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.

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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.

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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:

Source: dai.stablecoin.science

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.

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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.

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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.

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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.

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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.


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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.

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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.

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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.

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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.

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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.

Monday, April 29, 2019

The difference between two colourful bits of rectangular paper

David Andolfatto had a provocative and open-ended tweet a few days back:
We see two coloured pieces of paper, both with an old dead President on it. They each have a face value of $500. Both are issued by a branch of the government, the $500 McKinley banknote (at right) by the Federal Reserve while the $500 Treasury bond (at left) by the Treasury. Both are bearer instrument: anyone can use them.

So why do we bestow one of them the special term "money" while the other is "credit"? I mean, they seem to be pretty much the same, right?

The word money is an awful word. It means so many different things to different people that any debate invoking the term is destined to go off-track within the first fifty characters. So I'm going to try and write this blog post without using the term money. Why are the two instruments that David has tweeted about fundamentally and categorically different from each other?

One of them is the medium of account, the other isn't

Being a veteran of the monetary economics blogosphere, David's tweet immediately made me think of the classical debates between Scott Sumner and Nick Rowe about the the medium-of-exchange vs medium-of-account functions of assets like banknotes and deposits and coins. (For those who don't remember, here are some posts.)

As Scott Sumner would probably say, one of the fundamental differences between the two bits of paper is that the McKinley $500 Federal Reserve note has been adopted as the U.S.'s medium-of- account. The $500 Treasury bond  hasn't.

Basically, if Jack is selling his car for $500, this price is represented by the $500 note (and other sub-denominations like the $50, $20 etc), not a $500 bond. Put differently, the bill is used as the medium for describing the accounting unit, the $. The bond does not have this special status. Now it could be that Jack is willing to accept bonds as payment, but since he doesn't use bonds to describe his sticker prices, he'll have to do some sort of calculation to convert the price into bond terms. When something is the medium of account, the entire language of prices is dictated by that instrument.

So why has society generally settled on using banknotes and not the bonds as our medium of account?

First, let's learn a bit more about the bond in question. The image that David has provided us with isn't actually a bond, it's a bond coupon. A coupon is a small ticket that the bond owner would periodically detach from the larger body of the bond in order to claim interest payments. The full bond would have looked more like this:



This format would have hobbled the bond's usefulness as a medium of exchange. The bond principal of $100 is represented by the largest sheet of paper. Attached to it are a bunch of coupons (worth $1.44 each) that haven't yet been stripped off. To compute the purchasing power of the bond, the $100 principal and all of the coupons would have to be added up. Complicating this summation is the time value of money. A coupon that I can clip off tomorrow is more valuable than the one I can clip off next year.

So if Jack is selling a car, and Jill offers him a $500 Treasury bond rather than a banknote, he'll have to spend a lot more time puzzling out the bond's value. A $500 McKinley note, which pays 0%, is much easier on the brain, and thus less likely to hit some sort of mental accounting barrier. (Larry White wrote a paper on this a while back).

Another hurdle is that there are many vintages of $500 Treasury bonds. A $500 bond that has been issued last year will be worth more than one that has been issued ten years ago and has had most of its coupons  stripped off. Put differently, Treasury bonds are not fungible. Banknotes, on the other hand, don't come in vintages. They are perfectly interchangeable with each other. So in places like stores and markets where trade must occur quickly, banknotes are far more convenient.

Further complicating matters is capital gains tax. Each time the $500 Treasury bond changes hands its owner must go back into their records to find the original price at which they received the bond, compute the profit, and then submit all this information to the tax authority. The $500 note doesn't face a capital gains tax. Better to use hassle-free banknotes, and not taxable bonds, to make one's day-to-day purchases.

Which finally gets us to why notes and not bonds are the medium-of-account. Since banknotes are such a convenient medium of exchange, everyone will have a few on hand. And this makes it convenient to set our prices in terms of notes, not Treasury bonds.

Why is it convenient? Say that Jack were to set the price of the car he is selling at $500, but tells his customers that the sticker price is in terms of Treasury bonds. So the $500 Treasury bond will settle the deal. But which Treasury bond does he mean? As I said earlier, at any point in time there are many vintages of $500 bonds outstanding. The 1945 one? The 1957 one? So confusing!

Jack's customers will all have a few notes in their wallet, having left their bonds locked away at home. But if Jack sets prices in terms of bonds, that means they'll have to make some sort of foreign exchange conversion back to notes in order to determine how many note to pay Jack. What a hassle!

If Jack sets the sticker price in terms of fungible notes he avoids the "vintages problem". And he saves the majority of his customers the annoyance of making a forex conversion from bond terms back into note terms. Since it's better to please customers than anger them, prices tend to be set in terms of the most popular payments instrument. Put differently, the medium-of-account tends to be married to the medium-of-exchange.

