Financial rules for the algorithm age

Published in the Australian Financial Review

A lot has changed in cryptocurrency since the last bull run in 2017. And these changes have made the regulatory regime that emerged in Australia since the invention of bitcoin look decidedly creaky – if not completely incoherent – and a serious barrier to fintech innovation and investment.

For the most part, Australian policymakers have preferred to squeeze digital assets into existing regulatory frameworks rather than create new frameworks.

For tax purposes, cryptocurrency has been treated as a traditional financial asset subject to capital gains tax – unless it is used in regular transactions, then it is treated like currency. An initial coin offering, where tokens are sold to early investors and users, is generally treated as a share offering or managed investment scheme.

This was the right approach. Entrepreneurs may not have loved the heavy compliance burdens, but at least those burdens were well understood. And we have avoided regulatory disasters like New York’s “BitLicense”, which led to cryptocurrency firms fleeing the city almost the moment it was introduced.

But where in 2017 cryptocurrency users and investors were limited to a relatively small number of digital assets trading on a couple of centralised exchanges, a new class of decentralised finance (DeFi) products have enabled the development of complex financial products and services that are completely decentralised. DeFi completely undermines Australia’s regulatory approach to cryptocurrency and blockchain.

Everything from loans to derivatives to exchanges are being rebuilt as autonomous digital products outside the traditional finance system. These are not niche innovations. Some estimates have upwards of $50 billion locked up in DeFi products right now.

Consider one of the most innovative financial services in the DeFi space: automated market makers. These AMMs allow users to trade one digital asset for another without going through a traditional central orderbook. Investors – “liquidity providers” – put assets into a pool. People who wish to trade one asset for another make exchanges with the pool, which reprices each asset automatically to keep the pool in balance. Investors get fees and bear risk if the external price of the assets change.

AMMs are a brilliant innovation and a regulatory nightmare. Let us start with tax. The Australian Taxation Office treats any token-to-token exchange as a capital gains event, where profits and losses incur a tax liability is incurred, just like a normal exchange of financial assets. This regime makes sense for traditional finance. But it creates huge burdens for DeFi.

Imagine a relatively simple DeFi investment – putting bitcoin in an AMM. First, you have to bring your bitcoin onto a smart contract network like ethereum. Bitcoin can only truly exist on the bitcoin blockchain, so you vouchsafe your coins with a provider who then mints a digital representation of your bitcoin on the ethereum network. You deposit this “wrapped bitcoin” token (and usually another token) into the AMM. You get a receipt – just another token – that represents your share of the pool.

Each of these exchanges are capital gains events. None of them are denominated in Australian dollars. Even the most diligent DeFi user will inevitably make mistakes when trying to account for the capital gains and losses. Few users even realise they are actually performing a token-to-token exchange when they make AMM investments. It is hard to describe the capital gains treatment of DeFi as a functioning part of the tax system at all.

The tax regime may be a compliance nightmare, but at least it is navigable. There are even harder compliance questions in our imagined DeFi investment. For instance, what actually is an AMM, in law? It looks a lot like a managed investment scheme – that is probably what ASIC will think. Like a traditional managed investment scheme, investors pool money in return for profits and don’t have day-to-day control of the investments. But if an AMM is a managed investment scheme … well, it doesn’t have a manager. Algorithms can’t hold financial licences. Nor on a censorship-resistant blockchain can they be shut down.

There are solutions to these problems. Capital gains events should be limited to when cryptocurrency is converted to fiat or used to buy goods or services. My colleagues Darcy Allen, Aaron Lane and I have called for a new exemption to the managed investment scheme framework – what we call “autonomous investment products”. Where a product is entirely algorithmic, has no ongoing responsible party, and is completely open source and auditable by investors, the heavy compliance burdens of a managed investment scheme don’t make sense.

But these solutions will almost certainly require legislative change. Until now, Australia’s cryptocurrency policy has been made via regulatory guidance. That approach has reached its use-by date. Fintech innovation can’t be left to suffocate under regulatory uncertainty and incoherence.

Response to Questions on Notice: Senate Select Committee on Financial Technology and Regulatory Technology

With Darcy W.E. Allen and Aaron M. Lane

Response to questions on notice at Senate Select Committee on Financial Technology and Regulatory Technology.

