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Trust and Liquidity

In my last post I seemed to be criticizing some new 2.0 platforms like Ripple when I said that liquidity is not necessarily the answer. That's a bit ironic since, among other things, I'm working on a Ripple gateway as we speak.

Liquidity may not be "the answer," but it can be an important answer in certain contexts. Because "store of value" is such an important feature for a currency, we need trust that the currency will retain its value. As we noted, the primary way of getting at this is via a market. To a certain degree, the larger and more liquid the market, the less we have to trust in the value. However, even with a small but liquid market we have the ability to easily and quickly get in and out.

One problem is that in a small market liquidity increases volatility. That's not really an issue for a startup. A startup issues stock, the valuation is unknown and very volatile. Most startups fail and go to zero. A couple go to the moon. Once they go to the moon (i.e. they IPO), the relative value of their stock tends to stabilize.

The typical governmental way of erecting these walls is to only allow intimately knowledgeable and/or wealthy people to invest in startups in the early stage, while opening it up once things have stabilized. This is ostensibly a consumer protection device, since there are very many fraudulent money making schemes (e.g. Ponzis) that sometimes require careful research to figure out.

If you have a captive audience (e.g. you run a country), you have the option of doing things like running centralized exchanges and pegging your currency to some thing else, like the price of some other currency or, more classically, a scarce commodity. That's a different type of trust proposition, often one that stands on the basis of a status quo or long standing political organizations. These can establish a certain degree of trust, but this is usually the product of a long and costly process of evolution (i.e. wars and constitutional convention).

The interesting thing about the Bitcon blockchain is that it ostensibly allows things to be trustless. That's sort of true in that there is no person or organization you have to trust. But that's primarily true because of the static nature of the protocol. You have trust that nothing will change. But, even if that mirrors precious metals and commodities, that's rarely what you want at an institutional level.

To re-iterate Satoshi's great thought experiment, what if in a laboratory they created a scarce dull grey metal that had no use value but could be transported instantly across the globe. That clearly has some utility. It could be traded easily and used as a unit of account.

But what if at the same laboratory a year later someone created a dull pink metal that had the same properties but actually looked pretty. The presumed scarcity of the first invention is actually not quite the quality that you originally thought it was, insofar as anyone can create their own "scarce" colored metal. This also means that the utility of the first metal, as determined by the market, may be progressively marginalized.

So where is your trust? Is it in the "value" of the underlying metal? There is none. Is it in the presumed scarcity? This is only partially true. Is it in its value as a transportation mechanism? This is also not unique. Is it because people expect that the value will rise? Well what if they suddenly stop?

As I've explained in my article, "John Law gambles with Bitcoin" (BTC Magazine, Issue 16), the closest historical analogue for dynamics in cryptocurrency is the birth of the stock markets. Although there is lots of liquidity, there remains no coherent valuation mechanism for a digital currency, which means that, like John Law's own Mississippi Colony, it was more hype driven than value driven.

The actual process of settling a new territory, especially a muddy swamp like Louisiana, requires an especially hardy and rugged type. The people that show up first to buy the stock certificates are probably not those that will finish the job. That's because, among other things, the trails to promised lands are littered with corpses (yes, yes, you can tell I'm still scarred from my own Oregon trail playing experiences. "Tuberculosis! Again! OMG! Remind again me why I chose to be a farmer instead of a banker?").

It's worth reminding ourselves that we are still in the very early stages of digital currency. We've sold the idea, but our implementations often seem more focused on integrating with the existing economy than forging new ground. Accountability models are gradually emerging.

One part of this is very simple. Trust is what we know. One key feature, that we discussed at a recent event on the Future of Cryptocurrency at the Institute for the Future in Palo Alto, was faces. As Vitalik Butlerin and others noted, people want faces. People trust the organization, not only because of the ostensibly trustless nature of the blockchain, but because they know your track record and who you are.

One other core feature of trust that is often neglected is the incentivization structure. You want a structure in which each participant is appropriately incentivized to deliver the benefit that is in the public interest. Although this hasn't been equally across Bitcoin exchanges, Brian Armstrong of Coinbase is strongly incentivized to keep your Bitcoins safe. Everyone knows who he is, so there's no way he could disappear, and his company, his bank, and his venture backers would all suffer an immense reputational loss if anything should happen to the Bitcoins. I'm a Coinbase user not because I think that Brian Armstrong is a good guy (although I do), but because I can see that their incentives clearly align with my own.

Making sure that these incentives are appropriately aligned is a vital aspect of any new digital currency business, regardless of the model. Incidentally, it's also one of the core features to any political system. Constitutional design emphasizes not a perfectly trustless or disinterested state, but a level playing field where conflicting interests can be resolved and a balance of power among decision makers.

Sadly "trust" is somewhat of a neglected topic in the cryptocurrency world, which seems to assume that the "crypto" aspects are necessary and sufficient. The real world, however, presents a much more complex picture in which both faces, aligned incentives, and the appropriate balance of power are important design features that will ultimately determine overall growth prospects.

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