Alpha leaders vs beta followers

There is another fundamental difference between the two pieces of paper. Say that the Treasury were to adopt a few small changes to the instruments it issues. It no longer affixes coupons to Treasury bonds. And rather than putting off redemption for a few years, it promises to redeem them on demand with banknotes at any point in time. This new instrument would look exactly like the McKinley note. Without the nuisances of interest calculations, Treasury bond transactions should be just as effortless as the those with Federal Reserve notes.

But a fundamental difference between the two still exists. Since the Treasury promises to redeem the bond with banknotes, the Treasury is effectively pegging the value of the Treasury bond to the value of Federal Reserve notes. However, this isn't a reciprocal relationship. The Federal Reserve doesn't promise to redeem the $500 note with bonds (or with anything for that matter).

This means that the purchasing power of the bond is subservient to that of the banknote. Or as Nick Rowe tweets, "currency is alpha leader, bonds are beta follower."
This has much larger implications for the macroeconomy. In the long-run, the US's price level is set by the alpha leader, the Federal Reserve, not by the beta follower, the Treasury.

The Treasury could remove the peg. Now both instruments would be  0% floating liabilities of the issuer. Without a peg, their market values will slowly diverge depending on the policy of the issuer. For instance, a few years hence the $500 Treasury bond might be worth two $500 Federal Reserve notes. We could imagine that in certain parts of the U.S., custom would dictate a preference for one or the other as a medium of exchange. Or maybe legal tender laws nudge people into using one of them. And so certain regions would set price in terms of Treasury bonds while others will use Federal Reserve notes as the medium of account.

The Treasury's monetary policy would drive the price level in some parts of the U.S., whereas the Fed's monetary policy would drive it in the rest. This would be sort of like the 1860s. Most American states adopted Treasury-issued greenbacks as the medium of exchange during the Civil War, but California kept using gold coins issued by the US Mint. And thus prices in California continued to be described in terms of gold, and held steady, whereas prices in the East inflated as the Treasury printed new notes. (I wrote about this episode here.)

In conclusion...

So in sum, the two instruments in David's tweet are fundamentally and categorically different because one is the medium of account and the other isn't. Treasury bonds just aren't that easy to transact with, so people don't carry them around, and thus shopkeepers don't set sticker prices in terms of Treasury bonds. But even if the Treasury were to modify its bonds to be banknote look-alikes, they are still fundamentally different. Treasury paper is pegged to notes, but not vice versa.

This peg can be severed. But for convenience's sake, one of the two instruments will come to be used as the medium-of-account within certain geographical areas. And thus in its respective area, the issuer of that medium-of-account will dictate monetary policy.

Wednesday, April 17, 2019

Supernotes

The U.S. $10,000 was available till Nixon nixed it in 1969

For the last few years the conversation about cash has been dominated by Ken Rogoff's proposal to remove high-denomination banknotes. In an effort to broaden the discussion, last year I wrote an essay for Cato Unbound about introducing a new U.S. supernote. The value of the current highest denomination note--the $100 bill--has deteriorated over the decades thanks to inflation. Is it time to restore the purchasing power of U.S. cash by bringing out a $1,000 note?

In the same essay I also floated the idea of taxing the supernote. Why a tax? A new $1,000 bill could be used for both good and nefarious purposes. Given that nefarious supernote usage (tax evasion and crime) could impose costs on society, a tax would make up for this by transferring wealth from note users to the rest of us. (I also blogged about the idea of taxing cash here and here). 

Josh Hendrickson, Will Luther, and Jamie McAndrews all had responses. Do read them, as they give a good sense of all the various nuances and complications involved in issuing a supernote and taxing it.

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Say we introduce a new supernote worth $1,000. What would Walter, a seasoned drug dealer, think about this new policy? Let's walk through the day-to-day costs that Walter absorbs as an illicit cash user.

Walter makes large value payments using banknotes. He also stores plenty of the stuff. A million dollars worth of $100 notes (i.e. 10,000 notes) takes up a lot of space. But one thousand $1000 bills can be packed into a container a tenth the size. This will make Walter's business much easier to expedite. His costs of counting, transporting, storing, and sorting notes will all drop significantly.

The risk of detection will also be much lower with supernotes. Hiding twenty supernotes in a car is a lot easier than hiding two-hundred $100 notes. Detection by authorities imposes costs on Walter and his associates. Banknotes can be seized under civil asset forfeiture laws. In many cases the police can seize cash on mere suspicion of wrongdoing--they don't even have to charge the owner with a crime.

