Research, Education, Design

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Stable Coin: Economics Perspective

By Lisa Tan

Reading Time: 3 minutes

Saw plenty of “opinions” on LinkedIn on stable coins and I’d love to debunk 4 myths of stable coins with facts and case studies.

1) Not An Illusion

Stable coin is not an illusion. Stable coin is a type of monetary policy a project chooses. For instance, to peg the cryptocurrency to something (e.g. USD).

When we talk about cryptocurrencies, we have to talk about the different types of monetary policy. One of them is fixing exchange rates. Other options are inflation targeting, price level targeting, mixed policies, etc.

Case in point:

(compare it to the fiat-world) You have countries like Panama, Ecuador, El Salvador using a 1:1 exchange rate with USD. For other countries, they peg their currency to USD like Belize, Barbados, Hong Kong, UAE. (Source)

2) Types of Monetary Policy

When we talk about international monetary policy, we have to mention the impossible trilemma. Basically, central banks/currencies have to choose 2 out of 3 options to create their currency. They are

  • fixed exchange rate
  • free capital flow
  • sovereign monetary policy

Many of the stable coins (e.g. USDC, Tether) collect 1 USD to create 1 USD equivalent of their token, hence the “stable-ness” relative to USD. This means they give up control of their own monetary policy.

This seems fine right now, but as the economy grows, monetary policy becomes very important because we are talking about inflation rates and interest rates (if any). If the stable coin is only controlled by the US-FED (external control), it is a risk for the internal environment to operate.

Case in point:

Greece crisis in 2012. Greece, being part of EU, had to give up their monetary policy control, and follow the ECB. Greece needed an expansionary monetary policy. But since it uses Euros and linked to the other Euro-nations like Germany, the expansionary policy suitable for Greece is NOT suitable for Germany at that time. Hence, Greece wanted to get out to resolve their economy.

Cryptoeconomics is all about the long-term sustainability of the project with minimal speculation.

If this were to happen in the stable coin universe in the foreseeable future as the internal economy grows, the dependent monetary policy will pose as a risk to the stable coin’s economy.

3) Stable doesn’t mean it does not change.

Stable means it is stable relative to something. E.g. gold, USD, GBP.

The point of stable coin is to reduce velocity of the currency, hence reduce the risk associated with it. A new technology (DLT, blockchain) is risky enough if we can mitigate the risk with stable coins, that is a huge bonus.

In our instant-gratification society, we want to see results now and fast. The fastest way to reduce velocity is to create a pegged 1:1 coin – my point #2.

There are other ways to create a more stable type of currency that works in the long-term. The downside: it takes time to perfect the monetary policy (mechanism design) & other tokenomics pillars.

4) “Stable coins don’t exist because fiat currencies are not stable.”

Okay… … but what do you mean by “stable”?

But there are other ways to create a stable currency using other monetary policy and nominal anchors.

*Quick crash course: nominal anchors in the fiat-world is what the government provides to increase stability to the economy at the expense of the government’s autonomy. They are the single variable to pun down the expectations of private agents (e.g. USD holders, token holders) about nominal price levels (not price levels less inflation).

Case in point:

USD does not have an exchange rate target. We learnt that from the failed Bretton Wood System. USD is also the global currency, so it doesn’t make sense for them to fix their exchange rate to something else. Instead, they use other methods, e.g. inflation rate targeting. US Fed does that. (Source) Bank of England does that too.

Conclusion

  • Stable coins are useful. It is real. It is not an illusion.
  • The idea of using a 1:1 peg is good in the short-term. For long-term success, I have my worries.
  • There are other ways to manage the monetary policy apart from exchange rate targeting.

Sources/Further reading:

  • General international macroeconomics: Feenstra, Robert C., and Alan M. Taylor. International
  • Macroeconomics OR Krugman, Obstfeld, Melitz International Economics
  • US Central Bank: https://www.federalreserve.gov/monetarypolicy.htm
  • EU Central Bank: https://www.ecb.europa.eu/home/html/index.en.html
  • UK Central Bank: https://www.bankofengland.co.uk
  • Bretton Woods System: https://www.imf.org/external/about/histend.htm
  • Inflation rate targeting using Fisher Effect: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=521402
  • Impossible Trinity: Oxelheim, L. (1990), International Financial Integration, Heidelberg
  • General Wikipedia page: https://en.wikipedia.org/wiki/Monetary_policy
  • Interesting area of further research: optimal currency area – optimal monetary and fiscal policy.

