Tuesday, October 23, 2018

Gold regulators

While our modern monetary system certainly has plenty of detractors, one of its successes is that we no longer need the services of the local gold regulator. In the late 1700s, the job of a gold regulator was to assay gold coins to determine if they were of the appropriate weight and fineness, modifying (ie 'regulating') the coin if necessary. When he was done, the gold regulator stamped the coin with his seal of approval and put it back into circulation.

The job of regulating coins may seem strange to us. But it was an ingenious way to cope with the lack of standardization that bedeviled monetary systems in the 1600 and 1700s, particularly in the colonies. There was no domestic supply of coins in North America back then, so settlers relied on a bewildering array of foreign coins as their media of exchange, each with its own weight and fineness, and most of poor quality. This included not only silver coins such as Spanish dollars, pistareens, and English crowns, but also a gamut of gold coins including Portuguese joes and moidores, English guineas, French Louis d'ors and pistoles, German carolines, and Spanish doubloons.

Each of these foreign gold coins was minted with a unique quantity of the yellow metal. For instance, the popular Portuguese half Johannes, or "half Joe", weighed 221 grains and was 91.7% pure when it left the mint, whereas a full-bodied Spanish doubloon weighed 416 grains (one gram equals ~15 grains). Thanks to constant wear and illegal clipping, these coins would inevitably lose some of their mass as they circulated. For merchants, the task of weighing each gold coin that was presented to them, checking if it was a counterfeit, and calculating its appropriate monetary value would have been fatiguing.

To help merchants determine the rate at which to accept a particular gold coin, the authorities published tables with coin weights and values. These coin standards were issued by various legislative bodies or by the merchants themselves. For instance, here is a table produced by the New York Chamber of Commerce in 1770:

Let's go through an example of how an American merchant might use this table. Say a customer offers a merchant a slightly worn half-Joe. The merchant measures the coin and discovers that it weighs exactly 9 dwt, or 216 grains. A dwt is a pennyweight, an archaic unit for measuring weights that derives from denarius weight. (1 dwt = 24 grains = 1.55 grams). Let's further assume say this exchange occurred in New York.

According to the above table, any half-Joe passed in New York that weighs at least 9 dwt 0 grains is legal tender for £3 and 4 shillings. Look in the columns titled "least weight" and "N. York". So if our merchant happens to be selling horses for £3 4s, then he'd be happy to accept the customer's slightly worn half-Joe as sufficient payment for a horse. But if the half-joe were to weigh less than 216 grains (or 9 dwt), then it would fail to meet the Chamber of Commerce's standards, and therefore the merchant wouldn't accept it—the coin is worth less than the horse's sticker price of £3 and 4 shillings.

Testing a coin's weight is easy, but it is unlikely that many merchants would have had the time or expertise to verify its purity. Whereas a Portuguese half-joe was minted with 91.7% fine, a good counterfeit half-joe might be just 88% pure. If a subsequent trading partner questioned a counterfeit's validity, a merchant who had accidentally accepted it could be out of pocket. To remove any doubt, a suspect coin could be brought to the local regulator to be assayed. After removing a small section of the coin, the regulator would then test the coin's gold content. If it was a good coin, he would plug up the test section and stamp his initials on it. Having been approved by a recognized member of the community, the coin could easily pass in trade.

This watchdog function reminds me of the part played by Chinese shroffs, or money changers, in the Chinese monetary system of the 17th-19th centuries. Like North America, China was inundated with a whole range of foreign coins. Local shroffs would assay a foreign coin to verify its silver content. If the coin passed their purity test, a shroff would stamp it with his own peculiar chopmark, usually a Chinese character or symbol. Over time, foreign coins circulating in China might collect multiple chops. The genius of this system is that a naive Chinese consumer could safely accept a strange coin knowing that it had successfully passed the smell test of professional appraisers—and the more chops the better.

Chopmarked 1807 Spanish silver dollar 

If you are interested in the Chinese practice of chopmarking, I wrote about it here and here.

