by Lior Messika
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.
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.
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.
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 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.
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.
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)