Automated exchange, liquidity pools and bonding curves

Some people are struggling to understand the difference between a credit commons system of exchange and another approach growing in popularity amongst blockchain advocates, which is to use 'liquidity pools' to 'convert' one token to another.

If you think that money is like a token, and you want to change one currency for another, you must find a counterparty prepared to do the swap. In a large market there are always buyers (many of them speculators of course) but in a small market run by a single activist, maybe there is no buyer at that moment, or if there is, the price might not be reasonable. A liquidity pool is a way around this problem that involves putting aside some of each of the currency pair into a 'pool' and programming a bot to exchange it whenever needed. The larger the pool, the more predictable the price, and the more tokens you can swap - meaning that the market has been made liquid. If the trade isn't balanced in either direction, the bot adjusts the prices in order to skew supply and demand back to parity. The conversion rate thus appears on an chart as a curve which 'bonds' one currency to another.

The problem is that varying exchange rates of an imaginary commodity can do nothing to address the root of the problem, which is that users of one currency collectively produce more real commodities than they consume while users of the other collectively consume more than they produce. Thus if money is really about facilitating 'exchange' it could never facilitate more exchange than weakest producer can produce or the weakest consumer can consume. Regardless of how the accounting is done if those parties attempt to exchange more it will lead to ever increasing debt.

The very idea of liquidity as a quantity of money, which can be pooled derives from the commodity view of money, which dominates blockchain discourse. In that paradigm, money itself has a variable price, which can help to balance the accounts but the moral problem remains. Floating exchange rates create a level of abstraction that that diverts attention towards 'strong' and 'weak' currencies. The end result though, is the same, the net consumer group has to cannibalise itself to match the what the more powerful net producer wants to sell them - even before interest is taken into account. A system to facilitate exchange all to easily becomes a system of wealth transfer. The post 1971 global economy is designed in this way.

Since the dawn of civilisation though, the view of money as a commodity has been opposed by the view of money as credit. While the commodity theory, which is suggested by any system that talks about tokens, views money much more as a 'thing', the credit theory (which is evoked in the name of the Credit Commons) views money as a set of relationships between creditors and debtors. From an accounting perspective the difference is clear. Credit money is an asset which always corresponds to a liability, the two adding up to zero, but commodity is just an asset. Credit money is valuable because debtors need it to pay their debts, commodity money is valuable because it is a commodity. Credit money has a fixed abstract value, like a dollar, while commodity money varies with supply and demand. That's why credit money is more suited towards fixed exchange rate systems, like the Credit Commons.

In a fixed exchange rate system, the flow of goods in and out of the economy is balanced, which is to say that the 'money' cannot flow wherever 'it' wants, but is subservient to the needs of trade. Rather than needing 'money' in order to make a payment, the payment is simply a record of indebtedness, in expectation of that trade being balanced by another trade in the opposite direction. The debt may be measured in different units, like inches and centimeters but it can easily be converted on a linear scale. There's no supply and demand for money. This addresses the liquidity problem of small communities because no counterparty is needed for the monetary part of the transaction.

The problem of how to balance exchange remains. The blockchain discourse is dominated by deep errors of thinking that human institutions like markets can be designed to be self-correcting (by an Invisible Hand), or latterly, all watched over by machines of loving grace; as if human problems can be calculated away, that human biases do not affect machines. Floating exchange rates as supported by liquidity pools and bonding curves are just such mechanisms derived from standard economic theory - they make lovely graphs, but often doesn't translate very well to the economic reality.

Changing the prices for example doesn't always affect supply and demand in the expected way, and if it doesn't then the system could constantly lean in one direction, redistributing purchasing power from net consumers to net producers. By contrast the Credit Commons uses an accounting methodology, mutual credit, in which the balance of trade is kept front and centre. It accepts from the outset that trade will probably not be balanced, and invites communities into a political space to work it out. If A wants to export to B, and B wants to import from A, then they must work together to ensure production and consumption in the opposite direction are balanced. A medium of exchange does not and cannot ensure that parties are able and willing to exchange, it only measures the extent of their imbalance at any one moment.

The credit/commodity vocabularies and mechanisms can be used for the same purposes but generally they aren't because language and tools restrict how we think about these things: a bot in a liquidity pool could buy and sell only at fixed rates up until a hard limit; the Credit Commons protocol would theoretically support variable exchange rates. To an engineer the two systems are more-or-less equivalent, but in practice will tend to favour different types of currencies. Ultimately currencies are not like engines designed by engineers but agreements within or between groups of people, and that means the way we talk about them, and think about them matters much more.

I know of only two blockchain projects that have ventured beyond commodity money theory into the interesting monetary territory. FairCoop guaranteed its members an exchange rate on Faircoin, but was unfortunately unable to maintain it. Secondly Grassroots Economics' static liquidity pools are actually fixed exchange rate credit money systems but using the language and tools of blockchain. This brings it more in line, monetarily speaking with the LETS and timebanking movements, whose members would not dream of negotiating their own exchange rates or creating a 'market' for their currencies.

Interestingly the business barter world, which uses dollar denominated currencies and so should have a fixed value and very clear exchange rates, actually has no formal system for exchanging between networks nor for establishing or demonstrating the purchasing power of its currencies. This has lead to a grey market in very highly discounted barter dollars, which mostly benefits middlemen.

Smart contracts and bonding curves have their uses, but the ideal of automated markets tends to be technotopian, obscuring the real need for coordination and organisation that economics requires.