Bitcoins are forever

This is a story of mania, panic, and crash. It’s not new. 

Today’s market cap is roughly $150 billion. Averaged over, say, 3 million holders, that’s $50,000 each. Peanuts, if you belong to the 1%.

The trick is to kite the price to anywhere from 5 to 20 times the current level of $4,000.

The sales are essentially wash sales, as coins just go round and round. That’s why they’re coins, see.

Spectators – the victims – then want in, and the insiders pump and dump swimmingly, until the 3 million can get out with huge profits, at the expense of the latecomers.

The end is a classic Minsky Moment, when the latecomers try to sell. The algorithms in the trading platforms would ask: ‘To whom?’ And the price spirals to nothing.

Question for economists: Can the end trigger a financial or economic crisis? A dire scenario is that the latecomers’ loss results in bankruptcies and loan defaults, a retrenchment in purchases of housing and consumer durables, or in a general malaise in business and consumer confidence. Banks may fail if they finance bitcoin purchases.

With the benefit of foresight, monetary authorities will likely institute safeguards. Trading platforms are like banks, and will need adequate capital in case of an epidemic of ‘fails,’ which can happen if traders engage in short sales, or in margin trading. The Know Your Customer rule will have to be integrated into the block chain data base, and imposed by banks on customers operating trading platforms. 

Of course, theoretically, since virtual currencies can function as money, all trading can take place outside the banking system. If that were the case, the ponzi won’t work: How would the victims’ money enter into the bitcoin system? The price would go up and down forever, but that’s all. It’s funny money after all.

Will Bitcoin crash and resurrect?

NOT BITCOIN but better.

One use of Bitcoin is for anonymous transactions, i.e., as a substitute for ordinary cash or bank notes.

The problem is that the currently available bitcoins fluctuate in value. The ideal is a bitcoin that is stable for at least a certain determinate or even indefinite time against a major currency, such as the US dollar. In short, we want or need an alternative bitcoin that is like a dollar banknote. We imagine this alternative works better than keeping banknotes under the mattress or in a safe deposit box, because it avoids thievery and the transaction costs of going to the safe deposit box.

It can be done. The easiest is for the US Fed to do it. It would allow anyone to buy something we might call the official bitcoin dollar in exchange for a guarantee that bitcoin dollars are exchangeable into US banknotes. If this works, it will be because it would reduce the costs now paid by the central bank for printing currency and going after counterfeits. In this scenario, the blockchain ensures that counterfeit official bitcoins cannot exist.

Another way is for a major private bank to ‘create’ its bitcoin dollar. Imagine that Chase does it, and calls it the Chase bitcoin dollar. All it is is a special debit card account where Chase guarantees to make the Chase bitcoin dollar exchangeable for cash. The guarantee is in effect a promise that Chase will honor Chase bitcoin dollar liabilities ahead of its any other liabilities. To ensure such a guarantee, Chase would enter into a ‘currency board’ arrangement with the US Fed by maintaining Fed fund balances in a separate special account solely for the purpose of redeeming Chase bitcoin dollars. In short, the fractional nature of the private banking system will not apply to bitcoin dollars.

The blockchain also allows Chase to ensure that no other entity can create Chase bitcoin dollars. The ‘supply’ of Chase bitcoin dollars will always be the same as the demand for such dollars.

Any other private bank would be allowed to participate in a ‘branded’ bitcoin currency. I can imagine HSBC issuing special debit cards for HSBC bitcoin dollars, HSBC bitcoin euros, or HSBC bitcoin yen. They may be allowed to compete through enhancements on convenience of use, allowing for fee-free global transfers, or even the payment of interest.

One important enhancement would be US consumer protections against fraud now being given to users of credit cards. Any merchant declining to honor a bitcoin debit card would be presumed to be up to no good.

The similarity with bank notes will have to be carried to an extreme that meets certain anonymity and privacy standards. The issuer of a bitcoin dollar will have to honor the bearer of the account provided that said bearer satisfies identity requirements.

