Saturday, August 31, 2019

Why the discrepancy?

Vitalik Buterin had a thought-provoking tweet a few days back about interest rates.
Today's post explores what goes into determining interest rates, not blockchain stuff. So for those who don't follow the blockchain world, let me get you up to speed by decoding some of the technical-ese in Buterin's tweet.

DAI is a version of the U.S. dollar. There are many versions of the dollar. The Fed issues both a paper and an electronic version, Wells Fargo issues its own account-based version, and PayPal does too. But whereas Wells Fargo and PayPal dollars are digital entries in company databases, and Fed paper dollars are circulating bearer notes, DAI is encoded on the Ethereum blockchain.

Buterin points out that DAI owners can lend out their U.S. dollar lookalikes on Compound, a lending protocol based on Ethereum, for 11.5%. That's a fabulous interest rate, especially when traditional dollar owner can only lend their dollars out to the government—the U.S. Treasury—at a rate of 1.5%.

Why this difference, asks Buterin?

Interest rates are a lot of fun to puzzle through. I had to think this one over for a bit—so let's slowly work through some of the factors at play.

Let's begin by flipping Buterin's question around. When the U.S. Treasury borrows from the public, the bonds it issues are promises to pay back regular dollars (i.e. Federal Reserve dollars). But what if the U.S. Treasury decided to borrow DAI by issuing bonds promising to repay in DAI? What would the interest rate on these Treasury DAI bonds be? Would it be 11.5% or 1.5%? Perhaps somewhere in between?

Credit risk

First, there's the question of credit risk. The U.S. Treasury is a very reliable debtor. It won't welch. If it issues both types of bonds, it'll be just as likely to repay its DAI bond as it will its regular dollar bond. Since the market already requires 1.5% from the Treasury to compensate it for credit risk (and a few other risks), the Treasury's DAI bonds should probably yield 1.5% too. (I'll modify this later as I add some more layers).

Now let's look at Compound. A DAI loan made on Compound (for simplicity let's just call it a Compound DAI bond) is surely much riskier than our hypothetical Treasury DAI bond. Compound is a blockchain experiment. It could malfunction due to buggy code. Maybe every single Compound borrower goes bust. To compensate for this risk, a prospective bond buyer will require a higher return from Compound DAI bonds than they will U.S. Treasury DAI bonds.

So Compound credit risk (Buterin's third option) probably explains a big chunk of the huge gap between the 11.5% interest rate on Compound DAI bonds and our hypothetical 1.5% interest rate on the U.S. Treasury's DAI bonds. But not all of it.

Collapse risk

Buterin mentions a second risk: the chance that DAI, the entity that creates blockchain dollars, collapses. Like Compound, DAI is a new monetary experiment. The code could be buggy. It might get hacked. By comparison, conventional dollar issuers—say Wells Fargo or PayPal—are far less likely to malfunction.

How does DAI collapse risk get built into the price of a hypothetical Treasury DAI bonds

The average market participant (I'm not talking about crypto fans here, but large & smart institutional actors) should be genuinely worried about purchasing a Treasury DAI bond—not so much because the Treasury is unlikely to pay it back—but because the DAI tokens that the Treasury ends up repaying could, in the even of DAI breaking, be worth 99% less than their original value. Average bond buyers will expect some compensation for bearing this risk. How much? Say 5.5% (I'm just guessing here).

Earlier I said that a Treasury DAI bond would yield 1.5%. But if we add 5.5% worth of failure risk to 1.5% in basic risk, a Treasury DAI bond should yield 7.0% before the average investor is going to hold it.

Now let's go back and look at a Compound DAI bond. As Buterin pointed out, they yield 11.5%, which is much higher than the 7.0% yield on our hypothetical Treasury DAI bond. We've already assumed that DAI collapse risk works out to 5.5%. If we subtract collapse risk from a Compound DAI bond's 11.5% yield, the remaining 6% is accounted for by risks such as Compound failing (11.5% - 5.5%). Put differently, investors in Compound DAI bonds will require 5.5% and 6.0% to compensate for collapse risk and credit risk respectively, for a total of 11.5%. Again, these are hypothetical numbers. But they help us puzzle things out.

Two different blockchain dollars: USDC vs DAI

Interestingly, Compound doesn't just facilitate DAI loans. It also expedites loans in another blockchain dollar, USDC. We'll refer to these as Compound USDC bonds. As Buterin points out later on in the thread, the rate on Compound USDC bonds is 6.5%, quite a bit lower than Compound DAI bonds.

What might explain this discrepancy?

Not credit risk, since in both instances the same creditor—Compound—is responsible for creating the bonds. Which leaves varying levels of collapse risk as an explanation. USDC is a regulated stablecoin (i.e. it has the government's approval). DAI isn't. And USDC has genuine U.S. dollars backing it, whereas DAI is backed by highly volatile cryptocurrencies. So the odds of USDC collapsing are surely lower than DAI.

How much interest do USDC bond holders require to compensate them for collapse risk? Assuming that Compound's risk of failing is worth 5.5% of interest (as we already claimed), that leaves just 1% attributable to the risk of USDC failing (6.5%-5.5%). Put differently, investors in Compound USDC bonds will require 5.5% and 1.0% to compensate for credit risk and collapse risk respectively, for a total of 6.5%.

Oddly, the yield on a Compound USCD bond is less than the hypothetical yield on our safe Treasury DAI bond (6.5% vs 7.0%). Why is that? Even though Compound is riskier to lend to than the Treasury, a DAI-linked return is riskier than a USDC return. Another way to think about this is that if the Treasury were to also issue USDC bonds, those bond would only yield 2.5%. To account for credit (and other) risks investors would require a base 1.5% with an extra 1.0% on top for the risk of USDC breaking.

The convenience yield

Let's bring in one last layer. Something called the convenience yield is lurking behind this.

When you lend me some tokens, you need to be compensated for more than just credit risk i.e. the risk that I won't pay back the tokens. You are also doing without the convenience of these tokens for a period of time. The replacement, my IOU, won't be very handy. For instance, the convenience of a dollar bill can be though of as the ability to mobilize it whenever you need to meet some pressing need. But if you've lent a $100 bill to me then you've given up all that bill's usefulness. Instead, you're stuck with my awkward $100 IOU. You need some compensation for this. (Unconvinced? Head over to Steve Randy Waldman's classic ode to the convenience yield).

So when we break down the components of the interest rate on DAI bonds, there must be some compensation required for forgoing the convenience of DAI, its convenience yield. Earlier I attributed the big gap between rates on Compound DAI and USDC bonds to varying odds of each scheme failing. However, the gap could also be explained by varying convenience yields. If the convenience yield of a DAI token is higher than that of a USDC token, we'd expect an issuer of a DAI bond to pay a higher rate than on a USDC bond, in order to compensate DAI holders for giving up on those superior conveniences. 

If DAI's convenience yield is higher than USDC's, what might explain this gap? DAI is completely decentralized and can't be monitored. USDC isn't. It is less censorship-resistant than DAI. So perhaps USDC just isn't as handy to have around.

So some of the 11.5% rate on Compound DAI bonds—say 2%—may be due to the convenience yield forgone on lent DAI. If DAI had the same features as USDC, and thus had a lower convenience yield, a Compound DAI bond might only yield 9.5% (11.5% - 2.0%). If so, the discrepancy between the Compound DAI and USDC bonds—9.5% vs 6.5%—wouldn't be as extreme.

Summing up, let's revisit Buterin's tweet:
If my line of thinking is right, the discrepancy is accounted for a messy mix of the higher risk of lending to Compound (3), the danger of DAI cracking (2), and whatever convenience yield one forgoes when one no longer has DAI on hand (4-other). And of course, Buterin's first option is right too. I'm assuming that people are rational and can easily buy and sell various assets. But the sorts of large institutional players who set market prices may not be operating in crypto markets.

Wednesday, August 21, 2019

Starbucks, monetary superpower

I recently spent some time on Twitter discussing the monetary wonders of Starbucks. In this post I'll bring a bunch of tweets together into a single blog post.

I don't go to Starbucks very often, so I only recently learnt that the company has succeeded in getting many of its customers to stop using cash and debit/credit cards to buy coffee. Instead, they are using  Starbucks's own payments option:
Starbucks has around $1.6 billion in stored value card liabilities outstanding. This represents the sum of all physical gift cards held in customer's wallets as well as the digital value of electronic balances held in the Starbucks Mobile App.* It amounts to ~6% of all of the company's liabilities.