Testing for fineness is just one theory for the role played by North American gold regulators. There is a second theory. Not only were they watchdogs, but regulators also acted as enhancers or correctors. To see why this might be true, let's delve a bit more into the dynamics in play in North America in the 1700s.   

If you look at the original table above, notice that the New York Chamber of Commerce listed the minimum accepted weight of the half-Joe as 216 grains. However, as I pointed out earlier, a freshly-minted half-Joe actually weighed 221 grains. So the Chamber of Commerce's standard tolerated the circulation of underweight half-Joes. (They did the same with other coins too, including the doubloon, which when freshly minted weighed 418 grains but was accepted by the Chamber of Commerce at 408 grains.) Providing some extra leeway was probably a wise move. The coins used by New Yorkers came from distant realms and inevitably suffered from wear & tear.

But if a half-joe had lost too much of it original heft it would fail to meet the Chamber's standard. This is where a gold regulator might come in handy. Say that a half-Joe was brought to a bank but found to only weigh 207 grains, well below both the Chamber's standard of 216 grains and its original mint weight of 221 grains. The bank would purchase it at discount, say by crediting the customer with just £3 1 shilling instead of the Chamber's standard £3 4s, then send the underweight coin to a gold regulator. The regulator would proceed to cut out a section of the coin and insert a purer (and heavier) gold plug into the hole, bringing its weight back up to the 216 grain standard.

The regulator would then stamp his initials on his modification, upon which the bank would pay the regulated coin out as change. The regulator's marks were proof that the coin lived up to the Chamber's weight standard, and presumably made it easier to pass from hand to hand. Here is what a coin that has been regulated with a plug looks like:
The coin in my tweet is a regulated 1747 Portuguese half-Joe. Notice that the plug is slightly raised on the face side of the coin, or the obverse side. On the reverse side of the coin, the plug is rounded and convex. So it apparent to the eye how the plug might add some heft to an underweight coin.

A coin could also be modified in a way that reduced it to the Chamber's standard. If a fresh half-Joe arrived in New York weighing 221 grains, it made no sense for its owner to spend it as-is. Given the Chamber's standards, a 216 grain half-Joe was sufficient to buy £3 and 4 shillings of goods and services (or settle £3 and 4 shillings debts). A 221 grain half-Joe was overkill. A customer could deposit their full-weighted half-joe at the bank for more then its value (say £3 and 5 shillings). The bank's gold regulator would then shave it down to size and stamp his initials on it. Thus the modified half-joe could circulate legally despite having a small amount clipped from it. It would have looked a bit like this:

Regulated 1774 Portuguese half-joe. Source

Note the flat part at the bottom where the half-Joe has been clipped by a regulator.

So a gold regulator's role, whether it be as a watchdog or an enhancer, or a bit of both, was to bring some much-needed order to the chaos of a multicoin monetary system. By bringing a gold coin up to standard, or reducing it to standard, they would have helped ensure the fungibility of North America's coinage. And by stamping their initials on it, regulators provided a guarantee of purity to the public—removing some of the uncertainty involved in accepting unfamiliar coins.

By the 1800s, there was no longer a need to have a gold regulators. Most of the deficiencies of the old non-standardized monetary system had been fixed. Paper money had largely displaced gold coins, so merchants had fewer occasions where they had to worry about accepting bad coins. As for smaller denomination silver coins, these were eventually replaced by token coins. The issuer's promise to buy them back at a fixed price, and not their metal content, dictates a token's value. While their time may be past, gold regulators remain a testament to monetary ingenuity.

Selected sources:
1. Sedwick, Daniel: The Regulated Gold Coinage of North America and the West Indies in the Late 1700s [link]
2. Michener, Ron: Money in the American Colonies [link]
3. Neufeld, EP: Money and Banking in Canada
4. The Yale University Brasher Doubloon [link]
5. Introductory Note: Report on the Establishment of a Mint, [28 January 1791] [link]
6. Mossman, Phillip: Money of the American Colonies and Confederation [link]

Saturday, October 13, 2018

Bitcoin and the bubble theory of money

A few months ago Vijay Boyapati asked me to "steel-man" the bubble theory of money. The bubble theory of money, which can originally be found in a few old Moldbug posts, has been used by Vijay and others to explain the emergence of bitcoin and make predictions about its future.

