I had the privilege of interviewing Stephen for our upcoming three-part audio documentary on tokenized and asset-backed securities, as well as meeting him in person in New York a few weeks ago.
This episode is a hyperfocused exploration of the economic forces affecting cryptoasset markets.
- Stephen’s background prior to the rise of distributed ledger technology.
- How Stephen first got involved in the cryptocurrency space.
- Why the act of spending bitcoin and other cryptoassets is very risky economic activity, but not in the ways you might first imagine.
- The economic case for stable coins, and the potential they have for dramatically increasing cryptoasset adoption.
- The size of payroll markets controlled by companies like ADP.
- Why we should think about differences between utility and security tokens through the lens of product markets and money markets.
- Fractional ownership and why tokenized assets become more valuable.
- The most expensive pizza ever purchased.
Links Relevant To This Episode:
- Stephen McKeon
- Stephen McKeon on Medium
- Stephen McKeon on LinkedIn
- Stephen McKeon on Twitter
- Lundquist College of Business
- Chris Burniske
- Blockchain Capital
- David Sacks
- Security Token Academy
- ARC Reserve Currency
- How to Succeed in Business by Bundling and Unbundling
Terms Mentioned in the Episode:
- Security Tokens
- Currency Mismatches
- Price Stability
- The Howey Test
- The Tulip and Bulb Craze
- Bid-Ask Spread
- Market Depth
Clay Collins: Welcome to Flippening, the first and original podcast for full-time, professional, and institutional crypto investors. I’m your host, Clay Collins. Each week, we discuss the cryptocurrency economy, new investment strategies for maximizing returns, and stories from the frontlines of financial disruption. Go to flippening.com to join our newsletter for cryptocurrency investors and find our just why this podcast is called Flippening.
Nomics: Clay Collins is the CEO of Nomics. All opinions expressed by Clay and podcast guests are solely their own opinion and do not reflect the opinion of Nomics or any other company. This podcast is for informational and entertainment purposes only and should not be relied upon as the basis for investment decisions.
Clay Collins: My guest today is Stephen McKeon, who’s an economist and professor of finance at the University of Oregon’s Lundquist School of Business. In this episode, which I’m titling Economics 101 for Crypto Investors, we’re going to discuss one, why the act of spending bitcoin and other crypto assets is a very risky economic activity, but not in the ways you might first imagine; two, the economic case for stable coins, and the potential they have for dramatically increasing crypto asset adoption; three, the size of payroll markets controlled by companies like ADP; four, why we should think about differences between utility and security tokens through the lens of products markets and money markets; this is one of the most profound economic distinctions you can grasp period in this space; and five, fractional ownership and why tokenized assets become more valuable over time. Now, for some background on this episode. In addition to having the pleasure of meeting Stephen in person in New York a few weeks ago, I had the privilege of interviewing him for our upcoming three-part audio documentary on tokenized and asset-backed securities. What you’re about to hear is material that did not make it into the documentary, but which I couldn’t bear to leave on the cutting room floor, because the content was simply too good. That said, this episode is not just a bunch of scraps loosely tied together. This is a fully-fledged episode on par and perhaps better than most of the content we’ve put out. As a note of housekeeping, I should mention that if you want to discuss these topics
Clay Collins: or this podcast episode with others, feel free to join us on our Telegram group at nomicstelegram.com. Finally, as someone who personally believes that the right ideas properly conveyed have the ability to change society, I want to say thanks to Stephen. He’s been generous with his time and ideas throughout this process. He’s reviewed transcripts, rerecorded parts of the interview, and helped shape much of the security token content that follows this episode. Please enjoy part one of my conversation with Professor Stephen McKeon. Can you tell us a little bit about your background? What were you doing before distributed ledger technology and this whole securitization of assets on the blockchain?