This is a pretty incredible number. Stored value card liabilities are the money that you, oh loyal Starbucks customer, use to buy coffee. What you might not realize is that these balances  simultaneously function as a loan to Starbucks. Starbucks doesn't pay any interest on balances held in the Starbucks app or gift cards. You, the loyal customer, are providing the company with free debt.

Starbucks isn't the only firm to get free lending from its customers. So does PayPal. That's right, customers who hold PayPal balances are effectively acting as PayPal's creditors. Customer loans to PayPal currently amount to over $20 billion. Like Starbucks, PayPal doesn't pay its customers a shred of interest. But Starbucks's gig is way better than PayPal's. PayPal is required to store customer's funds in a segregated account at a bank, or invest them in government bonds (see tweet below). So unfortunately for PayPal, it earns a paltry amount of interest on the funds that customers have lent it.

Starbucks, on the other hand, doesn't have to keep customer funds in a low yielding segregated account or government bonds. Why is that? PayPal allows people to cash-out of PayPal dollars into regular dollars, so for regulatory purposes it must keep an adequate reserve on hand to facilitate redemptions. But the only way to cash out of Starbucks balances is to buy a coffee--a promise that Starbucks can always keep! And so Starbucks can immediately put its customer loans to work in higher-yielding opportunities like funding its operations and expansion.

In addition to borrowing from its customers, Starbucks also borrows from professional investors. Here's a list Starbucks's long-term debt:

Starbucks is paying an interest to bond and note-holders that ranges as low as 0.46% (on its yen notes maturing in 2024) to 4.5% (on its 2048 notes). You can see why borrowing from customers in the form of stored value card liabilities is the better option. By expanding its borrowing from its non-professional lenders and using the proceeds to cancel its debts to professional lenders, Starbucks can make an immediate profit.

But there's more. As I pointed out in the following tweet, don't forget breakage. Bond and note holders are pros. They don't forget about debts. But customers aren't so exact. They are sloppy, or busy, or forgetful, which means that many gift cards and balances will go unspent:

Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly -10% interest rate!

On Twitter, Wayne points out to me that I need to add back the impact of Starbucks rewards. App users receive stars on each purchase which can be saved up for free coffee. This functions as a form of implicit interest that Starbucks pays to its customers.

That's a good point. But if were going to bring rewards into our calculation, then there are other non-pecuniary flows that need to be added in too. Keep in mind that each payment made through the Starbucks app is a payment that isn't made by credit card. Since each credit card payment will cost Starbucks 1-2% in interchange fees paid to the card networks and banks, the company saves a lot of money by guiding customers to its payments app. As for Wayne, while he may earn an implicit interest return in the form of Starbucks points, by forgoing a card payment he's giving up on the associated cash-back or airline points.

Another flow that needs to be accounted for is data. By capturing the customer's wallet, Starbucks is getting loads of free but valuable personal information that would otherwise be lost, or for which it would have to pay. Any customer who pays with cash forgoes rewards, but at least they get to retain their information. 

Adding all of this up, (0% interest + breakage - rewards + interchange savings + customer information), Starbucks's stored value liabilities are a terrific liability to have.

More generally, I think this calculation demonstrates how providing financial services to a retail customer base is a great business. Retail customers don't seem to be too fussy about the return they get. And they are busy and distracted and sloppy and forgetful. Take central banking, for instance, which serves a retail clientele. People are pretty happy to hold banknotes that pay 0%. But you never see businesses or professional investors hoarding banknotes. They quickly return the cash they take in during the course of the day to their bank so that they can harvest interest. Commercial banking is also a good example. Like Starbucks, banks are able to borrow from their retail customers at a measly rate approaching 0%. But professionals who lend to banks by purchasing their bonds require a much higher rate. To top it off, retail customers unnecessarily sign up for high-fee products and avoid changing banks when there is a cheaper option.  

Why doesn't every retail chain try get into this game? By borrowing as much as they can from the non-professional public, they'd steal plenty of profitable business from central banks and retail banks. Well they do. Gift cards are a big business. And if you think about it, retailers are perfect candidates for providing monetary services to the masses. Like banks, they already have a network of physical stores. But none of them have been successful at it as Starbucks. Walmart is much bigger than Starbucks, for instance, but it has just as many gift card balances outstanding:

Perhaps Starbucks's success has to do with the regularity and homogeneity of Starbucks purchases? And so customers are willing to preload a dedicated account? I'm not sure.

In any case, there are probably a few Starbucks executives who'd love to grow the amount of negative yielding liabilities that the firm issues. Why stop at $1.6 billion in stored value liabilities? Why not grow the program to $5 billion, $10 billion, or $100 billion? It would be a terrific business line to get into.

The problem here is that Starbucks only sells coffee. Coffee is great, but the demand for dollars that are only useful for buying coffee will always be limited. To really grow the amount of stored value liabilities it issues, Starbucks would have to increase the usefulness of Starbucks dollars. One way to do this would be to open up the Starbucks app up to other stores. If consumers could also buy Big Macs with the balances on Starbucks App, this would increase the demand for Starbucks balances. To secure McDonald's cooperation, Starbucks would have to share the savings, breakage, and data. Maybe companies like Home Depot and Costco would join the Starbucks-McDonald's alliance. (And other chains, say Kroger and Burger King, might join the competing Walmart Pay alliance).

Sure, each of these companies could simply pursue their own independent stored-value liability programs. But wouldn't an alliance be better? From the customer's perspective, balances held in a single payments app that can be spent at Starbucks, McDonald's, Home Hardware, or Costco would be far more useful then dollars held in four separate and walled-off apps. And so collectively these stores should be able to get the public to hold more stored value card liabilities than they could individually. Which means more breakage, free loans, and data for everyone (and less for the banks, card networks, and central banks).

Who knows if it would be successful. And it might not even be possible from a regulatory perspective. But it would be tempting, no? In a world where most debtors have to pay interest, being  a debtor who earns interest is pretty hard to beat.

*I believe that current portion of deferred revenue is equal to around $174 million. This comes courtesy of the current portion of an up front royalty payment from Nestlé. So the stored value card liability is actually closer to $1.46 billion. Still pretty high. 

Monday, August 5, 2019

Stigmatized money

Some payments systems are so awkward they scare away the average user. The only people with the patience to stick around must have a motivation for doing so. These include ideologues with an ax to grind, hobbyists who happily embrace complicated features, and criminals/weirdos who are shut out of everything else.

Here are a few examples of awkward payments systems:

-Local Exchange Trading Systems, or LETS
-Labor notes
-Stamp scrip

When usage of a payments system is confined to a narrow group of like-minded individuals, this may stigmatize these systems, scaring away mainstream users. Stigmatization only compounds the initial awkwardness. After all, if fewer venues accept the stigmatized payments option then it becomes harder for the small band of users to make purchases. A vicious circle has been created. Initial awkwardness leads to stigma which leads to more awkwardness etc.

While this vicious circle is the death knell for a payments system, it is less of a problem for other products. You can make a decent living by targeting a small niche of consumers, say communists who eat vegan food. Every big city needs a communist vegan restaurant. But a payments network is only as good as the size of the payments pathways that it facilitates. A payments entrepreneur won't get very far by building a platform that only allows communist vegans to pay other communist vegans. 

How to evade the awkwardness-stigma spiral? What is needed is a frictionless, non-awkward payments system. With little to learn, everyone—not just nerds and those with an ax to grind—can quickly start using it. Think M-Pesa or Visa or Octopus.

Even the haters will get onboarded. Gold bugs and bitcoiners may rail against banks and fiat money. But because everyone else is using these relatively simple systems, the bugs and the bits have no choice but to go along. By bringing the vast hoard of normies on board along with the weirdos, these systems avoid all connotation. They are safe for broad consumption. No stigma can attach to them. And so the vicious awkwardness-stigma circle I described gets sidestepped.

I'd argue that LETS are an example of a system that suffer from the awkwardness-stigma spiral. LETS are a pain to use. This article on the famous Comox LETS and its founder Michael Linton, an earlier proponent of LETS, explains some of the problems. And so the only people who use LETS will be those willing to put up with the awkwardness: folks who self-identify as leftist with anarchic views. Those who don't share those views might feel weird joining a LETS. So LETS remain small and fragile, or as Linton says, they're like "sandcastles on the beach."

You see the same awkwardness-stigma cycle at play in bitcoin. Bitcoin is an awkward payments medium. The stuff is so volatile that retailers don't like to accept it. Risk averse consumers don't want to hold it. So only a subset of the population will ever feel comfortable using bitcoins for payments.

