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Behavioral vs. Mechanical: Ideas to Evaluate Cryptocurrencies

Behavioral vs. Mechanical: Ideas to Evaluate Cryptocurrencies

It's easy to fall into the trap of seeing the crypto space within a mechanical framework. After all, Bitcoin and blockchain is just an amalgam of code, maintained on a decentralized network, and supported through a literal army of machines permeating across the globe. The architecture and design of crypto and blockchain matter a lot. However, it is easy to get lost in the engineering of this nascent technology and lose out on the bigger picture of actual utility and function. No matter if this peer to peer cash system is seen as a currency by some or as a store of value by others, one thing is evident: people buy, sell, and use Bitcoin for different reasons.

As the cryptocurrency ecosystem continues to mature, more and more players in the traditional finance space have latched on. With Wall Street execs observing and commenting and even bankers, researchers, analysts, and economists making their presence known, imparting their thoughts and speculation, nearly everyone has an opinion on digital currencies. They have their own perspectives, and those perspectives are much older, built upon decades of our time’s best economic minds, like Friedman, Hayek and Keynes. After all, money has existed far longer than the digital currency boom of 2009 and will continue to exist long after. That means, like good cryptography, these ideas have withstood the test of time, and as a result, we should carry the weight of their expertise with us when re-envisioning our economic ecosystem

In crypto circles, the current breakdown of cryptocurrencies is structured mechanically. In the case of stablecoins, they fall  into three neat categories which will help us understand their functions better:  

1. Fiat-collateralized (Centralized)
2. Crypto-collateralized (Decentralized)
3. Non-collateralized (Algorithmic)

However, these 3 mechanical classifications only tell you part of the narrative, and from an investment standpoint, a very small and potentially unremarkable part. For example, knowing that TrueUSD or Tether simply collateralizes fiat (US Dollars) and puts dollars on the blockchain doesn’t tell you very much as an investor. The mechanical component really leaves something to be desired when you want to know how a market might receive a coin, let alone behave once it’s released into that market.

A look at Tether ($USDT) showcases this. Tether recently had a period of heavily negative news. The news was inescapable and it focused on the fact that Tether was not being fully backed by US Dollars (USD). Mechanically, Tether stated that every 1 USDT would be backed by 1 USD. But when it was revealed that this 1:1 backing was not true, what happened? The price of Tether stayed the same. Why? Let’s look at what users care about when using Tether:

They could buy at $1
They could sell at $1
They had confidence they could do this whenever they wanted

In short, what makes Tether useful for investors is not whether it’s actually, mechanically backed 1:1 with the dollar. What matters is liquidity. This is behavioral and it’s how the coin behaves that caused it to retain it’s usefulness and therefore value.

Let’s key in on that word: Behave. It just so happens that a very valuable framework stems from how things behave. Instead of using a mechanical filter, what would happen if we used a behavioral classification. How would it be received if we put coins into behavioral buckets instead of mechanical ones? Let’s apply a few ideas and see how new buckets might provide us with additional, important information.

Inside vs. Outside Money

To start, let’s look at the fundamental differences between inside vs. outside money. Understanding whether a coin is an inside or an outside money can tell us about how the coin functions and behaves. For example, fiat-collateralized digital assets are inside money. You have an inside money anytime an asset is backed by a form of private credit (an “IOU”). Simply stated, inside money is collateralized. TrueUSD, for example, is an inside money. For every 1 TrueUSD, there is a corresponding liability of 1 actual US Dollar, assuming the system is working correctly.

Bitcoin on the other hand is an outside money. Ampleforth’s Amples (AMPL) are also an outside money. Outside money is not collateralized. Outside money is also a net asset for the private sector. There are different performance characteristics between outside money and inside money, with some being advantageous at times and harmful in other instances. That's why it's critical to understand if a digital asset is an inside money or an outside money, much like its crucial to know what a layer 1 protocols consensus mechanism is - PoW or PoS for example.

Rules vs. Discretion

Another view which can shed light on the behavioral side of things surrounds rules vs. discretion, with advantages and disadvantages to each approach. To outline some potential disadvantages, discretionary policies have the vulnerability to have subjective applications, which can introduce errors in terms of subjective timing, scope and participation. Discretion in the traditional finance world is often regulated to give protection to consumers. An example of this could be transparency about how an interest rate can change and by how much. In the decentralized world with no strong authorities, there's no guaranteed regulation except for rules-based code. Contrastly, rules-based policies can have the potential disadvantage of being too rigid, not allowing for unique action in times of full blown crisis.

