The Watergate banknotes

Cash isn't quite anonymous, it's anonymous-ish.

To illustrate this, a few years ago I wrote about the 1932 Lindbergh kidnapping case. The ransom was paid in gold certificates, not Federal Reserve notes. By coincidence, the U.S. went off the gold standard the next year, and all gold certificates were called in. So when the kidnapper spent some of his gold certificates in 1934 to buy gas, his purchase was odd enough to out him to the authorities.

I recently stumbled on a more recent example of cash de-anonymization. Most people know the gist of the Watergate scandal, but to recap five burglars were caught breaking into Democratic headquarters at the Watergate building on June 17, 1972.

Who were they and what were they doing there? At first, no one had a clue. But the police did find around $3,600 in cash on them, much of it in sequentially-numbered $100 banknotes. See the serial numbers below:

Testimony of Paul Leeper, May 1973, Hearings Before the United States Congress, House Committee on the Judiciary [source]

A series of sequential banknotes meant that the cash had come fresh from the U.S. Bureau of Engraving and Printing, the agency that produces banknotes on behalf of the Federal Reserve. The new notes would have been sent to a bank which in turn distributed the notes in their original sequential order to customers.

The serial numbers of the Watergate notes also gave a geographical sense of where they had been issued. There are 12 regional Federal Reserve Banks. Notes beginning with F are issued into circulation by the Federal Reserve Bank of Atlanta, those beginning with C by the Federal Reserve Bank of Philadelphia.

Two days after the break-in, FBI agents contacted these two district banks for more information. It turns out, Federal Reserve Banks do keep track of banknote serial numbers. The Philadelphia Fed informed agents that the notes in question had been shipped to a private bank, the Girard Bank & Trust in Philadelphia, while the Atlanta Fed had shipped theirs to the Republic National Bank in Miami. 

Unfortunately, the two commercial banks did not record the serial numbers of the bills that they had distributed to the public. However, one of the burglars--Bernard Barker--happened to have an account at the Republic National Bank in Miami. (The trail to the Girard Bank & Trust turned cold).

Scanning through Barker's bank information, investigators discovered that several months before five large deposits had been made into his account. This included four checks totaling $80,000 drawn on a Mexico City bank and one for $25,000 from a Miami bank. These funds were eventually traced back to the the Committee to Re-Elect the President, an organization created to help raise funds for Nixon's upcoming election campaign.

And there was a smoking gun. A money trail from the pockets of the Watergate burglars to the President's administration. The burglars, it was further discovered, had been hired by Committee to Re-Elect the President to wire-tap Democrat party phones and photograph documents. So the President was spying on his political enemies.

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There is an interesting sidebar to this story. Two days after the break-in, Senator William Proxmire, chairman of the Financial Affairs Subcommittee, contacted the Fed for information about the banknotes. In a book published in 2008, economist Robert D. Auerbach accused Arthur Burns, Nixon's appointee to lead the Fed, of refusing to cooperate with Proxmire's requests. Presumably Burns wanted to protect his boss.

In his book, Auerbach cited the following internal document, a timeline of the Federal Reserve Board's actions after the Watergate break-in. It is available in the Arthur Burns papers in the Gerald R. Ford Presidential Library:

Congressman Ron Paul aired Auerbach's allegations in front of Congress in 2010. An investigation was soon initiated by the Office of the Inspector General, an independent body that conducts oversight and audits of the Federal Reserve. In 2012, the OIG exonerated Arthur Burns and the Fed. The report noted that Burns was complying with FBI requests to avoid sharing the information lest this interfere with the investigation.

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So banknote users are never entirely anonymous--the serial numbers can be used to unveil who they are. In Watergate's case it was a fairly blunt tool. The notes could only be traced to the burglar's Miami bank, not to his account.  But if tellers at the Republic National Bank had been dutifully recording the serial numbers of notes they gave to their customers, the tool would have been much more accurate, pinpointing Barker as the direct source of the Watergate banknotes.

No bank teller want to tediously record numbers by hand. But in today's world, it is technically possibly for ATMs to record banknotes using built-in serial number readers. Is this actually happening? I am pretty sure that serial numbers are not being collected by North American banks. People would be furious about potential invasions of privacy.

But not so in China. Since 2013, Chinese ATMs and tellers are required by law to record the serial numbers of all banknotes. (I am not sure if the same law applies to Hong Kong):

Even cash can be tracked. The Chinese government has required bank tellers and ATMs to record & log banknote serial numbers since 2013: https://t.co/dxZHRGAOHi pic.twitter.com/kCILa5ndOR

— John Paul Koning (@jp_koning) December 26, 2019

I snipped the above screenshot from a marketing brochure from Glory Ltd, a Japanese company that specializes in cash handling technology. Chinese laws surrounding banknote serial number collection have ostensibly been put into place to prevent counterfeit yuan from entering into circulation. But one could imagine this technology being used by the authorities to track licit money flows.

Say that a Chinese human rights activist deposits ten ¥100 banknotes into their bank account. The police might be curious about who is financing this activist. In theory, they could ask the People's Bank of China, the nation's central bank, to search the various serial number databases for the name of the owner of the bank account from which the ten ¥100 notes originally came. In this way an anonymous cash donation could be de-anonymized.

Chinese citizens who use cash in potentially risky transactions have probably already devised a solution. They can evade serial number sniffing by going through an extra step of "mixing" their cash prior to spending it. This might involve breaking up the notes in a few shops prior to passing them on to the intended recipient. Of course, this trick will only work as long as retailers are not required to install their own note-reading hardware.

I often write about the contradictions of anonymous payments. It would have been great to catch Nixon's thugs with technology that completely de-anonymizes banknote movements. But it is abhorrent to know that human rights activists might be prosecuted using this same technology. Striking a balance is difficult.

Buying coffee with Tesla shares

It's fascinating to see how brokerages these days are offering no-commission trades, fractional share ownership, and debit card-linked accounts. With this combination of features, maybe we're getting closer to the day when we can buy a $2.50 coffee with 0.007 Tesla shares.

Right now, a debit card purchase can only proceed if there are uninvested cash balances in the linked-to account. But what if the securities held in your brokerage account could also be debit-cardized?

Imagine going to Tim Hortons, ordering a double double, and paying with your RobinHood MasterCard debit card. Behind the scenes RobinHood, an online brokerage, checks your account. All you own is a few shares of Tesla. RobinHood won't actually transfer the shares to Tim Hortons. Instead, it quickly sells a small fraction of these—0.007 shares—for $2.50 cash.

Since RobinHood doesn't charge commissions, selling the shares costs you nothing. MasterCard signs off on the transaction and presto, you've got your coffee. You own 0.007 fewer Tesla shares while Tim Horton's will soon get $2.50 in cash from RobinHood.

Stock markets aren't open on the weekend. So what happens if you want to buy groceries on Sunday? Maybe you've got 2.1 shares of Tesla in your RobinHood account. They were worth around $825 at Friday close. Something catastrophic could occur over the what remains of Sunday, but RobinHood is pretty sure that come Monday morning, those shares probably won't be worth less than $500. And so it will allow you up to $500 in weekend debit card payments. When the market opens on Monday it sells whatever Tesla shares are necessary to settle up your grocery purchase.      

If the option of paying with volatile assets like Tesla were to be widely adopted, you'd expect traditional banks to get into the game. Right now banks offer deposits denominated in fiat units like dollars or yen or pounds. But there's no reason they couldn't provide Tesla-denominated checking deposits. The fact that banks don't do this is a good tip-off that there isn't a very big demand to make transactions using volatile instruments.

