Crypto-not-Currencies
Crypto natives refer to Bitcoin as “sound money,” and Ethereum supporters take it a step further and call Ethereum “ultrasound money” … 1 2
… except neither of them is really “money.”
And that’s okay.
In economics, an asset that can serve as a medium of exchange, unit of account, and a store of value is bestowed with the label of “money.” You can buy a banana and pay a plumber in your country’s version of money - which we call “currency” - in a very straightforward way, because the prices of those goods and services are denominated in that currency to begin with, and because the people you’re transacting with agree that it has value.
We agree that a currency has value, because we can only pay our taxes in that currency. Since a large proportion of the population is liable to pay taxes, this ensures a base level of demand for that currency. This is true even in high-inflation countries like Turkey and Argentina.
General consent as a medium of exchange is a key property that an asset needs to have in order for it to have money-like characteristics. In other words, the asset needs to benefit from network effects. The asset has value because other people agree that it has value. Otherwise, your $100 bill isn’t even worth the paper that it’s printed on.
Inflation reduces the value of money in terms of its purchasing power. High inflation, then, erodes the integrity of the store of value function that money is supposed to provide, which generally prompts people to look for other assets - like real estate, gold, equities, and crypto currencies - to store wealth.
In fact, we would argue that BTC and ETH, by competing with each other to see who can be the “hardest money” (read: most deflationary asset), are actually making their assets less, not more, useful as a conventional currency. Scarcity may be a desirable characteristic for something that acts as a store of value, but not for something that needs to act as a medium of exchange.
A brief side note may be needed to explain why a little inflation might actually be desirable, since, after all, most people believe that inflation is bad. At the very least, a bit of inflation in the volume of the currency allows prices to potentially remain constant (or at least moderately stable) as money supply increases in line with real output. If the volume of goods and services is growing, but the supply of the cryptocurrency remains the same, then the entire ecosystem becomes deflationary.3
But forget what the economists say for a second (we don’t always have to listen to them) and just use common sense. You can’t pay for your morning coffee with SOL, simply because the majority of the world doesn’t know - let alone understand why - it exists yet. To verify this point, try and explain what a blockchain is to your grandmother.
All of that, however, is largely semantic. BTC and ETH may not be money, but that doesn’t necessarily detract from their value as assets. After all, prime Manhattan property doesn’t need to be money-like in order for it to be deemed valuable by the general population.
So, to label “cryptocurrencies” like BTC, ETH, SOL, and AVAX more appropriately, we will call them “crypto assets.”4
Cash
In TradFi and in everyday life, we settle transactions using “cash.” Sounds straightforward enough, but dig a little deeper and think about what “cash” actually is. As an exercise, let’s say you’re about to engage in a US $1 million transaction to purchase an asset. Select the applicable means of settlement:
[1] 10,000x $100 bills;
[2] Reserve balances held at the Federal Reserve;
[3] USD deposit held at Bank of America;
[4] USD deposit held offshore at AkBank in Istanbul;
[5] US Treasury Bills with 2 weeks left to maturity;
[6] US Treasury Coupon Notes with 11.5 months left to maturity;
[7] Prime Money Market Fund shares held with Fidelity;
[8] 3-month USD commercial paper issued by a Chinese real estate firm (no, it doesn’t have to be EverGrande);
[9] USD Coin stablecoin (USDC) on the Ethereum blockchain;
[10] Terra stablecoin (UST) on the Terra blockchain.
The 10 choices above can all be considered as “cash” - but to varying degrees. It should be obvious now that not all forms of cash are created equal; some are more “cash-like” than others. The ones that yield more tend to carry more risk, and all exist along a spectrum of different duration, credit, and smart contract exposures.
However, the question above is lacking a very important piece of information. It didn’t specify who “you” are. For example, unless you’re a Fed-regulated depository institution, you wouldn’t have access to a reserve account at the Fed, which you need in order to possess any of [2]. Neither did it specify what asset you’re trying to buy, and where you’re trying to buy it. Is it an on-chain asset? If so, which chain?
