Class #4: Financial Ethics

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Thursday, September 26th, 2019

Class Goals and Outline

• Understand cryptocurrencies as an experimental representation of value.
• Understand how money drives behavior in cryptocurrencies.
• Understand “traditional” financial public policy goals in the context of cryptocurrencies, focusing on Financial Stability.

Class Goals and Outline

• Later
• Wealth Inequality: Class #7: Wealth Inequality and Public Goods
• Fairness and Securities: Class #10 Securities Law
• Libra and Unbanked Story: Class #11 Applying EthicalOS to Libra
• Today
• Climate Change
• Programmable Money
• Responsible Disclosure

Cryptocurrencies as an experimental representation of value

Money Has Evolved Over Time

https://grizzle.com/brief-history-money/

What Does Money Do?

http://money.visualcapitalist.com/infographic-the-properties-of-money/

http://money.visualcapitalist.com/infographic-the-properties-of-money/

Why Does Bitcoin Have Value?

But Bitcoin is not just money...

Categorizing Cryptoassets

• Money (FinCEN: Financial Crimes Enforcement Network)
• Security (SEC: Securities and Exchange Commission)
• Commodity (CFTC: Commodities and Futures Trading Commission)

Cryptocurrency as Money

• Store of value, medium of exchange, unit of account
• FinCEN: Guarding against illicit activities
• Is money being used for bad things?
• Money transmitter
• KYC/AML
• The Fed: Ensuring financial stability

Cryptocurrency as a Security

https://www.nickgrossman.is/2018/a-visual-guide-to-the-howey-test/

• SEC: Investor & consumer protection
• If you’re promising to make someone money, what should the rules be?

Cryptocurrency as a Commodity

Commodities are used as inputs in the production of other goods or services.

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Pay to run smart contracts with “gas” (ETH)

Commodities and Futures

https://www.youtube.com/watch?v=CC9VeHrI3Es

Futures are a Derivative

• Futures (will buy), options (may buy), and swaps (through time).
• Risk ← → Predictability

Cryptocurrency as a Commodity

CFTC: Consumer and investor protection

• Mostly worried about futures (derivatives)

Comparatize Size of Crypto

$200B

$8T

40x

$70T stocks

$70T money

$700T derivatives

http://money.visualcapitalist.com/worlds-money-markets-one-visualization-2017/

1. Sound money

2. Internet payments

4. Open Finance

3. Web 3

5. Decentralized ledger technology

https://medium.com/@caseycaruso/the-five-camps-of-crypto-1aa8695b76bc

Finance is Embedded in Institutions

• International Institutions: IMF, World Bank
• Nation-State: Central Banks
• Companies:
• Commercial Banks
• Credit Card Companies
• Insurance
• Regulatory Bodies

What if...

https://twitter.com/arjunblj/status/1153381491511975936/photo/1

• Money, security, commodity (derivative)?
• Store of Value, Medium of Exchange, Unit of Account?
• Connect to institutions?

Where Does Money Fit?

Understanding a Complex System

Determining Impacts

Intervening in a Complex System

https://blog.ncase.me/evolution-not-revolution/

Two Levels of Money as a System

Level 1: Incentives drive behavior

Level 2: Keeping money fair and resilient

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Public Policy Objectives of Financial Regulation

• Micro:
• Consumer & Investor Protection (SEC, CFTC)
• Guarding against illicit activities (FinCEN)
• Macro: Financial Stability (The Fed)

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(Also, tech-enabled, crypto-specific affordances.)

Incentives Drive Behavior

Let’s do a dollar auction!

FOMO3D, an ETH-Based Dollar Auction

• Start with 1 ETH in the pot
• Can pay .1 ETH to get the pot if you hold it for 24 hours
• ...Everyone does this until eventually there’s $12M in the pot
• Human tricks bots into mispricing gas to win the prize

Incentives Drive Behavior

Positive

“Perhaps the idea behind capitalism is…: the system facilitates the conversion of selfish aims (or, to be correct, not necessarily benevolent ones) at the individual level into beneficial results for the collective.”

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— Nassim Taleb, Antifragile

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Greed is Good

Positive

In Crypto

• Tons of money into cryptography and distributed systems research
• zkSTARKs, zkSHARKs, Bulletproofs, PLONK, SONIC, HALO
• Security of the network is derived from modeling incentives.

