Is built-in inflation good for a network?

Token Inflation

By Michael Harris
Data Scientist at ABL

One thing that isn’t talked about much are the beneficial and harmful side effects of having a fixed, adjustable, or inflationary token supply. By the time we launch our own network, with the ABL token, we want to have figured out all the side effects, and decide what sort of economy we want our token to have. There are several types of players in a cryptocurrency economy, just like in a fiat economy, and so we need to look at each effect from all points of view. This article is written from the point of view of an end state, or at least a consistent level of user adoption, and doesn’t take into account changes in value due to the number of users changing, or other real world details. It’s a starting point, not the end of the conversation.

The Players - Creator, Investor, Trader, Established User, New User

There are five types of entities we will focus our attention on. The first is the network owner, manager, or creator. Depending on the nature of the network, their level of control over the network ranges from very little control, to quite a lot of control, and the benefits they receive also change based on the type of the network. This entity is often the hardest to summarize because there are a lot of different viable business models out there. Then there is the investor who could be someone that purchases tokens at the ICO, or buys them later. They are buying tokens in the hopes that the token values increase over time. They are passive members of the network, hoping that the network is popular, and the value of the token goes up because demand is higher than supply. They are useful to the creator because they are generally the driving force for the ICO and the value of the network, but otherwise they don’t participate in the network very much once it’s running at full steam.

Next we have the trader. They are similar to the investor, in that they don’t use the token for its utility function, but they do provide an increase in liquidity, so that other people wanting to buy or sell tokens can do so more easily, and with a narrow price spread. Then there is the established user. In our case, this could be large businesses, or professionals that have been using the network for a while. In the case of a pure cryptocurrency, this would be merchants, and consumers buying products. These users use the token as a utility, and they generally prefer to have a more constant value, instead of a fluctuating value. Lastly, we have the new user. These users are hesitant, often only purchasing a few tokens here or there, as they aren’t sure how the network will work, and they are worried about losing their money.

Fixed token supply

A fixed token supply is the easiest to understand, and so it will be the one that we focus on first. In a fixed token supply, there is a finite number of tokens available, and no more are ever created. This actually means that over time the supply shrinks, as some tokens get lost, or accidentally burned, but it’s not generally a very fast rate of diminishment. This means that fixed and deflationary are actually essentially the same, just with a different rate of change. I think most people will agree that rapid deflation isn’t very good for anyone except perhaps investors, so I’m going to focus mainly on fixed (Bitcoin) or very slow deflation (Ripple).

This style is the most beneficial for investors, as the token supply does not increase, so if the demand for the token increases, the price and value of the token will also increase. This has the potential to reduce the utility of the token however, as was seen with Bitcoin, when the value increased, and the cost of transactions increased along with it, the ability to use it for micro-payments disappeared. Traders will generally profit from a higher volatility in value, as they are buying and selling very frequently, and are able to profit on both the ups and downs. As the value is completely based on the demand, volatility is generally pretty high. This causes problems for both the established user, and the new user, as the value of the tokens they purchase could drop over night. It also means that merchants will be less inclined to accept the token as payment because they can’t be sure what the value is from moment to moment.

If the tokens were truly currency, buying them would not be an investment at all, but simply a means of converting monetary value from one form to another. Wheat farmers don’t consider selling their wheat for dollars to be investing in dollars, they are simply selling their product for the standard currency of exchange. As such, any fixed token supply will be unlikely to be useful as a currency, due to the number of people that invest in it hoping to profit off the increased demand and artificial scarcity. It’s true that people do purchase currencies in bulk on Foreign Exchange in the hopes of profiting off the rise in value of the currency relative to the value of another currency, but those cases are treating the currency more like a commodity. Essentially you are buying a swap rather than investing in a currency.

Whales, or very large investors, tend to have a very large impact on the value of the token, and its subsequent utility. Depending on the purpose of the token, a large or volatile value could be detrimental to the intended purpose. If a whale decides that the token isn’t worth their time, and they sell rapidly, it can cause a sudden drop in the token value, even though the demand from the legitimate users hasn’t changed. Because the token value is partially decoupled from the legitimate demand, it will serve the majority of the network poorly, and will be mostly beneficial to those with the largest supplies of tokens.

