With Ryan Garner, Lachlan Webb, Jason Potts and Sinclair Davidson
Abstract: In this paper we introduce Tracer: peer-to-peer financial infrastructure for the decentralised economy. Tracer lowers the costs of participating in financial markets, using blockchain technology to enforce property rights and settle financial contracts without the need for a trusted third party. Tracer’s Factory smart contract hosts an ecosystem of standardised financial contracts. The Tracer DAO can install proposed contract templates into the Factory, which can be accessed and deployed by anyone with a connection to the Internet. Once deployed, a contract is permissionless and not subject to DAO governance unless specified. A Reputation System allows users to identify financial risk and assess under-collateralised financial opportunities. Oracle financing is introduced as a novel model that incentivises the discovery and standardisation of new data for use in decentralised financial contracts. Tracer’s financial infrastructure stands to be the backbone of a secure, global financial network and provides strong foundations for future financial innovation.
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.
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.
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.
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.
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.
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.
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.
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.
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 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.
With Darcy WE Allen and Sinclair Davidson. American Institute for Economic Research, 2020
We are on the cusp of a dramatic wave of technological change – from blockchain to automated smart contracts, artificial intelligence and machine learning to advances in cryptography and digitisation, from Internet of Things to advanced communications technologies.
These are the new technologies of freedom. These tools present a historical unprecedented opportunity to recapture individual freedoms in the digital age – to expand individual rights, to protect property, to defend our privacy and personal data, to exercise our freedom of speech, and to develop new voluntary communities.
This book presents a call to arms. The liberty movement has spent too much time begging the state for its liberties back. We can now use new technologies to build the free institutions that are needed for human flourishing without state permission.