This past week I gave a new presentation at the 2nd annual Soranomics event (last year I presented on a related topic: pegged coins aka “stablecoins”). It includes a number of illustrations to discuss product market fit and infrastructure market fit.
Below is a copy of the deck as well as the A/V. Note: there are citations and references in the speaker notes. Note: I am to publish a long-form version based on this content.
[Note: Below is a guest post discussing a “real world asset” (RWA) tokenization use case that has been proposed and re-proposed for about a decade (first with Colored Coins and Counterparty). Among other articles, the author previously co-authored another thoughtful piece A Quick History of Cryptocurrenices BBTC — Before Bitcoin. Reprinted with permission; and the views are those of the authors alone.]
By Ken Griffith
Since the appearance of Bitcoin in 2008 numerous people have had the idea of issuing gold tokens on a blockchain, or using a blockchain to support a digital gold currency system. This short essay will look at some of the attempts to do this and suggest the reasons why this has not worked, and is unlikely to ever work.
In 2015 Roy Sebag borrowed a phrase from Satoshi and created a company called “Bitgold” which performed a reverse IPO on a Canadian stock exchange. Sebag raised several hundred million dollars to “put gold on the blockchain.” However, instead of creating Bitgold, he proposed a buyout to James Turk at GoldMoney.com. After buying out goldmoney.com, Sebag simply invested the funds into expanding that business which had been founded in 2001. Goldmoney has a ledger, but it does not use blockchain at all.
In the intervening years a dozen or more different gold tokens have been created on Ethereum and other platforms. Of these, many turned out to be scams, and one or two of them were legitimately backed by actual gold. However, none of these have gained any traction in the marketplace.
To understand why gold and blockchain do not mix we need to look at the history of digital gold and cryptocurrencies. E-gold was the first Internet money in 1996, 12 years before the Bitcoin whitepaper was published. By 2001 e-gold had one million users worldwide, and had an annual transaction volume of about US $2 billion per year worth of gold. By 2005 there were six such digital gold issuers. However, the US Treasury began a campaign of prosecuting the digital gold companies using the USA Patriot Act from 2006 to 2009, in which the four USA based issuers were indicted, their gold reserves seized, and officers indicted.
Goldmoney.com was the only digital gold issuer to survive the purge because they were fully licensed in Jersey, UK. However, they never allowed an independent network of exchange agents to provide exchange services to their users. So Goldmoney.com never became a popular means of payment. Goldmoney was primarily used by institutional investors to hold large amounts of physical gold.
The primary obstacle to developing a gold payments network is government regulations in various countries.
Blockchain tokens such as Bitcoin have the advantage of being decentralized with no person or company as the issuer. They are resistant to government regulation and control because there is no central server that can be seized or turned off. There is no person who can be arrested to stop the Bitcoin network from continuing to process transactions. The network continues to operate so long as the people operating servers with this software continue to operate them and keep the same rules.
When you create a gold-backed token you violate the basic social reason that has allowed blockchains to ignore government regulations. An asset-backed token is a promise by some person or company to deliver some asset in exchange for the token. That is implicitly a contract between the issuer and the holders of the token. The token may live on a blockchain, but the person who issues the contract lives in the real world. The physical assets used to back the token also exist in the real world. A government can arrest a person or a company and confiscate the physical assets.
The Crux of the Problem
Once a token is issued on a permissionless blockchain it is impossible for the issuer to control who gains access to that token. It can be transferred to someone in a country where such tokens are illegal or otherwise regulated.
We saw this in the case of EOS, which raised $4 billion in a year-long token sale from 2017 to 2018. The terms of the sale expressly forbade US Citizens from buying the tokens. The sale contract required the buyer to swear that they were not a US Citizen or resident of the United States. The website blocked US IP-addresses so the token sale could not even be seen by web browsers in the United States.
