Our civilization depends, not only for its origin but also for its preservation, on what can be precisely described only as the extended order of human cooperation. — — — — — Hayek
A Primer
In the past year, cryptocurrency market has grown exponentially. The scale and speed of its expansion has baffled people’s mind. Many question the inherent value of cryptocurrency, the question of whether cryptocurrency is a new kind of bubble or a new Ponzi scheme has crossed and hooked everyone’s mind save those few most ardent crusaders of cryptocurrency. It is not surprising then to see people from all backgrounds and working in the entire stratosphere of our economy show their eager curiosity about cryptocurrency by asking what exactly does cryptocurrency mean to our present day society?
In order to answer this question, we need to understand the nature of the financial market, and how the market defines value. Let us begin this journey of discovery by first going down to the basics by rigorously examining the expansionary structures of financial assets.
The Double Layered Structure of Capital
When we attempt to comprehend the structure of capital expansion, we have to first employ the concept of a basis layer, which represents our inherent value orientation. This layer corresponds directly to our most basic human needs, such as to feel secure and to survive. For instance, this capital layer corresponds directly but is not limited to our need for food, clothes for warmth, and a safe place to live out our lives. On top of this is the expansion layer, which is the new capital expansion model we aspire to construct. From our perspective, the most basic capital expansion structure can be separated into two layers: the basis layer and the expansion layer.
Basis Layer (Support Layer)
This is our original value floor, which is also the basis of confidence for our designers, operators and users. We will use this as the foundation in our attempt to build a new capital expansion model. If the top expansion layer requires restructuring or correction, we will always be able to come back to the basis layer through redemption.
Expansion Layer (Constructed Layer)
This is the heart of the new expansionary model we aim to build. In comparison to the basis layer, the expansion layer is able to adapt to a broader range of scenario and provide more liquidity. In order to satisfy these properties, the expansion layer will inevitable include more elements. However, the effects of these elements are still hypothetical and lacking empirical evidence and testing.
Risk of running
Due to the lack of empirical validation, people lack consistent confidence in the construction of the expansion layer. In the meantime, expansion layer attempts to support a broader range of circumstances. Combining these two handicaps, there will be an inevitable movement of the mass from the expansion layer to the basis layer when significant negative changes happen in the expansion layer. This phenomenon is known as a run. This also means that the increased liquidity provided by the expansion layer will create bottleneck as the flow from the expansion layer to the basis layer reaches a certain level that is above the liquidity threshold of the basis layer, causing congestion and a scenario not all redemption actions can be completed.
Decoupling Experiment
When the expansion layer attains a sufficient and sustainable level of stability, people will have enough confidence of the expansion layer to allow the expansion layer to break free from the liquidity bottleneck of the original basis layer. When the expansion layer becomes independent, it will start to accumulate capital. We call this process a decoupling experiment. When the expanding layer announced to the external world that it is no longer going to provide complete redemption for the basis layer, a decoupling experiment will take place. As the decoupling experiment takes place, the expansion layer has then truly transformed its role from been subsidized to subsisting. The success of the decoupling experiment depends upon the size of demand for the scenario that is created by the expanding layer. Whether or not the expansion layer can become mainstream finance is determined by the success of the decoupling experiment.
Decoupling Experiment
Definition of Ponzi Structure
Ponzi Structure is constructed by creating a set of specific rules between layers in order to build a comprehensive multilayer capital expansion structure that is built on a floor of fundamental value. This not only allows capital to flow freely within the same layer, but also enables capital to flow between each layer based on a set of specific rules, maximizing capital liquidity.
Ponzi Structure Characteristics Summary:
· Ponzi Structure is a genealogical structure where higher layers grew out of lower layers.
· Ponzi Structure is a payment support structure.
· Ponzi Structure is a leverage structure that has a discrete base of capital supporting a larger amount of capital.
· The value of every layer stems from the layer below; but each layer is relatively independent from one another in normal economic activities, and expands at an ever more rapid speed as one goes higher along the structure.
· Layer will not expand infinitely, as the degree of expansion is restricted by the supportive capacity of the layer below.
