Dr. Luzius Meisser, Frankencoin Association | The Macro Mechanics Behind Decentralized Credit

Let's uh dive right in the topic. So, the title is somewhat long. It's about the macro mechanics of decentralized credit money creation, and it's also uh rather theoretical topic. It dives into the purpose of what we are doing here. It dives in the purpose of credit and stable coins, and it shows how this can shape the world.

So, first let's see what kind of money there is. So, there's traditional cash to my right or to your left. Uh this is what you all know. It's direct central bank money. There's also the possibility to issue central bank digital currencies.

Uh this is also central bank money, and this is relatively boring. Supply is managed by the central bank. There's not not much else uh than just uh I I you with the central bank. It starts to get more interesting once you move to bank money, because what banks do, they mix central bank money with credit money. So, you get a mixture in the end when you hold a bank deposit, or maybe also a tokenized bank deposit.

This is what the Swiss Banking Association wants to do. They want to issue a deposit token. It represents money issued by a bank. And the bank in the background uh does something with that money, and then that uh is partially credit money. And this allows money supply to breathe.

So, banks can adjust to demand for money much faster than the central bank could. So, this is is actually good. Some people say you should have always full money, but it's good to have this credit money mixed in. You also have credit money mixed in when you have uh issues of stable coins. They have some reserve.

They have a little bit of bank account money, and then have a lot of government bonds and others. And then the most interesting part is the smart contract based DeFi stable coins, where we replace the issuer through a set of rules enshrined into a smart contract. So, I created some slides to show you what you're actually financing by holding different types of money. With bank money, you are mostly financing real estate and government bonds because this is what the banks are allowed to hold at the highest leverage. So, and the bank also keeps most of the returns they are making.

With centralized stable coins, it doesn't look much better. When you hold Tether in this example, you are mostly financing US government spending because 80% of the Tether balance sheet is US government bonds. There's also a little bit of gold and Bitcoin in there, and the issuer keeps all the returns for itself. So, this is part of the business model of stable coin. It's a big political topic.

Should stable coins be have an interest? Should the issuers be allowed to pay an interest? And of course, uh it it it's it's essentially a cartel that that's mandated by the government because if they're not allowed to pay an interest and keep everything for themselves, it benefits them. It also benefits the banks because the banks then have less competition. And the politicians also like it because then they keep everything under control.

But this is a little different with uh decentralized stable coins, as you will see. So, first, of course, there are ways to earn a yield on a stable coin. We have heard Stani from Aave just before. In this example, I have Morpho, which is a French project. So, what you normally do with DeFi lending is that someone, a lender, provides some funds, puts it into a pool, and on the other side, there's a borrower coming and say, "I have a collateral, which can serve as a safety deposit.

I want to borrow against that." And then you have DeFi lending. And this is nice and good, but it still uses existing stable coins. And by turning this order around like in the FrankenCoin system, you can actually create money. So, in the FrankenCoin system, we start with the borrowing.

So, a borrower goes there, deposits some uh maybe in this case Bitcoin or a CBTC, and borrows against these uh collaterals. So, the the the borrower mints new FrankenCoins, and then sells the FrankenCoins on the market. On the other side, there's maybe a a lender, so to speak, or better to say saver, that then can put the FrankenCoins in the protocol again and earn a yield. And by turning this order around, you get something with a completely different quality. You now get money creation on chain.

It's a little like when you go to a bank and want to get a credit. Often, the bank doesn't give you existing money from other clients. What the bank does, it pushes a button and expands its balance sheet. It prints new money. And that that's exactly what's happening with DeFi stable coins.

And what you also get with the DeFi stable coins, you are backing other things. So, with traditional bank money, you're mostly backing real estate and uh current spending. But you are actually financing here with a DeFi stable coin is whatever the the the those who borrow use as a collateral. So, in the case of FrankenCoin, this is very diverse. So, we have Bitcoin 40%, Ether 30%, 15% is Boss Info AG, which is a Swiss IT company, and this is very interesting.

This is really something that is different also than most other lending protocols. We have uh one of the key advantages of the FrankenCoin is that we don't depend on Oracle, and this makes us much more free to accept a much wider range of collaterals. We also have some Standard Poors ETFs and gold tokens in there that serve as a collateral. And the returns are distributed to the frank and coin holders that stake them in the savings module. So, maybe as a quick intermezzo, apart from the economics to show you how this is technically done to that we don't need an oracle.