Stablecoins
If you’re trying to buy ETH on Uniswap, only [9] would work.5 Given USDC’s peg to the US Dollar, the price you pay for it is pretty much the price quoted in USD.
This example neatly illustrates why stablecoins emerged in the first place. As digital assets proliferated, the ecosystem needed a unit of account and a medium of exchange to transact in these assets. By and large, the ecosystem chose the US Dollar to serve these functions. Through their pegs to the US Dollar, stablecoins are simply on-chain USD cash assets that can be more easily off-ramped to the fiat world.6
Economists might call this the fulfillment of the “transactional demand” for cash.
Essentially, what this means is that stablecoins are nothing fundamentally new - they’re merely an extension of currently existing financial technology that makes it easier for people to hold or use US Dollar-denominated assets on a blockchain (i.e. cash assets in an on-chain format). They’re a new form of private money, not unlike the proliferation of private money issued by individual banks during the “free banking era” in the United States during the mid-19th century.7
Furthermore, the money-ness of any given money-like asset might change depending on market conditions. Using the example above, unless we’re at the very peak of a liquidity-driven bull market, it’s unlikely that anyone would accept [8] - the commercial paper issued by a Chinese real estate firm - as a means of payment. Yet, stablecoin issuers can - and perhaps do - classify them as “cash reserves” or “cash and cash equivalents,” in turn claiming that they are “fully reserved.”
Precision matters when it comes to terms like “money,” “cash,” “reserves,” and “stable.” These terms are used too loosely far too often. They conjure notions of simplicity and inertness that mask the complexities underneath.
Stablecoins are stable only on the surface, and only most of the time. Pegging mechanisms suppress the natural volatility of asset prices, and almost by definition require resources or value to actively fight entropy. In finance and in capitalism in general, value inevitably comes with risk.
Our views aren’t pegged to any position - we’re solely committed to mechanical accuracy and soundness. With this publication, we hope to contribute to and inspire a more open exploration of this grey area between stability and volatility.
Bitcoin (BTC) proponents frequently refer to BTC as “sound money” in the tradition of Austrian economics. Something is “sound money” if it is not liable to significant decreases in purchasing power resulting from human intervention (e.g., money printing). Gold is typically held as the canonical example of sound money.
See: Sound Money | Pantera (panteracapital.com) for more information about the use of the term “sound money” regarding crypto assets.
In response to BTC proponents referring to their preferred crypto asset as “sound money,” Ethereum (ETH) proponents began to refer to ETH as “ultrasound money.” Specifically, ETH became “ultrasound money” after the implementation of Ethereum Improvement Proposal (EIP) 1559, when it was decided that all base fees (which are different from incentive or priority fees) paid on the Ethereum blockchain in ETH (“gas fees”) would be burned rather than distributed to miners as a reward. This change made ETH an outright deflationary asset with negative supply growth, as ETH burned from gas fees now exceeds new issuance.
See: EIP-1559: Fee market change for ETH 1.0 chain (ethereum.org) for more information.
For example, this was a problem during the late 19th century in the United States when economic growth was not accompanied by an increase in the money supply (because the US was on the gold standard), putting downward pressure on prices. The result was deflation and rising real debt burdens.
There is an inherent conflict between the creditors and debtors of any currency (or between those who hold an asset and those who do not). Deflation will always benefit the creditors of a currency (holders of an asset) at the expense of those who do not have it, and will incentivize holding as opposed to using. Inflation will always benefit the debtors of a currency (non-holders of an asset) at the expense of those who do have it, and will incentivize using as opposed to holding.
Neither outcome is good in the extreme, the key is to strike an appropriate balance between the two. Indeed, before the Federal Reserve’s current dual mandate of managing inflation and unemployment, they were tasked with “furnishing an elastic currency.” This meant increasing the supply of money when it was tight and restricting the supply of money when it was abundant. Most of the time, the optimal balance tends to lean slightly more towards inflation than deflation, because we typically assume that real output will grow over time and we want to ensure that our medium of exchange grows at least in line with real output - otherwise its scarcity may become a hindrance in conducting economic transactions.
