I think the goals of Mastercoin are really important. Specifically, the construction of derivatives that track the price of real-world currencies under normal circumstances.
I would like this to succeed. However, I'm positive that Mastercoin's implementation is seriously flawed. I think these flaws could be fixed, though I doubt they will be.
Nevertheless, I created this thread to document well-reasoned criticism specifically addressing how these derivatives will work. (my own criticism and that of others). I hope this will be useful to either Mastercoin, its competitors, or future projects.
I am removing any posts that I feel do not add significant value. My main criterion is that posts should offer positive predictions of what will happen in the Mastercoin derivative market. Normative judgements and blanket dismissals based on axioms are not useful for this purpose. For this reason, I am not allowing any Austrian commentary in the thread.
To get this started, I have collected the most useful critical comments in the long Mastercoin thread and am offering some brief comments that expand on them:
2) Seems to assume that one cannot control prices by controlling supply. I believe that is false. While the fed has indeed printed a lot of money, they could drive the value of the dollar to zero if they wanted to print billions of dollars and give them to every person on the planet.
Increasing supply to decrease price is the easy part. Decreasing supply to increase price is the impossible part.
I think you know that it won't track. You use terms like "Given a reasonably stable MasterCoin". But Bitcoin has shown that to be VERY unlikely. Also, its not even a stable MasterCoin that matters, but a stable RATIO between MasterCoin and the commodity...
Comments: Decreasing supply to increase price is not impossible, though it is a very delicate matter. I see the following options for decreasing supply:
a) impose demurrage rate on the stabilized asset as in freicoin; (as a grossly inferior substitute txn fees could be used instead)
i) reissue demurred assets when price is constant (e.g. as mining reward or distribution to someone besides the asset holder)
ii) destroy demurred assets when price is falling
b) maintain an escrow fund that purchases assets at a fixed exchange rate; the fund is always open to purchase assets until the escrowed funds are exhausted.
c) a mixture of (a) and (b); escrowed coins are returned to the initial asset issuer as demurrage occurs (for the issuer demurrage is interest)
Any of these could potentially work. I prefer (c). Mastercoin opts for (b). I am very concerned that Mastercoin plans to use mastercoins as the escrowed asset. BTC is an infinitely better choice because BTC valuations will be much more stable. Thezerg's comment is on point here. I am also concerned about the mechanism that rewards asset issuers for creating assets and backing them with escrow funds. Asset issuers need to get a positive risk-adjusted return on their escrowed capital. Demurrage fees could potentially fund this. It is not going to be sufficient to back assets one-to-one. Not with the value of the backing halving and doubling in value from month to month. You will need something like 3 to one backing to be credible. What motivates asset issuers to sink 3 USD worth of BTC into the creation of 1 USD worth of cryptoasset. It's going to have to be demurrage. i.e. the asset has to gradually melt returning its collateral to the asset issuer in the process.
Regarding helping the escrow fund, I was referring to the escrow fund creating a "self-fulfilling prophecy" ideally, the escrow fund would never have to intervene under normal circumstances. It's just there to correct persistent long-term deviations from the target.
Comments:This is a little unfair because I am deviating from my model of quoting criticism. Sorry. This quote reflects a serious misunderstanding of monetary economics which is worth emphasizing. The market price depends on the cryptoasset supply and cryptoasset demand. The cryptoasset is not identical to real gold or real USD etc. It has its own supply and demand curves. To keep price fixed, the escrow fund will need to intervene continuously to increase and decrease asset supply to accommodate changes in demand. The fund will need to be very well-endowed indeed. Demand fluctuations in the cryptocurrency world are something to behold.
We have seen often in discussion regarding Bitcoin, people have suggested, "well why not just peg it to gold, or to dollars, or some other other stable asset to eliminate the volatility?" (Max Keiser suggested such a thing a couple months ago...
) The reason is that you cannot peg one asset to another in an open market. The peg
will be broken.
The reason is what some of the others here have described - it will become the target of a speculative attack. And the attacker has a nearly guaranteed chance of winning if he has enough money to throw at it. In the real world, we have seen such speculative attacks on government currencies including the Thai Baht and UK pound (that's how Soros got famous). If private actors can break the pegs of government currencies, it can be reasonably inferred that breaking a crypto-asset peg with a market cap of only several million dollars would be trivial.
An escrow fund cannot be expected to keep an exchange rate stable when set against the forces of hostile speculators.
