Decentralized = volatile? (Warning: skip if you don’t like technical stuff)

A question that then needs to be asked is whether decentralized networks are inherently more volatile. A lot of the stability in current markets are maintained via the various banks, monetary authorities and government policies. We might say that they have done a bad job historically given the many spectacular crashes but how much better will a decentralized system fare?

A good point of reference for this would be the IMF. The IMF was established as a multilateral institution to coordinate exchange rate arrangements among nations. Their immediate focus was on avoiding the competitive devaluations of the 1930s while also encouraging liberalization of the world trade system. It was anticipated that there would be a worldwide system of ‘fixed, but adjustable’ exchange rates, with adjustments coming only when there was ‘fundamental disequilibrium’. As such, the IMF operated on the basis that exchange rates were generally stable enough for trade to be conducted but intervention was required during any black swan events, the trigger for which was usually the inability of a country to continue servicing its debt voluntarily.

There is a lot of debate on whether the ‘austerity’ measures required for IMF aid were too strict or even if the measures taken were effective at all but one thing is certain, even in hindsight, people can’t seem to agree on whether the IMF served its purpose of of economic stabilization (this is a good read for IMF effectiveness). If subject matter experts can’t agree on a result post-fact, what about a decentralized vote on the future exchange rates to stabilize currencies. The free markets might be a solution but it must be noted that globally, there have been many celebrities who were elected as leaders only for their incompetency to become apparent.

The answer then as always is that it depends. It can be said that decentralized systems are inherently more volatile as it will be more susceptible to social contagion but centralized solutions are not immune either. Centralized solutions modifies or keeps free market mechanisms in check but the lack of transparency leads to a lot of uncertainty and blind institutional trust. The debate around trust in institutions vs trust in networks is a whole other argument but what is certain is that the way incentives are structured and the limits placed on a system will critically affect the stability of a system.

As a general rule, countries tend to stabilize their currency by trying to match their money supply with changes in Real GDP (nominal) and inflation rates. This is achieved via a mix of reserves maintained by trusted institutions (Federal Reserve, European Central Bank, etc.) and complex financial mechanisms (bonds, collateralized debt obligations, etc.). Consequently, the dual nature of currencies being both a medium of exchange and a store of value will have to be balanced within this framework.

In theory, this should ensure currency stability but as always human unpredictability ruins any perfect system. Essentially, the value of a dollar will be dependent on the expectations which they have on its value in the future which leads to positive/negative feedback loops. If enough people believe their dollar will be worth less in the future, they will start spending/selling it resulting in a self-fulfilling cycle.

The inverse of this brings an interesting thought experiment: If people expect a currency/asset’s value to rise, they will continue pumping money into the asset up till a point where all the value that people want to store has been put into the asset. In effect, the more money people put in an asset in hopes of realizing a profit, the more the asset will function as a store of value especially if the asset is fixed in supply as most cryptos are. A possible result of this is that if an asset captures a large enough volume and proportion of an economy, it can actually function as a stabilization mechanism due to the same volume paradox we were addressing before. This is an effect some smaller countries do make use of by pegging their currencies to USD.

If this does happen to cryptos, it brings up the question again of whether a stablecoin is needed when the large majority of value will likely be locked up in the most likely candidate: Bitcoin. Granted, there still needs to be a medium of exchange role for day-to-day usage but this could be carried out by other coins/tokens or even in the same design as gas in Ethereum. Bitcoin will effectively function as a decentralized global reserve but rules will have to be in place to avoid any major runs. It will be interesting to see how this plays out especially given the single utility token model that many ICOs adopt today.

I would highly recommend this article on the DAI for those interested in the more technical aspects.