What is a Promise Worth?

How do you prevent hyperinflation without destroying the economy? The answer ain’t Bitcoin.

A virtual currency like Bitcoin uses a decentralized proof-of-work ledger (the block chain) to solve the the double-spending problem. “Satoshi Nakamoto” deserve serious accolades for this clever architecture, but Bitcoin has a few serious problems. The first is its lack of security. The infrastructure around the currency is shoddy and fragile. The website where 80% of Bitcoin trading currently occurs is called the Magic: The Gathering Online Exchange (a.k.a. Mt.Gox). Recently Mt.Gox has crashed and been cracked, and does not support easy shorting. More importantly, the Bitcoin system may never mature without a central authority spending a lot of (traditional) money to build-out the infrastructure, with negligible or negative financial return-on-investment. Without a social program, in other words.

Even if Bitcoins did have the infrastructure and liquidity of a traditional currency like U.S. dollars or Japanese yen, there is another more fundamental problem with Bitcoin becoming the money of the future. Bitcoins are intrinsically deflationary.

The future will always be in one of two states: Either Bitcoin miners are running up against the limits of Moore’s Law, and are unable to profitably mine new Bitcoins. Or some bullshit singularity has occurred, giving us all access to infinite computational power. In this state, we would run up against the Bitcoin architecture’s hard-coded monetary supply cap of twenty-one million Bitcoins.

If human desire is infinite, then people will always want more money for goods and services. (All else equal, of course!) So we have an intrinsically fixed supply of a fungible good along with increasing demand. Therefore a Bitcoin is guaranteed to increase in value over time. Any fraction of a Bitcoin is guaranteed to increase in value over time. This may sound good if you happen to have a lot of BTC (Bitcoin) in your wallet. However at a macroeconomic level deflation is catastrophic, which I will explain.

A Hamburger on Tuesday
Would you trade something today that is certain to be worth more tomorrow? What about if the “something” is a currency, a good that has no intrinsic value other than it being money? (You cannot heat your house with the digital dollars in your checking account. Gotta pay the utility company first.) In an emergency you might spend your deflating currency, but in general you should hold onto your BTC as long as possible. And since there is uncertainty about the degree to which Bitcoin will deflate, the market will not instantly price BTC correctly. The BTC price of goods and services will not instantly adjust to match the level of computational power available to miners.

Some Bitcoin proponents think we can instantly discount the BTC price of all goods and services to sync-up with systematic BTC deflation, but this would need a seriously high-tech payment infrastructure. Square and Stripe are trying, but does anyone seriously believe the prices of all goods and services can be discounted in real-time by a macroeconomic indicator? We can’t even ditch the wasteful dollar bill!

The Bitcoin bulls also emphasize a currency’s dual role as a means of transaction and a store-of-value, but intrinsic deflation trashes both roles simultaneously. As a means of transaction, deflation makes allocating capital (money) across projects and activities difficult, and again, requires that perfect payment infrastructure. Since systematic deflation destroys every asset’s value and discourages economic activity, deflationary currencies do badly as stores-of-value. Less economic activity means GDP contraction and decreased livelihood. Yes, despite what Professor von Nimby may have spewed in your Postmodern Marxist Studies class, GDP is a very strong indicator for overall human happiness. Perpetual economic contraction makes your savings account irrelevant. You might have a zillion super-valuable BTC in your digital wallet, but you have nothing to spend them on. In other words, if you think (hyper-) inflation is bad, deflation is even worse…

Passing Notes
Let us go back to a few of the original Bitcoin goals. Bitcoin proponents want an efficient, liquid currency immune from the distortion caused by a government or central bank’s monetary policy. This is reasonable since inflationary monetary policy has a sad history of trashing peoples’ savings accounts, in places like the Weimar Republic or more recently in Argentina. So how can we build the decentralized, non-deflationary currency of the future?

Notes are an ancient monetary concept desperate for rethinking in the Internet age. At its most basic level, a note is a promise to exchange money, goods or services at some point in the future. However a note is not quite a futures contract, because the promise need not ever be exercised. And a note is not really an options contract, because a note need not ever expire. The most obvious form of a note is what a U.S. dollar bill used to represent when we were on the gold standard. It was a promise that the holder of the note (dollar bill) could exchange the note for a dollar’s worth of physical gold at any time. Notes are a lot easier to store and deal with than gold, and so they make a lot of sense for getting work done efficiently. We could also talk about the fungibility of notes, but that is less important at this point. And notes are definitely easier to move around than loaves of bread, head of cattle, barrels of oil, or other physical stuff with intrinsic value.