The important take-away in either event is to understand what type of digital asset you are dealing with, which will provide you with an indication of how the asset might perform in a given scenario. As an investor, you may achieve a  more predictable performance out of a rules-based digital asset than a discretion-based digital asset.  

Maker DAO is in the news as a result of their discretionary policy. According to a Coindesk report borrowers are unhappy with exponentially increasing stability fees (basically, interest rates) in extremely short time frames. These stability fees are set via a vote, and the people casting votes are arbitrarily doing so based on their own discretion. They have passed rates that are 40X higher than they were mere months ago in order to prevent a negative outcome for their token. However, the outcome is increasingly negative despite their best efforts. The uncertainty surrounding how the chosen few will vote only adds to the problem.

This information is  - necessary - for an investor to know.

A discretion-based system may fail to act when action is needed, and may act when inaction is best. A rules-based system will act exactly when the rules dictate, irrespective of whether or not action is prudent. In a discretionary system, additional, sometimes unpredictable variables are added in the form of subjectivity, which are eliminated in a rules-based system.

It becomes increasingly important to know how digital assets behave. Be sure to understand if a digital asset is rules-based or discretionary if you want a full picture of that digital asset.

Tying It All Together: A More Complete Picture

Having a complete awareness and knowledge of asset classification and behavior provides a more useful, fuller picture of a digital asset.

Framing a digital asset under the lens of behavior and mechanics helps guide one to ask better questions to determine if the digital asset is the right one to invest in. For example, with the right behavioral lense, you can better understand the impact of how coins enter or leave the system. You have an idea of what to ask- are new coins entering through minting/selling? Buy-back and burn? Collateralized Debt Position (CDP)? If it’s through CDP we can apply another lens to determine another question we need answered- If it is CDP how is demand for CDP and stablecoin balanced?

Additionally, taking into account behavioral characteristics helps you to question other important ideas, such as what assumptions about the underlying economy does the protocol of a digital asset rely on? For example, if a project relies on bonds, there must be a long-term underlying growth for that bond market to make sense. Other questions will arise as well, such as what information is propagated into supply, if any? If that’s not the case, is supply scheduled deterministically? If it is scheduled deterministically, what might that mean for the future of the digital asset? Mechanically, that answer is simple - you know for example that Bitcoin will only have 21 million coins ever. Behaviorally, how will a fixed supply affect the price and performance of that digital asset? Clearly, the behavioral characteristics of a digital asset are important to consider.

Hopefully this has provided you with a few new ideas and additional lenses with which to view digital assets. Knowledge and information are powerful, so I hope this additional framework helps you in the future while evaluating digital assets.

/ Bretton Woods

With Money, Change is Certain

With Money, Change is Certain

The last time money changed, it happened with a whimper, then a bang. In the twilight of the Second World War, 44 nations sent delegates to Bretton Woods to build a global economic system that could avoid depression, indemnity, and hyperinflation. After a month, they had built the World Bank Group, as well as what they hoped was a stable global financial system. And it worked: for 26 years, the world had a near absence of banking crises.

But Bretton Woods had a fatal flaw.

One of the system’s core features was the dollar’s use as a reserve currency, which created for it two contradictory uses: one as liquidity within the United States economy, the other as an asset held by foreign nations. The first use required low inflation and a stable price while the second needed more appreciation to maintain value. These tensions, made of contradictory policy promises, pulled the dollar in irreconcilable directions. Rather than wait for the snap, Richard Nixon announced in 1971 that the United States Dollar would no longer be indexed to gold, ending the Bretton Woods system and moving the modern world into an era of pure fiat currency. It also triggered a decade of stagflation.

Today, Bitcoin too faces Triffin’s Dilemma. While proposed as a peer-to-peer digital cash system, the first cryptocurrency has found more lasting traffic as an extremely unstable asset, less liquid than its creators would have liked but more fitting to its profile as “digital gold.” Those long-term holders would prefer that Bitcoin continue to appreciate so they can make returns on their investment. Many early adopters would instead prefer that Bitcoin stabilize in order to facilitate mass adoption in commerce. Bitcoin, caught between these two extremes, by design lacks either a board of governors to force a resolution or an internal design that can resolve the issues of dual use.

But Ampleforth has a solution to this dilemma. With these pressures in mind, we’ve created a cryptocurrency both decoupled from Bitcoin’s fluctuations and immune to the pitfalls of a fully deflationary currency. To do that, we’re building on George Selgin’s proposal of “synthetic commodity money,” an asset with a real cost of production that can still be adjusted in response to economic forces. In short: cryptocurrency. To overcome the limits of old money, we’re making something new, with a unique structure and movement pattern that makes it not only different than bitcoin, but potentially uncorrelated as well.