Ponzi Structure in Conventional Financial Economics
In the history of currency, one of the earliest kind of popular currency was precious metal. Therefore, it is upon the basis of precious metal that fiat currency was developed. When Gold Standard was abandoned, fiat currency underwent a stark depreciation before gradually became an independent basis layer. Modern financial system expanded upon this basis layer and developed banking loans, securities and financial derivatives. Presently the general Ponzi structure of the financial system is demonstrated below. Local redemption crisis would create liquidity shortage or more severe limited scale system collapse, such as some companies going bankrupt. During general system collapse, the upper layers of the Ponzi structure will seek redemption support from lower layers. The lack of capacity for lower layers to fully absorb redemption demand from the above layer will trigger a systematic collapse from the top layer all the way to the bottom layer in a very short time. Without support from outside the system, the final result is that the system will collapse all the way to the bottom layer. In reality, nations will supply the eventual external support to avoid a systematic breakdown.
Note: after the decoupling experiment succeeds, the current structure has its basis layer made up of gold and fiat currency.
Why Ponzi Structure exists
View in this light, Ponzi Structure is a neutral noun and there is no need to stigmatize it. In fact, the biggest social contribution economic Ponzi structure has made is it has, to a very large extent, solved the problem of liquidity.
Imagine a world without banks, then all transaction has to be undertaken in paper money, or even in precious metal. It is without a doubt that in this world the circulation speed of the world economy would significantly decrease, which in turn would not be able to support the swift development of economics, politics and military around the globe. There are benefits to the development of human society in the existence of Ponzi structure.
The Two Extremes of Ponzi Structure
Out of the basic Ponzi structure, we found that there will be two extreme tendencies growing in diverging impulses. If we regard Ponzi structure as a lively order of expansion, then there is an inherent tendency for it to expand upwards and create more layers. Extremists on both sides either overly advocate or suppress this tendency. If we treat this property as a natural and organic characteristic, then the two extremes correspond respectively to extreme conservatism and endless indulgence.
Extreme conservatism — Capital Fundamentalism
Fundamentalism refers to those who tremendously distrust the upper layers of Ponzi structure, and insist that only the bottom capital layer is the core and most valuable asset. All the rest are, more or less, bubbles.
Property summary
· There is only one layer, there are no derivative expansionary structure.
· Do not accept the legitimacy of upper layers of capital, and do not support the development of upper layers of capital.
· Capital within an order of expansion will have an inherent tendency to flow upwards. Gold fundamentalists aim to suppress this tendency to the most extreme extent and imprison capital in the basis layer.
Fundamentalist is a highly stable status. It will not collapse as every economic action is conducted on the basis capital layer where physical goods are exchanged for fiat or gold currency. There are no bubbles in a fundamentalist world. However, behind the seemingly viable world are an overall economy that runs extremely slowly and inefficiently and a society whose development grinds to a halt. It is therefore evident that the upper layers of capital played an indelible part in the steady growth of global economy, from bartering in primitive communities to Jiaozi paper currency in North Song, all the way to the large scale distribution of paper money by English banks in the 17th century.
Fundamentalist ideology can never truly build an expansionary order. For instance, during the financial crises in the early 20th century, some countries reacted by quickly abandoning gold standard while others chose to preserve it at all costs. England, the first country that abandoned the gold standard, quickly escaped contraction by increasing money supply and elevating price levels. On the other hand, those countries that kept gold standard only exacerbated deflation. Following England’s lead, countries who timely abandoned gold standard, including the US, also successfully resuscitated their economies from the Great Depression.
Extreme expansion — Ponzi Scheme
A simple definition of Ponzi Scheme is the attempt to attract investment by promising returns that are unsustainably high, and continuously pay the promised returns to existing investors using new investment. Its tendency is the endless suction of capital from lower layers of capitals al the way to the top in order to maintain adequate speed to cover the operation of the structure of capital.
Property summary
· It has at least two layers of capital. The bottom layer of capital is supported by actual value, whereas the upper layers are hybrids of capital and bubble.
· Upper layers are not self-sustainable, so when the confidence of investors dropped to a certain degree, the decoupling experiment will induce value to drop to zero.
