The Market for Promises
I start my undergrad investments class by posing the following question: what is a financial asset?
Wikipedia gives the following painfully vacuous definition:
"A financial asset is a non-physical asset whose value is derived from a contractual claim, such as bank deposits, bonds, and participations in companies' share capital. Financial assets are usually more liquid than other tangible assets, such as commodities or real estate."
An academic economist might define a financial asset as essentially an Arrow security, or a combination of Arrow securities: a "claim" which pays something in some state of the world. This is a nice and useful formal definition, but also sheds little light on how financial assets differ from other assets, and what are the conditions needed for a well-functioning market in financial assets to exist.
Let me propose an alternative definition. Financial assets are promises. Every financial asset is a promise to give someone something, possibly dependent on some source of randomness in the future. I might promise to pay you an amount which depends on what the level of the S&P 500 or oil prices or interest rates is (futures, options). I might promise you a share of the profits from my company (equity). I might promise to pay you a fixed amount each month, or else you get to take my house or my car (mortgages, secured debt). Financial assets are promises to trade certain things in the future, if certain events happen in the world. The financial system is the market for promises.
Classical economic theory does not directly discuss the market for promises. Classical theory discusses markets for goods like potatoes. When I want to buy potatoes, I arrive at a market with cash, inspect and choose some potatoes, hand the potato merchant my cash, and receive potatoes in exchange. Potatoes are thus traded in an "arms-length" manner: once my cash has been exchanged for your potatoes, the trade is complete, and I do not have to interact with you thereafter. Trading potatoes thus involves very little trust.
Trading promises, in contrast, involves a large degree of trust. When you make a bet with me that the S&P 500 will fall, I need to trust that you will pay me even if the S&P 500 rises and you lose the bet. When you start a company and take my equity investments, I need to trust that you will operate the company profitably and pay me my share of the proceeds. When I lend you money against your house, I need to believe that it is possible for me to take your house if you fail to meet your payment obligations to me. Trading promises is only possible when we believe that promises will be kept.
The market for promises — the modern financial system — can thus only exist when it is built on top of a system for enforcing promises made between private individuals. This is the legal system. A government is a monopoly on violence. One use of this monopoly power is in contract enforcement: governments enforce promises made between private parties. Governments and courts ensure that bets on the S&P 500 are kept, that corporate executives answer to companies' equityholders, that mortgage borrowers make good on their payments, or are eventually evicted from their houses if they do not. Finance is possible to the extent that promises are kept, and promises are kept to the extent that governments and courts have the willingness and capability to enforce them.
Finance today is fundamentally a derivative of the legal system for promise enforcement. This simple fact explains why finance today is overwhelmingly centered in the developed world. Finance in society is only possible to the extent that the system for promise enforcement is functional, and developed countries tend to have higher state capacity — and thus more reliable promise enforcement systems, in normal times — than developing countries.
But state capacity is a double-edged sword. Promises between individuals are ultimately kept at the whims of the state. Governments have goals other than enforcing promises, and cannot commit not to renege on promises. The caricatured example is the government seizure of private assets in developing countries. But governments allow promises to be broken, and interfere with the ability of private parties to make contracts, even in developed countries, where we often think of courts as being neutral arbiters of justice. Governments have suspended debt payment obligations, or forgiven debts, and suspended the enforcement of evictions on mortgages and rent obligations, in times like the 2008 crisis and the COVID crisis.
Governments have reputational incentives to keep promises: governments want to be known to uphold promises, so that individuals and firms have the confidence to make promises and do business. But finance in any country eventually becomes big enough that states cannot afford to enforce all the promises that are made between private individuals. Certain promises, like promises from individuals to pay back mortgages against overvalued houses, or promises from politically connected companies to pay their debts, are judged by states to be so damaging if enforced, that states eventually face no choice but to refuse to enforce these promises. The fundamental problem with governments as arbiters of promises is that governments are ultimately human systems, with interests and goals. Human systems cannot credibly commit to enforce large-scale promises, even when it is against their own interests to do so. But the inability to commit to promise enforcement limits the set of promises that can be made.
How do blockchains change the state of things? Blockchains are an alternative system for promise enforcement, fundamentally different from any system human history has seen before. Promises in blockchain systems are enforced by miners, who — in reasonably competitive mining markets — have limited ability, and weak incentives, to do anything other than execute others' promises roughly according to the gas fees they pay. In other words, the blockchain can be thought of as a universal, extremely low-discretion promise enforcement engine.
