Crypto and incentive design with MIT Cryptoeconomics Lab’s Christian Catalini

Danny Crichton:
And so I'm going to just start with a normal introduction. We always record it later, so just so you know, there's always a little wobbly as we get going because I had [inaudible 00:00:09] for lunch. It's very spicy and don't do that on an empty stomach because I have serious heartburn right now. All right, everyone ready to do a pacho? You can count us in. 3, 2, 1.

Hello and welcome to Securities, a podcast and newsletter devoted to science, technology, finance, and the human condition. I'm your host, Danny Crichton, and today we're going to zoom in on the growing community and research surrounding crypto infrastructure and specifically incentive design Incentives drive all economic decisions, but in traditional meet space transactions, trust has also been a potent variable. So what happens when we move toward trustless cryptocurrencies and digital assets? How do we verify that a cryptocurrency offers the right incentives for all market participants?

Joining me to discuss all this and more is Christian Catalini, the founder of the MIT Crypto Economics Lab, which fuses the fields of economics and computer science with the goal of studying decentralized marketplaces and applications. In addition, he's a research scientist at the MIT Sloan School of Management. Christian is also the co-creator of Diem, formerly known as Libra, and also the co-founder and chief strategy officer at Lightspark. Joining alongside Christian me is my Lux partner, Grace Isford, who invests in Web3 and crypto infrastructure and is based here in New York City.

Grace Isford:
Thank you. Very excited to be here. Chris, thanks so much for joining. Really, really excited for the conversation.

Danny Crichton:
We've got a lot to talk on economic mechanisms as well as Chris's now famous MIT bitcoin experiment. So let's dive in. So Chris, I mentioned crypto economics, so this intersection of cryptography and econ and when I think about cryptography, I think of ciphers, Diffie-Hellman key exchange, elliptic curves, and then I walk over to economics and I think supply demand, bounded rationality, neuroeconomics. And so I'm curious what's the nexus of these two fields? Because they feel completely separate.

Christian Catalini:
Yeah, I know. And often I think they don't talk to each other as much as they should. Rolling back the clock to when I first started thinking about crypto, 2013, I was studying the economics of crowdfunding and equity crowdfunding. So I was coming from a world where ideally you could have digital platforms really revolutionize finance, revolutionize how we raise capital and more.

Something that got me really interested about Bitcoin at the time was the idea that dare you had a breakthrough in computer science, and I would combine cryptography, also with incentives with economic levers to really get people and participants of different types from institutions to individuals to coordinate around an idea, around the project, around the a vision in a fully decentralized way.

Economics has been kind of on the sidelines of a lot of the digital revolution, but now could kind of become a lot more center stage, could work closely with the cryptographers, people building these distributed systems to build new types of institutions. So when I think about crypto, what gets me most excited is that I look at these systems and I see the blend of economic levers and incentives with really clever new computer science, and that looks a lot like a new form of organization that we can build together in a distributor way.

Grace Isford:
I think that's really cool. Incentive engineering is something I discuss a lot with our scientists and residents [inaudible 00:03:21] I think a lot of crypto is about how do you get people to do things. Combining some of the economic teaching with the actual cryptography and underlying infrastructure is something I don't think is talked enough about.

Danny Crichton:
And Chris, I'm curious, when we talk about path breaking in a new field like this, you're combining two different disciplines. You're coming out of mathematics, which is a lot of cryptographers and economics. Are there unique aspects to the field that you're building and the ways that you do work or present work that's different from either of the two constituent fields?

Christian Catalini:
Not really. And I think often I find myself translating between the two sides. I've learned enough computer science to be somewhat dangerous and of course I can talk to economists for a long time, but what's interesting is that often the two crowds understand and work through the same concepts but don't speak the same language.

There's elements of economics that have been used in different systems from macroeconomic policy that's used at scale for currencies and how we think about targeting inflation or thinking about the supply of a fiat base that are quite relevant in crypto, as you can imagine. But those are different languages and so often the lessons from one event being imported into the other.

And likewise, I think it's really important for economists to understand and appreciate that cryptography really redefines the boundaries of what's possible, cryptography and distributed systems, and so suddenly things that you couldn't do before, think about the double spending problem, are solved. And those are not just breakthroughs from a computer science perspective, but also from an economics one.

To me, a lot of what's happening in crypto and blockchain is really about, okay, we can now define unique scarce digital assets that cannot be copied, and that's kind of a really important economic force when you think about everything from the movement of value and money to non-fungible tokens to Web3 applications and so on.