This article first appeared on LinkedIn.

Analysis: Risk of Stable coin & Venezuela’s Petro coin

By Lisa Tan

Reading Time: 2 minutes

When the word “stable coin” is used, it is referring to stable, relative to the underlying pegged asset. If we have to be technical, it is more of a “pegged coin” than a stable one.

Analysis 1: Stable coin is useful. But it could reduce the demand of actual currency and create serious devaluation.

✔️ Stable coins are good. Let’s get the straight.

❌ But the risk is that stable coins become a threat to the existing currency and its monetary policy.

Case in point: Venezuela’s Bolivar 🇻🇪

  1. Venezuela experienced hyperinflation in its currency. (Meaning if 1 banana costs 1 Bolivar, the same banana costs 3 Bolivar tomorrow. Your Bolivar cash is the same but everything suddenly becomes more expensive.)
  2. This means that Bolivar is less valuable.
  3. People move to an alternative; cryptocurrencies.
  4. More people use cryptocurrencies and more businesses accept currencies.
  5. This means less demand for Bolivar. (Actual currency)
  6. My fear is this risk: as less people demand Bolivar, it becomes even less valuable (see 3). So in the end, the currency might devalue to the extent where it is no longer valuable and the system is gone.

Funny thing: money only works when we believe in it. It’s literally just pieces of paper. When we stop believing in Bolivar, Bolivar will also cease to exist.

If that can happen in Venezuela, how about a large scale, say the US economy? One day, you wake up and realise the green bag is worth nothing.

Analysis 2: Strange math aside, Petro is centralised by few organisations.

✔️ Venezuela has oil. It’s how they have been sustaining themselves.

❌ But this can be easily manipulated.

My 4 questions:

  1. Accepted Petro rate is dependent on oil prices, determined by OPEC. (Arguably centralised)
  2. How is Petro/Bolivar determined? It is defined by operations authorised by the government. (Centralised)
  3. Oil prices defines the Accepted Petro/Bolivar rate in an ambitious manner. (Not transparent. Is opaque)
  4. Government controls the faction of Dv (discount rate in terms of oil prices). (Opaque and centralised)

Some ways to manipulate Accepted Petro:

1. Collude with OPEC (i.e. lobbying) to adjust the supply of oil, hence the price of oil. Or invest in alternative energy and reduce demand in oil, hence the price.

2. Be the government in Venezuela. Accept or reject “volume of operations of exchange house authorised by the gov” and affect the Petro/Bolivar rate.

3. Be the government and change the discount rate (Dv). E.g. if citizens are paying taxes in Petro, have a low discount rate (Dv) so the government gets a higher Petro than with discount. And when gov has to spend a lot, increase the Dv so less Petro is needed to pay for the expense.

Stable coin is good. In this case of #Petro, maybe not. Too opaque and centralised. If the government has a reputation of being honest and non-corrupt, maybe it might possibly probably perhaps work. But that is not the case.

This article first appeared on LinkedIn.

Introduction to the Types of Digital Currencies and Their Differences

By Lisa Tan

Reading Time: 2 minutes

Digital currency is a category of currency that exists electronically. Currencies are a form of money with 3 main functions:

  1. unit of account
  2. medium of exchange
  3. store of value

They are digital representation of currency, instead of physical representation like coins and dollar bills.

Read the full working paper

Characteristics of Digital Currencies

Digital currencies can be used to exchange for funds or other digital currencies. They are a digital representation of value that can be used for payment or investment purpose. Unlike digital assets, digital currencies are a more specific area of asset class that focuses on medium of exchange, a unit of account and store of value.

Added advantages that digital currency has over physical currency include, but not limited to:

  • instantaneous transactions
  • automatic update of accounting ledger
  • cross-border transfer of ownership

3 Types of Digital Currencies

3 Types of Digital Currencies

Virtual Currency

Virtual currency is type of digital money that is unregulated and accepted among a specific digital ecosystem or community. It has similar characteristics as traditional fiat money, except that is it not legal tender and not issued by a central bank.

Privately issued Cryptocurrency

Private issued cryptocurrency is a digital currency issued on DLT and secured with cryptography. Hence the term, “crypto” and “currency”.

