News of Bitcoin and Ethereum is everywhere these days. The two cryptocurrencies have had returns over the past year that make a big-time hedge fund manager look like he’s running a lemonade stand in front of his parents house.
Since last year, Bitcoin is up (at the time of this writing) 390.55 percent and Ethereum’s currency, Ether, is up a mind-blowing 1,896.13 percent.
New money is pouring into the cryptocurrency space, with one investment fund announcing a raise of $400 million dollars. Though talk of the inevitable Tulip mania and Internet 1.0 bubble burst abounds (and has for years), it does not feel a burst is likely anytime soon. (Note: not investment advice.) And that is actually kind of a problem.
If you go back to the Bitcoin whitepaper (everyone should read it, it’s fairly consumable), the title is very clear about its intent: “A Peer-to-Peer Electronic Cash System.”
Bitcoin, Ether and a host of other currencies are faced with hourly and daily price volatility (in relation to the US dollar). It is not uncommon to see drops of $50-$100 in Bitcoin and $30-$50 in Ether in a day, even if the overall trend line is up. On multiple occasions, we have seen drops of 10 and 20 percent in one day.
What this means in practice (and I know from firsthand experience) is that the earrings I bought for my wife with Bitcoin that cost $13 at the time of purchase were worth $16 a few hours later and today are the equivalent of $28. My wife is worth it, of course, but such volatility can wreak havoc on people. Even more so on companies, which desire stability for financial planning purposes.
The Bitcoin believer’s mantra of “HODL” or “Hold On For Dear Life” is precisely the opposite of what you want in a system designed to encourage people to treat digital currency like cash.
The need for crypto-stability
True believers in blockchain and decentralization recognize that these new technologies and monetary systems will never achieve mass mainstream adoption with these kinds of violent swings.
Ethereum’s creator, Vitalik Buterin, identified this challenge back in November, 2014 in his post “The Search for a Stable Cryptocurrency.” It’s a very long and complex read (as are many of his writings), but he ends it with a fairly prescient prediction:
“There would then be multiple separate classes of cryptoassets: stable assets for trading, speculative assets for investment, and Bitcoin itself may well serve as a unique Schelling point for a universal fallback asset, similar to the current and historical functioning of gold.”
The groundwork for this environment is being laid right now, as the number of new crypto-tokens continues to grow into the thousands. The second part, however, the “universal fallback asset” has not materialized fully. The SchellingCoin is the search for the stability.
Many of the advanced financial instruments that Wall Street uses and that are familiar to many of us through the 2008 housing crisis and the book/movie The Big Short have achieved some degree of notoriety. Still, we don’t want to throw the baby out with the proverbial bathwater.
Vitalik further wrote that “One of the main applications of Ethereum that people have been interested in is financial contracts and derivatives … [and] the underlying concept in fact has a number of legitimate uses, some of which actually help people protect themselves against the volatility of financial markets.”
A new crop of startups is emerging to do just that with “smart contracts.”
Smart contracts: The foundation of stability
In simplified terms, the smart contract takes the “if/then” statements that form the basis of legal and business rules and puts them into computer code. Then, with the security of the blockchain behind it, the contract is executed automatically without any human interference or risk of tampering.
Ethereum was built to support smart contracts in a way that Bitcoin was not (though a recent release by Rootstock is seeking to make it easier to run smart contracts on the Bitcoin blockchain). This fact explains why almost every new crypto-token being issued today happens in the ERC20 format, which is designed specifically for the Ethereum blockchain. It may also be a core driver of the huge Ethereum price run-up.
By relying on smart contracts, in theory, we have the ability to remove centralized systems (like banks), which introduce risk and lack transparency, and lower fees significantly. Venture capitalist and thought leader Vinay Gupta highlights that smart contracts can reduce “the 7 percent margins taken by all manner of middlemen to a more realistic 0.07 percent margin.”
If you can reduce the cost of executing contracts by 99 percent AND do it with increased confidence that the assets are not going to be highly volatile, that would be fairly appealing to an extremely large number of people.
The goal of each of these smart-contract-driven projects is to bring some degree of financial stability to the crypto-asset market.