Example of an asset forfeiture case involving cash [source]


These seizures can be contested by Walter and his associates, but this will involve significant time and legal expenses. There are also non-pecuniary losses associated with detection. If Walter or one of his associates is pulled over for speeding and the cops find a bag full of $100 notes in his car trunk, that may provide law enforcement with information and insight into his network.

Finally, Walter also incurs a "tax" on his cash holdings. Specifically, his cash does not earn interest. If Walter regularly stores $100,000 in cash, and the interest rate is 3%, he is effectively forfeiting around $3,000/year. This loss is the same whether Walter holds his stash in $100 notes or supernotes. Walter's $3000/year loss goes directly to the public. He is providing the rest of us with an interest-free loan, or a subsidy.

Weaving this all together, from Walter's perspective the new supernote is a great product. It reduces his storage & handling costs (S) as well as any costs arising from detection (D), and does so without increasing his taxes (T).

Civil society isn't quite as well off with a supernote. We've provided Walter with a superior means of avoiding detection. Not only does this mean that we've increased the odds of Walter staying out of jail. We've also reduced asset forfeiture revenues. Since law enforcement agencies uses forfeitures to fund their operations, any diminution in this flow means that the rest of us will have to pay higher taxes to compensate.

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Why don't we strike a deal with Walter? If supernotes allow him to enjoy lower S and D, why don't we ask for higher T in compensation? Setting a higher T involves an increase in the tax rate on supernotes relative to $100 notes.

One way to do this is to make the supernote depreciate a bit each day. The central bank will buy the note back today for $1000, but tomorrow it will only buy it back at $999.95. This constitutes a 5¢/day transfer from Walter to the public. At a yearly interest rate of 3%, he also loses around 5¢/day in forgone interest. This combination of a capital loss and forgone interest comprise the supernote tax.

Now when Walter and his colleagues switch from using the $100 bill to the supernote, society's decline in forfeiture income is compensated by higher tax income. Even with the higher tax, Walter prefers the supernote to the $100 because he saves enough on S and D to make it worth his while. So everyone wins if we issue a supernote.

Or as Hendrikson says in his response essay:
"the introduction of the supernote is in this instance welfare-improving (given the premise that illegal trade creates a social cost) because it allows policymakers to engineer a transfer from criminals to law-abiding citizens that would not be available otherwise."
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There may be some additional improvements in efficiency to be gained by replacing a bad tax--asset forfeiture--with a good one. Having the police directly raise funds by confiscating people's property is ripe for abuse.
By contrast, a supernote tax is automatic, predictable, transparent, and easier to collect.

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A supernote would provide at least some benefit to non-criminals. Say that Sarah wants to sell her car for $8000. She may be wary of accepting a check from the buyer, Todd, who she doesn't know. If she provides the car to Todd but his check bounces, then she's out of hand. Cash is a simple way to solve this problem. The moment that cash passes hands from Todd to Sarah, the payment is 100% certain.

Without a supernote, Todd will have to pay for the $8000 car with eighty $100s. Wouldn't it be more cost effective for him to make the payment with just eight $1000s? Less counting is required and the bills easily slip into a wallet. So S is reduced. (Detection, or D, is not a cost that licit users need worry about.)

Unfortunately the imposition of a tax will reduce the supernote's potential for improving the lives of non-criminals like Sarah and Todd. Since the tax raises the cost of the supernote relative to alternatives like the $100 note, many people who would otherwise have consumed the supernote just won't bother. Put differently, the  consumer surplus (for licit users) that is created by the introduction of a taxed supernote will be small than if the supernote was untaxed.

If the tax is set quite high, then usage of supernotes may be entirely confined to criminals. This the sort of monetary future that David Birch would probably say was first described by novelist William Gibson in Count Zero. Cash still exists, but it will have disappeared from polite society.

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A taxed supernote is a neat idea, but does it qualify as a "fancy monetary standard" i.e too abstract and academic to inspire confidence? "Fancy" is the word that Irving Fisher's critics used to denigrate his early ideas about price targeting.

Admittedly a taxed supernote doesn't present a very clean user interface. Having a round face value is one of the conveniences of a note. This feature ensures that it can be easily divided into smaller amounts. But the supernote tax means that the face value of the note will very quickly fall to some inconvenient number like $999.33. As McAndrews points out
"...the differential rates of exchange among the different denominations of notes is an inconvenience. The cost of all those calculations required to make change and set different prices based on which note a customer offers must be counted against whatever benefit a tax might achieve."
It might be possible to avoid the rounding problem by finding a different means for assessing the tax. In his paper Taxing Cash, Ilan Benshalom describes a withdrawal tax. This tax would be assessed whenever money is taken out of an ATM or bank teller. However, supernotes will probably circulate for long periods of time without every being deposited, which means the withdrawal tax will rarely be activated.

