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Merton, Trust, and Cryptoassets


The legacy of American economist Robert Merton is so significant that it is difficult to express it adequately. The Wikipedia entry dedicated to him lists a total of 23 honors and awards received over four decades, highlighting the Nobel Prize in Economics in 1997 for his contributions to options pricing.

On June 4th, he participated in an event in São Paulo, where he gave a fascinating lecture on financial innovation, showing how it is intrinsically related to economic development, with real-world examples. He also showed how such innovations have been occurring at an increasingly rapid pace, displaying a timeline between the years 1200 and 2010.

After the lecture, a session began in which three panelists asked Merton questions. The topic of cryptoassets came up in the second question: “What is your opinion on digital assets, Bitcoin, cryptocurrency, blockchain technology? Do you think this is a real innovation that can add value to society, or are they just a smokescreen for price bubbles and speculation?”

Merton began his response by saying that there is no doubt that the tool – blockchains – will be very useful, but he is skeptical about the applications, such as cryptocurrencies. In a way, he echoed the widespread idea that blockchains are good, but cryptos are bad. However, in reality, the two form a binary system, like a key and lock, and consequently, are inseparable. Blockchains are decentralized networks for digitally recording information, and to ensure that their participants act honestly, voluntarily, and independently, there needs to be some representation of value, neutral and without counterparty risk, that rewards good contributors and punishes malicious agents. The native cryptos of blockchain networks play this role, aligning participants’ incentives and allowing network effects to emerge without the need for mutual trust.

Returning to Merton’s answer, he went on to propose a four-question framework to evaluate applications: (i) what problem does the application seek to solve? (ii) how is this problem addressed today? (iii) how is the new application better than the existing one today? (iv) is there an even better alternative than the proposed new application? By presenting this framework, the economist gave some hints as to why he is skeptical about applications, implying that crypto fails in some of these questions, particularly in its application as a currency.

One passage of the answer, however, reveals a fundamental premise of Merton's with which the vast majority of those who believe in the disruptive power of the blockchain/crypto binomial disagree: “You need trust, and usually, the best trust you can find — it doesn’t mean it’s always valid — is in your government, unless it’s in crisis. That is generally the standard.” For the crypto community, the Reaganite adage holds true: “The nine most terrifying words in the English language are: I'm from the Government, and I'm here to help.” For crypto enthusiasts, it is easier to trust a transparent, predictable, and auditable algorithm than their governments. Departing from such different premises, it is not surprising that the conclusions are very discrepant.

Despite the differences in premise, it may be interesting to use Merton’s proposed framework to evaluate crypto applications (associated with blockchains) from the community’s perspective. Regarding what problem cryptos seek to solve and how these problems are solved today, there is great diversity. Nonetheless, more generally, cryptos seek to offer an alternative to the traditional third-party intermediary, which historically acts as a trusted and (ideally) neutral entity between two parties involved in different types of bilateral transactions.

Regarding the third question, about the advantages of the new application over the current one, it can be said that by eliminating the need for intermediaries, cryptos can increase security and efficiency of transactions, drastically reducing its costs, and make them more direct and transparent, without being subject to the control of any individual, company, or government. Evidently, not all problems require blockchain and crypto-based solutions. At the current, still nascent stage, there is much experimentation. It is likely that, in the future, only a fraction of the applications proposed today will establish themselves as predominant. It is likely that for some purposes, applications with and without crypto/blockchain will coexist and compete with each other.

As for Merton's fourth question, about the possibility of even better alternatives, it is very difficult to answer generally. Each case is different. However, in at least one example, it is possible to argue that the blockchain and crypto application has the potential to be the best possible: Bitcoin as a store of value, that is, an asset that maintains its value over long periods.

In his response, Merton mentioned that “every central bank has as its number one responsibility to keep the currency close to the price of the things people buy.” The numbers show that they have been failing miserably at this task. Not even the US dollar, one of the most resilient national currencies, was an exception. In the last fifty years, after the end of gold convertibility, the dollar has lost almost 85% of its purchasing power. In the last 20 years alone, and therefore after the development of inflation targeting frameworks, the loss of purchasing power of the dollar has exceeded 40%. It is clear that, on a decades scale, fiat currency does not fulfill the role of a store of value.

