During the first half of 2018, my colleague at Portfolio.io, Bob Bogaert and I wrote a white paper. In it, we looked to explore how new cryptocurrencies could be engineered to tackle inflation and reach a mainstream user base. This article borrows several unpublished excerpts from that whitepaper. It’s a love/hate story about money, how it works in the present day, and how we would like it to work in the future.
Money as we know it
Economists attribute four core functions to money — a medium of exchange, a unit of account, a standard for deferred payments, and a store of value. And while some new digital currencies purport to enhance one, or even all of these core functions, none have made it their primary mission to solve money’s idleness —
If you have to save your money in a bank account solely in order to make purchases and fulfill ongoing financial obligations, you cannot simultaneously invest it elsewhere, which results in depreciation and opportunity cost. The larger your savings, and the longer they stay idle, the greater that cost is. Furthermore, when you transfer your money to another individual or business, transmitting this cost is unavoidable.
Ultimately, most of us accept — by lack of an alternative — that money can be either useful (chiefly as a medium of exchange,) or productive (as an investment,) but never both at the same time.
Central banks — as the authorities on monetary policy — would be well equipped to introduce the world’s first productive money. However, they cannot be seen as partial to private companies by buying up their bonds or stocks and using them to value their currencies. And while limited actions like this have occurred, such as the Fed’s purchase of mortgage-backed securities, or the Bank of Japan’s purchase of ETFs, these were temporary measures in times of financial crisis, and rightly regarded as interfering with the free market. This leaves the issuance of a truly productive currency up to multi-stakeholder, private institutions.
In simple terms, central banks work through a balance sheet mechanism in which assets balance liabilities. On this balance sheet, all money in circulation is represented on the liabilities side. On the assets side, central bank notes are backed in large part by debt — which is issued through bonds — owed by governments, private banks, and citizens — and expected to be repaid at maturity with low-interest rates. By lending inspiration from this system, while choosing to issue a digital currency over banknotes, and while also replacing unproductive assets (i.e., debt,) with productive ones (particularly low-cost index funds,) we have the opportunity to reach the theoretical limit of a productive currency.
Never ending cycle
For as long as we can remember, fiat money has been a never-ending cycle of lost value and lost opportunity:
- Individuals and businesses get paid in fiat;
- They hold their fiat instead of investing it;
- They use their fiat to settle transactions, and the cycle repeats.
Since all major currencies are subject to inflation, the money households receive and transact with has a built-in decay mechanism. If it is not invested, it does not retain its value. In fact, it is worth less and less with each passing month.
In 1925, US $300 could buy you a brand new Ford Model T, while for many people today, this would represent just a few days of living expenses. If that same $300 had been invested in the top 500 companies listed on the US stock market, by 2017 the investment would have returned over US $2mm.
While accessing the stock market has never been easier through applications such as Wealthfront, and Robinhood et al., users of such services must still incur delays between the realization of their income, and the moment that income can be invested. In aggregate, these delays — the time spent holding reserves of money for no other purpose than liquidity, equates to a significant opportunity cost.
A new vision
The following chart could be titled ‘Income = Investment’, or ‘Cash = Investment’, or even “Checking Accounts = Investment Portfolio’ — All would be accurate.
I believe in a future where income/cash/checking accounts etc. and investment are the same thing. I hold the view that when an employer or customer pays someone, that new income should automatically go to work for that person, not waste away like cash in a bank account. I also think that a new digital or virtual currency must afford its users the option of choosing their own underlying assets.
By combining the best aspects of distributed ledger technology (DLT), passive wealth management, and central banking practices, such a currency could revolutionise the way in which households transact with — and even configure — their own money.
If currency had looked like the above ‘future’ chart 40 years ago, my parents would be significantly better off, without having made any additional sacrifices.
The importance of sound economics
Notwithstanding their zero-sum nature and volatility, the main weakness of most cryptocurrencies is their economics. In the case of Bitcoin, the instruments of fair distribution are tradeability on exchanges and the permissionless ability to mine. But in the years since 2009, early adopters have seen lucrative rewards, while all others who follow must endure inflated exchange rates. Likewise, late-entry miners tend to see prohibitive fixed costs, leading to the centralization of mining operations and a potential latent security threat.
Cryptocurrencies which are not backed by an asset, cannot justify high prices. They will find themselves at an eventual impasse because if you exchange an asset of equal dollar value for these cryptocurrencies, you neither gain or lose any value. Only the denomination changes. The benefits you gain are solely associated with the cryptographic security and future speculation of the new asset, as opposed to any real-life productivity or value-add.
Most high market cap currencies considered blockchain 2.0 don’t fare much better than Bitcoin, yet for different reasons. At their inception, these currencies allocate tokens between founders, team members, and the investors. This is a fundamental mistake because no widely adopted currency in history has ever been subject to an immediate distribution to its issuers. Just imagine if 5 to 20% of all newly minted hundred dollar bills went directly to U.S. Treasury executives. This would be outrageous and widely protested, yet it is exactly what is happening in the course of most Initial Coin Sales (ICOs). Founders, Co-founders, and early team members for some of the highest-market-cap cryptocurrencies hold a significant percentage of the outstanding tokens.
Many investors consider the number of tokens held by its core development team as a positive variable for projecting trust in a particular project. This is a perverse incentive structure stemming from a failure to distinguish between the appropriate practices of issuing tokens and the more tried and proven environment of building startups in which a good chunk of equity held by the core team is correctly viewed as an appropriate alignment of incentives. While team members who are holding substantial amounts of coins are generally prohibited from selling off large amounts in the first few years of operations, most members eventually gain full rights to perform any market action they choose. This creates an inherent risk in which a cryptocurrency’s exchange rate depends on the actions or inactions of private individuals.
Crypto for more than speculative investment
Since writing the above excerpts, Bob and I have gone on to launch Portfolio.io, a platform giving new entrants to the cryptocurrency market (mostly Gen-Z and Millenial users) exactly what our research is telling us they want — a fun and easy social platform for building portfolios of cryptocurrencies, without the need for managing a wallet or dealing with complex exchanges.
To be clear, I would never argue that making speculative investments (like investing in crypto) is a bad thing! On the contrary, I believe that if you limit your total investments to 10% or less of your net wealth, investing in crypto will make life a little more exciting, and you may be substantially rewarded for taking such big risks.
That said, let us keep in mind that the technology powering cryptocurrencies and blockchains defintely has a higher calling.
To would-be developers of cryptocurrencies that aim to change the nature of money as we know it, and globalize the kind of personal financial empowerment we already enjoy in the developed world (or if you just want to make the act of holding savings and investment 10x more convenient than it already is), I implore you to do the following:
- Create a currency that is autonomously metered through smart contracts and publicize the data contained in those smart contracts through a tamperproof, online balance sheet.
- Look to build revenue through traditional models only (i.e., do not allocate any portion of your currency to team members or shareholders. Token sales are doable as long as you adhere to points1,2,4).
- Back all aggregate holdings of your currency, in equal measure, by underlying assets such as USD and index funds — The more productive and reliable those assets are, the better.
- Find a way to let users choose their own underlying assets.