Bitcoins – Warren's space

The difference between Bitcoin and FTX

Bitcoin is a digital currency (cryptocurrency) that can be paid to another bitcoin user willing to accept it via a blockchain account. It is backed by nothing and promises nothing. Its US dollar value has fallen from $65,496 on November 14, 2021, to $15,630 on November 21, 2022.

“FTX Exchange was a leading centralized cryptocurrency exchange specializing in derivatives and leveraged products. Founded in 2018, FTX offered a range of trading products, including derivatives, options, volatility products, and leveraged tokens. It also provided spot markets in more than 300 cryptocurrency trading pairs such as BTC/USDT, ETH/USDT, XRP/USDT, and its native token FTT/USDT.12 In early November 2022, the exchange and the companies in its orbit began a steep fall from grace…. According to its bankruptcy filing, FTX, which was once valued at $32 billion and has $8 billion of liabilities it can’t pay, may have as many as 1 million creditors…. On November 16, a class-action lawsuit was filed in a Florida federal court, alleging that Sam Bankman-Fried created a fraudulent cryptocurrency scheme designed to take advantage of unsophisticated investors from across the country. ” “FTX exchange”

The difference between Bitcoin and FTX is that Bitcoin is a digital coin/token that some believe might achieve wide adoption as money and thus a stable demand that could stabilize its price. In my opinion, this is HIGHLY unlikely. I explained this potential eight years ago: “Cryptocurrencies the bitcoin phenomena” “The future of bitcoin exchanges” But most people buying Bitcoin are gambling that they can sell it for a higher price than they paid for it (first cousins to slot machine addicts).

On the other hand, FTX and its related products and services promised real things and to play by known rules (contracts). On November 11, FTX and its affiliated firms were put into bankruptcy. Billions of dollars where missing? Founder Sam Bankman-Fried (SBF) claims that he was just careless. It appears more likely that he was a lying fraudster. “An attorney also said the firm had been run as a ‘personal fiefdom’ of Bankman-Fried with $300 million spent on real estate such as homes and vacation properties for senior staff.” “Crypto lender genesis says no plans to file bankruptcy imminently” Presumably to promote himself as a good guy and to win influential friends, SBF also contributed millions to charities and politicians.

Most crypto product and service providers want regulations that will give potential investors and customers more confidence in their products but that will not stifle the potential creativity of a dynamic industry. Hopefully congress will get on with it — carefully. “Crypto bill criticized”

“Sam Bankman-Fried, the founder of the FTX exchange and Alameda Research, a cryptocurrency trading platform, seemed to confuse his bank and his companies. According to John Ray, the new CEO in charge of the restructuring of his empire which went bankrupt on November 11, Bankman-Fried received a personal loan of $1 billion from Alameda. He is not alone: the firm, which is a kind of cryptocurrency hedge fund, has also lent $543 million in personal loan to Nishad Singh, an associate of Bankman-Friend, and $55 million to Ryan Salame, the co-CEO of FTX Digital Markets, one of FTX’s affiliates.

“’Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,’ Ray wrote. ‘From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.’” “Bankman-Fried received 1bn in personal loan from his company”

“Bankman-Fried’s net worth peaked at $26 billion.^[11] In October 2022, he had an estimated net worth of $10.5 billion.^[12] However, on November 8, 2022, amid FTX’s solvency crisis, his net worth was estimated to have dropped 94% in a day to $991.5 million, according to the Bloomberg Billionaires Index, the largest one-day drop in the index’s history.^[13]^[10] By November 11, 2022, the Bloomberg Billionaires Index considered Bankman-Fried to have no material wealth.^[14]” “Sam Bankman-Fried”

I assume that jail is next, perhaps in the cell previously used by Bernie Madoff.

If you subscribe to The Economist you can read fascinating details here: “The failure of ftx and Sam Bankman-Fried will leave deep scars”

Econ 101: The Value of Money

During a discussion of Bitcoin with friends, it became clear to me that it might be helpful if I explained some fundamentals of how the value of money is determined. Like most everything else, money’s value is ultimately determined by its supply and demand.

Demand for money reflects the public’s need to keep an inventory of it in order to use it for making payments. Bitcoin are generally held as a speculative asset rather than for payments as almost no one will accept them in payment. “Cryptocurrencies-the bitcoin phenomena”

The supply of money is determined by those who created it, generally central banks. Generally central banks issue their currency, thus increasing its supply, by lending it (generally to banks) or by buying assets, generally their government’s debt. When anyone holding that currency no longer wants it and has the right to redeem it, the central bank takes it back in exchange for the asset it purchased in the first place, thus reducing the money supply. Under the gold standard, currency was redeemed for gold. The rules governing a central bank’s issuing and redeeming its currency defines the nature of its monetary regime. That is the topic of this econ 101 lesson.

As none of us has ever redeemed our currency, it is understandable that my friends confused spending their money with redeeming it. Spending it transfers it to someone else without changing its supply, while redeeming it reduces its supply. Cryptocurrencies add a new category to our discussion of money. As noted by “a billionaire hedge-fund manager… cryptocurrencies are a ‘limited supply of nothing.’” “Crypto skeptics growing”

As discussed further below, the supply of Bitcoin increases slowly and steadily over time as determined by an unchangeable formula and Bitcoin cannot be redeemed for anything. The U.S. dollar and virtually every other national currency in the world grow at more erratic rates as determined by their issuing central banks. So what makes the value of the dollar relatively stable over long periods of time? The fall in its value by about 8% over the last month is nothing compared to bitcoin’s fall of 23% over the same period and over 50% over the last half year. Over the past 15 years the dollar’s value has declined less than 2% each year. Unlike Bitcoin, dollars are widely accepted for payments that are denominated in dollars, including our taxes, and thus held (demanded) to make such payments. Almost no Bitcoins are held to make payments as almost no one will accept them for payments. But I want to focus on a currency’s supply.

