Sunday, January 14, 2018

Floors v corridors



David Beckworth argues that the U.S. Federal Reserve should stop running a floor system and adopt a corridor system, say like the one that the Bank of Canada currently runs. In this post I'll argue that the Bank of Canada (and other central banks) should drop their corridors in favour of a floor—not the sort of messy floor that the Fed operates mind you, but a nice clean floor.

Floors and corridors are two different ways that a central banker can provide central banking services. Central banking is confusing, so to illustrate the two systems and how I get to my preference for a floor, let's start way back at the beginning.

Banks have historically banded together to form associations, or clearinghouses, a convenient place for bankers to make payments among each other over the course of the business day. To facilitate these payments, clearinghouses have often issued short-term deposits to their members. A deposit provides clearinghouse services. Keeping a small buffer stock of clearinghouse deposits can be useful to a banker in case they need to make unexpected payments to other banks.

Governments and central banks have pretty much monopolized the clearinghouse function. So when a Canadian bank wants to increase its buffer of clearinghouse balances, it has no choice but to select the Bank of Canada's clearing product for that purpose. Monopolization hasn't only occurred in Canada of course, almost every government has taken over their nation's clearinghouse.

One of the closest substitutes to Bank of Canada (BoC) deposits are government t-bills or overnight repo. While neither of these investment products is useful for making clearinghouse payments, they are otherwise identical to BoC deposits in that they are risk-free short-term assets. As long as these competing instruments yield the same interest rate as BoC deposits, a banker needn't worry about trading off yield for clearinghouse services. She can deposit whatever quantity of funds at the Bank of Canada that she deems necessary to prepare for the next day's clearinghouse payments without losing out on a better risk-free interest rate elsewhere.  

But what if these interest rates differ? If t-bills and repo promise to pay 3%, but a Bank of Canada deposit pays an inferior interest rate of 2.5%, then our banker's buffer stock of Bank of Canada deposits is held at the expense of a higher interest elsewhere. In response, she will try to reduce her buffer of deposits as much as possible, say by reallocating bank resources and talent to the task of figuring out how to better time the bank's outgoing payments. If more attention is paid to planning out payments ahead of time, then the bank can skimp on holdings of 2.5%-yielding deposits while increasing its exposure to 3% t-bills.

Why might BoC deposits and t-bills offer different interest rates? We know that any differential between them can't be due to credit risk—both instruments are issued by the government. Now certainly BoC deposits provide valuable clearinghouse services while t-bills don't. And if those services are costly for the Bank of Canada to produce, then the BoC will try to recapture some of its clearinghouse expenses. This means restricting the quantity of deposits to those banks that are willing to pay a sufficiently high fee for clearing services. Or put differently, it means the BoC will only provide deposits to banks that are willing to accept an interest rate that is 0.5% less than the 3% offered on t-bills.

But what if the central bank's true cost of providing additional clearinghouse services is close to zero? If so, the Bank of Canada should avoid any restriction on the supply of deposits. It should provide each bank with whatever amount of deposits it requires without charging a fee. With bankers' demand for clearing services completely sated, the differential between BoC deposits and t-bills will disappear, both trading at 2.5%.

There is good reason to believe that the cost of providing additional clearinghouse services is close to zero. It is no more costly for a central bank to issue a new digital clearinghouse certificate than it is for a Treasury secretary or finance minister to issue a new t-bill. In both cases, all it takes is a few button clicks.

Let's assume that the cost of providing clearinghouses is zero. If the Bank of Canada chooses to  constrain the supply of deposits to the highest bidders, it is forcing banks to overpay for a set of clearinghouse services which should otherwise be provided for free. In which case, the time and labour that our banker has diverted to figuring out how to skimp on BoC deposit holdings constitutes a misallocation of her bank's resources. If the Bank of Canada provided deposits at their true cost of zero, then her employees' time could be put to a much better use.

As members of the public, we might not care if bankers get shafted. But if our banker has diverted workers from developing helpful new technologies or providing customer service to dealing with the artificially-created problem of skimping on deposits, then the public directly suffers. Any difference between the interest rate on Bank of Canada deposits and competing assets like t-bills results in a loss to our collective welfare.

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Which finally gets us to floors and corridors. In brief, a corridor system is one in which the central bank rations the number of clearinghouse deposits so that they aren't free. In a floor system, unlimited deposits are provided at a price of zero.

When a central bank is running a corridor system, as most of them do, the rate on competing assets like t-bills lies above the interest rate on central bank deposits. Economists describe these systems as corridors because the interest rate at which the central bank lends deposits lies above the interest rate on competing safe assets like t-bills and repo, and with the deposit rate lying at the bottom, a channel or corridor of sorts is formed.

For instance, take the Bank of Canada's corridor, illustrated in the chart below. The BoC lets commercial banks keep funds overnight and earn the "deposit rate" of 0.75%. The overnight rate on competing opportunities—very short-term t-bills and repo—is 1%. The top of the corridor, the bank rate, lies at 1.25%. So the overnight rate snakes through a corridor set by the Bank of Canada's deposit rate at the bottom and the bank rate at the top. (The exception being a short period of time in 2009 and 2010 when it ran a corridor floor).



Let's assume (as we did earlier) that the BoC's cost of providing additional clearinghouse services is basically zero. Given the way the system is set up now, there is a 0.25% rate differential (1%-0.75%) between the deposit rate and the rate on competing asset, specifically overnight repo. This means that the Bank of Canada has capped the quantity of deposits, forcing bankers to pay a fee to obtain clearing services rather than supplying unlimited deposits for free. This in turn means that Canadian bankers are forced to use up time and energy on a wasteful activity: trying to skimp on BoC deposit holdings. All Canadians suffer from this waste.

It might be better for the Bank of Canada (and any other nation that also uses a corridor system) to adopt what is referred to as a floor system. Under a floor system, rates would be equal such that the rate on t-bills and repo lies on the deposit rate floor of 0.75%--that's why economists call it a floor system. The Bank of Canada could do this by removing its artificial limit on the quantity of deposits it issues to commercial banks. Banks would no longer allocate scarce time and labour to the task of skirting the high cost of BoC deposits, devoting these resources to coming up with new and superior banking products. In theory at least, all Canadians would be made a little better off. All the Bank of Canada would have to do is click its 'create new clearinghouse deposits'  button a few times.

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The line of thought I'm invoking in this post is a version of an idea that economists refer to as the optimum quantity of money, or the Friedman rule, first described by Milton Friedman back in the 1960s. Given that a central bank's cost of issuing additional units of money is zero, Friedman thought that any interest rate differential between a monetary asset and an otherwise identical non-monetary asset represents a loss to society. This loss comes in the form of people wasting resources (or incurring shoe leather costs) trying to avoid the monetary asset as much as possible. To be consistent with the zero cost of creating new monetary assets, the rates on the two assets should be equalized. The public could then hold whatever amount of the monetary asset they saw fit, so-called shoe leather costs falling to zero.

In my post, I've applied the Friedman rule to one type of monetary asset: central bank deposits. But it can also be applied to banknotes issued by the central bank. After all, banknotes yield just 0% whereas a t-bill or a risk-free deposit offers a positive interest rates. To avoid holding large amounts of barren cash, people engage in wasteful behaviour like regularly visiting ATMs.

There are several ways to implement the Friedman rule for banknotes. One of the neatest ways would be to run a periodic lottery that rewards a few banknote serial numbers with big winnings, the size of the pot being large enough that the expected return on each banknote as made equivalent to interest rate on deposits. This idea was proposed by Charles Goodhart and Hugh McCulloch separately in 1986.

Robert Lucas once wrote that implementing the Friedman rule was “one of the few legitimate ‘free lunches’ economics has discovered in 200 years of trying.” The odd thing is that almost no central banks have tried to adopt it. On the cash side of things, none of them offer a serial number lottery or any of the other solutions for shrinking the rate differential between banknotes and deposits, say like Miles Kimball's more exotic crawling peg solution. And on the deposit side, floor systems are incredibly rare. The go-to choice among central banks is generally a Friedman-defying corridor system.