For now, taxed supernotes are science fiction. But who knows? Irving Fisher's fancy monetary standard was science fiction for decades, but it has slowly become the standard way of doing monetary policy these days.

Wednesday, April 3, 2019

Banknotes in bottles in coal mines



[This is a guest post by Mike Sproul. Mike has posted a few times before to the Moneyess blog.]


“If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well tried principles of Laissez Faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.”

-J.M. Keynes, The General Theory.


Keynes’ ruminations about bank notes and coal mines are a good place to draw a dividing line between classical economists and Keynesians.  In contrast to Keynesian optimism about the coal mine scheme, classical economists tell us that the newly dug-up bank notes will only succeed in causing inflation, while wasting the labor of those who dig up the notes.

Surprisingly, there is some middle ground about burying bank notes. Economists of both stripes generally agree that money shortages cause recessions. If there is not enough money for people to conduct business conveniently, then people are forced to revert to barter or other less efficient means of trade. Trade slows, and productivity suffers.  Some economists will call it a “money shortage”. Others will say “liquidity crisis”, “credit crunch”, “tight money”, “failure of aggregate demand”, and so on. Whatever the terminology, economists have been saying for centuries that money shortages cause recessions.
In the year 1722-3, the Governor and Assembly…thought themselves obliged to take into their serious consideration the distressed circumstances and sufferings of the people, through the extreme want of some kind of currency…These bills being emitted, their effect very sensibly appeared, in giving new life to business, and raising the country in some measure, from its languishing state. (Pennsylvania Assembly to the Board of Trade, 1726. Cited in Brock, 1941, p. 76)
Now we begin to see the middle ground. Both Keynesians and Classicals agree that the coal mine scheme could potentially provide badly needed liquidity and thus end a recession. Once this is agreed, the rest is just dickering over the size of various forces. A Keynesian might think that the misallocation of labor spent digging up bank notes might drag down national production by 5%, but that the notes dug up might lubricate trade enough to boost production by 20%.  A Classical might put the figures at 10% drag and 15% boost.

The backing theory of money gives us a way to clear up some confusion between these two views, and provides a liquidity-based theory of recessions that both Keynesians and Classicals can live with.

The backing theory is summed up in figure 1:


In line (1), the bank (which may be a central bank or a private bank) receives 100 ounces of silver on deposit, and issues $100 of bank notes in exchange. Each dollar note is worth 1 ounce of silver.

In line (2) the bank issues another $200 in exchange for 200 ounces worth (or dollars’ worth) of bonds. The backing theory view is that even though the bank tripled the money supply, the bank also tripled the assets backing that money, so it remains true that $1=1 ounce.

Now suppose that the $300 in circulation is 10% less than the “ideal” quantity of money, and that the economy is therefore in recession. A well-functioning bank would respond to the money shortage by issuing another $30 of bank notes, while getting 30 ounces (or $30) of bonds or other assets in exchange. This open-market purchase of bonds would relieve the money shortage, end the recession, and leave the value of the dollar at $1=1 ounce. The open-market purchase method gives excellent results. Keynesians would not be surprised at this, but Classicals might be surprised that the money injection caused no inflation.

Next, let’s try the bottles-in-coal-mines method. The bank prints $30 of bank notes, places them in bottles, and buries them in coal mines. Workers will waste (at most) $30 worth of labor digging up the notes. The bank gets no new assets as it issues the $30 of bank notes, so the value of the dollar falls by about 10% relative to silver. While there are 10% more dollars in circulation, each dollar is worth 10% less silver. The real value of the aggregate circulating cash is thus unchanged. There is no relief of the money shortage, and so the recession continues. The bottles-in-coal-mines method gives terrible results, just as Classicals would expect. Keynesians might be surprised to see that even in a recession, the money injection still causes inflation and fails to stimulate production.

We can improve on the bottles-in-coal-mines method by following Keynes’ suggestion and issuing bank notes in exchange for houses and such. The bank prints $30 of bank notes and spends them acquiring 30 ounces (or $30) worth of houses. The bank’s assets (including houses) rise in step with its money-issue, so the value of the dollar remains at $1=1 ounce. This method relieves the money shortage, ends the recession, and causes no inflation. Excellent results, and not especially surprising to either Keynesians or Classicals. The problem is that it is not always easy for the bank’s assets to keep up with its money-issue. If the bank had spent its $30 of new notes on houses that were only worth 29 ounces, then money-issue would outrun the bank’s assets, and inflation would result. Overall, it’s safer for the bank to spend its $30 buying bonds than buying houses.

