Lior M. Messika
October 23, 2020

Money and Value: An Unstable Relationship

17 min read
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The dramatic emergence of decentralized finance (DeFi) in the past decade, and more recently in the past year, has raised serious concerns regarding the volatility of digital decentralized assets.
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This volatility threatens to undermine DeFi’s existing progress and block its further adoption and expansion. Therefore, focus is currently on the creation of a stable DeFi asset, based on floating rates, on which other decentralized financial tools can be built. Currently, all decentralized stable coins use fiat as a stable reference point. Even DeFi currencies that have indirect pegs to fiat rely on fiat’s stability. Examining our traditional centralized economic systems to understand how money derives its value and what gives this value stability is crucial for the success of these DeFi initiatives.

Currencies are simply representations of value; their own value is a function of the accuracy of this representation. Even floating currencies, such as the U.S. Dollar whose value is unpegged from any underlying asset, still represent underlying value. Rather than scarcity which underpins the value of gold, it is the perceived strength and stable growth of the Dollar economy that gives the dollar its value. In this article, we will explore the potential for DeFi assets to achieve the relative stability necessary to serve as industry-wide reference points of stable value. We address this question by analyzing how the evolution of fiat has culminated in free-floating currencies.

The Paradox of Money

Money is a representation of value and it is what allows us to standardize the exchange of value. However, this system is itself paradoxical. While value is subjective by definition, money must be objective in order to be useful. Value is always determined by the evaluator and it depends on external circumstances such as sentimentality and individual supply and demand. What is priceless to one may be worthless to another. Likewise, an object of great value today may lose its value tomorrow. Something is only ever worth what someone will pay for it. Money on the other hand is fungible and it is critical to our entire economic system that it has the exact same value (in buying power) to any individual. Thus, the paradox is in representing subjective and fluid value with objective and fixed money.

No perfect solution to this paradox is theoretically possible. Societies have therefore focused on continually shrinking the discrepancies between value and money. Successfully aligning the two depends on two concurring means. First, value must be optimally fixed and objectivized through market forces. Second, money must be stabilized to optimally represent that fixed value. This second approach requires a robust narrative on one hand and, on the other, proportionality between the amount of money and the value it represents.

Objectivizing Value

It is difficult to establish a close link between money and its value when that underlying value is fluctuating and poorly defined. The marketplace has always been our solution for addressing this challenge. The idea is that by exposing an asset to a wide array of participants and transactions, we can average out the price of exchange to effectively value an asset. It’s a natural process. The larger and more freely a market is allowed to operate the more accurately it will be able to define an asset’s objective value. In a free market, the value of an object becomes the average of the value assignment of all of the market participants.

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The impact of internet-based trading on the collectibles market in the late 90’s illustrates this value-stabilizing force. Prior to the internet, the value of collectibles was largely determined by supply and demand forces within regional markets; prices would fluctuate wildly depending on circumstantial supply factors. The internet unified all of these isolated markets, greatly stabilizing the value of collectibles by exposing the market to a much larger, unified body of participants.(1)

Cryptocurrency investors use this principle when valuing assets. The price of crypto assets with large liquidities are known to be more reliable since the asset’s value is determined by a wide spread of transactions. In contrast, assets with little liquidity can see dramatic price discrepancies between exchanges, making accurate valuation illusive. Accurately objectivizing underlying value however, is only half the challenge. A stable currency with which to represent that value is required for any form of advanced financial transactions.

The Keys to a Stable Currency

The trustworthiness and stability of money rests upon two pillars; without both, money’s value crumbles. A strong, universal narrative represents the first pillar. Direct proportionality to money’s underlying value is the second. Narrative convinces people to use the money. It ensures that many people are incentivised in maintaining its efficacy and value. Narrative incentivises investor confidence and stabilizes money’s value on ForEx markets. Proportionality ensures that the money supply never exceeds or lags behind its underlying value. If the money supply fails to meet economic demand, severe economic stagnation can occur. If the money supply exceeds its underlying value, the consequence can be hyperinflation. The history of failed currencies always features the collapse of one or both of these pillars.

Narrative

A strong currency narrative reflects collective trust in both the currency’s usability and stability. People must believe that the money is usable — that it will consistently be accepted in transactions of all kinds — and that its value will hold predictably steady. Accordingly, one of the ways that governments promote the use of fiat is through mandating its use for tax payments, further driving the usability narrative. The history of currencies also demonstrates that trustworthiness depends on a currency’s ability to maintain value in the face of economic fluctuations. The stability and usability of the U.S. dollar for example, is largely dependent on this type of narrative. Narratives become self-reinforcing. The more people that trust the narrative of a currency, the more they will use it and in turn, the more entrenched the narrative will become. In other words, the more people who are invested into a particular currency, the more incentive they will have to continue to recognize and uphold its value. The dollar’s strength is, in part, because of its use as a global reserve currency; its use as a global reserve currency is because of its strength.