The capital gains taxation regime as it applies to cryptocurrency
is no longer appropriate

The Australian Taxation Office’s position that cryptocurrency is an asset for capital gains tax purposes and that every exchange between two cryptocurrency tokens should be treated as a “disposal” creates substantial regulatory compliance burdens on taxpayers, hinders fintech adoption, and achieves no policy objective.

This treatment of tokens poses unique challenges for cryptocurrency users. As each tokento-token exchange is treated by the ATO as a capital gains tax event, taxpayers are required to record gains or losses in the Australian dollars. However, token-to-token exchanges often occur at multiple times removed from Australian dollar-denominated markets. For many cryptocurrency tokens, liquid token-AUD exchange markets do not exist. In addition, the volume and complexity of some of these token exchanges make precise accounting of gains and losses on a per-transaction basis unrealistic, even for honest taxpayers seeking to fully ensure compliance.

Token-to-token exchanges of cryptocurrencies and other digital assets are foundational to the development of the digital economy, contributing to price and business model discovery. The current capital gains tax treatment to token-to-token exchanges imposes significant and unnecessary uncertainty and regulatory burden on cryptocurrency users, investors and the blockchain industry more generally.

The capital gains tax regime may have been appropriate five years ago when the cryptoeconomy was smaller, less complex and when there were relatively few places to make token-to-token exchanges. However, recent developments make the current policy regime inappropriately narrow and imposing. For example, the rise of decentralised finance (‘defi’) means that token-to-token exchanges are now commonly occurring through a vast ecosystem of decentralised protocols that operate at multiple levels removed from Australian dollar-denominated markets and provide no easy-to-use tools for the granular record keeping required by the ATO.

Additionally, the tokens that are being exchanged are also changing as the cryptoeconomy has developed. Defi activity can result in tokens being locked up in exchange for ‘governance’ tokens. Tokens that represent claims on other tokens through smart contracts – often necessary to acquire in order to participate in economic activity across multiple blockchains – can trade at a premium or discount. Treating these token-to-token swaps as capital gains events serves no policy purpose, and adds significant ambiguity and uncertainty to the Australian tax system.

The current regime also risks cryptocurrency users accumulating an Australian dollar-denominated tax liability that might be tied up in illiquid tokens.

The committee should understand that compliance with this regime in the Australian public is likely to be very low and the risk of taxpayers making errors in attempting to comply with the current legislation is very high.


We recommend that CGT events be limited to exchanges where it is reasonable to comply with the capital gains tax regime. These would be when:

  • Cryptocurrency is exchanged with fiat currency (most commonly the Australian dollar),
  • Cryptocurrency is used in the acquisition or disposal of a tangible good or service, or a non-fungible token (such as a piece of digital art). Depending on the CGT classification of the respective token (for example a personal use asset or collectable), these transactions may yield the normal concessional treatments.

The burden of demonstrating compliance with these rules would remain with the taxpayer. This approach would significantly simplify the capital gains tax regime while reducing regulatory burdens, encourage innovation and the expansion of blockchain and cryptocurrency jobs in Australia, and be revenue neutral to the Commonwealth government.

The managed investment scheme regime doesn’t suit autonomous (algorithmic) financial products

A managed investment scheme (MIS) is an investment structure where a “responsible entity” manages investments for unit holders. In summary, the Corporations Act 2001 (Cth) provides that a MIS will exist where (i) members contribute money or money’s worth as consideration to acquire rights to benefits produced by the scheme; (ii) any of the contributions are to be pooled, or used in a common enterprise, to produce financial benefits, or benefits consisting of rights or interests in property, for the members; and (iii) the members do not have day-to-day control over the operation of the scheme. Generally, a MIS is required to be registered with ASIC if it has more than 20 members. A registered entity is required to be a public company and hold an Australian Financial Services License.

There is a significant risk facing blockchain companies in Australia that the MIS regime will be inappropriately applied, particularly as it pertains to decentralised finance (‘defi’) products. There is approximately US$41.5 billion worth of tokens in the defi ecosystem. Inappropriate and high cost regulation threatens the viability of the defi industry in Australia and will send entrepreneurs and job-makers overseas.

