Stake {in} tender : Finders Keepers
The future of disintermediated & diffused financial economy in the age of PoS blockchains.
The world economy had been moving away from the hard currency in favor of digital systems for many years, even before the arrival of Bitcoin. Prominent economists like John Nash and Milton Friedman spoke openly about the opportunities for an algorithmic currency. The role of central banks and discretionary monetary policy could be usurped according to a mathematically fixed policy rule; however, a global digital native transactional economy didn’t exist. That was until the smart contract platform Ethereum introduced a universal mesh economic network for anyone from anywhere to conduct their financial needs in a trustless and permissionless manner. So let’s dive into the evolution of transactional economies, the role of financial institutions as conduits of societal representation on financial resource allocation and distribution, and the parallels in the Ethereum transition from PoW to PoS.
At the top of financial markets, it is the Central Bank. The Federal Reserve of the United States Of America is the most powerful and the one who leads the pack; however, it stands out from other Central Banks. It is highly autonomous and decentralized in structure with an operational interdependence among the Regional Federal Reserves. So what makes this unique?
The story begins in the late 17th century in Europe. King William III of England, devastated by a stunning defeat in the Nine Years’ War, committed his court to rebuild the English Navy. The only problem: money. The government’s coffers had been exhausted, and William’s credit dried up. A Scottish banker, William Paterson, had a solution: “form a company to lend a million pounds to the Government at six percent 6% (plus 5,000 ‘management fee’) with the right of note issue.” By 1694, the idea was revised (a 1.2 million pound loan at 8 percent plus 4,000 for management expenses), but goes ahead: The magnanimously titled Bank of England was created.
It was a private bank, not a government entity, and owned by private shareholders for a profit with a charter from the King that allowed them to print the money and lend it to the crown. At the birth of the Bank of England in 1694, it was the creation of a template that would be repeated in country after country around the world: privately controlled central banks lending money to the government at interest.
In 1781, the United States was in financial turmoil. Congress turned to the Superintendent of Finance, Morris, who argued in his capacity for the creation of a privately-owned central bank, deliberately modeled on the Bank of England. Backed into a corner by war obligations, Congress reluctantly agreed, which resulted in the Bank of North America as the nation’s first central bank. And precisely as the Bank of England came into existence loaning the British crown 1.2 million pounds, the First Bank of the United States started the business by loaning 1.2 million dollars to Congress.
Since the American people have continuously struggled against the bankers who wanted to control their money. As Thomas Jefferson wrote: “the spirit of war and indebtment, which, since the modern theory of the perpetuation of debt, has drenched the earth with blood, and crushed its inhabitants under burthens ever accumulating.”
In 1816, President Madison signed the charter for the creation of another central bank, the Second Bank of the United States. Just as previous central banks, the majority was privately-owned and granted the power to loan money that created to the government. The 20-year bank charter was due to expire in 1836, but in 1832 the bankers forwarded a bill to renew the bank’s charter. Remarkably, Jackson vetoed the renewal charter and staked his reelection on the people’s support of his move. He writes in no uncertain terms about his opposition to the bank in his veto message.
Throughout the late 19th century, the United States was rocked by banking panics brought about by wild banking speculation and sharp contractions in credit. By the dawn of the 20th century, the bulk of the money in the American economy had been centralized in the hands of a few industrial magnates, who enjoyed near-monopoly on a sector of the economy.
For centuries the people of the United States had been at war with international banking oligarchs. In 1913, that war was finally over with the creation of the Federal Reserve, and the money supply itself depended on interdependence and self-autonomy. The objective of the Fed was to help banks acquire emergency cash reserves to meet panic withdrawals so that the shortage of funds at one bank didn’t disrupt the entire banking system. To achieve these goals, the Fed, then as they do now, combined national authority through the Board of Governors made up of regional reserve banks. A third entity, the Federal Open Market Committee, brought together the expertise of the first two entities in setting the nation’s monetary policy.
The Decentralized Central Bank: The Federal Reserve System consists of twelve Reserve Banks operating under the oversight of a Federal Reserve Board. The Reserve Banks were separate corporate entities designed to provide services to commercial banks.