This subset has developed its own norms and codes. Bitcoin steak dinners are a good example. A large group of predominately male bitcoiners will get together to eat meat while avoiding vegetables, then broadcast it on Twitter:

I'm sure it's a lot of fun. But these sorts of traditions will inevitably be perceived as weird by the majority. And so the majority will go out of their way to avoid bitcoins for fear of being tarred as an oddball. Other niche groups who can't sympathize with male carnivores, say lesbian vegans, will avoid bitcoin payments on principal. This stigma cuts down on the potential pool of bitcoin payees, which only makes bitcoin more annoying to use.

Mastercarders don't have their own set of traditions. For instance, you won't see Mastercard users setting up meetups to eat organic food and talk about the latest development in tokenization technology. The Mastercard/Visa user-bases are devoid of culture and character. This lack of a class consciousness is one of the features that makes them such effective  payments networks. Systems without norms and traditions never face the risk of falling into the stigmatization hole.

Facebook's Libra has attracted plenty of attention over the last few months. But Libra risk encountering the same awkwardness-stigma cycle as Bitcoin and LETS. Unlike other social media-based  payments tools (Wechat, Kakao, Line etc), Libra's architects have chosen to create a new unit of account rather than marrying Libra tokens to existing units like the dollar or euro.

But as I suggested in a previous post, it's a pain to learn a new unit of account, just like it's a hassle to learn a new language. So only a certain type of motivated person will bother using Libra, just like only motivated people—language nerds—learn Esperanto. This weirdo factor could stigmatize the system. Hey, look at those Libra-using elitists! What snobs! By crowding out normies (and the massive number of potential payment pathways they bring to the table) Libra runs the risk of never self-actualizing as a payments system. Better to take the safe and boring route of linking Libra to dollars and yen and whatnot. 

The vicious awkwardness-stigma cycle has already started to hit cash. In places like Sweden, cash is being stigmatized. When the middle and upper class are convinced that only the poor and criminals use coins and banknotes, many of them will go out of their way to avoid using cash. Cash becomes "grungy and unsexy," as Brett Scott puts it. Unfortunately, an ever narrower base of cash users will only make the stuff more expensive for retailers to handle, leading to a rise in cashless stores (especially ones that cater to the rich), leading to more awkwardness and stigma, leading to less users, etc.

David Birch has an interesting parable from William Gibson's Count Zero that illustrates what happens when this stigmatization is brought to its logical conclusion. Basically, cash is still around in Gibson's imagined future, but it has disappeared from "polite society". And so the story's protagonist, Bobby Newmark, describes it as unspendable:

If cash is to avoid a Gibsonian future, it needs to be de-stigmatized. But this requires that it re-attracts many of the people and businesses that have deserted it because it is no longer convenient. In a post  at the Sound Money Project (and earlier on this blog) I suggested paying interest on cash. Thus individuals and businesses would be compensated for the relative inconvenience of note storage and handling. And with a wider range of people using notes, any stigma that they have attracted would dissipate.

Stigma is dangerous for a payments system. A system will become stigmatized if it attracts a clique rather than a broad group of users. Cliques kill a payments system since they suppress the system's connectiveness. To avoid the potential for clique-ization, systems should try to be as easy to use and accessible as possible.

Friday, July 5, 2019

Classifying cryptocurrencies

Whenever biologists stumble on a strange specimen, they first try to see if it fits into the existing taxonomy. If it doesn't fall within any of the pre-existing categories, they sketch out a new one for it.

For people like myself who are interested in monetary phenomena and finance, Bitcoin and other cryptocurrencies like Dogecoin and Litecoin have presented us with the same challenge. How can we classify these strange new instruments?

Because they have the word 'currency' in them, the knee-jerk reaction has been to put cryptocurrencies in the same bucket as so-called fiat money, i.e. instruments like bank deposits and banknotes. But this is wrong. Bitcoin, Dogecoin, and other cryptocurrencies are fundamentally different from $100 bills or Citibank deposits. 

To see why, here is a chart I published last year at Sound Money Project:

I've located cryptocurrencies in the zero-sum outcome family. Banknotes and deposits are in a different family, win-win opportunities. The property that binds all zero-sum games together is that the amount of resources contributed to the pot is precisely equal to the amount that is paid out of the pot. Jack's ability to profit from his cryptocurrency is entirely dependent on the next player, Jill, stepping forward and taking them off him at a higher price. Likewise, the amount Jack wins from the lottery is a function of how much Jill and other players have contributed to the pot.

Compare this to a stock or a bond. As long as the firm’s managers deploy the money in the pot wisely, the firm can throw off more resources than the amount that shareholders and bondholders originally contributed.

People have been asking me to extend this classification to other assets. Below I've made a more extensive chart:

Similar to the first chart, I've put Bitcoin, Dogecoin, and other cryptocurrencies in the bets & hedges category along with insurance, futures & options, and various gambles such as lotteries. I describe the members of this family as sterile uses of wealth. Unlike more productive uses of wealth, which increase society's resources, bets and hedges transfer existing resources from one person to another.

I disagree with you, JP

No doubt others will disagree with my classification scheme. For instance, why not put cryptocurrencies in the consumer goods section? After all, aren't cryptocurrencies sort of like collectibles? Don't people primarily collect sports cards, old coins, and crocheted doilies because they expect these objects to rise in value, just like the people who buy cryptocurrencies?

Collectibles and other knick-knacks have sentimental, symbolic, ornamental, and ceremonial value. Even if they can't be sold (most knick-knacks can't), they are still valuable for the above reasons. Not so Bitcoin, Dogecoin, and Litecoin. Cryptocurrencies are pure bets on subsequent people accepting or buying them. If no one steps up, the tokens don't have any other redeeming features that can salvage their value.

Are cryptocurrencies like art? Leonardo da Vinci's Salvator Mundi sold for $450 million to a Saudi prince in 2017. Surely Salvator Mundi's consumption value isn't that high. It would seem that its value is entirely predicated on what the next aesthete will pay, in the same way that bitcoin's value hinges on whether another bitcoiner arrives.

Perhaps. But most art pieces aren't Leonardo's Salvator Mundi. The great mass of paintings that have been created over time are relatively cheap. Secondly, prices in high-end art markets may seem to be disconnected from the consumption value they provide, but that's only because these prices are being drive by the preferences and tastes of consumers who are far richer than most of us. It is this ability to consume the beauty and meaning of art that separates it from cryptocurrency.

What about categorizing cryptocurrencies as commodities? For instance, Bitcoin is often described as digital gold. Or consider George Selgin's reference to bitcoin as a synthetic commodity. Selgin's argument is that cryptocurrencies are commodity-like because they are scarce. And they are synthetic because, unlike commodities, they have no value apart from what other people will pay for them (i.e. they have no nonmonetary value).

I agree with Selgin's analysis. But because cryptocurrencies are synthetic—i.e. their purchasing power is entirely predicated on another person entering the game—I've put them in the bets & hedges category along with other zero-sum games, not the commodity family. Sure, the supply of cryptocurrencies is fixed, say like copper. But that only makes it a very special type of bet, not a commodity.

Blurred lines

The categories in my classification scheme do sometimes blur. At times the stock market becomes incredibly speculative. People start buying shares not because they expect the underlying business to produce higher cash flows, but because they expect others to buy those shares at a higher price, these buyers in turn expecting others to purchase it at a higher price. Thus buying stocks becomes for like betting on a zero-sum game than an effort to appraise the earnings potential of an underlying business.

The same applies to gold:

There is another type of blurriness. Notice that neither chart has a category for money. That's because I prefer to think of money as an adjective, not a category. More specifically, moneyness is a characteristic that attaches itself by varying degrees to all of the instruments in the chart above. A more money-like instrument is relatively more tradeable, or marketable, than a less money-like instrument.

So we can have money-like commodities, bonds with high degrees of moneyness, and heck, money-like lottery tickets. Even some types of banknotes will be more money-like than others. For example, you'll have much better luck spending fifty C$20 bills than you will one C$1000 banknote. Or take the example of choice urban land, which is a lot more saleable than property in the middle of nowhere. Lastly, spending bitcoins is probably much easier to do than spending Dogecoins.

For the last few centuries, the most money-like instruments have tended to be in the debt category. There are many reasons for this. Debt instruments are stable, they are light and thus convenient for transporting, they can be digitized and used remotely, they are fungible, they are difficult to counterfeit, and they can be efficiently produced.

