Frozen coins

ANOTHER FLAW OF BITCOIN

Its cost of ‘production’ or mining can only go up because of the nature of the 21 million cap.

When the cost of mining exceeds bitcoin’s price, miners will shut down. What happens then? You can’t transact bitcoin if miners won’t validate the deal. You can’t even have your Minsky Moment.

Ok, it becomes a Disney asset: Frozen. It will be a winter of discontent.

SATOSHI 2.0, or how to create a better Bitcoin

Will Bitcoin survive? In what form? These are the two most pressing questions on the most popular ‘virtual’ currency, or crypto currency, today.

Bitcoin emerged along with a computing technology called block chain. Once understood, block chain promises to permit security arrangements for payment and even barter systems that are vastly superior to existing ‘centralized’ systems.

For the use of a virtual currency, the block chain has already proved itself as a solution to the counterfeiting problem while also giving transactors a relative degree of privacy. With the internet, the portability of a cryptocurrency clearly surpasses that of gold. Because of advances in computing technology, the transaction costs of a virtual currency are likely to be smaller than for existing payment systems, including the use of cash. Economists and thoughtful policy makers, including some heads of central banks, consider that virtual currencies have a useful role to play.

But the existing Bitcoin has a fundamental flaw. Its market price is too volatile for anything that aims to be a substitute for fiat money.

The problem can be traced to Bitcoin’s fixed supply (21 million coins) coupled with its lack of a ‘commodity anchor.’ The first means that the market price will be volatile, subject to shifts in demand. The latter – the lack of an anchor – underlies and exacerbates the price volatility problem.

The extreme upside is supposedly when bitcoin could supplant gold, and one calculation suggests that it would do so at $500,000 per coin. This scenario has driven wide-eyed fanaticism and speculators into the Bitcoin ecosystem.

The extreme downside, on the other hand, is that bitcoin holders could for some reason ditch the cryptocurrency and make it worthless.

In between, there could be ‘pump and dump’ scenarios, characteristic of a legal-but-Ponzi-like speculative asset that would occasionally have its Minsky Moments.

A better approach may be to think of a cryptocurrency as a ‘digital’ banknote that at least maintains its real purchasing power. To some extent, the banknotes of central banks with low inflation targets already provide the best protection there is to those who hold their monies. Can there be a better, kinder, saner version of Bitcoin?

Perhaps, if the pricing problem could be solved.

The way out seems to be as follows.

A new virtual currency, to be called, say, the bitdollar, is initially priced at par with the existing dollar. Its initial supply is then set as elastic as can be — the first ‘investors’ in the bitdollar will decide, through the amounts they commit to buy, the initial stock of bitdollars.

From there, bitdollars would go on ‘secondary’ trading just like the current Bitcoin.

If the price of a bitdollar falls below par, the initial investors would realize that they were too optimistic. Nothing else happens, and the crypto currency may fall into disuse.

But the initial stock of bitdollars is fixed, and sooner or later its price would recover if it attains usefulness as an alternative to currencies. It may then be seen as an alternative to banknotes but with a supply that an issuing central bank cannot control or alter.

When the price gets to exceed, say, 20% of the fiat dollar, by prior agreement among bitdollar holders, they would expand the supply by 10%. This should be enough to keep the price from shooting up, and also enough to keep it above ‘par.’ If the price continues to remain above 20% over parity, a sliding scale of new ‘issuance,’ say, 5% of the initial stock is calendared.

If the initial issuance is judged too small relative to (growing) demand, new secondary offerings would be issued at prices close to then market prices.

Over time, the price is likely to fluctuate in a range above par, but perhaps close to 10-15% over par. The stock of bitdollars would naturally rise to meet demand but at a price that is essentially anchored to that of the fiat dollar.

This scheme depends on the soundness of the anchor currency. If the central bank prints too much money, the bitdollar holders can or would decide to slow down issuance with a view to stabilizing the purchasing power of bitdollars. In effect, the fiat and virtual currencies will compete as different but similar moneys.