Why do people prefer to pay for things using stable instruments rather than volatile ones like Tesla shares? My guess is that it has something to do with FOMO.

Given a choice between paying with their regular bank debit card or a RobinHood card, most people will choose their regular card. Spending away Tesla shares could mean that they miss out on a potentially big jump in price. But spending away fiat-denominated deposits doesn't produce any negative emotions, since deposits can always be replaced at the exact same price come next week's paycheck.

(As I suggested last year, this is a weird example of Gresham's law, where lottery-type instruments like Tesla don't get recruited as money because the market puts less value on them than a hopeful individual does.)

If no one wants to use Tesla shares to buy coffee, they might prefer to set up their RobinHood debit card to sell lower-risk securities. For example, a RobinHood customer could have their card draw down on a bond ETF like the iShares Short Treasury Bond ETF (SHV), which primarily invests in US Treasury bills.

Since SHV's price hardly fluctuates, anyone who uses SHV units to buy coffee needn't fear missing out on a big payday.

At the same time, they'd earn far more than they would on checking account. SHV currently pays around 1.68%, which after a 0.15% management fee comes out to around 1.53%. That's about the rate you could get on a high-interest saving account, which aren't usually designed for everyday spending.

Will this sort of debit-cardization of stocks & ETFs ever happen? I don't know. There could be regulations that prevent the practice, or maybe some sort of hidden cost that makes it too expensive. On the other hand, cryptocurrencies and gold have already been debit-cardized, the gold and bitcoins being sold the moment that a card purchase is initiated. I don't see why it wouldn't be technically possible to do the same with other exchange-traded liquid assets like stocks.

Crypto-linked cards haven't been very successful, probably due to the FOMO problem I mentioned earlier. (Last year, Coinbase shut down its Shift crypto card). Tesla shares would probably suffer from the same. But a low-risk ETF held in a Robinhood account wouldn't be quite so hobbled. 

Bitcoin and sanctions

I recently watched a video with Alex Gladstein on the importance of financial privacy. In general I agree. We should be working on expanding the scope for transacting privately, although I am conscious of the tradeoffs. Anonymity helps good people evade bad rules, but we need to be wary of how it abets bad people evading good rules. (See for instance my recent post on the good & bad of using prepaid debit cards to donate anonymously).

In the above list, Gladstein intimates that bitcoin has a positive role to play in evading U.S. sanctions. I have two quick points to make.

I mean, there are U.S. sanctions that I agree with and those that I don't agree with, and I'm sure the same goes for Gladstein. I hope that the sanctions that I agree with are in fact the morally justified ones, and the ones I don't agree with are the immoral ones. By my reckon sanctions on the apartheid regime in South Africa were justified, and same with the ones on North Korea and Zimbabwe government officials. Those on Cuba and the recent ones on Iran are not.

One (admittedly-blunt) sorting mechanism for determining the morality of U.S. sanctions is how much international consensus there is on levying them. If plenty of nation's support sanctioning a regime then the odds that the target is a genuinely bad actor are higher than if just the U.S. thinks so.

Trump's recent round of Iran sanctions has almost no international buy-in. America's European allies are furious that the U.S. left the Iran nuclear deal, a carefully negotiated agreement to control Iran's access to nuclear technology. The Chinese and Russian are upset too. On the other hand, Obama's earlier round of Iran sanctions had broad support. Even Russia and China were on board.

So if consensus is a reasonable hurdle for judging sanctions, then Trump's Iran sanction don't pass muster, but Obama's passed the smell test.

All of which is to say that if bitcoin is indeed an effective tool for evading the current round of Iranian sanctions, then it had a negative role to play as spoiler to the previous round of "good" sanctions. Bitcoin might have delayed (or prevented) the 2015 Iran nuclear deal that did eventually emerge. Which would have been unfortunate.

If we do care about the morality of sanctions, bitcoin doesn't really solve anything. We need to get the sanctions correct at the outset. Don't like Trump's Iran sanctions? Try to convince your neighbours about it. Tell your American friends. Go to a protest. Dial up your government representative. Yep, it's an incredibly blunt tool. But it's the best we got.

The second point I want to make concerns how useful bitcoin actually is as a sanctions buster. In his presentation Gladstein mentions Ziya Sadr, an Iranian who can't use Visa or PayPal but can use bitcoin.

I CAN'T use Apple pay/PayPal/Visa/Master or anything like them

I'm from Iran

I CAN use Bitcoin

What do you have to say?!

— Ziya Sadr (@Ziya_Sadr) July 5, 2019

Sure, Bitcoin may give some tech-savvy Iranian freelancers a means to connect to external buyers. But it hasn't helped where it really counts. It hasn't allowed Asian refiners to keep buying Iranian oil or European manufacturers to keep their factories running. Pretty much every foreign company has stopped dealing with Iran. As a result, the nation's oil exports have cratered and its economy has gone into a tailspin. This has had a tremendously negative effect on regular Iranians.

Let's not just single out bitcoin for being ineffectual. The euro, the world's second largest currency, has also been a useless sanctions buster.

Last month I wrote a post about why U.S. sanctions are so effective. Let me give a brief recap. A foreign company--say a European refiner--currently has to choose between continuing to buy crude oil from Iran or no longer accessing U.S. markets. This means not only being shut off from U.S. energy exports, but also doing without U.S refining technology, expertise, and financial access. Any refining executive who ignores the sanctions could be blacklisted from entering the U.S. for travel, or sending their kids to U.S. schools, or getting U.S. medical care.

Source: BBC

And so given an explicit choice between the US and Iran, most companies have chosen the US, since it has much more to offer. In our globally interconnected world, the population of willing-to-be-sanctioned companies is pretty much non-existent.

Having some sort of alternative money like euros or bitcoin doesn't provide much of a work-around.

Say that our European refiner decides to do a bit of business with Iran under the table in euros (or bitcoin) rather than dollars. All sorts of people will touch this transaction, not just the payment side but also the movement of crude. A banker, a bitcoin exchange, or a freighter captain could rat the refiner out to the US Justice department. And so the refiner would be fined or even worse blacklisted, which would means losing all access to US resources. The risk is simply too high.

In sum, the case for bitcoin as a sanctions buster is not clear-cut. Genuine evil leaders probably should be sanctioned, the less ways to short-circuit the blockade the better. And given the way that U.S. sanctions are structured, bitcoin may not provide much help anyways.

A way to make anonymous online donations

Paying for things online usually means giving up plenty of privacy. But this needn't always be the case. Last night I donated to a local charity via their website and didn't have to give up any of my personal information.

The trick for achieving a degree of online payments anonymity? Not bitcoin, Zcash, or Monero. I used a product created by old fashioned bankers: a non-reloadable prepaid debit card. (I wrote about these cards here and here).

Had I used a credit card or PayPal, all sorts of parties would have gotten access to my personal information including the site owner, the payments processor, my bank, the site owner's bank, the credit card networks, my partner, and many more. To get a good feel for how many different parties touch an online payment, check out this graphic by Rebecka Ricks, which shows how PayPal shares your information.

A powerful visualization by @baricks showing how PayPal shares your data: https://t.co/vd8w8d8xn6 ht @akadiyala

Due to Europe's new privacy laws, PayPal is obliged to make this information public: https://t.co/xmOpfXkNGG pic.twitter.com/vMTQCRfdLA

— John Paul Koning (@jp_koning) August 31, 2019

I bought my prepaid card--a Vanilla card--with $25 cash at a pharmacy. For it to be usable online I had to register it at Vanilla's website. That meant inputting my postal code. But that's all the information that Vanilla asks for. In my case I used my actual postal code, but I doubt that the system would have protested if a privacy-conscious user were to submit the wrong one.*

So at this point I've got a fully-loaded online-enabled card that has not been directly fed any information about my identity. (Note that this is how the process work in Canada. It may be different in the U.S. and elsewhere).

