Monday, September 23, 2019

A fifty-year history of Facebook's Libra

Last week, we finally got some information about what Libra's currency basket would look like.
If you haven't heard, Libra is a proposed global blockchain-based payments network. It is being spearheaded by Facebook along with a coalition of other companies including Uber, MasterCard, PayPal, and Visa.

The hook is that rather than going the conventional route and expressing monetary values using existing units-of-account like the dollar, yen, pound, or euro, the Libra network will rely on its own bespoke Libra unit-of-account as its "base language." Libra originally revealed in its whitepaper that the Libra unit would be defined as a basket, or cocktail, of other currencies. Now we know what that mix will likely look like.

Interestingly, the Libra isn't the world's first private unit-of-account. Back in the 1960s and 1970s, several financial institutions came up with their own bespoke units. I learnt about this strange and fascinating episode courtesy of a very readable paper by two economists, Joseph Aschheim and Y.S. Park.

As I gathered from the paper, the first private artificial currency unit was Luxembourg-based Kredietbank's European Accounting Unit (EUA). Originally devised in 1961 as 0.88867 grams of fine gold, the EUA was soon used to denominate a bond issue by SACOR, a Portuguese oil company. Over the next two decades, Aschheim & Park claim that around sixty or so bond issues would rely on Kredietbank's EUA as their accounting unit.

Between 1968 and 1971, the U.S. Treasury ceased to redeem dollars with gold. When the Smithsonian Agreement—a band-aid attempt to re-cement all currencies to the U.S. dollar—collapsed in 1973, the post WWII system of fixed currencies came to its final end. To help people cope with the sudden babble of floating currencies, several new private units-of-account joined Kreietbank's EUA.

N.M. Rothschild & Sons kicked things off in 1973 with its European Composite Unit, or Eurco. The Eurco was made up of nine currencies issued by members of the European Community, including Deutsche marks, French francs, and Danish kronor. According to Aschheim & Park, Rothshild developed the Eurco "to elicit investors' confidence" in long-term bonds, but as of 1976 only three bond issues had been denominated in Eurcos.

In 1974 Hambros Bank introduced the Arab Currency-Related Unit, or Arcru. The Arcru was comprised of twelve Arab currencies and designed to appeal to Arab investors flush with oil profits. The next year Credit Lyonnais created a bouquet of the ten currencies, both European and non-European, and dubbed it the International Financial Unit, or IFU. This was a far more broad-based unit than the Arcru or Eurco, the relative weights of the IFU's component currencies being based on each country's share of international trade.

Barclays Bank also got into the game in 1974 with the Barclays Unit, or the B-Unit. The B-Unit was made up of five currencies: the U.S. dollar, the British pound, the German mark, the French franc, and the Swiss franc. Aschheim & Park note that whereas the Arcru, IFU, and Eurco were primarily intended for denominating bonds, the B-Unit was designed to be used for making international payments.

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Which makes the B-Unit a direct predecessor of the Libra unit.

Look around you today, however, and not one of these private units-of-account listed below exists. Anyone want to pay me in B-Units? I didn't think so. I think this says something quite fundamental about the market's demand for artificial currency units. Businesses and consumers don't really like to use them.

Table from Aschheim & Park

If private artificial currency units have been failures, what about government-provided ones?

Take the International Monetary Fund's Special Drawing Right (SDR) basket, which has been in existence since 1970, almost fifty years. If there was a demand to make international payments using public artificial units of account, surely commercial banks would eventually have met that demand by implementing SDR-denominated payments systems. Indeed, Aschheim & Park speculate on the possibility in their 1976 paper. It's worth reading this section in full:
"International banks may soon be willing to accept deposits denominated in SDRs because a potential demand for SDR funds already exists, as manifested by recent SDR bond issues by the Swiss Aluminum Company, the Swedish Investment Bank, and Electricite de France. The process, indeed, is already under way. In July 1975 the Bank Keyser Ullmann in Geneva (a subsidiary of Keyser Ullmann of London) announced that it would henceforth accept demand and time deposits denominated in SDRs. These SDR deposits are to be convertible at any time into any currency at the SDR exchange rate applicable on that day. Similarly, in August 1975 the Chase Manhattan Bank in New York instituted a range of banking facilities in SDRs, including loans, deposits, and futures trading. As this process spreads and as more international transactions are denominated in SDRs, banks may begin to allow direct transfers between SDR accounts, internally and then between banks. In consequence, the SDR may be transformed from mere numeraire (international quasi-money) into an outright means of payment (full-fledged international money)."
Again, look around you today. How many banks let you open an SDR-denominated bank account and make SDR payments? None that I'm aware of. Maybe the IMF's SDR was never well designed, or maybe Barclays was too small to drive B-Unit adoption. Or more likely SDRs, B-Units, and the other artificial currency units mentioned in Aschheim & Parks paper are all monetary dead-ends. In pursuing the same path, Libra could be making a big mistake.

