Category Archives: blockchain

The multifaceted collapse of SBF and FTX

11 Friday Nov 2022

Posted by in blockchain, Decentralization

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There are at least three different angles to the SBF/FTX/Alameda collapse.

  • The most obvious one is that the crypto industry as a whole is still standing on shaky foundations and there are at least some Ponzi-style elements in some parts of it. See, for example, this Odd-Lots podcast with SBF himself and Matt Levine from April this year, which compares crypto yield farming as a ‘black box’, without an economic purpose, where people keep putting money “and then it goes to infinity and everyone makes money”. This note is not on this as the topic has already been profoundly explored in the media space.
  • Then there is the political angle which is related to SBF personally contributing substantial amounts of money in both Democrat and Republican primaries but having a clear agenda for the 2024 presidential election.
  • Finally, there is the technical angle in which there is this great ‘battle’ between centralised and decentralised banking/finance, tradfi vs defi. The rest of the note will dwell on these two, with an emphasis on the latter.

Bottom line is that it seems SBF was trying to move FTX more towards traditional finance and thus make it more stable and bullet proof, which ironically links all these three different angles together. Which begs the question, did someone want SBF down and out? And while going down, can FTX take the whole crypto industry in the gutter?

Many comments in the media regarding the collapse of FTX focus on the supposedly shambolic due diligence process on SBF/FTX/Alameda by some venerated names in the private equity, hedge fund and pension fund industry. Unfortunately, the likes of “SBF was playing video games in the due diligence process meetings” (the original Sequoia note was taken down before this was ready to be published, but a copy can be found here: https://archive.ph/xy4MR) are taken hugely out of context and despite the shortcomings and Ponzi-like structures in parts of what FTX was doing (see above, yield farming), the vision and ideas SBF was projecting did perhaps deserve the money thrown at them. Their execution, however, left a lot to be desired.

SBF himself was a big political donor. Even though he had contributed most recently to both Democrat and Republican causes, he had said he would spend up to a $1Bn “to help influence the 2024 US presidential election campaigns”($1Bn is a humongous amount of money in politics; the largest single donors currently are Sheldon and Miriam Adelson, to the Republican Party, with $218m in 2020), specifically if he were to bankroll the person running against former President Donald Trump.

It seems SBF was not a fan of Bitcoin as a payment network because its proof of work system does not allow scaling up. FTX US exchange was much more tradfi than defi, for example. SBF had testified before the House Financial Services Committee and had slightly different crypto regulation ideas from the other market participants there.

This stance by SBF did not win him many sympathizers in the crypto community. For example, see here main rival CZ/Binance: “We won’t support people who lobby against other industry players behind their backs”.

From that point of view, the collapse of FTX is somewhat intriguing. On November 2, Coindesk leaked supposedly Alameda’s balance sheet which showed that, “Bankman-Fried’s trading giant Alameda rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto”.

Even though Coindesk admitted that “[I]t is conceivable the document represents just part of Alameda”, and even though Alameda’s CEO Caroline Ellison later tweeted that this leaked balance sheet was indeed not complete and there were $10Bn of assets not listed there, the damage was already done and competitors were starting to pile on – for example, Binance sold more than $500m of FTT tokens.  

SBF wanted to incorporate the best features of rivals Coinbase, a basic US-regulated crypto exchange, and Binance, an unregulated exchange which offers much more advanced transactions. In the process he wanted to become filthy rich but only so that he can give away all his fortune in the spirit of effective altruism: “The math … means that if one’s goal is to optimize one’s life for doing good, often most good can be done by choosing to make the most money possible—in order to give it all away.”

Also in the process, did SBF ‘anger’ some very important people in politics and in business who eventually did their best to take him down? Conspiracy theories aside, the tale of the collapse of FTX is one which we have seen over and over again in banking and finance: unregulated entities which manage other people’s money cannot last forever: without the explicit backing of a lender of last resort they eventually fold when trust suddenly evaporates. If that is indeed the case, what is the future of decentralised finance?

And if that is indeed the case (no lender of last resort), can FTX take the whole industry down with it? It may certainly do. Everything in crypto land is ‘tethered’. Both literally (courtesy of USDT being the most widely adopted stable coin) and figuratively (as seen lately by the collapse of so many crypto-related firms). So, it is unlikely we will get to the bottom of this before all this gets fully ‘untethered’.

While Tether was quick to point out that it has no exposure to Alameda/FTX, it’s not a given that the opposite exposure does not exist to the point that it could affect USDT itself. According to this article (arguably from a year ago, I wonder how current it is now) two firms account for the majority of Tether/USDT ever received. Alameda is at the top with about 30% of the total.

