There are a lot of interesting projects related to lending and stable currencies on the Ethereum platform, like EtherLoan, Stabl, and Maker DAO, but when Dominic Williams announced Phi at Ethereum’s DevCon 2, it made a spectacular promise:

A decentralized lending platform with a stable currency as a side effect.

Yup, an amazing goal with a holy grail as a side effect! Clearly this deserved a closer look. You can watch the 10 minute talk explaining Phi here:

I’ve laid out the mechanics he describes below, I think in enough detail to reason about. If you think I’ve made a mistake, please highlight the relevant point and comment on it.

How Phi Works, point-by-point

In the Phi system, borrowers, who need some money but promise to pay it back, and you have you have validators, who are a hybrid of a lender, and a loan checker.

A validator puts up a deposit (let’s say $50k)

They can validate individual loans worth up to $5k each.

They can validate loans totaling a quantity of up to $500k.

If a validator likes a loan, they can create a loan proposal, becoming a proposer.

Two other validators are chosen at random to become checkers, who review the loan, and may approve or reject it.

If the loan is approved by the checkers, the requested Phi is minted from thin air and given to the borrower.

When the borrower makes a payment, the payment is made in Phi. The principal portion is instantly burned.

The proposer gets a portion of the interest portion of the payment (say 60% of the interest portion).

The randomly chosen checkers also each get a share of the remaining interest, let’s say 20%.

If the borrower does not pay, the payment comes from the validators’ deposits, proportional to their shares of the interest payments.

When the borrower is paid in Phi, they take it to the open market to sell on an exchange.

People who are paying back their loans need to buy Phi to pay back their loans, making the demand greater than the supply, ensuring the Phi has value to new borrowers.

What about defaults?

Phi has a clever interface to the legal system:

At loan creation time, the borrower is required to sign a contract by the validator that says “If you don’t pay the computer, the computer will charge me, and you will owe me the amount I was charged.”

This activates the legal system for debt collection.

Phi’s Three Claims

In his presentation, Dominic made three claims about Phi:

It doesn’t involve banks.

It creates loans.

It creates a stable currency.

The first claim is obvious, so let’s look at the other two.

Are these loans? Is that the right question?

Loans and debt have a rich history, with some of the earliest records suggesting that people wrote down records of debt before they wrote anything else. Loans can range from casually unenforced, to legal usury, so I don’t actually think creating a loan alone is an impressive feat. Instead we should ask if it creates good loans.

A good loan would satisfy all the parties of the loan in at least a few ways:

It lets the borrower achieve some financial goal.

It allows the lender to make some money back.

The borrower is able to pay off the loan with reasonable effort.

These things can only be achieved if Phi remains a stable currency, but Phi’s issuance rate is entirely dependent on the rate of new loans given out. When few loans are issued, Phi becomes scarce. When many loans are issued at once, Phi production could exceed demand, crashing its value for new borrowers.

This delicate balancing act is entirely in the control of the validators, who are granted considerable leverage over their deposit relative to the loan they can issue (10x, in the example in the presentation).

I think there are some big questions around the leverage that the platform extends to its lenders, and how it would behave in the real world.

For one thing, a greedy lending culture could enjoy short-term profits so much that they begin issuing increasingly dubious loans until too many collapse at once (sound familiar?), and the lenders’ deposits could be insufficient to burn the outstanding Phi, creating a demand deficit, making it harder to sell newly borrowed Phi.

That’s just the dumb lenders playing the game poorly. What about evil ones playing it well?

There’s a hard-to-exploit but highly lucrative loophole in the validator’s incentives. Since they can approve the computer to lend out loans totaling ten times their own deposit, a validator and a group of a hundred collaborators could arrange a hundred good-looking loan applications, and pass them off on twenty random checkers, default on the loans, and only be legally liable for the percentage of the loans owned by the random checkers (40% in the example).

This means:

theft_size = proposer_bond_size * proposer_share_of_loan * 10

Where proposer_share_of_loan is 40%, this comes out to a 4x profit over the proposer’s original bond once the theft was completed, with no outstanding legal liability to anyone but the loan-proposing lender, who is presumably making off like a bandit.