Ethereum (ETH), Solana (SOL), and Avalanche (AVAX) are all competing “layer 1” blockchains. Each requires their own native asset (ETH, SOL, or AVAX) to pay “gas fees” to utilize the network to conduct any transactions.
See: What Is Layer 1 in Blockchain? | Binance Academy for more information about what a “layer 1” blockchain is.
Uniswap is one of the largest decentralized exchanges (DEXs) on the Ethereum blockchain. DEXs are exchanges, similar to regular centralized exchanges (CEXs), but DEXs use specialized programs called “automated market makers” (AMMs) to provide trading liquidity. Uniswap is also one of the oldest DeFi protocols, having launched in November 2018.
See: What is a DEX? | Coinbase, What is Uniswap? | Coinbase, and What Is an Automated Market Maker (AMM)? | Binance Academy for more information.
See: Stablecoins | ethereum.org and What is a stablecoin? | Coinbase for more information about the basics of stablecoins. See: A Classification Framework for Stablecoin Designs | Avalabs for a more comprehensive treatment of the topic.
We will cover this in more detail and depth in the next issue of Unpegged.
Guys,
sorry to steal the wind out of your sails, but I would’ve expected your first post to be about the quite lofty ‘manifesto’ (https://unpegged.substack.com/p/coming-soon?s=r), namely that: “It is our strong conviction that stablecoins and cryptocurrencies will have an indispensable part to play in the future of financial intermediation, holding significant promise in improving the traditional financial system.”
Even as a layman I would have doubts about such a stance, given that the crypto-space is up and running for a good decade and it hasn’t crowded out virtually anything in TradFi. So what exactly is your “strong conviction” based on? How would you address, for example, the assertions of @smdiehl (https://www.stephendiehl.com/blog/against-crypto.html)?
Now on to this, your first post. Just a few critical thoughts:
1. There are other reasons why a currency has value, besides taxation. For example, the fact that legislation requires (not necessarily in the US) that pricing for certain transactions happen in the national currency. For example, that there are institutional guarantees to ensure a relatively low volatility in the value (the purchasing power) of the currency. For example, that the rulebook for this environment is reasonably stable over time and cannot be easily amended at the whim of someone (read: politician). For example, that processes (from decision-making to money issuance and many others) are transparent and decision-makers can be held accountable. – I fail to see any of this in crypto. In fact, what I see is that most of these things were never desired in the crypto-sphere and, therefore, were excluded by design.
2. Later on you write that “The asset has value because other people agree that it has value. Otherwise, your $100 bill isn’t even worth the paper that it’s printed on.” – Well, not really. Partially, maybe. The 1 dollar bill isn’t worth 1 dollar only because people believe in it. It’s because it is well enforced that it is so (see my point 1 above) and there are many indirect reasons, as well (the quality of US financial markets, i.e. how active, liquid, competitive they are; quality of market oversight and legal settlement mechanisms; foreign trade and other balance of payments transactions; US diplomatic prowess and military might; historical reasons; etc.). A dollar is a dollar because all of this, too. People’s belief in it is but one factor.
3. While the FED usually refrains from using the term, only number [1] from your list would unequivocally qualify as “cash”. Cash usually means physical money, i.e. coins and notes. All the rest is not cash. Anything beyond number [5] wouldn’t even be in the monetary aggregates of the FED.
4. Private money doesn’t really exist. Even if it (or should I rather say “they”?) would, in a large and highly complex economy it could never become prevalent. The fact that money works as well as it does today (which is not to say that it’s perfect), is because the state is up to its elbows in it. If you remove the state (which is one of the central tenets of all things crypto) it won’t work. If you believe that somehow the AI or the technical solution behind a certain crypto asset or the blockchain will substitute the myriad functions of the state in the financial system, you’re chasing a mirage. If you think that we haven’t had this before (i.e. private money), you don’t know economic history.
Need I say more?