Some reflections on trust and digital currencies

Economics of Initial Coin Offerings

Here is an interesting read about initial coin offerings and digital currency. But it urged me to reflect on trust and digital currencies.

This article brings up an interesting concept about trust and economics. In fact, the primary cause of the Great Depression and the Great Recession was a lack of trust. I would be more than happy to expound on these topics if asked, but I want to avoid a novel type digression today. More importantly (from the article), if the separate Pachinko businesses that buy back teddy bears and other nonsense has a run on (i.e. too many people win too many prizes) then it will run out of cash. This will effectively halt the Pachinko business and potentially ruin the future prospects of the business because patrons will no longer trust that their will be cash available for their meaningless teddy bears. The economy works in a similar manner. We all go to work trusting that we will get paid, we go to the bank trusting our money will still be there (unless of course we voluntarily spent it all), and so on. Without trust, the economy will grind to a halt.

This simple concept of trust can be extended to digital tokens (cryptocurrencies) and initial coin offerings (ICOs). ICOs – simlar to their more commonly known IPO brethren – are when a company issues digital tokens or currency to be used to buy whatever products that particular company has to sell. For instance, Amazon could issue $Prime that can only be used to buy Amazon products (and I suppose can be used at Whole Foods now). And $Prime can be sold by other buyers of $Prime on an exchange. So, if you have too many tokens or need to raise money for something else, you can put your $Prime on the open market for others to purchase. The problem here is that the open market price of $Prime will fluctuate. Could be more, could be less than what you initially paid. This is problematic for obvious reasons.

More problematic is the possibility that Amazon (or other large institutions) hoard $Prime to drive the price of one token up to make more profits on their product. For instance, digital coins have a value of 1 unit. And let’s say a shirt costs $10 and 1 $Prime is equivalent to $10. So long as this equilibrium remains balanced, consumers are OK. But what if Amazon decides to purchase tokens (i.e. take tokens out of the system) to drive the value of 1 $Prime higher? Now, 1 $Prime will cost you $15 to buy, but that shirt still costs 1 $Prime. Now you are paying 50% more for that same shirt.

The opposite can hurt sellers. Let’s say sellers collect $Prime and redeem them to Amazon for cash. If you are selling that shirt for $10 (1 $Prime) and Amazon decides to issue a new batch of $Prime, then the value of 1 $Prime token may fall to $5. Now, as the seller, you receive 1 $Prime token for your shirt and redeem it to Amazon for $5. You just lost 50%.

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