Stephen McKeon: I first started dabbling with Bitcoin and blockchain in probably about 2013, but I was really busy working on Skyward. I co-founded a drone software startup called Skyward back in 2012, and so I didn’t have a lot of time, when I was first introduced to it. It sounded really interesting and I had a background in finance, but it really wasn’t until about 2015 when I left Skyward’s board and I was looking for something where I could merge kind of the experience I’d developed in tech working with Skyward and couple that really with the formal training I had in finance through my doctoral program, and I was a professor at that point as well. I’ve actually been studying securities my whole career. One of the first papers I ever wrote was on debt financing. My doctoral thesis was on employee stock options. I’ve always been interested in securities, and as soon as I started diving in and really learning more about blockchain, I realized that this was sort of the perfect merger of all these different sorts of life experiences that I’ve had. I fell down the rabbit hole, as they say. There were some corollaries, too. One of the things I looked at around employee stock options is the fact that in recent decades, it’s actually the case that most equity has been issued to employees, rather than through things like IPOs and SEOs. It’s something that not everybody appreciates, but when you look at a lot of token models and a lot of the tokens being issued for work
Stephen McKeon: on the network, there’s some corollaries there. I started diving in. I was later introduced to Chris Burniske and he was definitely looking at this through a financial lens and trying to think about why value accrues, and we started doing regular calls, and then the real piece that led me to security tokens was when I participated in the Blockchain Capital offering. That was probably a little over a year ago. It was about March or April of 2017, and that was sort of an epiphany, to see that, you know, we could take this asset that is traditionally characterized by very little liquidity, so I actually have a small venture fund here in Oregon, and we lock up our LPs for up to 10 years, right, because we invest in the liquid securities, and we can’t handle redemptions, but this idea that you could tokenize a fund like this and offer, you know, liquidity to the investors while actually retaining the capital to invest in the liquid securities, that was really the epiphany for me. That’s when I started writing later that summer about traditional asset tokens and some of the experiences I’d had at Skyward, and that’s when David Sacks reached out to me, and he had also been, you know, interested in this topic and thinking about this topic and had started the group that became Harbor. I joined them as an advisor, and then to bring it up to the current point, most recently, I’ve joined a group called the Security Token Academy, which is really doing kind of advocacy
Stephen McKeon: and media and content around this space. I joined them as a Chief Security Advisor, and we’re going to be doing actually a whole conference around this topic on June 11th in New York.
Clay Collins: Very cool. I hope to be able to attend that event in New York. Now, in an upcoming episode, you and I do a deep dive into the topic of security tokens, but before we launch that documentary, I’d like to have a conversation with you about economics and particularly the economics of tokens and tokenization. Having spoken with you a bit, I think the best entry point into this discussion is an overview of your thoughts on stable coins. I’ve had lots of guests on this show, and opinions are really varied on this topic to say the least. But to be fair, most of the people I’ve had on this show are viewing stable coins through the lens of an investment opportunity rather than a lever for economic change. As an economist, Stephen, what are your thoughts on stable coins?
Stephen McKeon: I’m so glad you asked me this, because stable coins are probably the one thing I talk about almost as much as security tokens and traditional asset tokens. The TL;DR version is that we need one. Stable coins elicit strong opinions from both proponents and skeptics, and a lot of that debate centers around feasibility, particularly with the algorithmic versions. I’ve also seen people ask, why do we need a stable coin? Let me address that, and just to be clear, my definition of a stable coin would be a class of cryptocurrencies that exhibits low price volatility relative to a benchmark, and that benchmark might be US dollars or euros or any other unit account, or if the desire is stability against the price of goods and services, then there must be an index that stands proxy as the unit of account. But if you think about the problem we’re trying to solve, there are at least two economic concepts behind demand for stable coins. It would be currency mismatches and price stability. If you step back from crypto for just a minute to convey the concept of currency mismatches, these are things that induce currency risk. Think about taking out a fixed-rate mortgage loan to purchase a home, but instead of taking out the loan in your native currency, you borrow in a different currency, perhaps because the interest rate is lower. Now, in exchange for the lower interest rate, you’ve given up certainty about the cost of your mortgage each month, in terms of your native currency where you generate your income.