All of you folks with some spare funds who are mulling a big cryptocurrency purchase: be careful. There are plenty of people on the internet who are aggressively marketing crypto as some sort of new society-transforming elixir, or tomorrow's money. But much of their marketing is unfounded. It is unlikely that Bitcoin or Dogecoin will ever attract the same degree of moneyness as the most popular debt instruments. Their zero-sum game nature will always interfere with their ability to attract usage as a medium of exchange. But I could be wrong.

While there are elements of cryptocurrencies that are really neat, they aren't fundamentally new. Rather, they fit quite nicely in the traditional 'bets and hedges' category. If you wouldn't bet all your savings in a zero-sum game like poker, neither should you do the same with cryptocurrencies. A bond or equity ETF is naturally productive, as is an investment in human capital. Consider them first.

Tuesday, June 25, 2019

Esperanto, money's interval of certainty, and how this applies to Facebook's Libra

Facebook recently announced a new cryptocurrency, Libra. I had earlier speculated about what a Facebook cryptocurrency might look like here for Breakermag.

I think this is great news. MasterCard, Visa, and the various national banking systems (many of which are oligopolies) need more competition. With a big player like Facebook entering the market, prices should fall and service improve, making consumers better off.

The most interesting thing to me about Facebook's move into payments is that rather than indexing Libras to an existing unit of account, the system will be based on an entirely new unit of account. When you owe your friend 5 Libras, or ≋5, that will be different from owing her $5 or ¥5 or £5.  Here is what the white paper has to say:
"As the value of Libra is effectively linked to a basket of fiat currencies, from the point of view of any specific currency, there will be fluctuations in the value of Libra."
So Libra will not just be a new way to pay, but also a new monetary measurement. Given how Facebook describes it in the brief quotation provided, the Libra unit will be similar to other unit of account baskets like the IMF's special drawing right (SDR), the Asian Monetary Unit (AMU), or the European Currency Unit (ECU), the predecessor to the euro. Each of these units is a "cocktail" of other currency units.

Facebook's decision to build its payments network on top of a new unit of account is very ambitious, perhaps overly so. When fintechs or banks introduce new media of exchange or payments systems, they invariably piggy back off of the existing national units of account. For instance, when PayPal debuted in 2001, it didn't set up a new unit called PayPalios. It used the dollar (and for the other nations in which is is active, it used the local unit of account). M-Pesa didn't set up a new unit of account called Pesas. It indexed M-Pesa to the Kenyan shilling.

I couldn't find a good explanation for why Facebook wants to take its own route. But I suspect it might have something to do with the goal of providing a universal monetary unit, one that allows Facebook users around the globe to avoid all the hassles of exchange fluctuations and conversions.

Global monetary harmony an old dream. In the mid 1800s, a bunch of economists, including William Stanley Jevons, tried to get the world to adopt the French 5-franc coin as a universal coinage standard. Jevons pointed out that the world already had international copyright, extradition, maritime codes of signals, postal conventions—so why not international money too? He wrote of the "immense good" that would arise when people could understand all "statements of accounts, prices, and statistics." It would no longer be necessary to employ a skilled class of foreign exchange specialists to take on the "perplexing" task of converting from one money to the other.

But the plan to introduce international money never worked out. (I wrote about this episode for Bullionstar).

Global money like Libra might seem like a great idea. But ultimately, I suspect that the decision to introduce a new unit of account will prevent Libra from ever reaching its full potential. Units of account are a bit like languages. If you are an English speakers, not only do you communicate to everyone around you in English, but you also think in English. Likewise with the dollar or yen or pound or euro. If you live in France, you're used to describing prices and values to friends and family in euros. You also plan and conceptualize in terms of them.

It's hard to get people to voluntarily switch to another language or unit of account once they are locked into it. For instance, in the 1800s L.L. Zamenhof attempted to get the world to adopt Esperanto as a language in order to promote communication across borders. To help facilitate adoption, Zamenhof designed it to be easy to learn. But while around 2 million speak Esperanto, it never succeeded in becoming a real linguistic standard. The core problem is this: Why bother learning a new language, even an easy one, if everyone is using the existing language? 

Facebook's Libra project reminds me of Zamenhof's Esperanto project. Nigerians already talk and compute in naira, Canadians in dollars, Indonesians in rupiahs, and Russians in rubles. Why would any of us want to invest time and effort in learning a second language of prices?

Let me put it more concretely. I do most of my families grocery shopping. Which means I keep track of an evolving array of maybe 30 or 40 food prices in my head. When something is cheap relative to my memory of it, I will buy it—sometimes multiple versions of it. And when it is expensive, I avoid it. But this array is entirely made up of Canadian dollar prices. I don't want to have to re-memorize that full array of prices in Libra terms, or keep two arrays of prices in my head, a dollar one and a Libra one. I'm already fluent in the Canadian dollar ones.

Nor will retailers like Amazon or the local corner store relish the prospect of having to advertise prices in both the local unit of account and Libra, plus whatever unit Google and Netflix choose to impose on us. 

So Facebook is inflicting an inconvenience on its users by forcing us to adopt a new unit of account. To make for a better user experience, it should probably index the Libra payments network to the units of account that we're all used to. 

If not, here is what is likely to happen. We'll all continue to think and communicate in terms of local currency. But at the last-minute we will have to make a foreign exchange calculation in order to determine out how much of our Libra to pay at the check-out counter. To do this calculation, we'll have to use that moment's Libra-to-local currency exchange rate. This is already how bitcoin transactions occur, for instance.

But this means that Libra users will lose one of the greatest services provided by money: money's interval of certainty. This is one of society's best free lunches around. It emerges from a combination of two fact. First, most of us don't live in a Libra world in which we must make some sort of last-minute foreign exchange calculation before paying. Rather, we live in a world in which the instruments we hold in our wallet are indexed to the same unit of account in which shops set prices.

Monetary economists call this a wedding of the medium-of-exchange and unit-of-account functions of money. This fusion is really quite convenient. It means that we don't have to make constant foreign exchange conversions every time we pay for something. A bill with a dollar on it is equal to the dollars emblazoned on sticker prices.

Secondly, shops generally choose to keep sticker prices fixed for long periods of time. Even with the growth of Amazon and other online retailers, Alberto Cavallo (who co-founded the Billion Prices Project) finds that the average price in the U.S. has a duration of around 3.65 months between 2014-2017. So for example, an IKEA chair that is priced at $15 will probably have this same price for around 3.65 months. This is down from 6.48 month between 2008-10. But 3.65 months is still a pretty long time.

Why do businesses provide sticky pricing? In the early 1990s Alan Blinder asked businesses this very question. He found that the most common reason was the desire to avoid "antagonizing" customers or "causing them difficulties." Blinder's findings were similar to Arthur Okun's earlier explanation for sticky prices whereby business owners maintain an implicit contract, or invisible handshake, with customers. If buyers view a price increase as being unfair, they might take revenge on the retailer by looking for alternatives. (I explore these ideas more here).

Anyways, the combination of these two factors—sticky prices and a wedding of the unit of account and medium of exchange—provides all of us with an interval of certainty (or what I once called money's 'home advantage'). We know exactly how many items we can buy for the next few weeks or months using the banknotes in our wallet or funds in our account. And so we can make very precise spending plans. In an uncertain world, this sort of clarity is quite special.

Given Libra's current design, the interval of certainty disappears. Store keepers will still keep prices sticky in terms of the local unit of account, but Libra users do not benefit from this stickiness because Libras aren't indexed to the same unit as sticker prices are. Anyone who has ≋100 in their account won't know whether they can afford to buy a given item two weeks from now. But if they hold $100, they'll still have that certainty, since dollar prices are still sticky.

If money's interval of certainty is important, it is particularly important to the poor. The rich have plenty of savings that they can rely on to ride out price fluctuations. The fewer resources that a family has, the more it must carefully map out the next few day's of spending.  The combination of sticky prices and a wedding of the unit-of-account and medium-of-exchange affords a vital planning window to those who are just barely getting by.

This clashes with one of Libra's founding principles: to help the world's 1.7 billion unbanked. Here is David Marcus, Libra's project lead:

Most of the world's unbanked people are poor. But Libra won't be doing the poor much of a favor by choosing to void the interval of certainty that they rely on. If Facebook and David Marcus truly wants to help the unbanked, it seems to me that it would better to index Libras to the various local units of account.