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What is it about artificial currency baskets that makes them non-starters? My first post about Libra delved into this question. Let me repeat my argument below to spare you the effort of clicking through.

In an alternative reality, let's imagine that Facebook only allows users to join and converse on its platform after having learnt Facebook's artificial language, Facebookish. English, French, Chinese, and all other languages are banned.

In this alternate reality, all Facebook users understand each other because each one is fluent in Facebookish. Comprehension is a great thing. But hardly any of us would be on Facebook to begin with. Who wants to go through the effort of learning a new language? Not me.

In the real world, Facebook has long since decided against the Facebookish approach. Instead, it supports a multitude of local languages—Arabic, Chinese, English, Hindi, and more. Sure, the drawback is that we can't always understand what other Facebook users are saying. But at least users don't have to go through the hurdle of learning new grammar and syntax. And Facebook has thrived as a result of this simple and obvious design choice.

The adoption of a Libra unit of account is the monetary equivalent of forcing users to learn Facebookish. Sure, at least with Libras we'll all be using the same currency units. But this ignores the costs we'd all have to incur as we learn a new monetary patois. From a very young age we all figure out how to "speak money". We speak in our local unit-of-account. As a Canadian, the Canadian dollar has always been the means by which I describe prices to people around me, and remember values, and engage in cost-benefit calculations. Facebook wants to force us all to learn a new monetary language, a Libra-based one. But in doing so it's setting a huge hurdle to adoption.

So I'll just repeat. No matter how skillfully it goes about designing Facebookish (or Libras), artificial languages and artificial units are dead-ends. They're utopian, and definitely not user-friendly. (Ok, I may have described it all better in my original post, so just head on over.)

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That being said, over the last few months I've been slowly warming up to Libra. Out of the millions of crypto projects that have come out over the last decade, it comes close to the Fedcoin vision I originally outlined on my blog back in 2014, and twice now for R3.

To begin with, a Libra token would be stable (unlike bitcoin) thanks to credible and strong issuers. Since it would be decentralized, the network would be resilient. And since a Libra is a token, and not an account, it should be relatively open for everyone to use. At the same time, David Marcus, the architect behind Libra, is making the right noises about financial privacy. (Whether his intentions are genuine or not, it's tough to say.)

From the Libra whitepaper

I think (and I could be wrong here) that there is a growing desire on the part of consumers for more financial privacy. Unfortunately, governments hew to a post-9/11 mindset that regards privacy as a pervasive threat. Facebook may be one of the only organizations with the financial heft to articulate consumers' desires for more privacy in a way that regulators can't ignore.

Having Facebook as financial privacy advocate is a fragile win, no? It would be too bad if Libra (and whatever level of financial privacy it promises to bring to mainstream consumers) never attains widespread usage because of a basic design flaw, one that obligates us all to adopt the monetary-equivalent of Facebookish

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If not an artificial currency basket, what should Facebook do? I think that most consumers who engage in cross-border transactions want to keep swimming in their domestic currencies up until the last minute. Only at the 'buy now' or 'send now' moment—i.e. when a purchase it to be consummated or funds transferred to a friend—do we want to leave the bubble of our home currency. Pre-accumulating some strange alien token, whether those be SDRs, B-Units, or Libra, just isn't on the table.

If it wants to stay customer friendly, Libra needs to design its network to allow for the flow of tokens denominated in state currencies (U.S. dollars, Chinese yuan, British pounds, Indonesian rupee). And then it needs to design a cheap, transparent, and easy way for these tokens to move from person to person. This is what PayPal does. It's also worked for Transferwise. Visa and MasterCard too. None  of these platforms have created their own curious units, PayPalios or TransferWise-units or Visa-oos. They've allowed customers to remain safely ensconced in their domestic currency bubbles until the final 'send now' moment.

