Smart Contracts: Killer Enabler for Stable Value

Piers writes that stable-value cryptocurrencies are necessary for smart contracts to take off. I’d like to stake out the reverse claim: that smart contracts are necessary for stable-value crypticurrencies to take off.

Background on the Stablecoin Problem

I’ve argued in the past that fractional reserve banking is an essential part of a stable currency, and specifically that it’ll be a necessary part of any stablecoin.

The basic argument is this:

1. the value of a currency is determined by the conjunction of the supply of that currency, and the demand for it – just like any other good.
2. Money needs to be relatively stable in value, for cognitive reasons, or else it’s not much of an improvement over barter.
3. Because today’s demand depends on expectations of its price tomorrow, a currency won’t be stable unless people expect it to be stable. And people won’t expect it to be stable unless there’s a reason to think it will be.
4. An explicit redemption commitment – a pegged currency – is one way to do this. An agency that promises to buy or sell any quantity of its currency at some fixed price. This has the effect of adjusting supply to demand, which is ultimately what we’re after.
5. Unfortunately, even if you can adjust the supply to demand, you still get a lot of bumps and hiccups unless those adjustments go through a banking system, which distributes the changes in such a way as to minimize price changes.
6. A banking system actually solves the distribution problem and the supply problem in one stroke, because the bank can issue liabilities that are almost-perfect substitutes for cash. The quantity of liabilities it can issue is limited by demand, and adjusts to demand.

Leverage is the Solution

In Cryptocurrency and the Problem of Intermediation, I argued along these lines that cryptocurrencies will need fractional reserve banks in order to become stable. However, the important thing is not fractional-reserve banking in itself, but rather a leveraged money supply.

Leverage – or “pyramiding” – is when some entity issues a quantity of assets “backed” by a smaller value of assets. Fractional reserve banking (FRB) obviously qualifies: a bank can issue $200 of IOUs even if it only has $10, which gives it a reserve ratio of 5% – or, equivalently, a leverage ratio of 20:1. It can do this as long as it’s confident that all the holders of its IOUs won’t all demand repayment at once. It’s in banks’ interest not to be too risky here. Even so, reserve ratios are regularly below 2% – meaning people aren’t demanding redemption very often.

Why would people just keep IOUs out forever? Well, in most cases those IOUs are just as good as cash. They substitute for cash. And because the bank can issue as many IOUs as people are willing to hold indefinitely, this ends up stabilizing the value of the currency.

There are lots of other ways to get leverage. Swaps, derivatives, options, even insurance – in fact, most financial assets are levered in some way or another. but the important thing about FRB is that the levered asset (bank deposits) and the base asset (cash) are nearly perfect substitutes. This is why FRB is a solution to both problems 4 and 5 from the previous section. You can’t spend a credit default swap at Wal Mart, so it doesn’t count as part of the money supply. But you can spend your bank deposit if you have a debit card.

Smart Contracts as Leverage

Crypto-FRB faces a big technical problem, though: any asset pyramided on top of, say, Bitcoin, will not itself be a Bitcoin. You’d have to use something other than the Bitcoin software to trade it. And most disturbingly, you’d have to trust the issuer. Well, why use Bitcoins at all then? The prospects of making a bitcoin IOU just as acceptable as a bitcoin looked remote.

So what about smart contracts? Smart contracts are extremely flexible – especially in an environment like Ethereum – but they can be thought of as varieties of promises to coin. An IOU. A liability. Most importantly, they can be traded on the block chain – a huge hurdle crossed.

Based on the history of banking, the end-goal will be to have smart contracts – promises to coin – become a near-perfect substitute for coin. the Here’s how I see the process happening:

1. A contingent smart contract is settled upon as a convention. Standardization – here as with any money – helps it become more widely accepted.
2. People begin to send the contracts as payment alongside or instead of money, possibly accompanied by an interface change in the client to make it easier to reckon total balances side by side.
3. Once the demand for money can be in large part satisfied by the issue of smart contracts, there’s your stablecoin – and no adjustment to the quantity of coin needed!
4. Prices begin to be quoted in terms of coin – it finally becomes a unit of account even as its use as a medium of exchange is mostly displaced by smart contracts.

At this point, cryptocurrency will be truly ready to support a modern economy without leaning on existing national currencies. So long as contract issuers can compete with one another, the supply of (broad) money adjusts to the demand for money, which is now inclusive of the contracts, meaning its value bounces around a lot less. And because people now have a reason to expect stability, speculation can be marshaled as another stabilizing force.

Whatever the particular features of the standard bank-liability contract, it’ll have to be a contingent promise. An ironclad protection against default (like the contracts that hold coins in escrow) will prevent any leverage at all. This does imply some trust in the issuer. Banks can and do fail. Still, most people eventually found it in their interest to trust banks with their cash, which (I hope) bodes well for the prospects of trustworthy contract-issuers. There’s always coin for those who don’t trust the issuer, just as there’s always cash for those who don’t trust the banks.

So who are the issuers? It’s hard to say. Maybe well-known and well-capitalized entities are the only trustworthy issuers, who then turn around and make loans. On the other hand, it’s possible that blockchain technology – especially given public ledgers – makes it possible to directly issue debt, like corporate bonds, rather than going to the bank for a loan. In this case there can be innumerable small issuers.¹

In either case – to reverse Piers’ conclusion – “It is these smart contracts that are fundamentally critical to the wider prospects of value stability; removing value uncertainty, and radically broadening the real world applicability of crypto currencies in general.”

Footnotes

1. I myself am skeptical that contracts issued by individuals could circulate as money; they’d be too heterogeneous and too difficult to trust, and even corporate bonds don’t circulate as money.