There are many more methods of issuing banknotes, but I’ll mention just one: Print $30 of bank notes and give them away to passers-by outside the bank. Then have the government give $30 of bonds to the bank. The bank’s assets will rise in step with its note issue, so there is no inflation. At the same time, the real money supply rises by 10%, so the money shortage is relieved and the recession ends. Excellent results once again. The only problem is that the government will eventually run out of wealth, and will be unable to help the money-issuing bank’s assets keep up with its money issue.

Conclusions:
1) Money shortages cause recessions, and the solution is to issue more money.
2) Issuing new money won’t cause inflation, as long as the new money is adequately backed.
3) It is best to issue new money via conventional open-market purchases of bonds. Failing that, it’s ok to issue new money for houses, or even to give it away, provided the government can cover the give-away. But whatever you do, don’t bury the money in coal mines.

Sunday, March 31, 2019

Prepaid debit cards. The other anonymous payments method


When it comes to financial privacy, good old fashioned banknotes and privacy cryptocurrencies like Zcash & Monero get all the attention. But as I recently wrote for the Sound Money Project, let's not forget about prepaid debit cards.

Having written a bunch of posts over the last two years about financial privacy, I recently decided that it was time to step up my own personal financial privacy game. A few months ago I walked into my local pharmacy and bought my first non-reloadable prepaid debit card (i.e. gift card), a Vanilla card.

You've probably seen the rack of prepaid cards near the front of pharmacies and department stores. Some of them are closed-loop cards. They can only be used to buy things at the issuer, say Tim Horton's or Starbucks. But some of them, like my new Vanilla Prepaid card, are open-loop cards. That means they can be used wherever Visa or MasterCard are accepted. In Canada, Vanilla cards are sold in denominations from $25 to $250.

The Vanilla card that I bought doesn't have my name on it, nor did I have to show any ID to buy it. I paid for it in cash. This means that whenever I use my card, my identity won't be associated with the purchase. My card is backed by dollars held in a pooled account at Peoples Trust Company, a Canadian bank. It gives me the right to anonymously route my portion of the pooled funds along the MasterCard network to a retailer who operates a MasterCard terminal.

Given that authorities and banks have spend decades constructing a vast financial surveillance apparatus (the Bank Secrecy Act, FATF, AML, CFT, suspicious transaction reporting etc), it seems odd that this small window for accessing the digital payments system anonymously would have remained intact. To comply with Canadian anti-money laundering requirements, card-issuing banks require that the prepaid card seller (my pharmacy) collect the buyer's personal information if the face value of the card exceeds $1000. For amounts below that, due diligence is waived. The same practice is followed in the U.S. This regulatory exemption is why I didn't have to give up my anonymity when I bought my card.

The idea motivating the sub-$1000 exemption is that small amounts of anonymity can't easily facilitate criminal activity, but larger amounts can. (Note that I can convert my non-reloadable Vanilla card into reloadable format—i.e. a card that I'll be able to add money after the first batch is used up—but I'll have to register and forfeit my information. Only non-reloadable cards below the $1000 cap are exempt from due diligence.)

I'm not obsessed with privacy. I still use my information-laden credit card for a big chunk of my day-to-day purchases. But from time-to-time I want to have the option of shielding my data from outside observers. Cash is good for that. I already use banknotes and coins to pay for about half of my face-to-face purchases. This is usually for the sake of convenience, but sometimes it's because I'd prefer not to give up too many of my personal details to the retailer (especially small shops I've never been to before).

By adding a non-reloadable prepaid debit card to my wallet, I've gained an extra degree of protection. Say that I've used up all of the cash in my wallet, or I need to make a purchase in a place that doesn't accept cash, or I want to buy something online—well, a prepaid gift card offers me a way to make a transaction while still protecting my data.   

Law abiding citizens who are conscious of their financial privacy are a pretty small demographic. Sellers of non-reloadable prepaid cards have much larger markets in mind, specifically: 1) people looking to buy convenient gifts for friends and family or; 2) the unbanked and underbanked, i.e. those who don't have bank accounts or have them but don't use them. By allowing people to buy prepaid cards without identification, those without formal credentials such as driver's licenses, social insurance numbers, or credit scores can still make digital payments. Think the homeless, children and teenagers, immigrants, and refugees.

The post-9/11 brigade of security-at-all-costs zealots would love for regulators to shut the prepaid anonymity window. They worry that terrorists and money launderers will abuse prepaid cards. The anonymous prepaid window has only stayed open because these zealots have been countered by a collection of banking lobbyists who want to keep doing business with the unbanked and politicians who care about the disadvantaged.