One reason behind central bankers' hesitation to implement the Friedman rule is that it would threaten their pot of "fuck you money", a concept I described here. Thanks to the large interest rate gaps between cash and t-bills, and the smaller gap between central bank clearinghouse deposits and t-bills, central banks tend to make large profits. They submit much of their winnings to their political masters. In exchange, the executive branch grants central bankers a significant degree of independence... which they use to geek out on macroeconomics. Because they like to engage in  wonkery and believe that it makes the world a better place, central bankers may be hesitant to implement the Friedman rule lest it threaten their flows of fuck you money, and their sacred independence. 

That may explain why floors are rare. However, they aren't without precedent. To begin with, there is the Fed's floor that Beckworth describes, which it bungled into by accident. At the outset of this post I called it a messy floor, because it leaks (George Selgin and Stephen Williamson have gone into this). The sort of floor that should be emulated isn't the Fed's messy one, but the relatively clean floor that the Reserve Bank of New Zealand operated in 2007 and Canada did from 2009-11 (see chart above). Though these floors were quickly dropped, I don't see why the couldn't (and shouldn't) be re-implemented. As Lucas says, its a free lunch.

Wednesday, January 10, 2018

XRP and bitcoin as bridge currencies

Eshima Ohashi Bridge, Japan


The value of all outstanding XRPs recently surpassed that of bitcoin, hitting $300 billion or so last month. XRPs are a cryptocurrency issued by Ripple, a company that is trying to shake up the business of cross border payments. Ripple has a number of strategies for doing this, but the one that has caught people's imaginationespecially as the price of XRPs rocket higheris to have banks and other financial institutions use XRP as a 'bridging asset' for moving value across borders. The idea of using a cryptocurrency as a bridge isn't a new idea. Bitcoin remittance companies have been trying to do this for several years now, without very much success.

So what do I mean by using a cryptocurrency like bitcoin or XRP as a bridge asset? Does it make any sense? To answer these questions, let's dissect a hypothetical cross border payment.

Straddling two universes

As users of banks and other financial institutions, we rarely think about what is going on underneath the hood of a money transfer. If I send money from my account to yours, the language of this transaction implies that money is flowing from my bank account to bank account. But moving funds from one bank to another bank is physically impossible. If my account is at Bank A, and yours is at Bank B, I cannot send value directly from my account to your account. Our two accounts may as well exist in entirely separate universes.

The only way I can make a bank-to-bank payment to you is indirectly, by turning to a third-party who straddles both universes. Say my hair dresser has accounts at both my bank and your bank, and for a small fee she'll do the transaction for us. I tell my bank (Bank A) to credit my hairdresser's account at Bank A by $10, and my hair dresser in turn tells her bank (Bank B) to debit her account and credit you account at Bank B by $10. The payment is done. I have $10 less, you have $10 more, and my hair dresser is flat, her $10 having been erased from Bank B's ledger with a new $10 deposit appearing in her account at Bank A.

The same principle is at work in cross border payments, except the person who is doing the straddling between the two bank—my hair dresserwill need to have a domestic bank account, say in Canada, and an international account, say Philippines. And instead of crediting you $10, she will have her Filipino bank send you the peso equivalent of $10, which is around ₱400 at the current 40:1 exchange rate. But apart from that, the concept is the same.

In principle, a cross border payment like this could go very fast. Assuming that it only takes the Canadian bank a few moments to transfer $10 from my account to my hair dresser's account, then she can quickly start the Philippines leg of the transaction. And if the Filipino bank is just as fast, you'll have the ₱400 just a few moments after she clicks the send button. This whole chain needn't take more than twenty minutes of fiddling with bank websites.

The benefits of queues

But there are factors militating against speed. Say that I need to send you money several times a day. It would be a hassle for my hair dresser to log in to her Philippines bank account and process each payment as it arrives in her Canadian accountshe has to cut hair, after all. Instead, she chooses to wait till the end of the day when several of my payment requests have accumulated, upon which she batches the payments into one large payment and clicks the send button.

There is a trade-off here between speed and cost. Putting transaction requests into a queue slows down each of my payments to you, but it imposes less costs on my hair dresser. Slow speeds aren't necessarily a bug. If we all want to save some money, sluggishness may be the best solution for all of us.

Pre-funding: expensive but speeds things up

Imagine that over the course of a few weeks I make so many payments to you that my  hairdresser's Filipino account runs out of funds. When this happens she will no longer be able to make outgoing payouts to your Philippines bank account. To keep the system up and running, she will have to replenish her account with pesos. One of her options would be to withdraw cash from her Canadian account, fly it to Philippines in a suitcase, trade it at the airport for peso banknotes, and deposit these into her Filipino account. This would be slow, expensive, dangerous, and potentially illegal, but it's a theoretical option.

A more realistic option would be to sell her Canadian dollar deposits to a foreign exchange dealer and get Filipino peso deposits in return. This dealer, who will have accounts in both Philippines and Canada, will execute this trade for a commission. My hairdresser will have to ask her Canadian bank to credit the dealer's dollar account while the dealer asks his Filipino bank to credit my hair dresser's peso account. There will be some lag as the dealer processes the transaction, say because helike my  hairdresseruses a queue to batch payments together so as to save on fees. But once my hair dresser's Filipino account has been topped up, I can once again make payments to you.

Instead of allowing her Filipino account to periodically run down to zero, my hairdresser may try to maintain a permanently-funded peso account. After all, if she doesn't prefund the account, then you and I will have to cope with constant delays as she waits for the foreign exchange dealer to refill her account. Prefunding her Philippines account isn't without  cost, however. Instead of being able to invest the money in bonds or upgrading her salon, my hair dresser must tie her capital up in a low-yielding bank account as she awaits my payments requests.

Thus, as in the case of queuing on the Canadian side, prefunding on the Philippines side involves a trade-off between cost and efficiency. Reducing the amount of pesos held in anticipation of incoming payment request will allow my hairdresser to reduce costs, but it will simultaneously slow down payments from you to me since the odds of having to wait for a refill increase.

To sum up, for cross border payments to occur someone must straddle the divide between isolated banks. This straddler uses techniques like queuing and prefunding in order to make cross border payments proceed as fast as possible without costing too much.

Cryptocurrency as a bridge

So where do XRP and bitcoin come in? The two of us want little more than a flow of recurring peso payments to arrive in your Filipino bank account as fast and cheaply as possible, but what goes on underneath the hood doesn't concern us. If she can increase payment speeds without having to pay a higher cost (or, alternatively, if she can reduce costs without sacrificing speed), it may make sense for my hairdresser to incorporate an asset like XRP or bitcoin in the payments process.

Say at the end of Monday my hair dresser has amassed four $10 payments in her queue, or $40. She logs into her Filipino bank account, and sends you one ₱1600 payment. She wants to rebuild her Filipino account balance in preparation for the rest of the week's incoming payments. Normally she would do so by asking her foreign exchange dealer to swap her some Filipino deposits for her Canadian dollar deposits.

Instead, she decides to pre-fund by turning to the market for cryptocurrencies. One option is to take the $40 I've transferred her and buy $40 worth of XRPs from her foreign exchange dealer, then sell these XRPs to another dealer for ₱1600 in deposits. Alternatively, she may turn to an organized exchange to complete the refunding. She sends the $40 to a Canadian cryptocurrency exchange, buys some bitcoin or XRP, quickly sends these coins to a Filipino cryptocurrency exchange, and then sells them for pesos. At which point she will transfer the pesos to her bank. Voila, her Filipino bank account has been reloaded using cryptocurrency as a bridge.

Comparing fees and speed

Let's compare these two routes. By exchanging dollars directly for pesos via a foreign exchange dealer, only one transaction had to be completed, and thus one set of hassles and fees incurred. By going through the cryptocurrency market, my hairdresser must make two transactionsa purchase of XRP or bitcoin on the Canadian crypto exchange (or from a dealer) using Canadian dollars, and a sale of XRP/bitcoin on the Filipino crypto exchange (or to a dealer) for pesos. If the sum of these two sets of hassles and fees is less than the traditional single set of hassles and fees, then going the cypto route may make some sense for her. But I confess that I think it is highly unlikely that two sets of fees beat one.