So, usually there's an oracle that tells a lending protocol or a DeFi stablecoin the price of this collateral is too low, you need to liquidate it. And sometimes there's an auction to liquidate it, there's other possibilities as well. But typically auctions can be used to liquidate the collateral. And in the frank and coin system, we use these auctions for two purposes at once. We use it not only for liquidation, but also for price determination.

So, this goes as follows in this example. Maybe a borrower comes and says deposits one Bitcoin and borrows 50,000 frank and coins. And then someone says Bitcoin is maybe not 50,000 Swiss francs worth anymore. Let's challenge that and he deposits another Bitcoin. And then an auction starts and depending on where the highest bid ends, either the Bitcoin of the challenger is sold or the position is liquidated with the with this bid.

And this of course, there's a little more to it. This is quite simplified, but it just This is the the essence of it. Through this process, we get a way to accept any kind of collateral that is somewhat liquid. So, you cannot use NFTs or so, you need to have something fungible that has uh uh some free float that has a lot of holders. So, so there's candidates to to challenge it, but then it works.

And that's why we can accept uh the shares, the tokenized shares of a Swiss IT company as a collateral. And the effect on the economics on that is quite big. So, if you look at an example here, let's say very boring business, 5% organic growth per year, it grows 10x in 50 years. But if the exactly same business gets access to leverage, if it can deposit its shares or its asset in a protocol and borrow against it at an LTV of 50% and 3% interest, it grows 30x in in the same time. So, and this is a very important function of credit.

Credit can accelerate growth. And what also matters a lot is the loan-to-value ratio. So, if you take an even more boring business with only 4% organic growth per year, but it's allowed to borrow at an LTV of 80%, it can overtake the other business with 5% growth. And this is a very interesting observation. It means that the capital requirements that are imposed on the banks and the resulting maximum loan-to-value ratio that you're they're allowed to to to give, they determine what kind of businesses are financed and what are not.

And it might lead to a misallocation of resources, namely when banks are allowed to have a huge leverage on something that's actually not so economically meaningful. And maybe they don't invest in something that would have a higher growth where the society would and the economy would benefit more, but they don't do that because they're not allowed to leverage so much. So, capital requirements have an influence on the economy and to the degree that the capital requirements are not aligned with the true risk of the underlying asset, it distorts resource allocation in the economy. So, there's another nice effect of leverage and this is it increases the value of something. The exact same security with the exact same return is more valuable, has a higher market price if you can borrow against it.

So, I did a simple calculation here as an example. If you have a security that yields 5 euros per year, and you're not allowed to leverage it, and you have apply a discount rate of 10%, it's worth 50 euros per unit. If the If you have security B with the exact same return, but you're allowed to leverage 2x at 3% interest, then the market price jumps to 77 euro per unit because you can leverage against it. You can You can use it to to earn more. And the same effect can of course apply of course when you suddenly allow new types of assets to be used as a collateral to borrow against.

So, in the end, what we have here is we have democratization of money creation. We can allow small companies like Bos Info or other companies that tokenize their assets to finance themselves, and not only finance US government spending when you hold a stablecoin. So, the conclusion of that is that if you look at that at it from a macro perspective, so if you compare to socialist communist system in a communist system, there's a centralized planning committee that decides this hotel gets built, this factory gets capital, this factory doesn't get capital. This role in the capitalist system is occupied by the financial sector. In a free economy, it's the financial sector that decides what gets built, what doesn't get built, which startups get financing, which don't.

And this machine, it's the financial system, is essentially a calculated risk-taking machine. This, if it works well, it will allocate the resources of society such that society discovers optimal growth path. So, that that you have maximum wealth in the long run. And the freer the financial system is, the better it can fulfill that role. So, uh I think DeFi and stablecoins have a big role to play here because we live in a world where the financial sector is extremely tightly regulated, where we have capital requirements that distort uh risk allocation.

We have interest rates that are set politically and not necessarily by economic reality. Uh and we have a tendency, generally, for governments to encourage investments in government spending and real estate, and that might not lead to the optimal path. It might lead to stagnation. And I think with stablecoins, and especially decentralized stablecoins, we enable money creation for everyone. We also enable the financing of categories of investments that are potentially underfinanced by the traditional financial system.

And uh that's my note. Thank you.