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Proportionality

While narrative might support a currency’s value, simply maintaining a narrative is not enough to stabilize a currency. The currency must also have mechanisms for maintaining its proportionality relative to the amount of value it is representing, as well as the demand it is responding to. In other words, if there is an intimate relationship between money and underlying value, when the underlying value of the assets rises (or falls), the money supply must be adjusted as well.

We can imagine money and value as two parallel meters: the money meter and the value meter. The objective is to keep the level of these meters as equivalent as possible. As the value meter rises — the economy expands and strengthens — the money meter must also rise accordingly. If the supply doesn’t adjust to meet the rising value, the currency could experience deflation and economic stagnation could result: there would not be enough capital for adequate economic exchange of value. The reality is that the value of the currency MUST change. It will either change in terms of price or in terms of supply. If the supply fails to adjust, the price will fulfil the obligation, destroying any promise of stability.

In contrast to narrative which strengthens with more people, proportionality actually becomes more difficult to maintain as the pool of participants grows. This is because, as economies grow, it becomes more difficult to accurately objectivize their value. Without an objective value, identifying the proper supply of money is impossible. If the only commodity present in an economy was gold and wood, one could simply add the total sum of each asset’s value to generate the total value and manipulate the supply of money accordingly. But as economies grow more complex and direct value is continually further abstracted into advanced financial instruments, it becomes challenging to quantify this total value. While the narrative of the dollar has strengthened, the Fed has struggled to manipulate the dollar’s supply in line with its extremely convoluted underlying global value. (2)

Historical Perspective

The history of a global currency’s progression from precious metals to certificates of deposits and later to the dollar demonstrates the importance of a strong narrative and accurate proportionality. History shows that both monetary stability and instability are self-perpetuating. When confidence is shaken due to the collapse of one of money’s underlying pillars, the consequences tend to spiral.

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Precious metals like gold and silver were the first global currency. By the middle of the 2nd millenium B.C., gold was already used as an international trade standard. (3) The universal trust in gold’s value was based on its scarcity and the considerable efforts required to mine it. In other words, the price of an ounce of gold reflected the cost of extracting an ounce of gold from the earth. This scarcity drove the narrative of gold’s value and the consistent global use ensured its perpetual demand. Once adopted, this narrative became self-perpetuating and only strengthened further. The more that gold was used to represent wealth, the more individuals there were who relied on the propagation of this narrative. However, while the narrative of gold continued, the second element on which the stability of money rests steadily eroded. Gold was not proportional. This was not relevant to the lethargic economies of the pre-capitalist, pre-industrial world, where investment was not a presupposed factor. Economic value was not expanding quickly — rather, it was simply changing hands. Thus, the supply of gold did not have to increase rapidly to meet an expanding economy. This all changed during the economic explosion of the post-enlightenment period. As free market economics emerged and access to global trade expanded, the scarcity of gold began to hinder economic development. There simply wasn’t enough gold to keep up with the economic growth. (4)

Eventually, the complexity and size of economic transactions grew so large that Certificates of Deposits (CDs) were adopted to represent their equivalent value in gold. At first, CDs were produced by individual banks in return for gold deposits. This system was soon replaced by centralized national printing which offered greater standardization, stability, and control. This shift however merely reflected the increased trust in economic institutions issuing the CDs; it did not change the fundamental medium for representing value. (5)

The First World War represented the first time that many countries unpegged their currencies from the gold standard. The war was so costly that many countries simply ran out of gold and began printing more money to fund their war efforts. Predictably, this led to hyperinflation in the interwar period which drove those countries back to the safety of the gold standard. (6) Both gold and the unpegged fiat currencies in this example demonstrate the necessity of proportionality. Gold and CDs lacked enough proportionality to be able to support the explosive economic demands of a world war. Fiat proportionality imploded in the opposite direction, greatly outpacing the value it was meant to represent, leading to hyperinflation.

During World War II, Allied countries were forced to spend huge amounts of their gold reserves to procure arms and supplies from America. By 1944, the U.S. controlled three-quarters of the world’s gold reserves, effectively cornering the global gold market. Other countries suffered as they no longer had assets with which to back their fiat. This was solved by the Bretton Woods Agreement in 1944 which saw the US dollar replace gold as the official global reserve currency. (7) This meant that although the U.S. pledged to continue pegging the dollar to the value of gold, all other currencies would simply be pegged to the dollar. Instead of gold, countries would now maintain large reserves of dollars which could be sold on the ForEx market to manipulate supply.