Adjustable

Tether is likely the best example of an adjustable token supply. In an adjustable token supply, there is a third party, likely the creator, that will create more tokens under specific circumstances, and destroy tokens under other specific circumstances. Tether for example, will create new tokens when it receives USD, and will destroy tokens when it sells USD. This keeps the price generally fixed between the bid and ask price of the creator which are likely close but slightly separated. This means that over time, the creator will probably make a steady stream of money, as people buy from the ask, and sell to the bid, and they will be separated by a couple percentage points. This means the value of the currency is very stable, which is excellent news for both established and new users, as it means they can use the token without worrying about the value changing between one transaction and the next.

One of the problems with an adjustable currency is that it is generally pegged to something else. If the something else is fiat, you are effectively just creating an alternate means of shifting fiat around. If the adjustable isn’t pegged to something, it gets a little more interesting. For example, it could automatically remove tokens from wallets that haven’t been used in a while, or automatically add tokens to wallets that have been used. This would just shift money around, but if it added more than it removed, or removed more than was added, it could change the overall supply level. Due to the complexities of choosing something other than a fiat peg for a variable token supply, for our purposes I’ll treat an adjustable supply as a dollar peg for now. But there are other adjustable schemes out there, and it’s something we will be looking into in the future.

If our adjustable supply cryptocurrency is pegged to a real world fiat currency, it means that the true value of the currency is controlled by the government that issues that currency, rather than by the network or the utility of the token. This is great if it’s intended to be a drop-in substitute for that currency, but generally not very good otherwise. It does mean that user adoption is generally faster and easier, because the users already know the value of the fiat currency, and so they don’t have to think about the cryptocurrency any differently than they think about the currency in their bank account.

Inflation

Currently, modern economic theory says that mild inflation (generally 1-3% per year) is good for the economy and thus for the participants in said economy. Inflation spurs spending because it means that the value of the currency very slowly declines over time. This is great for something that is a medium of exchange, and if the decay is slow enough, it will even act as an effective store of value over the short to medium term. A dollar is a good store of value over the time period of a few years, but when you consider inflation, investing in a house, or a stock market index will provide a better store of value over a period measured in decades. But because the value of the dollar declines slowly over the large timescales, people use it to purchase things they need, instead of holding onto it for the long term gains.

For example, there is a popular concept that if consumers had invested in Apple shares instead of buying their computers in the 90’s, those consumers would be very rich now. If Apple computers had been priced in shares, instead of in dollars, that very well might have happened. But the ripple effect of nobody buying computers because they are holding on for the expected rise in value of the stock is that the company tanks because it doesn’t have sales.

One thing to consider when designing a network is how important transactions are to the network. If very few people make transactions, what is the purpose of the network? Part of the value of a currency is the mutual trust that it is exchangeable for anything. This is not faith in the currency, it’s faith that the other people using the currency believe in it and also use it. The two are similar, but distinct. The British pound might be worth a lot, but I’m not going to accept it as a medium of exchange in Canada because it’s not used frequently in Canada, so I would have trouble getting the correct value for it when I go to purchase something else with it. That doesn’t mean that the pound has less value than the dollar, it just means that its value is not as a medium of exchange in Canada, but as a commodity instead of a currency. In the UK, the reverse would be true.

As such, slow inflation can actually increase the functional value of a currency by stimulating use, even if the nominal value of the currency is declining over time.

Mechanism of Inflation or Deflation

The mechanism in which inflation or deflation is applied to the network also changes how it it impacts its users. Inflation is often perceived as a tax applied to everyone, but that’s mainly due to the fact that governments take all newly minted money for themselves, and then loan it out to banks. If the inflation were distributed to all participants based on the money in their wallet, it would not be a tax, but could be seen as being similar to a stock split. There are other ways in which the newly minted currency could be distributed that are fair and provide useful functionality. While there are a lot of systems for inflation that use mining of one sort or another, we are going to focus on systems that will work without needing miners. Mining can always be added into a system if it’s desired (although it seems outdated at this point).