For example, popular defi applications include a class of automated market makers (AMMs) that allow users to make token-to-token exchanges outside ‘traditional’ centralised exchanges like Binance or Coinbase. Investors pool tokens in these automated exchanges, earning profit through fees. The pool automatically prices exchanges in a way that rebalances the pool, guaranteeingthat each asset is always available.

It is likely an AMM would be considered a MIS within the legal definition outlined above. However, there are several regulatory problems in applying the MIS regulatory framework to defi products like AMMs:

  • These schemes have no manager – that is, there is no responsible entity on whom the obligations of a financial services licence could be meaningfully imposed or exercised. The scheme – and thus the return on the investment – is determined entirely algorithmically.
  • Automated market makers like this have no responsible agent. Amendments to the protocol (for example, varying the fee for investors) are entirely controlled by the voting behavior of governance token holders (typically investors).

Applying the rules governing managed investment schemes to these autonomous and algorithmic financial products is a category error.

In any case, treating a defi product as an MIS would not achieve the government’s policy goals. Defi products are censorship resistant and fully digital. Australian investors are able to interact with defi products developed around the world at almost zero cost. Regulatory avoidance is trivially easy because these products can be freely “forked” (that is, their code copied, modified, and re-deployed permissionlessly). Applying the MIS framework to Australia-built defi products means that Australian companies are highly reluctant to innovate in this frontier fintech field.

The committee might consider amending the government’s enhanced fintech sandbox or develop a new blockchain technology specific sandbox to deal allow for defi products. However, we do not recommend this approach. One problem is that the current sandbox rules (such as limitations on the amount of money invested, or persons involved) would be inappropriate for defi because of the absence of centralised management, the ease of forking, and the quantum of funds. For example, automated exchanges have no mechanism to limit the size of the total pool (doing so would potentially reduce the stability of the pool) and even if limits were implemented they could be avoided through forking the pool and re-deploying it. Furthermore, if regulators were to determine that the defi product no longer compliant with the sandbox rules, given the uncensorable nature of blockchain, there would be no mechanism by which regulators could insist that the product could cease trading.


We recommend that the Corporations Act be amended to exempt “autonomous financial products” from the existing definition of a MIS. To qualify as an autonomous financial product, the product needs to be:

  • Fully algorithmically deterministic (that is, all investment decisions are made by an algorithm rather than a responsible human entity);
  • Governance decisions are sufficiently decentralised and made solely by those who have invested; and
  • Fully open source, with its code published on a recognised platform (such as
    GitHub), allowing investors to scrutinise the code themselves.

This change would be straightforward and is consistent with the existing legislative approach of the Act. While legislative change is preferred to provide certainty, we note that this approach could also be achieved through regulation as section 9 of the Act provides a mechanism for the Regulations to declare that a scheme is not a MIS.

PDF version with references and footnotes available in here.

After GameStop, the rise of Dogecoin shows us how memes can move markets

Published in The Conversation with Jason Potts

One of the most difficult problems in finance right now is figuring out the fundamental economic value of cryptocurrencies. And the past week has complicated this further.

For many cryptocurrency investors, the value of Bitcoin is based on the fact it is artificially scarce. A hard cap on “minting” new coins means there will only ever be 21 million Bitcoin in existence. And unlike national currencies such as the Australian dollar, the rate of release for new Bitcoin is slowing down over time.

Dogecoin, a cryptocurrency that takes its name and logo from a Shiba Inu meme that was popular several years ago, have a cap. Launched in 2013, there are now 100 billion Dogecoin in existence, with as many as five billion new coins minted each year.

But how can a currency with a seemingly unlimited supply have any value at all? And why did Dogecoin’s price suddenly surge more than 800 per cent in 24 hours on January 29?

At the time of publication, the “memecoin” was worth about $5.6 billion on the stockmarket.

Dogecoin is one of the original “altcoins”: cryptocurrencies released in the few years after the pseudonymous Satoshi Nakamoto first released Bitcoin into the wild.

From a technical perspective, Dogecoin isn’t very innovative. Like many early altcoins, it’s based on the original source code of Bitcoin.