Stephen McKeon: Fast forward a little bit and assume the interest rate moves against you, and nothing else has changed. You earn the same income. You live in the same house, same mortgage, same interest rate, but now the payment in terms of your native currency has increased substantially. Depending on the rest of your budget, that difference might constitute the entirety of your disposable income, and it actually turns out that more than a million households suffered this exact fate in 2015 when the Swiss franc was unpegged from the euro and moved 16% in a month, because borrowers from all over Europe had had mortgages denominated in Swiss francs because they could get a lower interest rate. This currency mismatch exposes the transaction participants to currency risk, and in this example, it combined a speculative investment on currency with a mortgage, right, so there was sort of a coupling of these two things. Now, in many transactions, people don’t want to bear the additional currency risk through speculation, particularly if they can establish that speculative position independently. I want to be clear that, you know, saying we need a stable coin, it’s not taking anything away from Bitcoin. It’s just a different use case, right? As you mentioned at the beginning, some people will point to, you know, hyperbitcoinization, where Bitcoin is the global reserve, and at that point, Bitcoin is the stable coin, because everything’s priced in Bitcoin. Even if that’s your position, you have to acknowledge that we’re a ways away from that,
Stephen McKeon: and perhaps there’s a transitional role for a stable coin. Today, you can hedge out this currency risk using Bitcoin futures, but it doesn’t solve the problem entirely, because futures might work for some transactions, but not others. Take a sale of a home. Any time there’s any contingency, you’ve got an issue, because what if I enter a futures contract, but the house fails on inspection midway through the escrow period? Meanwhile, the price of Bitcoin has mooned, so I’m left with this loss on the futures, but no offsetting gain from the house sale. Contingent transactions are not good candidates for hedging with futures; plus, most people just don’t want to have to manage a futures position, just to use smart contracts and transact in cryptocurrencies. This overarching issue is that we live in a world priced in fiat, which is colliding with smart contracts that require a crypto unit of account. This mismatch creates friction, which slows the adoption of tokens as a means of exchange. Prices in all currencies adjust over time. The issue is that they’re not adjusting in lockstep, and it’s important to understand that this stability problem is temporal in nature. It’s not a function of one currency being inflationary and another deflationary; it’s that the rates of the inflation and the deflation are time-variant. They don’t move in the same amount at the same rate. If they did, it would be easier to solve. This mismatching, it adds uncertainty to decisions
Stephen McKeon: made today about prices and transactions in the future. By adding this currency risk, it acts as a friction to trade, because of what economists call the certainty equivalent is reduced. This idea with stable coins is to disentangle the ability to store an exchange value in the form of a token from the concomitant speculation on exchange rates, to try and decouple those two things. There’s all kinds of scenarios where the separation in time between the moment of contracting and the moment of value transfer occurs. Stable coins are a more natural fit for credit products, for prediction markets, for transactions for goods that are priced in fiat and involve a time delay in delivery. Something as simple as buying a phone, Vitalik actually tweeted about this in December. You know, what happens if you spend ETH and you purchase a phone, but then the price of ETH moves, and the seller decides not to ship it. I became interested in stable coins at the same time I became interested in traditional asset tokens, because these assets generate recurring distributions like lease payments. But an even larger category of recurring payments is payroll. What happens if payroll services want to utilize smart contracts? The volume of value transferred via payroll is underappreciated in this space. Consider this: Amazon, very large retailer, right? They received $136 billion in payments last year. That sounds like a lot, right? But it’s actually not a lot, compared to the amount of value transferred through payroll systems.
Stephen McKeon: ADP, one payroll processor, processed 1.35 trillion in payments last year. Payments in exchange for labor are one of the largest value transfers on earth, and recurring payments like salaries are much more likely to switch to a token-based system using stable coins versus one where you’ve got currency mismatching. Those are the alternatives right now. Stable coins allow people to store value tokens without bearing currency risk, and regardless of how you want to construct your investment portfolio, even if you still want to hold Bitcoin, stable coins are a more natural fit for storing value that’s expected to be spent in the near term, like the amount you might keep in your checking account. They’re a unit of account with which people are already familiar. To me, they are really the gateway in the transition from fiat to a token-based means of exchange for the broad economy, and they represent one of the clearest paths to adoption in my view. Let’s acknowledge that a universally-accepted stable coin is not here yet. There’s lots of challenges. I’m not stating an opinion on whether the winner will look like a fiat-backed reserve like TrueUSD or ARC Reserve Currency or a crypto-backed version like Maker or an algorithmic version like Basis. There’s going to be lots of speculation, and probably some of these will blow up spectacularly. My bigger point is that the effort is worthwhile, because if we can find a structure that works, it will facilitate a migration to payments on Crypto Rails for a wide variety
Stephen McKeon: of financing activity that’s still on the sidelines.