It could very well be quicker for my hair dresser to reload her Filipino account via XRP/bitcoin than the traditional route. For instance, the dealer who is buying her Canadian dollars and selling her pesos may delay the peso leg of the transaction for twenty-four hours. But this sluggishness isn't inherent to a fiat-to-fiat transfer. If she asks nicely, there is no reason the dealer can't expedite the transaction so that the pesos appear in her account within the hour. By queuing her request with many others over a twenty-four hour period the dealer reduces his overall costs, these benefits flowing back to my hair dresser in the form of reduced fees. Likewise, my hair dresser could choose to queue her XRP/bitcoin payment into a big chunk along with other people's cryptocurrency payments. This would slow things down, but reduce fees.

US dollars a bridge currency

Not all traditional cross border payments involve one transaction. Canada-Philippines is a relatively popular payments route, but rarely used payments corridors, say like Canada to Uzbekistan, will incorporate a third fiat currency—probably U.S. dollarsas a bridge currency. For this payment to proceed, my hairdresser will need both a Canadian dollar account and a U.S. dollar account. She will have to find a counterpart who straddles the U.S. and Uzbek banking systems by maintaining a U.S. dollar account and an Uzbekistani Som account. Once she transfers her counterpart some U.S. dollars, then he can execute the Uzbek leg of the payment.

Even on exotic corridors I have troubles seeing how XRP/bitcoin can compete as a bridge. The dollar is the world's most entrenched currency. The CADUSD market will always be deeper than the XRP-to-CAD or bitcoin-to-CAD market, and same on the Uzbek Som side. This depth means that transaction costs on U.S. dollar trades will be lower than on crypto trades. For this calculus to change, bitcoin or XRP will somehow have to displace the U.S. dollar as the world's most liquid medium of exchange. But this is unlikely to happen due to the incredible volatility of cryptocurrencies.

Crypto-volatility

Which leads into the next defect of crytocurrencies as bridge assets. XRP and bitcoin are inherently volatile assets, so using crypto as a bridge means the risk of encountering a plunge in value.  In the case of XRPs, my hairdresser will have to hold them for at least a few moments (or even minutes), but that could be enough time to cause some damage. As for bitcoin, which is slower, she will have to carry them for an hour or two before they can be sold in Philippines. That's an eternity in cryptoland. To top it off, crypto exchanges are notoriously risky, outages and thefts being a regular occurrence. These are pretty big risks for my hair dresser to take, so using crypto markets will only make sense if they provide her enough compensating efficiencies.

Where might these come from? Traditional cross border payments have typically offered very little in the way of transparency. If my hair dresser's payment is stuck, it'll be hard for her to get information on its status. To cope with this informational gap, she may choose to constantly over-fund her peso account, which hurts her pocket book. One advantage of something like Ripple is that all XRPs are recorded on the public Ripple ledger, and thus my hair dresser should have a better idea about what stage her payment has progressed. And this may give her the confidence to reduce the amount by which she pre-funds her peso account, the freed up capital being invested in her salon.

That's a nice feature, but I don't quite see how increased transparency can possibly make up for 1) the inherent risks of holding cryptocurrencies, even if just for a few moments, and 2) the aforementioned transactions costs involved in running the bridge. Furthermore, the transparency advantage is being eroded as traditional payments systems respond to the competitive threat posed by players like Ripple. SWIFT, the communications network that is relied on to facilitate traditional cross border payments, has recently incorporated a tracking number to all payments, thus allowing users to get a real-time end-to-end view on the status of their payments.

So for now, I don't think there is much merit to using crypto as currency bridge in cross border payments. That doesn't mean XRP must crash because it has no use case. Dogecoina parody cryptocurrency that recently rose above $1 billion in valuedemonstrates that coins don't need a fundamental use case to justify their price. But I've been wrong many times about cryptoland, so let's see what happens.

Tuesday, December 19, 2017

Money as a generally-accepted medium for short selling

Jim Chanos, famous short seller. We are all Jim Chanos.


Most people find the idea of short-selling to be incomprehensible. Buy a stock and hold it, that's what one does. To the majority of us it's just down-right odd to do the reverse, borrow stock in order to sell.

At the same time, pretty much everyone in the world is a short seller, even if we don't realize it. The credit card debt we wrack up, the lines of credit, the pay day loans, the mortgages—they're all examples of us going short. We borrow a certain type of security—dollars or yen or other types of money, either in paper or digital format—and immediately sell it. And then after a little time passes we cover that short, buying the dollars or yen back and repaying the loan. We are all Jim Chanos, the world's most famous short seller, the only difference being we tend to short different instruments than Chanos does.

The only time I ever sold a stock short was back in 1999. I was still in university and probably a little bit reckless. What I didn't know at the time was that there was still a year or so left in the crazy late 1990s bull market. The price of the stock that I had shorted immediately began to move higher, and I got worried. The problem with short selling is that because a stock can keep rising forever, losses are theoretically infinite. After a month or two I bought the stock back to cover the loan, then got back to my studies.

While I've only sold stock short once, I've sold money short umpteen times. Borrow some Canadian dollars, sell it for things like groceries or a plane ticket or tuition, wait a while, repurchase the money, pay the loan back.

So why don't I finance my consumption by shorting things like Netflix or bitcoin? Why do I short dollars instead?

The nice thing about shorting money rather than Netflix shares or bitcoins is that I know exactly how much it'll cost me to repurchase the necessary securities to cover my short. Our labour is almost always priced in term of money, say $30 per hour. So if I've shorted three one-hundred dollar bills, I know ahead of time that I only need to sell ten hours of my time to buy that $300 back.

What's more, labour tends to stay sticky for months. This means I don't have to worry about my per-hour rate plunging temporarily to $15 next Wednesday, forcing me to spend twenty hours of time instead of just ten to cover my short. And since the central bank sets an inflation target of 2% or so a year, I already know far ahead of time that if I'm making $30 per hour this year, I'll be making ~$30.60 next year. So whereas one hour of my labour allowed me to cover a $30 short position in 2017, that same hour will allow me to cover a $30.60 short position in 2018. That sort of long-term certainty is a great feature.

Not so with bitcoin or Netflix. The big problem with using these instruments to finance consumption is that labour is never paid in terms of bitcoin or Netflix, but in yen or dollars or pounds. So while the sticky nature of labour means I know ahead of time that I'll be able to sell an hour of my time for $30, I don't know how many bitcoins or Netflix shares this $30 will allow me to repurchase to cover my bitcoin/Netflix shorts. This would be less of a problem if Netflix and bitcoin were fairly stable in price, but both are terrifically volatile, as I described here.

Consider a scenario in which I short one share of Netflix in order to fund my weekly supply of groceries (which costs ~$200)—or alternatively I short 0.01 bitcoins—and the price of either of these two assets doubles over the next few days. I'll end up having to pay $400 to cover the short, or fourteen hours of labour. If I had just shorted $200 dollars instead, I'd only owe seven hours ($200/$30).

A worst case scenario is one in which Netflix of bitcoin start to rise to infinity. If so, I'd have to work every waking hour of my life just to repurchase Netflix/bitcoin and cover my short. No thanks, I'll take the predictability of shorting money to pay for $200 worth of groceries. Central banks can create and cancel whatever amount of money they need to keep the purchasing power of money on a narrow path. I'll never have to worry about the nightmare of working every day for the rest of my life just to cover a tiny short position.

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Without the institution of short selling, society is made worse off. The timing of people's incomes do not always coincide with their consumption plans, and a short sale is a great way to bridge the gap.

And if short selling is a vital tool for bridging the gap between our incomes and consumption plans, it is important that the various media we use for shorting are capable of facilitating this process. When the future costs of covering a given short are difficult to predict, people will shy away from shorting to fund their spending needs, and the benefits of trying to bridge the gap between income and consumption plans will go unexploited. Society is made worse off.