Or more technically, it’s based on Litecoin, which in turn was based on Bitcoin — but with some small modifications such as faster transactions and the removal of the supply cap. But Dogecoin is much more interesting when seen through a cultural lens.

The cryptocurrency was created by software engineers Billy Markus and Jackson Palmer — although Palmer, an Australian, has since walked away from the project. They branded it with the Doge meme partly to be funny, but also to distance it from Bitcoin’s then questionable reputation as a currency for illicit transactions.

Now, Dogecoin has outlasted almost all the early derivative altcoins and has a thriving community of investors. In 2014, Dogecoin holders sponsored the Jamaican bobsled team. Soon after, they sponsored a NASCAR driver.

Elon Musk, the world’s richest man, is among the cryptocurrency’s high-profile advocates. In December last year, a tweet from Musk sent Dogecoin’s price soaring.

Reddit threads proclaim Dogecoin’s value as a new global currency. Musk himself shared a similar sentiment a few days ago. Speaking on the app Clubhouse, he said:

Dogecoin was made as a joke to make fun of cryptocurrencies, but fate loves irony. The most ironic outcome would be that Dogecoin becomes the currency of Earth in the future.

But Dogecoin is best thought of as a cultural product, rather than a financial asset. The reality is few cryptocurrency users hold it as a serious investment or to use in regular transactions. Instead, to own Dogecoin is to participate in a culture.

People buy it because it’s fun to have, is inherently amusing and comes with a welcoming and enjoyable community experience.

If we start thinking of the cryptocurrency as a cultural product, last week’s sudden jump in Dogecoin’s price makes sense. The boost came just after a meme-centric community managed to drive the share price of videogame retailer GameStop from US$20 to US$350 in mere days.

This swarm behaviour was unlike anything seen before — and it frightened global financial markets.

One particularly interesting aspect of the Reddit forum r/WallStreetBets — which coordinated the attack on the hedge fund that had effectively bet on GameStop’s share price falling — was how many users were having fun.

It’s no surprise activity surrounding Dogecoin has a similar vibe; it was designed to be fun right from the start.

Some people participate in financial markets as a form of consumption — meaning for entertainment, leisure and to experience community — just as much as they do for investment.

Cultural assets such as Dogecoin are hard to systematically value when compared to financial assets, a bit like how we don’t have a fundamental theorem for pricing art.

Almost by definition, the demand for a memecoin will fluctuate as wildly as internet culture itself does, turning cultural bubbles into financial bubbles. RMIT professor and crypto-ethnographer Ellie Rennie calls these “playful infrastructures“.

By inspecting Dogecoin closely, we can learn a lot about the interplay of technology, culture and economics.

Moreover, cryptocurrencies are extraordinarily diverse. Some are built for small payments or to be resilient holders of value. Others protect financial privacy or act as an internal token to manage smart contracts, supply chains or electricity networks.

Under the hood, Bitcoin and Dogecoin look almost exactly the same. Their code differs in only a few parameters. But their economic functions are almost entirely opposite.

Bitcoin is a kind of “digital gold” adopted as a secure hedge against political and economic uncertainty. Dogecoin, on the other hand, is a meme people add to their digital wallet because they think it’s funny.

But in an open digital economy, memes move markets.

Quantum crypto-economics: Blockchain prediction markets for the evolution of quantum technology

With Peter P. Rohde, Vijay Mohan, Sinclair Davidson, Darcy Allen, Gavin K. Brennen, and Jason Potts

Abstract: Two of the most important technological advancements currently underway are the advent of quantum technologies, and the transitioning of global financial systems towards cryptographic assets, notably blockchain-based cryptocurrencies and smart contracts. There is, however, an important interplay between the two, given that, in due course, quantum technology will have the ability to directly compromise the cryptographic foundations of blockchain. We explore this complex interplay by building financial models for quantum failure in various scenarios, including pricing quantum risk premiums. We call this quantum crypto-economics.