I'm neither unbanked nor underbanked. I've got several bank accounts that I often use. Nor am I buying these cards as gifts. So I'm not really the target market for non-reloadable debit cards. My ability to get anonymous access the digital payments system is really just a by-product of the wider effort to make it easy for the unbanked to plug in. This is a precarious position for a privacy-conscious individual to be. In the U.S., where only ~93% of the population is banked, the constituency for anonymous prepaid access is relatively large. But in places where the banked population is approaching 100% (Canada, Finland, Germany, Netherlands, Denmark, Belgium, Sweden, UK), there is probably diminishing political support for providing anonymous access to the banking system.

In Europe, for instance, the window for anonymous access to digital payments seems to be closing. When the EU's 4th Anti-money laundering directive was passed in 2015, up to €250 in electronic money (the EU's term for prepaid instruments that reside on a device, say a card or a phone) could be bought without being asked to give up personal information. With the passage of the 5th Anti-money laundering directive in 2018, this amount has been reduced to just €150. And a new ceiling on online purchases of €50 was introduced. As I wrote in my recent Breakermag article, such a tiny amount of anonymity just isn't that useful.

One thing I've noticed about prepaid financial anonymity is that it is expensive. My first Vanilla card had a face value of $25. But I had to pay an onerous $3.95 to activate it. Buying higher value cards defrays this expense, but it still costs $7.50 to activate a card with a face value of $250. That's a 3% levy. Keep in mind that when I use an anonymous prepaid card not only am I paying the activation fee, I am also forgoing 2% cash back that my not-so anonymous credit card would otherwise provide me with.

Think about it this way. Let's say I decide to buy my groceries anonymously using a prepaid card. My $250 only gets me $242.50 worth of goods ($250 less the $7.50 activation fee). With my credit card, I can get $255 worth of food ($250 plus $5 cash back). That's an extra $12.50 in spending power if I decide to go the non-anonymous route. Sure, by using a prepaid card I've prevented my grocery store from being able to collect information about my eating habits. But is the $12.50 I've given up worth it? (Incidentally, this calculation also indicates how costly it is to be unbanked!)

While prepaid anonymity is handicapped by a low ceiling and high fees, the drawbacks don't stop there. Non-reloadable prepaid debit cards are great for buyers who want small amounts of privacy, but they don't help out retailers who want to shield themselves. In a recent article, privacy advocate Timothy May made a great distinction between buyer privacy and seller privacy:    

If someone is selling a controversial product (May uses birth control information as an example), they must always be wary of snitches who make a purchase only to "out" the seller, either by reporting the transaction to the authorities or posting it to social media. Controversy-wary payments providers will quickly cut the seller off. To protect themselves, sellers need a payments method that doesn't leave a paper trail. They also need a payments system from which they can't be censored. Cash is a good example—it doesn't leave a paper trail and is censorship resistant. So are privacy-friendly cryptocurrencies. But prepaid cards don't cut it. The seller can easily be reported to the network and banished.

The last drawback of non-reloadable prepaid debit cards is that they can't be used to make anonymous person-to-person payments. As far as I know, there is no technical reason that I shouldn't be able to use my Vanilla debit card to anonymously send $100 to anyone else with a Visa card, just by inputting their card number and clicking send on a website. In theory, this payment should get pushed across the Visa network.

But there are regulatory reasons that I can't do so. In the U.S., the Financial Crimes Enforcement Network (FinCEN) prohibits anonymous debit cards from offering person-to-person capabilities, and I believe the same rule applies in Canada. Meanwhile, cash and privacy-friendly cryptocurrencies do allow for anonymous person-to-person payments.

In sum, non-reloadable prepaid debit cards allow for a small extension of one's financial privacy. But in an age where the ability to make payments without someone snooping is getting increasingly rare, I suppose we have to take whatever crumbs we can get.

Thursday, March 28, 2019

Should governments finance themselves through their central bank?



In places like the U.S. and Europe, it is actually difficult—if not impossible—for a government to have its central bank pay for government programs. All government spending must be financed by issuing bonds to the public or collecting taxes.

Canada, my home country, is an interesting counter-example. The financial relationship between the Federal government and the Bank of Canada—our central bank—is fairly permeable. The government has the authority to ask the Bank of Canada to directly fund a portion of its spending.

This avenue is rarely taken, however. Justin Trudeau, our current Prime Minister, currently uses bonds and taxes to fund almost all of the Federal government's spending. Just one small and unknown government program is directly funded by the Bank of Canada: the prudential liquidity management plan, an old Stephen Harper-era program. (I wrote about it here and here). The goal of the prudential liquidity plan is to provide a cash cushion that the Federal government can rely on to “safeguard its ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.”