There are fundamentally three broad approaches to determining the supply of a currency. Historically, the supply of most currencies were determined by fixing their price to what they could be redeemed for, such as gold or silver. I have called such a system for regulating money’s supply, a hard anchor. “Real SDR Currency Board” The value of a currency can be fixed (the price set) to something real such as gold or a basket of goods. A country with a strict gold standard, which the U.S. never really had, issues its currency (dollars) whenever anyone wants to pay the fixed gold price for more of them. If the dollar price of gold in the market rises above its official price, there would be an arbitrage profit from buying gold from the central bank at its lower official price. Such gold could be resold in the market at the higher price. But the key point is that this mechanism (what I call currency board rules) of redeeming currency reduces its supply and thus reduces prices in this currency in the market (deflation). Several of the monetary systems I helped establish, work in this way (Bulgaria and Bosnia and Herzegovina). “One Currency for Bosnia”

The most common system of monetary control today is for the central bank to determine its currency’s supply by buying or selling it in the market (the Federal Reserve can buy treasury bills, etc. to increase the supply of dollars). Most central banks today adjust their money supplies in an effort to achieve an inflation target (a much more complicated subject). “Czech National Bank: Inflation Targeting in Transition Economies” Generally they do so by setting an intermediate target for a short-term interest at which market participants (banks) can borrow from the central bank. Such fiat currencies, such as the U.S. dollar, are not redeemable but are widely accepted in payment for goods, services and debts.

This brings us to Bitcoin. The supply of Bitcoin is determined by a formula that predetermines its gradual growth to 21 million by 2140. There are currently about 19 million in existence. The supply is increased by giving them to successful miners for verifying the legitimacy of each transaction (another complicated subject). Thus, the issuer (the formula) received services (protection against double spending the same coin) but no assets such as gold or treasury bills for creating and issuing new Bitcoins. Once created, an issued bitcoin can never be redeemed (i.e. the outstanding supply can never be reduced). When you spend or give away your Bitcoins you are circulating them to other holders, not redeeming them.

When my imaginary aunt Sally discusses Bitcoin and cryptocurrencies more generally, she tends to mix up the marvelous new payment technologies for paying my dollars all over the world with private money such as Bitcoin and Tether. She also doesn’t seem to quite understand that most money has always been privately produced including the U.S. dollars that we spend in various ways (occasionally even by handing over cash). “A shift in monetary regimes”

But these distinctions are critical when considering what role the government should play in our monetary system. The truly amazing technical progress we have experienced and the dramatic increase in the standard of living of the average person it has delivered over the last century was made possible by a government that provided a general framework in which we, the consuming beneficiaries of this progress, could make informed choices. Our government, wisely, generally did not make such decisions for use.

With that in mind consider “a letter addressed to Senate Majority Leader Charles E. Schumer (D-N.Y.), Senate Minority Leader Mitch McConnell (R-Ky.), House Speaker Nancy Pelosi (D-Calif.) and other congressional leaders, [from 26 influential technology personalities that] outlined what it described as potentially grave dangers of cryptocurrencies.” They are absolutely correct to expose and condemn the technical and economic weaknesses of blockchain technology—the distributed ledger with which Bitcoin claims to avoid the need for trusted third parties to record and document payment transaction (as happens on a centralized ledger when you pay from your bank deposit).

But the fact that foolish people invest in Bitcoin and other cryptocurrencies does not justify our government prohibiting and restricting them from doing so. The government requires the banks in which we put our money to publish properly audited financial statements of the assets backing our deposits and to set minimum capital requirements to protect against the possible loss of bank asset value (e.g., loan defaults). Cryptocurrencies claiming redeemability at a stable value (so called stable coins) should similarly be required to disclose the rules by which they operate and the composition and value of the assets backing their digital coins. In short, government regulations should help us decide what we want to buy and/or hold without restricting the ability of fintech pioneers to explore and innovate products to offer.

Overly restrictive regulations create incentives for incumbents to create barriers to competition. Large and intrusive governments tend toward corruption. The Federal Reserve System seems quite aware of these risks as it cautiously explores whether to compete with the private sector in developing a central bank digital currency. “Econ 101-Central Bank digital currency-CBDC”

So when considering the government’s role in money and payments be sure to clearly distinguish money from payment technology and limit government to setting the rules of the game that maximize the ability of private consumers to make wise choices. But perhaps the biggest policy decision of all is how the government should determine/regulate the supply of its currency, most of which is privately created. I support a currency whose value is fixed to something real (a hard anchor) and whose supply is determined by the market via currency board rules. “A libertarian money”

Bitcoin, Cybercurrencies and Blockchain

What would we do without money/currency? Money is the unit in which we express prices (making it easer to compare the relative cost of things) and the asset with which we pay for our purchases and debts. A good currency has a stable value relative to goods and services (low or zero inflation) and is universally (or very widely) accepted in payment. The U.S. dollar receives high marks by these criteria. Bitcoin, however, fails miserably in all of these respects.

Why would anyone want to hold a highly volatile “currency” whose value one year ago was $1,230, then rose to $19,343 on December 16, 2017, dropped to $6,915 February 5 of this year and is now $9,364 (March 10, 2018). In addition, bitcoin is not accepted in payment almost anywhere? See my earlier explanation of bitcoin: “Cryptocurrencies-the bitcoin phenomena”

Bitcoin is better characterized as a security – an investment asset. It’s sort of like an option on a lottery, except that a lottery promises to pay something to the lucky person(s) holding the ticket. Bitcoin doesn’t promise to pay out anything to anyone. Its value is simply what you can get someone else to pay you for a bitcoin you want to sell. Buying bitcoin is a bet that its value will rise for some reason while you own it. Its ideological appeal for some is that it exists and functions totally independent of government; and its economic appeal is that it allows the transfer of funds (illegally gained or not) without much chance of being detected. For an excellent review of these points see Peter Morici’s: “Bitcoin-investors-have-reason-to-worry”.