The transition of the dollar away from the gold standard and to a floating exchange rate in 1973 happened subtly. (8) The narrative hardly changed. The dollar’s global narrative had already become at least as much a guarantee of the dollar’s value as the gold bullions being held in the vaults at Fort Knox. Thus, countries continued using the U.S. dollar as a reserve currency, regardless of its lack of underlying physical value. The U.S. dollar remains the most prominent global reserve currency to this day, with over 61% of global foreign bank reserves being held in dollars. (9) Just as in the case of gold, the dollar’s global use created a self promoting effect which bolsters and reinforces its stability. However, unlike gold, the dollar’s proportionality to economic value is fully flexible and controllable by U.S. financial institutions. The U.S. Fed adjusts the dollar’s supply by printing dollars or selling treasuries (along with many other supplementary tools) to maintain a reliable proportionality of the U.S. dollar to the value that it represents (the U.S. economy). This faculty of control is even harnessed to spur economic growth by purposely inflating the dollar’s value at a predictable rate, incentivising spending and investment. (10)

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Ultimately, the scarcity of gold undermined its stability in the tumultuous modern economic age. The U.S. dollar was able to so successfully replace gold, not only because of its strong narrative, but also because of the success of the U.S. economy and the proportionate and stable representation of that success in the form of currency.

Scarcity in Crypto Assets

When Bitcoin first emerged, many hoped that it would become the first stable, digital currency. Unfortunately, while Bitcoin has seen unprecedented success as a digital asset, neither it nor any other cryptocurrency has achieved the necessary stability to be used widely as a general currency. Historical lessons from the evolution of centralized currencies inform us that this was to be expected. In many ways, cryptocurrency is following the trajectory of centralized money. This parallel provides us with an important analytical tool for understanding the future of cryptocurrency.

Both gold and Bitcoin represent uniform, fungible value built on scarcity. Bitcoin’s underlying economic value is based on the cost of energy required to “mine” a block. The huge, global energy market ensured that the underlying value of Bitcoin remains relatively constant and provides equal opportunity for all to participate in the mining process. However, Bitcoin is plagued with volatility since it has neither an established narrative nor an ability to manipulate its proportionality in response to fluctuations in its underlying value. As time goes on, the Bitcoin narrative is strengthening, although the global belief in its usability is still negligible. This has resulted in continuing volatility for the asset.

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Digital CDs and representational currencies were eventually introduced to help make currencies more scalable. The Lighting Network is an excellent parallel to this evolution. The inefficiencies of the Bitcoin network have caused people to resort to transacting on side-chains while holding their balances in escrow. When the lightning channel is closed, the balances are totaled and credited to the proper main-chain accounts. (11)

If decentralized currencies follow the trajectory of centralized currencies, the next step is for the establishment of a stable floating currency. Currently, there are only decentralized “representational” currencies which maintain direct or indirect relationships to their underlying value. Tether is an example of a stable currency which has a direct relationship to the U.S. dollar. Dai is an example of a stable currency which has an indirect relationship to (once again…) the dollar. Only when decentralized assets gain enough stability to stand on their own two feet will they be able to join, or even replace, the dollar as a referenceable floating value.

For crypto assets, scarcity will not be enough to generate stable value. This holds true for any currency that has scarcity and narrative but lacks proper proportionality (Bitcoin, Ethereum, Monero, Litecoin, etc.). Crypto assets will need both narrative and proportionality to gain stability. From this perspective, it is our belief that Bitcoin has the highest chance of generating a successful narrative. Already, it is the oldest and most established cryptocurrency. Given more time and a longer history of value retention, it’s likely that global trust in Bitcoin will increase significantly. However, as with gold, scarcity will not be enough to create a large scale stable currency. Instead, even as the narrative strengthens, Bitcoin’s inflexible proportionality control will fail to sustain the increased economic growth. This comes down to a fundamental economic principle we discussed earlier: Narrative and proportionality are inversely affected by increasing numbers of currency users; narrative is strengthened, while proportionality is undermined.

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Ethereum (ETH) will likely follow the same trajectory as Bitcoin. While Ethereum does have more accurate proportionality than Bitcoin given its infinite (albeit un-manipulable) inflation rate, this will likely not be enough to keep up with a constantly fluctuating underlying economic value. The underlying value of Ethereum depends on the amount of DApps and ecosystem users. This number will rise and fall, reflecting natural economic trends and the presence of other competitive platforms. If Ethereum cannot adjust the proportionality factor in line with this economic movement, increasing or decreasing supply, then the price of Ethereum will be the fluctuating variable. This will preclude Ethereum from serving as a stable coin.