Negative

1. People do anything for money
2. Ignores externalities
3. Reinforcing feedback loops consolidate power

1. People Do Anything for Money

• 95% of exchange volume faked
• 25-80% of ICOs are scams or frauds
• Of the real use, almost all of it is for speculation or gambling

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Bitconnect

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→ Consumer protection (fair launches and securities: class #10)

2. Climate Change as an Ignored Externality

• 2008 white paper. Turn electricity into Bitcoin.

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10 years later...

• 1/500th of global electricity consumption.
• 1/2,000th of global CO₂ emissions.

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How "bad" is this? That involves looking at the costs (+ externalities) and benefits (the Bitcoin network).

Compared to What?

Compared to What?

• Censorship-resistant resistant store of value?
• Kickstarting non-nation-state money?

3. Reinforcing Feedback Loops Consolidate Power

Class #7: Wealth inequality and public goods

Negative

• People do anything for money
• Ignores externalities
• Reinforcing feedback loops consolidate power

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• Coordination problems
• Doesn’t capture all value
• Predicated on growth

Two Levels of Money as a System

Level 1: Incentives drive behavior

Level 2: Keeping money fair and resilient

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Public Policy Objectives of Financial Regulation

• Micro: Consumer Protection
• Macro: Financial Stability

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(Also, tech-enabled, crypto-specific affordances.)

Financial Stability

Financial Stability

• Tech is NOT a highly regulated industry. Finance is.
• Financial systems “play with” risk. Two big kinds:
• Systemic or market risks
• Counterparty risk
• Connected to “market confidence”.

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• Financial Stability: The absence of system-wide episodes in which the financial system fails to function (crises).
• Too big to fail

Example: $440M Lost in HFT

• Shows the dangers of automation (no human-in-the-loop).
• Knight Capital deployed code that lost $10M/minute for 45 minutes.
• 50% of all trading volume.

Financial Stability

→ loss of market confidence → crisis in BTC/ETH

• Counterparty Risk
• Exchanges custodying coins (Mt Gox)
• Code risk
• Smart contract (Parity bug)
• Protocol (IOTA and Bitcoin Cash)
• Cryptoeconomic Risk
• Smart contract incentives (MakerDAO)
• 51% attacks

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→ loss of monetary policy → crisis in fiat

• Fiat-Crypto Connection (Libra’s basket of currencies)

Counterparty Risk

Mt. Gox “lost” 750,000 BTC

Counterparty May Be a Contract

Parity Bug

$300M in ETH

Example: IOTA and Bitcoin Cash

Two security vulnerabilities: IOTA and Bitcoin Cash

• What was the problem with IOTA? What were the downsides? How did you go about resolving it?
• What was the problem with Bitcoin Cash? What were the downsides? How did you go about resolving it?
• How do you think about financial stability and security in these systems more generally?

Example: IOTA and Bitcoin Cash

• Both: Consumer protection
• Bitcoin Cash: Financial Stability

Example: Stablecoins

https://hackernoon.com/stablecoins-designing-a-price-stable-cryptocurrency-6bf24e2689e5

Example: MakerDAO

Example: MakerDAO

• Systemic risks to Maker (and DAI)
• Systemic risks to ETH

Example: Libra

• Countries can “dollarize” or “Libra-ize”
• Then they don’t have control over their monetary policy
• AND Libra has control over the basket of currencies

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Simulation November 19th at HKS

Financial Stability

→ loss of market confidence → crisis in BTC/ETH

• Counterparty Risk
• Exchanges custodying coins (Mt Gox)
• Code risk
• Smart contract (Parity bug)
• Protocol (IOTA and Bitcoin Cash)
• Cryptoeconomic Risk
• Smart contract incentives (MakerDAO)
• 51% attacks

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→ loss of monetary policy → crisis in fiat

• Fiat-Crypto Connection (Libra’s basket of currencies)

Solutions?

→ loss of market confidence → crisis in BTC/ETH

• Counterparty Risk
• Exchanges custodying coins (Mt Gox)
• Code risk
• Smart contract (Parity bug)
• Protocol (IOTA and Bitcoin Cash)
• Cryptoeconomic Risk
• Smart contract incentives (MakerDAO)
• 51% attacks

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→ loss of monetary policy → crisis in fiat

• Fiat-Crypto Connection (Libra’s basket of currencies)

Class Goals and Outline

• Understand cryptocurrencies as an experimental representation of value.
• Understand how money drives behavior in cryptocurrencies.
• Understand “traditional” financial public policy goals in the context of cryptocurrencies, focusing on Financial Stability.

Homework for Class #5

• Reading on Institutional Ethics and post on the forun
• Cryptoeconomic Systems Summit, Oct 5-6