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Putting aside my criticisms of Libra's decision to use an artificial currency unit, what do I think about its choice of basket?

I am left wondering what sort of process David Marcus and the folks at Facebook have used to generate the basket components. Potential Libra users will want to know ahead of time how they can expect a basket's components to be updated as time passes. After all, if their wealth is to be held on the platform, customers will wonder what is to prevent a sudden rewriting of the basket in a way that favors the network at their expense?

One important rule that everyone will want to know is what economic thresholds are being used to filter out or include various currencies. For instance, if the Korean won starts to become a popular international currency, at what point will Libra decide to include it in the basket? If so, would it boot out another currency to make way for the won, or keep it?

The current Libra components are definitely odd, and give no indication of what process the architects are using to populate the Libra basket. For instance, I'm not aware of any selection process or rule that would lead to the Singaporean dollar comprising 7% of what is supposed to be a "global currency." Don't get me wrong. I like Singapore. It punches above its weight. But Singapore doesn't account for 7% of world trade, or 7% of the world's population, or 7% of global anything.

Or why does the euro account for just 18% of the Libra basket while the U.S. makes up a mammoth-sized 50%? The European Union has twice the population of the U.S. and accounts for a far larger share of exports. And where is the Chinese yuan? Exiled for political reasons?

One wonders if the euro's small share has to do with the effect that Europe's negative interest rates might have on network profits. For each Libra it has issued, the consortium will have to keep a Libra's worth of assets in reserve. Far larger profits can be earned it it reduces the euro portion of the basket and increases the U.S. dollar portion. After all, that would mean more exposure to high-yielding U.S. dollar assets and less to negative-yielding European ones. But that's a terribly ad hoc way to construct a currency basket.

My last thought is this. If Libra has its heart set on choosing an artificial currency unit as the basis for its global currency, it should have probably just go with the IMF's SDR basket rather than brewing its own strange currency concoction.

The IMF's SDR basket (source)

Consider how exchange-traded funds which track an index outsource all of the decisions about index methodology and components to third-parties like Standard & Poors, MSCI, and FTSE. This makes the exchange-traded fund more credible. Using SDRs would pre-commit Libra to avoiding conflicts of interest and thorny politics, the IMF becoming the theater for determining the basket. One could find worse third-parties than the IMF.

Wednesday, September 18, 2019

The life and death of an internet monetary meme


Over the last few years I've increasingly crossed paths with the following claim on the internet: "The average life expectancy for a fiat currency is 27 years." Is this claim true? What definitions are being used? I mean, are we talking about inconvertible paper money here, or currency that was convertible into gold, too?

I finally got curious enough that I decided to chase down the source of this meme. After all, without knowing what data it is based on, it's hard to evaluate the claim's truthfulness. Below I give a description of my trek through internet history.

The average-life-of-fiat meme has become particularly popular among cryptocurrency types. For instance, here is Jimmy Song, a popular bitcoin educator/developer, confidently invoking the slogan back in 2017:
"When a society lacks prudence, what happens is that the society collapses or goes into chaos. It’s not a coincidence that the average lifespan of a fiat currency is only 27 years."
A long list of cryptocurrency luminaries have dutifully mentioned the meme including Dan Held (2018), Taylor Pearson (2019), Barry Silbert (2019), Tuur Demeester (2015), Francis Pouliot (2018), and Adam Back (2019). Grayscale Investments, a firm that provides cryptocurrency-based investment products, even includes it in their marketing material:

As is often the case these days, crypto bugs have cribbed their ideas from their older cousins, the gold bugs. Nathan Lewis, author of Gold: The Once and Future Money, mentioned the idea in written testimony to Congress in 2012. Ralph Benko, a gold standard advocate, invoked the meme in a 2011 article. And Max Keiser, a long-time gold bug turned cryptocurrency advocate, began mentioning it as early as 2013. Where did Keiser, Benko, and Lewis get the meme from?

