Thursday, February 21, 2013
Financial deepening and currency internationalization, the bitcoin edition
Much of the conversation about bitcoin adoption focuses on its use in goods and services transactions. Breaking bitcoin news, for instance, draws attention to the fact that the Internet Archive will be giving employees the option to be paid in bitcoin. This focus on brick & mortar transactions means that the role that bitcoin financial instruments—stocks, bonds, and derivatives—have to play in promoting bitcoin adoption often gets overshadowed.
I'm currently reading Barry Eichengreen's Exorbitant Privilege which goes into the mechanics of what it takes to create a truly international currency. Eichengreen points out that prior to World War I the dollar played a negligible role relative to the pound sterling in world markets, but by the mid 1920s it was the dominant unit for invoicing payments and denominating bonds. Eichengreen's theory is that the US dollar became the world's go-to currency because of the emergence of a very specific financial instrument—the banker's acceptance.
An acceptance is much like a bill of exchange, a financial instrument I explained in my last post. Say a merchant decides to pay for a shipment of goods with a personal IOU, or bill. If a bank first "accepts" the bill i.e. if it agrees to vouch for the IOU, then this gives the bill more credibility. It is now a banker's acceptance.
According to Eichengreen, around 1908 or 1909, a concerted effort to foster the growth of the US acceptance market began. Up till then, US banks had been prohibited from dealing in acceptances and branching abroad—both these limitations would be removed by new legislation. To promote liquidity and backstop the acceptance market, the Federal Reserve, established in 1914, was given authority to buy and sell acceptances via open market operations. Furthermore, these acceptances could legally "back", or collateralize, the Fed's note issue. This feature was particularly helpful. Although the Fed was also legally permitted to purchase government securities, government securities could not "back" the note issue. Acceptances, therefore, became the more flexible and preferred asset for Fed open market operations, at least until 1932 when the limitations on government collateral were removed. According to Eichengreen, the Fed was the largest investor in the acceptance market and sometimes held the majority of outstanding issues on its balance sheet.
By the mid-1920s foreign acceptances denominated in dollars exceeded those denominated in sterling by a factor of 2:1 and more central banks held US forex reserves than sterling. London was on the way out, and New York on the way in. By 1929, the amount of outstanding foreign public bonds denominated in dollars (excluding the Commonwealth) exceeded sterling bonds. The lesson here is that a key step in the sequence of internationalizing a currency is getting it to be used in financial markets. This involves the development of deep, liquid, and accessible markets in securities denominated in that currency.
What sort of financial deepening do we see in the bitcoin universe, and how might we compare it to the dollar's emergence in the 1910s and 20s?
There are a number of healthy signs of financial deepening. I count five competing bitcoin securities exchanges that provide a forum for trading bitcoin-denominated stocks and bonds. These include Cryptostocks, BTCT, MPEx, Havelock, and Picostocks. A sixth, LTC-Global, provides a market in litecoin securities, a competing altchain. Holders of bitcoin needn't cash out of the bitcoin universe in order to get a better return. Instead, they can buy a bond or a stock listed on any of these exchanges.
The largest publicly-traded company in the bitcoin universe is SatoshiDice, a bitcoin gambling website listed on MPEx. With 100 million shares outstanding and a price of 0.006 BTC, SatoshiDice's market cap is ~600,000 BTC which comes out to around $17 million. SatoshiDice IPOed last year at 0.0032 BTC. With bitcoin only trading at $12 back then (it is now worth $29), the entire company would have been worth $4 million. Given today's $17 million valuation, SatoshiDice shareholders have seen a nice return over a short amount of time—much of it provided by bitcoin appreciation.
While SatoshiDice certainly provides some depth to bitcoin financial markets it has the potential to shallow them out too. Because MPEx charges large fees to trade on its exchange, a few of the competing exchanges have created what are called SatoshiDice "passthroughs". Much like an ETF, a passthrough holds an underlying asset—in this case SatoshiDice shares on MPEx—and flows through all dividends earned to passthrough owners. As a result, investors can get exposure to SatoshiDice without having to pay MPEx's expensive fees. BTCT, for instance, lists two different SatoshiDice passthroughs (GSDPT and S.DICE-PT) which together account for more trading volume than all other stocks and bonds listed on BTCT.