I suppose there is an argument to be made that Libras could provide poor people in nations with bad currencies a haven of sorts. Better Libras than Venezuelan bolivars, right? But the nations with the world's largest unbanked populations—places like India, Nigeria, Mexico, Ethiopia, Bangladesh, and Indonesia—all have single digit inflation, or close to it. Extremely high inflation is really just a problem in a few outliers, like Zimbabwe and Venezuela.

Besides, providing those who endure high inflation with a better unit of account isn't the only way to help them. Offering locally-denominated Libras that offer a compensating high rate of interest would probably be more useful. Not only would these types of Libra offer inflation protection, but they would preserve the interval of certainty.

Thankfully, I suspect that Libra is very much a work-in-progress. The current whitepaper seems to give only a hint of what the project might become. If so, one of the changes I suspect Facebook will have to make if it wants to get traction is to link the Libra network to already-existing units of account. A new unit of account is just too Utopian.

Wednesday, June 12, 2019

Is bitcoin getting less volatile?

I'm going to make the following claim. The price of bitcoin is inherently volatile. Even if bitcoin gets bigger, its core level of volatility is never going to fall.

Bitcoin's hyperactive price movements prevent it from becoming a popular medium of exchange. Merchants are too afraid to accept bitcoins. If they do, they could experience large losses. Consumers who hold bitcoins are loath to spend them. Many of these hodlers are trying to change their financial lives by getting exposure to the very same roller-coaster ride that merchants are trying to avoid. If they use their bitcoin to buy stuff, they risk losing out on the opportunity for life-changing returns.

Why is bitcoin's high volatility intrinsic to its nature? Bitcoin is a rare example of a pure Keynesian beauty contest. Players in a beauty contest gamble on what John Maynard Keynes described as what "average opinion expects the average opinion to be." No matter how big the game gets, the best collective guess—bitcoin's current market price—will always by hyper-volatile.

By contrast, other assets like stocks, gold, commodities, and banknotes have a fundamental value that helps to anchor price. This ensures that their prices can't travel very far as time passes.

But the standard deviation is falling!

In response to the claim I've just made, people have given me a version of the following: as bitcoin gets bigger and more popular, its volatility will inevitably fall. This eventual stabilization is one of the assumptions at the core of Vijay Boyapati's bubble theory of bitcoin. Bitcoin guru Andreas Antonopolous has also adopted this viewpoint, noting that "volatility really is an expression of size."

Manuel Polavieja provides evidence for this view by tweeting a chart of the 365-day standard deviation of bitcoin daily price changes.

The general slope of the curve in the chart seems to be declining, the inevitable conclusion being that bitcoin's price isn't intrinsically frenetic. As bitcoin has become more popular, its volatility has been retreating.

Sure, but bitcoin's median absolute deviation isn't falling

Manuel has chosen to illustrate bitcoin's price dispersion with its standard deviation. But the standard deviation of an asset's daily price change isn't the only way to get a feel for its volatility. There are other measures of dispersion  that can flesh out the picture, particularly for distributions that are characterized by extremely large outliers.

One problem with standard deviation is that it amplifies the influence of extreme price changes. The calculation for standard deviation squares each day's difference from the mean day's return. By their nature, outliers will boast the largest differences. Squaring them has the effect of causing the extremes to have a disproportionate influence on the final score. The calculation further promotes outliers by taking the average of the squared deviations from the mean. But in distributions such as bitcoin daily returns, the average return will always be skewed by a few crazy daily fluctuations.

Median absolute deviation is one way to reduce the influence of outliers. It calculates the differences from the median daily return, not the mean. And rather than squaring the differences, and thus amplifying them, the calculation simply takes their absolute value (i.e. it gets rid of all negative amounts). It then locates the median of these absolute differences. The advantage of using the median difference is that—unlike standard deviation, which locates the average difference—the median can't be influenced by insane values.

Below I've recreated Manuel's chart of bitcoin's 365-day standard deviation of daily returns and overlaid it with bitcoin's 365-day median absolute deviation of daily returns. The contrast is quite striking.

Standard deviation of bitcoin returns, the blue line, has been falling since 2011. But median absolute deviation of bitcoin returns, the green line, has stayed constant. What I believe is happening here is that the craziness of bitcoin's outlier days have been steadily falling over time, and thus the standard deviation has been declining. But a typical day in the life of bitcoin—i.e. the usual price volatility experienced by bitcoin holders, its non-outliers—hasn't changed since bitcoin's inception. A regular day, as captured by the median absolute deviation, is about as frenetic today as it was back in when bitcoin was a fraction the size.

What is happening at the ends of the distribution?

We can get an even better feel for the dispersion of bitcoin's returns by splitting them into quartiles and percentiles.

Let's look at the blue line first, the 25th percentile (or first quartile). This measure gives us a feel for what a lethargic day is like in bitcoin-land. Out of a sample of 365 days of bitcoin returns, 25% of them will fall below the blue line. If bitcoin is indeed getting more stable, we'd expect the 25% most lethargic bitcoin days to be getting even more lethargic. But this isn't the case. Rather than falling, the blue trend line is flat (and even slopes up ever so slightly). It seems that lethargic days are getting a bit less lethargic as time passes.

The median (already discussed above) shows a similar pattern. The middle-most day's return shows no sign of slackening, despite bitcoin's incredible growth over the last decade.  

Let's look at the top two lines. 25% of all bitcoin daily price changes are in excess of the red line, the 75th-percentile. Unlike the median, this line has been steadily falling. This means that the 25% most frenetic bitcoin days have been getting a little less frenetic. The purple line, the 90th percentile, shows an even steeper decline. The 10% craziest bitcoin days are quickly becoming less crazy.  

The interpretation of this chart seem pretty clear. The typical bitcoin trading day is not getting more subdued. It's the outliers, those outside of the 90th percentile, that have mellowed. The softening of bitcoin's extreme price fluctuations, the purple line, explains why bitcoin's standard deviation has been trending downwards. But if we only focus on standard deviation, we'll fail to see that the typical day—i.e. the median day—is just as hyperactive as before.

What about Netflix?

It's always nice to get some context by looking at how a similar data series behaves. I've chosen Netflix. Like bitcoin, Netflix has gone from nothing to billions of dollars in market capitalization and millions of users in the space of a few short years.

As Netflix has grown, its median absolute deviation and its standard deviation have softened. So both Netflix's outliers and its regular days have been tempered over time. Compare this to bitcoin, where the typical day continues to be just as frenetic as before.

I believe that the contrast between the two assets can be explained by the fact that at its core, bitcoin is a Keynesian beauty contest. Netflix isn't. As Netflix has grown and its earnings have become more certain, Netflix's typical day-to-day price fluctuations (as captured by its median absolute deviation) have softened. But the failure of a prototypical bitcoin day to stabilize, even as the asset grows, can be explained by bitcoin's basic lack of fundamentals. Its price is permanently anchorless.  

Intrinsic vs extrinsic price fluctuations

So why has bitcoin's typical volatility stayed constant while its extremes have become more tame? If bitcoin is a Keynesian beauty contest, shouldn't both its typical volatility and extreme volatility have stayed high and constant?

Let's assume that there are two types of bitcoin price fluctuations. Intrinsic price changes are due to the nature of bitcoin itself. Extrinsic changes occur because of malfunctions in the unregulated third-parties (wallets, exchanges, investment products) that have been built around bitcoin. Mature assets like stocks and bonds that trade on well-developed and regulated market infrastructure tend not to suffer from extrinsic volatility.

Over the years, third-party catastrophes have accounted for some of the largest shocks to the bitcoin price. When Mt. Gox failed in 2014 it caused massive fluctuations in the price of bitcoin. But this was extrinsic to bitcoin, not intrinsic. It had nothing to do with bitcoin itself, but a security breach at Mt. Gox.

If you've been around as long as I have, you'll remember Pirate's Bitcoin Savings & Trust—a ponzi scheme that caught up many in the bitcoin community. When BST collapsed in 2012, it dragged the price of bitcoin down with it. Again, this was an extrinsic price fluctuation, not an intrinsic one.

The infrastructure surrounding bitcoin has grown up since those early days. Mt. Gox blow-ups and BST scams just aren't as prevalent as they used to be. There are enough robust exchanges now that the collapse of any single one won't do significant damage to bitcoin's price. And so bitcoin's price outliers have gotten less extreme. The declining influence of third-party infrastructure on bitcoin's price is reflected in bitcoin's falling standard deviation. As the infrastructure surrounding bitcoin reaches the same calibre as the infrastructure that serves more traditional assets, bitcoin's extrinsic price fluctuations will cease to occur. At that point the steady decline in bitcoin's standard deviation will have petered out.