Two years after the token sale was complete, the SEC began an investigation, and a class action lawsuit was filed against EOS for selling tokens to US citizens. This means that some US citizens made a false statement under oath to buy those EOS tokens, and then handed that evidence to US law enforcement agencies. Because the company had raised $4 billion, the large pile of money was very attractive to US law enforcement agencies. EOS ended up settling with the SEC for 24 million dollars.
The value of the assets is the critical factor in determining which companies are prosecuted and which ones are ignored.
We conclude that any tangible asset digitized on a blockchain is vulnerable to lawsuits and criminal prosecutions from countries that regulate or otherwise make such payments illegal.
Law enforcement agencies do not immediately prosecute every company who issues such a token. They bide their time and wait until they see a large pile of value that is vulnerable to prosecution. Only then, do they begin an investigation and prosecution in order to seize those assets using asset forfeiture laws.
How to Avoid this Problem to Issue Real Digital Assets
An Internet ecosystem which allows persons to issue real-world financial contracts for various assets would require a contract-based ledger such as one based on Ricardian Contracts.
Rather than creating one company, such as Goldmoney.com, that offers gold accounts to citizens of many countries, it is better to create a network of lawful institutions in different countries that only offer asset accounts to residents of that country. Thus, each institution need only concern itself with the laws of one nation, rather than the laws of all nations.
A clearing mechanism will allow payments to clear between different institutions in different countries. This short video explains the concept of a clearinghouse in two minutes:
It is better to have many small issuers of gold or other assets than one large centralized issuer. Each of the small issuers should have a license for a money service business in their jurisdiction.
Since corruption is part of human nature, and will always be a problem, it makes more sense to build a system that anticipates the cost-benefit factors that drive corruption. Even law enforcement agencies have a cost to seize financial assets. They have to bring a case in court, which costs money.
Many small piles of gold are much more expensive for a government to seize than one large pile of gold. If there are many issuers, then a government would have to indict each issuer with a separate court case in a separate jurisdiction. This is too expensive and inefficient. Ideally, you would want issuers to hold the amount of gold roughly equal or less in value than the cost of prosecution. So, for example, a typical prosecution of such a company would cost $1 to $5 million USD.
In traditional banking, bank ledgers were protected by financial privacy laws. Unfortunately, the twentieth century saw the steady weaponization of banks against their customers by the State. However, banking privacy worked effectively for centuries. The best long term solution is for states to reform their banking laws to restore and protect financial freedom and privacy.
We find that permissionless blockchains are not environments that are ever likely to work for contract-based financial transactions. They have no native means to record consent to a contract, nor to restrict access to a token to those who have consented to a contract.
By contrast, a Ricardian Contract based ledger would be ideally suited to enable an online financial ecosystem with securities and asset-backed tokens operating within the law. Ricardian Contracts were invented a decade before Bitcoin. Yet, there has been very little community interest in building Ricardian Contract based systems. The reason for this appears to be ideological.
The ideological spectrum of cryptocurrency users leans heavily towards anarchy. Even classical libertarians believe in the necessity of courts of law to enforce contracts. Yet, the majority of cryptocurrency fans seem to reject even the idea of courts of law, as seen in their reaction to the CSW defamation case. Without courts of law, contracts are unenforceable.
The idea that computer code can be a replacement for law and courts is popular but fatally flawed. It is extremely difficult to write and maintain error-free software. It is fine to say that the code is the law, until an error in the code allows an outcome that was not intended. Human courts of law are the ultimate error processing routine. This is unavoidable, and therefore should be embraced in the design of any financial ecosystem.
The dream of creating online financial ecosystems that live on the blockchain, free from courts of law is doomed to perpetual anarchy. Financial institutions, by definition, hold assets in trust for their account holders. Such relationships require contracts and courts of law to enforce. Without contracts and courts of law, all that can be expected is a wild west of online fraud. The long string of failed cryptocurrency exchanges and other projects testifies to the truth of that assertion.