The best media for this purpose—those most capable of providing a predictable price—will become society's generally-accepted media for shorting. So maybe money isn't just a medium of exchange, store of value, and unit of account; it's also a popular short-selling medium. That's why we see stable instruments like Federal Reserve dollars or Bank of Tokyo-Mitsubishi yen deposits or Barclays pound deposits serving as the world's most prolifically-shorted media. Sure, bitcoin and Netflix short sellers certainly exist, but this is a very niche sort of transaction undertaken by highly-trained financial practitioners or fools. They aren't generally-accepted short media.

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Bitcoin is a particularly awful medium for short selling because its lack of fundamental value leads to jaw-dropping volatility. Anyone who borrows one bitcoin (which currently trades at $19,000) and then sells it to finance a $19,000 purchase, say a car, could easily end up owing $190,000 two or three months down the road. That'd be a mere 10x price increase in the price of bitcoin, which is just a regular month or two in bitcoinland. A price move of this degree could easily bankrupt the car buyer.

Which in turn could bankrupt the person who lent to them. A bitcoin lender must account for the potentially lethal effect bitcoin's price spikes will have on his or her customer base by incorporating a premium into the interest rate charged to their customers. This means that the interest costs of borrowing and shorting $19,000 worth of bitcoin in order to buy a car will always be more than the costs of borrowing $19,000 worth of Federal Reserve banknotes. 

Because this volatility is inherent to bitcoin, it will always be bad at helping people build vital bridges between incomes and consumption plans. Don't expect it to ever become a generally-accepted medium for short selling.    

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What other features make for a good generally-accepted medium for shorting? When it comes time to cover one's shorts by buying back Netflix or bitcoin, there may not be enough of these instruments available, which can lead to a huge spike in their price. These are called short squeezes.

Money is different. The supply of modern money is tiered, with the public at the top, commercial banks in between, and a central bank at the bottom layer. When a spike in the public's demand for money occurs (otherwise known as a bank run), private banks will try to accommodate that spike until they can't, at which point they can turn to the central bank for help. The central bank can in turn manufacture whatever quantity of new money is necessary to meet that demand. So short squeezes will always be prevented by the central bank. That's a feature that neither Netflix nor bitcoin can offer.

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If the central banker's job is to maximize people's ability to bridge long gaps between income and spending by ensuring the predictability of the generally-accepted medium for shorting, might there be a better rule for managing things than inflation targeting?

Say that a recession hits and a large part of the population loses their jobs. If the central bank has an inflation target, those who have jobs can continue to easily cover the same quantity of dollars shorted by selling their labour whereas those without jobs will not be able to cover their shorts at all. Aggregating these two groups together, there is a net reduced capacity for short covering. So we might say that the central bank is failing at its job of providing a predictable medium for shorting.

If the central bank were to temporarily boost inflation to 4% when a negative shock occurs, it would be easier for the unemployed to cover their shorts than under a permanent 2% inflation targeting regime. For instance, with inflation at 4% rather than 2% an unemployed person would be able to sell their car or couch at a higher price than otherwise in order to cover a short position. For those on the flip side of the coin—those who make their living lending the medium for shorting—a temporary increase in inflation to 4% means their loans will be less valuable. But at the same time, the increase in the odds that the unemployed will be able to cover their shorts means that creditors needn't fret so much about the hazards of bankrupt customers.

So everyone wins. The converse could work too. When the economy is booming and jobs plentiful, the central bank could reduce inflation to 1% or so, thus making it slightly harder for people to cover their short positions. By using a rule that improves predictability in both regular times, downturns, and booms, the central bank provides a superior shorting medium for bridging gaps between incomes and consumption plans than under a flat inflation targeting regime. I suppose this is an argument for NGDP targeting over inflation targeting?

Friday, December 15, 2017

Electronic money will only save central banks from subjugation if it is anonymous

50 SEK banknote issued by the Riksbank in 1960

"Do we need an eKrona?" asks Stefan Ingves, the Governor of the Riksbank, Sweden's central bank. The Riksbank is probably the central bank that has advanced the furthest in discussions surrounding the introduction of a central bank-issued digital currency (CBDC)—a new form of risk-free digital money for use by the public. Canada, New Zealand, Australia, the ECB, and China are also dissecting the idea, with more central banks to come in 2018.

Sweden is approaching the issue from a unique angle, says Ingves. It is the only country in the world showing a consistent decline in cash and coin usage. I've written about this interesting pattern here, here, and here. Below is a chart:


Ingves floats two theories. Either the Swedish public no longer wants central bank money, or alternatively they do want central bank money but not the type that is "made of pieces of paper," preferring instead an as-yet non-existent digital alternative. If so, then it may be the Riksbank's duty to provide that alternative, says Ingves.

Duty is an admirable motivation, but let me propose another reason for why the Riksbank is exploring the idea of an eKrona—self preservation. I think Sweden's central bank is terrified that it will become powerless in the future. It is desperately casting around for solutions to resuscitate itself, one of these being an eKrona. This fear is rooted in the fact that declining cash usage has led to a collapse in the resources that the Riksbank believes that it needs to function.

These worries about powerlessness are shared by central bankers around the world, many of whom expect advances in private payments technology to lead them to the same cash-light situation that Sweden is currently experiencing. Their respective degrees of discomfort probably depend on how advanced their citizens are in the process of shifting away from cash. The Federal Reserve, which issues the world-renown $100 bill, is perhaps the farthest from having to worry, whereas central banks like the Norges Bank and Central Bank of Iceland are much closer to approaching peak cash.

What do I mean by a collapse in resources? Central banks have always been unique among government agencies for their self-sufficiency. Rather than depending on tax revenues to pay for their operations, they are capable of funding themselves internally. Central bankers have even made a habit of providing their masters in government with juicy dividends each year.

The magic behind this ability to self-fund is due to the central bank's monopoly on banknotes. Banknotes get into circulation when a central banker buys an asset, usually a government bond. Because the central bank doesn't have to pay any interest on the banknotes it issues whereas the bonds it holds yield 4% or so, it gets to collects the entire 4% margin for itself as revenue. Out of those revenues it pays its expenses, the remaining profit flowing back to the government as a dividend. 

These dependable and juicy margins, otherwise known as seigniorage, have afforded central bankers a number of luxuries. First, consider the creature comforts. These include large research departments, well-paid staff, good benefits, high status, nice new office buildings, museums with free admission, and plenty of international travel and conferences.

But seigniorage also serves a more important function; as fuck you money. Fuck you money (pardon the expletive, but its such a great phrase) can be thought of as any resource base that is large enough to allow an individual or institution to reject traditional hierarchies (i.e. one's boss) without fearing the consequences. The central bank's seigniorage—its fuck you money—finances a dividend that flows to the government, effectively buying central bankers a uniquely-large degree of autonomy from the vagaries of their political masters. This safe space allows folks like Ingves to pursue their most important task in peace, namely jigging the interest rate up and down in order to set the price level. A government department that must pass around the hat each year for funding would never be able to attain the same degree of independence.

At this point you may be able to see the Riksbank's problem. As the supply of krona banknotes in circulation withers, the Riksbank's seigniorage is getting smaller and smaller. This threatens not only the creature comforts that Swedish central bankers have gotten used to, but also the flows of fuck you money necessary to secure their sacred independence. If the popularity of kronor banknotes continues to drop, the perceived risks of political subjugation of the central banking machine will only grow.  

Let's take a look at some numbers. Below is a chart of Riksbank seigniorage going back to 2008.



The Riksbank calculates this number by taking the total earnings from its assets (both income and capital gains) and allocating an appropriate portion of this to the banknote component of its liabilities. The total costs of managing the bank note and coin system (printing, handling, salaries, designing etc) are deducted from this amount, leaving banknote seigniorage as the remainder.

Whereas Riksbank seigniorage clocked in at around SEK 5 billion in the late 2000s, it has plunged to SEK 560 million in 2016. If the rate of decline in banknote usage continues, my calculations show that seigniorage could fall to half that amount by 2018 and go into negative territory at some point in the early 2020s.