Danny Crichton:
I want to go back to this piece about building this new field because as an undergrad I wrote a thesis on the theoretical development of computer science as a field and as a discipline, and at Stanford in that context, it was coming out of mathematics and MIT came out of systems engineering and electrical engineering, which is why course six at MIT and Berkeley oftentimes combined electrical engineering, computer science into one field. Who are the people who are sort of backing you and pushing you forward and goating this ahead? Because at Stanford it was sort of Frederick Turman, this grandfather Silicon Valley, who sort of nurtured and protected this unique field so that it could have its own norms, its own publishing standards, its own ability to connect folks together in this interdisciplinary niche. And so I'm looking at MIT and I'm thinking, who are the leaders for you that really backed and moved the field forward in your work?

Christian Catalini:
What I would say is that often at this stage it's literally individual PIs or people that are passionate about the topic. The community is still extremely, extremely small. You could probably organize a conference and keep them all in the same room. Now, hopefully I think there's a lot happening and we're seeing more of this institutes happening whether on the corporate side, the VC side, or even the academic sector, there's enough of these blockchain crypto think tanks or groups. There's not a flagship journal and often that can be quite important for shaping careers.

The challenge is that, and this is where often for a student it'll be the second topic and now maybe their job market paper is that until you have a reputable journal with a good impact factor that's rigorous, it's high quality, that's how academic careers are made, especially in the early years. Now, some academics take a bit more risk and they just publish what they think is interesting even if it doesn't land immediately in a top outlet, but there's always this tension in nurturing it kind of a completely new community.

Grace Isford:
Yeah, I've seen a lot of the blockchain clubs be pretty pivotal in that, both the Stanford MIT Berkeley. I was at dinner a few weeks ago with a group of Stanford undergrads and it was amazing to see 80% of them were really excited about crypto and potentially willing to bet their careers or their next internship or job on it. And so seeing the rising tide of that, particularly maybe for the undergrads, to filter into some of these computer science programs, obviously like Dan Bennett at Stanford has done a lot there, is exciting to me.

Danny Crichton:
And I think we mentioned, yeah, obviously MIT was very early, so you were part of this thing called the MIT Bitcoin experiment, which sounds like if you managed to not screw it up, you could have done something really amazing. So talk about that back in 2013.

Christian Catalini:
We might have screwed it up.

Danny Crichton:
I would not have survived Mt. Gox. There's just no way. I'm just saying that out loud. But please.

Christian Catalini:
There's a lot of lessons from the MIT Bitcoin experiment. Just a bit of history. So Jeremy and Dan Elitzer essentially got together, I think they started emailing some MIT alumni for funding and their idea was give everybody Bitcoin. And they did a lot of progress actually. I think they raised pretty much off a million dollars within a couple of weeks. And then the problem was like, okay, how do we do this? And the administration, as you can imagine, this was 2013 when Bitcoin was more of a Silk Road headline and people were thinking, okay, this is some deep net, underground, shady asset and there was a lot of panic. And as we were talking through, okay, this sounds like a really good idea, it's a new asset, it's like the frontier of finance, how do we expose the students to it in a safe manner?

I came up with an idea, I was like, "Well, if we design a research experiment, we go through the full RRB process, I'm telling you it's going to be painful, first of all, not only are we going to get to distribute the Bitcoin, but we're also going to learn something from it," because I was really worried about, okay, you just distributed the Bitcoin and that's it. Now you just wasted a bunch of donors' funding for nothing. I reached out to one of my most trusted colleagues, Katherine Tucker, who is a longtime digital privacy scholar, and I was like, "Look, here in crypto, there's a lot about privacy that's novel and I think you'd be really excited to work with us."

So the team came together and we started designing actually the research study and all the flows of how do the students get onboarded, how do we teach them about crypto? How do we get them to set up a wallet? And we had a lot of questions around, okay, how does the adoption of a new technology actually work? You often don't get to observe the counterfactual, right? So you see the diffusion of some technology, others fail, but you never get to ask the question of, why would've happened if we have done X rather than y? Kind of your classic AB testing, but at massive scale.

The first set of questions we focused on was really like, how do you accelerate Bitcoin adoption? What are the drivers? What is the role of early adopters in that process? And then we had a bunch of questions around privacy. Do people really care about their digital privacy? Once they have a technology like crypto that gives them a lot more fine grain controls, will they take advantage of it?