The details of the program aren't really that important. The point I want to make is that the Federal government hasn't had to issue bonds to the public in order to fund the prudential liquidity management plan, nor has it had to wait for taxes to be paid. All it did was tell the Bank of Canada to create some dollars for it out of nothing, and the Bank of Canada shrugged and complied.

So would it make sense for Justin Trudeau to have the Bank of Canada fund other programs than just the prudential liquidity management plan? Why not get it to fund the Federal government's share of health spending, or national defence, or Old Age Security?

Let's take the example of national defence. Say that the Trudeau government has been planning to follow conventional funding procedure and intends to issue $400 million in new treasury bills to pay the salaries of our soldiers for the months of April and May. But Trudeau changes his mind and tasks the Bank of Canada to create $400 million in fresh deposits for the government, ex nihilo. As the soldiers' salaries come due, the dollars will be wired to the commercial banks where the soldiers do their banking, these banks in turn crediting the soldiers' accounts.

Are there any real differences between the two funding scenarios? Under both the treasury bill and Bank of Canada routes, the soldiers will get paid. What about cost savings? The Bank of Canada is obligated to pay interest to banks on the $400 million in new balances it has created. It pays a rate of 1.75% or so, which is pretty much equivalent to what the government would have paid on $400 million in new treasury bills.

Thus, from a cost savings perspective there's really no difference between the two scenarios. Either way, the government is going to be paying 1.75% in interest to whomever happens to be holding the instruments it has issued.

So my initial reaction is: meh, who cares which way Trudeau funds soldiers' salaries.

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There is one asymmetry that might worry me as a citizen. Treasury bills are a useful instrument for individuals and businesses (like insurers) because they are quite safe. Bank of Canada deposits are likewise very safe, but whereas anyone can buy a treasury bill, deposits are exclusive. Only commercial banks can keep an account at the central bank. So if our soldiers are to be paid $400 million by the Bank of Canada, the supply of treasury bills will contract by $400 million leaving folks like me with fewer options for investing.

But there's an easy way to fix this shortage. Introduce central bank accounts for all. In short, allow non-banks like insurers and individuals to keep accounts at the Bank of Canada. A similar fix would be to provide a means for commercial banks to establish 100%-reserve pass-through accounts. Life insurers and individuals who open a pass-through accounts at a bank would be assured that these accounts are 100% backed by Bank of Canada deposits, the interest flowing straight from the Bank of Canada to the account holder. These accounts would function just like treasury bills.

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There is one other potential asymmetry. It has to do with the unit-of-account function of money.

Like the metre, kilogram, or minute, the dollar is a key element of Canada's system of weights and measures. The dollar is by far the most complex of these standardized measurements. Unlike metres, kilograms, or minutes, Canadian prices are measured in terms of a set of items—banknotes and Bank of Canada deposits—that are constantly fluctuating in value. By carefully regulating these items, the Bank of Canada tries to keep the pricing standard as stable as possible.

Treasury bills have no role to play in the pricing standard. If a car has a sticker price of $10,000, this indicates ten thousand one-dollar banknotes, or a thousand ten-dollar banknotes. The "$10,000" indicated on the sticker is not represented by a given quantity of treasury bills.

This has important implications. If all Canadians simultaneously decide that they want to reduce the quantity of Bank of Canada notes and deposits that they hold, then every price in the Canadian economy will have to rise. After all, these instruments are the standard media that people use for describing prices. But if all Canadians decide they want to hold fewer treasury bills, goods and services prices needn't adjust—treasury bills aren't the media that Canadians use to describe the dollar. Only the price of treasury bills will have to adjust.  

So if Trudeau decides to use Bank of Canada deposits for financing, he is involving himself with the standard itself. Every price in the Canadian economy may have to adjust to his actions. But if Trudeau relies solely on treasury bills/bonds for financing, he avoids implicating himself in Canada's pricing standard, and so his influence will be much more muted. It would be better if Trudeau's political ambitions couldn't entangle Canada's system of weights and measures... more on this later.

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It may be useful to work through an example in which Trudeau decides to use the Bank of Canada for a large percentage of government spending. Say that Justin is fighting for his political survival, so he comes up with a bright idea. Let's increase the number of Canadian provinces by occupying Burkina Faso. That way Canadians will have a warm place to go in the winter. Trudeau promises voters that he will carry out the invasion without burdening Canadians with new taxes. That very month he tells the Bank of Canada to start creating billions in new deposits and quickly spends them on military equipment.

At some point the recipients of these new deposits (anyone with a Bank of Canada account) will suffer deposit bloat. They will try to get rid of their excess, and as they do so prices across the Canadian economy will start to rise.

In order to preserve the standard unit, the Bank of Canada has a useful tool for halting this incipient inflation. It can increase the interest rate it pays on reserves. A higher reward will coax those who would otherwise have spent their unwanted Bank of Canada deposits into keeping them on ice. And this should alleviate the pressure on prices.