The regional banks are themselves private corporations: “Instrumentalities like the national banks or the federal reserve banks, in which there are private interests, are not departments of the government. They are private corporations in which the government has an interest.” [1928 Supreme Court ruling]
The Federal Open Market Committee is responsible for setting interest rates. The Federal Open Market Committee, most of the membership is the presidents of the regional Federal Reserve Banks representing their interests. They have significant input in setting interest rates. The Federal Reserve goes to great lengths to make its organizational structure decentralized as possible to avoid any conflicts of interest. The privately-owned member banks of each Federal Reserve Bank vote on the majority of the Reserve Bank’s directors and the directors vote on members to serve on the Federal Open Market Committee, which determines monetary policy.
The member banks in the district own the stock of each Federal Reserve Bank. They are 100% privately held and have private boards of directors. The majority of those boards are appointed by the independent banks, private banks in the district. These private corporations issue shares that are held by the member banks that make up the system, making the banks the ultimate owners of the Federal Reserve Banks. Although the Fed’s profits are returned to the Treasury each year, the member banks’ shares of the Fed earn them a 6% dividend. According to the Fed, the fixed nature of these returns means that they are not being held for profit. [Federal Reserve’s senior counsel: Yvonne Mizusawa: watch the clip here]
So if you want a piece of the Federal Reserve, the best option available is to get a piece of the bank you like in a district.
In December 1977, the Federal Reserve Bank of New York published information pamphlets, complete with cartoons, for the general public attempting to illustrate the functions of the Federal Reserve System, where the money creation process is explained:
“Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars to accounts on their books in exchange for a borrower’s IOU. Banks create money by ‘monetizing’ the private debts of businesses and individuals. That is, they create amounts of money against the value of those IOUs.”
Just like the Federal Reserve’s objective to ensure stability and liquidity to the market, Ethereum with ETH2 is upgrading its monetary issuance to pay for its security.
Rise of the Economic Commons
Looking at how economies have evolved in the real world, the Federal Reserve had three iterations before it became what is now, Ethereum is at the doorstep of its second iteration as it moves ahead to a Proof-of-Stake network. It will provide its users the ability to become consensus validators and get rewarded for their participation. This also brings challenges to the economic dynamics of the existing network and its dapps that rely on base asset ETH with such a large active user base. This pivotal moment in crypto history will earmark the most significant transformation of a transactional society from one system to another.
Almost 120,000 wallets are ready to stake on Phase 0 of Ethereum 2, which potentially results in a massive windfall of wealth transformation from ETH1 to ETH2 Beacon chain. According to the latest report (wallets holding over 32 ETH), 77% of the network is eligible for ETH2 staking, which is approximately 86M ETH (~20 Billion USD). During this process, staked ETH will move into native ETH2 wallets that support the staking process and collect rewards from the Beacon chain consensus validation process. The rewards are accumulated on the corresponding address and only available for withdrawal on Phase 2.
While users lock up their ETH for ETH2 staking, they will be burning their ETH for receiving ETH2 1:1 for deposited ETH. The new ETH will only be available for withdrawal when the accounts and withdrawal processes have been formalized and activated on Phase 2. This accumulation of ETH for running a validator on ETH2 projected to be between 3–10 Million ETH and will generate native earnings of 5 to 10% from inflation for staking rewards. That would result in a substantial liquidity crunch on ETH1.
As the staked ETH will continue to increase over time, so will the accumulation trend continue towards ETH2. It would lead to a significant shortage of ETH in circulation, which in turn could trigger a considerable increase in price. However, this lack of liquidity in Phase 0 will also cause unpredictability and centralization as well. Given the lack of transaction capabilities in Phases 0 and 1, a secondary derivative market could form around centralized exchanges that could exploit the situation.
A high concentration of centralized validators creates a centralization risk of becoming the Genesis ETH2 Custodians CARTEL. This is an inherent existential threat to the Ethereum DeFi and Dapp ecosystem in general.
Unlike other PoS networks that have governance over treasuries, ETH2 PoS is an entirely defensive mechanism, since it doesn’t provide any fund coordination protocols to pay for attacks.
PoS Network: Decentralized Intermediaries
The rise of the PoS Staking market is analogous to the fundamental problem of exchange coordination. Exchange is universal, rooted in the human desire to ‘truck and barter,’ has always existed. In the Moral Sentiments by Adam Smith(father of modern economics) states “society may subsist among different men, as among different merchants, from a sense of utility, without any mutual love or affection” and in The Wealth of Nations, he claims that in commercial society every individual “lives by exchanging, or becomes in some measure a merchant.”
Smith believed that society could subsist without benevolence but not without justice. The maintenance of justice in commercial society required that justice prevails in the economic relations among its members and that the state takes measures “to prevent the almost entire corruption and degeneracy of the great body of the people.” The basic tenet of how Proof of Stake Networks follows this with monetary incentives designed around social coordination and stake processes to ensure the security of the network.
