Risk Markets And Politics

Monday, January 08, 2007

Yootle interest rates and inflation

There is some excitement around Yahoo's planned "Yootles" currency and group decision-making mechanism. Near the end of the above paper, one sees that the initial interest rate for Yootles will be set to 5.375%. This strangely precise level is 1/8th of a percent higher than the current Fed Funds target rate. Yahoo will play central banker to its currency and is keen on controlling inflation.

Perhaps interest rates are not the best way to combat inflation in a new currency like Yootles. In "play" money exchanges, inflation can be caused by traders opening multiple accounts in order to push prices and build profits in their main accounts. (This might be the best strategy where automated market makers set initial prices away from fair value.) Yootles are a little different in that you aren't given any Yootles by virtue of creating an account, but a trader could still credit his main account arbitrarily. The trader doesn't care about the second account, so it is not clear how the high interest rate would discourage borrowing (Yootle issuance). If anything it would encourage Yootle issuance since the trader only cares about the account that is earning interest. Although credits and debits always net to zero, higher interest rates will lead to more Yootles over time. Traders will also be able to specify custom interest rates on transactions and so will be tempted to use high rates on bogus transactions. Similarly, what's to stop someone from abandoning an account that went negative through genuine transactions? Their past counterparties have already been paid and will continue to receive interest so they have no incentive to report users switching to new accounts. All of these scenarios underline the importance of user authentication in controlling inflation.

What are the interest rates on other play money exchanges? HSX currently pays the Fed Funds rate of 5.25% on cash balances. The rationale behind this is unclear since it discourages trading. Possibly HSX feels that the interest rate improves the quality of trades that are made, and inflation is not a concern there. Foresight's market rate has traded roughly between 3% and 0.5%, and since tying-up currency that is less recognized has less opportunity cost, one would generally expect play money market rates to be lower than real money rates. It is also expected that market interest rates for new exchanges will decline over time, as inefficiencies and reliable profit opportunities are competed away.

Regarding money supply, as a currency becomes more widely recognized and therefore useful, a "network effect" will accelerate its acceptance. This network effect will work against potential inflation from the increasing money supply.

Illegitimate transactions might again be the more important issue in practice. If they cannot be stopped, a high interest rate might do little to control inflation, and unexpected monetary operations could confuse traders.

Many will be especially focused on the emergence of a dollar-Yootle exchange rate. Although some qualms have been expressed about this from the perspective of fairness in the decision-making process, Yahoo has not indicated that it will block dollar-for-Yootle transactions. Even identifying such transactions may not be possible, as users might resort to suitably cryptic descriptions ("Craig's List style" indeed!). Exchange rate transactions have some very interesting implications.

1 Comments:

  • Thanks for this excellent posting! My intuitive understanding of interest rates is that they are an incentive for people to enter the monetary system sooner than later; the downside is that it encourages saving/hoarding and not spending. Allowing inflation is a way of neutralizing this incentive to save. In all, I feel more comfortable going back to the fundamentals than trying to copy the existing systems without full understanding of what is going on.

    By Anonymous Aleks, at 4:30 PM  

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