Even if bitcoin had a well-behaved value and was widely accepted, the engine for maintaining and delivering it, a permissionless distributed public ledger of all bitcoin transactions linked together in blocks attached to an ever growing chain (blockchain), is deeply flawed. Records of who owns bitcoins and all transactions involving them are maintained in a database (ledger) copied to everyone with a bitcoin address (account). The system is open to everyone (permissionless) and not dependent on trusting any participants. Each bitcoin transaction is directly between the seller (or payer) and the buyer (payee) peer-to-peer without passing through a central registry such as would be maintained by a bank. Given the ease with which electronic data can be copied, preventing the spending of the same money multiple times when it openly exists in thousands of copies one as official as the other (the so-called double spending problem) in an environment where no one is trusted by design is the main challenge that blockchain ledgers need to overcome.

The majority of payments today are made by digitally transferring the ownership of digital records of money, i.e. electronic transfers of bank deposits. Our deposits of money with banks, which are a bit over half of so-called narrow money in the U.S. (M1= Currency outside of banks + demand deposits in banks), exist as digital records in each bank’s central deposit registry. Banks are so called trusted third parties responsible for insuring that our deposits are not touched and moved without our permission and are responsible for resolving any disputes or problems with regard to our deposits.

If we are paying money to someone who has their account in the same bank, we can go on line and transfer the money from our account to theirs in a millisecond without a service charge. These central registries are fortified with very robust protocols that insure their safety. The process is a bit more complicated if we are making a payment to someone whose account is in a different bank and there is scope for the speed, efficiency and cost of such interbank payments to be improved.

Blockchain’s claim to eliminate the need for trusted third parties by transferring ownership (e.g. of bank balances) directly peer to peer and publishing copies of the ledger containing the record of our transactions and resulting ownership in hundreds of nodes (our computers) around the world. The objective of a system that eliminates the need to trust anyone to safeguard your money from double spending necessitates some very complex and costly operations to substitute for a trusted third party.

For bitcoin, so called, miners are given increasingly difficult mathematical problems to solve to establish that the latest blockchain transaction is unique rather than a copy. The first miner to solve the problem cryptographically stamps the digital transaction record as genuine (in effect notarizes it) adding a new block of transactions to the chain and distributes it publically to all nodes. The winning miner is rewarded with new bitcoin (for as long as they continue to be created). Not only is the manpower and computer capacity required for this competition enormous, but the electricity consumed in bitcoin mining is now greater than is consumed in all of Ireland. https://powercompare.co.uk/bitcoin/

It takes around ten minutes to confirm the authenticity of a bitcoin transaction on average. Ten minutes standing at the check out counter waiting for your payment to be confirmed is an unacceptable eternity. “A familiar critique of Bitcoin is that “it does not scale” in the sense that, as it is currently implemented, the network is not capable of supporting a global payments system that requires many thousands of transactions per second. At the moment, this is true; Bitcoin can support up to 7 transactions per second as compared to the 2,000 transactions per second typically processed by Visa (with the potential to scale to an estimated 56,000 per second).” “The-bitcoin-scaling-debate”

Moreover, most bitcoin users don’t have the IT sophistication to operate and manage their own copy of the blockchain and thus deposit their bitcoins (or other cyptocurrencies) with exchanges that manage transactions for them. These trusted third parties in all but name are in effect banks (though they do not lend your bitcoins to others while waiting for you to use them). “Every-disadvantage-has-its-advantage-reviewing-blockchain”

To participate in the bitcoin system (to buy, use or sell bitcoin, to take the example of the best known cybercurrency) you must register to obtain an address (account). It is a closed system in that you can only deal in bitcoin with other registrants (account holders). If a central bank, for example, issued a digital version of its currency, it would also be a closed system in the same way. Participants would need to be registered with it (i.e. open accounts with it) in order to participate and could only use this Central Bank Digital Currency (CBDC) with other account holders.

When problems arise or views differ on whether and what changes might be desirable in the permissionless blockchain world, there is no one responsible to address it. There is no trusted third party to take responsibility. The bitter disputes among bitcoin “leaders” and its several hard forks (breaking off different versions of bitcoins) illustrate the seriousness of this problem.

The claim is often made that even if blockchain-DLT systems are fatally flawed as the vehicle for making payments, the blockchain technology may have revolutionizing uses for other public records such as property ownership and its transfers. However, the blockchain has so many serious disadvantages that even this more limited claim is very doubtful. “Blockchain Demystified”

To address or minimize these serious drawbacks of Distributed Ledger Technology, cryptocurrencies (there haven’t been any other applications of blockchain after ten years talking about it) have been rapidly moving away from the purer, permissionless, Proof of Work version used by bitcoin to more restricted and limited permissioned, Proof of Stake approaches. None of these to date are as efficient and secure as centralized ledges of the sort used by our banks. “What-if-blockchain-is-useless?” “Ten-years-in-nobody-has-come-up-with-a-use-case-for-blockchain”

This is not to say that exciting things aren’t happening in the ownership registry area. Digitizing ownership records introduces dramatic economies in tracking ownership and transfers of ownership. Automating many or all of the steps involved in real estate sales with the use of digitized smart contracts can significantly shorten the time and cost of the many steps (mortgage loan agreement and disbursement, collateral confirmation, settlement, title transfer, etc.). “A-pioneer-in-real-estate-blockchain-emerges-in-Europe.” In addition, a number of central banks are considering issuing digital versions of their currencies. These will probably use central registries rather than blockchains. “Central Bank Digital Currency: Bordo-Levin.” But does blockchain technology have any advantages to outweigh the many disadvantages that can’t be achieved quicker, cheaper and more securely with central registries operated by trusted third parties. Probably not. Project Jasper of the Bank of Canada concluded that: “the versions of distributed ledger currently available may not provide an overall net benefit when compared with existing centralized systems for interbank payments. Core wholesale payment systems function quite efficiently.” https://www.bankofcanada.ca/wp-content/uploads/2017/05/fsr-june-2017-chapman.pdf “SWIFT says blockchain not ready”