Falling global nominal interest rates are one important explanation for the decline in Riksbank seigniorage. As I said earlier, central bankers garner the margin between the supply of 0%-yielding banknotes in circulation and the interest payments they earn on bonds. If bond rates are declining, the margin shrinks and seigniorage suffers. But even if Swedish interest rates were to slowly recover over the next few years, this wouldn't halt the deterioration in Riksbank seigniorage. The constantly eroding base of banknotes on which the Riksbank relies for its profits would more-than-cancel out the effects of higher rates.

To shore up its flow of fuck you money, the Riksbank needs to find other sources of income. Which may be the true reason for Ingves's recent broaching of the idea of an eKrona. Given that a decline in banknotes in circulation is at the heart of the Riksbank's flagging seigniorage, then perhaps by developing a new 0%-yielding product and pushing it into circulation, the Riksbank can rebuild its once plentiful resources.

In terms of design, one option the Riksbank is putting forward is to allow Swedes to keep accounts directly at the central bank. It refers to this option as register-based eKrona. I'm afraid that register-based eKrona is destined to be a dud. Private banks have decades worth of experience in providing accounts to the public. A central bank account will always be a poor competitor. Former New Zealand central banker Michael Reddell recently blogged on the topic of an eNZD, recalling the days when his employer offered accounts to employees:
Central banks almost inevitably would lag behind commercial banks in their technology anyway, which wouldn’t make a central bank transactions account product particularly attractive... Frankly, I’d be a bit surprised if there was much (normal times) demand at all (and I think back to the days –  decades ago –  when the Reserve Bank offered –  in direct competition with the private banks –  cheque accounts to its own staff; perhaps some people used theirs extensively,  but I used it hardly at all).
As for the supposed superior credit risk of a central bank account, I just don't see it. Sweden already insures private bank accounts for up to 950,000 kronor ($112,500) and even up to 5 million kronor in special circumstances. A central bank account could only be the superior alternative for amounts north of $112,500, but how many members of the public really keep that much in deposits?

Types of eKrona compared to cash and bank account money (source)

Given that register-based eKrona would fail miserably in securing the Riksbank a new stream of fuck-you money, Ingves and his research staff should probably be focusing entirely on the alternative form for eKrona: electronic banknotes. The Riksbank refers to this option as value-based eKrona. Unlike register-based eKrona, a value-based eKrona would possess a very special feature; anonymity. Like physical banknotes, they would be untraceable, only they would be superior to their physical forbears since they would be transferable not only face-to-face but also over the internet. The Swedish public's desire for online economic privacy would be sufficient to generate a positive demand for the lone product providing said services, the eKrona, thus restoring at least some part of the Riksbank's lost seigniorage.

In his recent speech, Ingves seems tepid on the idea of privacy for the eKrona, blithely writing that "perhaps it could contain some element of anonymity." Here's a message for him (and all those other central bankers who will eventually be in Ingves's position). "Perhaps" isn't good enough. Without a differentiating feature like anonymity, eKrona will never gain any acceptance among a public that already has decent private bank digital money. And so the Riksbank will only continue on its path to losing its wellspring of fuck you money and the independence it buys. Anonymous digital money or bust.

Wednesday, December 6, 2017

Store of value

LSD tabs like these ones have an incredibly high value-to-weight ratio


When bitcoin first appeared, it was supposed to be used to buy stuff online. In his 2008 whitepaper, Satoshi Nakamoto even referred to his creation as an electronic cash system. But the stuff never caught on as a medium-of-exchange: it was too volatile, fees were too high, and scaling problems resulted in sluggish speeds. Despite losing its motivating purpose, bitcoin's price kept rising. The bitcoin cognoscenti began to cast around for a new raison d'etre. Invoking whatever they must have remembered from their old economics classes, they rechristened bitcoin as the world's best store of value.

Store of value is one of the three classic functions of money that we all learn about in Money and Banking 101: money serves a role as a medium of exchange, unit of account, and store of value. So presumably if bitcoin wasn't going to be a medium of exchange (and certainly not a unit of account thanks to its volatility), at least some claim to money-ishness could be retained by having it fill the store of value role.

In his 1867 Money and the Mechanism of Exchange, political economist William Stanley Jevons formally introduced the term store-of-value into monetary economics (although Nathan Tankus tells me that Marx may have originated the idea albeit with different terminology, and Daniel Plante tips Aristotle):

Jevons's store of value function refers to the process of preserving value across both time and space. Now in one sense, every good that has ever existed has been a store of value, as Nick Rowe once pointed out. If a good isn't capable of storing value, we'd be incapable of handling and consuming it. Even an ice-cream cone needs to exist long enough for value to be transferred from tub to mouth.

What Jevons was implying in the above passage is that some goods are better than others at condensing value. Goods with the low bulk and weight, including the "current money of the land" (i.e. banknotes), are the best condensers. Below is a list of items ranked according to price per pound, which I get from Evilmadscientist (beware, these are 2008 prices). While all-purpose flour can store value, a $100 bill is better at the task, and while both are surpassed by championship thoroughbred semen, nothing does the job better than LSD.


To condense value over time and space, a store of value will need to be durable. Saffron has a fairly high value-to-weight ratio, but its quality depreciates much quicker than a dollar bill, thus compromising its ability to store value through time. Same with copper and silver, both of which will steadily corrode whereas gold does not. It also helps to have low storage costs. Oxen may have been a great way to store value across space, yet feeding and sheltering them over long periods of time would have been quite expensive. 

Jevons was writing before computers and the internet had emerged. Nowadays, billions of dollars in value are represented digitally. These digital tokens—stocks, bonds, deposits, credit, bitcoin, and whatnot—are weightless and volumeless. Which means they far exceed the ability of any physical item to condense value over time and space.

How does bitcoin rank relative to other digital stores of value? Let's say you needed to condense a certain amount of value and had a choice between either holding bitcoin or Netflix stock. (I choose Netflix because its market cap is close to the market value of all bitcoins ever mined, and because both their prices have done exceptionally well over the last six years). Bitcoin is great for conveying value across space, especially if it involves crossing national borders. All you have to do is remember your private key and you can access your funds no matter where you are. Netflix isn't quite so fluid. While you can certainly access your online brokerage account when you are in Vietnam on holiday, you can't actually sell Netflix stock in Vietnam (as you presumably could with bitcoin). Instead, you'd have to sell the stock and transfer the proceeds to a bank account in Vietnam via the correspondent banking system. That could take a few days and you might run into some hassles.

What about for storing value across time? Bitcoin has a few neat features, including censorship resistance. Since bitcoin isn't centrally managed, there is no way for an administrator to censor you, i.e. erase your bitcoins. With Netflix (or any other centrally-housed digital asset), however, if you are a considered to be a bad actor by those who control the system, presumably your shares can be frozen or confiscated. Counterbalancing this, bitcoins are notoriously susceptible to being stolen. But I've never heard of a thief getting away with someone's shares. There's a bit of give and take.

But in general, I'd argue that bitcoin and Netflix stock are both pretty bad for temporally storing value, although bitcoin is particularly bad. For an asset to do a good job condensing property over time it has to provide its owner with predictable access to a future basket of consumption goods. Assets with prices that have gone parabolic do not fulfill this requirement. After all, there is no reason that the price won't reverse and start to plunge, thus compromising that instrument's ability to store predictable amounts of consumption through time. Anything with a highly stable price across all time frames (minute-by-minute and year-to-year) provide the requisite predictability. Assets that gyrate do not.

The chart below shows the relative variability of the prices of bitcoin, Netflix, and gold since 2011.


Specifically, the chart measures each assets' median change in price over a given month. For instance, in November 2017 bitcoin had the tendency to close up or down by around 3.2% each day, Netflix by 0.8%, and gold by 0.3%. Averaging out all months since 2011, gold's variability comes in at 0.5%, Netflix at 1.5% and bitcoin at 2.2% (see dashed lines above), which means the yellow metal has done a much more predictable job of storing value over time than the other two assets, and Netflix is more up to the task than its digital counterpart. 