It took great minds to solve the currency shocks and crises of the past century, and now we are putting their Nobel-winning theories to work by creating Amples (AMPL). To learn more, please check out our Red Book, where we outline the economic principles guiding our design. Now, as before, money is set to change. Satoshi Nakamoto took the first great step in 2009. At Ampleforth, we’re ready to make the next leap.

/ Ampleforth

Independent Currency in a Multi-Chain World

Independent Currency in a Multi-Chain World

Ethereum, EOS, STEEM, ONT, NEO, NAS, Cardano, Tezos, POA, Dfinity, ThunderCore, Solana, RChain, Oasis Labs, Zilliqa, VeChain… there are enough Layer-1 blockchain projects released, or nearing release, that it’s hard for even a dedicated developer in the space to keep track of them all. Even individual platforms are planning sub-chains, like Ethereum’s sharding and plasma projects. There are chains on top of chains. How should you make sense of a world with so many chains?

Many Chains, or One Chain?

One question we often get is whether we believe there will be a single stablecoin that rules them all… we think the answer here should be no. We subscribe to Hayek’s theory that there should be many competing currencies and the best ones will get continued and lasting use. Competition between currencies will be driven by better stability, philosophy, economic scalability, or incentive alignment with network growth, and that competition between monies is itself a form of decentralization worth fighting for.

Just as different digital currencies have different behavioral characteristics, different layer-1 chains also have different platform characteristics. Ethereum explicitly trades transaction throughput for increased decentralization. EOS explicitly trades decentralization for increased transaction throughput. Each of these will be home to different kinds of applications that care about different tradeoffs.

DApp vs Money

If you’re a decentralized application, like Augur for example, it makes sense to choose one chain and deploy there. All your data is in one place and your users only need to manage one wallet to interact with it.

If you’re building a new money that aims to eventually become a medium of exchange, you want to be everywhere anyone is making a transaction. ALSO, if you’re aiming to be a real money, you need a way of regulating supply with market demand.

This seems to lead to a conflict between the needs of two different parts of a monetary system. A monetary policy looks a lot like a DApp and wants to be on a single platform, while a token contract looks a lot like a money and wants to be on every platform.

Ampleforth Everywhere

As a refresher, here is the single chain Ampleforth architecture as described in the whitepaper:

Single Chain Architecture

We’d like the Ampleforth Monetary Policy, Oracles, and Governance modules to exist on the chain with the highest level of decentralization.

Fortunately in the case of Ampleforth, the set of users who interact with the Monetary Policy is much smaller than the set of users who interact with the token. There is currently one publicly callable function, rebase, that users can call that will initiate a monetary policy action and this executes at most once every 24hrs. Similarly, our Oracle data sources receive data about 4 times per day. For these modules we’re not that concerned with transaction throughput, so we’ll gladly sacrifice speed for decentralization. As of today, Ethereum meets these needs very nicely. It has a high level of decentralization, enough usage to guard against 51% attacks, and has an amazing and supportive community of developers around it.

The ERC-20 (or perhaps in the future, the zkERC-20) contract will be deployed on every platform capable of supporting the arithmetic necessary to power the token transfer and supply operations, which is mostly simple arithmetic.

Now instead of one “Ampleforth ERC-20” box, there will be one on every platform on which we’ve launched. In order for this to work, we need a few things:

  • A user must be able to transfer Amples from their wallet on one chain to another wallet on a different chain — Value-transfer.
  • The monetary policy must be able to call rebase() on the token contract of a different chain, or otherwise sync its state to the other chain — State Transfer.

Thanks to Evan Kuo.


This Article was originally posted on Ampleforth's Medium Blog.

/ Ampleforth

Ray Dalio: Correlation 'Holy Grail'

Ray Dalio: Correlation 'Holy Grail'

In the video “Ray Dalio breaks down his ‘Holy Grail’”, he sets out to break down what were the marginal benefits of diversification within a portfolio. Ultimately, using the graph below, Ray Dalio broke it down into 3 pieces: Risk, which he called the standard deviation, the number of assets or the sample size, and the correlation of the bets.

Ray Dalio Discusses His Diversification "Holy Grail" 

What he found in doing so was the higher the correlation between assets in a portfolio, the lower the ability to reduce risk by increasing the number of investments. Essentially what this means is if you take a group of investments that are 60% correlated, there is no real reduction in risk after adding more than 4 investments to the portfolio. It’s only in diversifying your portfolio that allows you to cut your risk.