An important question: What happens to the money paid in by initial investors? I suggest that this be sequestered into essentially risk-free long-term government securities held by an agreed custodian bank. It will be set up as a trust fund to cover the possibility that the bitdollar would be unwound. The same rule can be applied to any new secondary public offerings of the cryptocurrency. This approach sets up the crypto currency as akin to commodity money, with the anchor currency as the underlying ‘commodity.’ (It is also akin to a share of stock in the trust fund holding the backing for the virtual currency.)

How would the block chain system be maintained if there is no ‘mining’ as in the current Bitcoin scheme? The obvious answer is that the computing services needed for validating the block chain will be bidded or contracted out in such a way that their cost can be recovered through fees paid by cryptocurrency holders.

Who will profit from the new scheme? As with the current Bitcoin, competing platforms for validating transactions (‘mining’), trading, and transferring of bitdollars will emerge, and would earn fees for transaction processing. Merchants who accept bitdollars would profit from paying a lower transaction fee than that paid to credit card companies. The trustee holding the backing for the bitdollar earns seigniorage in the same way that issuers of travelers checks do, and some of that seigniorage could be distributed to bitdollar holders.

Although in theory the block chain and efficiencies in computing would minimize the cost of operating the system, any crypto currency remains vulnerable to untoward events that generate mistrust in its operation. Trust in the cryptocurrency will have to be earned, requiring the participants to abide by legislation and guidance from monetary authorities. This is particularly important in combatting money laundering and use of virtual currencies by organized crime or terrorists. New platform providers who might try to cartelize transaction fees could also undermine the demand for virtual currencies.

CONCLUSION. Like Humpty Dumpty, Bitcoin is good but with its fixed supply, it is likely to take holders and speculators on a frenzied ride headed for a great fall. Caveat emptor.

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.

PIMCO plays (or PIMCO’s play)

I’ve listened to this for the nth time and still can’t figure it out. So I must be very dumb. Gross is saying easy money will backfire (why I can’t tell), and fiscal policy can’t be relied upon because of politics. It leads to a story of double dip. But with bond yields already low, and PIMCO supposedly holding cash, they want you to think they will prop up stocks.

It could be a soccer play. They want you to buy stocks as they sell short; then later get you scared so you sell back as the economy tanks.

I suspect they also have a way of betting on interest rates falling some more without having to hold bonds. And when they think interest rates are as low as they can sell, they will short bonds while also publicly knocking them with an inflation scare story.

But what if stocks don’t fall, and bond yields rise “too soon”?

… Will PIMCO get bailed out just like LTCM?

Idiots and “normals”

I thought the “new normal” was just a PR gimmick.  At one level it justifies how supposedly smart folks didn’t call the 2007-08 crisis, so that now it is ok to do some Monday morning QBing to say, ok, the world changed after 2008.

Here comes another view that the new normal is idiotic because the “old normal” is still around.

Both views are probably misguided.  Obviously, the financial world had had its 9/11, and things will never be the same.  But to offer pablum while continuing to play the legal Ponzi Buffett-PIMCO game is, well, at the very least, morally reprehensible.  Yeah, yeah – as they say in the Street, “Greed is good.”  Milton F must be turning in his grave.

There is no new normal because there was no old normal to begin with.  The old normal was the view that risk could be contained within statistical models using the Gaussian (or normal) distribution.  Taleb and Mandelbrot have pretty much shown that the distribution has to be other than normal because there is a fat-enough tail that means that those using Markowitz-Black-Scholes models would eventually lose their pants.  If there were a new normal, it would just have different values for the statistical parameters of mean and variance, but it would not be a fundamentally different probability concept.  And those who didn’t learn their lessons from 2008 (or even 1987) would continue to lose money for themselves and their foolish clients.

My best guess is that big money managers are simply competing for the lemmings.  Now, that’s a case of old dogs not learning new tricks.

Why it pays to be BIG – the tales of Buffett and PIMCO

Warren Buffett
Warren Buffett

Financial markets feature a phenomenon called “herding.”  This is when investors mimic each other.  Perhaps this is so because when times are bad, misery loves company.  And when times are good, they can party.

The phenomenon upends one of the maxims of economics.  Convention has it that the big guy can’t move without having prices move against him.  When he buys, the market takes notice and the price rises; and of course when he sells, the price declines.  For the big guy, it should be difficult to “buy low, and sell high.”

Continue reading “Why it pays to be BIG – the tales of Buffett and PIMCO”