Maker, MKR, and SAI: Stability through programmatic collateral
The first effort I’ve come across of a crypto-native solution to volatility came from an organization called MakerDAO. In its original white paper, it introduced a very complex concept known as a DAI, that would derive its value (and stability) from a simple centralized collateral custodian model.
However, in a sign of how quickly things change in this industry, MakerDAO has already abandoned that pursuit because, in the company’s own words, “an individual custodian takes on some level of risk, and no one enthusiastically stepped up to take this risk on.”
[Correction 6/20/2017: According to a Maker spokesperson, “We have not abandoned Dai but rather decided to release an alpha version — Sai — in order to gather crucial data before releasing Dai into the wild.]
But don’t confuse the company’s change in focus as a lack of intellectual rigor. On the contrary, there is some heavy thinking in its latest effort, known as a SAI (or Simple DAI). A SAI is designed to be the stable coin that people need to make long-term investments. It is backed by collateral (at this time, only Ether, aka ETH) through a mechanism known as a collaterized debt position (CDP). The total number of SAI available is limited by a debt ceiling, and SAIs are created and destroyed (through the power of smart contracts) as people open and close their positions.
A SAI does its accounting in US dollars, a peg of 1:1, that is based on an “oracle” that automatically pulls its information from trusted resources. (How you know those sources are trusted is a different topic that I’ll leave aside for now). There is no guarantee that the peg will stay at this level. However, the designers believe that the fact a SAI is basically “backed” by ETH means an efficient market will form around this price point.
The ETH itself is not the direct collateral in this system. Instead, all of the ETH are kept in a global pool for liquidity that creates the system’s collateral token, called SKR (Simple MKR). You need SKR to open a CDP.
You get SKR (which ultimately represent a proportional claim on all of the Ether in the system) by depositing Ether into the central pool. The SKR tokens you get in return are created at a rate that maintains the ETH:SKR ratio. Here’s a short example from the company’s whitepaper.
There are 345 ETH in the system
There are 678 outstanding SKR
The ETH:SKR price is 345/678 = 0.5088
Bob deposits 100 ETH
Bob receives 100 / 0.5088 = 196.54 SKR
Now there are 445 ETH in the system
There are 874.54 SKR
The ETH:SKR price is 445/874.54 = 0.5088
In other words, you
- put Ether into the global liquidity pool
- You get SKRs
- You use the SKR to create a collateralized debt position (CDP)
- You get SAI tokens
The “magic,” if you will, is in how the underlying smart contracts enforce the relationship between total Ether, total SKR, the components of the collateralized debt position, and the SAI token to try and keep everything in balance.
Confused? Don’t feel bad. It’s confusing. Even more so, as Andy Milenius (the white paper’s author) writes, “the value of ETH could fall so far that there isn’t enough value to back the outstanding SAI, forcing the SAI holders to take a haircut as well.”
What’s important here isn’t necessarily how this whole system works, what’s important is that this is one of the first serious efforts to address volatility in the crypto-market.
DCorp and DRP: Stability through decentralized derivatives exchange
Understanding what DCorp is trying to do may take a bit less effort, but it’s an equally bold vision. [Disclosure: DCorp is a client of mine.]
Let’s put the DCorp opportunity in context first. Last year, the world’s largest derivatives exchange, Chicago Mercantile Exchange & Chicago Board of Trade (described by The Economist as “The biggest financial exchange you have never heard of”) created 3 billion contracts, all done via centralized systems, and pulled in revenues of $3.5 billion and profits of $1.5 billion. DCorp’s goal is to create a more transparent, more secure, and more open exchange, all while distributing the profit to its “shareholders,” i.e. those who own a DRP token.
How, specifically, will DCorp bring less volatility to derivatives and crypto-assets in particular? In a few ways. Its smart contracts will allow people to:
- Apply risk management strategies in order to limit potential losses to an asset’s option price or the spread between the bid and ask with multi-asset derivatives.
- Reduce volatility by locking assets into derivatives contracts, making them unavailable for panic sell.
- Enable futures with ascending stakes. For example, participants who use leverage to buy futures while speculating the decline of an asset’s value will need to keep contracts valid by buying the asset over time while the price is declining. In doing so, the participant reduces volatility by buying while others are selling.
Furthermore, in a significant departure from how the CME operates (or any other exchange, for that matter), the governance of the decentralized exchange is open and transparent as well.