And according to SBF himself today, “Alameda Research is winding down trading”, which means that they may be unloading a good portion of their USDT stack. In fact, it seems the selling has already started. And this selling may be just part of the normal process of unwinding Alameda Research, or it may have other ulterior motives as well. SBF closed his Twitter thread today, November 10, with this:

‘State’ money creation – this ghost from the past is badly needed for the future

17 Thursday May 2018

Posted by in blockchain, Monetary Policy

≈ 3 Comments

At present, majority of money (medium of exchange=inside money) creation in the developed world gets done by private banks. The state (government and/or the central bank =outside money) does create money but it is either as a medium of exchange within the banking system only, or on the back of demand for physical cash in exchange for inside money.

I have written about this before here (‘A simplified hierarchy of money’). The problem with the current monetary transmission mechanism (‘A simplified version of the monetary transmission mechanism’) is that it is set up almost by default to produce a scarcity of money. One alternative could be that the central bank distributes money directly using all the available data management techniques and recent advances of technology (central bank digital cash).

Given the state of our economy, and in order to properly address the level of technological advances we are experiencing, i.e. to minimize the risk of disruptions which could lead to social upheavals and loss of our prosperity, it could be a good idea to look at history to see how money was created and distributed in similar periods of development.

(Click to enlarge)

Indeed, inside vs. outside money creation is only a recent phenomenon (late 20th century) while state money creation had been the norm for the majority of human existence. And that’s the thing. Unfortunately, our current views of state money creation are really shaped by the most recent examples which had been disasters. For example, the Gold Standard came into existence to curb the rampant money creation to fund wars during the European Dark Age. In addition, that was a period without any major commercial innovations and characterized by population stagnation across Europe.

The late 18th and the 19th century, on the other hand, saw the 1st and 2nd Industrial Revolution which introduced new modes of production. The second half of the 19th century up to early 20th century was also characterized by a period of general peace (Pax Britannica). By then the great innovations of the previous two centuries were also commercialized. As a result of all this, Europe, in particular, became very prosperous.

Unfortunately, the existence of the Gold Standard, prohibited the state to issue enough money to correspond to the increased potential of economic activity. The Great Depression in the 1930s was thus characterized by a positive supply shock, on the back of these innovations, and a negative demand shock on the back of insufficient supply of the medium of exchange.

Early 20th century was probably the first time humanity was experiencing the fruits of progress on a basis similar in scale to the period of the Song Dynasty (960-1279) in China and the Roman Republic (509BC-27BC). Yet, policy makers failed to take full advantage of this by unnecessarily restricting the flow of money. It took a global war which destroyed/redirected a large part of Europe’s industrial capacity to re-address the imbalance between supply and demand.

Even then, policy makers, still did not take note that there was a paradigm shift in the late 1800s after the 1st Industrial Revolution, when a period of innovations massively shifted our economic potential much higher. While the developed world was slowly moving away from ‘scarcity’ and closer to ‘abundance’, they continued to operate from the basis that supply of resources is the bigger issue. The period from the end of the WW2 to the early 1970s continued to be characterized by a restrictive flow of money, the quasi gold standard. Luckily, it did take some time for capacity to come back on line after the war, so there were no major financial disasters.

In fact, it was quite ironical, that as soon as President Nixon decided to finally fully abandon the gold standard and introduce the age of fiat money, the world experienced a supply side crisis: due to problems in the Middle East, the supply of oil became restricted leading to a rise in inflation. This actually emboldened policy makers even further to focus on issues emanating from insufficient supply of resources and thus manage the demand side of the economy more closely to reflect that. The problem on the supply side, however, was short-lived, and as soon as the Middle East crisis subsided, oil started flowing back and ‘equilibrium’ ensued.

Nevertheless, even to the present day, our economic policy is still dictated by the mantra of supply side economics and inflation targeting.

Alongside these developments, the second half of the 20th century was also characterized by the start of the 1st Digital Revolution with the invention of the computer in the 1950s and its commercialization in the 1980s. Starting in the 1990s, globalization also took off. These developments boosted even further potential supply, while at the same time, money flow, despite no restrictions on actual money supply due to its fiat nature (but actual restrictions due to the separation of outside and inside money) continued to be restrictive.

These were the developments which led to the Great Financial Crisis in 2008, which, just like the Great Depression before, was characterized by a positive supply shock due to a burst of the commercialization of previous innovations and a negative demand shock due to insufficient money supply. The present time seems also to be the beginning of what could be called the 2nd Digital Revolution of AI and VR, which has the potential to even further increase our economic potential. Yet, when it comes to money creation, we are still operating with the mentality the Gold Standard: money is kept excessively restricted for fear of rising inflation.