The Future of Bitcoin Exchanges

A major selling point for Bitcoin is its ability to transfer money directly between two entities (peer-to-peer) without the need for a trusted third-party such as a bank. Virtually all electronic payments today require (ultimately at least) the transfer of the ownership of deposits with banks. The settlement of such payments between banks takes the form of transfers of bank balances with the central bank. Peer to peer transfers have cost advantages (if the costs of preventing double use are less than those of the services of the trusted third parties) and confidentiality advantages (though a ledger record of every transfer of bitcoins is publically available). The difference between Bitcoin and bitcoin and other features of the system are explained in my earlier blog: “Cryptocurrencies: The bitcoin phenomena”.

As with bank deposits or mobile phone deposits, Bitcoin must also provide some means for paying cash in to the Bitcoin system and of getting it out. Banks have teller windows or ATM machines. Bitcoin now also has a few ATM machines and organized gathering places for individuals wanting to buy or sell bitcoin to meet. But the overwhelming convenience of buying and selling them through an exchange has resulted in most in and out transactions taking place through exchanges.

One of the oldest and largest of these exchanges, Mt. Gox in Japan, recently declared bankruptcy as the result of misplacing or otherwise losing about 850,000 bit coin (valued at about $470 million at March 1 prices). Mt. Gox had bitcoins in its care (as a pure exchange it would only have its own bitcoin capital for trading purposes) because it was also a depository or wallet. Apparently the software for individuals dealing in bitcoins is not particularly user-friendly. As a result, many have chosen to deposit their bitcoins with trusted third parties to hold and transfer on their behalf. As these depositories do not lend or invest these bitcoins, they are not required to be licensed as banks. 750,000 of Mt. Gox’s missing bitcoins belonged to (i.e. were owed to) such depositors. It is still unclear whether Mt. Gox’s bitcoins were stolen or misused by Mt. Gox. “Hackers allegedly stole 400 million in bitcoins-here’s how to catch them” WP 2/28/2014.

This seemingly devastating development has not yet killed interest in bitcoin. While the price quoted by Mt. Gox (which tracked closely the price index published by Coindesk until February 8) fell from $1,236.90 on December 5, 2013 to $130.95 when it closed on February 28, the Coindesk index for all exchanges has “stabilized” in the neighborhood of $600. A debate has broken out among bitcoin supporters over whether exchanges and depositories should be regulated in order to strengthen public trust in them and what sort of regulation would be helpful.

Jeremy Liew, a leading bitcoin investor at Lightspeed Venture Partners, stated that:

“I think a regulatory solution would do more to increase ordinary consumer confidence in Bitcoin and its institutions than one that is purely market driven or industry led. I am well aware of all the challenges that regulatory solutions have, but if Bitcoin is to become a mass market product, then it will require measures to lift confidence from those who will not understand a technology solution that their BTC is safe. I advocated against new BTC specific regulation at Lawsky’s hearings last month, but I now think that some sort of regulation covering customer funds security may make sense if there is going to be a BitLicence.”

Reliance on trusted third parties, such as exchanges and depositories, requires trust in their honesty and competence. The question for bitcoin and other cryptocurrencies is how such trust can be best developed. Bank and financial service industry regulators care about the safety and soundness of banks and the financial sector. Unfortunately, however, much of the regulatory concern with cryptocurrencies has to do with Anti Money Laundering and the Combating of the Financing of Terrorism (AML/CFT), a well-meaning but almost totally wasteful effort to fight crime by making it harder to spend the proceeds of crime by monitoring the use and users of money. See “Report Global Surveillance of Dirty Money” 1.30.2014 for a very critical evaluation. Regulatory bodies also have a disadvantage in promoting the safety and soundness of regulated entities deriving from the natural timidity and caution of bureaucrats.

While licensing exchanges and depositories and requiring public disclosure of their beneficial owners and of their financial conditions and activities (audited financial statements) should contribute to public trust, self regulation benefits from a stronger profit incentive to get it right. The Bitcoin Foundation exists to promote bitcoin and thus has a strong incentive to ensure that exchanges and depositories’ behavior contributes to the health and profitability of the industry. It has the right incentive to find the rules that best contribute to public trust at the least cost of compliance. Certification by the Foundation that individual exchanges and depositories comply with their standards should contribute more to public trust than would oversight by a government regulatory body.

The P2P technology reflected in or inspired by Bitcoin may evolve in unforeseen ways if allowed. It might, who knows, transform payments as we now know them (I am referring to Bitcoin—the means of payment—not bitcoin the currency, for which I see no future). “Our Flawed Financial System is Reflected in Bitcoin” March 2, 2014, FT. Unnecessary or overly restrictive regulations could prevent that. If the internet and the World Wide Web, whose potential few of us imagined twenty years ago had been regulated beyond addressing and messaging protocols, we might be stuck with something like the French Minitel, an ahead of its time State designed and run digital forerunner of the WWW. Not able to keep up with the exploding features of the Web, Minitel was retired in 2012.

Tax treatment will also be important. Payment transactions (as opposed to investments) are not generally taxed. Thus it is encouraging that the UK has just ruled that bitcoin trades will not be taxed. “Britain to scrap VAT on Bitcoin trades” FT 3/3/2014 . My assessment remains that bitcoin will not succeed as a private money, but that Bitcoin and Bitcoin like means of payment have exciting promise to further improve and lower the cost of making payments and transferring money. We would be wise to allow any such potential to develop.

