Another week, another Bitcoin panel, another opportunity to hear the same old myths being propagated about the world’s worst currency.
This time the favoured mythology was the idea that Bitcoin is apparently the only truly debt-free economic system in the world.
Which, of course, is a fallacy.
Leaving aside the existence of outstanding claims on Mt Gox following its bankruptcy, the proliferation of Bitcoin derivatives markets, the attempted creation of an etf, all sorts of dodgy custody businesses that have failed to keep promises, and the rise of offchain clearing — all of which show Bitcoin is entirely prone to debt, leverage and finding itself short — let’s tackle the specific claim that it’s the fundamental unit of Bitcoin itself that is debt free.
This argument is based on the notion that because you can’t fake Bitcoin units in the master ledger, whatever debt exists in the economy is an inferior subordinated claim and thus totally separate to Bitcoin. The master unit remains debt free.
So even if you can’t control how many times people oversell claims to the underlying Bitcoin, if anyone tried to move it, you would soon know because the receipts or certificates they hold are inferior and thus subordinate to Bitcoin. Ta dah! No debt.
Except, of course, that describes our current system as well.
The Fed’s money/deposits have absolutely nothing to do with how much debt there is in the system.
That’s because the Cbank system is what you call a “closed system” more akin to equity than debt. In that sense it operates just like Bitcoin.
The confusion for the bitcoiners I think comes about because they mistake being fully funded with being debt free. But the two are totally different concepts.
Let me explain the difference.
Imagine I am a Fed member bank with full and rightful title over x percent of the fed’s deposit stock. I own these reserves unconditionally. They are mine. No one else’s.
Yet they also amount to a claim on the Fed. That means they must de facto be a Fed liability as well.
The only way this varies from the Bitcoin set-up is that the claims I own unconditionally are on the Bitcoin network instead of the Federal reserve system. They are the Bitcoin network’s liability (i.e. They represent the equity of that community).
With gold, you could argue, the asset is nature’s liability — because every bar of gold supposedly entitles the holder to some form of consumption that relies on the resources of Mother Nature.
Okay. Here’s where the confusion comes about I think.
If I, the unconditional owner of a Fed liability, choose VOLUNTARILY to lend this unconditional asset of mine to someone else (rather than transfer it to them on an unconditional basis because I feel they’ve earnt that asset by providing me with something else I value) I enter into a debt contract with the transferree.
The transfer still occurs in plain vision of everyone whether the asset is a fed deposit or a Bitcoin. As far as they are concerned the transfer has occurred. The only thing they don’t know is on what conditions the transfer has happened.
But say I’ve lent that asset on the condition I get it back one day. In that case — despite the fact I was entirely fully funded — I become exposed to counterparty risk and default. There is now undeniably debt in the system.
You see, the fact that the agreement I struck exists on some other ledger or paper is neither here nor there. As far as the Bitcoin network is concerned there has been no increase in network liabilities. Yet a debt DOES exist. And It exists on a supplemental piece of paper that adds “duration” to the scheme. A paper that can now be “discounted” for instant liquidity.
And here’s a truly mind blowing fact! Not only is debt totally possible in the Bitcoin system, it is possible in a way that can create state debt just as easily as it can private debt.
For example, if the Winklevii decided to lend all their Bitcoin to a state like Colombia, what would they get in return if not a Bitcoin denominated obligation which would trade like a bond?
What’s more, if the state couldn’t pay that Bitcoin back on time as agreed — maybe because the price of Bitcoin had shot to the moon and it couldn’t afford to buy it back — wouldnt’t you get the same sort of debt crisis as the one on Greece? Of course you would. What’s more, it would be up to the Winklevii as creditors and bond holders to determine the debt penalties or writedowns in arduous debt discussions with Colombia.
Bitcoin does not stop debt.
Neither does a full reserve system.
All it does is ensures that the debt is fully funded.
Does fully funded debt or a full reserve system stop rehypothecation and/or the equivalent of naked shorting in money (lending something you don’t yet have) – yes, it does.
You can’t officially lend something you don’t have in a full reserve system.
Is a full reserve system actually enforceable? History tells us probably not.
That’s because there are two ways to get around it.
First, you increase the velocity of the cycle. Colombia borrows from the Winklevii then pays for goods from a company that does business with the Winklevii and the Winklevii relend that income once again to Colombia to extend its debt even more. But with colombia’s debt growing more and more, and no spare float in the system to help it match that liability on an affordable level, the liability just gets so big that eventually the system itself breaksdown. Colombia defaults. The Winklevii in their greed lose everything, and mainly because they chose to choke the debtor to death before he could repay. (These are the conditions that brought about the end of the gold standard btw).
Second, you create a side chain/off block chain business. In the real world that’s called a shadow bank which operates outside of the world of Fed full reserve regulations and cares not if it is fully funded or not, or how many times the same piece of collateral is lent out. All it needs to start its business is someone’s trust. I transfer my deposits conditionally to that shadow bank (because, you know, it’s offering a much more tempting interest rate than the full reserve banks) but it has no qualms about lending something which isn’t really theirs to someone else. It can get away with this because of the temporal lag between when I want my deposits back and when it thinks it will get them back from its borrower. It has, you could say, a short-term funding exposure.
