be rewarded with lower interest rates than
Citibank borrowers, and Dai stablecoin holders with higher interest rates
than Citibank depositors.
There are a set of actors who are excluded from the banking system. For
instance, thanks to embargo threats emanating from the U.S. Treasury, Iran
has been mostly cut off from accessing U.S. banks. American marijuana
companies can't get bank accounts because banks consider them to be too risky
to serve. Thanks to decentralization, MakerDAO is (in theory) much more
resistant to censorship than Citibank. Dai can be used in these sorts of
small but risky markets because those who run the Dai system needn't worry
about being punished by regulators.
So there is certainly a natural clientele for decentralized dollars. But
whether the benefits arising from decentralization--lack of regulation and
censorship resistance--are enough to overcome the awkwardness of
non-fungibility remains to be seen.
I also wonder how genuine the decentralization of MakerDAO is. I mean, say
that Dai became popular in a place like Iran. Wouldn't the U.S. Treasury have
a number of levers it could pull in order to reverse this? Many of the
MakerDAO developers are public figures, as are MakerDAO shareholders. If the
U.S. threatened to arrest them for breaking sanctions rules, would they fall
into line and write Iran out of the system? A centralized and non-fungible
stablecoin doesn't seem to offer many benefits.