Central bank issued digital currency (CBDC)

CBDC is a digital form of fiat money. Fiat money is money established that government regulation or law. It is issued by the state or central bank. Other terminologies include digital fiat currency or digital base money.

Base money is money in the economy. That includes money held by commercial bank’s reserves, total money circulating in the public and cash that is held in the bank’s vault. It is money that is liquid, meaning you can change them to other assets without difficulty.

While CBDC is commonly associated with DLT, the underlying technology that CBDC is built upon need not be DLT. Hence, it is called central bank digital currency, not central bank cryptocurrency. 

Read the full working paper

SUMS of Token Functions

By Lisa Tan

Reading Time: 2 minutes

It seems like everything is a token these days. Let’s make it easy and break things down into 4 primary token functions — the SUMS. Mainly, security, utility, money and stable token.

There are many ways you can define the specific token functions, especially from a legal standpoint, and start specifying what the token can and cannot do. But this post is not about that. This post is about the general high-level functions a token can have:

SUMS of Token Function
  • Security
  • Utility
  • Money
  • Stable token

Security Token

A token is a security token when it represents an underlying asset. Traditionally you determine it using a Howey Test. Just think of it as a token that presents the value of an asset. It could be a tokenised stock, where you own a stock equity of a company. It could be a tokenised property, where you own part of the property. Ultimate, it is a digital representation of the underlying asset. And the fun part is that you can trade it!

Utility Token

A token is a utility token when it is used to access the platform. Think of your university giving you credit to book the university’s facilities. Or perhaps the airlines frequent flyer program, where you can access the hotel and car rental partners, and upgrade your flights. These are tokens used to access the platform (university facilities) or network (network of airlines partners). They are used to interact between people in the ecosystem.

Money

Money is basically currency. We are talking about liquid money, where you make payments with. The money has 3 main purposes: store of value, unit of account and medium of exchange. Think of USD, GBP, EUR. With money, there is even more sub-categories. You have physical fiat money issued by a country’s central bank and digital money. In digital money, you have cryptocurrency (BTC), virtual money (World of Warcraft’s money) and even central bank digital currency CBDC (central bank issued digital money).
Money is a huge topic. I’ll get into that in the near future.

Stable Token

This is a new category that I included recently, after speaking to Peter DeMeo from IBM and Kevin Talbot from Delchain. Stable Token can have features of security, utility and money, but the main feature is that it is stable by pegging towards something. So, I created a category on its own.

Should stable token be a category on its own? Let me know what you think!

Evolution of Economics

By Lisa Tan

Reading Time: 2 minutes

Economics and physics can explain the foundation of life. Economics with why we do what we do, our behaviors, our actions, our incentives, our outcomes. Physics explains the metaphysical world that we live in. Both economics and physics, although sciences, are different in their application but equally important in how we shape the world.

Evolution of Economics

With economics, technology has changed the way we apply economics. The good news though, is that principles in economics do not change. They remain and same, and now are just used differently. Just like in physics, gravity is a fact. It doesn’t change be it on Earth or the Moon, just different intensity and use-cases.

So how is this related to token economics?

We used to be in traditional physical economics: producing, consuming and distributing mostly physical products.

Then we moved to digital centralized worlds with new variables like digital assets. The production, consumption and distribution of this new class of asset has changed drastically. We need to account for that in our little ecosystems like how Amazon, Airbnb, Uber runs. These companies are not always producing physical products, and that changes the dynamic of business and business plans.

And next, we are going towards digital decentralised worlds, with the same sets of economic foundation as the worlds before, but now we have to consider more about governance and other variables.

So why foundational economic blocks need to exist?

Because they are the structure for us to build this new digital decentralized worlds on. We apply the learnings of “ordinary” economics to make ecosystems, digital assets (information, computer engineering, systems design) to amplify our objectives, do useful things and coordinate in all directions.

Not A Recipe Cookbook

It is not a cookbook. I would even argue that many things might not even apply. But it is the basic economic concept that is the most important. A cookbook says to add flour, butter, egg and baking soda into the cookie and bake it at 180C. The concept is to mix ingredients and cook it. For a person that can’t take gluten, you have to change the flour. For a vegetarian, you have to change the egg and butter. But the concept remains, to mix ingredients and cook it.

Similarly, the foundational economic blocks are the main ingredients to bake this cookie. You change it according to your constraints (permission vs permission-less, stable coin vs cryptocurrency, etc).