Cryptocurrencies – The Bitcoin Phenomena

Revised February 14, 2014

Bitcoins are digital fiat currency passed directly between two people without the need for a trusted third party, such as a bank.[1] In this respect they resemble banknotes. Bitcoin with a small “b” is a privately created and issued medium of exchange, the value of which is the subject of this note. Bitcoin with a capital “B” is a public ledger that records all transfers, hence changes of ownership, of bitcoin. Thus Bitcoin is the means of payment of bitcoin. Unfortunately the two, bitcoin and Bitcoin (the medium of exchange and the means of payment) are often mixed carelessly in discussions of bitcoin. This note is primarily about bitcoin—the medium of exchange—rather than Bitcoin—the means of delivering them.

While a growing number of digital competitors[2] claim to overcome one or more of bitcoin’s (and Bitcoin’s) technical weaknesses, bitcoin is the frontrunner among cryptocurrencies with the most developed supporting infrastructure. It is the very nature of money that its usefulness depends on how widely it is accepted (so called network externalities) and thus the dominant currency tends to suppress potential competitors and is itself hard to displace. Thus while bitcoin is likely to continue to dominate over its cryptocurrency rivals, the key question is whether it is likely to seriously challenge national currencies such as the U.S. dollar or the Euro.

Though Bitcoin’s digital and peer-to-peer (P2P) nature poses serious technical issues for bitcoin, a key question for its future is whether it will ever achieve a stable value, the most important quality of a successful currency. In this note I will review the factors that determine the value of a currency and how they might apply to the long run value of bitcoin and thus its prospects of ever achieving a stable value. With regard to the protocols and algorithms underlying big B Bitcoin, many have claimed potentially dramatic improvements in how payments are made, and titles of all sorts more generally are maintained and transferred.

Background

The difference between cash (physical banknotes and coins) and other means of payment such as checks, wire transfers, Visa, and Paypal, is that the payment of cash is made directly between the parties to the payment, i.e. peer-to-peer. All other means of payment involve trusted third parties, such as banks, credit companies, and exchanges, that keep records of the ownership of money and its transfer from one party to another. These alternatives describe means of payment, not what is being paid, i.e., not money. These various means of payment can be used to make payments in any money desired. Wire transfers of bank balances can make a payment in whatever currency the bank balance is in—U.S. dollars, Euros, Renminbi, gold, or what ever. This distinction between means of payment and money is very important.

Money by its nature combines the functions of a medium of exchange (the thing paid), a store of value (the inventory of that medium held pending payment), and a unit of account (the unit in which things are priced). [3] All combine to promote money’s raison d’être—reducing the cost of exchange.

While a medium of exchange can potentially be anything acceptable to the payee (barter), and almost any durable good can store value (uncooked rice), the unit of account function of money stands out as its most central and critical quality. As such, the value of that unit—the value of the money—what it can buy—is basic to its usefulness. Like standards of weights and measures, the nominal value of money is almost universally established by governments,[4] while its real value is determined by markets. The various means of payment of that money—can be and generally are privately developed and provided (Visa, Paypal, bank checks, etc).

The value of a bitcoin

Bitcoin (small “b”) is a privately produced fiat money in every respect. So how is its value determined? Like everything else, its value is determined by the interplay of supply and demand.

The behavior of bitcoin’s supply is its strong point. New bitcoins are minted by a publicly visible formula at a decreasing rate until its supply approaches 21 million units in 2040. There are currently about 12.3 million bitcoin in existence. Currently an additional 25 bitcoins are minted every ten minutes and they are issued to miners for verifying that bitcoin used in transactions are not counterfeit. Their price is not fixed to anything and they are not redeemable for anything. They can be exchanged for dollars or other national currencies for whatever buyers are willing to pay and sellers are willing to accept.

Thus the story of the determination of the value of bitcoins is on the demand side. Such a system is the opposite of the gold standard or my real SDR currency board system[5] in which the value of the monetary unit is fixed and the supply adjusts to the market demand at that price. Bitcoin is a system with centralized control (via a rule) of the supply of money and decentralized (market based) determination of its value, while the gold standard was a system of centralized determination of the value of money and decentralized, market based determination of its supply.

Who demands bitcoins and what factors influence that demand? Money of any kind is demanded and held in order to have some available when we want to make a payment or to buy something. Money holdings also reflect the lack of synchronization of the timing of receipts of money, such as for wages, and its expenditure. An inventory of ready cash (and or bank account balances or credit) is needed in order to make payments. The bigger each person’s inventory of money is, the easier it is to make any payment that is needed or desired. However, as with any other inventory, there is a cost to maintaining it. A very large amount of empirical evidence supports the theoretical expectation that the more expensive it is to hold cash between its receipt and expenditure, the less people will hold. When the interest rate opportunity cost of holding money is high, cash holdings, like all other inventories, will be reduced. When inflation is higher (a tax on holding cash), cash holdings will be lower. When the cost of holding money in one or the other of these ways is more uncertain, e.g., because of fluctuations in its value, cash holdings will be lower as well.

The value of a bitcoin, or any other money, is measured by what it can buy. This has two dimensions, a) how widely it is accepted in payment; and b) how much it can buy where it is accepted? Thus the best measure of the value of a bitcoin in the second sense is its exchange rate with the U.S. dollar as the dollar is widely accepted and its purchasing power is quite stable (though any other good or basket of goods could be used as well). Bitcoin’s value is famously highly unstable and unpredictable (and it is still not accepted in very many places).

Over the three months between November 1, 2013 and February 1, 2014 its price (exchange rate) on the Mt. Gox exchange has ranged from around $200 USD per bitcoin to $1,200 and is currently (February 14) around $425 per bitcoin ($220 on Feb 16). These reflect huge bitcoin inflations and deflations. The price on the Mt. Gox exchange plunged from the mid $900s last week to the low $400s this week after it announced the suspension of withdrawals as a result of a bug in the bitcoin software (a claim denied but some). Coindesk has removed Mt. Gox from its bitcoin price index until this problem is resolved, which in mid day Feb 14 was $659 dollars per bitcoin.