Next step, choose a charity. At the charity's website I entered my Vanilla debit card number, the CVV, and $10 as my amount to donate. The site also asked me to enter the name on the card. Because a prepaid card only says "For You" on it and not your name, just enter that or John Doe. Voila. Payment made:

Why on earth would anyone want to make an anonymous online donation? For my part, I was simply experimenting with my prepaid card. But I can think of several licit reasons for why people might want to donate anonymously with prepaid debit cards:

1. Many people share bank accounts. They might not want their partner to know that they are donating to a cause that their partner might not support.
2. A donor may not want the donee to know their identity lest the donee use it in a way that hurts the donor. For instance, if in public life I am a well-known conservative Evangelical, but I donate to a cause (say abortion education) that I privately support, I might prefer avoiding any chance that the donee leak my information in an attempt to 'out' me.
3. I like the charity, but don't trust it or its chosen payment processors to protect my information from hackers.
4. I don't want the charity to have my information so it can't inundate me with spam.

If non-reloadable prepaid cards can meet people's legitimate privacy needs, there is also a nefarious side to them. Anonymity allows people to evade rules about donations. For instance in Canada, there is a certain type of donation that is highly regulated: political donations. Below I've listed a few keys regulations:

• No cash donations above $20
• No anonymous donations above $20
• The identities of contributors that have given $200 or more must be reported to Elections Canada, which will publish them
• No single individual can contribute more than $1600 in a year.

Canadians have good reasons for supporting these limits. We don't want wealthy people to have an outsized influence on politicians. And we want donations to be transparent so we can see how politicians might be influenced by certain donors.

I can imagine plenty of scenarios in which motivated donors may want to break these rules. Say that a set of business owners in the restaurant industry stand to profit if the Liberal candidate wins because she supports removing regulations that increase restaurant operating costs.

After legally donating $1600 to the Liberals, some less savoury restaurant owners might want to illegally funnel more funds into party coffers. Cheques, credit cards, and other banking routes would be too risky. They establish a clear connection between the owner's identity and the donated funds.

A motivated restaurant owner can instead use $10,000 in cash to buy prepaid debit cards. They then go to the Liberal's website and donate $199.99 fifty times (for a total of $9999.50) using bogus names like John Doe, Jane Doe, etc. Since each transaction is under $200, they won't trigger the rule that requires such donations be reported to Elections Canada. And the Liberal Party probably doesn't have the capacity to cross-check each of the fifty payees to verify that they are associated with real identities.

This rinse-and-repeat strategy highlights one of the ambiguities of prepaid regulations. To reduce the potential for fraud and money laundering, regulators in Canada and the U.S. disallow non-reloadable prepaid cards with a face-value in excess of $500 (I believe that's the number). But since these cards are relatively anonymous, there's nothing preventing a would-be fraudster from using multiple cards to get around the cap.**

In any case, I'm not saying that this sort of donation fraud is occurring. But it's plausible. There's a reason that gift card and prepaid card fraud is rampant in North America. The relative anonymity that cards offer makes them a tempting tool for criminals.

As always, there is a yin/yang nature to anonymous payments. Anonymity is great when it protects well-meaning people from harm, but not so great when it protects bad people from good rules. Striking a balance is tricky.

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* To access Vanilla's website, I had to disable my tracking blocker. Which means that the website probably has all sorts of processes going on in the background while a Vanilla user enters their postal code. These processes could link the user to their identity by cross-referencing the data gleaned by Vanilla's trackers against other data that has been collected elsewhere. This is probably an issue for these who want all-out privacy, and steps would have to be taken to mitigate information leakage. As they say, there is probably no such thing as pure anonymity, only degrees of anonymity. But for anyone who simply wants to enable a prepaid card in order to prevent their partner or the donee from seeing their transactions, then it's probably not a big deal.

**The way to nip donation fraud in the bud would be to require payment processors to avoid processing any prepaid debit card payment for political parties, or to limit cards to some inconvenient amount like $5 so that a rinse-and-repeat strategy is too costly to perform. It is possible that this tactic has already been adopted by payment processors.

Mooning over daylight overdrafts

Every few days for the last month or so I've been refreshing a Federal Reserve page that shows data about daylight overdrafts. For some reason the Fed only updates it every few months. I had been getting quite curious to see what happened during the great September interest rate spike. Well, finally the Fed has uploaded the data.

If you don't know about the September rate spike, I'd suggest reading Nathan Tankus's tweet, listening to David Beckworth's podcast with Bill Nelson, or picking through this blog post from Stephen Cecchetti and Kermit Schoenholtz. In short, there was a sudden increase in the demand for Fed balances (also known as reserves), and the Fed was slow to react by increasing the supply of balances. And so the rate at which banks were willing to borrow balances spiked to desperation levels.

Why did the demand for balances increase?

That's where daylight overdrafts can inform us. By way of background, the Fed has had a long-standing policy of providing banks with daylight overdrafts. These are loans that last a few minutes or hours and are always paid back by the end of the day.

Why overdrafts? Banks often have to make large and unexpected payments to other banks on behalf of their customers. To facilitate this, banks keep balances on hand in payments accounts held at the Fed. For instance, say that Microsoft wants its bank to wire $200 million to Google. Microsoft's bank tells the Fed to debit its account and credit the account of Google's bank by $200 million.

But say Microsoft's bank only has $50 million in its Fed account. How can it make good on Microsoft's request? No problem. It gets a $150 million overdraft from the Fed. Combined with the $50 million it already had, it can now make the $200 million payment to Google's bank. Microsoft and Google are square, but Microsoft's bank still owes the Fed $150 million. Over the course of the day, Microsoft's bank may get enough incoming payments from other banks to settle up. (Or it may have to sell some assets to pay back its overdraft, or borrow from another bank to make good with the Fed).

Banks have to pay a fee for each minute that they borrow from the Fed. They can avoid this fee by providing collateral to secure the loan. Collateralization protects the Fed from fallout should a bank that is in overdraft go bankrupt. Either way, overdrafts are costly to banks. Fees must be coughed up or collateral sacrificed.

In the 2000s, the Fed kept a tight lid on the supply of balances it issued. Banks couldn't keep very much money in their Fed accounts--there just wasn't that much of it. So there was a big demand to get daylight overdrafts from the Fed to facilitate payments like the one between Microsoft and Google.

But during the credit crisis, the Fed created a massive amount of balances. Suddenly, banks could (and did) keep a lot of money at the Fed. And so when Microsoft wanted to pay Google $200 million, Microsoft's bank just didn't have to rely on overdrafts anymore. Odds were that it already had the money in its account. Overdraft usage cratered, as the chart below illustrates. Whereas peak Fed daylight overdrafts typically came in near $250 billion in 2008, by 2013 peak borrowing by banks typically registered below $10 billion.

(Note, to bring out the data I have used a log scale for this chart, which may not entirely convey the degree to which overdraft usage collapsed.)

Which leads back to the September jump in demand for Fed balances. One potential explanation is that banks are concerned about holding sufficient liquidity in anticipation of customer payment requests. Perhaps banks are running into more situations in which they can't immediately satisfy Microsoft's request to pay $200 million to Google, and so they want to build up the amount of balances they keep in their accounts at the Fed.

