In a previous blog post we introduced the concept of Mutual Credit and highlighted some of its benefits, such as low to zero interest rates, monetary independence, and its sustainable growth promoting dynamics. As we’ve already shown, despite its century-long track record of lifting entire economies out of poverty, Mutual Credit isn’t perfect. At least not yet.
There are some serious issues that need to be addressed before Mutual Credit can serve as the basis for the monetary revolution that we here at ReSource envision, primarily its limited ability to manage risk. In this post we want to discuss how ReSource harnesses DLT and tokenised incentives to overcome this limitation, allowing it to compete, and dare we say — outcompete, traditional credit products.
A Short Recap
As we have shown in our previous post, the relationships within mutual credit systems do not resemble those we may be familiar with from banks and other financial institutions. Instead of a creditor lending capital (their own, or leveraging customer deposits) to a borrower, mutual credit allows a network of participants to extend credit to each other. However, instead of doing so with money, as it would be the case with a credit union, participants lend their excess capacities (free labour time, unused inventory, etc), and in return can access goods and services provided by their peers.
This allows businesses to grow and expand without being reliant on third parties — be it banks, or even investors. However, one crucial barrier has kept Mutual Credit networks, such as the Swiss WIR cooperative which we discussed last time, relatively small and slow-growing: in contrast to traditional finance, mutual credit tends to collectivise risk.
Collectivised Risk and The Blue Screen of Death
In traditional finance, if a borrower defaults it is mostly the problem of the lender who has made the loan available; other borrowers will in most cases remain unaffected. However, in a Mutual Credit scenario, the default of one borrower may affect all other borrowers, whether they have direct relations with the defaulter or not. This is what we mean by collectivised risk — the entire network is exposed to the risks associated with each individual credit line. This is so since all participants are exposed to the same internal currency minted by the mutual credit network.
As explained in great detail in our previous post, this internal currency or unit of account, is “spent into existence” when a participant goes into debt, and destroyed when they rebalance their account. As a result, if a participant defaults, the created currency units keep on circulating instead of being reabsorbed by the debtor’s repayments, causing inflation; but this is not the end of it. Alongside the increase of currency units, defaults also lead to a contraction of spending opportunities for holders of this same currency.
By “contraction of spending opportunities” we simply mean less stuff to buy. After all, the defaulting participant was supposed to repay their debt by accepting the network’s currency as a means of payment for the goods and services they produce — hence, providing a spending opportunity for holders of the currency. Consequently, a participant’s default leads to a contraction of the supply of goods and services available for purchase with the network’s currency. This, to remind you, is coupled with an inflation of currency units. Students of economics may recognize the contraction of productive output in conjunction with inflation as stagflation, which is the economic equivalent of the Blue Screen of Death.
To make matters even worse, harm that has once been inflicted on the network will trouble it permanently. Most traditional mutual credit networks are closed systems, which means that their units of account can’t be bought or sold with other currencies. As a result, once the system becomes inflationary, excess currencies can’t be sterilised (bought by the network’s operator and destroyed); they can only be taxed away with an increase of transaction fees, which essentially makes all network participants pay for damage that occurred by no fault of their own.
Traditional mutual credit systems deal with this shortcoming by exercising extreme prudence; for the better and the worse. The aforementioned WIR cooperative, for example, obliges its members to surrender parts of their inventory to cooperatively owned warehouses. This inventory is then sold directly to coop members when one of their peers defaults. This obviously limits the kind of members that could possibly join the trading network, presumably those who would benefit from it the most. A side effect of this hyper-conservative credit strategy is extremely slow growth that has a hard time to compete with a significantly less conservative financial sector.
Decentralizing Gatekeepers and Re-privatizing Risk
To port Mutual Credit to the blockchain and reap its benefits, these problems need to be addressed and solved. When it comes to complex economic systems, especially the ones that are designed to function automagically without much human intervention, such as DAOs and DLT protocols in general, two principles are paramount: externalities need to be internalised and risk needs to be privatised.
In other words: No one should be exposed to risks they didn’t assume willingly and against a proportional reward; and — the cost of failure should be inflicted on parties that have caused it and deflected from the uninvolved. These are not ethical presuppositions, and in many social contexts they may even be wrong, but when it comes to designing an economic machine that is governed by an interplay of code and Game Theory, they are an absolute necessity.
When remodelling Mutual Credit to adhere to these principles, it becomes immediately apparent that Mutual Credit’s externality and risk problem is intimately related to yet another one: centralised administration. Luckily, this means that by solving one we will also address the other.
While Mutual Credit has been invented by people who shunned centralisation, with the specific goal of “abolishing the monopoly of pre-existing capital”, it has, as it so often is the case, introduced a monopoly of its own. Money may be created through peer-to-peer interactions in a marvellous display of decentralised ingenuity, the privilege of entering this distributed Valhalla however requires the permission of a centralised administrator who essentially holds a gatekeeping monopoly within the system.