Deflation in the form of fees that destroy the money (i.e. Ripple) is seen as a tax on the users that are actively using the currency the most, and as such could be considered similar to a consumption tax or sales tax. This is a very regressive form of taxation, as it generally hurts the poor the most, as they spend the majority of their income, and as such are taxed on the majority of what they make, while the rich don’t generally spend as much of their money, so they avoid much of the tax in percentage terms.

Deflation simply by restricting the number of tokens to a fixed size can be compared to a tax on the late adopters of the technology, and also on the poor, as they can’t afford to invest in as much as the rich. This is partially why many early adopters of cryptocurrency like the idea of a fixed or deflationary currency pool and believe that buying the tokens is a good investment. Even if the token was the sole currency on the planet, the restricted number available means that the value will continue to go up over time, potentially leading to currency hoarding, rapid deflation and perhaps even the eventual crash of the currency.

While the fairest and most even way to distribute inflation in a crypto currency would be to issue more tokens in a manner similar to a stock split, so everyone gets the same percentage increase, it’s not necessarily adding any additional functionality to the network, and might not quite achieve the intended effect of encouraging spending. This is likely the best way to distribute the value from inflation, if no beneficial side effects are required, although we are going to be validating that over the next few months.

An alternative that has beneficial side effects is to have savings accounts where people can lock up their coins in exchange for a share of the inflation. This would have the benefit of reducing fraud, if the savings accounts had an unlock period of several days, or a month. This also means that inflation will still be felt by those who don’t have savings accounts, thus serving to spur spending, and anyone can choose to save their currency to obtain a dividend and so while the poor will still be at a disadvantage compared to the rich, they will still be able to participate, unlike the current fiat inflation system that mainly only benefits the governments who issue it.

If fraud prevention was desired, and mandatory holding periods were applied to each transaction before the money could be spent by the recipient, we could treat money that is in the holding period as if it was invested in the above mentioned savings account, and provide the recipient with a small dividend. That dividend would help cover the cost of fraudulent transactions, and would provide the merchants and other users in the network who might not be able to lock it away for an extended period, with a share of the inflation. The dividend for money being held should be very slightly lower than the dividend for money in the savings account, so that the savings account is the best way to earn it, rather than sending it back and forth between two accounts. We might also want to enable two users who frequently transact with each other to more formally establish trust between themselves and thus skip the holding period when specific conditions are met. This will allow businesses with frequent customers to make use of the money from their return customers right away, which helps manage cash flow for the business, and allows users to receive a steady paycheque in tokens and have them be spendable right away.

Summary

As we can see, each of the different token supply models have very different effects on the network participants, and in many cases those effects tend to favour one class of participant over another. When choosing which supply model to use, consider which participants will bring the most value to your network, and then choose the supply model that favours them the most, while hindering the second most important participants the least. If inflation is chosen, choosing a distribution method that fits your network is also an important decision.

One conclusion that some people might reach is that what is good for the investor is bad for the end user, and vice versa. That isn’t quite true though, as this article has not taken into account the rise in value due to increased adoption. This article is written under the assumption that level of adoption somehow magically remains constant. It’s like those physics exercises where you talk about how fast a spherical cow falls in a vacuum. Great for introducing a basic concept, but it doesn’t include all the extra details that apply in the real world. So in reality, what is good for the end user and drives adoption will also end up being good for the investor, at least for the first few years.

We are still researching this area, and will be working together with some economics students from UBCO to validate our assumptions, and to make our final decision as to which token supply type will be most beneficial for our final network.

Here is a handy chart that helps summarize the different types of token supply for the different types of users. Please note that this chart is very subjective, and your use case will probably have different values for each cell.

5 star rating

             \ Player

Supply   \

Creator

Investor

Trader

Established User / Business User

New User

Fixed

4

5

5

2

1

adjustable (pegged)

5

1

3

5

5

Inflation (slow)

4

3 (5 due to increased adoption rate)

3

5

5

Inflation (fast)

1

1

1

1

1




Notes and Citations:

https://www.coindesk.com/deflation-and-bitcoins/

http://www.pkarchive.org/theory/baby.html

http://www.bbc.com/news/business-30778491

https://www.investopedia.com/terms/k/keynesianeconomics.asp