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.


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.