This scheme assumes strong trust between the lender and colluding borrowers, since at this point a really evil lender could then also try to call in those debts, but with a large enough bankroll, the incentive for 4x profit could justify considerable effort.

Are these loans good for the borrower?

Another effect of making Phi’s stability dependent on incoming borrowers is that there most certainly is some volatility in its demand, especially when it isn’t yet established.

If there were not enough loans being issued, and Phi’s liquidity was low, the outstanding debtors would essentially be auctioning for the available Phi, forcing the price up, and so a debt’s accrued interest could effectively end up being much more than was originally intended.

As Dominic rhetorically asked while he presented,

“So I may get $10k worth of Phi, but when I pay back, I pay back $11k worth of Phi, right?”

Great question!

Is this a stable currency?

When you sell your Phi, you’re betting that you’ll be able to buy more of it later on, for a similar price.

However, like I mentioned, Phi’s availability depends on other people being issued Phi loans at a rate that keeps its price stable. This means that Phi needs to be stable, but that isn’t proof that it will be.

For Phi to remain stable, the continuously issued Phi needs to be equal in value to the payments that are being made over that period.

If more loans are issued, it will be a buyers’ market, and people repaying debts will be able to purchase cheap Phi, because the market is flooded, while new borrowers end up with possibly less value than they’d intended to borrow.

If fewer loans are issued, there will not be enough Phi in the world to pay the outstanding debts, forcing defaults, and draining validators’ deposits.

This suggests that the validators’ bonds are vulnerable to their own inability to continuously issue more loans, creating an urgent incentive for them to issue loans as quickly as they are repaid, a historically dangerous incentive for lenders. This incentive starts slow but snowballs.

new_loans_per_period = outstanding_loans * interest_rate_per_period

Each month, loans totaling the payments of all outstanding loans need to be issued for the price to remain stable. Since these payments include interest, that means the number of outstanding loans needs to continuously expand by its interest rate for the system to maintain equilibrium. There’s a shape this pattern evokes for me.

In other words, the only way for a maxed-out lending community to keep the Phi market from crashing is if they continuously reinvest all of their newly earned interest into their Phi bonds. Otherwise, they will require fresh lenders in order to cash out. That said, there isn’t really any incentive for a paid-back lender to try to maintain a stable Phi, so they might just exit, depreciating other validators’ bonds, creating a sort of race-to-the-door.

As validators exit, fewer bonds can be issued, which means not enough Phi is minted, which causes the price of Phi to rise, which causes borrowers to default.

I suppose the hope is that this price spike incentivizes additional lenders to become validators, but presumably they’d be lending at the inflated price, so I’m not sure that solves the issue.

Where does Phi come from?

After writing the above, I’ve come upon some further explanation by Dominic.

In it, he clarifies that the price is stable, because there will be a Phi for every major currency, for example, a PHI-USD would be a single token type.

Furthermore, the bonders are required to post their bond in this PHI-USD currency. This now seems like a cyclical system. If the PHI-USD is only minted when loans are issued, how is the first bond posted?

If there is another way of minting PHI-USD, who has that authority?

If PHI-USD is only stable against USD, and you have a mechanism of issuing it in the first place, why not just keep that? Who needs the Phi version for the stable currency?

What’s Wrong?

As you can see, this system is fairly complex, and very worthy of some careful consideration.

I actually think there’s something fundamentally correct in Phi’s design, namely in the way it issues new value at the point in time that new trust is created. I’m still working those thoughts out, but I think building actual trust may be the kind of thing that is under-valued, but is actually very democratic, and minting coins at that moment has some honest properties.

That said, there are definitely some mechanics in here that look like they could be volatile in combination.

I suspect the very smart people at String.technology have some more formal analysis in their labs, but I’d like to hear those thoughts laid out in more detail before I can get genuinely excited about this proposal. The goals are wonderful, but we owe ourselves careful reasoning before we investing in big new ideas.