In late 2016 bitcoin's volatility seemed to have fallen permanently below Netflix levels and—for a month or two—approached that of gold. The digital stuff had become a mature asset! That wasn't to be, however, and bitcoin volatility has since reverted to levels significantly above its long term average.

I'd argue that bitcoin's high volatility is inherent to its nature. As such, it will always do a fairly bad job of storing value over time. The problem, as I outlined in my recent BullionStar article, is that bitcoin is a pure Keynesian beauty contest asset. People only buy bitcoins because they expect others to buy them at a higher price. The markets for gold and Netflix, on the other hand, are populated by a second set of participants who value those assets for reasons apart from whether others will buy them later. In the case of gold, industrial buyers step up whereas with Netflix it is value investors. The buying and selling of this second set of participants has a calming effect on prices.

The most predictable way to condense value through time is a U.S. dollar deposit. Anyone who has $100 in their account knows with a high degree of accuracy what they'll be able to buy next week. This stems from the fact that consumer good prices are measured in terms of the units issued by the central bank, and retailers keep these prices fairly rigid over the short term. For longer time periods, say one year out, the U.S. dollar will have naturally suffered from some inflation. But this decline in purchasing power is a known quantity. The Federal Reserve has an inflation target of 2%. So it's a safe bet that $100 will be worth $98, not $92, or $84, or $104. That's pretty good predictability. Interest earned on the deposits will make up for the lost purchasing power.

So is bitcoin a store of value? Sure, everything is to some degree... and bitcoin certainly does a good job of condensing value across distances. But relative to other assets, in particular U.S. dollar deposits, it does a poor job storing value across time. I don't think this is going to change, but I could be wrong.



P.S: In the interest of full disclosure, I still own some bitcoin and XRP, not much though. Own some gold too, but no Netflix.
P.P.S: Here is a rewrite of Satoshi's whitpaper, substituting in store of value system for electronic cash system:

Monday, November 27, 2017

Central banks shouldn't ignore their duty to provide anonymity

Cross section of a banknote with a cotton paper core surrounded by two layers of polymer [Source]
 
Central bankers are at their most comfortable when engaging in technical debates over the finer points of monetary policy. But over the next few years they may be forced out of their comfort zone into a thorny philosophical debate over anonymity and financial censorship. They are poorly equipped for such a debate.

When central bankers monopolized the issuance of banknotes in the 1800s and early 1900s, little did they know that a hundred years later anonymity would become an important public good. And because banknotes are the only generally-accepted way for law-abiding citizens to make uncensored anonymous payments, central bankers effectively became—by accident rather than design—the sole purveyors of these vital services.*

Banknotes are anonymous because it is very difficult to link banknotes to identities, say by monitoring usage of notes via a note's serial number. As for 'uncensored', this means that banknotes are available for anyone to use—i.e. they are highly resistant to censorship. There are no gateways involved, no need to get permission ahead of time by opening an account or installing some sort of proprietary software or hardware, and no way for the issuer to halt a payment while it is being made.

If you glance through the research papers that central banks typically publish, they're almost all on monetary policy. And why not? A stable medium of exchange is one of the most important services provided by a central bank, so they need to do their homework. But if you try to find research on the topics of anonymity and censorship resistance, good luck. What this tells me is that central bankers know very little about the unique set of services they are providing to the cash-using public, despite being the world's only suppliers. Not only have they blundered into their role of monopoly provider of anonymity and uncensored payments, they are trying their best to pretend the role isn't theirs.

Take for instance the European Central Bank's decision to stop printing the €500 note, which was motivated by the desire to cut down on crime. No doubt a significant chunk of €500 notes are used by criminals, but the ECB seems to have made no effort to quantify the anonymity services lost by the tax-paying non-criminal public. Because the ECB has never officially admitted its role as Europe's sole provider of uncensored payments anonymity, it lacks the sorts of datasets and institutional wisdom that are necessary for formally approaching problems about anonymity and censorship-resistance. So while their decision about the €500 wasn't necessarily wrong, it was surely uninformed.

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Related to all this is Tyler Cowen's recent article criticizing central banks that take an active role in developing their own cryptocurrencies. His critique includes the Fedcoin idea, or a public cryptocurrency available to anyone that is pegged by the central bank to the national unit of account. Cowen says that this "new and potentially risky responsibility" might tax central bankers' resources. The problem with this is that the responsibility of delivering anonymous and censorship resistant cash is an old one. In this context blockchain technology isn't anything special, it's just another technology among many that central bankers might use to upgrade the quality of the public services that they are already providing.

Banknote technology has been constantly improving over the decades. For instance, anti-counterfeiting technology began with serial numbers and elaborate engravings on notes in the 18th and 19th centuries. Even after banknote production was monopolized by governments, improvements continued into the 20th and 21st centuries with security threads, watermarks, holography, raised images, clear windows, latent images, microprinting, and luminescent ink. The substrate on which notes are printed has evolved from cotton and/or linen to polymer, or a hybrid of the two (see image at top). If central bankers had applied Cowen's advice to avoid new technology, banknotes would still be printed on cotton and lack modern anti-counterfeiting devices.

So think of encoding banknotes onto a public blockchain—the Fedcoin idea—as just another change in substrates. In the same way that the anonymity and censorship resistance embedded on a cotton substrate was replicated on a polymer one, why not test out the idea of replicating these features on a blockchain? Along with anonymity and censorship resistance, a public blockchain would capture the decentralization of banknote systems, and thus their robustness in the face of disasters, a feature I wrote about here.**

The advantage to digitally delivering these services rather than physically delivering them on polymer or cotton is that a payment no longer requires face-to-face meetings; it can occur over the internet. This would constitute a dramatic upgrade to the quality and breadth of the anonymity and censorship resistance services that are currently being provided by our central bank monopolists.

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With the emergence of bitcoin and the slowly percolating Fedcoin debate, central bankers are thinking for the first time in ages about designing cash-like systems from scratch. And since these systems may eventually replace the physical stuff, central bankers will have to accept the fact that they are the only providers of anonymity and censorship resistant payments services, and that maybe they should get their act together and think hard about the value of these services to the public. A great start can be found in former Fed policy maker Narayana Kocherlakota's Monetary Mystery Tour, which ends with the exhortation: "Need more economists working on these issues!"

Bringing this back to Cowen's article, I don't agree that central bankers should refuse to test the idea of a central bank-issued cryptocurrency because this represents a new and risky technology. That would be shirking their duty as a monopolist provider of the unique services embedded in paper cash. Central bankers should only say no to Fedcoin because they've done a rigourous cost-benefit calculus that takes into account the social value of anonymity and censorship resistance to the public, and that effort has resulted in a conclusion that the status quo—the provision of these public services on a polymer or cotton substrate—is the best option. 

Having blundered into their role as monopoly provider of anonymous payments, here's hoping that the cryptocurrency revolution means that central bank's finally take that role more seriously. If they don't, maybe they should just give up their monopoly.




*Can bitcoin serve as a suitable replacement for cash? Unlike cash, bitcoin can't be used to make anonymous payments. Bitcoin payments are pseudonymous—so they don't quite make it over the line. The other problem is that bitcoin is not pegged to national units of account. Thanks to its terrific volatility, bitcoin has failed emerged as a genuine medium of exchange, so it can't take on the responsibility of providing law-abiding citizens with a generally-accepted anonymous and censorship-resistant medium for making payments.
**I am by no means wedded to blockchains as a way to digitally capture anonymity,censorship resistance, and robustness. There are other ways to go about this that do not involve blockchains.

Tuesday, November 21, 2017

Zimbabwe and hyperbitcoinization

Art by Daniel Krawisz

The narrative that drives any speculative market needs constant fuel in order to attract new buyers. Bitcoin is no exception, which is why recent events in Zimbabwe have been recruited—albeit sloppily—by the bitcoin press to provide more fuel.