As a DRP token holder, an individual not only gets a share of the profits that accrue from the trades that occur on the network, they have the opportunity to vote on how the business itself evolves.
Anyone can submit a governance or funding proposal, but these proposals require shareholder approval to be implemented. In order to eliminate spam, submitting a proposal will require a payment in Ether.
It’s a message that seems to have some resonance. DCorp has so far pulled in over $2.2 million in its crowdsale.
DCorp may or may not be the ultimate winner in this market, but someone is going to figure out how to decentralize and reduce volatility in this massive industry. The token holders of that protocol are going to be pretty happy.
Bancor and BNT: Stability through liquidity
Though the number of cryptocurrencies has exploded recently, the Bancor team believes there are not enough of them yet. They foresee a future where anyone or any organization can create their own digital currency. And they just pulled in almost $150 million in the first day of their crowdsale, June 13, breaking all previous token crowdsale records.
Let’s take an offline example and bring it back to the online world.
Say you belong to a church, synagogue, or mosque, and the organization offers coupons or gift certificates for doing business with other members of the group or, perhaps, local merchants.
The goal of this type of initiative is to build a reinforcing circular economy that enriches and empowers its members. In theory it’s great, but in practice it’s tough to get off the ground. The reason is liquidity. You end up with a lot of coupons and certificates, but you cannot redeem them for all of the things you need, so at a certain point, the economy hits a limit.
It’s great to support the cause, but you won’t keep doing it at the expense of feeding your family.
Now, let’s look at the same example viewed through the lens of Bancor. The same church, synagogue, or mosque decides to create a “OneGodToken” (OGT for short).
If you agree to accept one of the OGTs, you need to be confident you can actually use it for something you need.
What Bancor, which issues the Bancor Network Token (BNT), provides is a smart contract that allows the creator of the OGT to establish a constant OGT-BNT rate that is backed by a pool of Ethereum as well. This functionality is delivered via a “token share” mechanism.
How it all works is the subject of a multi-page white paper and is based on the established Constant Reserve Rate (‘CRR’), but what it means is you can happily take OGTs from your fellow congregants for your services with the full confidence that, at any time, you can trade out the OGTs for BNT. Having that BNT is the liquidity security you need, because the BNT, which backs a large number of other crypto-economies, can then be transferred to another asset or back into ETH, if you so desire. They call this entire capability a “token changer.”
A visit to any of the crypto-exchanges out there like Bittrex highlights the need for something like BNT. There are a ton of tokens that have been issued. However, since a traditional exchange requires a “coincidence of wants” (two people who want opposite things — buy/sell — at the same time) or a centralized market maker to keep liquidity, many of them are just sitting there, with the owners of the assets unable to sell and buyers not always able to buy.
The Bancor Protocol essentially does away with this by making a smart contract the automated market-maker of this “long tail” of crypto-tokens. By building a guarantee of liquidity into the token creation itself, Bancor’s belief is that BNT enables an explosion of financial innovation from tokens with huge network effects all the way down to the individual level.
Like the rest of the examples here, this is a really new concept, but when you think about it (and read the company’s material a few times), you see that it’s actually very powerful.
Having BNT as the de facto exchange token for all of these micro-economies (what they call “Token Networks”) creates a network effect, the potential upside for BNT token holders.
Conclusion: It’s the beginning either way
In 20 years time, we may look back at each of these examples and laugh at them for their simplicity. They could be the Boo.com of this era. Or they could have real staying power. No one knows.
What we do know is that in order for the decentralized, crypto-based economy to take off, we will need a next wave of financial tools and technologies. They will build on the initial, simplified use cases of “digital cash” to help create greater stability and less volatility. When that happens, we will see even more people and organizations have the confidence to move their activities to cryptocurrencies.
[Disclosure: I own some Bitcoin and Ethereum. I also have (or plan to acquire) nominal amounts of SAI, MKR, DRP, and BNT — mostly so I can better understand how these things work.]
Jeremy Epstein is CEO of Never Stop Marketing and currently works with startups in the blockchain and decentralization space, including OB1/OpenBazaar, Internet of People, and Storj. He advises F2000 organizations on the implications of blockchain technology. Previously, he was VP of marketing at Sprinklr from Series A to “unicorn” status.