Impossible Task of Possibility

I will be honest here. It is impossible to build a completely holistic model, but hey, Rome isn’t built in a day. We take baby steps in building a nation and building a new field in economics. In my model and research so far, it is to combine market, mechanism and aspects of monetary + other macro economics fields and concepts into token economics. It is absolutely more than just the design of the token, aka how to value the token. It includes the decentralised governance, the coordination of people, allocation of resources, etc.

Game Theory and Token Economics

By Lisa Tan

Reading Time: 2 minutes
What does that mean? Say the example of Airbus and Boeing. Airbus wants to produce and Boeing has little incentive to. But as a airlines company (e.g. British Airways), I know I need a bigger plan to fulfil the demands. That is my outcome: for the superjumbo jet to be produced.
Through game theory analysis, I can see that the probability of superjumbo jets happening is quite slim.

What can I do?

Some mechanisms to change the behaviours and outcomes:
  • Maybe I can pre-order 100 superjumbo jets from Airbus and Boeing, so they know they have a confirmed demand for it
  • Lobby the UK government to increase subsidies for the R&D part, so both parties have less losses/risks. Maybe that might entice them to develop
  • Look for a new competitor that produces plans and ask them to work with Airbus
Those are just basic simple (& maybe crazy, not-practical) ideas. But you get what I mean. I can introduce mechanisms to change the behaviours and outcomes, so it suits an objective.

What’s the link with token ecosystems?

Similarly, we want to analyse the outcomes and build in some mechanisms and rules to ensure that the outcomes are in line with the objectives.
Remember I mentioned that every ecosystem has 1 main objective? The truth is, that can be challenging to achieve sometimes, when you have a decentralised ecosystem and everyone behaves differently.
However, you can change that through rules.
I want my ecosystem to have honest miners. So I can make the hardware expensive and difficult to get, to reduce cheats from entering the game.
We can do that through incentives (rewards) or disincentives (punishments). These act as the mechanisms and rules to ensure that the outcomes are in line with the objective of the ecosystem.

What rules and mechanisms?

There are many, but to make it easy, let’s call it governance. Governance, in my opinion, is the most important aspect in the token ecosystem.
There are many types of governance:
  • How can we get the true value of the participants so we can allocate the goods efficiently? (e.g. there are 2 transactions waiting to be validated. What mechanism or governance can I have in place, to prioritise which transaction to approve first?)
  • How can I ensure that my rules induce a game among strategic agents in order to realise a system-wide objective or social choice function, in an equilibrium of the game? (e.g. how can I reduce instances of pump-and-dump, since this is not an objective of my ecosystem?)
We are just scratching the surface of game theory and its application to token economics. At the end of the day, it forms part of the design model for the ecosystem to exist.

How can a global cryptocurrency increase efficiency in the global economy

By Lisa Tan

Reading Time: 2 minutes

I attended the Singapore-France Economic Forum 2019 2 weeks ago. The discussions were around global macro policies and international issues.

One panel brought up the some points regarding problems in the world economy today. It got me to think about the massive issues and conclude that global cryptocurrency has a shot at reducing some problems.

Note: I said reduce, not resolve the problems

Here’s how and why.

Some problems that exist in the physical global economy today:

  • Credit. Too much, too unmanaged, too out of control.
  • Geopolitics and dollar dominance. That’s the USD.
  • Execution of policies
  • Inequality amongst individuals, companies, countries
  • Volatile capital flow
  • High debt levels
  • Juridictions
  • Anti-trust institutions
  • Burden of central bank
  • Policies are not reacting fast enough
  • Different objectives with changing times (E.g. IMF, World Bank)
  • People in power like to accumulate power
  • People are not rational whereas the system is built with expectation of rational agents

How crytocurrency could reduce some problems

I mention CURRENCY because I am talking about global MONETARY policies and the relation between MONEY and economic activities.

Other token function includes utility and securities. I am NOT talking about them. Just 💵.

  • Easier to track, manage and limit credit with baked-in governance codes.