The facts of the matter are this: if you head over to Golix, Zimbabwe's only bitcoin exchange, you'll see that bitcoin last traded at $13,800 whereas its price on an American exchange like GDAX is $8260. That's a difference of around $5000. Strange, right?

The bitcoin press, and I'll pick on Zerohedge here, has interpreted this divergence to mean that bitcoin usage is skyrocketing in Zimbabwe. Zimbabweans are seemingly so desperate to get their hands on some bitcoin that they are willing to pay $5000 more per coin than they would pay if they bought on an international exchange like GDAX.   

Recall that one of bitcoin's earliest and most potent use cases was to provide unbanked Africans with an efficient way to transact. The effort to bring bitcoin to Africa has significantly underperformed the earlier hype—but nevertheless the dream of helping out the poorest continent still beckons. Well, we've finally got a real-world case of bitcoin being used by Africans. And if Zimbabweans have adopted the stuff as money, goes the story, then it's only a matter of time before other developing countries and then the whole world goes full hyperbitcoinization. This last term refers to an oft-quoted idea originating from Daniel Krawisz that currencies will fail to compete with bitcoin, leading to a rapid bitcoinization of the world. Think of it as dollarization, except really fast.

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The truth is that Zimbabweans are not paying $5000 more per bitcoin than everyone else. As I've written many times on this blog, and recently at BullionStar (see my postscript at the bottom of this post), Zimbabwe is no longer on a U.S. dollar standard, having had a new Zimbabwean currency thrust on it by the government over the last year or two. This new currency was supposed to be fully convertible into U.S. dollars, a promise that has proven to be illusory. It has since slipped to a large discount to the dollar.

So when Zimbabweans buy bitcoin for $13800—they aren't paying with U.S. dollars, they are paying with this new unit. The Zimbabwean price for bitcoin therefore deviates from the U.S. dollar price  for the same reason that the Mexican bitcoin price of Mex$153,000 deviates from the U.S. dollar price—Zimbabwe, like Mexico, has its own freely-floating currency. This explanation for Zimbabwe's peculiar bitcoin price certainly makes for less interesting headlines than the explanation put forward by the bitcoin press.

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Here's why I find the price of bitcoin in Zimbabwe interesting. The prices of easily transportable items with high value-to-weight ratios should trade at the same real price all around the world. Included in this category are things like human blood, diamonds, plutonium, gold and silver, heroin, $100 bills, stock certificates, and of course bitcoin.

From Evil Mad Scientist, the Monetary Density of Things

The law of one price prevails because if the price of gold in a country like Zimbabwe falls below the world price, than arbitrageurs will buy gold in Zimbabwe and sell it overseas until the price has converged back up to the world price. If the gold price rises above the world price, they'll buy overseas and export it to Zimbabwe until the price falls.

Items with high-value-to-weight ratios like gold and bitcoin provide an opportunity to infer currency exchange rates. Because a bitcoin trades for Mex$153,000 in Mexico and $8260 in the U.S., we don't even have to visit a foreign exchange website to know that the exchange rate is about 19 Mexican pesos to US$1. Just divide $153,000 by $8260. Likewise in Zimbabwe. Given a bitcoin price of $13,800 in Zimbabwe and $8260 in the U.S., we can safely assume that the exchange rate is around 1.70 Zimbabwean currency units to US$1.

This ability to back out an exchange rate using items with high value-to-weight ratios is especially handy for researchers and reporters who are observing countries from afar that lack official venues for trading currency. In Zimbabwe, the market exchange rate is set unofficially, on street corners and such. Without an on-the-ground data gathering network to canvas street corners, an outside observer can get a decent proxy for the exchange rate by gathering bitcoin prices on the internet.

In fact, inflation researchers like Steve Hanke have long-since been gathering data on high value-to-weight items to back out exchange rates, although they have typically used the prices of inter-listed stock rather than bitcoin for this purpose. In this post I described the inter-listed stock technique being used in Zimbabwe, and here I describe how it could be used in Greece and Ecuador. In the future, bitcoin exchanges may offer yet another way to formally gather unofficial exchange rates.

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 Zimbabwe's autocratic leader Robert Mugabe was put under house arrest by the army on November 14. Let's use what we now know about bitcoin prices to observe what has happened to the exchange rate since then. The price of bitcoin on Golix has been stuck in a range between $12,000 to $15,000 even as the U.S. dollar price on bitcoin exchange GDAX has jumped by ~$1500, or 26%. Golix prices are incredibly variable, far more so than international prices, so I don't want to overstate my case, but it seems likely that the purchasing power of Zimbabwean currency—inferred from bitcoin prices—has actually improved since the coup. 

As I said in my BullionStar article (again, see note at bottom), this firming up of the Zimbabwean currency may indicate that markets see some improvement in the odds that a stable new regime emerges in Zimbabwe, one that enjoys acceptance by the international community. Due to its pariah status, the Mugabe government has been unable to get aid from the World Bank or IMF for many years now. If its status changes, a new loan could allow the country to a re-peg the Zimbabwean currency at a 1:1 rate with U.S. dollars.

The improvement in the exchange rate that I've inferred from bitcoin prices is corroborated by looking at the prices of other items with high value-to-weight ratios. As I pointed out earlier, Steve Hanke uses inter-listed stocks to back out exchange rates, in Zimbabwe's case the shares of Old Mutual which are traded both in Harare and London. The ratio between the two listings is known as the Old Mutual Implied Rate, or OMIR. Gareth from Twitter, who knows a lot about Zimbabwe's financial situation, sends me the following chart of OMIR (the green line).



You can see that there has been a big decline (35.1%) in the Zimbabwean price of Old Mutual (white line), but almost no change in its London price (orange line). As a result, the green line—the ratio of the London price to the Zimbabwe price—has moved higher. Which means that the purchasing power of Zimbabwean currency has improved since Mugabe's arrest, albeit just by a bit, corroborating what we already learned from the Golix-to-GDAX bitcoin ratio.

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None of this is evidence of hyperbitcoinization in Zimbabwe. In fact, if you spend some time on Golix you'll quickly notice that volumes are very thin and the trading range incredibly wide. Over the course of a few hours, I saw the price on Golix rise and fall by $1,500 whereas the U.S. price on GDAX has been relatively immobile. Bitcoin is attracting some traders, but it hardly seems popular. Any Zimbabwean who wants a safe haven has probably been buying U.S. dollars on the street corners. Sorry folks, but as far as I can tell Africa still lacks a bitcoin use case.




P.S. I am happy to announce that for the first time I'm being paid to blog. The folks at BullionStar will be hosting blog posts from me over the next few months. Expect the posts to be on some of the same topics I blog about here; monetary policy, gold, bitcoin, and more. My first effort gives a quick overview on the Zimbabwean monetary situation. I am always looking for more opportunities for paid blogging in my general area of expertise; contact me if you have any leads.

Monday, November 6, 2017

The bootstrapping of Thorne, Magic Money, and Cyberbucks: three pre-Bitcoin monetary experiments



Bitcoin boasts many technical achievements, but none is more interesting to me than they way it was successfully bootstrapped. How did a small group of cypherpunks—activists interested in widespread use of cryptography and digital currency—manage to get an intrinsically valueless token to have a consistently positive price? Hal Finney, a cryptographer and early adopter of bitcoin, put it this way in 2009:
"One immediate problem with any new currency is how to value it. Even ignoring the practical problem that virtually no one will accept it at first, there is still a difficulty in coming up with a reasonable argument in favor of a particular non-zero value for the coins."
The bootstrapping of bitcoin seems to have been achieved with some care. William Luther has gone through old bitcoin message boards to show how early adopters, including Finney and bitcon-creator Satoshi Nakamoto, coordinated to 'enter the network' at the same time, thus generating a positive value for worthless bitcoin tokens. A token that is already valuable, perhaps because it is useful for some non-monetary use like jewellery, or because it is directly convertible into an already-existing money, is much easier to launch than one that isn't already valuable. Bitcoin didn't have the benefit of non-monetary usefulness.