As a result of such volatility, virtually nothing is priced in bitcoin, even things that can be purchased with them. Many who pay with bitcoin and most merchants that accept them never actually hold them for more than a few minutes. A toy selling for $100 can be purchased with bitcoin with minimal inflation or deflation risk in the following way. The buyer of the toy pays dollars to a seller of the bitcoin equivalent of $100 via an exchange such as Mt. Gox in Japan and instantly transfers them to the merchant selling the toy. After a few minutes delay while “miners” verify that the bitcoin being transferred (first to the buyer of the toy and then to its seller) are genuine and not electronic copies (i.e. counterfeit), the merchant sells them through an exchange for dollars. Thus the buyer pays dollars and the seller receives dollars but with bitcoin transferred between them. The risk of exchange rate movements is thus minimized. Trusted third party transaction processors like bitpay[6] or coinbase[7] absorb the exchange rate risk over the up to ten minute verification periods. While such trusted third parties provide badly needed support for bitcoin transactions, they undermine the alleged uniqueness of direct peer-to-peer payments.

The above practice is needed to reduce the risks to merchants of “accepting” (fleetingly) volatile bitcoins and thus promises to promote the broadening of their usability. So far the use of bitcoin is a negligible fraction of total payments but not trivial and is growing. However, the fact that few bitcoin transactors actually hold them, and the fact that all bitcoins in existence must be held by someone, implies that the demand to hold bitcoin today comes almost totally from speculators. As long as speculators think the value of bitcoins will continue to increase they will be willing to continue to hold or add to the stock they now hold. This will maintain or increase their value. The moment speculators lose such optimism or decide to cash out while they are ahead, the price of bitcoins will fall and bitcoin prices have experienced a lot of both. The dollar price of bitcoin has skyrocked to unbelievable levels (over $1,200) but it could just as easily fall to zero.

For the value of bitcoins to stabilize, the transaction demand for them (the demand to hold modest inventories of them in order to make payments with them) will need to increase to the point that it crowds out or at least dominates the speculative demand for them. This is not impossible, but in my view is very unlikely.

The future of bitcoin

The use of bitcoin at this point is driven more by ideology than economics. Its promoters like the fact that bitcoins’ supply and value are not controlled by any government and that transactors can be anonymous (or at least Pseudonymous). But there is no compelling reason for anyone to replace the dollar as the American economy’s unit of account with bitcoin, which has been wildly more volatile than the dollar. If goods and services are not priced in bitcoin, however, it will always suffer from the added cost of exchanges between bitcoin and the dollar or other national currencies at the time of a payment.

Bitcoin enthusiasts point to its current low cost of transfer when making payments as a source of its attractiveness and thus its future demand. However, this claim is subject to two challenges. The first is that the means of payment used by bitcoin (i.e. Bitcoin) is equally usable for any other medium of exchange. The entire payment infrastructure that has been developed and continues to develop for bitcoin could be used to make payments with U.S. dollars or other currencies if in fact it provided a superior means of payment. This is the model used by rival cryptocurrency Ripple. Two simple modifications could replace bitcoin with U.S. dollars in the existing Bitcoin system. Rather than being fixed by a rule, the number of dollars in the bitcoin like system would be whatever people paid for, dollar for dollar, and existing Bitcoin exchanges would accept and hold traditional dollars (currency or deposits) in exchange for the same quantity of digital dollars to be used via the Bitcoin system.

The systems of mobile phone payments in local currencies that are growing rapidly around the world are similar in many respects but require the central accounting records of a trusted third party. These systems are driving down the costs of making payments and are instantaneous (faster than bitcoin, which must first authenticate that the bitcoin are genuine). A P2P system has inherent technical challenges and is likely to always be slower than systems relying on trusted third parties.

The use of M-Pesa in Kenya to make small payments of Kenyan Shilling and remittances from abroad has grown at a spectacular rate. Over 70% of Kenya’s adult population used the system by the end of 2012. Based on the record keeping of a trusted third party, M-Pesa payments are simpler and quicker than bitcoin payments. Such new technologies are also driving down the costs of making payments. Cash in and out when buying or selling M-Pesa is almost all in cash requiring street vendors or physical windows rather than virtual exchanges with all digital payments as with bitcoin.[8] However, should bitcoin be used in Kenya it would also need physical cash in – cash out facilities, which would increase its costs relative to those in more advanced economies.

The cost of M-Pesa or Bitcoin type payments should be less than credit payments such as Visa, or Master card because users must pay for the currency in advance of its use and because credit payments can be reversed with charge backs. Each has its advantages and disadvantages and there is room for both

The second challenge to bitcoin’s claims as a superior, lower cost means of payment is that its business model will ultimately require the introduction of fees (some already exist for trusted third party services now being provided). The miners, who perform the service of authenticating bitcoins used in every transaction, are currently remunerated on the basis of the first to complete the authentication of a payment block (public ledger of transactions) earning newly minted bit coin. Over time as the number of bitcoin minted declines to zero and the number of transactions to authenticate increases (should that happen) the remuneration to miners will fall and will need to be supplemented with fees to ensure that the authentication service continues to be provided. Aside from providing its own medium of exchange, Bitcoin is one among many means of payment. Competition and further technical innovations promise to lower the cost of making payments in any currency and it is difficult to see any particular advantage for Bitcoin and considerable disadvantages in this regard.

If a well-defined transactions demand for bitcoin does not emerge to sustain its value, and it is difficult to see why it would, its value will remain at the mercy of the whims of speculators. My expectation is that it will never achieve importance and that it is likely to vanish all together, giving way to more robust means of payment of more stable mediums of exchange. However, it deserves the chance to compete.