But if this was the case, we'd also expect to see a big jump in overdrafts. After all, overdrafts are an alternative way for Microsoft's bank to satisfy Microsoft's payment requests. The chart above shows that peak daylight overdrafts clocked in at $19 billion during the two-week period ending September 25, the highest level since 2013. But that's still a tiny amount compared to $250 billion in 2008.

So the big jump in the demand for Fed balances probably arises from something other than a desire on the part of banks to facilitate routine intraday payments flow. Banks still aren't making much use of daylight overdrafts, a good indication that they still have plenty of balances on hand for transactional purposes. Other motivations must be behind the demand for Fed balances, presumably various regulations that might not have existed in 2008 or increase supervisory expectations.

In-game virtual items as a form of criminal money

A few weeks back Vice had an interesting story about Valve, a game maker, putting an end to trade in various in-game items because "worldwide fraud networks" had been using these items to "liquidate" their gains. You can see the blog post from Valve here:

"Why make this change? In the past, most key trades we observed were between legitimate customers. However, worldwide fraud networks have recently shifted to using CS:GO keys to liquidate their gains. At this point, nearly all key purchases that end up being traded or sold on the marketplace are believed to be fraud-sourced."

Having not played a video game since the original Super Mario Bros, this all sounded all very strange to me. But I couldn't resist digging a little deeper. After all, strange media-of-exchange are a major theme here on the Moneyness blog.

Let's set the stage. Anyone who plays Valve games can access something called the Steam Community Market. Players can go to this market to buy and sell in-game items from each other. So for instance, a Counter-Strike: Global Offensive game player may want to buy (or sell) a "skin" which is a texture that can make their gun look fancier. Some skins are apparently quite rare and valuable.

To make a purchase, players will need to have some funds in their Steam Market wallet. Wallets can be funded by credit card or a gift card. The catch is that once funds are on Steam, they cannot be directly transferred to other players. I can't send $100 in Steam balances directly from my Steam wallet to my friend's Steam wallet. Funds can only be used to buy items from other players. Furthermore, there is no way to cash-out of the system. Once money is deposited into Steam, it never leaves.

Now let's get to the fraud stuff, and we'll circle back to Steam later. Say that I'm a fraudster. My shtick is to dial up corner stores, claim that there is a bomb hidden in one of the aisles, and ask for a ransom of $5000 or I will set it off. The store owner has 30 minutes buy five $1000 MoneyPaks, then text me their PIN numbers. Upon which I quickly load the funds into my reloadable Green Dot prepaid debit card, the bomb being a hoax. (I kid you not, this is a true story).

Below is another variation of the scheme, the fraudster claiming to be law enforcement:

Bitcoin extortion scams are all the rage, but other semi-anonymous payments options like Green Dot prepaid MoneyPak cards will do in a pinch: https://t.co/gT2eEItrOw pic.twitter.com/xJCG1W1iDs

— John Paul Koning (@jp_koning) September 11, 2019

There are many versions of these prepaid scams.

In any case, say I pull this threat off fifty times. This leaves me with $250,000 and a pile of prepaid cards. The Green Dot cards aren't linked to my identity, so I needn't worry. But I really want to do something with my money, say buy a house. To do so I will somehow have to get the $250,000 into my bank account, and probably quickly before the money gets frozen. How do I do this safely? Obviously I can't just directly transfer the money from my card to my account. The authorities will connect the dots pretty quick and arrest me. I need to obfuscate the transaction chain.

And that's presumably where Valve's Steam Community Market comes in. If I can send the stolen funds through a market like Steam, maybe I can throw off anyone who comes after me.

First, I go to as many drug stores as I can and use my prepaid cards to buy up Steam gift cards. I'd have to buy around 500 or so $500 cards. And then I upload the $250,000 in card value to a bunch of online Steam accounts that I've created.

Remember, Valve doesn't allow for cash-outs, so the money is effectively frozen in Steam. This is where the items listed on the Steam Market come into play. I now buy $250,000 worth of skins or some other digital knick-knack. These items are now my get-out-of-jail card.

I proceed to sell the items I've stockpiled to other players who desire them for legitimate in-game use. The important thing here is to get actual dollars in return, not Steam dollars. I won't use Steam's in-game market for this, but third-party venues like OPSkins, Bitskins, or Skins.cash. Each of these sites provides an external trading venue where buyers and sellers of in-game items can meet and advertise prices. They also offer a wallet and escrow service to ensure neither buyer nor seller scams the other.

Since I'm in a rush to sell my virtual items, I'll probably lowball my prices on OPSkins, which means I may only get $150,000 for the original $250,000 I've spent. This is a great deal for regular game players. They don't have to fund a Steam account with, say, a $100 credit card transfer. Instead they can buy items from me for $70 on OPSkins and sell them on Steam for $100, saving themselves $30!

I then have OPSkins wire the $150,000 I've earned to my genuine bank account. And now I buy a house. Voila, I've hidden the source of the my money by running it through Steam. Somewhere between converting my prepaid funds into Steam gift cards, and then buying digital items with them, and then selling them, a would-be law enforcement agent will likely lose my scent.

Now that's roughly what I think that Valve is talking about in its blog post when it talks about "fraud networks", add or subtract a few steps. I wouldn't know, I'm just a writer.

What about Valve's response to the fraudsters? From what I gather, one of the most liquid items on the Steam Market are Counter-Strike: Global Offensive (CS:GO) keys. The price of keys is quite stable. Valve sells them at a fixed price, whereas the price of other goods are set by the Steam community, and fluctuate. And so keys have become a sort of currency. By adopting keys as their exit route, fraudsters would have made them even more liquid, and thus better capable of serving as a medium of exchange.  

Valve's defence is to freeze keys. "Starting today, CS:GO container keys purchased in-game can no longer leave the purchasing account," it said. This effectively cuts off any fraudster from existing the system... via the key route. However, there remain many other CS:GO items that folks can buy on Steam and sell on third-party exchanges like OPSkins. And there are other games that provide in-game items, like Dota 2 and Team Fortress 2. One wonders if some other item will become a go-to digital currency for fraudsters now that the CS:GO key route has been terminated. On Reddit, a few players speculate that Dota 2 Arcanas will take the place of CS:GO keys.

Usage of in-game virtual items as a bridge currency of sorts isn't without precedent. When conditions are right, instruments that we don't traditionally use as money, like CS:GO keys, get recruited for that purpose. Usually this occurs because there is some sort of hurdle or friction that prevents mainstream media-of-exchange from functioning, and only an exotic instrument can overcome that speed bump.

Equities are one of the more common exotic media-of-exchange. For instance, to avoid exchange controls Zimbabweans have traded in the inter-listed shares of Old Mutual, lifting them from the Zimbabwe Stock Exchange to London. Argentinians used American Depository Receipts in 2001 to dodge the "corralito". I wrote about both of these here.

More recently, gold was recruited as a payments rail for evading Obama's sanctions.

Heck, even I'm guilty. In Canada, retail foreign exchange conversion fees are ridiculously high thanks in part to our banking oligopoly. So I use Norbert's Gambit to get around the blockade. The gambit involves using dual-listed stocks or ETFs as a bridging asset between U.S. dollars and Canadian dollars. Debit card fraudsters are doing the same when they use CS:GO keys as a go-between asset for cleaning their money.

The desire to engage in trade is voracious. Blockades may be put up, but people will devise all sorts of ingenious monetary solutions for getting around them.

Notes from an inter-planetary monetary anthropologist

My work as an inter-planetary monetary anthropologist has brought me to dozens of different planets to study their monetary systems. The monetary system of the most recent planet that I visited, the planet of Zed in the Xv2 galaxy, falls into the same classification as the systems on Vigil X and Earth (which I last visited in 1998 and, according to other anthropologists, hasn't changed much).