So here is my attempt. I am using not only an article by Vijay as my source text, but also one by Koen Swinkels, a regular commenter on this blog. Both are interesting and smart posts, it's worth checking them out if you have the time.

Steel-manning the bubble theory of money and bitcoin

1. Unlike a stock or a bond, which is backed by productive assets, bitcoin cannot be valued using standard discounted cash flow analysis. And since it has no intrinsic uses, it can't be valued for its contribution to various manufacturing processes, nor for its consumption value. Rather, bitcoin is a bubble. Its price is driven by a speculative process whereby people buy bitcoins because they think that other people can be found who will pay an even higher price.

2. There is no reason why bitcoin must pop. At first, bitcoin will be bought by those on the fringe. As more people get in, the price of bitcoin will rise further. It will continue to be incredibly volatile along the way. But once bitcoin is widely held (and very valuable), the flow rate of incoming buyers will fall, and so will its volatility. At this point it has become a stable low-risk store of value. The eventual stabilization of bitcoin's price is a commonly held view among the bitcoin cognoscenti. For instance, bitcoin encyclopedia Andreas Antonopoulos has often said the same thing (i.e. "volatility really is an expression of size").

3. Once its price has stabilized, bitcoin can transition into being a widely used money, since people prefer stable money, not volatile money.

So having steel-manned the bubble theory of money as applied to bitcoin, where do I stand?

I agree with points 1 and 3. My beef is with the middle point.

Will a Keynesian beauty contest ever stabilize?

First off, let me point out that there are elements of the second argument that I agree with. Yes, bitcoin needn't pop, although my reasons for believing so are probably different from Koen and Vijay.  In the past, I used to think that a popping of the bitcoin bubble was inevitable. After all, as a faithful Warren Buffett disciple, I believed that the price of any asset eventually returns to its fundamental value, and bitcoin's is 0.

But the eternal popularity of zero-sum financial games, or gambles, has disabused me of this view. People are lured by the promise of winning big and changing their lives without having to do any work. Heck, even though a Las Vegas slot machine will take on average 8 cents from every $1 wager, people still flock to insert $1 bills into slots. And so they will play bitcoin too, which like a slot machine is also a zero-sum game.

But I digress. The key point I want to push back on is Vijay and Koen's assumption that bitcoin volatility will inevitably decline as it gets more mature. I'm going to accuse them of making a logical leap here.

If bitcoin is fundamentally a bubble, or—as Vijay describes it—if bitcoin's price is determined game-theoretically, then why would its price dynamics change if more people are playing? Almost a century ago, John Maynard Keynes described this sort of game as a beauty contest. Presented with a row of faces, a competitor has to choose the prettiest face as estimated by all other participants in the contest:
"...each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees."
Whether 100 people are participating in Keynes's beauty contest, or 10,000, the nature of the game has not changed—it is still an nth degree mind-game with no single solution. Since the game's underlying nature remains constant as the number of participants grows, its pricing dynamics—in particular its volatility—should not be affected.

The stabilization of Amazon

We can think about this differently by using actual examples. I know of an asset that has become less volatile as it has gotten bigger: Amazon. See a chart below of its share price and volatility over time:

Why has Amazon stabilized, and will bitcoin do the same? When Amazon shares debuted back in 1997, earnings were non-existent. Jeff Bezos had little more than a hazy business plan. Since then the stock price has steadily moved higher while median volatility has declined. Amazon shareholders used to experience day-to-day price changes on the order of 2.5-4.5% in the early 2000s. By the early 2010s, this had fallen to 1-2% or so. Over the past several years, volatility has typically registered between 0.5-1%.