Appendix – What are bitcoins?

Bitcoins are digital monetary units created according to a well-specified rule, which will gradually increase their total supply to 21 million sometime beyond 2033. Newly minted bitcoins are paid out to “miners” who perform the services of vetting the authenticity of each bitcoin being transferred from one address to another. This is a critical service to prevent the multiple use of the same bitcoin (double spending problem) given the ease of making electronic copies of what are digital codes to begin with.

Bitcoin may be purchased from those who have them at a mutually agreed price. Such transactions may be conducted face to face or via exchanges established for this purpose. A significant infrastructure has been and is being developed to facilitate these exchanges between bitcoin and national currencies, thus introducing an important role for trusted third parties.

The digital records of the receipt and transfer of bitcoins are maintained in thousands of copies of Block Chains (public ledgers) on the internet. The approach uses public key and private key encryption much like email, where our email addresses are public for everyone to see but our passwords are (hopefully) known only to us. If I receive an email from your address I can be confident it came from you if you keep your password secret. Apps have been developed for bitcoin users to separate their transactions from all others. These “wallets”, make the process more user friendly. If the record of a bitcoin users private key (password) is lost because the hard drive crashes (without back up) or is lost or stolen, the bitcoins held by that user are lost to him/her without recourse. For this purpose and to further simplify the transaction and exchange process, trusted third parties provide on-line wallet and related services. Though at least one on-line wallet service has absconded with the bitcoin deposited there (rather like hacking your email by discovering your password and changing it to something you don’t know).

The ultimate purpose of bitcoin is for making payments for the purchase of goods and services or the discharge of debts. They may be used to make a payment to anyone (person or merchant) willing to accept them anywhere in the world. Given the extreme volatility of their value, a number of trusted third parties have been established to take the exchange rate risk by guaranteeing the exchange rate at which bitcoins can be acquired and resold as close to simultaneously as the authentication process permits (usually no more than ten minutes). Thus a merchant selling goods priced in dollars can accept the bitcoin equivalent (at the moment of the settlement) and resell them for dollars without holding them more than a few minutes.

Bitcoin payments are final, i.e. cannot be reversed without the agreement of the recipient to send them back. They are currently cheaper than most existing means of payment. Information on ownership and transfers is decentralized with many copies of the history of all transaction publically available to anyone. They are somewhat slower than some other means of payment (the average time to authenticate and thus complete a transaction is currency around 9 minutes) but much faster than most bank transfers. The authentication of transaction may become problematic as the number of them increases and the remuneration of miners is reduced.

In my judgment, the use of Bitcoin for making payments and transferring titles and records of all sorts offers much more promise for future efficiencies than do bitcoin or any other private media of exchange.

An easy to read guide to most aspects of using bitcoin can be found at: http://www.coindesk.com/information/. A more detailed and outstanding guide is also provided by Jerry Brito and Andrea Castillo at the Mercatus Center, George Mason University: http://mercatus.org/publication/bitcoin-primer-policymakers

[1] http://bitcoin.org/en/

[2] https://en.bitcoin.it/wiki/List_of_alternative_cryptocurrencies

[3] For a fuller discussion, see my article on the Future of Money in the 2012 Winter issue of the Cayman Financial Review http://www.compasscayman.com/cfr/2012/01/11/The-future-of-money—What-is-it-/

[4] See Section 8 of the Constitution of the United States.

[5] Real SDR Currency Board, Central Banking Journal XXII.2 (2011), also available at http://works.bepress.com/warren_coats/25)

[6] https://bitpay.com/faq

[7] https://coinbase.com/about

[8] Warren Coats, “The Technology of Money” Cayman Financial Review, January 18, 2012.

Printing Money

Isn’t that just printing money? Here is a quick, and hopefully simple, primer on what central banks do.

Central banks print money. They are responsible for issuing a country’s legal tender (banknotes and bank deposits with the central bank) and regulating its value. Most of what we call money is actually privately produced (deposits at commercial banks, credit and debit cards, paypal, etc.) but tied to the money printed by each country’s central bank by the public’s demand that it be redeemable for the central bank’s money. There are a few exceptions to this demand by the market, such as bitcoin (see: the-rise-of-the-bitcoin-virtual-gold-or-cyber-bubble), but they shall ever remain unimportant fads. There is never a question about whether central banks print monetary or not. It is their responsibility to do so. This is as true for a pure gold standard or other fixed exchange rate monetary regimes, as for the variety of fiat money regimes (from monetary targets to inflation targets to flying by the seat of their pants day-to-day).

The important and proper question about a central bank’s behavior is what guides its decisions about when and how much money to print. A secondary question is what does it buy when it issues money (there are no helicopters that drop it from the sky)?

The gold standard: Under a gold standard the central bank buys gold with the money it prints and is legally bound to buy that money back with gold at the same price whenever anyone holding its money wants to redeem it. While this is still printing money, the supply is determined by the preferences of the market (each and every one of us) to hold and use that money. Such central banks have no monetary “policy” in the usual sense. They passively supply whatever amount of money the public demands.

Fiat money: If the central bank issues money with no obligation to redeem it for anything in particular nor at a particular price, its value is determined in the market by its supply and demand. The amount supplied by the central bank relative to the market’s demand for it will determine is value (the price level). Monetary policy consists of the decisions made by central banks that determine the amount of the money they supply and manner in which they supply it.

The public’s demand for money reflects its convenience for making payments, its expected value when exchanged for goods and services, and the opportunity cost of holding it (inventory costs, i.e., the interest rate that could have been earned on holding wealth in other forms). Rapidly changing payment technology (debit/credit cards, Paypal, e-money, etc.) has a profound impact on this demand. There is a vast academic literature on this subject. Unlike any other good or service money’s value derives solely from what it can be exchanged for or more specifically from the economy it brings to exchange/trade. Fiat currency is always useable and thus “redeemable” for the payment of taxes and other obligations to the government that issued it. These obligations are denominated (valued) in the same units as the currency. These guaranteed uses of fiat money anchor its demand and thus value in the same way that the demand for gold for jewelry and other non-monetary uses anchors its value. Bitcoin has no alternative use and thus has no anchor to its value.