[quoting evoorhess]
+1. This is exactly what I meant by "Norman-Lamont-y". Except this would be easier than breaking a national peg, not only because of the reduced volume required, but the fact that the escrow will behave entirely predictably. You know when it will buy and sell, and how much.
Comments:As much as it pains me to give evoorhess credit for anything, he is 99% on point here. Let's go over how a speculative attack works and why it guarantees devaluation of the derivative when its backing falls below parity under certain assumptions (the 1% where evoorhees goes wrong is his failure to state the qualifying assumption (b) [if (b) does not hold, a speculative attack becomes impossible])
Assumptions:
a) I assume that the mastercoinUSD derivative is initially trading at parity. (plan is to demonstrate that this assumption is inconsistent with assumptions 2 and 3)
b) I also assume that the escrow fund is insufficient to back the mastercoinUSD derivative on a one-to-one basis. (fractional reserve)
c) I assume that the attacker can get collateral sufficient to borrow a significant fraction of all existing mastercoinUSD derivatives. He will tempt people into this by offering to pay very high interest rates on the loan.
Executing the attack:
1) The attacker borrows mastercoinUSD derivatives, offering a high rate of interest to anyone who is willing to lend them. If the lenders actually expect (a) to hold in the future, then they should be delighted to accept the high rate of return. If not, then they should be selling mastercoinUSD now and thus assumption (a) could not hold.
2) The attacker now controls a bunch of mastercoinUSD and can exchange them using the escrow fund. He does this, depleting the escrow fund in the process. Other people observe what is going on and start joining the attack either by selling on the market or using the escrow fund to sell. Their participation helps a lot, but is not essential for this to work. In the process, the attackers accumulate the escrowed assets. These will end up as pure attacker profit. The attack continues until the escrow fund is completely exhausted. Exhaustion is possible due to assumption (b).
3) The mastercoinUSD is now unbacked. It is completely worthless paper trading for pennies on the dollar if we were hoping for an IMF bailout and $0.00 under the harder realities of cryptocurrency markets.
4) The attacker's work is done. He purchase up the valueless mastercoinUSD and pay back his mastercoinUSD creditors worthless paper. The hapless holders of mastercoinUSD suffer a total loss.
The key takeaway here is that a 1-to-1 reserve is never going to be credible. Any loss in value of collateral will set off the attack process. The derivative's price will collapse to zero even under a quite small adverse market fluctuation. Suppose we have a 100-to-1 reserve, however. A speculative attack can never happen in this case except under the most extreme circumstances (e.g. the price of collateral falls 100-fold relative to the USD). The problem then becomes how do we get people to spend 100 USD of coin to create an asset which they then sell for 1 USD. It is a thorny problem, but not impossible as evoorhees implies.
I'm super-pleased that you have taken a look at my paper. (By the way, anybody who hasn't seen Erik's excellent talk at the San Jose conference should do so right now:
http://www.youtube.com/watch?v=H2YllvbJo6g)
I think it is worth taking a minute to define how a speculative attack on a pegged currency works. A government can actually peg their currency indefinitely just fine, and not worry about speculative attacks. The problem comes when they ... (i.e. control the money supply to juice their economy).
This response to evorohees here is correct technically, but completely misses the point. If supply can always adjust downwards when demand drops, then as dacoinminster says there will be no problem stabilizing price. However, the so-called freely adjusting supply is a pipe dream. Supply cannot adjust freely unless the escrow reserve exceeds 1-to-1. The escrow fund manages supply by purchasing the derivative at the price of the real world asset and destroying it. This reduces derivative supply and prevents the derivative's market price from falling. However, if there is a fractional reserve, the escrow fund will run out, leaving unbacked supply outstanding. The unbacked excess supply cannot be removed from the market. At this point, the derivative price drops to zero in order to equilibrate supply and demand (why pay anything for unbacked paper). This eventuality is a certainty not just a possibility. When speculators see a fractional reserve for an asset trading at parity, they force immediate adjustment via speculative attack and take profit. There is no IMF to scare them off in the cryptocurrency world. Speculative profits are free for the taking.
I don't believe this is true. A government (or any other entity) cannot maintain a peg indefinitely unless they have a indefinite amount of resources with which to do it
Comments:Here we step into the 5% territory where evoorhees spouts his usual nonsense. Let's watch d'aniel take him down.