Median absolute volatility screens out the effects of the Mt. Goxes and BSTs. And so it is the best measure for capturing bitcoin's intrinsic volatility. Think of this as the base level of volatility that emerges as people try to guess what average opinion expects average opinion to be. And as I pointed out earlier, this sort of volatility has stayed constant over many years. A Keynesian beauty contest is manic by nature, it isn't going to mellow out with time.


In sum, on a typical day bitcoin is about as volatile in 2019 (at a market cap of +$100 billion) as it was in 2013 (when its market cap was at $1 billion back in 2013). Which would seem to indicate that if and when it becomes "huge" (i.e. $10 trillion), it will continue to be just as volatile as it is now.

New recruits are being introduced to bitcoin on the premise that they are buying into tomorrow's global money at a bargain price. But shouldn't they be warned that they are playing a new sort of financial contest? Sure, bitcoin can be used for payments. But the underlying beauty contest nature of bitcoin will always interfere with its payments functionality. Which means that usage of bitcoin for paying is likely to be confined to a small niche of enthusiasts who are willing  to put up with these nuisances, and the de-banked, who have no choice. Bitcoin is risky, play responsible.

Tuesday, May 28, 2019

Revisiting stablecoins

Source: Gravity Glue (2014)

Cryptocurrencies were supposed to destroy the traditional monetary system. Ten years on, where are we?

Bitcoin has been wildly successful, but as a financial game--not as a medium of exchange. It's a fun (and potentially profitable) way to gamble on what Keynes once described as what "average opinion expects the average opinion to be." But no one really uses it to pay for stuff. It's nature as a gambling token makes it too awkward to serve as a true substitute for banknotes and credit cards.

A number of stablecoins have emerged over the last five or six years. (I first wrote about stablecoins four years ago). Like bitcoin, stablecoins exist on a blockchain. But unlike bitcoin, these tokens have a mechanism for ensuring their stability. Stablecoin owners can convert tokens at par into underlying dollar balances maintained in the issuer's account at a regular bank. So stablecoin entrepreneur have basically built a new blockchain layer on top of the existing financial stack. This is interesting, but not very subversive. It's not that different from what PayPal does, or a mobile money operator like M-Pesa.    

Which gets us to MakerDAO. MakerDAO is the name of the decentralized organization that manages the Dai stablecoin. Dai is unique because like bitcoin (and unlike other types of stablecoins), it has no connection whatsoever to the traditional financial system. So Dai has all the rebelliousness of bitcoin. But unlike bitcoin it isn't a gyrating Keynesian beauty contest. Which means that it has a much better chance of becoming a generally-accepted medium of exchange than bitcoin.

This post is for monetary economists and others who would like to know how MakerDAO works, without necessarily getting into the specifics. Since cryptocurrency jargon, like all jargon, is complicated, I'm going to explain it by comparing it to something we can all recognize, a bank.


The Dai system is in many ways like a regular bank, say Citibank. Citibank create 'stablecoins', specifically deposits, out of unstable assets like personal promises, property claims, flows of future business profits, etc.

The process of creating Citibank deposits begins with a loan. Jim pledges his house that is appraised to be worth $1 million to the bank, and the bank creates $500,000 digital Citibank dollars for Jim. He spends the $500,000 into the economy, which ends up being held by Terry, who is most comfortable investing in safe assets like Citibank deposits. Thus Jim's unstable house has been transformed into Terry's stable deposit.

The creation of Dai tokens works the same way. Jim pledges $1 million in assets to the Dai system, and in return he gets $500,000 Dai. After Jim spends those stablecoins into circulation, they end up with Terry, who wants to hold a stable cryptocurrency.

One difference between Dai and Citibank emerges pretty quick. To get his hands on Citibank dollars, Jim pledges his house as collateral (or some real world instrument, like business inventory or a boat or equity shares). But with Dai, Jim can only pledge assets that exist in blockchain space. Because Dai exists on a particular blockchain--Ethereum--the key pledgeable asset for a Dai loan is Ethereum's native token, ether, a volatile cryptocurrency.

What ensures that Terry's Dai tokens will be worth the same as a Federal Reserve dollar? First, lets revisit why a Citibank dollar is always worth a Federal Reserve dollar.

Citibank maintains a network of ATM machines and tellers that will redeem Terry's deposits at par with paper currency. Since he knows that he can always cash them in 1:1 at a Citibank outlet, Terry needn't ever sell his Citibank dollars at a discount on the open market.

Unlike Citibank, Dai doesn't maintain a network of dollar-filled ATMs. There is simply no way to redeem or cash out of Dai, as there is with other stablecoins. To provide a cash-out mechanism would contradict the whole point of a fully decentralized stablecoin. Dai is trying to recreate a virtual version of the dollar, but entirely within the world of blockchains. It can't rely on out-of-blockchain dollars to secure the system.

So how is the price of Dai kept at $1? 

Let's go back to our Citibank illustration. Imagine that Citibank were to announce that henceforth all its deposits are inconvertible. Its network of ATM machines is to be shut down and cash can no longer be withdrawn at the teller. If Terry can no longer return his Citibank deposits to the bank at par, will their value collapse? Or will the 1:1 exchange rate somehow hold?

The short answer is that the exchange rate will hold... to a degree. Remember that Jim is still obligated to repay $500,000 to Citibank. Even if Terry can no longer directly bring his $500,000 worth of Citibank dollars to Citibank for redemption into Federal Reserve dollars, he can do so indirectly, by offering to sell them to Jim for Federal Reserve dollars, who in turn is obligated to bring deposits to the bank to clear up his loan.

Say that Jim's debt is due and he has decided to take up Terry on his offer. The price that Jim decides to pay Terry for his deposits depends on how many other buyers he must compete with. On any given day, a number of Citibank borrowers will have to purchase Citibank deposits in order to settle their existing debt to Citibank. If they are all anxious to settle their debts, Jim may have to offer Terry as much as $1.05 or $1.06 for his deposits. Again, with ATMs and tellers no longer providing 1:1 convertibility, it is possible for these odd exchange rates between Citibank dollars and Fed dollars to emerge.

Terry isn't the only Citibank depositor. There may be many other depositors who are anxious to sell Citibank deposits that day. If Jim is one of the only buyers, he may be able to convince Terry to accept 93 or 92 cents for each Citibank dollar.

So under inconvertibility, the price of Citibank deposits relative to Federal Reserve dollars depends on the short term demand for deposits and desire to settle debts to Citibank. If there is a large demand to settle debts on Wednesday, and few sellers of Citibank deposits, then the price can spike well above $1. But if everyone wants to sell on Thursday, and no debtors want to settle, it could collapse to well below $1.

The soft Citibank peg I'm describing is exactly how Dai functions. You can actually see below how relaxed Dai's peg is below. Sometimes Dai trades far below $1, sometimes it trades above:


This flexibility is not so much a bug, but a feature. It's the same sort of behaviour that Citibank's inconvertible deposits would exhibit.


Returning to our Citibank analogy, there are limits to how far the price of Citibank deposits can stray from $1. When the price of Citibank deposits falls too low, say to 90 cents, then existing Citibank borrowers will smell a deal. They can buy cheap Citibank deposits, cancel their loans (and thus unencumbering their housing collateral), and then proceed to another bank (say Wells Fargo) in order to re-open the same loan (using the same collateral). The whole process of closing and re-opening the loan will result in a 10% profit. The pace of Citibank debt cancellation will increase as a result, thus shrinking the supply of Citibank deposits and bringing its price back up towards $1.

Conversely, when the price of Citibank deposits gets too high, say $1.10, then borrowers will be eager to mortgage their homes with Citibank (and not another bank). After all, they can mortgage a $1 million home with either Citibank or Wells Fargo and get $500,000 in deposits. But Citibank deposits are worth $1.10 which means that a Citibank borrower gets 10% more bang for buck. A splurge in new Citibank loans will increase the supply of Citibank deposits and drive the premium back down to $1.


In addition to these automatic forces that push Citibank deposits towards $1, Citibank can use monetary policy, specifically interest rate changes, to keep the exchange rate between their dollars and Federal Reserve dollars close to $1. 