Central banks have learned the value of establishing clear rules for issuing money, such as targeting the rate at which the money supply (by one definition or another) grows, or targeting nominal income, or inflation. These rules guide how much money they “print.” They also influence the public’s demand for money by informing its expectations of the central banks actions. The policy regime adopted—rule—determines the behavior of the money supply and thus its value (or visa versa). The supply of bitcoin also follows a well-defined rule, but its demand is unanchored. The fact that the central bank is printing money is irrelevant by itself.

A secondary consideration is what it is that the central bank buys with the money it prints. Under a gold standard it buys gold. Under a fiat money standard central banks generally buy government securities because these securities are generally of unquestioned safety and in most countries have the deepest and most liquid secondary markets. Central banks also traditionally adhere to a “bills only” policy, i.e., they buy short-term government security, in order not to interfere with the market’s determination of the term structure of interest rates, i.e. the relationship of interest rates on securities with longer maturities relative to those with shorter maturities. In a free market, rates on longer maturities are determined by the expected value of overnight rates over the period in question plus a risk premium for the uncertainty over the behavior of overnight rates.

Whatever the ultimate or intermediate targets of monetary policy, most central banks in recent decades have pursued them by targeting a short-term interest rate, their so-called “operating target.” The Federal Reserve targets the overnight interbank rate, the so-called “federal funds rate,” as its approach to targeting the money supply, nominal income, or inflation. Given all other market factors, a particular fed funds rate target will result from and result in a particular rate of growth in the money supply.

Because most money and related means of payment are privately produced by banks or is ultimately settled through banks, and because banks only keep a small amount of the money produced by their central banks for which bank deposits are redeemable (the so-called “fractional reserve banking system”), central banks have also been given the role of insuring that banks have sufficient liquidity to function smoothly. They are mandated to lend to solvent but illiquid banks when banks need to convert loans into cash to accommodate deposit withdrawals (the so-called “lender of last resort” function).

As more and more central banks successfully adopted the techniques of inflation targeting and most of the rest fixed the exchange rate of their currencies to an inflation targeting currencies such as the U.S. dollar or the Euro, the world entered a long period dubbed “the great moderation.” However, the long period of very low interest rates following the bursting of the “dot com” bubble produced the housing price bubble in many locations in the U.S. and Europe. Its collapse in 2007-8 plunged much of the Western world into the long, Great Contraction.

Monetary Policy Plus (MP+): In the last few years the Federal Reserve, the European Central Bank (ECB) and other central banks have undertaken many non-traditional actions in an effort to help lift their respective economies out of recession. In the early days of the serious liquidity crunch following the collapse of Lehman Brothers in September 2008, the Fed, ECB, Bank of England and a few other central banks very successfully pumped needed liquidity into their financial systems by expanding the number of counterparties they would lend to, increasing the eligible collateral, and entering into currency swap arrangements to supply dollar liquidity to foreign banks.

However, after unblocking the flow of funds between banks and other financial firms, the Fed’s concern shifted to fighting deflation, then to reviving economic activity. After driving its operating target to almost zero, the Fed continued increasing monetary growth beyond the rate resulting from a zero fed funds target and dubbed it quantitative easing. However, the channels through which monetary policy is traditionally transmitted to the economy (interest rate, credit, asset price, portfolio/wealth effects, exchange rate channels) seemed ineffective. Thus, the Fed began to purchase non-traditional, financial instruments, such as Mortgage Backed Securities (MBSs) and longer-term government securities, in an effort to keep mortgage interest rates low and to encourage the flow of funds into the mortgage market and stimulating investment more generally. These quasi-fiscal policy measures do not square easily with the Fed’s legal mandates of price stability and employment.

With the Fed’s third program of quantitative easing it is now pushing on a string (QE3: http://works.bepress.com/warren_coats/28/). It is attempting to stimulate an economy that lacks a clear policy environment that would encourage more investment rather than one suffering from inadequate liquidity. While market measures of inflation expectations remain very low, long periods of very low interest rates influence the capitalized value of income streams. A given monthly mortgage payment will purchase a more expensive house when interest rates are lower. What people and firms invest in is distorted toward more capital-intensive projects than are economically efficient and justified at normal rates of interest. Pension funds and other endowments lose income that must be made up somehow (often by moving into riskier investments). Asset price bubbles emerge. On top of these economic risks, the Fed’s need to unwind its huge portfolio of securities (purchased by printing money) when the economy recovers more fully is becoming more and more challenging.

Moreover, the policies of one central bank can affect the exchange rate of its currency if its policies are not coordinated with those of other central banks. This can either improve or worsen the balance of payments between countries (balance of imports and exports). The very wide swings over the last decade in the exchange rate of the US dollar with the Euro, for example, cannot be justified by economic fundamentals and is very disruptive to trade and international capital movements. Recent monetary policy initiatives by the Bank of Japan raise such concerns.

In short, the problem is not that the Fed and other central banks are printing money. The problem is the amount they print and their conceit that they can do more to help the real economy than they really can, thus adding to the market’s uncertainty over the economic, policy, and financial environment in which their decisions to spend and invest must be made. The solution is to reestablish a hard anchor for monetary policy that allows the supply of money to be market determined (as proposed in my: Real SDR Currency Board, paper).

The fantasy of a purely private money that would overcome the weaknesses of government money, remains for the foreseeable future a utopian fantasy: “The Future of Money”. But those of you who enjoy fantasy, might enjoy the following story by Neal Stephenson: “The Great Simoleon Caper”.

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