A hoard of notes would also be a decent store-of-value in your savings account, as long as the writer of the notes remains solvent and trusted. For example, a million dollars worth of U.S. gold-convertible notes is a great retirement nest-egg, since most normal people expect the U.S. government to honor its promises for a long time.

When the entity writing the note is trusted by just about everyone — expected to honor its contract — then the writer can declare the notes to be unconvertible, all at once. The notes become fiat currency, currency that is not explicitly backed by anything but the trust that the note writer will not issue too many notes and inflate away peoples’ savings.

Why does most global economic activity happen using a handful of fiat currencies, like the U.S. dollar or Euro? Nations have traditionally supported their (fiat) currencies through policy and war, because before the Internet trust did not scale. Imagine a small town. Mel and Stannis are neighbors in this town. Mel trusts Stannis to honor his promises, and accepts a note from Stannis in return for mowing Stannis’s lawn for the next year. Stannis’s note he writes for Mel says something like “Stannis promises to give the bearer of this note 100 loaves of bread, anytime.” Mel’s landlord Dave also trusts Stannis, and so he has no problem taking Mel’s note as rent. Stannis has essentially printed his own money that is a lot more convenient that baking 100 loaves of bread. Now in the next town over, no one really knows Stannis. Therefore Dave will have a hard time making use of Stannis’s note when he visits there to spend time with his grandparents. Dave and Mel trust Stannis, but the people living in the next town over do not.

In this parochial example, trust has not scaled across the network of transactions and relationships. The money Stannis created, the note he wrote, is not all that useful to Mel. Instead she could insist on being compensated by a note from an entity more trusted the world over, say the First Bank of Lannister which has a branch in both towns. Mel, Stannis, Dave and his grandparents all probably trust the First Bank of Lannister to pay its debts.

If Dave wants to spend Mel’s note written by Stannis in the next town over, he can ask a third party to guarantee or sign-off on the note. This can be done by exchanging Stannis’s promise for a promise by the First Bank of Lannister, which is more trusted throughout the realm. The First Bank of Lannister would be compensated for extending its trust by taking a cut of the promise from Stannis.

So before he leaves on his trip, Dave takes his rent check (note) from Mel into the First Bank of Lannister. They write a new note saying “The First Bank of Lannister promises to give the bearer of this note 95 loaves of bread, anytime” and gives this note to Dave in exchange for the note written by Stannis. The bank has decided to take responsibility for chasing down Stannis if he turns out to reneg on his promise, and in return they are compensated with the value of five loaves of bread. Here the Bank of Lannister has also issued its own currency, but more as a middle-man than someone doing economic activity like Mel’s lawnmowing or Dave’s landlording.

This middle-man role is very important but also difficult to scale across a physical economy. Eventually someone refuses to trust the First Bank of Lannister, and then the chain of economic activity halts. This is why the world’s global economy has consolidated onto a few currencies, for reasons of both efficiency and trust.

The Internets
In the age of the Internet and pervasive social networks like Facebook and Linkedin, everyone is connected in a global network. This is the famous degrees -of- Kevin Bacon or Erdös Number concept. Any two people are connected by just a few steps along the network. Most of Stannis’s friends on Facebook would be willing to accept a note or promise from Stannis, and the same holds true for Dave, Mel and the First Bank of Lannister’s social networks. Since the whole of humanity is probably connected in a trust network, software can automatically write those middle-man notes along the chain of connections. Therefore any two people can automatically find a chain of trust for spending money.

Back to our example, but in the age of the Internet. Mel, Dave and Stannis all trust each other, since they are Linkedin contacts. Peter reneged on a note a few months ago, so no one really trusts Peter except Stannis. Everyone unfriended Peter but Stannis, so Peter has a very isolated social network. This time around we do not need to care about geography and small towns, since everyone is connected via the Internet and social networks. Let’s say Peter wants to buy an old iPad from Dave, and Dave thinks the iPad is worth about a hundred loaves of bread. Peter could try to write a note promising a hundred loaves of bread, but Dave would not accept this note since he does not trust Peter. Now for the cool part.