As on Earth, markets on Zed tend to lie towards the free end of the spectrum. Zedians can own property. And property rights are enforced. Zedians often put their savings in institutions much like banks and earn interest. Banks in turn lend to individuals and business.

However, one of the oddities of the planet of Zed is that its inhabitants universally adhere to an economic religion, Zodlism. One of the strictures of Zodlism is that all monetary instruments must yield at least 2% interest. Even a transactional account, say like Earth's checking accounts, must offer the account holder a minimum 2% per annum.

This requirement is based on the Zodlist stricture that anyone who is temporarily deprived of an object to the benefit of someone else deserves a minimum reward for their sacrifice. Banks that fail to meet the 2% requirement risk censure from the planetary religious organism, the Zodl Council, and ostracism by customers. (For a full account of Zodlist economic doctrine, see Smith & Elf33, pgs 450-512).

Interestingly, banknotes (which on Zed are issued by all sorts of different institutions and individuals, unlike Earth which confines that role to central banks) also pay 2% interest. Each note has a sensor in it that records how much interest the note has accrued. Any Zedian can access unpaid balances by uploading them to their account or claiming them at a trading post when making a purchase. Zed is a little further ahead than Earth in this respect, which still hasn't bothered digitizing its banknotes.

While I was visiting Zed, the planet's economy was facing an unprecedented economic slowdown. With optimism sapped, borrowing on Zed had been plummeting. Zedians were simply too afraid about the future to take out loans to fund business expansion or enlarge their underground shelters. In response to this decline in loan demand, bankers had been trying to make loans more attractive to the Zedian public by pushing lending rates ever closer towards 2%. 

Bankers have even been entertaining the revolutionary idea of lending at rates below 2%, say to 1.5%.

This would leave Zedian banks and note issuers in an odd position. If they only earn 1.5% from borrowers while paying depositors the obligated 2%, banks would be effectively paying out more than they receive in interest. But this is the opposite of what banks are supposed to do! They would soon go out of business. (Any Zedian could make a risk-free profit by taking out a bank loan at 1.5% and depositing those funds at the bank to earn 2%.)

Pressure is building on Zed's religious leaders to alter the 2% rule. Some moderate Zodlists have proposed that a ceremonial 2% rate continue to be paid to depositors and banknote owners, but a fee be levied to claw back a part of the interest. So that if someone is paid 2 Zed in interest, the bank or banknote issuer will take back about half that in fees, ie. 1 Zed. This would allow issuers to 'synthesize' an interest rate of 1% while still conforming to the letter of Zodlism. Once this change is implemented, banks would be able to safely lend at 1.5% or so.

These pragmatists argue that at 2% per annum, borrowing it just too expensive for most people. The planet requires an interest rate of 1.5% if lenders are to be successful in luring the public back into taking on loans. They further argue that when would-be borrowers are priced out of the market, the downturn is exacerbated and prolonged. But strict Zodlists refuse to budge. The idea of earning just 1% on banknotes appalls them. "It's unnatural!" they cry.

The debate certainly reminds me of my time on Earth. Historically, Earth's religions also set limits on interest rates. But whereas Zodlism dictates a minimum interest rate on deposits, Earth tended to set a maximum rate on loans. These rules were referred to as usury laws. Perhaps Zed could learn from its distant planet, since Earth (or at least parts of it) saw it fit to end usury laws long ago. I feel like this softening is likely to happen. In their survey of 450 planetary monetary systems, LeGuin & Xsszym find that law and religious practices tend to bend to planetary economic exigencies. 

Unfortunately, I never saw the resolution to Zed's 2% debate. My ship had arrived to take me to the next planet. Perhaps I can come back one day to see if Zedians have solved the problem.

---

Addendum: In 2019 I returned for a quick return visit to Earth. Who would have guessed, but they are facing many of the same problems that Zed is experiencing!

"Controllable anonymity"

Reuters and Coindesk report that that the People's Bank of China's imminent central bank digital currency (CBDC) is going to have a feature called controllable anonymity. Perhaps some wires have been crossed in the translation, but it'd be hard to come up with a more Orwellian piece of double speak than this. Plenty of people on Twitter are sneering.

But in this post I'm going to take China's side, if only tepidly.

None of the news articles have made much of an effort to explain controllable anonymity. But we've actually known about this feature for quite some time. Back in 2018, the project's head, Yao Qian, provided a short description of it. It's not as Orwellian as it seems.

China's new CBDC, otherwise known as the Digital Currency Electronic Payment (DCEP) platform, requires users to provide their real identities when they sign up. In the link above Yao calls this real-name at back-end. So the People's Bank of China will be privy to the identity of each user. This is to guard against money laundering and tax evasion. So not much anonymity here.

The element of anonymity crops up in a different part of the transactions cycle. It seems that a payee will be able to control what sort of information they throw off to the counterparties that they are dealing with. Yao calls this voluntary anonymity, presumably meaning that payors/payees can volunteer how much of their personal information they wish to leak out to stores, suppliers, customers, or whatnot. This sort of fine-grained control over one's data isn't something that you can do with, say, a credit card. If I buy groceries at Loblaw, who knows what sort of personal information they are collecting about me.

Source: Technical Aspects of CBDC in a Two-Tiered System, by Yao Qian [link]

So the upshot is that China's CBDC will be providing a certain sort of privacy to users. Which reminds me about what Rodney Garratt and Morten Bech, two economists that specialize in payments systems, have written about payments anonymity. According to Garratt and Bech, there are two grades of payments anonymity. With third-party anonymity, a person's true identity is hidden from everyone who participates in a transaction, including the system operator. Banknotes are the best example of third-party anonymity, since the issuer—the central bank—has no idea who is using them.

Counterparty anonymity is less strong. This sort of anonymity prevails when personal information about the two counterparties to an exchange remain hidden from each other but the system operator is still privy to each user's identity. Yao's controlled anonymity presumably means that DCEP will provide Garratt and Bech's second sort of anonymity, counterparty anonymity.

Federal Reserve researchers like Charles Kahn, William Robers, and Jamie McAndrews have delved into the benefits of counterparty anonymity. The ability to cloak your information from sellers or payees reduces the risk of identity theft, the possibility that a counterparty might stalk you and rob you, or the odds of becoming a victim of direct advertising and other solicitations.

Here is Kahn:

"Suppose, for example, that I wish to make a perfectly legal transaction with a stranger but wish to ensure that there are no unpleasant ramifications down the road. It is not hard to think of examples where the information about the purchase of a good makes the individual vulnerable: a purchase indicating that the individual has high wealth, or a purchase that may be embarrassing, even if perfectly legal (certain medications, for example). More prosaically, making a purchase on the internet involves the revelation of identity in ways that make you subject to spam or harassment. In short, sometimes we want the ability to ensure that others cannot use the information in the history of our transactions against us."

Where does all this leave Chinese consumers with respect to payments privacy? It could be that they are worse off. If the People's Bank of China's new CBDC is being designed to replace cash, then on net Chinese citizens will lose the ability to transact in a way that is anonymous to all parties. Cash provides third-party anonymity, DCEP doesn't.

But it's also possible that Chinese consumers will be better off. If the new CBDC is designed as a complement to cash, then Chinese citizens may actually have more privacy options than before. Not only do they still have access to cash's third-party anonymity, but they also will gain strong digital counterparty anonymity. Surprisingly, this would mean that they will end up with more information-cloaking tools than us Westerners.

