The Financial World of the Future, Part 3
Central banks have made a mess of the global monetary system. Today, I’m going to show you a way it could be fixed.
It’s all part of Decentralized Finance (DeFi) — a monetary system that is very different from the one we know today.
In this financial world of the future ...
- Middlemen for trillions of transactions are replaced by cryptocurrency blockchains or other Distributed Ledger Technologies (DLT).
- Institutions like commercial banks, investment banks and brokerage firms are no longer needed for most custodial services.
- The risk that they might fail and cause a financial market meltdown is largely eliminated.
- And all kinds of financial services — especially loans and investments — are accessible to nearly anyone with an internet connection.
A pipe dream? Not really. In fact, the infrastructure for this new world of DeFi is already being built.
But as I explained in Part 1 of this series, DeFi has one major challenge: Cryptocurrency prices are very unstable.
And as I explained in Part 2, one coin seeking to meet that challenge is DAI.
What is DAI?
It falls under the general rubric of “stablecoins.”
But unlike other stablecoins, DAI does not use a centralized custodian to hold the assets that back it, such as U.S. dollars.
Instead, DAI users deposit the back-up assets in a smart contract. That smart contract itself holds the assets. And then the smart contract creates the corresponding DAI tokens. In other words ...
The DAI Smart Contract Creates New Money
This is revolutionary.
It means that DAI can, in effect, act like a central bank.
What’s even more revolutionary is this:
Unlike at the Fed, the money-creation is not decided by a chairman or a Federal Open Market Committee (FOMC). It’s decided by a piece of self-executable code that lives on an immutable distributed ledger.
In effect, this computer code is what replaces key central bank functions that are currently manual and often arbitrary.
This code is what allows users to participate in the process of creating new DAI money.
This code is what ensures all rules are applied consistently, transparently and fairly across all actors in the system, regardless of who they may be.
And that code is what ensures monetary stability.
Suppose You Want to Be a User and Participate in the DAI System. How Do You Do That?
Here are the steps:
Step 1. You buy some Ether. To do so, you can use U.S. dollars, euros, Japanese yen or any major currency.
Step 2. You go to a portal such as this and deposit your Ether in the DAI smart contract. That Ether is now your collateral.
Step 3. You take out a certain amount of DAI tokens. Like a loan.
Step 4. With your collateral in the form of Ether and your loan in the form of DAI tokens, you now have what’s called a Collateralized Debt Position, or CDP. Thus ...
- Your CDP is a loan you take out from the DAI smart contract.
- Your Ether is the collateral to guarantee you’re able to pay back the loan.
Step 5. As with any loan, you can’t borrow for free. You have to pay interest.
Now, as you went through these steps in your mind, you were probably thinking of yourself as the consumer, and the DAI smart contract as your bank.
If that helps you better understand the process, fine. But another, even more appropriate way to think about it is this:
You’re the bank. And the DAI smart contract is like the Federal Reserve.
You deposit your reserves with the Fed. Then, you borrow money from the system and pay interest based on the Fed Funds rate.
In either case, this lending system has two unique characteristics:
- Your CDPs (loans) have no term. You can keep the CDP open as long as the value of the Ether you deposited is at least 50% higher than the value of the loan. If the value of your Ether deposit falls below that threshold, the smart contract will liquidate your loan. And it will use your Ether collateral to recover the amount owed.
- When you pay back the loan, your money is taken out of circulation. All the DAI tokens that you pay back to the smart contract are effectively destroyed and taken out of circulation.
When new CDP loans are created, money supply expands.
When CDP loans are paid off, money supply contracts.
Automatic, market-driven expansion and contraction in the money supply ensures monetary stability.
This feature is the key to monetary stability — not just for DAI tokens but, potentially, for the entire world of the future.
So, bear with me while I explain
the process, which starts here:
The DAI smart contract sets the value of each DAI token at exactly one U.S. dollar.
But that’s just the beginning.
In the real world, anyone who thinks they can control the price of anything with a few lines of computer code is obviously dreaming.
The developers behind DAI know that. So, they have created a mechanism that deals with the natural ups and downs of supply and demand in the marketplace.