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By way of Timothy May's Cyphernomicon, I recently discovered that bitcoin wasn't the first attempt by cryptographers to launch an intrinsically worthless digital token into positive-value space. Similar bootstrapping attempts occurred back in a previous era of digital currency experimentation, the mid-1990s.

In 1993 the extropians—a group that believes in the technological possibility of immortality (among other things)—set up an experimental market called the Hawthorne Exchange where individuals could trade units of reputation. There seems to be some crossover between extropians and cypherpunks with the reputations of folks like Timothy May and Nick Szabo, both key contributors to the Cypherpunks electronic mailing list, being listed on the Hawthorne Exchange. Trades were made using the exchange's own native currency called thorne, which had a fixed supply. Not only did the extropians succeed in generating a positive price for twenty or thirty reputation tokens, but by extension the native currency—thornes—was also bootstrapped.

As part of the experiment, people began to sell stuff for thornes, including copies of digital cash papers and old books. They made bets in thornes and even established a U.S. dollar price for the nascent digital currency (it was somewhere between 100 and 1000 thornes per dollar).

The problem with the whole endeavour is that—as Hal Finney would point out not long after it had begun—the tokens were essentially worthless. By convention each unit was supposed to represent a person's reputation, but there was no independent force that could possibly make a token correspond to a reputation:
"It is important to understand that Thornes are not like dollars. Unless HeX shares can be given a grounding other than the whim of their owners, the market will surely collapse, because there is nothing to support it."  
Finney would be proven right, since the Hawthorne exchange was shut down sometime in 1994.

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In their next effort the cypherpunks would bootstrap a set of play currencies that had been created using a toolkit called Magic Money, a digital cash system programmed by the pseudonymous Pr0duct Cypher and made available in February 1994. Here is Pr0duct Cypher in the introduction to the software:
"Now, if you're still awake, comes the fun part: how do you introduce real value into your digicash system? How, for that matter, do you even get people to play with it?

What makes gold valuable? It has some useful properties: it is a good conductor, is resistant to corrosion and chemicals, etc. But those have only recently become important. Why has gold been valuable for thousands of years? It's pretty, it's shiny, and most importantly, it is scarce.

Digicash is pretty and shiny. People have been talking about it for years, but few have actually used it. You can make your cash more interesting by giving your server a provocative name. Running it through a remailer could give it an 'underground' feel, which would attract people.

Your digicash should be scarce. Don't give it away in large quantities. Get some people to play with your server, passing coins back and forth. Have a contest - the first person who (breaks this code, answers this question, etc.) wins some digital money. Once people start getting interested, your digital money will be in demand. Make sure demand always exceeds supply."
From the cypherpunks mailing list we learn that over the course of the next few months four or five unique tokens were created using Magic Money, including Tacky Tokens, GhostMarks, DigiFrancs, and NexusBucks. As in the earlier case of thornes, an attempt was made to sell goods and services in these new currencies. One poster on the Cypherpunk message board offered to pay coders to write software with NexusBucks, and another tried to sell GIF art of tacky tokens.

After a flurry of activity, however, interest died off. "It appears that the Magic Money/Tacky Token experiment is not succeeding in producing an informal digital currency," wrote Hal Finney in May 1994. "People have offered services in exchange for this money but have had no takers." In a post entitled Why Digital Cash is Not Being Used, Tim May blamed the failure of Magic Money on the lack of items to buy with tokens and confusion about how to get them and send them. It's worth a read.

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No sooner had the Magic Money experiment died when a new new opportunity for bootstrapping digital tokens emerged. David Chaum, an early advocate of privacy, had established a company called Digicash in 1989 to commercialize the use of blind signature technology in electronic currency. In a trial that was first announced in July 1994, Digicash offered the first 10,000 applicants one hundred free cyberbucks, or e$, up to a maximum issue of one million cyberbucks.

Despite the fact that these tokens were intrinsically worthless—they had neither commodity value nor could they be redeemed into U.S. dollars—people soon began to transact with them. On its website, DigiCash listed around 100 shops that accepted cyberbucks, including those that sold postcards and various types of information services. Zooko Wilcox-Hearn, who recently founded the anonymous cryptocurrency Zcash, offered to sell his PGP software for cyberbucks. A coding contest by the omnipresent Hal Finney offered cyberbucks as a prize and Adam Back, a cryptographer who is currently involved in administrating bitcoin, sold "export-prohibited" cryptographic t-shirts for a price of e$250. In the same way that a pizza was the first good to be bought with bitcoin, Back's t-shirts may have been the first to be bought with cyberbucks:

To Digicash's surprise, several primitive financial markets emerged to trade cyberbucks for genuine currency. On the Ecash Exchange Market, which was hosted on the website of company called Firecloud Solutions, a price of around five cents per e$1 was established (see image below), effectively valuing the entire market capitalization of cyberbucks at $50,000.

Source: A Common Currency System for Spontaneous Transactions on Public Networks


For those with long memories, the above Ecash market looks very similar to New Liberty Standard's bitcoin-to-paypal market, the first bitcoin exchange that was established in 2009.

The cyberbuck trial did not last. While there was plenty of discussion about the topic in 1995, there are only a few mentions of cyberbucks on the Cypherpunk mailing list in 1996, but almost nothing in 1997. When I asked Zooko if he still had cyberbucks, he told me he had long since lost his. Who knows? They might still be worth a lot as collector's items.

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Like cyberbucks and the other mid-90s experiments, bitcoin began as a mere play thing among a small coalition of technologists interested in privacy. Why did bitcoin get successfully boostrapped while the others failed? How did one form of monopoly money spread over the entire globe while the others were never used by anyone other than a small band of cypherpunks?

One answer is luck. Perhaps nothing more than a fortuitous flap of a butterfly's wings in Brazil set the whole thing off. Another is experience. After three failed efforts to bootstrap electronic tokens, perhaps the cypherpunk community had developed a better understanding of what not to do to get the ball rolling. Hal Finney for one participated in all four digital currency experiments.

The technology was different as well. Because it utilized David Chaum's patented blind signature protocol, Magic Money was technically illegal, and thus unlikely to spread to more timid adopters. As for cyberbucks, once the trial was over the server running the software would have to be shut off, at which point there would be no way to verify cyberbuck transactions. Knowledge of this imminent shutdown would have handicapped the ability of cyberbucks to propagate beyond the core group of hobbyists. Bitcoin, on the other hand, used a decentralized (and unpatented) method of verifying transactions, so the threat of winding up the system was less salient.

I'm not sure these technical factors were as important as the different macroeconomic environments in which the various digital currencies were issued. Cyberbucks, Magic Money, and thorne all appeared when the global economy was humming along and interest rates were high. Owning these zero-yielding tokens meant that users had to make a large sacrifice. In 2009, interest rates around the world had fallen to near zero, so holding a digital currency like bitcoin did not involve forgoing much in the way of interest income.

If usage of an intrinsically worthless token is to spread beyond an inner clique of hobbyists, a whole army of dreamers and speculators has to be encouraged to jump onto the bandwagon. What better pool to recruit from than the ranks of unemployed and underemployed in the wake of the 2008 financial crisis? This pool of downtrodden simply didn't exist in the humming 1990s. Folks back then had no need for a bubble asset to get them ahead—they enjoyed full-time jobs and plenty of opportunity.

Perhaps we were all a bit innocent in the 1990s and didn't understand how much our privacy could be invaded by governments and corporations. Magic Money and cyberbucks, which promised  protection from these threats, arrived too early. When bitcoin was finally introduced, it may be that we had all become a bit wiser and thus more willing to endure the hassles of switching some of our wealth into cludgy digital currency.

Lastly, people weren't upset with the finance establishment back when thornes, Magic Money, and cyberbucks were being introduced to the world. While recessions had hit in the early 1980s and 90s, they weren't accompanied with large-scale financial meltdowns. But in 2009, the credit crisis and bailouts were just in the rear-view mirror. Many were furious with banksters, and justifiably so. Turning to bitcoin was a protest vote.