An alternative would be sovereign bonds, which, by yielding nominal interest, could compensate for the loss of purchasing power caused by inflation. In this case, the issue of default risk by governments comes into play. Only a handful of countries do not have a history of failing to meet their commitments to creditors. Not even the government of the US, the world's largest economy, deserves maximum creditworthiness (or trust) according to Fitch Ratings.

Excluding more exotic alternatives, gold remains. Indeed, gold has been successful in preserving purchasing power over centuries. It is, most likely, the best-established technology for this purpose. Despite this, gold has some relevant problems. To truly preserve its value over time, gold needs to be stored in a safe place, which is usually expensive. But it is not just against thieves that the saver needs to protect their gold. On certain occasions, the government itself, the same one that, according to Merton, is trustworthy, plays the role of burglar, confiscating citizens' gold. This happened, for example, less than a hundred years ago in the US during the presidency of FDR.

In addition to storage difficulties, gold also presents difficulties (and costs) for transportation and, consequently, for transactions. Many billions of dollars in gold lie peacefully on the ocean floor in sunken ships, never reaching their intended destination.

Another problem with gold concerns its verifiability. There are scientific methods to assess the purity level of the shiny metal, but suspicions can still arise. Numerous cases of potential fraud involving the use of tungsten, a metal with a density similar to gold, can easily be found on the Internet. Even if they are not true, the mere suspicion highlights this weakness of gold.

Bitcoin solves all these problems. As long as the owner of the bitcoins can remember the password used to sign transactions, their bitcoins will be safe, out of reach of criminals and governments. To transfer bitcoins, simply make a transaction, which costs a few dollars, and a few minutes later, it will be completed and irreversible. As for verifiability, all transactions can be easily and directly verified by any network participant. There is no such thing as a fake bitcoin.

However, there are challenges to be faced by Bitcoin. Despite never losing value over four-year windows (approximately one halving cycle), its price fluctuates greatly in the short term, meaning it has high volatility. It is true that the 360-day volatility was much higher, exceeding 150% about ten years ago. Since last November, this indicator has been below 40%. Today, more than 10% of S&P 500 constituents have values higher than Bitcoin for this metric, including significant names like Tesla and Nvidia. Despite the significant improvement, current numbers are still about twice those of gold.

Most of the volatility observed in Bitcoin today is due to the still speculative nature of its value, with uncertainties about its potential and adoption curve. Adoption has been growing vigorously, and according to estimates, about 15,000 establishments worldwide accept Bitcoin as a form of payment. Being a good means of payment is not a necessary condition for being a good store of value, but in the case of Bitcoin, it can be an important means for reducing its volatility. The more establishments accept Bitcoin, the easier it is for the next ones to accept it. The network effect plays a very important role in this process. It is expected that volatility will undergo a significant reduction over the next few years.

But what ensures that, once the volatility issue is resolved, Bitcoin can become the best possible store of value? To answer this question, we can turn to another Nobel Prize-winning economist, Milton Friedman: “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” Bitcoin was born with an austere and predictable monetary policy in its DNA. The rate of bitcoin supply expansion is currently less than 1% per year and therefore lower than gold's and minuscule compared to major fiat currencies. This rate is halved every four years and will reach zero around the year 2140. Under no circumstances will there be a sudden increase in the quantity of bitcoins. It is hard to imagine a better store of value than this.

Besides Bitcoin, various other crypto applications are expected to consolidate over the coming years. If this indeed happens, Merton will not be alone among renowned economists who were wrong about the potential of cryptoassets. He will have the company of other Nobel Prize winners, such as Paul Krugman, Robert Shiller, and Joseph Stiglitz. In 1998, LTCM, the hedge fund in which he was a partner and committee member, collapsed, ironically, as a consequence of default of a Russian government bond (which was in crisis, to be fair). His reputation is so solid that even this event could not tarnish it. I trust it will be no different with cryptoassets.


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