Crypto, Dollars, Gold, and Layer 4 Money

Money seems like a straightforward thing in our day-to-day lives. However crypto has shown many what an often deeply philosophical question it can be: what is money?

A unit of account. A medium of exchange. We know the technical definitions. However the proliferation of things like algo stablecoins and wrapped tokens has forced us to hone down on where the value of these assets lies. Can you collateralize bits with more bits (bits meaning in the digital realm)? Or do your bits need be collateralized with atoms that exist in the physical world? What makes those atoms/bits money and others not money?

Just like there are layer 1 and 2 blockchains, there are layers of money that act as building blocks for more money.

Layer 1 money

The base layer for money is often a commodity, or commodity-adjacent asset. Up until 1971 that was gold for the US dollar, also known as the Gold Standard. In crypto, Bitcoin would likely be the leading candidate for digital gold.

The base-layer asset is secure and something widely considered valuable, but typically difficult to readily transport and/or use as a medium of exchange. Transacting in gold is impractical. Bitcoin holders typically don’t want to spend their sats, and the Bitcoin network TPS isn’t the fastest around. So, we must abstract.

Layer 2 money

US dollars used to be an IOU that could be redeemed for gold at any time; making the USD layer 2 money built atop gold’s layer 1. The US government however opted to remove the gold base layer in the infamous year of 1971, and now has layer 2 money masquerading as layer 1.

Fiat currencies with no formal backing is layer 2 money with no value-oriented base layer. The US military is effectively the base layer now for the USD. The US military isn’t a Proof of Work protocol, it’s Proof of Violence. The world’s largest violence network, which ironically uses more oil than any other institution on the planet. And they say Bitcoin is bad for the environment.

Layer 2 crypto money comes in several forms. BTC held on centralized exchanges is effectively an IOU for a Bitcoin deposit. This also includes lending platforms (eg. BlockFi). There is a difference of activity behind the scenes with these deposits, represented by the yield you’re provided for lending it to the platform. In the case of BlockFi, a form of fractional-reserve banking is happening where they lend your crypto deposit out for yield, effectively creating money the same way banks do.

Tokens like WBTC (wrapped Bitcoin) are another version of crypto layer 2 money. Bridging your Bitcoin to Ethereum creates an asset whose sole value is that it represents a demand deposit on the bridge that’s holding the BTC.

Layer 3

Using the US military as USD’s base (enforcement) layer, the dollar’s layer 3 is represented by demand deposits at banks. The USD was once an IOU on gold, which when deposited into a bank becomes an IOU for dollars.

Bitcoin’s layer 3 is created via DeFi applications like Yearn and Aave. With your WBTC you can then deposit it into a yield-farming vault, which gives you tokens like yvWBTC (representing your demand deposit). Your WBTC is then lent out repeatedly across multiple DeFi apps to generate yield for the vault, providing you yield.

Layers on layers.

Layer 4?

Layer 4 for USD is an esoteric, and in the author’s opinion, a highly underappreciated one. The eurodollar market is a ledger-money system that represents USD that is held by non-US banks. These deposits are then lent out, very repeatedly, creating many, many more dollars. Because these banks and deposits exist outside the US they are not regulated by the Fed. They are something of an unfettered lens into USD demand and interest rates for those deposits. A wild west of dollars.

No one wants actual dollars in this market (meaning accepting pallets of cash) they just want keystrokes in their account that give larger numbers that represent dollars. But there aren’t 1:1 dollars backing all these eurodollars. We don’t have any idea how large the eurodollar market is because it’s unregulated and opaque with no formal reporting; however it’s estimated to be at least as large as the US dollar market.

Stablecoins are an interesting abstraction. I’ve analogized them in a previous piece as sovereign money market funds. But another way to interpret them may be as cryptodollars, aka onchain eurodollars. A continuation of the USD layer 4.

Take Tether’s USDT. USDC represents dollars held at a US-based institution that trade onchain, kind of like a bank deposit. But USDT’s reserves are held outside of the US banking system, and USDT represents a demand deposit on these offshore US dollars. Tether claims they’re 1:1 backed, however there is a well-known murkiness to just how backed all USDT is.

The parallel to eurodollars is almost too perfect. You have an offshore entity that’s not regulated by the US government who is suspected of not having complete 1:1 backing of the dollars they issue.

USDC feels more appropriately described as layer 3 cryptodollars: USD that’s on the 3rd abstraction layer, similar to bank demand deposits. USDT is closer to layer 4 cryptodollars: likely not fully backed, less regulated, and are dollars created outside of US jurisdiction.

Does crypto itself have a layer 4 yet? Tweet at @BackTheBunny if you can think of any!

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