Available at arXiv

Submission to Select Committee on Financial Technology and Regulatory Technology (Response to Interim Report and Second Issues Paper)

With Darcy W. E. Allen and Aaron M. Lane

A submission to the Senate Select Committee on Financial Technology and Regulatory Technology (‘Committee’) following the tabling of the Committee’s Interim Report and the publication of the Second Issues Paper, focusing on the regulatory implications of blockchain technology.

Available in PDF here.

Commitment voting: a mechanism for intensity of preference revelation and long-term commitment in blockchain governance

With Sinclair Davidson and Jason Potts

Abstract: Commitment voting is a mechanism for signalling intensity of preferences and long-term commitment to governance decisions in proof of stake blockchains. In commitment voting, the voting weight of a vote in any given election is determined by 1) the amount of tokens under a voters control and 2) the time that the voter is willing to lock their tokens up for that election. Winning votes are locked up for the nominated amount of time. Losing votes are released as soon as the election has results. Commitment voting requires voters to commit to the decisions they make while still allowing those who disagree with the majority to exit the community.

Available at SSRN and in PDF here.

Exit, Voice, and Forking

With Alastair Berg. Published in Cosmos + Taxis, Volume 8, Issue 8-9, 2020

Abstract: This paper offers a new framework to understand institutional change in human societies. An ‘institutional fork’ occurs when a society splits into two divergent paths with shared histories. The idea of forking comes from the open-source software community where developers are free to copy of a piece of software, alter it, and release a new version of that software. The parallel between institutional choice and software forking is made clear by the function and politics of forking in blockchain implementations. Blockchains are institutional technologies for the creation of digital economies. When blockchains fork they create two divergent communities with shared transaction ledgers (histories). The paper examines two instances of institutional forks. Australia can be seen as a successful fork of eighteenth-century Britain. The New Australia settlement in Paraguay can be seen as an unsuccessful fork of nineteenth century Australia.

Available at Cosmos + Taxis and in PDF hereEarlier version available in working paper at SSRN

The Cryptoeconomics of Cities, Data and Space

With Darcy W E Allen, Kiersten Jowett, Mikayla Novak, and Jason Potts. Published in in Cosmos + Taxis, Volume 8, Issue 8 + 9, 2020

Abstract: We explore the connection between new decentralised data infrastructure and the spatial organisation of cities. Recent advances in digital technologies for data generation, storage and coordination (e.g. blockchain-based supply chains and proof-of-location services) enables more granulated, decentralised and tradeable data about city life. We propose that this new digital infrastructure for information in cities shifts the organisation and planning of city life downwards and opens new opportunities for entrepreneurial discovery. Compared to centralised governance of smart cities, crypto-cities are more emergent orderings. This paper introduces this research agenda on the boundaries of spatial economics, the economics of cities, information economics, institutional economics and technological change.

Available at Cosmos + Taxis and in PDF here. Preprint available at SSRN. (Previously titled ‘Spatial Institutional Cryptoeconomics’)

What we think we know about defi

This essay follows an RMIT Blockchain Innovation Hub workshop on defi. Contributions by Darcy WE Allen, Chris Berg, Sinclair Davidson, Oleksii Konashevych, Aaron M Lane, Vijay Mohan, Elizabeth Morton, Kelsie Nabben, Marta Poblet, Jason Potts, and Ellie Rennie. Originally a Medium post.

The financial sector exists solely to smooth economic activity and trade. It is the network of organisations, markets, rules, and services that move capital around the global economy so it can be deployed to the most profitable use.

It has evolved as modern capitalism has evolved, spreading with the development of property rights and open markets. It has grown as firms and trade networks became globalised, and supercharged as the global economy became digitised.

Decentralised finance (defi) is trying to do all that. But just since 2019, and entirely on the internet.

Any business faces the question of “how do I get customers to pay for my product?” Similarly consumers ask the question, “Where and how can I pay for the goods and services I want to buy?” For the decentralised digital economy, defi answers this question. Defi provides the “inside” money necessary to facilitate transactions.

But what in traditional, centralised finance looks like banks, stock exchanges, insurance companies, regulations, payments systems, money printers, identity services, contracts, compliance, and dispute resolution systems — in defi it’s all compressed into code.

From a business perspective trade needs to occur in a trusted and safe environment. For the decentralised digital economy, that environment is blockchains and the dapps built on top.