Now, the fun part is that even at MIT in 2014, the usability of crypto turned out to be a major, major barrier. So we had students create their own wallets, they could choose between different wallets. Self custody was something that we really wanted to test and students had to send us their address, essentially the public key. We got everything. We got private keys that of course we destroyed. We got seeds for their election wallet back in the day. Everything that could go wrong with the setup of their wallet did go wrong.

Now, some people were really savvy. They even encrypted and signed their address to us with PGP, which was something that we wanted them to do for extra safety. We were paranoid about safety. Luckily all the coins made their way to their recipients and nothing went wrong. And we worried about nation states trying to subverted. We had reached out to treasury to make sure that they wouldn't, the day after, come after all the students who were holding crypto, all sort of things that we had to do, probably a bit overkill.

But what happened, I think everybody wants to know what happened. And I think the short answer is that despite the setbacks, MIT students were smart, the vast majority hold on to their Bitcoin, and so they made a pretty good return on. I think the price would be coming back in the day was 350. Some people ate their most expensive sushi lunch or dinner of their lives because the only location on campus, actually around campus, this was still on East Monkfish in Central Square, for those of you that know Cambridge.

Danny Crichton:
Oh of course, yeah.

Christian Catalini:
They were the one place where you could spend your Bitcoin so a bunch of people went there. I think I got some angry emails after that. I shouldn't have done it. Many people lost their keys, so I think some of those funds are forever lost. All the things that you've seen in crypto happen during that experiment.

The punchline on the early adopter story was that actually early adopters are super important for adoption. Where we see the coins in the ends of early adopter types, 300 days later almost adoption was twice as big and activity was way more high and people were a lot more engaged with crypto. The privacy results were a lot more depressing. Even at MIT, even within a community that's known for open source work or caring about privacy, most people were willing to give away their privacy either for small incentives or for a faster flow. All sort of things that we know are problematic for digital privacy right now happened at MIT too, so that part of the research result was a lot more depressing. But yeah, that was the experiment. Then again, don't ask me how much Bitcoin we actually distributed by today's value no matter what the day is.

Grace Isford:
I think we're 22K or something right now, something far higher than 350. But I love how you framed that around what can we learn and how can we see how early adopters act and in turn improve usability, learn and almost create more of a feedback loop. I think it's so relevant as you think about some of the underlying cryptographic infrastructure and just how do you actually increase adoption and people aren't thinking enough about that bridge. Danny and I chatted a lot about Web2.5. Is that a thing? Shall that exist? But it's a lot about bridging the gap and for people who have no idea what Bitcoin is, how do you get them to adopt and how do you get them to use and engage?

Danny Crichton:
Well, all these folks who have experienced the wealth creation that comes from this, to me, when I was an undergrad and did psych studies, point at the red thing and you get $20 after 30 minutes and you spent the $20 on a burrito, I should have asked for crypto back then in the psych ward. Nonetheless. So I want to pivot the conversation.

So Chris, your work is mostly focused on, I would say economics and the market microstructure, so how markets get developed, how do you develop incentive compatibility for all the participants, whether they're buyers, sellers, traders, liquidity providers, et cetera. And you recently had a paper, this was last year in August, called the Economics of Stablecoins in which you've done a lot of work around design mechanisms, and in that paper you said you had surfaced two critical dimensions that underpinned the economic design of every stablecoin.

The first was the volatility of the reserve assets against the reference asset, namely whatever you're using to sort of back the stablecoin to sure that it is able to cover what the value is on the fiat value. And then, two, the degree to which the stablecoin is exposed to the risk of a death spiral, which is the kind of thing you don't want to have in your sort of stablecoin product. I would love to hear a little bit about the work that you've been doing on stablecoins on this paper and how you're thinking about market microstructure today, given broadly the events over the last couple of months we've seen in the crypto industry.

Christian Catalini:
Yeah. So that is a really good question and a very painful one to go through, mostly because, as you can tell from the dates of that paper and a few related ones, we described some of the challenges that we were seeing in this space, and unfortunately, as we all know over the last few months, we're recording this in July of 2022, a lot of that happened. When it comes to stablecoins, the simple version is that as part of the Libra Diem journey, we actually worked extensively on what is the best design from a consumer perfection perspective? How do you build an asset that that's actually kind of bank grade and people can trust? And the conclusion we came to after exploring all the more clever algorithmic setups was that if you're trying to peg to an asset that is defined offline like the dollar, and by offline I mean off chain, then you don't have a lot of tools, you'll have to rely on some form of trusted intermediary bridge and that bridge is going to be your issuer of sorts.