Once again I'm reminded of something Charles Kahn wrote. Privacy needs are different, so we should "expect a variety of platforms to emerge for specific purposes." In this context e-cash probably won't "play all the privacy roles that physical cash currently plays," says Kahn. It is possible that this multi-faceted approach to privacy is what is playing out in China.

From unknown wallet to unknown wallet

Antony Lewis recently published a useful article on stablecoins. In it he describes something called "permissioned pseudonymity". In traditional payments systems, people only get to access to payments services after opening an account. This requires that they provide suitable identification. So these systems are not pseudonymous. Usage and personal identity are linked.

Stablecoins operators, on the other hand, sever this link. Users can transfer stablecoins to other users without providing personal information. John Doe can pay Jane Doe, no questions asked. Antony calls this permissioned pseudonymity because regulators permit pseudonymous usage of stablecoin networks.

🚨 🚨 30,000,000 #USDC (29,926,581 USD) transferred from unknown wallet to unknown wallet

Tx: https://t.co/ujdi6cvpZ8

— Whale Alert (@whale_alert) October 9, 2019

The above payment is an example of permissioned pseudonymity. It is a $30 million transfer between two unknown wallets along the USD Coin stablecoin network. The operator of this network, Centre, may have no idea who did this transfer.

I do wonder how long regulators will allow pseudonymous usage of stablecoins to continue. Most of the rules surrounding payments emanate from the Financial Action Task Force (FATF), a global committee of regulators that meets together every once in a while to determine how to fight ghoulies like money laundering and terrorist financing. The FATF guidelines are in turn applied by local regulators in each country with some modifications, and monitored by FATF for compliance.

FATF regulations are supposed to be technology-neutral. In short, the same principles apply to new technologies and incumbent technologies alike. This makes sense. We probably don't want regulators to picking winners and losers by setting one set of requirements for companies A-E and another set for F-J. The competition for market dominance only begins after they've complied with the same rulebook.

So far FATF hasn't had much to say on stablecoins. But you can be sure that something is in the works, and it isn't likely to be good for stablecoin operators. The problem is that granting permissioned-pseudonymity to stablecoin operators contradict technology-neutrality. It sets one set of standards for bank accounts and another for stablecoins.

Banks are already obliged to collect the personal information of all their account holders. If two people transfer $30 million along the bank payments network, you can be sure that the banks who manage these accounts have already gone through the costly process of collecting personal information. 

5,000,000 #PAX (4,989,146 USD) transferred from unknown wallet to #Binance

Tx: https://t.co/IRjcUFh1bL

— Whale Alert (@whale_alert) August 14, 2019

Why should stablecoins like USDC and PAX be exempt from this obligation?

Antony suggests that stablecoins qualify for an exemption because they meet regulatory concerns through other sensible means. Because stablecoins use blockchains, and blockchains record transactions, the information trails left by pseudonymous stablecoin users can be traced and monitored for suspicious activity. The stablecoin issuer can then toggle a kill switch and freeze potentially dangerous addresses.

This makes sense. But if stablecoin issuers can avoid identifying its customers by implementing a process of monitoring and freezing, it seems to me that the incumbent technology, the bank account, should also be granted the same opportunity. After all, account-based systems can do kill switches and tracing just as well as stablecoins can.

For instance, say that Citibank were to set up its own pseudonymous account payments network, call it Citibank HushAccounts. Customers can open a HushAccount without providing personal information. They can then use the HushAccount network to trade balances pseudonomously to other account holders. Citibank bankers monitor HushAccount transactional patterns and freeze anything that looks odd. Personal information only needs to be provided when a user wants to cash out of the HushAccounts system.

Of course, we already know that Citibank can't implement HushAccounts. It's illegal. Which underlines my point about technology-neutrality. Why can a stablecoin like USD Coin get away with pseudonymity but Citibank can't?

Let me put it differently. If stablecoin issuers can get away with not collecting user ID, then expect to see Citibank make a few cosmetic changes to its traditional account-based system so that it qualifies as some sort of stablecoin blockchain thingy. And now that it needn't collect as much information about its customers, it can fire a bunch of its compliance staff. Other banks would copy it. Soon we'd get hyper-stablecoinization. Every bank account would be converted into a stablecoin. But FATF rules aren't supposed to favour any one technology.

So for the sake of maintaining neutrality, I wouldn't be surprised to see regulators put an end to pseudonymous stablecoin usage. Stablecoin issuers will only be able to give out addresses to people who have passed through some sort of know-your-customer process.

🚨 🚨 20,000,000 #USDT (20,113,052 USD) transferred from unknown wallet to unknown wallet

Tx: https://t.co/f7BTC2S6U4

— Whale Alert (@whale_alert) September 27, 2019

There's a second possibility. As Antony points out, there is one notable regulatory exception to universal identification in payments. In many parts of the world, people can buy prepaid debit cards (or in Europe, e-money) without providing any ID. This provides the card owner with pseudonymous access to the Visa or MasterCard networks. I've written about these cards before (in fact, it's one of the most popular posts I've ever written). You can also trek over to my article at Sound Money Project on the topic.

Stablecoins, like prepaid debit cards, might be granted their own exemption.

There is a caveat to pseudonymous prepaid access. Regulators have set a very low ceiling for the amount of pseudonymous value that prepaid cards or e-money wallets can hold. In the case of the U.S. it's just $1,000. (In Europe, it's just 150 euros). Anything above that and a prepaid card holder must submit identification. There are other limits too. In the U.S. the cards must be non-reloadable, and people can't use them for person-to-person payments, at ATMs, or for international purchases. This makes for an extremely constricted payments product.

Regulators believe that by keeping the pseudonymous prepaid ceiling low and reducing the features that a card offers, they achieve two things. The risk of money laundering and terrorist financing are minimized. At the same time the unbanked and those without ID still get access to the retail payments system.

If FATF were to allow stablecoins to offer a limited amount of pseudonymity, the ceiling for it would probably be quite low, much like prepaid debit cards. No more $30 million person-to-person payments, just $20-$2000 ones. After all, it's hard to make an argument for why genuinely needy folks without IDs would need to make million dollar stablecoin transactions. 

I should point out here that I'm not saying that I'm a fan of FATF and its mission to unveil every single transaction. I've written many times about the benefits of financial anonymity. And a lot of smart people that I read think that the cost of enforcing anti-money laundering rules far outweighs any benefits that it provides. All I am saying is that I suspect that permissioned pseudonymity for stablecoins isn't going to last very long, in its current form. It'll either be banned altogether, or a very low ceiling will be set on it.

---

P.S. If I had to predict, I'd go with a ban. It's easy to get around a ceiling. If the ceiling is set at $1000, then users can set up 1000 pseudonymous accounts in order to get $1 million in pseudonymity.

Bitcoin, 11-years in

Satoshi's first email [source]

Eleven years ago, Satoshi Nakamoto announced the bitcoin whitepaper to the world. Coinbase, a large cryptocurrency exchange, recently celebrated this milestone with a retrospective.

I'm going to remix Coinbase's narrative to tell a different account of bitcoin's last 11-years.

The thing that fooled us all for a while, myself included, is that we all thought bitcoin was solving a monetary or payments problem. It was labelled a coin, after all, and coins fall within the realm of monetary economics. To further complicate matters, Satoshi told his story using phrases like "electronic cash system" and "non-reversible transactions". Perhaps we deserve to be forgiven for not seeing bitcoin's underlying nature. After all, tearing down the existing monetary system and building a new one was a fresh and exciting narrative.

Anyways, Coinbase still believes this old tale. "As with other technologies, money has gone through many upgrades over the years," its marketing team writes. "Bitcoin is the latest breakthrough in a technology that’s millennia old."

