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.

Stock markets as indicators of economic sanity

Which is better?

One, where corporations compete “fairly and squarely” in a market of monopolistic competition. Or two, where corporations are oligopolistic, not quite successful in forming a cartel, but stifling competition enough so that there is little risk of loss or subnormal profits.

Continue reading “Stock markets as indicators of economic sanity”

Parents and children (subsidiaries) in the financial crisis

What happens when a parent corporation has a local subsidiary in the Philippines, and the parent appears to be a candidate for bailout in the current financial crisis?  What are the legal rules under the Philippine Corporation Code that apply to this situation?  These questions apply to AIG and its insurer subsidiary, Philamlife, in the Philippines.  Some answers are given here.

Explaining economic models and corporations – a comic respite

Here’s an interesting quick take, courtesy of Lasse Lien.


You have two cows.
You sell one, and force the other to produce the milk of four cows.
Later, you hire a consultant to analyze why the cow has dropped dead.

You have two cows.
You worship them.

How would you define a Philippine corporation? Here’s an attempt:

You have two cows.
You send one to look for grass abroad.
The other plays basketball and drinks Red Horse.

Why pre-need plans are attractive to their holders

Frank & Ernest

As noted in my other piece on rural banks, a Ponzi scheme is one where investors are paid out of money from subsequent investors. As a rule, a Ponzi scheme involves an element of fraud, since the operator of the scheme does not intend to repay the returns promised to all investors, but only to those who participated early in the scheme.

What about pre-need firms, some of which have recently closed? The pre-need industry has also recently been seeking a government bailout. Would such a bailout be in order? Should the bailout be denied if a pre-need firm has been operating a Ponzi scheme?

The sensible rule on bailouts seems to be one that has been applied to banks. Going back to the days of Bagehot (1873), lenders of last resort have established a rule to help maintain stability of the banking system, while containing moral hazard on the part of banks. (Moral hazard, an insurance concept, is defined as the presence of incentives for certain parties to act in ways that incur costs that they do not have to bear. Since the activities of a lender of last resort act as a form of insurance that the banking system will remain in place, there is an element of moral hazard on the part of banks or their depositors who expect a bailout.)

The rule is: Lend to solvent banks on sound collateral, but at a penalty interest rate; but let the insolvent banks fail. A further modification of this rule is that some banks are “too big to fail.” A failure of such a bank would have catastrophic effects all around, and it should be bailed out simply to preserve the banking system as a whole.

While the rule looks simple enough, it may be difficult to apply in practice. In particular, disputes on the valuation of bank assets and liabilities have to be resolved. Such disputes pose difficulties when some of the assets or liabilities do not have a ready market price, or if the market valuation is distorted for reasons unrelated to the activities of the bank in question. It is also arguable that in the depths of a deep recession or depression, even the best banks are technically insolvent because the market valuation of their assets is temporarily and irrationally too low.

With pre-need firms, the potential to do a “Ponzi” exists if their owners or stockholders also manage them. It does not follow that because such a potential exists that any of the pre-need firms actually operate a Ponzi. The fact that a pre-need firm is illiquid or insolvent is, by itself, not enough to establish that it has run a Ponzi. Nonetheless, it is illuminating to try to find out how a pre-need firm might be able to operate a Ponzi.

The following is a sketch of such a Ponzi scheme. A firm would sell some of its assets, realizing the capital gains on these because they had appreciated in value. The firm may also gain from forfeitures of customer payments if, under a default clause, such customers fail to keep up their payments on their plans. The stockholders of the firm might then find a way to pay themselves large salaries and dividends because the audited financial statements would show income from such forfeitures and capital gains. The result is a high probability of insolvency later on, when loss-producing assets eventually have to be liquidated, which usually occurs when new business slows down or ceases. An indicator of such a fraud is when a pre-need firm’s expenses for salaries and dividends, or for some unexplained expenses, are high in “good” years, where “good” depends on forfeitures of customer payments and recognition of capital gains on assets held. Of course, how high salaries and dividends are is a subjective issue, but there could be benchmarks from industry practice in insurance companies. Unexplained expenses are “red flags” for auditors, but a Ponzi operator will make fraudulent claims as to their legitimacy.

What if it is impossible to determine if a pre-need firm has been running a Ponzi? What if it can prove its good faith, and that its illiquidity is temporary? It seems that a pre-need firm that is solvent should qualify for a bailout in the form of loans to relieve it of its illiquidity. Under the Bagehot rule, the loan will have to be given on good paper, properly discounted, and the lender doing the bailout will be charged with overseeing the rehabilitation of the firm into a state of liquidity. A pre-need firm that is insolvent qualifies for bankruptcy protection, but transactions made prior to such a bankruptcy may be attended with indicia of transactions in fraud of creditors. Under the applicable legal rules, such transactions may be reversed, and recovery can be had against the counterparties of the pre-need firm.

As a matter of public policy, what is the remedy when pre-need firms have a tendency to fail? One remedy is to subject them to the minimum capital rules imposed on insurers. In my view, this may or may not be a sufficient remedy. Pre-need firms are more like banks, where the regulations impose a duty on a bank to maintain reserves based on possible “loan losses” on its investments. Pre-need firms who invest in risky assets, such as real estate or the stock market, should, like banks, be required to set aside reserves against the possibility of capital losses on all such investments. If a pre-need firm guarantees the quantities (and not just the value) of the plan, reserves should also be set aside against price increases of such quantities.

What is the likely effect of imposing a more stringent minimum capital requirement on pre-need firms? Inadequately capitalized firms will have to drop out of the business. As to the remaining firms, obviously, the likelihood of insolvency is reduced, and their plan holders would be better protected. But the need to maintain adequate reserves also means that pre-need plans will be more expensive. Consequently, a potential plan holder may opt to simply manage his own savings in order to have enough funds for the day when the “need” arrives. After all, a pre-need plan is another form of savings.

One final word. If a pre-need firm has been doing a Ponzi, its operator has committed fraud. It does not make sense to bail out such an operator. A more difficult question relates to any remedy that would be sought by its “victims,” i.e., the plan holders who have not been paid. Ideally, recovery can be had against the operator if he has assets, and the doctrine of piercing the corporate veil should be invoked. But that is an ideal world. Alternatively, a form of “default insurance,” similar to deposit insurance for banks, may be contemplated: Pre-need firms would pay periodic premiums into such an insurer, who would protect plan holders against a default of a pre-need firm. Such an insurance scheme would provide incentives for pre-need firms to police each other’s practices since, obviously, the premiums that have to be paid to the insurance fund would rise with an increase in the probability of insolvency of any pre-need firm.