Tuesday, July 31, 2018

Tainted money

In many parts of the world, cash held in ATMs or in cash-in-transit vehicles is protected by so-called intelligent banknote neutralization technology. When a thief tries to force the ATM open, plastic packs filled with dye explode, spraying both the thief and the banknotes. These notes have now been demarcated as stolen. A shopkeeper may refuse to accept marked notes or may only accept them at a large discount to their face value. At this point, cash has ceased to be fungible. One banknote is not a perfect substitute for another.

The dye used in banknote neutralization is often mixed with a taggant, a chemical marker that contains a unique combination of elements chosen from thirty or so rare earth metals. This ensures that a given block of cash is protected by a one-of-its-kind dye pack. So if the authorities apprehend the ink-stained thief with the marked cash, they can actually trace the stuff back to its original owner and return it. This incentivizes any would-be ATM thief to think twice.
An analogy can be drawn to bitcoin. Each bitcoin's history is indelibly recorded on the bitcoin blockchain. So if a coin is reported stolen, it is theoretically possible for law authorities to see the movement of the stolen coin as it passes from owner to owner. Any buyer of bitcoins needs to be concerned with the possibility that they will be confronted by the authorities and obliged to return that coin to its original owner. This possibility could affect the fungibility of bitcoins. Coins with clean histories may trade at a premium to those without clean histories.

This similarity between tainted bitcoins and banknotes is only superficial, however. In most parts of the world accepting stolen bitcoins is far more risky than accepting stolen banknotes. Even if a seller does their best to make sure that a buyer's bitcoins aren't stolen, they could be legally obliged to return the bitcoins to their rightful owner if their analysis is wrong. The legal treatment of stolen banknotes is different. A seller can mistakenly accept stolen banknotes but as long as they have done so in good faith, they cannot be legally obliged to return them to their original owner.

Good faith means honestly. If a seller knows that the buyer is using stolen banknotes, then the seller would not be acting in good faith if they accepted those notes. If the seller has no knowledge about whether the notes have been stolen, then they are acting in good faith if they accept them. This state of mind is sometimes referred to as acting with a pure heart and an empty head.

The difference between bitcoins and banknotes is best illustrated by an example. Say I am holding a garage sale. A thief buys a knickknack from me using a stained $10 note. I am not familiar with intelligent banknote neutralization, so I do not know that the banknote has been stolen. I try to deposit the stained note at the bank and the bank notifies the police. Thanks to the taggant, it can be proven that the note was stolen from Bank X's ATM a few days before. Since I innocently accepted the note i.e. I did so in good faith, I am not obligated to give it up to Bank X. If, on the other hand, I knew about intelligent banknote neutralization, and this could be proven in court, then I would be obliged to give the note back. But it was an honest mistake, and so I am forgiven.

Continuing the example, say the thief bought another knickknack at my garage sale using bitcoins. Prior to accepting his bitcoins, I did a careful analysis of the blockchain to see if the coins had been stolen, but nothing turned up. It turns out my analysis was flawed. In actuality, the thief held-up a bitcoiner at gun point the night before and stole her bitcoins. Even though I did my very best to ensure they weren't stolen, I could be obliged by the law to give the bitcoins back to their original owner.   

The law is very forgiving towards users of banknotes. Sellers can be fairly uninformed, or objectively stupid if you will. They can make honest mistakes accepting banknotes. But an honest mistake with bitcoin could be very costly. With bitcoin, there is no protection for fools.

In the above example, bitcoins are treated by the law as regular property. When someone steals a piece of property, say a painting or a car or a piece of jewelry, and sells it, the law needs to determine which of two innocent parties gets to keep the property; the owner who was robbed or the buyer who innocently gave up something to the thief in return for the stolen property. For almost all types of property, including paintings and cars and jewelry (and bitcoin), the law usually favours the original property owner. Even though the new owner participated in the transaction in good faith, they must return the stolen goods. 

Banknotes have been granted special status by the law. They are one of the few types of stolen property that an innocent third party gets to keep. As a result of this exception, trade conducted with banknotes is far more fluid than trade conducted with other types of property. A seller who is offered a banknote doesn't have to worry about investigating that note's past history to verify that it was stolen. This greases the wheels of commerce. But it comes at a price. The property rights of the original owner have been thrown under the bus.

Should the exemption that has been granted to banknotes be extended to bitcoin? Probably not. Property rights are very important. If we trample on them at all, it should only be in certain situations where there is a very good reason for doing so. At the time that English courts originally granted the property exemption to banknotes they were already responsible for a large portion of England's commerce. This is still the case, with cash generally participating in for around half of the UK's retail payments.

Treat banknotes as regular property and people would have to take on the full risk of accepting stolen notes. This would put a significant damper on trade. Bitcoins are not used for buying and selling things at a retail level. When bitcoins pass from one hand to the other, it is almost always for speculative reasons, not mercantile ones. Given that the bar for removing the property rights of the original owner should be a high one, bitcoin probably doesn't clear the hurdle.