What is now apparent is that bitcoin was never a monetary phenomenon. No, bitcoin is a new sort of financial betting game. It is a digital, global, highly-secure, and fairer version of the old-fashioned chain letter.

The premise behind bitcoin-the-game is that the current wave of buyers must guess when (or if) a subsequent wave of buyers will emerge, this second next wave's participation being contingent on when (or if) they believe a third wave of buyers to emerge. If they guess right, the early birds win at the expense of the late ones. And they can win a lot of money, as Coinbase points out in its post:

Source: Coinbase

Think of bitcoin as a pure mind game, a Keynesian beauty contest in which we "devote our intelligences to anticipating what average opinion expects the average opinion to be." Those old fashioned chain letters that you (or your parents) used to get in the mail were an early type of beauty contest. The price that Alice was willing to place on a chain letter was a function of whether she expected the next recipient, Bill, to play by the rules and send it on, Bill's expectation in turn depending on the odds that Jack would join the game.

But chain letters had a major flaw. The chain order could be easily compromised by a fraudster who miscopied the list and put their name at the front. Bitcoin fixes this by introducing robustness to chain letter-type games. Bitcoin's blockchain is an unbreakable public record of where in line game players stand. Altering this chain order would require tremendous amounts of computer power, as Coinbase illustrates in this chart:

Coinbase: Source

Bitcoin-the-game has been spectacularly successful. As Coinbase points out, it "went from an idea in 2008, and a first transaction in 2009, to over 27 million users in the US alone in 2019, or 9% of Americans." Below, Coinbase has charted the number of active bitcoin addresses that have been created over the years:

Source: Coinbase

Why did bitcoin-the-game succeed?

First, it's a fun and cutting-edge game. Many people dream of thrusting themselves out of financial obscurity into millionaire land. Bitcoin is a technologically-sophisticated way to get there. No one wants to play grandpa's lottery.

Secondly, the way that bitcoin is designed helps it spread. Most of the legacy financial games that bitcoin competes with (poker, lotteries, sports betting) are regulated by the government. Strict rules prevent game providers from reaching a wide audience. For instance, online casinos may be prevented from serving out-of-state players, problem gamblers may be banned, and those who are under 18 must be excluded. These financial games are usually centralized. This means they are hosted on a single website, or at a physical location like a casino, or by a government-run lottery corporation. Which makes it easy for regulators to shut down game providers who break the rules.

But bitcoin is different. Because it is a decentralized and digital financial game, it can't be regulated or shut down. And so it can serve the entire globe with impunity. Which it has done by spreading into every crack and cranny on earth. As is illustrated by another of Coinbase's charts:

Source: Coinbase

Based entirely on whisps and storms of psychology, the price of bitcoin is inherently volatile. Its core volatility has stayed pretty much constant over the last 11-years. Users should expect the same for the next 11 years. Even if more people join a Keynesian beauty contest, the average opinion of the average opinion will always be a fickle, inconsistent thing, and so price will always be jittery.

So what about bitcoin-as-money? Yes, people do use bitcoin for payments. But this gets dwarfed by its popularity as a financial game. The problem is this. Bitcoin payment functionality is implemented on top of a highly volatile chassis, a fun but fickle beauty contest. Which hobbles the effectiveness of the payments platform. Regular folks won't use the stuff to pay. They don't want the value of their spending stash to fall by 20% overnight. And game players don't want to waste their tokens on buying goods & services. That could mean potentially missing out on a life changing jackpot. That's why the promise of mainstream bitcoin payments has died a thousand deaths over the last 11 years.

That being said, the demand for bitcoin in economically volatile regions such as Venezuela has hit record highs. Coinbase suggests that thanks to inflation and capital controls, bitcoin is finally being used as the electronic cash for which it was originally designed.

Source: Coinbase

Coinbase could be right. In places like the U.S. with functioning monetary systems, bitcoin is just too awkward to serve as a payments alternative. But in places where monetary breakdowns have occurred, regular folks may be more willing to put up with the inherent pitfalls of transacting with bitcoin. And so we finally get to see bitcoin-as-money emerging.That's a good thing.

But bitcoin's popularity in Venezuela is also consistent with the bitcoin-as-game narrative. When people are desperate to improve their lives, they may have little other option but to roll the dice. In Run Lola Run, Lola needs to quickly make 100,000 Deutschmarks to save her boyfriend's life. She races to a casino and plays roulette. Likewise, in the face of societal collapse,  Venezuelans may simply be gambling on whatever potentially life-changing bet they can find. Bitcoin is one such a bet. Unwinding what portion of Venezuelan usage is due to bitcoin-as-game versus bitcoin-as-money is tricky.

Coinbase goes on to spout the typical cryptocurrency industry nonsense about legacy payments. It claims that "sending an international wire transfer by major US banks costs around $45, can take days to process, and can be done only during banking hours." And here is the chart it uses:

Source: Coinbase

That may be a good critique from ten years ago. But with SWIFT gpi having rolled out a few years back, multinationals can make near real-time cross border payments using the traditional correspondent banking system. For individuals and small businesses, fintech Transferwise offers instant remittances over fiat rails. These can settle on weekends in nations like the UK, which have real-time retail payments systems. I've touched on this before.

Continuing along with hyperbole, Coinbase makes the claim that bitcoin remittance fees are minimal compared to fiat. But this ignores the sizable foreign exchange fees that one must pay when converting fiat into bitcoin and back into fiat. I've gone into this calculus before.

What's next for Bitcoin? asks Coinbase in closing. Let me give it a shot. It's possible that bitcoin-as-game will stay popular for a very long time. And if it does, that could be a good thing. As I've suggested before, there is a demand as-such for financial games and bets, specifically early-bird bets. Compared to many of the fly-by-night games out there, bitcoin provides a fair and trustworthy option.

What about the original vision that got us all so excited, bitcoin-as-money? Crippled by bitcoin's game-based engine, bitcoin payments are probably never going to move beyond the niche role that they currently occupy. That's better than nothing. When those on the fringes are temporarily cut off from the conventional payments system, they'll always have an option for making transactions. It might not be a user-friendly option, but at least it's there.

Is the strength of U.S. sanctions due to U.S. dollar hegemony?

I often hear the idea that the U.S. dollar is the means by which the U.S. implements sanctions. And since the U.S. dollar pervades all corners of the globe, the U.S. government's sanctions are uniquely powerful. For instance, Reuters reports that Russian resource giant Rosneft is shifting all its contracts over to euros in order to "shield its transactions from U.S. sanctions."

Another version of this idea was recently floated by David Marcus, the head of the Libra payments project:

"The future in five years, if we don’t have a good answer, is basically China re-wiring” a large part of the world “with a digital renminbi running on their controlled blockchain,” Marcus said. He warned about the prospect of “having a whole part of the world completely blocked from U.S. sanctions and protected from U.S. sanctions and having a new digital reserve currency” with no alternative."

The shared assumption of both the Rosneft and David Marcus quotes is that the U.S dollar is the primary pathway for projecting U.S. sanctions. By going out of their way to adopt a different currency, euros or renminbi, a nation or corporation can sidestep the sanctions threat.

But that's not quite right. Sure, the U.S. dollar is the world's reserve currency. However, the U.S.'s ability to apply strong and effective sanctions has very little to do with the U.S. dollar itself.

To see why, we need to visit how sanctions work. If the U.S. doesn't like a particular company, say Rosneft, and wants to cripple it, it starts with primary sanctions. The government tells U.S. companies to stop dealing with Rosneft on threat of fine.