Clay Collins: I read a Harvard Business Review article claiming that all value creation was essentially bundling or unbundling. What I’m reminded of when I hear you speak about this topic is that Bitcoin has shown that something as simple as perhaps buying a pizza can become a highly speculative activity, and we shouldn’t require people who want to do things like buy homes or even buy groceries to gamble at such a high level if we want mass adoption of crypto assets. Hey, it’s me cutting in from the editor’s booth for some context on how buying a pizza can become a highly risky activity. In 2010, someone purchased two pizzas for 10,000 Bitcoins. Those Bitcoins are now worth 75 million, making that pizza the most expensive pizza ever purchased. I understand the pizza buyer’s pain a little bit, as back in the day, I purchased a $300 notebook with roughly one Bitcoin. Huge mistake.
Stephen McKeon: That’s absolutely right and even if there are use cases for many of these things with higher volatility, you’re exactly right that what they’re doing potentially is coupling that speculation or that investment, with some other transaction, when it could be decoupled to facilitate adoption.
Clay Collins: Okay, time out. I’m going to do some native advertising for the Nomics API. This episode of Flippening is sponsored by the Nomics API. The Nomics API offers squeaky-clean and normalized primary source trade data offered through fast and modern endpoints. Instead of having to integrate with a bunch of exchange APIs of varying quality, you can get everything through one screaming-fast fire hose. If you found that you or your developers have to spend too much time cleaning up and maintaining datasets instead of identifying opportunities, or if you’re tired of interpolated data and want raw, primary source trades delivered simple and consistently with top-notch support and SLAs, then check us out at nomics.com. Okay, back to the show. It strikes me that there are a lot of things being coupled in this space that really need to be decoupled. One example of this is the coupling of utility token and security token use cases. There’s just so much demand for highly liquid assets on the part of investors, and we’re absolutely seeing investors purchase crypto commodities and utility tokens with the expectation of returns. In some cases, investors are purchasing utility tokens, but analyzing the investment opportunity as they would securities, and in other cases, crypto projects are pitching utility tokens as they pitch a security. How would you describe the hard boundary between utility tokens and security tokens?
Stephen McKeon: There’s a couple pieces to this. You mentioned these supply and demand factors. So, if you think about something like Bitcoin, I think that’s closest to a commodity. So, maybe it doesn’t fit in either the utility or security token category, and you’re right that if the markets are relatively thin and you see shifts in demand, either up or down, it can have a fairly large price impact. But if you talk a little bit more about the utility token landscape, so, I’m an economist, so I view things in terms of markets. Rather than use security utility framework that’s sort of the common parlance, let’s think of things in terms of capital markets and product markets, because this, to me, is an easier way to frame the discussion. Capital markets are used to fund a project, right? Investors invest, hoping for a return, and it’s one of the prongs in the Howey test. That could be equity or debt or whatever, but the central theme is return on investment by investing in a project. Now, people participate in product markets primarily to consume the good or service. Let’s take Starbucks as an example. If I think Starbucks’s network is going to grow and that they’re going to sell a lot of coffee, then I buy Starbucks stock so that I can be the residual claimant on the value generated by that growth. Now, if I want to consume the products, perhaps I load $20 onto my Starbucks app, and they may as well be tokens. They could be tokens, actually, if Starbucks decides to go that route, and that would actually make it
Stephen McKeon: easier for me to transfer them. Say I want to give my brother a latte for this birthday. Now, I hold this value electronically on their app, and when I go into a store, they allow me to hold up my phone to the scanner, and then they actually give me the coffee. But I never expect to walk in the store, look at the balance on my phone, and realize that I can buy twice as many lattes that day. There’s no expectation of profit. The good they’re selling is relatively price stable with regards to the value that I’ve loaded into the app. Utility tokens are interesting because they’re causing capital markets and product markets to collide. But this is running afoul of security laws, as we’re seeing. We may have to find a way to separate these functions in a way that preserves the network value and maximizes usability of the product market token. What you may see happen is sort of a two-token structure. You have a capital market token that funds development of the network, and generates, a perpetual distribution of product market tokens to the holder. It’s sort of like an in-kind dividend. That was a long way of saying that I think there’s still room for innovation in token design, and I think we’re going to start thinking about these things in terms of capital markets and product markets.
Clay Collins: That was so helpful to me, thinking about this distinction between product markets and capital markets. Unless there’s real problems with the US economy and the value of the dollar, nobody goes around using Starbucks gift certificates as money. I guess one exception I can think of to this is the tulip frenzy, which, apparently a lot of people misunderstand. My understanding of what happened then, and maybe you can elucidate some of this for me, is that it wasn’t that people were paying a lot of money for tulips or tulip bulbs; it was that there just wasn’t a functioning currency, and so people started swapping shares that represented fractional ownership in the tulips as a replacement for money, and that drove up the price of tulips. What was happening in that case was, in fact, this colliding of capital and product markets. Is that a fair characterization or how would you refer to that?