I'd argue that the stabilization of Amazon hasn't been driven by a larger market cap and/or growing trading volumes. Under the hood, something fundamental has changed. The company's business has matured and earnings have become much more stable and predictable. And so has its stock price, which is just a reflection of these fundamentals.

I've just told a reasonable story about why a particular asset has become less volatile over time. But it involves earnings and fundamentals, two things that bitcoin doesn't have. I'm not aware why a Keynesian beauty contest, which lacks these features, necessarily gets less volatile as more people join the guessing game.

Vijay and Koen draw an analogy between gold and bitcoin. Their claim is that if gold once transitioned from being a volatile collectible into a low-risk store of value, then so can bitcoin. But we really don't have a good dataset for the price of the yellow metal, so we really have no idea how its volatility changed over time. Going back to 1969—admittedly far too short a time-frame—gold has certainly increased in size (i.e. the total market value of above-ground gold has increased), but unlike Amazon there is no evidence of a general decline in price volatility:

I'd argue that in gold's case a lack of a correlation between size and volatility makes sense. A large portion of gold's daily price changes can be explained by speculators engaging in a Keynesian beauty contest, not changes in industrial demand or earnings (unlike Amazon shares, gold doesn't generate income). There's no good reason to expect that the volatility generated by gold speculators' beliefs should level off as participation in the "gold game" grows. Any game in which speculators base their bets on what they expect tomorrow's speculator to do, who in turn are guessing about potential bets made by next week's speculators, who in turn form expectations about the choices made by next month's players, is unlikely to converge to a stable answer for very long.

Will Proof of Weak Hands 3D tokens ever become money?

As a third example, let's take Proof of Weak Hands 3D (PoWH3D), an Ethereum dapp that I've blogged about a few times. PoWH3D is a self-proclaimed ponzi game. Basically, a player purchases game tokens, or P3D tokens, with ether. Each player's ether contribution goes into the pot, or the PoWH3D smart contract, less a 10% entrance fee which is distributed pro-rata to all existing P3D token holders. When a player wants to exit the game, their tokens are sold for an appropriate amount of ether held in the pot, less another 10% that is distributed to all remaining players.

So if a new player spends one ether (ETH) on some P3D tokens only to sell those tokens an instant later, they'll end up with just 0.81 ETH, the first 0.1 ETH having been paid to everyone else upon the new player's entrance, the other 0.09 being deducted upon their exit. Why would a new player take such a bad bet? Only if they believe that a sufficient number of latecomers will join the game such that they'll get enough entrance and exit income to compensate them for the 0.19 ETH they have already given up.

PoWH3D is a pure Keynesian beauty contest. A new entrant's expectations are a function of whether they believe latecomers will join, but latecomers' expectations are in turn a function of whether they believe yet another wave of even greater fools will pile in, etc, etc.

Applying Koen and Vijay's assumption that volatility decreases with adoption, then the return on P3D tokens should become less volatile as more people join. It might even transition into a stable investment, say like a blue chip utility stock. Who knows, it could even become a medium of exchange to rival the dollar. But surely Koen and Vijay don't want to walk out on a limb and argue that a pure ponzi game like PoWH3D will ever stabilize. Or that it might become a form of money. I think the most reasonable thing we can say about PoWH3D is that once a ponzi game, always a ponzi game. The volatility of its returns will not decline as the game grows, and that's because the game's fundamentals, its ponzi nature, doesn't vary with size. (If you are interested in PoWH3D, here are some great charts and stats).

At this point, it may be useful to map out a chart of bitcoin's 200-day median volatility. As in the case of Amazon and gold, I use the median rather than the average to screen for outliers:

I haven't updated the chart for two months, but volatility has declined since then. Vijay and Koen will probably say that as of October 2018 bitcoin is less volatile than it was in 2011. That's certainly true. But eyeballing the chart, we certainly don't get the same clean relationship between size and volatility as we do with the Amazon chart.