Intermediations & Information monitories.
In traditional financial markets, banks are information monitories and function as financial intermediaries to solve the problem of information asymmetry in the credit market between lenders and borrowers. Banks also have a beneficial role in liquidity provision versus other financial intermediaries due to their core banking functions of taking in deposits on-demand and originating loans. Banks leverage this synergy by combining deposit-taking with loan commitments. Providing liquidity is very good for banks because deposit withdrawals and loan commitment drawdowns are not correlated.
Current financial intermediation built upon the notion that intermediaries serve to reduce transaction costs and informational asymmetry. In the age of blockchains with decentralized financial (DeFi) markets, both transaction costs and informational asymmetries are negligible compared to the traditional world.
Also, in traditional finance, an intermediary with a good reputation and large funds of capital is required to manage the risk of assets. PoS Networks will flip this through its base assets at stake. Consequently, they engage in qualitative asset transformation activities. DeFi capital instruments are sufficient enough to provide the primitive of full risk diversification with algorithmic information aggregators so that market actors are congruent with expectations and act rationally. DeFi protocols will initiate, arrange, and underwrite the floating of these instruments and, in some cases, maintain a autonomous market that facilitates atomic clearance of deals that enables lending and market makers in options and futures.
Financial intermediaries can be seen as information sharing coalitions. These coalitions can achieve economies of scale by claiming that intermediaries who perform the monitoring are diversifying their portfolio.
DAOs for Information sharing coalitions.
Cooperation begins with small groups and then evolves into larger, more Fluid Societies. Trust and collaboration here are composed of indirect reciprocity. The key idea here is that an individual’s actions affect their reputation and trustworthiness. Since any two individuals rarely, if at all, interact more than once, the punishment of a defector must be carried out by agents who were not directly cheated. Therefore, the shift from direct to indirect reciprocity coincides with a change from personal to community enforcement.
Agents can observe whether there was a defection by any player during the period, and all agents condition a trigger strategy on this information.
Trading networks from the Middle ages sustained trust and cooperation by facilitating the flow of reputational information. Today credit rating agencies fulfill this information sharing function in financial markets.
The sharing coalitions created to sustain cooperation could be shared amongst strangers, while others drew upon instincts for reciprocity. For example, the Champagne fairs of the twelfth and thirteenth centuries became known as an institution of law merchants providing information on each merchant’s trading history for a fee. These trade fairs operated as the undisputed fulcrum of international exchange and financial settlements in Europe from c. 1180 to c. 1300 and were central to the ‘Commercial Revolution.’ International trade grew at the Champagne fairs because of private order courts in which private judges kept records of traders’ behavior (Milgrom).
On the other hand, when the social coalitions transform from one system to another, social norms and culture matter. In the early 1990s, the transition to market-based economies in Eastern Europe and the former Soviet Union was unremitting. They failed to adjust to the new market economics just as the role of the legal institutions of market-based economies since they were supported by a more extensive network of social norms and moral beliefs.
Economic success is better guaranteed by institutions which are accessible to all economic participants, not privileged to institutions such as communities or guilds which guarantee property rights and contract enforcement only to member networks.
In an open interdependent market, hedging enables an entity to unbundle and get out of business altogether, leaving tasks to the market and eliminating the need for excessive “governance.” An efficient capital market will makes governance better in its functional aspect by retaining a comparative advantage.
The optimal governance apparatus depends on the accurate pricing of financial instruments issued by entities with different governance structures. Pricing will be inaccurate if the price-discovery function of underlying markets has shortcomings (price-discovery is costly).
Derivatives market serve as a powerful price-discovery function that is well established. Futures markets are the best source of information regarding asset value. Informed traders prefer derivative markets, mainly because it is easier to conceal identities in these markets, and greater liquidity makes it possible to buy or sell additional quantities before price changes in response to the volume of trading.
Synthetic Entities & Exoteric Liquid Governance
Myron Scholes suggested in his Nobel lecture that derivatives markets would permit the creation of “Synthetic Entities.” Governance is necessary for long-term multi-party entities. Governance is a second-best solution for residual claimants in ongoing synthetic organizations. If uncertainty can be controlled via derivatives markets, the organization of production can be simplified and handled by direct contracts rather than by “governance” of any kind.