It's trivial to create a currency with a perfectly stable peg: just maintain 100% reserves in the same asset you're pegging to. Decrease this reserve ratio, or swap out the reserves for ones whose price has less than a guaranteed perfect correlation with the pegged-to asset going forward, and you increase the risk of being overrun and the peg breaking.
The scheme presented here proposes 0% of the reserves be held in the pegged-to asset, and all of them to be held in a new and unnecessary asset with no established liquidity, whose price has no reason to be anything other than completely uncorrelated with that of the pegged-to asset. It strikes me as maximally risky.
Comments:This is the best comment yet in my opinion. The scheme proposed here is indeed absurdly unstable. However, as d'aniel implies, this does not mean that all schemes are unstable. The risk all depends on the reserve ratio. If you are using stuff as volatile as bitcoin and you lack a lender of last resort (FED, IMF, etc.), the reserve ratio is going to have to be well in excess of 100%. I'm thinking 400% as a ballpark figure. The higher you go the more stability you get, but it doesn't come free. You will need to pay the insurer for providing the escrow funds via demurrage (txn fees could work too in theory, but demurrage is a much more logical choice here).
If the total value of the backing drops below the total nominal value of the issued currency, then why anyone would ever bother to buy this one over a freshly created copy? The latter always begins its life with full backing, and thus has a relative advantage over the former. It seems to me that once this threshold is breached, the old currency will have to sell at a discount to compete with the new one, thus depleting the escrow fund until it's wiped out completely. Notice that the old currency remains technically insolvent no matter how much buying the escrow fund does, and it can never eliminate the advantage that the new currency has over it. Its demise is a certainty at this point.
Comments:D'aniel has outdone himself. Clearly the most knowledgeable contributor in the thread. Ignore him at your peril. An equally important question: Why anyone would bother to create a new mastercoinUSD unless the escrow fund drops into fractoinal reserve? If you have a reserve > 100% and the >100% reserve derivative trades at parity, newly created mastercoinUSD will be unsaleable unless they match the reserve level of outstanding mastercoin. However, backing a USDcoin with 1+x USD of BTC and selling it for 1 USDcoin is a sure way to lose x dollars. Nobody is going to create new mastercoinUSD under these conditions. Similarly,
This implies a (long-run) supply curve for mastercoinUSD trading at parity, you have infinite supply of mastercoinUSD minting if the reserve falls below 100% (this is an arbitrage opportunity). Uh oh, infinite minting as soon as the coin gets into trouble, that sounds like a sure way to move the price to zero. So the price can't trade at parity. If mastercoinUSD trade at parity and backing exceeds 100%, then you have zero (long-run) supply. Supply is capped at whatever the outstanding issue is until the reserve drops. This tells us that (at least in the long-run) mastercoin USD will trade above parity when the reserve exceeds 100%. The design is seriously borked. MastercoinUSD only trade at a price of 1 USD when the escrowed backing is precisely equal to 1 USD in value. Any type of market fluctuation (no matter the direction) will knock the currency off the peg.
If the total value of the backing drops below the total nominal value of the issued currency, then why anyone would ever bother to buy this one over a freshly created copy? The latter always begins its life with full backing, and thus has a relative advantage over the former. It seems to me that once this threshold is breached, the old currency will have to sell at a discount to compete with the new one, thus depleting the escrow fund until it's wiped out completely. Notice that the old currency remains technically insolvent no matter how much buying the escrow fund does, and it can never eliminate the advantage that the new currency has over it. Its demise is a certainty at this point.
All GoldCoins are backed by the same escrow fund, to the same degree. GoldCoins are fungible, and there wouldn't be one that was more funded than another.
These constraints are artificial. The market is much bigger than your system.
Man, d'aniel are you my sockpuppet? I would have written "These constraints are unenforcable in a decentralized system" but I remain totally on d'aniel's nutsack in anycase. Why are the constraints unenforceable? The currencies are user-created! Anyone can always create a mastercoinUScent or mastercoinUSdime. The system has no way of knowing that a mastercoinUSD already exists and therefore that these constructs break the rules. Okay, maybe the rules can be a little clever at detecting these so-called cheaters. The cheaters can then create a mastercoinEURODOLLAR = 0.99 mastercoinUSD + 0.01 mastercoinEUROs. Functionally this is still a USD, but a program will have a devilishly hard time making this judgement with out centralized intervention.
Conclusion:Mastercoin, as described, is seriously fucked. Is there any interest in fixing it? No responses to this thread so far. I'd rather not waste my time describing how if I don't have an audience.