Say that there are is a glut of Citibank depositors who want to get rid of their deposits, and their desire to sell has temporarily pushed Citibank dollars down to 95 cents. By increasing the interest rate on existing loans, Citibank makes it more onerous for those who have Citibank debt to meet their interest payments. These borrowers will start to buy up Citibank deposits in order to cancel their burden. This wave of buying will counterbalance the glut of depositors who want to sell, pushing the price of Citibank dollars back up to $1.

Citibank can also set monetary policy using the rate it pays to depositors. Say that a horde of debtors have lined up to repurchase and cancel their debts to Citibank, pushing the price of Citibank deposits up to $1.05. By lowering the interest rate it pays depositors, Citibank reduces the incentive that people have to hold Citibank deposits. Depositors will flock to sell, thus pushing the purchasing power of Citibank deposits back down to $1.

MakerDAO manipulates a rate called the stability fee to a level that is consistent with $1 Dai. The stability fee is the rate that Dai borrowers must pay. MakerDAO is in the midst of implementing the Dai Savings Rate. This savings rate provides Dai holders with a reward, much like how Citibank depositors are paid interest.

Does Dai monetary policy work? The price of Dai recently fell to a large 3-4% discount to the dollar. In response, MakerDAO jacked up the stability fee. I documented what happened in this series of tweets:

This effort seems to have successfully brought Dai back to $1.


Under times of stress, how can these systems continue to ensure that the value of their deposits/tokens stays close to $1?

Each inconvertible Citibank deposit is twinned with a lender who will eventually have to repurchase it. Say that Jim and a few other debtors go bust and can no longer pay back their loan. Now there are a bunch of orphaned deposits. This spells disaster for the peg. There won't be enough debtors to repurchase Citibank deposits from Terry and the remaining depositors. And as a result, the price of Citibank deposits will slide far below $1.

But Citibank has a tool to prevent this. Remember that Jim provided collateral in order to get his loan. When Jim can no longer pay his loan, the bank can seize Jim's collateral--his house, inventory, boat, or whatnot--and sell it to repurchase Citibank deposits. All the orphaned deposits can be withdrawn, driving the exchange rate back up towards $1.    

The same goes for Dai. But rather than seizing debtor's houses, MakerDAO takes control of the cryptocurrency collateral that Dai debtors have provided.

Another feature that helps keep Citibank inconvertible deposits near par is the fact that Citibank can always wind down its operations and go out of business. If so, all debtors must settle their debts, which means buying up Citibank deposits and thus cancelling out what is due to Citibank depositors. Debtors who can't pay their dues will have their collateral seized and sold, the proceeds used to pay remaining depositors US$1 for each Citibank deposit.

As long as Citibank has properly appraised the value of the collateral that has been deposited with it, then it will be able to make everyone whole. The proximity of a wind-down, the mere chance that this event can always occur, should be enough to help push the price of Citibank deposits towards $1.

MakerDao also has an equivalent feature called global settlement. Global settlement occurs when the Dai system is shut down and all Dai holders are paid out an equivalent of US$1, with debtors to the system getting all that remains. The odds of global settlement being invoked should help keep the price of Dai close to $1.


There is a lot of skepticism surrounding stablecoins. Folks like Preston Byrne, for instance, are convinced like stablecoins are Dai inherently doomed. And some of them have collapsed. (Just read my old post on the demise of Nubits.)

I'm more sanguine. As I've illustrated, Dai isn't that strange of a beast. Apart from the fact that it is inconvertible, a Dai token is very much like a Citibank deposit. Both Citibank and MakerDAO take unstable assets and turn them into stable-priced ones.

These sorts of water-into-wine institutions have been a regular feature of the financial landscape for centuries. Yes, banks have often failed. But they can also be incredibly durable. Here in Canada, the Bank of Montreal has been operating since 1819, some 200 years, without going under. And for those who attribute the Bank of Montreal's longevity to government sponsorship ad support--nope. Canada only got a central bank in 1935 and a deposit insurance scheme in the 1960s.


Will the new digital upstarts like Dai be able to unseat the incumbents, as many of its fans believe?

Relative to convertible Citibank deposits, inconvertible Citibank deposits really aren't that great of a product. Thanks to Citibank's convertibility mechanism, regular Citibank deposits are fungible not only with Federal Reserve dollars but all other brands of bank deposits including Wells Fargo dollars, Bank of America dollars, JP Morgan Chase deposits, and more. To be fungible means to be perfectly interchangeable.

Harmonization, or interoperability, is pretty useful. People can walk into a store and purchase goods with whatever brand of dollar they want. Neither the buyer nor seller need think twice about which one is being used. But not so with inconvertible Citibank dollars or Dai. Lacking direct 1:1 convertibility into underlying Federal Reserve dollars, the price of these "soft-pegged" versions of the dollar will never be quite the same as other dollars. Any purchase that is made with these exotic dollars would be a bit like walking into a Taco Bell in New York with euro banknotes or Canadian dollars.

I mean, the purchase can still go forward, but there is an extra layer of awkwardness that must be endured. The exchange rate between inconvertible Citibank dollars and Federal Reserve dollars at that instant must be determined, conversion fees must be incurred, and foreign exchange risk absorbed. Likewise with a purchase made with Dai. Sure, Dai tokens are relatively stable. But they aren't fungible with the underlying instrument they are trying to represent--U.S. dollars--and that hobbles their payments functionality.

The same awkwardness occurs when taking out a loan in inconvertible Citibank dollars, say to invest in a business or renovate a house. Businesses and individuals earn income and salary in regular Federal Reserve dollars (and all the other dollars that are interoperable with Fed dollars), but if their loans and interest must be repaid in Citibank dollars, they effectively owe what is a foreign currency.

This undoes one of the most useful features of dollars or yen or pounds, which is that they can be used as general medium for short selling, or put differently, a standard for deferred payment. Standard of deferred payment is "that other function" of money, the one no one thinks about because it is overshadowed by the triumvirate of medium-of-exchange, unit-of-account, and store-of-value.

Briefly, since income is earned in local currency, and income is fairly predictable--especially salaries--a borrower (i.e. a short seller) has a pretty good idea ahead of time how much of their future budget they will be required to pay to cover the bank loan. But when the units borrowed are different from the units that make up most of one's income, all of that pleasurable certainty is lost.


But what about decentralization? Doesn't this feature give Dai an advantage over other types of dollars?

Unlike inconvertible Citibank deposits, which are issued by a centralized financial institution, Dai tokens are decentralized. What does this mean? The organization that maintains the system--MakerDAO--doesn't exist in a fixed physical location. It resides on the Ethereum blockchain, which is maintained by a crowd of validators that is distributed all across the world. Whereas the authorities can easily exert pressure on Citibank--they know its address--MakerDAO's crowd of decentralized nodes cannot be so easily controlled.

Citibank relies on people in offices to do much of the work of running the bank. MakerDAO uses smart contracts: automated bits of code that cannot be tampered with. Governance of the system occurs over the internet, with MakerDAO shareholders voting on resolutions such as interest rate changes. MakerDAO shareholders needn't reveal their identities, which means the authorities can't exert pressure on them as easily they might on Citibank executives.

Decentralization allows for subversiveness. A regular bank is obligated to meet a long list of regulatory requirements including those on how much capital they must hold, customer identification practices, and more. But since the authorities can't easily get a bead on MakerDAO stakeholders in order to punish it for infractions, the Dai system may be able to avoid all sorts of costly regulations. And these cost savings means that Dai borrowers might be rewarded with lower interest rates than Citibank borrowers, and Dai stablecoin holders with higher interest rates than Citibank depositors.

There are a set of actors who are have been censored from the banking system. For instance, thanks to embargo threats emanating from the U.S. Treasury, Iran has been mostly cut off from accessing U.S. banks. American marijuana companies can't get bank accounts because banks consider them to be too risky to serve. MakerDAO is (in theory) much more resistant to censorship than Citibank. Dai tokens can filter into all sorts of unserved and risky markets because those who run the Dai system needn't worry about being punished by regulators.


So there is certainly a natural clientele for decentralized dollars. But whether the benefits arising from decentralization--lack of regulation and censorship resistance--are enough to overcome the awkwardness of non-fungibility remains to be seen.

I also wonder how genuine the decentralization of MakerDAO is. I mean, say that Dai became popular for skirting Iranian sanctions. Wouldn't the U.S. Treasury have a number of levers it could pull in order to reverse this? Many of the MakerDAO developers are public figures, as are MakerDAO shareholders. If the U.S. threatened to arrest them for breaking sanctions rules, would they fall into line and write Iran out of the system? If so, Dai is about as subversive as PayPal or Citibank. A centralized and non-fungible stablecoin doesn't seem to offer many benefits.