SatoshiDice's sheer size is to some extent problematic since Bitcoin financial markets are not as deep as they might appear. Should something ever happen to SatoshiDice, a big part of the bitcoin financial universe's liquidity will be wiped out, and this would ripple out across the entire field of bitcoin securities. The same might have happened to banker's acceptances in their day, except for one difference—the Fed was willing to back the acceptance market up. In the bitcoin universe, there's no buyer of of last resort to provide liquidity support to SatoshiDice shareholders.
Another impediment to deeper bitcoin markets is the hazy legality of the bitcoin securities exchanges. The first major bitcoin securities exchange, GLBSE, was closed in October 2012 with no prior warning. According to this article, potential regulatory and tax liabilities convinced GLBSE's founder to shut it down on his own behest. If any of the existing bitcoin exchanges were to grow too noticeable, one could imagine the SEC (or its equivalent) knocking on their door and forcing the exchange-owner to pull the plug. This sort of regulatory uncertainty can only dampen the liquidity and depth of bitcoin financial markets.
US authorities, on the other hand, didn't need to heed the rules when they built the banker's acceptance market. They created the rules. If financial deepening in the Bitcoin universe is to proceed it will happen despite regulations and not because of them.
The last headwind to bitcoin financial deepening is bitcoin's volatility. Eichengreen writes that the seesawing of the pound sterling during the war period encouraged financial markets to search for a more stable unit in which to express debts. The pound had always been anchored to gold (or silver), but it was unpegged from its century's long gold tether when the war broke out. Although it was repegged in January 1916, this time to the dollar, this did not secure confidence in the sterling's value since the peg was dependent on American support. When this support was withdrawn at war's end, sterling fell by a third within a year. Through all of this, the dollar continued to be defined in terms of gold, a feature which no doubt attracted issuers.
Bitcoin, on the other hand, has more than doubled in just two months. Back in June 2011, it fell by 50% in just two days. Like pound sterling during the war, bitcoin's lack of stability will do little to promote deeper financial markets.
Although I've stressed the difficulties that bitcoin markets face in developing more depth, the sheer amount of financial innovation I'm seeing from those involved in the various bitcoin securities exchanges is impressive. I wish them the best. The more they build up bitcoin securities markets, the better an alternative bitcoin presents to competing currency units.
Disclaimer: I am long SatoshiDice and several bitcoin mining stocks.
Subscribe to: Post Comments (Atom)
Have you hear of Sealswithclubs, the poker site? Any idea how much it's worth?ReplyDelete
Btw, did you ever get involved in the poker boom? Seems like poker would be a natural fit with econ people (risk/reward, probability, game theory, bankroll management, etc).
John, as far as I know the company you ask about doesn't trade on any of the bitcoin exchanges.Delete
Nope, the poker boom pretty much passed me by. I do like playing it though.
Maybe this is a variation of the "what backs bitcoin" question, but I'm wondering if the success of the US banker's acceptances was implicitly backed by economic output as the US real GDP growth was very strong in the ~1890-1920's period? Thus the bill liquidity was "backed by" highly liquid goods. The BTC-denominated stock exchanges provide liquidity but the underlying stocks don't look very liquid (i.e. you can't trade Cisco). Internet gambling looks to be a good application though.ReplyDelete
jt, it makes sense that real GDP growth helped internationalize the US dollar.Delete
The same never really happened with the yen, though, even though Japan grew tremendously up till the 1990s. Something else is needed, namely financial openness and innovation, which Japan lacked since it had a relatively closed capital account.
The bitcoin economy has tonnes of financial innovation. It has an incredibly open capital account... you can convert your dollars into bitcoin and buy a bitcoin-denominated stock in about 60 seconds. But bitcoin GDP is minimal... too much speculation I fear.