Stephen McKeon: It may be, and I don’t claim to be an expert on the so-called tulip bubble. What I have read is actually that it was not nearly as much of a bubble as people might like to think. It was a little bit of speculation. There was some evidence that a few of these tulips were traded for sort of crazy prices. What you just described is essentially the idea where the tulip was being used as a medium of exchange and a unit of account.
Clay Collins: Stephen, one of the biggest benefits of tokenization is fractional ownership and increased liquidity. In fact, one of the most interesting aspects of this movement towards the tokenization of assets is the possibility for fractional ownership of assets, including physical assets, and fractional ownership actually increases liquidity, because there are so many more people who might be able to sell 1/1000th of a Van Gogh painting who wouldn’t buy an entire painting or who couldn’t afford it. It’s interesting how something being more liquid actually increases its value. I’ve heard economists talk about one of the reasons why tokens are so expensive or why we’ve seen sharp rises in the prices of assets like Filecoin and Siacoin and other crypto assets or crypto commodities is precisely because they have liquidity, and that, in and of itself, adds to the value of the asset. Putting your economist hat on yet again, do you think tokenized properties will continue to be worth more because of the liquidity that comes with tokenization?
Stephen McKeon: Yeah, it’s definitely part of the thesis. It’s a central part of the thesis, is this idea of a liquidity premium or erasing the, or I should say mitigating the liquidity discount. You touched on two things there in that question. There’s a couple baskets of shifts in value. One is just becoming more efficient. Taking some of these costs that are involved in transactions and automating them to some extent, which just makes it easier to transfer these things and reduces the kind of direct transactional costs relative to moving value. And then another idea is this idea of liquidity premium. If you just break it down and you think about why does this thing exist, when we think about measuring liquidity, we often look at, so what economists do, financial economists, will look at price impact. Say I own an asset, and I need to sell it right now. How much would I have to discount the price or how much would the price move because I’m executing this trade? You can kind of measure these things with like a bid-ask spread or you can look at, you know, how much did the price move in response to a particular trade, and so if I’m an investor and I know that once I buy this thing, there’s going to be price impact when I want to go sell it at some point in the future, what that means is, I’m not going to pay as much for it today, because I’m anticipating that cost in the future. You can just follow that all the way through the chain and sort of understand why the illiquidity discount exists.
Clay Collins: I can see the liquidity premium applying to things other than sort of traditional securities and to things like artwork. There might be a very rare piece of artwork, and maybe it’s valued at 100 million or 150 million, and that might be the value, but there’s like, 10 people in the world that would be willing to pay that much for that piece of art. But once you have a scenario where there’s fractional ownership and there’s liquid markets around it, now we might get more accurate pricing in those instances. Is that something that people are contemplating around this space?
Stephen McKeon: Absolutely. The idea that you’re touching on there is something called market depth. Market depth is an integral piece of this liquidity premium idea, because as I’ve said before, just because you tokenize an asset, that doesn’t automatically make it more liquid, right? It only becomes more liquid if it also increases market depth for the reasons that you touched on. If you have a high unit value asset, and there’s very few people in the world that can sort of wrangle the resources to purchase that asset, but if you were to fractionalize ownership, you now get a much larger pool of buyers. Then you’ve increased market depth; then you’ve potentially increased liquidity. Transferring that value would be less impacted by the trade, because there’s more buyers out there that are interested in owning it. Yes, that’s a really important piece.
Clay Collins: That’s it for this episode. Tune in next week for the first installment of our audio documentary about security tokens, and just a heads up that we’re looking for sponsors for this series. Stay tuned, and see you next week. That’s it for this week. To sign up for our free crypto investing newsletter, listen to other episodes, or get the show notes from this episode, please visit flippening.com. I also invite you to check out the startup that funds this podcast, Nomics, spelled N-O-M-I-C-S at nomics.com. Finally, if you got value from the show, the biggest thing you can do to help us out is to leave a five-star review with some comments and feedback on iTunes, Stitcher, or wherever you listen to podcasts. Thanks for listening, and see you next week.