And as we can see, defi doesn’t just finance individual trades or firms — it finances the trading environment, in the same way that taxes finance regulators and inflation finances central banks. If blockchain is economic infrastructure, defi is the funding system that develops, maintains and secures it.

These are heavy, important words for something that looks like a game. The cryptocurrency and blockchain space has always looked a little game-y, not least with its memes and “in-jokes”. The rise of defi has also had its own cartoonified vibe and it has been somewhat surreal to see millions of dollars of value pass through tokens called ‘YAMs’ and ‘SUSHI’.

Games are serious things though. A culture of gaming provides a point around which all participants can coordinate activity and experimentation — what we’re seeing in defi is the creation of a massive multiplayer online innovation system. The “rules” of this game are minimal, there are no umpires, and very little recourse, where the goal is the creation and maintenance of decentralised financial products, and willing players can choose (if and) to what extent they participate.

Because there is real value at stake, the cost of a loss is high. Much defi is tested in production and the losses from scams, unethical behaviour, or poor and inadequately audited coding are frequent.

On the other side, participation in the game of defi is remarkably open. There are few barriers to entry except a small amount of capital that players are willing to place at risk. Once fiat has been converted into cryptocurrency, the limit on participation in decentralised finance isn’t regulatory or institutional — it is around knowledge. (Knowledge is a non-trivial barrier, excluding people who could be described as naive investors. This is important for regulatory purposes.)

This is starkly different from the centralised financial system, where non-professional participants have to typically go through layers of gatekeepers to experiment with financial products.

The basic economics of defi

The purpose of defi is to ensure the supply of an ‘inside money’ — that is, stablecoins — within decentralised digital platforms and to provide tools to manage finance risks.

In the first instance defi is about consumer finance. It answers basic usability questions in the blockchain space: How do users of the platform pay native fees? Which digital money is deployed as a medium of exchange or unit of account on the platform?

In the second instance defi concerns itself with the operation of consensus mechanisms — particularly proof of stake mechanisms and their variants. The problem here is how to capture financial trust in a staking coin and then how to use that trust to generate “trust” on a blockchain. Blockchains need mechanisms to value and reward these tokens. Given the (potential) volatile nature of these tokens, risk management instruments must exist in order to efficiently allocate the underlying risk of the trading platform.

As we see it, the million yam question is whether the use of these risk management tools undermine trust in the platform itself. It is here that governance is important.

Which governance functions should attach to staking tokens and when should those functions be deployed? Should they be automated or should voting mechanisms be used? If so, which voting mechanisms and what level of consensus is appropriate for decision making.

Finally defi addresses the existence of stablecoin and staking tokens from an investor perspective. Again there are some significant questions here that the defi space has barely touched. How do these instruments and assets fit into existing investment strategies? How will the tax function respond? How much of existing portfolio theory and asset pricing applies to these instruments and assets?

Of course, we already have a complex and highly evolved centralised financial system that can provide much of the services that are being built from the ground up in defi. So why bother with defi?

The most obvious reason is that the blockchain space has a philosophical interest in decentralisation as a value in and of itself. But decentralisation addresses real world problems.

First, centralised systems can have human-centric cybersecurity vulnerabilities. The Canadian exchange QuadrigaCX lost everything when the only person with access to the cryptographic keys to the exchange died (lawyers representing account holders have requested that the body be exhumed to prove his death). Decentralised algorithmic systems have their own vulnerabilities (need we mention yams again?) but they are of a different character and unlike human nature they can be improved.

Second, centralised systems are exposed to regulation — for better or worse. For example, one of the arguments for UniSwap is that it is more decentralised than EtherDelta. EtherDelta was vulnerable to both hackers (its order book website was hacked) and regulators (its designer was sued by SEC).

Third, digital business models need digital instruments that can both complement and substitute for existing products. Chain validation instruments and the associated risk management tools presently do NOT have real world equivalent products.

Fourth and finally, the ability to digitise, fractionalise, and monetise currently illiquid real-world assets will require a suite of instruments and digital institutions. Defi is the beginning of that process.