In light of this, it could be worthwhile to point out that there were actually periods of successful state money creation in the past: Rome in the last five centuries BC and China between 10th and 13th century. Why did state money creation work back then? Three main reasons:

  • massive prosperity on the back of the commercialization of previous innovations,
  • a period of relative peace, and
  • a properly working institutional framework

It is important also to note that both in the beginning of the 20th century and now, all these three reasons above are present. If history is any guide, failure to supply the necessary amount of medium of exchange to ‘record’ this existing prosperity could lead to war, followed by disappearance of the economic prosperity, and in the worst possible scenario (did not happen during the Great Depression) the dismantling of the institutional framework. Or, if more recent political developments are any guide, could this time be different and the decline starts with the dismantling of the institutional framework, followed by war and the natural disappearance of prosperity?

To sum up:

  • state money creation is good when it is done within a solid institutional framework, and it follows (or is accompanied) by a positive supply shock brought about by previous innovations leading to economic prosperity (past examples: the Roman Republic, China during the Song Dynasty; no current examples);
  • state money creation leads to negative outcomes when it follows a negative supply shock brought about by war, natural population declines, or inadequate institutional framework (Europe during the Dark Age, the Gold Standard; more recent examples: Zimbabwe, Turkey, Argentina, etc.)

A simplified hierarchy of money

22 Wednesday Nov 2017

Posted by in blockchain, Monetary Policy

≈ 3 Comments

This is a simplified diagram of the modern monetary system from the point of view of liquidity (horizontal axis – liquidity increases as we move to the right) and safety (vertical axis – safety increases as we move upwards). It distinguishes among three types of monetary systems: traditional banking, shadow banking and crypto money. In addition, it defines money as ‘private’, i.e. money created in the private financial system (majority of money) and public or state, i.e. money created by the central bank or the government. Finally, the diagram shows which type of money the general public has access to at the moment.

This is work in progress, any feedback is welcome!

Traditional Banking System

The traditional banking system is centralized with the central bank sitting at the top issuing central bank reserves. To connect to the major payment systems, such as BACS or CHAPs in the UK or Fedwire in the US, financial intermediaries must have a reserve account at the central bank. Generally speaking, because central bank reserves are used only for settlement purposes between the central bank and commercial banks, they are sometimes called ‘outside’ money, i.e. money which sits outside of the real economy: the general public does not have access to them.

‘Outside’ money has gone to also comprise all state-issued money: in the US this is the physical coins issued by the government (the US Mint) and the paper dollars issued by the Federal Reserve (US Bureau of Engraving and Printing). It is only to this state money that the general public has access to. ‘Outside’ money is the safest money instrument out there: a fully sovereign government can never willingly default. The risk, as always, is only inflation.

Below state money lie commercial bank deposits which is private money created out of thin air on the back of public borrowing. This privately issued money comprises the majority of money in the system. Because of that, it is also called ‘inside’ money, i.e. this is the money that circulates within the real economy.

Commercial bank deposits are not as safe as state money because banks can go under (the money created is on the back of loans which are inherently risky). However, through the fractional reserve system which we have in place, part of that money is ‘backed’ by state money, i.e. every single time the commercial bank issues a loan by creating bank deposits it has to make sure it also has (or acquires/borrows) a portion of central bank reserves at the same time. In addition, some portion of the public deposits is insured by the state, so that even if a commercial bank goes bankrupt, some of the deposits will be made whole. Finally, all commercial banks are regulated by the central bank and subject to capital, liquidity and leverage requirements.

The public generally does not dwell much on the riskiness of commercial bank deposits. Except for Northern Rock in the UK in 2008, we have not had many major bank-runs in the developed world since the Great Depression. In fact, to most people who have deposits well below the insurance limit, commercial bank deposits are safe. It is this inherent link to the state which gives this impression of safe commercial bank deposits. In the words of former Bank of England governor, Mervyn King, “[M]any treat loans to banks as if they were riskless.  In isolation, this would be akin to a belief in alchemy – risk-free deposits can never be supported by long-term risky investments in isolation.  To work, financial alchemy requires the implicit support of the tax payer.”

The money created within this traditional banking system is the safest and most liquid form of modern money.