All of this does not mean that digitally-scarce tokens won’t be valuable. A strong narrative and scarcity is a powerful combination for establishing value. In many ways, cryptocurrencies boast a stronger value proposition than gold ever could. Algorithmic scarcity and decentralization make cryptocurrency’s value more predictable than physically-mined gold. In addition, the underlying cryptocurrency protocols build upon underlying economic value. For Proof of Stake currencies this underlying value is the total number of staked tokens. For Proof of Work currencies, like Bitcoin, this underlying value is the total hash rate. The assumption is that since more users equate to more underlying value, the price of the cryptocurrency will also increase accordingly. This tight relationship between underlying economic value and price will likely continue to contribute to a strong value narrative. A recent study from the University of Wisconsin, demonstrates that despite Bitcoin volatility, prices tend to stabilize around this fundamental “value,” supporting the concept that Bitcoin does in fact have intrinsic value. (12)

The Future

Not all is lost for DeFi assets. Decentralized assets with encoded proportionality may serve as digital stable coins, although they will not be totally disconnected from centralized assets. The MakerDao protocol for example, provides adequate stability through its collateralization and price stability algorithms. It adjusts the supply of the Dai token based on market forces in order to impact its price. A value-driven narrative also encourages arbitrage that helps to stabilize the price should it rise or fall too dramatically. However, MakerDao still depends on the U.S. Dollar for Dai’s ultimate stability, by guaranteeing that a borrower will only owe back the equivalent Dai that was originally borrowed (valued in USD). If the value of the collateralized asset (again valued in USD) drops too dramatically, the debt position must be collateralized in a sufficient amount of ETH to satisfy the drop in relation to USD. Even with MakerDao, the dollar provides a stable and trustworthy reference point. Dai is just one more step removed than Tether from its underlying value. This link to the dollar appears unavoidable, just as it is for currencies of developing countries. This raises questions regarding the actual degree of decentralization of assets such as Dai. If the dollar rose or fell dramatically in value, MakerDao would be forced to execute a global settlement (MakerDao’s version of a kill switch) or it would be forced to realign with a different stable currency. (13)

While still pegged to an underlying centralized asset, solutions that do not require centralized management of dollar deposits (such as MakerDao) still offer much more security and, theoretically, stability. Assets such as Tether, USDC, and TrueUSD that still require centralized vaults storing dollars provide no additional trust, security, or decentralization than institutionalized banks. Rather, despite the correlation to the dollar, solutions that can operate in a decentralized manner, independent from auditors or physical vaults are still less centralized and ultimately more trustworthy. In recent months, the rise of Defi has shed some light on the limitations of less centralized solutions such as Dai: reaching stability is difficult, and Dai’s current broken peg (and severe lack of supply) makes interacting with Defi protocols a lot less decentralized and independent of centralized forces — including the dollar. We hypothesize that “trial and error” and a degree of experimentation on live systems will help us refine the models that should maintain stability in the face of adversarial environments (Black Thursday a great example of an adversarial environment). A few examples of live experimentation in Maker’s incentives include driving Dai’s stability fee to 0%, as well as an imminent vote on proposals to reduce USDC-Dai collateral requirements quite substantially.

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DeFi assets may, potentially, continue to follow the trajectory of the dollar. For this to happen, the narrative around DeFi tokens’ stability and usability must become strong enough to enable them to unpeg from their underlying value. Paralleling the dollar, this would require DeFi assets and markets to generate enormous global demand. It would also require that they have strong proportionality controls in place.

Stable Coins: A DeFi Unicorn

As we’ve discussed, scarcity alone is insufficient for stabilizing the value of either traditional or decentralized currencies. Even given a strong narrative of stability and usability, mechanisms for maintaining proportionality in the face of supply and demand fluctuations are indispensable. The current attempts at stable crypto-assets compromise on decentralization by using the dollar as a reliable reference point. Even currencies with strong narratives that successfully hold and maintain value such as Bitcoin, Ethereum, and Monero will likely never serve as stable currencies due to their lack of proportionality control mechanisms.

In the industry today, this challenge has become a practical constraint on the development of a truly decentralized stable coin. This is not necessarily a theoretical constraint; it merely reflects the limitations of existing projects. The challenges overcome by centralized currencies on their path to floating rates can help guide DeFi towards the eventual establishment of a truly decentralized, stable currency. Eden Block will continue to support gradual decentralization of economic frameworks, including a stable currency that will enable fully decentralized financial ecosystems.

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https://arxiv.org/pdf/1805.07610.pdf

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