In this sense, the defi movement is building a set of financial products and services that look superficially familiar to the traditional financial system using a vastly different institutional framework — that is, with decentralisation as a priority and without the layers of regulation and legislation that shape centralised traditional finance.

Imagine trying to replicate the functional lifeforms of a carbon-based biochemical system in a silicon based biochemical system. No matter how hard you tried — they’d look very different.

Defi has to build in some institutions that mimic or replicate the economic function provided by central banks, government-provided identity tech, and contract enforcement through police, lawyers and judges. It is the financial sector + the institutions that the traditional finance sector relies on. So, initially, it’s going to look more expensive, relative to “finance”. But the social cost of the traditional finance sector is much larger — a full institutional accounting for finance would have to include those courts and regulations and policymakers and central banks that it relies on.

Thus defi and centralised finance look very different in practice. Consider exchanges. Traditional financial markets can either operate as organised exchanges (such as the New York Stock Exchange) or as over-the-counter (OTC peer-to-peer) markets. The characteristics of those types of market are set out below.

Image for post

Defi exchanges represent an attempt to combine the characteristics of both organised exchanges and over-the-counter markets. In the very instance, of course, they are decentralised markets governed by private rules and not (necessarily) public regulation. They aim to be peer-to-peer markets (including peer-to-algorithm markets in the case of AMM).

But at the same time they aim to be anonymous (in this context meaning that privacy is maintained), transparent, highly liquid, and with less counterparty risk than a traditional OTC market.

Where is defi going?

Traditional finance has been developing for thousands of years. Along with secure private property rights and the rule of law, it is one of the basic technologies of capitalism. But of those three, traditional finance has the worst reputation. It has come to be associated with city bros and the “Wolf of Wall Street”, and the Global Financial Crisis. Luigi Zingales has influentially argued that the traditional finance system has outgrown the value it adds to society, in part because of the opportunities of political rent seeking.

This makes defi particularly interesting.  Defi is for machines. Not people. It represents the automation of financial services.

A century ago agriculture dominated the labour force. The heavy labour needs of farming are one of the reasons we were poor back then. As we added machines to agriculture — as we let machines do the farming — we reduced the need to use valuable human resources. Defi offers the same thing for finance. Automation reduces labour inputs.

Automation of course has been increasingly common in financial systems since at least the 1990s. But it could only go so far. A lot of the reason that finance (and many sectors, including government and management) resisted technological change and capital investment, was at the bottom, there had to be a human layer of trust. Now that we can automate trust through blockchains, we can move automation more deeply into the financial system.

Of course, this is in the future. Right now defi is building airplanes in 1902 and tractors in 1920. They’re hilariously bad and horses are still better. But that’s how innovation works. We’re observing the creation of the base tools for entrepreneurs to create value. Value-adding automated financial products and services comes next.

What we’ve learned from working with Agoric

With Sinclair Davidson and Jason Potts. Originally a Medium post.

Since 2017 we (along with our colleague Joe Clark) have been working with Agoric, an innovative and exciting smart contract team, who are about to launch a token economy model we helped design.

At the RMIT Blockchain Innovation Hub we’ve long been thinking about how blockchain can drive markets deeper into firms, resolving the electronic markets hypothesis and giving us new opportunities for outsourcing corporate vertical integration.

What we’ve discovered from working with the Agoric team is the possibilities of driving markets down into machines. Mark Miller’s groundbreaking work with Eric Drexler explored how property rights and market exchange can be used within computational systems. Agoric starts economics where we start economics — with the institutional framework that secures property rights.

This has been one of the most intellectually stimulating collaborations of each of our careers, and has shaped much of how we think about the economics of frontier technologies.

We first met the Agoric team through Bill Tulloh at the Crypto Economics Security Conference at Blockchain @ Berkeley in 2017, just as we were forming the RMIT Blockchain Innovation Hub. CESC was the first serious attempt we were aware of to bring the blockchain industry and social science together — such as our disciplines of economics and political economy.

In the presentation to CESC, we applied some of Oliver Williamson’s thinking to understand the economic properties of tokens and cryptocurrencies.