> SatoshiDice's sheer size is to some extent problematic since Bitcoin financial markets are not as deep as they might appear. Should something ever happen to SatoshiDice, a big part of the bitcoin financial universe's liquidity will be wiped out, and this would ripple out across the entire field of bitcoin securities. The same might have happened to banker's acceptances in their day, except for one difference—the Fed was willing to back the acceptance market up. In the bitcoin universe, there's no buyer of of last resort to provide liquidity support to SatoshiDice shareholders.ReplyDelete
One could've said the same thing about the Pirateat40 ponzi scheme. When it finally shut down, that took out all the Pirate passthroughs, obviously, but as far as I know, it only took out one or two small funds which had been quietly investing in it.
Yes, exactly like that. If I recall, bitcoin's price fell in half because of it.Delete
Offhand, I don't remember any such fall. (What would cause it? No one has been able to point to Pirate cashing out for fiat, and if you are buying bitcoins, then unless you were buying them to invest directly in Pirate, why would you care?)Delete
Even if there were such a fall, 'because' is a pretty strong claim to make of price movements in a currency you've already pointed out fluctuates large amounts constantly.
It seems to correlate well with pirate.
But you are right, correlation is not necessarily causation. I'll soften my point and say that there is a reasonable chance that the Pirate event caused a fall in bitcoin.
"(What would cause it? No one has been able to point to Pirate cashing out for fiat, and if you are buying bitcoins, then unless you were buying them to invest directly in Pirate, why would you care?"
As Eichengreen points out, one of the valuable services a currency provides is access to deep financial markets. The pirate debacle destroyed this market, at least temporarily, and as a result bitcoin provided less services than before.
"The largest publicly-traded company in the bitcoin universe is SatoshiDice, a bitcoin gambling website listed on MPEx. With 100 million shares outstanding and a price of 0.006 BTC, SatoshiDice's market cap is ~600,000 BTC which comes out to around $17 million."ReplyDelete
Actually with the exception of a few days during its very strong January month, S.DICE is and always was the second largest publicly traded Bitcoin company. The largest for the past six months or so has been S.MPOE. Lately the market cap difference is small, but still present.
Interesting. Is that because MPOE owns a bit of SatoshiDice?Delete
The two are unrelated. S.MPOE operates the options bot and also owns MPEx itself. You can review the birth certificate here : http://polimedia.us/trilema/2012/sa-ne-jucam-de-a-investitiile-n-bitcoini/#comment-78745Delete
It also publishes P&L statements, the most recent being http://polimedia.us/trilema/mpoe-january-2013-statement (another one is due at the end of today).
If you still have an irc client anywhere you could drop by on #bitcoin-assets on freenode, it's where most of Bitcoin finance takes place at the moment (most exchange ops are present there, most traders of consequence etc). If not http://webchat.freenode.net/?channels=bitcoin-assets.
Awesome, thanks for the invite, I may take you up on it. Let me read through your stuff first so I don't look like a dummy. Just looking over your financial statements. Now I see why you've got a big market cap. Learn something new every day.Delete
Banks are about to suffer their biggest disruption since the gold standard was abandoned. The advantages that Bitcoins give you far outweigh the disadvantages. It's just a better product than what traditional banks offer us. Don't miss the boat and get started using Bitcoins here! http://thebitcoinmaster.blogspot.comReplyDelete
"Banks are about to suffer their biggest disruption since the gold standard was abandoned. The advantages that Bitcoins give you far outweigh the disadvantages."ReplyDelete
Nothing more to add.
The largest for the past six months or so has been S.MPOE. Lately the market cap difference is small, but still present.ReplyDelete
International Financial Markets
Most of the time I don’t make comments on websites, but I'd like to say that this article really forced me to do so. Really nice post! Click here : bitcoin robotReplyDelete
This only shows that those bitcoin casinos are one big asset to increase bitcoin trading volume. Legality and volatility are the biggest challenges in bitcoin ecosystem. Imagine, if that would be overcome and BTC price will stabilize, for sure, central banks will start to cry. Bitcoin is their strangest competitor now; you can predict its future.ReplyDelete