Peter goes to a notes exchange website (NoteEx), and asks for a hundred-loaf note that Dave will trust. The website knows that Stannis trusts Peter, and that Dave trusts Stannis. (See the triangle?) Through the website, Stannis writes Peter a note for one hundred loaves of bread that Peter gives to Dave in exchange for the iPad. Dave has a note he trusts in exchange for his good, at the price he wanted. Similarly Stannis receives a note written by Peter, whom he trusts. This note might be for 105 loaves of bread, giving Stannis a little cut in exchange for trusting the dodgy Peter. This five loaf interest, cut or edge is Stannis’s compensation as a middle-man.

This can all be done automatically by the NoteEx server with a list of middle-men volunteers. People volunteer to be middle-men up to a maximum amount of exposure or risk (i.e. one thousand loaves of bread total). Or middle-men could even offer to guarantee up to two degrees of Kevin Bacon away, for a much higher cut. After a bunch of people volunteer to be middle-men in the NoteEx process, all economic activity could be subsumed, with social networks ensuring that you only ever receive payment (promises) from people you trust. A NoteEx transaction could have more than one middle-man, up to the six degrees of Kevin Bacon maximum that we assume connects all people.

Ironically, the good or service underlying the notes is not all that important, since notes are very rarely redeemed. In the same way that powerful governments can support fiat currencies backed by nothing, fiat notes backed by loaves of bread will not actually turn everyone into a baker. Usually notes are exchanged with their value being the trusted promise, but not necessarily the realization. Heavy stuff here.

Decentralized Bakery
The NoteEx website would be built atop an open and standard protocol, and competing notes exchanges could borrow from the Bitcoin architecture to be decentralized (i.e. the shared ledger). More importantly, there would be a natural level of inflation in the system as the cuts or interest that middle-men demand increase the total value of all promises across the economy. And of course, notes are an excellent store-of-value because who would you trust more to support you in an emergency or retirement than your tightest friends & family?

So! We have a theoretical monetary system free from government interference, and one that encourages economic activity through modest and natural inflation.

Under the Hood of Buying & Selling Predictions

How do those futures markets like Betfair and Intrade work?

The managers of a prediction market decide upon a finite number of prediction contracts. A contract is essentially a description of some hypothetical future event. For example, a contract might be “Fadebook trades at least $50 per share in 2012.” Another important aspect of the contract specification is the anticipation and preemptive resolution of ambiguity. If Fadebook does a 2:1 split, does the event become “…at least $25 per share?” What if the asking price for Fadebook shares reaches $50, but the bid price does not? Contracts also specify an expiration date, a time by which the event must occur. In the case of the Fadebook contract, the obvious expiration date would be January 1st of 2013. For other contracts, the expiration will be arbitrary to allow for a final decision on the event’s occurrence or nonoccurrence.

Virtual Currency
A prediction is a single user’s opinion on the likelihood of the contract’s event occurring. The prediction market encourages users to form opinions about contract events, and encourages users to wager virtual currency on a contract. Users purchase virtual currency (henceforth “credits”) with real money, or perhaps are granted an amount of virtual currency in a freemium offering.

Contract Size
Each contract also specifies a size, which is both the minimum number of credits a user can wager on a contract, and the marginal increase in the size of a wager. If the prediction market choose a size of “5 credits” for the Fadebook contract, then an individual user can wager only 5, 10, 15… credits on the contract. Contract sizes are necessary in order better match both sides of the wager. Somewhat confusingly, experienced traders refer to each increment of the contract size as “a contract.” If I wager 15 credits on the Fadebook contract with a size of 5 credits, then I am said to be wagering “3 contracts.”

Direction
When making a wager on a contract, the user specifies the number of credits she will risk, in contract size units, and the direction of the wager. If a user believes the event is certain to occur and the user is eventually proven correct, she will profit from buying a contract whenever its likelihood is less than 100%. If a user believes an event is certain not to occur and turns out to be right, the user will profit from selling the contract when its likelihood is greater than 0%. The buyer of a contract is said to be long and the seller of a contract we call short.

Payoff
When the contract’s event occurs, the long side earns the contract size in credits for each contract, less the likelihood level where she initially make the wager. So if Fadebook’s stock hits $50 in October of 2012 while I am long 3 contracts bought at 25% likelihood, then the prediction market would immediately close the contract and credit my account with 5 credits (size), times 3 contracts, less 25% of the total, or 11.25 credits. The opposite also occurs for the short side. In this case, the 3 contracts the short side sold are closed out worthless at 0%, and the short’s account is reduced by 5 credits size, times 3 contracts, times 25% of the total. Again this is 11.25 credits but deducted from the short side of the wager.