Now, there's a lot that you can do to [inaudible 00:15:16] that infrastructure, especially in countries that have good institutions and good rule of law and established financial sector regulation. You can have a reserve that's managed by an entity that does all the appropriate transparency and disclosures, it's audited regularly. You can ensure that reserve, to your point about the correlation with the reserve assets or the one you're trying to peg that only old 90 days or less US treasuries and cash, kind of the gold standard, and as closely as you can get as a non-public sector participant to a central bank currency.

That category of stablecoins, I think we'll get there. We're not there yet. I think some of the existing stablecoins are pretty close. If you have equity backing, what is otherwise on demand claim against that reserve, if the value of that equity changes, and that could be just because the asset has deteriorated in expectations, or even people are worried about that, even the expectation of a failure leads to a failure in all of these algorithmics stablecoins, then what happens is what we've seen, which is essentially really rapidly, these systems collapse.

And what's sad about what happened, I would say is that, crypto didn't need to relearn the history of a currency board. Fundamentally, that's how currency board failed, and that was just a different flavor of that. Even with weaker guarantees, we could have avoided that. But hopefully, to your point about what happens next, I would say, hopefully we'll get more savvy, we'll get more thoughtful. Maybe we'll call these new objects that are creative and are trying to do new things not stablecoins. I just think stablecoin is a misnomer for a lot of them.

We'll go back to the drawing board and keep consumer protection and ensuring some guarantees are really transparent to the public in mind when we build these things because, to me, the part that was the most sad is not the experienced crypto traders, the institutions that were exposed to these assets, all of those will recover. But around the globe, people are starting to use crypto and from Africa to Latin America to Southeast Asia, I think there's some that find this is the future of money and they've bought into it and they were caught into this. So you could see a lot of people online saying, "I put my savings into this," and now they lost all of their funds. So that that's not great for crypto and I think we should all aspire to be a lot better than that.

Grace Isford:
That was extremely well said. I hope everyone listens, re-listens to that, because this was well said. Just one thing I'll add, a lot of people don't talk about what has held up pretty well too. And so whether it be Maker, Aave, Compound, I hope we continue to hear more stories of some of these decentralized systems holding up better because of their smart market structure or how they were originally set up and their values. So I think it's critical.

Danny Crichton:
Well, I think there's a huge spectrum between pragmatism and purity, right? What we seen in stablecoins is you had the algorithmic stablecoins, most notably Terra LUNA, which was designed to be just totally trustless, there's no fiat backing, it's designed self-contained. And so from a computer science perspective, I'm like, this is gorgeous, it's beautiful, it's a work of art, and there's no way to actually function. On the flip side, you have a completely fiat-backed currency with short term treasuries that are working to make sure that it's actually stable. And so I'm curious, I'm going to go to Grace, you first, you've talked a lot about this transition into crypto and this sort of balance between pragmatism and purity and specifically this concept of sort of Web2.5. So I'm curious, particularly in stablecoins, how do you feel like where should we be in that spectrum today?

Grace Isford:
I think you see USDC, you see some projects continuing to grow in maturity and grow in awareness. I think stablecoins are going to be part of many folks' portfolio as they enter into DeFi or if they're opening up their Coinbase account or Gemini account, wherever they have their assets. But I think you need to proceed with caution. And I remember when I started trading DeFi, someone told me, "You have to tread carefully." We don't quite have the same regulatory frameworks or risk provisions. And so we are still very early in both the regulatory and kind of consumer retail institutional investor protection journey. And you need to make sure you actually understand what you're investing in and read the white papers, understand stable point economics and go read through all of Chris's wonderful work as you continue to grow and diversify your assets. So work in progress, I'd say.