Saturday, July 14, 2018

The €300 million cash withdrawal

The eyes of the world are on one of history's largest cash withdrawals ever. Earlier this week, the Central Bank of Iran ordered its European banker, Hamburg-based Europaeisch-Iranische Handelsbank AG, to process a €300 million cash withdrawal. Germany's central bank, the Bundesbank, is being asked to provide the notes. If the transaction is approved, these euros will be counted up, stacked, and sent via plane back to Iran. German authorities are still reviewing the details of the request.

Iran claims that it needs the cash for Iranian citizens who require banknotes while travelling abroad, given their inability to use credit cards, says Bild. Not surprisingly, U.S. authorities are dead set against the €300 million cash transfer and are lobbying German lawmakers to put a stop to it. They claim the funds will be used to fund terrorism.

The picture below illustrates $1 billion in U.S. dollars, so you can imagine that €300 million in euro 100 notes would be about a third of that. That's a lot of paper.

One Billion Dollar Art Piece by Michael Marcovici (source)

The fate of this transaction is important not only for Iran but the rest of the world. It gives us a key data point for answering the following question: just how resistant is the global payments system to U.S. censorship? If a payments system is censorship resistant, third-parties do not have the power to delete a user or prevent them from accessing the system. If the U.S. can unilaterally cut off any nation from making cross border payments, then the global payments system isn't censorship resistant.

We already know that the global payments system is highly susceptible to U.S.-led censorship. From 2010-2015, Barack Obama successfully severed Iran from the world's banks, driving the nation's economy into the ground and eventually forcing its leaders to negotiate limits to their nuclear plans.

The global payments system's susceptibility to U.S. censorship stems from the fact that an incredibly large chunk of international trade is priced in and conducted using U.S. dollars. To make U.S. dollar payments on behalf of clients, a foreign bank must be able to keep a correspondent account with a large U.S. bank. This reliance on U.S. correspondents allows U.S. authorities to use their banks as hostages. International banks can either comply with U.S. requests to cease doing business with Iran, or have their access to U.S. correspondent banks cut off. Dropping Iranian customers is generally the cheaper of the two options.

Following in Obama's footsteps, Donald Trump has decided to inaugurate the next round of Iranian payments censorship. But this time around Europe has not gone along in declaring Iran to be a banking pariah. (I wrote about this here). Europe is responsible for managing the world's second-most important currency: the euro. Its reluctance to sign on to the U.S.'s new censorship drive is a sign that the global payments system may be a little more resistant to censorship than the first round of Iran sanctions might have implied. If a nation is prohibited from using one end of the global payments system, the U.S. dollar end, but not the other (albeit smaller) end, then they haven't really been cutoff.   

Digital euros flow through pipes operated by the European Central Bank, the ECB. This financial piping system is otherwise known as Target2, the ECB's large value payments system. Any bank that is connected to Target2 can route euro-based payments on behalf of its customers to the customers of any other bank that is connected to those same pipes. While a Target2 connection might not be as good as being connected to the US-based financial pipes, it's a close second.

In addition to facilitating digital euro transfers, the ECB also makes euro cash available to member banks when they need it. The way this works is that European commercial banks like Deutsche Bank or Santander or Europaeisch-Iranische Handelsbank have accounts at the ECB. They can ask the ECB to convert balances held in these accounts into euro cash to meet their customer's withdrawal requests.

The ECB can censor a bank—and its customers—by cutting of said bank's access to Target2. It can also censor a bank by refusing to allow the conversion of that bank's ECB account balances into cash. Europaeisch-Iranische Handelsbank's request to withdraw €300 million on behalf of Iran's central bank is a litmus test of the ECB's willingness to continue providing the second of these services: cash withdrawals. Will it comply with U.S. demands and censor Europaeisch-Iranische Handelsbank, and thus Iran, or will it treat Europaeisch-Iranische Handelsbank like any other bank and process the withdrawal? If Europe can successfully resist U.S. pressure, and the cash is sent, then the world's payments systems will be significantly more resistant to censorship than it was before.   

It may be tempting to belittle the topic of censorship resistance as only being relevant to a small group of international pariahs like North Korea or Iran. Only the "bad" guys will ever be cutoff from the global payments system, not us. But nations like Turkey, Russia, and China could one day become tomorrow's pariahs, and thus targets of U.S. monetary sanctions. Heck, in Trump's America, even traditional allies like Canada, South Korea, and UK should probably be worried about being targeted by the U.S. for censorship from the global payments system.

There are sound political and moral reasons for both censoring Iran and not censoring it. Moral or not, my guess is that most nations will breathe a sigh of relief if German authorities see it fit to let the €300 million cash withdrawal go through. It would be a sign to all of us that we don't live in a unipolar monetary world where a single American censor can prevent entire nations from making the most basic of cross-border payments. Instead, we'd be living in a bipolar monetary world where censorship needn't mean being completely cutoff from the global payments system.

The sooner the Bundesbank prints up and dispatches the €300 million, the better for us all.