This article was originally published as a blogpost on Medium
So I sat down to read one of the “Economics of Libra” documents and found a nebulous spin on fundamental concepts that are all messed up and misunderstood.
Let’s start with the Market Design for a Blockchain-Based Financial System paper on SSRN, only an “extended abstract”, that confuses the very meaning of “market design” with the consensus protocol that a said platform uses. I am reading this in the context of Libra.
The Market in “Market Design”
Market design is about demand and supply, not the consensus protocol. What’s being demanded and supplied on a blockchain protocol? Let’s for a second, assume that computing power is both the demand as well as the supply in a decentralized protocol. The suppliers are miners and the people demanding computing power are…? Who are the people demanding computing power? No one! It’s a cost in the system in order to secure the system. Bitcoin (let’s stick with the Bitcoin blockchain as per the reference in the paper) is more of a clearing house of transactions and the clearing house is powered by demand for electricity that goes in the computing power. The market, where demand and supply match, is off the network — these are informal forums where people predetermine what the transaction is for, how much of bitcoin would be sent and when. Simple, right? Just like anything else in the world. Now, let’s say it’s an auction of some sort (where I am willing to fulfill the demand for a service to the highest bidder; let’s keep it simple), so then, as a supplier (miner) I would only validate transactions that have the highest transaction fees (now we are in the Ethereum world) and hence fulfill the ‘demand’ for computing. What have hard forks got to do with it? All I am looking to do is provide supply where there is demand and all I need is a clear set of rules for this system and prices for fulfilling demand in order to operate. We can talk about network attacks etc, but that’s not market design aka auctions theory or matching theory.
Here’s what economists consider instead. Markets are designed such that:
- Markets are efficient, that is, the equilibrium price reflects the aggregate demand and supply.
- Markets have sufficient number of buyers or sellers, which ensures that the prices stay stable.
- Markets are not congested, that is, there is a smooth matching of demand and supply whether in a centralized or decentralized manner.
- Markets have low search and transaction costs, because if they are too high, people wouldn’t want to transact at the first place! Imagine paying $100 to send $10 to someone.
Market Design is the field that determines, given a certain good/commodity, how to bring together buyers and sellers, such that the above conditions hold. You can observe three things:
- All of them need to simultaneously hold true.
- Centralized versus decentralized matching is one component of market design. And it’s a choice that should be determined by the specific characteristics of a certain market (which partially varies on whether the market for a good/service exists or not).
- There are trade offs when it comes to market design. It’s just like you can’t have the cake and eat it too (everybody understands that!). And that’s where the genius of an economist lies.
The obsession with long-run equilibrium
It’s one of those cult things, or you can call it confirmation bias but many of my colleagues in the profession (really do) believe that all prices converge in the equilibrium state. What in the world does that mean? Imagine a unicorn world where everything is perfect (we don’t know why anyone would be doing economics in such a world but anyway), the equilibrium is that perfect world that is never going to come true. We are never going to see an actual unicorn. But that doesn’t stop people from talking about it, right? For example, you can compare the current world with the unicorn world and argue that the goal of all economics is go from the current heck-of-a-mess we live in, to the unicorn world. In fact, more outrageous than that, how about this: let’s all collectively believe that all markets converge to this unicorn standard! That’s basically what this equilibrium talk is all about. Are you sold? I’ve been studying, researching and teaching economics for a total of 13 years. I am not.
Whenever you see an argument for long term equilibrium (where markets automatically clear), that’s the unicorns-and-rainbows world that I just described above is what we are talking about. Back in the day we lacked empirical knowledge of the world (at least at the macro level), our computations tools were severely limited and most science was — you guessed it? — storytelling. Imagine explaining how childbirth happens to a 2-year old. You have to simplify things. That’s basically what it is. Only 200 years old.
For an economist designing markets, it hence provides a weak anchor — or actually — no anchor at all on how to achieve an efficient market.
If it comes down to relational contracts (law), where is the economic engineering?
The extended abstract talks about how a) proof of work wastes energy and is only useful if the relational contracts are weak and; b) proof of stake is the way to go if relational contracts are strong. Why waste energy if you don’t have to? Duh. So my question really is: why in the world even use blockchain (sure, I know the data sharing efficiencies in the network argument etc, but let’s stick with the economics for a second here) when you’re basically just relying on the law, enforced by courts? Where is the genius economic engineering? What’s new here after all? The answer? Nothing at all. Basically, the paper just says that there would be custodians (like we have now in our centralized economies), who would have relational contracts with the nodes/users in the network (like the citizens of a country owning assets that are managed by custodians) and these custodians control the nodes (viola, just like in our current financial system). Here’s what you need to know: as of 2018, the 4 largest custodians in the world have $114 trillion in AUC/A. A tad too much?
Actually, the current centralized systems we have are much better than Libra. At least they are regulated.