Synthetic entities provide a way to derive the informative function of PoS Consensus systems validation alpha(+/-) and can aggregate on-chain data from other synthetic entities. The increased role of markets will shrink what is in the domain of governance and expand what is in the domain of markets.
The synthetic control method is based on the idea that a combination of unaffected units often provides a more appropriate comparison than any single unchanged unit alone. This method also opens the door to a mode of quantitative inference for comparative validator performance within the network and the price of the underlying asset.
In PoS Networks, derivatives may influence the conduct of staking users more directly and make formal governance tools less critical. Derivatives allow users to hedge the risks they bear, which would allow them to counterbalance validators’ performance. Staking entities may not want users to hedge in this way; if they do so correctly, their fortunes will be uncoupled from the market. Therefore it paves the way for alternate packaged incentives to exist that strike an optimal balance between calculated risk and reward.
Mitigating risk at the validator level is more attractive. If there is an explosion of derivatives markets, it will immediately demonstrate a high velocity “Exoteric” governance at play. Traders prefer derivatives markets because execution is faster and cheaper with a higher probability of pseudo-anonymity. Price swings depend more on who is trading than on how much is being traded. Movement of traders from external price-feed based markets to on-chain PoS consensus derivatives markets has another potential effect on pricing of the base asset, an impact that could be substantial.
Tokenized ETH2 DAO Validator staked assets not only provide liquidity, but they are doing it by enabling different assets into the Ethereum backed by ETH. They simultaneously grant ETH2 (Beacon Chain) with permanent or long-term capital and lenders with liquidity deposits for their asset holdings. These deposits are liquid enough to be utilized by the Ethereum chain DeFi dapps.
Fluid Society on Shared Practise
Communities of practice were common as far back as ancient times. In Greece, “corporations” of metalworkers, potters, masons, and other craftsmen had both a social purpose and a business function as members trained apprentices and spread innovations. In the Middle Ages, guilds played similar roles for artisans throughout Europe. Today’s communities of practice are different, especially in the blockchain world: instead of being operated as a corporation, they exist as DAOs.
The current Ethereum DAO ecosystem is a network of users who coordinate around a common goal and pool capital to execute with. So how do we see the next evolution of existing DAO roles as a dynamic entity that coordinates effective collective resource management for compounding returns?
DAOs are based on communities of practice theory that were learning together by focusing on problems directly related to their work. Since communities of practice generate knowledge, they renew themselves. They give you both the golden eggs and the goose that lays them. The strength of communities of practice is self-perpetuating. Although communities of practice are fundamentally informal and self-organizing, they do benefit from cultivation.
For DAOs to grow communities of practice from seed, they should have:
- reliable infrastructure to apply their expertise effectively;
- fluid integration rails into the economy to reach its full potential;
- trackable on-chain metrics to assess the value of the DAO’s practice alpha.
Being a member of a CoP is not necessarily people knowing one another or having a sense of togetherness but organizing themselves around negotiating a practice that they all share and identify with. An excellent example of culture based on the community of practice is the Ethereum Foundation. The “everyone” COLAB principle makes the Ethereum chain a highly conducive environment for builders.
In a fast-paced market economy with a lot of collaborative initiatives, it is imperative to track real-time performance and identify the outliers. Typically, the highest-payoff links can be leverage points with disproportionate synergies.
Communities of Practice (CoPs) have been around for 25 years and became prevalent with the advent of the open-source movement and New Information Economies powered by the Internet. In CoPs, ‘belonging is enacted through three structural elements of CoPs:
- mutual engagement: how and what people do together as part of a practice,
- joint enterprise: a set of problems and topics that they care about,
- shared skills: the concepts and artifacts that they create.
DAO: Power of Choice!
Shared indwelling shows that people with different domain expertise find ways to meaningfully address the same problems by indirectly sharing their tacit knowledge. DAOs enable anyone interested in operationalizing a concept and be a better practitioner with a specific purpose.
In a world of seven billion people, with a permissionless smart contract platform, we can have better systems in place for resource allocation and peer production, building a new future for mankind. A pragmatic way is to try efficient alternatives built from the bottom up, leveraging the truly composable nature of financial protocols on blockchains.
People are again rallying around the cause of a permissionless economy that is censorship-free and seizure resistant; on the threshold of a transformation almost unimaginable before. The future is now in our hands, and we can choose to get active and build or do nothing at all.
Story to unfold as we move ahead on DAO Validator for ETH2.
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Disclaimer: Much of the above is for informational purposes and should not be construed as an investment thesis.