This is neither an accident nor a conspiracy, but an honest attempt to recreate artificially what is achieved naturally in normal credit scenarios. If a creditor lends money to a party that then defaults, they’ll lose their precious funds and, over time, their ability to lend. So no gatekeepers are necessary, lenders are their own gatekeepers. In our case, no one lends money to anyone to begin with. Members simply trade with each other and settle debts while trading with other members in a circular fashion. So for this system to be sustainable, someone needs to protect it from potential adversaries and troublemakers.
However, in contrast to a bank or a credit company, our gatekeeper is in no danger of losing their own money. It’s the solvency of the network as a whole that’s in jeopardy.
Good intentions aside, this is a very problematic position to be in: to hold the keys to a golden orchard of liquidity, while having no skin in the game. Meatspace institutions can get away with such arrangements if it is necessary, or convenient. Decentralised code machines made up of strangers from the internet? Not so much.
So our first step at ReSource was to decentralise the system’s gatekeepers. No one entity decides if and to what extent an applicant is granted a line of credit. For this we have Underwriters, who are independent actors, much like miners or validators are in most DLT protocol environments.
Inspired by PoS architectures, our second step was to create a skin-in-the-game mechanism for Underwriters. The same way a Celo Validator node needs to stake in order to validate transactions, our Underwriters are required to lock SOURCE to approve credit lines. If the underwritten credit line goes belly-up, so does the underwriter’s stake.
Currency Shenanigans to the Rescue
So one problem is already solved: our former unaccountable gatekeeper monopoly is now a network of competing entities with skin in the game. How does this help us to keep risks from spilling over to unsuspecting credit consumers? How do we prevent the Blue Screen of Death, meaning currency devaluation combined with nothing to buy? This is where blockchain technology comes in in all its glory.
Thanks to DLT we can do something hitherto existing Mutual Credit systems simply couldn’t. In contrast to the traditional method, in which a network mints its own single unit of account to settle mutual debts, ReSource entertains two currencies: a stablecoin as the unit of account (rUSD), and a second, free floating one, as a means for staking, rewards, penalties and fee payments (SOURCE). In short, the relationship between the both is what keeps us away from The Blue Screen of Death: since credit lines are denominated in rUSD, but stakes, transaction fees, and rewards are paid in SOURCE, the network can use the latter to stabilise the former.
If a borrower defaults, their Underwriter’s stake is confiscated and used to buy up excess rUSD. Underwriter’s stakes alone may not cover the entirety of the lost debt. In such a case the network’s Reserve jumps in and uses its holding to buy up the remainder of the debt. The Reserve itself gains its holding from transaction fees paid by users, which also pay for Underwriters staking rewards. This way, transaction fees and underwriter stakes secure the network against defaults and stabilise the currency.
Currency Shenanigans, but with Extra Steps
Now you may have noticed that buying excess rUSD with SOURCE takes care of the inflationary part of the Blue Screen of Death; but what about the “nothing to buy” part? After all, a borrower’s default still contracts spending opportunities for rUSD holders.
In the most crude implementation of the ReSource protocol the answer to this riddle would be pretty simple: SOURCE is a liquid and freely traded asset, using it to buy rUSD replaces the lost purchasing opportunity within the network with one outside of the network. In other words — Joe’s Burger Joint may have defaulted, leaving you without the ability to purchase Joe’s Burgers with your rUSD; but instead you can now use your rUSD to buy SOURCE, which can then be used to buy all the burgers your heart desires outside of the trading network.
This is fair enough and pretty straight forward. However, in some cases it may not be entirely legal, especially under US regulations governing trade networks. Luckily, this bug actually turns out to be a feature.
Since directly buying rUSD with SOURCE would put us in merky regulatory territory, the DAO governing ReSource does something slightly more sophisticated. SOURCE gathered from the Reserve and from penalised Underwriters will be used to purchase goods and services from external sources, which will then be offered on the ReSource marketplace, available to purchase with rUSD.
In other words, if Joe’s Burgers go bust, the system will automatically list Mike’s Burgers on the marketplace, which will be available to purchase for rUSD — without Mike even having to know what rUSD is; he has already been paid by the network’s Reserve which used its SOURCE holdings to do so. The rUSD proceeds from these Burger sales can then be burned, solving both problems in one strike: inflation and contraction of supply.
Why is this seeming bug actually a feature? Well, by buying large quantities of goods, and reselling them to the ReSource network, ReSource doubles as a giant buyers’ coop which can weigh down its purchasing power to extract significant discounts and get more out of its SOURCE reserves than its nominal value.
Using the same mechanism, ReSource can significantly lower the operational costs of its members, while enhancing their access to liquidity. But this is a topic worthy of its own post, which will be up shortly, so stay tuned.