At the same time, the use of such accounts will have to be protected by bank secrecy rules, but subject to money-laundering limits. For example, bitcoin dollar transactions in a particular account cannot exceed $10,000 per day, and a bank cannot allow a depositor more than one bitcoin dollar account. A maximum-balance limit of, say, $100,000 per account, could be imposed, in parallel with limits now applied under existing deposit insurance schemes.
Central banks could also impose limits on how many bitcoin dollar accounts an individual can have. To protect banks from money-laundering, bitcoin dollar accounts would not be available to corporations.

Will the advent of such official or private bitcoin dollars kill the existing bitcoins? It could, especially if bitcoins continue to be more attractive as speculation vehicles than as means of payment.

But bitcoin exchanges could create ‘hybrid’ bitcoins whose ‘mining’ or supply-side arrangements are fully transparent, and whose value could be stabilized in some fashion desired by the bitcoin holder. In short, there could be different bitcoins for different purposes. Caveat emptor and ‘know your customer’ rules would still be needed. However, such bitcoins would remain without guarantees similar to deposit insurance, and they may still be vehicles for speculation.

My best guess: Bitcoins will evolve, i.e., the fittest will survive. The Dutch tulip variety will become extinct. As of now, they’re pretty much as primitive as Dutch tulips.

Wall Street’s “Perfect Crime”

[Here’s a piece of fiction I received in a brown unmarked envelope in my snail mail box, along with a copy of a special issue of Critical Review on “The Causes of the Crisis,” Vol. 21, Nos. 2-3, 2009.]

What did Jamie D know and when?

Mankiw on financial crisis

Belatedly perhaps, Mankiw gives out some good ideas on the next crisis.  It looks like Kindleberger, Minsky, and Taleb finally got to him.  Perhaps Shiller too.

But somehow I find it hard to  see Greenspan saving his reputation out of all this.

Sober readings on the financial crisis

Two must reads if you’re worried about a repeat of “It” (the Great Depression, that is).

One is by a former chief economist of the IMF.  The other is a kind of “puff piece” in praise of Timothy Geithner on the “victory” of Obama’s economic team over the crisis.

To some extent both articles discuss the uncertain state of the “toxic assets” in the balance sheets of the big American banks.  The stock market has nonetheless seemed to pronounce that the health of the banks is much better now than a year ago, but not so good that we can say that life post-crisis is already “normal.”  There may well still be hidden “events” that can turn things for the worse for the the American and global economies.  But the financial reform legislation (Volcker rule, a tax on on overly expanded bank balance sheet) may well help inspire more confidence.

Despite the residual uncertainty, or because of it, we should try to reach for a Taleb disciple with whom to have a beer.  Maybe that way we will survive the next bubble/crash that no one can yet  sketch out definitively.

When the deposit insurer should resist paying all claims

Can the Philippine Deposit Insurance Corporation (PDIC) resist paying on deposit insurance? In particular, would the PDIC have a legal basis not to pay the claim of a depositor who participated in a Ponzi scheme run by a bank where an essential part of the scheme is to let the bank fail? If the PDIC has already paid on an insurance claim, can the PDIC recover the payment if there was legal ground for not paying on the claim?

It is submitted that the answer to these questions is in the affirmative. The reasoning is based on the nature of the deposit contract entered into between the parties in bad faith (the bank and the bad-faith depositor) and of the insurance contract undertaken by the PDIC.

The Panic of 1907, by Robert F. Bruner and Sean D. Carr – a book review

This is a case study of what the authors call “a perfect storm” in the financial markets. It is a highly readable historical account, and should be read by anyone who seeks to understand today’s global crisis. And we can a century later benefit from the lessons drawn from the panic of 1907.

The story features high drama – a failed attempt by speculators to corner the market for the stock of a copper mining corporation, classic bank runs and the failure of the Knickerbocker Trust Co., suicides of major personalities and investors, the Herculean efforts of J. P. Morgan to organize rescues of financial institutions considered solvent after ad hoc through-the-night audits, a near default by the city of New York, the efforts of the US Treasury to help ameliorate the crisis, and a key decision made by then President Theodore Roosevelt that on its face ran counter to his anti-trust sentiments.