One of the meme's earliest and most cited appearances comes from Washington's Blog, a platform for a group of anonymous financial writers. We know little about this group except for the fact that George, "website owner and lead writer – is a busy professional, a former adjunct professor, an American and a family man." 

In August 2011, Washington's Blog published an article with the brutally long title The Average Life Expectancy of a Fiat Currency is 27 Years... Every 30 to 40 Years the Reigning Monetary System Fails And Has To Be Retooled. The author failed to explain how the 27 years claim was derived. Instead, he/she relied on another article by a writer named Chris Mack for backup. In a disclaimer the author noted that "I don't know Chris Mack," and thus couldn't vouch for the figures. "However," he/she went on to say, "the general concept is correct."

That's an odd way to do analysis, no? I've to this number for you, 27. I don't know how the number was generated, or who came up with it. But it's good enough. So go ahead and use it.

After a bit of hunting, I found Chris Mack's article here (the link at Washington's blog is dead). It is dated January 2011, pushing back the meme's genesis by another few months. At the time, Mack was President of Trade Placer, a "real-time marketplace where you can buy or sell items such as gold, silver, platinum, wine and other collectibles." Now he is the CEO at Levidge, a platform for trading cryptocurrencies. Note again the well-trodden corridor between gold buggery and crypto buggery.

Anyways, in 2011 Mack wrote:
"According to a study of 775 fiat currencies by DollarDaze.org, there is no historical precedence for a fiat currency that has succeeded in holding its value. 20 percent failed through hyperinflation, 21 percent were destroyed by war, 12 percent destroyed by independence, 24 percent were monetarily reformed, and 23 percent are still in circulation approaching one of the other outcomes.

The average life expectancy for a fiat currency is 27 years, with the shortest life span being one month. "
Mack mentions a study by DollarDaze, but doesn't provide a link to the article. Aha, the missing data! I hopped over to DollarDaze's website, a blog dedicated to talking about the failings of the U.S. dollar. But there are no blog posts older than 2018. No study, folks.

This puts all the meme users--Jimmy Song, Grayscale, Max Keiser, and the rest--in an absurd situation. There are some words on some websites about a study, but ask our meme users where the study is and none of them can actually find it. Did it ever exist? Why are they so confidently transmitting data when there is no data? DollarDaze has got to be right, no? How could you doubt it, JP?

Since no one was able to help me, I turned to the Wayback Machine to see if I could pull up older versions of the DollarDaze website. It took a while, but I finally found pay dirt. Back in 2009 the editor of DollarDaze, Mike Hewitt, wrote an article entitled The Fate of Paper Money. I tried to track Hewitt down, but he seems to have disappeared from the internet.

No matter. Finally, some data to evaluate! In his article, Hewitt claims to have counted 176 currencies in circulation and 599 currencies that are not in circulation. Of the 599 in his discontinued list, Hewitt comments that the "median age for these currencies is only fifteen years!" He provides links to both lists (1 and 2).

I downloaded Hewitt's list of 599 defunct currencies and put it into an Excel spreadsheet. The median age is indeed 15 years, as Hewitt claims, and the average is 27 years, as Mack claims in his subsequent 2011 article. So voila, we finally have the basis for the modern internet meme that the average age of a fiat currency is just 27 years. It's based on Hewitt's list of 599 dead currencies, with Mack taking the average duration. (They conveniently don't include the list of 176 existing currencies in their calculation, which would have increased the number). 

Now for my criticisms.

The 27-years meme has been used for many years now as a prop for making gold and cryptocurrencies look good. "Ha ha, suckers! Only 27 years until your paper is worthless!" But many of the 599 defunct currencies in Hewitt's list weren't failures. Rather, they were replaced for political, economic, and cultural reasons.
For instance, the list contains all of the pre-euro currencies (Dutch gulder, French franc, Italian lira, etc). These currencies had good reasons for disappearing: they were swapped for a new monetary unit. Existing currency holders weren't robbed. They were fairly compensated for this switch.

Another example of monetary reorganization occurred in East Africa. From 1919 to the 1960s, Britain's former east African colonies relied on the East African shilling, produced by the East African Currency Board. When these countries gained their independence, the currency board was dismantled. In its place Kenya began issuing its own shillings at par with the old ones, as did  Tanzania and Uganda.