Correlation of Assets Impact on Risk and Return

Dalio says for an ideal return on investment, investors should find 15-20 good, uncorrelated return streams, as that will allow for the most return on investment while cutting risk. In taking 15-20 good investments, with a 0% correlation, using Dalio’s chart, the return to risk ratio is 1.25, meaning the probability of losing money in a year is 11%. With any one investment with a 10% risk, the probability of losing money in any given year is 40%, almost 4 times as much.

What this all boils down to is the power of diversification in balancing risk. There is no great 1 best investment, but you are able to improve your return to risk by 5 times as much when diversifying across 15-20 good investments.

Since Bitcoin was created, it has shown to be an asset that is uncorrelated to the stock market. This provides investors with a tool for diversifying their portfolio, but many investors prefer to have more than one tool. Since Bitcoin thousands of altcoins have come onto the scene. Combining Bitcoin, all altcoins and all future projects has the resulting effect of an entirely new asset class: Digital Assets.

That begs the question: How does this relate to digital assets? You need only look at Bitcoin and the subsequent other similar coins found in the market to see the issue in diversifying your digital assets. Correlations within the crypto space are for the most part high, but there are a few different coins that break the mold of digital assets, which allows investors to diversify and improve their return to risk. One such token is Ampleforth, whose movement pattern in reality should have a much lower correlation to Bitcoin. For those who subscribe to modern portfolio theory and have a mindset like Ray Dalio, seeking out digital assets that don’t correlate strongly with Bitcoin may allow investors to improve their return to risk, while digital assets on the whole may help reduce correlation to other traditional holdings.

To learn more about modern portfolio theory and how it can apply to digital assets, check out our piece on the subject which you can find here.

/ Ampleforth

Ampleforth is not a Stablecoin... (And that’s OK!)

Ampleforth is not a Stablecoin...            (And that’s OK!)

When people think of Stablecoins, they have something very specific in mind. A Stablecoin is meant to remove volatility. A Stablecoin is something you can use for payments. A Stablecoin is something you could use as a base trading pair on an exchange or as a refuge from positions in other digital assets. A Stablecoin is a stand-in for the dollar on the blockchain.

While Amples may be used for such tasks at some point in the far future, they are absolutely NOT stablecoins today. (And that’s OK!) Here’s why...

A Stablecoin removes volatility

Ampleforth does not try to remove volatility from the system. In fact, by design it allows volatility. Movements from the price target is the primary mechanism that engages the supply policy.

A Stablecoin can be used for payments

Until Amples have reached any kind of economic price-supply equilibrium, other stablecoins will be easier to use for payments and should be preferred for that use case. Dollars will be even easier still. Using Amples for payments will be about like using BTC or ZCash for payments, as we expect both price and supply to be volatile at launch.

A Stablecoin can be used as a base trading pair

Since Amples will likely be volatile, you’d be better served trading with a stablecoin (or the dollar) against Amples, instead of trying to use Amples as a base trading pair itself.

So Ample is not a stablecoin… Why was it created?

The Ample is an asset we’ve never seen before--it’s a Smart Commodity Money that incorporates price directly into supply. When supply needs to increase, it doesn’t go to any special group--it goes to everyone universally. Same for supply decreases.

Since commodities are naturally fair and independent, Amples were designed to uphold those same principles. Ample supply is governed strictly and automatically by rules, with no discretion on supply policy decisions. There are no added transaction fees, stability fees, or interest rates that need to be balanced with the market. There are no central collateral balance sheets that need to be maintained. There are no regular votes on monetary policy. Amples are never minted and sold, or bought and burned. Amples are fair, direct and independent, with no special class of stakeholders.

Amples will move differently

We expect that Amples will move differently from other digital assets, making them uniquely useful as a way of diversifying risk in a broader portfolio of assets or as a collateral asset in decentralized banks like MakerDAO.

Amples are macroeconomically friendly

Amples are a commodity money that doesn’t suffer the same deflationary drawbacks of fixed supply currencies.

Amples can scale economically

The Ampleforth protocol is an outside money that doesn’t rely on any collateralized debt. It can scale to a global ecosystem without having to lock up exogenous assets.
In short, Ampleforth is not trying to recreate fiat money on the blockchain. It is a new formulation of a smart, synthetic commodity money that we believe to be the next natural experiment after Bitcoin. In the beginning, it will likely be useful for diversifying risk within a portfolio or as an uncorrelated reserve asset. Much later, it could become an alternative to central bank money.