But the real story begins with secondary sanctions. Here, the U.S. government tells Americans that on top of breaking ties with Rosneft, they must stop doing business with all other foreign entities (European, Canadian, Japanese, etc) that does business with Rosneft.

A foreign company now has a choice. If it is a European refiner, it will have to choose between continuing to buy crude oil from Rosneft or no longer accessing U.S. markets. This means being shut off from U.S. energy exports, doing without Texan oil & gas technology, forgoing U.S. repairs and refinery parts, being exempt from Silicon Valley tech expertise, being excluded from purchasing American assets, and having its existing U.S. subsidiaries threatened. There are also financial repercussions. It will lose access to New York's capital markets and the dollar payments system.

Given a choice between Rosneft or America, which will our refiner choose?

As I wrote a while back at Bullionstar, their are additional costs to being blacklisted by the U.S. government. Blacklisted executives would have to face the possibility of "no longer being able to send their kids to Ivy league schools, travel to Las Vegas for holiday, or seek medical care at Johns Hopkins or the Mayo Clinic." They wouldn't be able to visit the U.S. for business purposes, or explore U.S. job opportunities. I doubt that Russia has enough good job opportunities, universities, vacation spots, and high end hospitals to compensate.

This impressive list of penalties is why the U.S. government's secondary sanctions are so powerful. Almost every foreign company will prefer to give up Rosneft and keep doing business with America.

Now, Rosneft might nudge and wink at its European customers and say "hey, let's just deal in euros. That way we can get around the sanctions. We'll keep doing business together and you won't lose access to the U.S."

But using euros doesn't change the economic calculus facing our refiner. Even if it does business with Rosneft in euros rather than dollars, it is still doing business with Rosneft. And the moment that the U.S. justice department catches a whiff of this (say one of its bankers rats it out), the European company will be blacklisted. And that means losing the entire list of goodies that is associated with access to America. The risk is simply too high.

Fancy payment options like bitcoin or gold don't solve this either. Say that Total, a big European refiner, buys Rosneft oil with bitcoin. Total execs hopes that a bitcoin payment might prevent its bankers from tattling on it to U.S. authorities. But it's very difficult to camouflage the opposite side of that trade--massive movements of crude oil back to Europe. There are just too many bodies involved in that sort of operation. A large law-abiding organization like Total can't take the risk of being discovered. And so, bitcoin or not, it will disconnect Rosneft.

To summarize, what makes American secondary sanctions so effective isn't U.S. dollar hegemony. It is the impressive amount of technology, wealth, goods, services, and experience generated by American companies and individuals. When firms are threatened with losing access to this treasure trove, they will make whatever sacrifices are necessary to keep it.

As for Libra, in an effort to sell his new payments system to American regulators, David Marcus conjured up a world "completely blocked from U.S. sanctions" thanks to a new digital renminbi. But even if firms have the ability to make transactions in digital renminbi, this doesn't change the fact that America's home-grown economic bounty is massive, and foreigners value that bounty above any other, U.S. dollar or not. There are other reasons for regulators to welcome Libra. But bolstering U.S. sanctions isn't one of them.

A free market case for CBDC?

Central bank digital currency, or CBDC, is a form of highly-liquid digital debt that most governments have, till now, held back from issuing. But there is a growing push to change this. Free market economists are generally not big fans of CBDC. They see it as government encroachment on the banking sector.

In this post I'm going to push back on the free market consensus.

(This post was inspired after reading posts by Tyler Cowen and Scott Sumner).

Look, we're always going to have a government. Right? And that government is going to have to raise funds somehow in order to keep the lights on. The question is, how? Should it issue 30-day Treasury bills? Fifty-year bonds? Perpetual debt? Paper currency? Why not issue currency-ish debt instruments in digital form?

Let's start with a parable. Imagine a world in which the government has only ever issued 30-year bonds. But next month it wants to shift some of its borrowing from the 30-year bond range to the 10-year range. Government officials believe that this will reduce the government's interest costs and diversify government sources of funding.

Seems like a good idea, no?

But wait. The grocery industry has historically relied on funding itself with 10-year bonds. Till now, it hasn't had to compete with the government for the attention ten-year bond investors. Grocery store owners are furious over the impending decision. We could have difficulties funding ourselves! they fret. We might have to cut back on selling food!

Meanwhile, the restaurant industry in our imaginary world prefers to fund itself by issuing 30-year bonds. If the government raises more money in the 10-year end of the debt market and less in the 30-year end of the spectrum, restaurants will face less competition for investor attention. Go for it! say restaurant owners.

Which sector should the government choose to favor, grocery stores or restaurants? The choice seems entirely arbitrary. Government shouldn't be picking winners or losers, right? Civil servants should choose the most cost-effective form of financing.

The same argument goes for CBDC.

Bonds, bills, and CBDC are all just forms of transferable government debt.* But instead of having a fixed maturity like a bond, CBDC never matures. And whereas the interest rate on a bond is fixed and its price floats, the interest rate on CBDC is periodically adjusted while its price is fixed to $1. Either way, the government can use these instruments for funding projects and investments.

(For the rest of this post I'll use the terms CBDC and fixed-value floating-rate perpetual debt interchangeably.)

For whatever reason, modern governments choose not to fund themselves in the fixed-value floating-rate corner of the debt market.** No industry benefits more from this than banks. Individuals and businesses who want to buy fixed-value floating-rate perpetual debt have only one option available to them: bank-issued deposits. Regulations prevent all other industries from participating in this end of the debt market. So these non-banks have to turn to the 3-month to 30-year segment of the debt market where they must face the full brunt of government competition.

The presence of government competition means that non-banks' funding costs will be more onerous than otherwise. Conversely, banks' funding costs will be less onerous given a lack of government competition.

I don't see any compelling reason for why the government should avoid one end of the debt market and, in the process, favor the banking industry over other industries. I mean, if the government can cost-effectively issue CBDC in a way that reduces its overall interest obligations, then that's a win for taxpayers, no? It shouldn't go with an option that hurts taxpayers because it wants to help out a certain sector, should it?

The argument could be made that the banking industry is far more important than other industries because it does a lot of lending, and if lending slows then everyone loses. 

If the banking sector really deserves to be subsidized, why doesn't the government just pay the subsidy in a more transparent way, say by taking money directly from the pockets of individuals and non-banks and giving it to banks? 

Also, banks aren't the economy's only lenders. There are many non-bank lenders too. Sure, if a government were to issue CBDC, banks would now face more competition in the fixed-price floating-rate corner of the debt market, and perhaps would choose to lend less. But at the same time the government would be issuing less 30-year bonds, or 10-year bonds, or treasury bills. Non-bank lenders that issue debt in these ends of the debt market would face less competition than before, and might lend more.

In the end, it's a wash. One industry's loss is another's gain.

So let governments issue CBDC and compete for the attention of the fixed-price floating-rate investor, just like they already compete for the attention of the 30-year bond investor. This would remove an inefficient distortion, namely a subsidy to banks and a penalty on non-banks. This seems to be the free market position, no?

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*It could be argued that one type of debt is a currency, and can be transferred from you to me, while the other isn't. But I don't buy that. Both types of debt are liquid. They can be bought and sold on exchanges. Or they can be transferred bilaterally. With bonds, a bilateral transfer can be conducted by conveying an old style physical bearer bonds, or by transferring a bond to a recipient using Treasury Direct.

**The government does issue banknotes, which are sort of like perpetual floating-rate debt, where the decision has been made to keep the rate at 0%. And it does issue reserves to the banking sector. But the quantity of banknotes and reserves is quite small relative to overall government borrowing.