Here's the biggest oddity. By December 2017 bitcoin had reached a market cap of $300 billion, its highest value to date. If Vijay and Koen are right, peak size should have corresponded with trough volatility. But this wasn't the case. In late 2017, bitcoin volatility was actually quite high. In fact, it exceeded levels set in late 2013, back when bitcoin was still a tiny $3 billion pup! The lesson here is that with bitcoin, bigger is just as likely to correspond with more volatility as it is with less volatility. More broadly, when it comes to Keynesian beauty contests there seems to be no fixed relationship between volatility and size. It's chaos all the way down.

This leads into Koen and Vijay's final point, that once bitcoin's price has stabilized, it can transition into a widely used money. I agree with the underlying premise that only stable instruments will become accepted by the public as media of exchange. But since I don't see any reason for bitcoin to stabilize, I don't see how it will make the leap from a speculative instrument to a popular means of paying people.

Bitcoin isn't on the verge of going mainstream. It's already there.

Vijay's message (Koen's not so much) can be taken as investment advice. Because if he is right, and bitcoin has yet to progress to a popular store of value and finally a medium of exchange, then we are still in the first innings of bitcoin's development. Vijay points to what he thinks are the features that will make bitcoin win out against other popular stable assets, including portability, verifiability, and divisibility.  Given that only the “early majority” has adopted bitcoin (the late majority and laggards still being far behind), Vijay thinks it would be reasonable for the price of bitcoin to hit $20,000 to $50,000 on its next cycle, and hints at an eventual price of $380,000, the same market value of all gold ever mined. So buying bitcoin now at $6,000 could provide incredible returns.

I have different views. Whereas Vijay thinks bitcoin has yet to go mainstream, I think that bitcoin went mainstream a long time ago, probably by late 2013. Bitcoin is often portrayed (wrongly) as a payments system-in-the-waiting, and thus gets unfairly compared to Visa and other successful payments systems. Given this setup, cryptocurrencies seems to be perpetually on the cusp of breaking out as a mainstream payments option. But bitcoin's true role has already emerged. Bitcoin is a successful decentralized gambling machine, an incredibly fun censorship-resistant Keynesian beauty contest.

Viewed this way, bitcoin's main competitors were never the credit card networks, Citigroup, Western Union, or Federal Reserve banknotes, but online gambling sites like Poker Stars, sports betting venues like Betfair, bricks & mortar casinos in Vegas, and lotteries like Powerball. By late 2013, bitcoin was at least as popular as some of the most popular casino games, say baccarat or roulette. It had hit the big leagues.

Whereas Vijay hints at a much higher price, where do I see the price of bitcoin going? I haven't a clue. But if I had to give some advice to readers, I suppose it would be this. Like poker or slots, remember that bitcoin is a zero-sum financial game (For more, see my Breaker article here). You wouldn't bet a large part of your wealth in a slot machine, would you? You probably shouldn't bet too much with bitcoin either. Vijay could be right about bitcoin hitting $380,000. It could hit $3.80 too. But if it does go to the moon, it will do so for the same reason that a slot machine pays off big.

It's worth keeping in mind that when it comes to gambling, the house always wins. Searching around for the lowest gambling fees probably makes sense. As I said earlier, Las Vegas slots will extract as much as 8 cents per dollar. Lotteries are even worse.

In bitcoin's case, the "house" is made up of the collection of miners that maintain the bitcoin system. All bitcoin owners must collectively pay these miners 12.5 bitcoins every 10 minutes to keep things up and running. So if you hold one bitcoin and its market value is $6000, you will be paying around 62 cents per day in fees, or $230 per year. That works out to a yearly management expense ratio of 3.8%. Beware, this number doesn't include the commissions that the exchanges charge you for buying and selling.

So before you start gambling, consider first whether the benefits of decentralization are worth 3.8% per year. If not, find a centralized gambling alternative. If the costs of decentralization are worth it, then buy some bitcoin, and good luck! But play responsibly, please.