Shadow Banking

Shadow banking has been around for a while. In fact, in the mid-1990s, shadow banking liquidity in the US surpassed traditional banking liquidity. This, plus the fact that it is not part of the traditional monetary transmission mechanism (a lot of the liquidity created until 2008 was off banks’ balance sheets – not easy for regulators, or for that matter even bank analysts to spot it), contributed to the 2008 financial crisis. Since 2008, however, shadow banking liquidity has massively declined and now is again less than traditional banking liquidity.

In a similar fashion to the traditional banking system, the core of the shadow banking system is a state money-like asset: US Treasuries. The actual ‘money’ in the shadow system is also, similarly, a private asset in the form of a repackaged loan: the mortgage CDO/CBOs. US Treasuries are used as collateral for the mortgage packages, or one could say as settlement instruments not unlike the central bank reserves. Unlike in the traditional banking system though, the public has direct access to the US Treasury market.

The safety of the US Treasuries is on par with the safety of the state money in the traditional banking system. In terms of liquidity, it depends on the usage. The mortgage packages, however, are private ‘money’ which are substantially less safe than the private commercial bank deposits of the traditional banking system (even though, in most cases, the former had actually higher ratings, a fact which was at the core of the mortgage crisis of 2008).

The shadow banking system grew out of the inadequacy of the traditional banking system to distribute money efficiently. It was a perfect timing as well, coming on the heels of the dotcom crash when the authorities were more than eager to see the residential real estate market driving the bounce.

Crypto Money

This is the latest development in the transformation of the modern monetary transmission mechanism. In a similar fashion to the rise of the shadow banking system in the early 2000s, crypto currencies have come in to fill in the void of lost income post the 2008 crisis and the inability of modern money supply to reach the end consumer.

Crypto money is even worse (less safe) than shadow money because it lacks state money collateral. In addition, the private asset is created outside of the private financial system in a decentralized/distributed fashion. However, its claims of ‘equality’ when it comes to money creation (a permission-less system) may have been valid in the beginning, but with the complexity of the verification process increasing and the need for extra computer power, it is not the case any longer: a few ‘miners’ are now ‘in control. The hard forks which have happened in Bitcoin are an example of these vested interests.

Finally, on the positive side as this is the whole point, the public does have access to cryptocurrencies, but with their price having risen several times over just this year, reality is that now only the ‘privileged’ can afford to buy the major cryptocurrencies. And because they are considered a store of value, with a lot of buyers claiming they are going to hold them ‘forever’, cryptocurrencies are much less likely to be exchanged and thus their liquidity will continue to suffer.

Access to central bank balance sheet

The sovereign state through the central bank is the only issuer of safe assets. Ironically, in the process of QE with the aim to prop up the deleveraging banking system, the amount of safe assets has been greatly reduced (the central bank buys sovereign bonds, to which the public has access to, and issues reserve balances to which the public does not have access to). The demand for physical cash has actually risen in the developed world, partially on the back of this.

In fact, the central bank or the government does not have direct control over any of the safe assets the public has access to: coins are issued by the government and paper dollar are issued by the Federal Reserve but only on the back of demand for physical cash by the public (the public swaps electronic commercial bank deposits with physical cash – in other words, there is no mechanism by which the central bank/government can give physical cash to the public unless it passes through commercial bank deposits). US Treasuries are issued by the government but again they can generally be purchased only by swapping them with commercial bank deposits.

Because access to its balance sheet is so restricted, the central bank’s efforts to increase monetary liquidity post the 2008 financial crisis have been highly inadequate. In fact, in light of this, the central bank should have focused more on how to directly help the financial system with its deleveraging process, than on affecting the money supply. To that effect, it would have been much more beneficial for the central bank to focus on buying mostly private assets. Both the BOJ and ECB have eventually started doing this but more on the back of declining supply of sovereign paper rather than by design.

In addition, the ability of commercial banks to increase the money supply is severely limited not only because there is less borrowing demand from the public but also because capital and leverage regulations (Basel III) make it prohibitively to do so. So, as the money transmission mechanism stalls, similar to the period post the dotcom crisis in the early 2000s, the market has gone and created alternative private safe assets to supplement the public’s need for money: this time, cryptocurrencies. Because they are even more toxic than the sub-prime mortgage packages, the more widespread they become with the pubic, the higher the risk of an even bigger-than-2008 financial accident.

The answer could be widening out access to the central bank balance sheet for the whole population. This can be done in various ways using the same blockchain technology now prevalent amongst the various cryptocurrencies. Indeed, a previous post listed some of the major central banks and their efforts in this direction.