· Running risk is high. The upper layers need uninterrupted and ever growing infusion of capital from the lower levels to sustain their own operation. When the speed of capital infusion becomes slower than capital outflow, the structure will collapse.
Ponzi Scheme is a highly unstable form of Ponzi structure, it is an extreme subset and does not represent Ponzi structure as a whole. Ponzi Scheme is wholly reliant on capital infusion from lower layers in order to maintain its structural integrity. Ordinary Ponzi structure does not rely solely on the flow of capital from lower layers to upper layers to maintain its structure.
Balance is King
What is unavoidable however, is that even for ordinary Ponzi structure, a 100% run is unbearable. In other words, if the upper layers seek a wholesale value support from the lower layers, and if there wasn’t a transfer of confidence, then any Ponzi structures will collapse to the bottom layer of the capital structure.
From this angle, the problem of Fundamentalism is that under such a regime, capital is not utilized to its fullest extend, and there is no way for an expansive economy to speed up its natural circulation, leading to the retardation of economic development and the growing tendency of deflation. On the other, Ponzi Scheme eventually explodes as the economy becomes extremely congested. A healthy Ponzi structure is somewhere between the two extremes as its order of expansion is able to reach a balanced state that does not suppress the expansionary tendency of capital nor extract capital from lower layers unrestrainedly. In such a state, the economy is able to function in a relatively stable and sustainble homeostasis.
A Stability Measure of the Order of Market Expansion: Density of Confidence
To measure whether a Ponzi structure is stable or not, we will introduce a new concept — Density of confidence. This concept can be extended to a broader range of ordinary order of expansion. Here we aim to give a description of the density of confidence in the sphere of Ponzi structure.
The density of confidence in any layers of capital is quantified as the amount of capital that is confident about this layer to the total capital of this layer. To be more exact, if the confidence level of unit capital is between 0% and 100%, then the density of confidence is the collective sum of the confidence of all unit capital divided by the total amount of confidence in this layer (equals to total capital). We think that when the density of confidence of a Ponzi structure is to a certain extent negatively correlated with its degree of derivative, then this Ponzi structure can be deemed to be relative stable.
Let us elaborate this view. For simplicity, we choose a two-layer Ponzi structure model as our subject. In this case, whenever the top layer attempts to redeem an amount of capital that exceeds the amount of capital in the bottom layer, the structure will collapse. If we introduce the concept of density of confidence into the model, then so long as the amount of capital that has confidence in the upper layer is no less than the difference in the amount of capital between the two layers, the structure will maintain its integrity. This is because only those people that don’t have confidence will seek redemption in the lower layer for value support. However, for capital confident in the upper layer, the upper layer has already become their basis layer and acts as a value support. They will not voluntarily seek redemption in the lower layer. In other words, in their mind, the boundary between the top layer and the bottom layer has all but disappeared. They believe what they are holding are value capital.
The Evolutionary pattern of Order of Financial Expansion
If our society is indeed in need of a balanced Ponzi structure, then what would the ideal Ponzi structure look like? What is our expectation of it? Below are certain points that are worth discussing:
· Expansionary Order
Each layer will have a tendency to expand outwards. The constituents of each layer inherently desire upward expansion in order to seek greater liquidity. In real life, people with good credit can replace paper money with IOU in some scenarios. This is a voluntary tendency to expand. This expansionary order induces the density of confidence to continuously expand into a new layer.
· Capital Exchangeability
Capital within adjacent layers can be exchanged under certain logics and rules. Capital in different layers must have a window of exchange. It is through this window that capital can be exchanged smoothly under ordinary conditions.
· Value Convergence
Capital from each derived layer will converge in the long run. Scilicet the layer becomes self sustainable and can operate without the support from layers below. Banks need a certain amount of capital, but they do not need an unending tap of capital influx to operate independently. The most typical example is the decoupling experiment, where the expanding layer would show stability regardless of any temporary breaks in the exchangeability between supporting layer and expanding layer resulting from human or environmental factors.
· Stability as a whole
The structure is able to absorb a certain degree of external shock without losing structural integrity. Ideally, the structure can continuously improve its ability to withstand and adapt to external shock.
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