And this mechanism is the key to maintaining the value of each DAI token at $1.
How? Consider these two scenarios:
Scenario A: DAI Token = $1.01
Let’s say the value of the DAI token happens to trade one penny above par — at $1.01.
Oops. If that continues, it could mean deflation. Because the more the money is worth, the less everything else will cost.
Not good. It’s a problem that needs to be nipped in the bud. Before it gets out of hand.
How is that done?
Simple: The DAI smart contract lowers the interest rate.
Since the rates are lower, more people take out CDP loans.
More DAI money supply is created.
And the larger supply naturally brings the value of each token back down to $1.
Scenario B: DAI Token = 99 cents
Now, suppose the opposite happens. DAI trades a penny below par, at 99 cents.
This could also be a big problem. If it continues, the currency is debased. Inflation is kindled. And who knows what distortions could follow.
But again, this kind of disaster is cut off at the pass ...
The smart contract raises the interest rate.
This prompts more people to close out their CDP loans.
The DAI money supply contracts.
And the smaller supply naturally helps push up the value of each token back to parity with the dollar.
The smart contract makes sure that the interest rate responds organically to free-market forces.
No central banker or committee “decides” what interest-rate levels are supposed to be.
No one tries to manipulate price levels or fool the nature of the markets.
And it is THIS flexible, free-market-driven interest rate that’s the key to stabilizing the currency.
The DAI developers get this. In fact, to make it absolutely clear that’s what they’re trying to achieve, they don’t even call the interest “interest.” They call it the Stability Fee.
Free Markets for Money: The Mission-critical Lesson That Governments Have Forgotten
You’d think governments and central banks would have figured this out by now.
You’d think they would have accepted the fact that their mission is to keep the currency stable.
But they haven’t.
Instead, for the most part, their mission has been to prolong economic booms, create financial bubbles, win elections or even pad the pockets of their cohorts.
That means manipulating interest rates.
And it can also mean spending, borrowing and printing money like there’s no tomorrow.
We thought the U.S. Federal Reserve had learned this lesson and changed its ways four decades ago. But it didn’t.
The Great Interest-rate Crisis of 1979
It was fall in New York, and the United States was in big trouble.
So was most of the rest of the world.
After years of reckless budget deficits and monetary expansion, everything was going haywire ...
The value of the U.S. dollar was collapsing ...
U.S. consumer inflation had reached 13% ...
The price of gold had surged by 2,190% ...
Something drastic had to be done.
And it was.
Most economists remember that period. At least vaguely.
They remember Paul Volcker, the newly appointed Fed chairman. And they recall that interest rates spiked higher.
What most people don’t is that what he really did was much more than just raise interest rates:
Fed Chairman Volcker announced that, from that point forward, the Fed would STOP targeting interest rates.
Instead of manipulating rates, the Fed would let the supply and demand for money determine interest-rate levels.
The Fed would let interest rates rise automatically as far as needed to stabilize the currency.
If that reminds you of DAI, your mind is in the right place. In effect ...
Volcker wanted the Fed of four decades ago to function much like the DAI smart contract is designed to work today.
The very next day, interest rates rose sharply.
Sure, the higher interest rates were traumatic — at first.
But later, the dollar regained its strength and stabilized. Inflation subsided. Interest rates fell back down to normal levels. And the U.S. economy enjoyed two decades of sustainable growth.
That was the lesson of free markets for money. But unfortunately, it’s a lesson that today’s central bankers have forgotten.
In fact, their monetary sins of the 2010s make the excesses of the 1970s look saintly by comparison.
A decentralized system like DAI has the potential to help restore sanity to the monetary system — not just in the U.S., but globally.
It could happen in the wake of a debt crisis and financial collapse, such as the one that almost took place in 2008.
Or it could happen with a less chaotic, step-by-step, evolutionary process.
We hope it will be the latter. But we’re not counting on it. And either way, it could take many years.
In the meantime, look forward to a new kind of credit market, where you can borrow and lend crypto assets, earn interest, trade with leverage, go long or short and more. This will be the subject of Part 4 of this series. Keep a close eye on your inbox for that.