If the contract expires as the year 2012 comes to a close, and I shorted 2 contracts at 60% back in February of 2012, then I will earn a profit of 5 credits size, times 2 contracts, times 60% or 6 credits. This is exactly what the long side of those 2 contracts would lose. The long side may be 1 user, or 2 different users each long 1 contract.

By definition, the long and short sides of a contract will always balance. A user is not able to be long a contract unless another user is short. This would be similar to a real futures contract traded in Chicago or New York, but where the long side is committed to “buying” the event for 100% if it occurs.

Orders
The current likelihood (henceforth “price”) of a contract is determined by looking at the contract’s order book on the prediction market. Order books are how buyers and sellers of contracts are matched, and indicate a prediction contract’s current price or likelihood. An order book is an ordered list of buying and selling prices. If there is no market in a contract and a user wishes to make a wager, her estimated likelihood becomes the best buying or selling price for the contract. From now on we drop the price or likelihood’s percent sign for brevity.

Say the Fadebook contract has just been listed and publicized on the prediction market. If I believe the event is very likely to occur, then I might offer 99 to anyone willing to sell at 99. If I am correct, then I will eventually earn 1 credits per contract for my trouble. I will have paid 99 for something that will earns me 100. Though perhaps I want to leave myself more room to profit, and instead offer 25 to anyone willing to sell at 25. This would mean a profit of 75 per contract when it expires. The prices at which every user is willing to buy forms one side of the order book, the buying prices or bids.

A similar process happens on the selling side. I want to be short a contract when I do not believe the event will occur. So I would sell to anyone for more than 0 likelihood or price. If I end up correct in my prediction and the event does not occur when I went short at 90 likelihood, then I earn 90% of the contract size for each contract. The collected prices at which all users are willing to sell forms the other side of the order book, the selling prices or asks.

Market Orders
When a wager occurs at a price matching one of the buy or sell orders currently available in the market, the order is instantly made complete by matching a long and a short side of a wager. If I want to buy the Fadebook contract at 30 or 35 and there is already a user with a selling price or ask of 32, my wager will be immediately matched. In this sense, my order never actually appears in the prediction market order book for the contract, since the wagers are instantly matched.

Often a user will want to buy or sell at whatever likelihood or price the market is currently offering. In this market order, the user takes whatever happens to be the best price available at the time. Market orders are risky because the user may not know the exact price at which she commits to the wager. Market orders are also said to leduce liquidity in the market, and may be considered less healthy for the prediction market than regular limit orders.

Trading Out Early
The fundamental advantage to prediction markets over traditional oddsmaking is the option for a user to exit out of a profitable or loser wager early, before the contract event’s expiration. A user who is currently long or short a contract is free to trade the position to another party at any point, even if the user has only held the contract for a few minutes. This is advantageous for a user who wants to cut their losses early on a losing contract, or wants to take their profit early on a contract that becomes profitable.

If I went long 5 of the Fadebook contracts at 35 a few months ago, but that contract now has an order book centered around 50 bid/ask, then I can sell the 5 contracts for a 15 profit per contract right now. I do not need to hold my Fadebook contracts until 2013. This is not going short the contract, but selling to a willing buyer in order to net out my position with a profit.

Liquidity & Accurate Predictions
The more users are actively participating in wagering on a contract, the more accurate the collective estimate of likelihood. The most recent trade price or likelihood of a very busy and popular contract is an excellent estimate of the real likelihood of the contract event occurrence. If a single user believes a contract has a 35% likelihood, but a thousand other users are trading that contract around 75% likelihood, chances are the first user is wrong!

Prizes & Incentives
Prediction markets are more powerful when users are incentivized with real compensation. Therefore even if the prediction market’s virtual currency simplifies the regulatory aspects of the project, credits need to be closely tied to real money or prizes, so users assume actual risk when making wagers. Also any prizes need to incentivize users to make careful wagers and not necessarily “swing for the fences” on each wager. In other words, each bit of virtual currency must contribute to winning prizes.

Users who risk nothing of value when making wagers will not turn out to form a particularly accurate prediction market.