Bill — who had thought along similar lines — came over to chat during a break. We met again at the 2018 Consensus Conference in New York. Bill introduced us to Mark Miller. What started out as a quick chat to say hello over breakfast turned into a long discussion about Friedrich Hayek, Don Lavoie, and market processes in computer science. Through Bill and Mark we then met Kate Sills and Dean Tribble.

It is true that economic thinking is everywhere in the blockchain and cryptocurrency community. There’s a lot of lay reasoning about Austrian economics, monetary policy, central banks, and inflation. These ideas have brought a lot of people into the cryptocurrency space. Some of the thinking that brought them here is good economics (we’re very passionate about how Austrian economics can inform the blockchain industry ourselves — see here and our colleague Darcy Allen here) but unfortunately a lot of it is not-so-good economics. Many developers have self-taught economics, many have intuited economics from first principles, and we have observed a combination of brilliant insight, economic fallacy, and knowledge gaps.

Developers, however, tend to be very good at game theory; if only because unlike our colleagues in academia, the blockchain community is testing the assumptions of game theory and applying it in the real world for business models with real value at stake. Reality can be bracing. Only invest what you can afford to completely lose. This is still a highly experimental industry.

But economics has much, much more to contribute to our understanding of the blockchain economy than just Hayekian monetary theory and textbook game theory. Our friends at Agoric know this — they already had an economist in their team. They know and understand that it isn’t enough to have good code — to succeed, you need to have economically coherent code.

To that end, we have developed a new field of economics: institutional cryptoeconomics. In this field, we apply the transaction cost economics of Ronald Coase and Oliver Williamson to explore blockchain as an economic institution competing with and complementing the schema of firms, markets, states, clubs and the commons.

The economic foundation of our institutional cryptoeconomics is broad and solid. In addition to economics Nobel laureates like Hayek, Ronald Coase, and Oliver Williamson, we have also incorporated the work of other laureates such as Herbert Simon, Douglass North, Elinor Ostrom, and Jean Tirole into our blockchain research. Then we’’ve drawn on should-have-been-laureates such as Joseph Schumpeter, William Baumol, Armen Alchian, and Harold Demsetz are included. Economists such as Andrei Shleifer and Israel Kirzner could still win a Nobel.

Merton Miller — himself an economics laureate — once argued that there was nothing more practical than good theory. Our experience working with Agoric has convinced us of the value of very good theory. We have had plenty of help — actual practitioners trying to solve immediate real-world problems are hard task masters. Ideas cannot remain half-baked — they must be fully explained and articulated. Working with Agoric has been an intellectually intense, extended interactive academic seminar where ideas are taken from vague hunch to ‘how can this be implemented’ and back again. From whiteboard to business model.

As academics we have learned which ideas, models and tools are of immediate use and value in the blockchain world. There have been some surprises here. Whoever would have thought that edgeworth boxes would have a practical real world application? Or indifference curves? But here we are. When building an entire economic ecosystem — the Agoric economy — we have had to draw upon the full breadth of our economic training. We suspect that having an economics team on board will become an industry standard in the years to come.

We have benefited as educators too. Of course, explaining complex ideas to highly intelligent laypeople is a large part of our day job. The stakes, however, are much higher. The Agoric team aren’t seeking information to pass a class test. They are seeking information to pass a market test — that the market will grade. As another favorite economist of ours Ludwig von Mises explained, consumers are hard task masters.

Our own students particularly have benefited from our Agoric experience. We now have a deeper understanding of industry needs and thought in the blockchain space. We know which ideas interest them and which don’t. The Agoric team questioned us closely on some topics. Our students will know how to answer those questions.

It also turns out that financial engineering is far more important than we thought it would be when we first started working on blockchain economics. The work with Agoric has coincided with the defi boom — a richly anarchic and innovative movement within the blockchain space. As a consequence, the blockchain for business degree programs that we have launched at RMIT have huge dollops of finance in them.

We share with Agoric a vision of the future where technology leads to an improvement in human flourishing and an enhancement of our capacity to lead full lives.

In a new book published by the American Institute for Economic Research we’ve argued that blockchain and other frontier technologies offer us the tools to actively take back liberties we may have lost.

With Agoric, it is incredibly exciting to be able to actually build the economy of the future that we’ve been studying.