Friday, May 10, 2019

Kyle Bass's big nickel bet

In 2011, hedge fund manager Kyle Bass reportedly bought $1 million worth of nickels. Why on earth would anyone want to own 20 million nickels? Let's work out the underlying logic of this trade.

A nickel weighs five grams, 75% of which is copper and the rest is nickel. At the time that Bass bought his nickels, the actual metal content of each coin was worth around 6.8 cents. So Bass was buying 6.8 cents for 5 cents, or $1.36 million worth of base metals for just $1 million.

To realize this 6.8 cents, Bass would have to sell the copper and nickel as metal, not coin. But liberating the actual metal from each token isn't so easy. Since 2006 it's been illegal to melt pennies and nickels down. As a regulated hedge fund manager, Bass probably isn't willing to break the law. Which means he'd only be able to realize the metal content of nickels indirectly, by on-selling them to a buyer who is willing take on the risks of melting nickels. That wouldn't be me, mind you. Five years in jail sounds like a long time.

At the right price, would-be smelterers will surely emerge out of the woodwork to buy Bass's stash. Say the prices of nickel and copper explode such that a nickel now contains 20 cents worth of metal. Bass should have no problems finding someone who'd pay him 12-15 cents for each of his nickels. Bass wouldn't be doing anything illegal, he'd just be selling nickels on to a stranger at a premium. And given that he only paid face value for each nickel, he'd be more than doubling his bet. 

So Bass has upside exposure to the next bull market in copper and nickel prices. The neat part of this trade is that he has no downside exposure. That's because a nickel can never be worth less than its face value of five cents. For example, consider that the price of base metals has fallen by quite a bit since Bass bought his stash of nickels. And so the melt value of a nickel has tumbled too, currently registering at around 4 cents, or 41% less than when he bought them. But Bass needn't worry. His nickels can still be taken to the Federal Reserve where they can be exchanged for twenty to the dollar, or five cents each.

Huge upside and no downside—why isn't everyone doing this trade? There's a catch. Carrying costs. Bass's trade has yet to pay off. A bull market in commodities hasn't developed. Which means that Bass has had to store 20 million nickels for eight years. But storing stuff isn't free. What follows is an estimate of the cost of doing so.


The first big cost that Bass faces is storage. His nickels take up a lot of space. Stacked one on top of the other, would twenty million nickels fit into a standard 20 foot freight container? Given that a container measures 8 x 8.5 x 20 ft, it has enough space to fit around 32,700 nickels per layer, 1,328 nickels high. That's room for 43,480,000 nickels—more than enough for Bass's hoard.

Stacking individual coins on top of each other isn't a realistic storage technique. Imagine the amount of time this would take. The industry standard for storing and handling large amounts of coins is using certified bags. According to the Fed, the standard bag size for nickels is $200, or 4,000 nickels per bag. In addition to bags, it also typical for banks to sell customers boxes filled with $100 worth of rolled-up nickels. Either bagged or boxed, there will be plenty of 'honeycombing,' or gaps between coins and packaging material.

Bass's hoard would be extremely heavy, far exceeding the capacity of a lone shipping container. Twenty million nickels weighs 100,000 kg, or 220,462 pounds. But a 20' container is only rated to hold 25,000 kg (55,120 lbs). Both the weight of the coins and the honeycombing effect mean that it could take as much as four freight containers to handle $1 million worth of nickels.

Bass could find a farmer who would be willing to store four freight containers in his field for a few hundred bucks a year. But he probably wants something more formal than that. One option is a warehouse. Warehouses charge by the pallet. A pallet can hold up to 4,600 lbs worth of goods, which works out to around 417,000 nickels, or 104 bags per pallet. Which means Bass will have to store 48 pallets of nickels. 

I searched around a bit and found that warehouses generally charge a monthly fee of anywhere from $5 to $20 per pallet. There are a lot of variables that can affect this amount. If the pallets are stackable, and thus take up less floor area, then the monthly fee will be less. Location of the warehouse is another factor. Securing space in the vicinity of New York costs more than Des Moines.

Coins on a pallet at the Federal Reserve (source)

Given that Bass has the flexibility to choose an out-of-the way warehouse (he doesn't need to access his inventory every few days), he should be able to get a cheap deal. Let's assume $5/month per pallet. With 48 pallets of nickels, that works out to around $2875 per year, or 0.29% of the total value of his $1 million stash.

Over eight years, that works out to $23,000. So after storage costs, Bass's $1 million in nickels has dwindled to just $977,000.

Bass probably wants to insure his nickels for theft and damage as well. Commercial property insurance seems to cost around $750 per year for each million dollars insured. Over eight years, that's $6000, which brings Bass's stash of nickels down to $971,000.

The last major cost is foregone interest. Instead of investing his $1 million in Treasury bills, Bass is keeping his wealth inert in warehoused nickels. Interest rates have been pretty low for the last decade, which means that Bass has only given up around 0.1 to 0.15% per year in interest income, or $1500. So for the period between 2011 and 2016, he would have given up about $9,000 in interest. That brings the value of his nickles down to $962,000.

But in 2017, Treasury bill rates began to rise, hitting 1%. At today's t-bill rate of around 2%, Bass is giving up $20,000 per year to invest in 0%-yielding nickels. Ouch. Interest costs from 2017 and 2018 mean that Bass's nickel stash has effectively dwindled to around $930,000.

So as you can see, even though Bass doesn't have to worry about taking a capital loss on his stash of nickels, the ongoing grind of carrying costs means that it's been a pricey trade. In eight years he's down by around $70,000, or 7%. In the end it could still all be worth it. If base metal prices triple, he'll still be able to make a lot of money on his initial investment. And I'm sure they will triple... at some point.


I've described the nickel trade from Kyle Bass's perspective. But let's view it from the perspective of the taxpayer. The U.S. Mint and the Federal Reserve (and therefore the taxpayer) are providing Bass with the opportunity to win big while offering him protection him from capital losses. In options lingo, they've sold him a put option. Is this a smart thing to do? Bass's isn't an isolated trade. For every Kyle Bass there are probably dozens of others trying the same thing. So the stakes aren't small.

The taxpayer is not providing this put option for free. There is at least some quid pro quo. In choosing to hold $1 million in nickles, Bass is effectively loaning money to the government at an interest rate of zero. If Bass had chosen to hold $1 million in Treasury bills instead of coins, the government would have to pay him 2% a year in interest, or $20,000. Coins don't yield interest, so the government needn't pay Bass a cent for his loan. We can think of the $20,000 in interest as the fee or compensation that tax payers get for providing Bass with downside protection on his speculative bet on metals prices.

But is the government extracting enough out of Bass for the trade? When interest rates were still at 0.1% a few years back, and Bass's yearly interest costs were a mere $1,000, Bass was probably getting the better end of the deal. But with rates at 2%, it's not so obvious who is coming out ahead. Whatever the case, should the government even be in the business of providing principle-protected commodity bets to citizens? Aren't exotic financial bets more Goldman Sach's game? 

One way for the government to extract itself from these bets would be to reduce the commodity value of the nickel. Put differently, it can debase the coinage. The last time the U.S. debased the nickel was in 1965 when it stopped minting them with silver.

The U.S. Mint could carry out a debasement by switching to steel, which is cheaper than copper/nickel. With a lower metal value, the nickel would be much less inviting for Bass and other speculators. He'd need a much bigger bull market in metals prices before he'd be able to break even.

Or maybe the U.S. could adopt plastic nickels, like Transnistria.

Whether steel or plastic, the key is to avoid an possibility of being Bass's dupe.

An even better way to avoid being the dupe? The nickel is monetary pollution. Let's just get rid of it. It made sense to have a five-cent coin back in the 1950s. A five cent coin back in the 1950s would have been worth about as much as a fifty cents, and fifty cents is a meaningful amount of money. You can buy stuff for fifty cents, say a cheap drink. But go to a grocery store today and try to see what you can buy for a nickel. Nothing.

Most nickels are used just once. Cashiers pays them out as change to customers, and from there they go straight into people's cupboards where they are forgotten. Or they get thrown in the trash. Or they're hoovered up by speculators like Kyle Bass. All of this is socially wasteful behaviour. Bass's speculation is no exception: the resources he consumes storing nickels could be put to far better use. Let's put an end to all this waste by ceasing to produce five-cent coins.