Consider, for example, automated market maker (AMM) protocols, such as Uniswap. An automated market maker allows anyone to become a liquidity provider, that is, to contribute capital, to make markets in a pair of tokens. Fees are collected from anyone trading with the market maker, and can be programmatically redistributed to liquidity providers. These "terms" are promises in the same way classic financial contracts are — but, rather than promises stated in English enforced in courts of law, they are written in Solidity and "enforced" by Ethereum miners.
Lending protocols, such as Aave, allow agents to borrow if they pledge their risky assets to the system as collateral. Aave values the collateral automatically using price oracles, and automatically seizes and liquidates collateral when the amount borrowed is worth too much compared to the collateral staked. MakerDAO similarly functions like a virtual "pawn shop", taking risky assets and printing tokens whose value derives from the fact that they are overcollateralized by risky collateral, automatically valued using collateral price feeds. Aave and Maker function similarly to margin lending systems in traditional finance, except that the lenders are bots instead of banks. A nontrivially large fraction of the useful promises that are traded in financial systems, it seems, can be approximately as easily expressed in Solidity as they can in English, and thus can be enforced by miners rather than by courts.
The consequences of the existence of blockchains are thus that, for the first time in human history, we have a real alternative to governments and legal systems for the enforcement of promises. What are the effects this will have on the world?
On a broad scale, blockchains are unlikely to substantially change outcomes in developed countries. In the US and similar countries, it is fairly straightforward to write promises enforced by local courts, and courts are generally fair and exercise limited amounts of discretion in contract enforcement. But this is not universally true. In many parts of the world, legal systems are much more dysfunctional — they are inconsistent, under-resourced, and corrupt. Blockchains, as a substitute system for promise enforcement, have the potential to revolutionize the market for promises in these parts of the world. On Ethereum, terrorists will be able to trade interest rate swaps, and nobody will be able to stop them from doing so. This is by no means necessarily a good thing for the world. But it is a significant change in what is technologically possible in human society.
What will the stance of governments in developed countries be towards blockchains?
There is a natural tension between blockchain systems and governments. Governments, through their monopoly on violence, have until today held a monopoly on the enforcement of promises. This is core to the functions of government. The power of governments over their subjects arises not only from their ability to compel subjects to obey, but also in the threat that subjects can only participate in the market for promises to the extent that they submit to other requirements imposed upon them by governments. Individuals and firms obey laws, pay taxes, and submit to the occasionally capricious demands of government, partly because of the importance that the market for promises holds for individuals and firms. A firm, in particular, is essentially a synthetic entity constructed out of a set of promises made between human beings. Firms, until the present day, have existed only at the whims of the arbiters of promises.
Blockchains are a natural enemy to governments, because they are a new, mechanical arbiter of promises. It is an arbiter with limited power, currently allowing the enforcement mainly of promises involving only on-chain assets. But as an arbiter of these promises it has higher consistency, and is not ultimately subject to the whims and incentives of governments. Large governments are naturally predisposed against any technology which can displace their role as promise enforcers.
Traditional finance could grow only in developed countries with functional courts and high state capacity. Blockchain finance, in contrast, has a natural advantage in undeveloped countries, precisely because of their lower state capacity. Most governments will tend to try to oppose blockchain, to protect the state's monopoly on promise enforcement. But some states will do this more effectively than others. Blockchain-based financial systems will thrive precisely in those countries where state capacity is too low for governments to effectively shut down the development of blockchain-based finance. The lack of state capacity, which was the insurmountable weakness of developing countries in the development of traditional finance, will become their greatest strength in supporting the development of blockchain-based financial systems.
Finance — the market for promises — thus has the potential to bifurcate in the near future: into traditional financial markets based on legal promise-enforcement systems in developed countries, and blockchain enforcement systems in developing countries.
Let me end with an ambitious prediction for the next few decades of financial development. In a few decades, finance will be more advanced, in many ways, in much of what is the third-world today, than in the first world today. The US, China, and Europe will operate "walled gardens" of insulated, law-based traditional finance systems. They will go to great lengths to limit their access to blockchain-based financial systems, preserving the status-quo of powerful incumbent financial organizations using traditional systems and technology.
What is currently the developing world will become a "wild west" of financial innovation. The developing world will inevitably embrace blockchain finance, since their governments will be unable to stop its proliferation. And financial innovation in developing countries will rapidly overtake developed countries, because software innovation is always fastest where there is the least amount of regulation and the lowest barriers to entry.
The future of finance will not be built on Wall Street, by a handful of privileged graduates from a handful of top colleges in a handful of high-income countries. The future of finance will be built on blockchains, in Africa, South America, Southeast Asia, through the combined efforts of many billions of people, who for the first time in human history will be able to participate on an equal footing in the market for promises.
Thanks to @0xfbifemboy, Wanran Zhao, Will Diamond, and Zoey Wang for reading early drafts of this post!