Danny Crichton:
And Chris, you mentioned the second factor of stablecoins, which is avoiding the death loop or the death spiral. And I'm curious, so I'm looking at it Italy, which is having a huge economic catastrophe right now. Mario Draghi just left as Prime Minister last week. And the fear that's always going on in the Italian financial world is the doom loop, as they call it, because Italian banks own huge numbers of Italian bonds. And so when the Italian economy gets weak, those bonds are worth less. People don't want to buy them, therefore all of the banks are under-collateralized, which means they need to buy more bonds, which creates more demand, not enough supply, et cetera, et cetera, and you have this doom loop that caused the last crisis in Italy, but a decade ago, and we're sort of entering the same one.
And so when I look at stablecoins, at some point you're entering kind of the reality of the definition of money, which is ultimately what is something worth? Why is the dollar so strong right now compared to other currencies? Why do we trust USDC and not Terra LUNA? And I'm curious because you're focused on economics and cryptography and clearly there's a mathematical overlap between these two. But in the last couple of years, in the economics world at least, there's been huge focus on psychology of buyers and sellers and how they either make mistakes in their rationality or that they just sort of glom on to other folks and sort of social organizations and social webs, and I'm curious what role that psychology plays in your work as you're thinking about economic incentive compatibility.

Christian Catalini:
I would say that behavioral economics, which is the part of economics that has kind of imported the most from psychology, has a lot to teach us about the consumer experience. And I think when it comes to consumer protection or even consumer choices like privacy, we know what the tricks are to get people to make better choices. Unfortunately, the same tricks are used also by companies and apps to get people to do what's best for the app or the company.

I think when it comes to stablecoins, look, on the fiat-backed, we know the playbook. Actually, with the Libra Diem journey after four years of regulatory interactions, I think we have fine-tuned the model. People should just take that model and run with it. It's going to lead to a very good robust consumer experience. For the other ones, I think education, ensuring that consumers understand the conditions, ensuring that they understand that, look, this is not meant to be stable in the broader sense and these are the conditions where it might not be stable. I think that's going to be extremely important.

How we get there, it's going to be a mix of better participants elevating their own standards from the industry side, and also regulation. Regulation being really difficult I think in a lot of this space because it's not always the most constructed dialogue and it's not always clear that regulators understand some of the complexities of some of these stablecoins. Again, we had plenty of conversations where we described some of the challenges, ongoing algorithmic, but as you can imagine, all the focus was on Diem and Libra and what we could do, and as it turns out we weren't that dangerous.

Danny Crichton:
So let's close it up because I know we were open almost up on time. Let's project forward. So we're recording this July 2022. You had this paper last year. A lot of stuff happened the last couple of months. There was a bill in Congress right now talking about stablecoins that actually just got punted yesterday as we're recording this that the treasury secretary, Janet Yellen, sort of had some concerns about some of the language in the bill. And my understanding is the house finance committee has sort of pushed off on that and they're not going to regulate it right now, but project forward. We're going into an election year in a couple of months, another election two years, crypto has sort of burbled up in some of these scenarios. It seems to be on regulators' mindset certainly after the events of the last couple of months. What's important if you are a regulator, policymaker right now? What would help this community thrive and improve while protecting consumers?

Christian Catalini:
It's a really difficult question because to some extent, unfortunately, I think that a lot of the dialogue and discourse is not based on the facts and the objective nature of the technology. I think crypto as a field needs to do a much better job at communicating the upside. It's still very surprising to me, for example, that one of the key messages to me, at least from an economics perspective about crypto, is this is a tool for bringing more competition to verticals from payments to finance to digital platforms that you as a regulator have been concerned about, where you see concentration, you see, when you think about the processing of payments, two players essentially dominating the market on a global scale. When you think about finance, of course there's a lot of incumbents that retain a lot of control over access to financial services.

Digital platforms, same issue. How come that part of the app set has not made it? This is a technology that can lower cost, can reduce friction, can extend the segments that have access to a set of tools that should be, especially in the United States, I think even for granted, but we still have 7% and banked or underbanked and up to 14% if you look at the bottom 40% of the income distribution, and we're in a leading FinTech nation still struggles to include everyone.

I think those elements are not part of the discourse. And to your point, I think what could regulators do? I think there's a lot of areas where Sandbox or kind of better guardrails that would really help the good sector participants that want better standards, that want clarity. The challenge being that often because it makes more headlines to attack project X, Y, and Z, or to ride the wave of panic around one single project that runs into trouble. We see this reaction where, and we've experienced it also with stablecoins, where the conversation is not about the facts. The conversation is not about, okay, can this actually improve our current system? The conversation is a lot more about, oh, do we want these new entrants in, say, payments or financial services? And then the response is always lukewarm because there's an established interest in keeping the status quo up as it is.

Danny Crichton:
Well, Chris, Grace, thank you so much for joining us.

Grace Isford:
Thanks, Chris.

Christian Catalini:
Thank you. It was really fun.