Ah ha! (You think to yourself.) The Bitcoin system would never allow this. NOT TRUE. It would.
Remember, I am transferring my asset into the custody of a third party agent that treats it like a deposit. In Bitcoin I may do this for a plethora of reasons (I can’t operate my own wallet, don’t have technical know how, want the interest being offered).
If I’m only looking at my Bitcoin deposits as stated on the third party site not on the blockchain, my claim is on the third party not the Bitcoin community. In the meantime, they can do whatever they want with my Bitcoin. They can even keep processing transactions on a Centralised basis between respective clients matching flows in their own closed system.
But, I’d argue, that’s not actually the main way the Bitcoin system currently gets leveraged. The main way is through the FX platform operators due to their poor market making skills.
How does this work?
Well, say I open an account at an exchange and plan to source Bitcoin from the system. The process usually involves depositing dollars and waiting for a favourable price from a respective counterparty in the system who happens to have bitcoin deposits.
This is a coincidence of wants scenario. When it occurs it’s like magic. My dollars are swapped directly for bitcoins and all is well in leverage land. No new capital enters or exits the system. We are square.
If only things could always work as perfectly as that though! Usually they don’t.
The coincidence of wants is a rare, rare thing, especially in an illiquid and tiny market like Bitcoin. Chances are at any given point more people want dollars than Bitcoin. Or vice versa. Or alternatively there’s simply no trade going on at all.
To facilitate exchange therefore the custodian of all the respective deposits (in Bitcoin, that’s usually the exchange itself) is usually tempted to intermediate in some shape or fashion. The main temptation is to become a market maker for the purpose of inducing liquidity and stabilizing the volatility of prices.
But market making is a risky business. It requires good knowledge of risk management, skill at pricing markets and sophisticated hedging. That’s why, by the way, it’s usually pretty difficult to get a market maker involved in a market where deep and liquid hedging options are not available. No such luck in Bitcoin.
Since flows are rarely equal the temptation for inexperienced exchanges that “believe ” in the underlying asset is to take undue temporal risk when acquiring bitcoins.
For example, say the flow is biased to dollar outflows (more people want to sell Bitcoin than buy it), as an MM you might be inclined, as a less than objective party, to offer to buy Bitcoin at a higher price than it can really be passed over to the market. You do, after all, have all that cheap dollar funding from client accounts at your disposal. What’s more, you think, if I buy now at $200, when it goes to $300 on real demand I can sell out making a handsome profit and be able to return the money to clients and pocketing the difference for yourself. If you can control the redemption timeframe as well you think “wow” I can manage my funding liabilities easily.
But say the position goes the other way and your clients start wanting their dollars back. Suddenly you’re left with a major dollar shortage exposure and a debt to clients you can’t make good on.
What’s the temptation then?
I’d argue probably to borrow even more client funds and start offering to buy Bitcoin at rates that you hope induce a bull run so that you can dump your coins into it. That, or a dollar capital raising.
Except it all gets vey circular very quickly. Without major new capital injections into the system (as a whole) all you’ve got are the same dollars chasing the same bitcoin, leaving you short no matter how much you attempt to manipulate the price.
Eventually you turn into Colombia.
No debt eh?!
*The reason we don’t operate a full reserve system btw is because central bankers have learnt over the ages that allowing licensed banks to lend some portion of their liquid assets in a supervised structure is preferable to having shadow banks you can’t control or understand do it it outside of your catchment area. There’s also the fact that most depositors want to put their money to work and don’t mind lending via an intermediary that can manage the various funding duration exposures. That’s how capital gets put to work in productive ways. With a full reserve system every bank would be a p2p lender rather than a duration intermediator. There’s nothing wrong with that and some people think it may add to stability but sometimes for an economy to grow there needs to be some slack in the system. The idea with fractional reserve is simply that all you really need in the reserve system is the liquid float needed to satisfy emergency unexpected redemptions, everything else is a wasted opportunity, especially since every loan extended with depositors’ money still creates a new (performing) asset that can be discounted and liquefied on demand.
The Cbank knows if the banks mismanage the duration risk they will be forced to come cap in hand for more liquidity, which the cbank will charge them for at a punitive rate. If the bank is clearly insolvent and can’t manage that cost the cbank will let it fail as a lesson to the industry.
The only measures that matter for the cbank when it considers adding Fed liabilities into the system are inflation and employment rates, because these indicates whether there is too much liquidity for the system to handle or alternatively not enough. The objective is incentivizing growth in the real economy and the fear is a full reserve system could stifle it.
In Bitcoin, however, the borrowed “shadow” money is often just consumed/burned/squandered for personal profit or experience.
Fully funded debt = you don’t lend what you don’t own.
Fractional reserve = you lend other people’s money that they have lent you on a short-term basis.
Private banks’ money creation = you lend your own equity because it’s liquid enough to be treated as money, and worry about funding it later.