In each case, existing owners of East African shillings could convert their holdings into new currency. No wealth was being destroyed during any of these switches. But people who throw around the phrase the average life expectancy for a fiat currency is 27 years as a criticism of the very institution of currency are using the data in a way that implicitly assumes that the East African experience--and others like it--were negative. They weren't.

So the idea that Hewitt's list somehow measures the length of time between a fiat currency's birth and its impending worthlessness is just wrong. I'd go even go so far as to say that the plasticity of the listed currencies is one of their strengths. As national borders change and political circumstances shift, the writing on the bills should be updated too. 

Hewitt's list contains many data errors. He makes the odd claim that the Japanese gold oban and silver momme were created in 1904 and met their end in a hyperinflation in 1905. But these were both historic Japanese coins that had existed for centuries. Hewitt also lists the U.S. greenback ("US Paper Dollar) as lasting from 1862 to 1878. But this isn't correct. Greenbacks were repegged to gold in 1878, but they continued to be issued for many decades after.

Or take Hewitt's categorization of British Military Authority (BMA) lira as dying in hyperinflation. This is an odd claim to make. BMA Lira were issued in Libya by occupying British forces both during and after World War II to provide the nation with a circulating medium. These notes were basically a military version of the British pound, with 480 lira equal to a pound sterling. In 1951 BMA Lira notes were converted into Libyan pounds, issued by Libya's new currency board, at a rate of 480-to-1. No hyperinflation here.


Finally, take Hewitt's claim that the Hawaiian dollar was "destroyed" by WWII. Not so. I've written about the Hawaiian overprints before. To protect against a potential Japanese invasion of Hawaii (and a confiscation of dollars by Japanese soldiers) all dollars on Hawaii were overprinted. Once the threat of Japanese invasion had disappeared they were swapped for regular U.S. dollars and withdrawn . But not a single Hawaiian lost anything during the entire process.

I don't want to nitpick too much, but given that it only took me a few minutes to find these four mistakes, one can only conclude that the rest of Hewitt's list is riddled with errors.

Finally, there are some semantic issues. Fiat currency is generally considered to be inconvertible money. It can't be redeemed for gold or silver. The world really only shifted onto a fiat standard between 1968-71 as the dollar ceased to be redeemed in gold. But Hewitt's list is replete with many metallic currencies (i.e. the riksdaler riksmynt). Are people using his data to make a claim about currencies in general, or just fiat ones? The meme isn't clear on this.

So having examined the life of an internet monetary meme, I'd like to kill it. It's time for us to retire the idea that says that "the average life expectancy for a fiat currency is 27 years." God knows there's plenty of problems with currencies. But good criticism requires diligence and accurate data. The meme in question is an example of sloppy work and bad data.

I know that the crypts and the bugs and the fiats are engaged in constant meme warfare--the bugs and the fiats for many decades now, the crypts only joining the battle a few years ago. Messages must be crafted for best efficiency, whether this be to pump bitcoin to the moon, or to push gold into the stratosphere, or to lock the fiat system in place. But most of the serious people involved in these debates, no matter which side, still keep at least one foot in the truth. Let's flush the 27-years meme down the toilet, folks.  

Saturday, August 31, 2019

Why the discrepancy?

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

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

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

Why this difference, asks Buterin?

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

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

Credit risk

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

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

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

Collapse risk

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

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

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

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

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

Two different blockchain dollars: USDC vs DAI

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

What might explain this discrepancy?

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

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

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

The convenience yield

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

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

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

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

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

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

Wednesday, August 21, 2019

Starbucks, monetary superpower



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

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

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

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

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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



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

Monday, August 5, 2019

Stigmatized money


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

Here are a few examples of awkward payments systems:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, July 5, 2019

Classifying cryptocurrencies



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

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

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

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


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

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

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


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

I disagree with you, JP

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

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

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

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

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

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

Blurred lines

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

The same applies to gold:

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

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

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

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

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

Tuesday, June 25, 2019

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


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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, June 12, 2019

Is bitcoin getting less volatile?


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

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

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

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

But the standard deviation is falling!

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

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

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

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

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

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

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

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



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

What is happening at the ends of the distribution?

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



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

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

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

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

What about Netflix?

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



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

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

Intrinsic vs extrinsic price fluctuations

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

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

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

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


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

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

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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.