Relevant interesting papers to kickstart this very complicated topic:

> Changes in Bank Lending Standards and the Macroeconomy (Bassett et al., 2013)
> Capital flows and the risk taking channel of moentary policy (Bruno et Shin, 2013)
> Financial stress and economic dynamics: the transmission of crises (Hubrich et al., 2014)
> Open market operations (Rocheteau et al., 2016)
> Risk, uncertainty and monetary policy (Bekaert et al.,2010)
> The optimal inflation rate under Schumpeterian growth (Oikawa et Ueda, 2018)

  • Reduce dollar dominance with a currency less tied to geopolitics: Global institutions are trying to increase the global dominance of EUR and CNY. (Bye bye GBP & JPY). But those currencies are still very much tied to geopolitics, in the interest of their economic region and not global economy as a whole. Even Dr Zhou Xiaochuan, Governor of the People’s Bank of China, mentioned in 2009 that we need an international monetary system reform.
  • Quicker execution to policies due to baked-in governance as mentioned above.
  • Different governance levels with various specific objectives to react to situations

MakerDao has 4 layers of governance, each with a key purpose.
Think about each governance as a “union” in traditional sense. They fight for a single objective.

  • Limit people with power accumulating more power (E.g. the consensus designs of various blockchain platforms.)

These solutions are very general and there are limitations and downsides to them. However, even a 1% increase in efficiency in the current system can bring about a significant change with the multiplier effect.

Also, it’s time to shift the focus of “world economy = macroeconomics”. As we move towards higher degrees of digitisation, we need to start bringing in conversations around more engineering, computer science & math (aka microeconomics).

This article first appeared on LinkedIn.

Macro vs Micro Token Economics

By Lisa Tan

Reading Time: 3 minutes

Economics is divided into 2 branches: macroeconomics vs microeconomics. Similarly in token economics, we can divide the various categories into these branches.

Macro Token Economics

Traditionally, macroeconomics looks at business cycles and economic growth. It means understanding how the economy, as a whole, behaves by looking at indicators. For example, inflation, price levels, income level, etc.

Business Cycles

This is where your governance comes in (see where I’m going?). For example, monetary policy and fiscal policy. These are movement or actions by the government to make sure that the economy is healthy. For example, we don’t want inflation to be too high or inflation to be too low.
Macroeconomics also includes analyzing how different sectors relate to each other, especially in times of international trade. For example, how does consumption, investment, savings and international trade affect each other? What policies (or rules) the government needs to have, to ensure that the economy is healthy and balanced?

Economic Growth

Economic growth is just growth of your economy or ecosystem. Here, we want to understand the factors that contributes to the long-run and income growth. For example, technology innovation helps economic growth as according to the Solow Growth Model.

So, what’s the link with my token ecosystem?

This link is in the design of your token.
Macro Token Economics
Macro Token Economics

Business Cycles

Although token ecosystems do not have a centralised government to respond to changes your ecosystem, there are rules that can be coded and embedded. For example, MakerDao uses various stability mechanisms like target rate feedback and risk parameters to govern the ecosystem.
We can also analyse the aggregate behaviour of the economy.
If the token function is a currency, there are plenty of literature to analyse the inflation model, interest rate, allocation of tokens, supply and creation or burn rates.

Economic Growth

Since token ecosystems are a form of business models, you have to consider the long-run growth and factors contributing to it. And it is also important to remember that these factors have to be endogenous, not just exogenous.
For example, if your business model is tokenising common data, what are the internal factors (endogenous) that will affect the long-run growth? Maybe proprietary IoT technology hardware, sale of data with confirmed partner, etc.
If the token function is a security, check out financial literature on asset valuation, profit distribution and other relevant factors.

Micro Token Economics

As the name suggests, microeconomics focuses on individuals actors. The 3 types of actors in the physical fiat economy are households (people), firms (companies that hire people), and government (sets rules for households and firms).
It means understanding how actors behave, as an individual, given the limited resources. For example, why you are happier drinking the first cup of tea than the 10th cup of tea in a row.
Microeconomics looks deeper into various allocation mechanisms of resources, methods to extract the right value from participants, and how people make decisions. We look at demand and supply, production theory (inputs to outputs), production costs, etc. The field is endless.

So, what’s the link with my token ecosystem?

This link is in the design of your market and mechanism.
Some fields in microeconomics that is applicable to token economy:
Micro Token Economics
Micro Token Economics
These are part of the factors to consider when designing a token ecosystem. There is not “right answer” or “perfect model” for the ecosystem. It depends greatly on the token function, use-case, business model, etc. The only way is to read, apply, test, improve.
In the next few videos and articles, I will share more about each field in details and its application to token economics.