But what happens if Trudeau keeps on spending? His next idea is to send a fully-manned space mission to Pluto without raising taxes or issuing treasury bills to fund the mission. He tells the Bank of Canada to create $50 billion and immediately starts to spend it on building a rocket.

The Bank of Canada can of course raise rates again. But if you think about it, the Bank of Canada gets the money to pay higher interest by issuing more brand new dollar deposits. If the underlying cause of the inflation is Trudeau bringing too much money into existence, issuing even more of the stuff as an inducement to hold what has already been created doesn't seem like a long-term solution. At some point, the Bank of Canada will have to attack the root of the problem--the bloat of deposits itself--by reducing the supply.

There are a couple of ways to reduce the supply of deposits. The first would be to "sterilize" Trudeau's spending. The Bank of Canada can try and coax depositors to lock their funds into central bank term deposits rather than keeping them in their regular Bank of Canada accounts. Transferring the funds to a term deposit renders them non-spendable and removes the bloat, at least temporarily.

But Trudeau keeps on spending new Bank of Canada deposits, this time on the construction of a 5-metre high border wall between Canada and U.S. The Bank of Canada will have to convince an ever-growing crowd of deposit owners into locking away their funds. At some point the demand for term deposits will be saturated, and the Bank of Canada will have to increase the carrot they provide by raising term deposit rates. Additional deposits will have to be created to generate this reward. But as before, fixing an excess of deposits with more new ones only kicks the can down the road.

The Bank of Canada has a permanent way of removing the deposit bloat: it can buy deposits back and cancel them. But to do this, it needs to have some real assets sitting in its vaults. Gold, property, mortgage-backed securities, bonds, etc. Because Trudeau has been spending deposits into the economy willy-nilly, the Bank of Canada simply doesn't have assets to carry out a buy-back.

Which leaves the Bank of Canada with one last option for removing supply. Rather than repurchasing deposits, it can just destroy them outright. By declaring that x% of all deposits that have been issued will simply cease to exist, it can remove the bloat once and for all. Thus ends the inflation.

But the Bank of Canada doesn't have the power to annihilate depositors' funds. This would basically constitute a tax, and democracies don't generally give central bankers the power to tax (understandably so). Which means that only Trudeau can carry this operation out on behalf of the Bank of Canada.

To do so, he will have to levy a new tax and then destroy the proceeds. (He can't re-spend the deposits, this would only recreate the problem). Once destroyed, the deposit bloat has been remedied. But if Trudeau is determined to follow through on his vote gathering strategy of spending on programs without raising taxes, then he won't see much to be gained in carrying out the annihilation. So the inflation will continue.

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I think that all of these threads can be brought together to provide an argument for why we don't want Trudeau to rely too much on the Bank of Canada for funding.

Low and consistent inflation is valuable to Canadians. Just as our measures of time, volume, and weight stay consistent (the metre doesn't get longer or shorter from one year to the next), the dollar unit should be reliable. If we all have a pretty good idea where average prices will be down the road, we can better coordinate our long-term plans. Price stability is also the fairest way to ensure neither debtors nor creditors benefit at the other's expense.

The Bank of Canada has all the tools to provide this service to the public, save one. In the extreme event that the Prime Minister decides to resort to the Bank of Canada for financing of a bunch of novel government services, and the inflation target is exceeded, the Bank of Canada can't salvage things by resorting to the definitive response: annihilating deposits. Instead it must rely on Trudeau to destroy deposits on its behalf via a tax. If the Prime Minister refuses to do this, then the reliability of the unit of account is effectively sacrificed.

Were Trudeau to rely on treasury bills and bonds rather than central bank financing to invade Burkina Faso, send a rocket to Pluto, and build a border wall with the U.S., then the Bank of Canada would never have to ask the Prime Minister to annihilate deposits in order to hit its inflation target. And so the dependability of the unit of account would be assured. Instead of every price in the economy having to adjust to Trudeau's new programs, only the market price of treasury bills and bonds would have to bear the burden of adjustment.

So should governments finance themselves through their central bank? In general, it's probably harmless. For instance, it makes no difference whether the prudential liquidity plan is financed by the Bank of Canada, the taxpayer, or government-issued treasury bills.

But in a scenario where the government is being wildly imprudent, a degree of separation between the Prime Minister and the Bank of Canada is advisable. Imagine if the whims of Canada's politicians could cause metre sticks all over Canada to grow or shrunk a bit each year. That would make for a confusing system of weights and measures, wouldn’t it? The dollar is one of Canada's most important weights & measures. It too deserves to be immunized from the political process.