Bitcoin is not the future of money

06 Monday Nov 2017

Posted by in blockchain, Decentralization, Monetary Policy

≈ 4 Comments

This is a follow-up on “’Mining’ for money is a ridiculous idea”

 

Source: https://coinmarketcap.com/ , Author’s calculations

Summary: By creating private alternative money supply and payment systems, cryptocurrencies are threatening the raison d’etre of both the central bank, which governs the current monetary transmission process, and the private money institutions, which create the majority of the money. This is a dangerous precedent which history shows does not end well for the incumbents. Bitcoin, specifically, while it has developed an ingenious way of money creation through the blockchain, has unfortunately, other flaws, namely fixed end supply, high energy costs, limitations of the number of transactions it can process, security and privacy risks.

A ‘bubble’ is a dangerous thing to play with

Below, I am questioning in theory the rise in Bitcoin’s price, specifically, but also the viability of all cryptocurrencies. However, I am absolutely not doing anything about it in practice. Even though the sudden increase in cryptocurrencies’ market capitalization looks absolutely ridiculous to me, I have been around the markets long enough to have been burnt by the Siren call of shorting a bubble before it is ready to pop. I do not have positions in any cryptocurrencies, nor am I advocating positions in any at this point.

Even in real life, I hate the bubbles equivalents: the balloons. They make me nervous because of the uncertainty and suddenness of that popping sound whenever the balloon touches something sharp eventually. When my kids were little and they were invited to a birthday party, I always tried to find an excuse not to go: it was inevitable that balloons would be popping up. The funny thing is that when they brought a balloon home, left it somewhere in a corner and forgot about it, I had no problem: I knew, sooner or later, that the balloon would naturally deflate.

Being right vs. making money

So, I was never a bubble chaser when I was a trader. I preferred to make the money on the way down, after the sudden pop or even when the bubble slowly filtered away. 2008 was my best year, but not because I predicted the crisis. Not at all. I mean, in the years preceding the crisis EVERYBODY knew that credit spreads were ridiculously tight, that the US consumer had too much debt, etc. But nobody, that I know, had the bearish trade on when the bubble eventually burst in 2008. I remember though trying (to put it on) – buying protection in a number of US and UK banks and especially in Eastern European sovereigns – but it was always too early and the negative carry eventually made the trade not worthy.

Going into 2008 I was at least not long the market. By the end of that summer, my P&L was chopping around 0 (but more often on the negative side): the shorts did not work out, and I did not have the stomach to be long. It was basically a waste of time. In fact, I was convinced that they would not let Lehman go. I mean, they had ‘saved’ Bear Stearns…But, moreover, I had done my homework and was aware that Lehman was probably the main character in the shadow banking game. You take Lehman out and the whole show is over: a run on the banks. But not from the retail depositors side – the broker/dealers (Morgan Stanley, Goldman Sachs) did not have retail depositors – rather from the institutional side. I knew that the shadow banking system had produced the majority of the monetary liquidity and that once it was blown apart, the central bank would have to step in big time.

I think if you were in the markets back then, you would always remember exactly what you were doing when you first found out that Lehman Brothers declared bankruptcy. The importance of the event was enormous even by itself: a venerable institution, more than 150-years old, which survived even the Great Depression. (I think the equivalent of that would have been the collapse of Barring Brothers, the second oldest merchant bank in the world, in 1995. Sadly, I started my career on Wall Street in 1996 and have no recollection of that event). However, that Sunday, September 7, 2008, I was waiting to board a flight from Venice to London – we had been there to attend a relative’s wedding. Checking my Blackberry, I was stunned when I read the news! What followed in the weeks after was a relentless buying of Eurodollar futures contracts (short-term rates, not the currency for those that may be confused here by the terminology). And that is why 2008 was my best year managing money…

2008 was year zero in modern banking

While I seemed to be on top of the (trading) world back then, for all intends and purposes, 2008 could be considered the end of traditional banking. The big deal in that sense, however, and in hindsight (always in hindsight – hindsight is the best friend we have ever known) was not Lehman’s bankruptcy, but a white paper by a person or an organization by the name of Satoshi Nakamoto. The paper came in late October of that year. I said in hindsight because I did not know about the paper until much later (and anyway, I was too busy trading Eurodollar futures contracts in 2008). It was the creation of Bitcoin and, more importantly the process associated with it, the Blockchain, which would mark the year 2008 for me: the time before that would be considered BB (Before Blockchain), and the time after – AB (After Blockchain)!

In fact, I do not remember when I first found out what Bitcoin is: 2011, 2012? Yes, I think it was in the midst of the Greek debt crisis when Bitcoin appeared on my trading horizon. You see, I love the idea of technology but I am absolutely rubbish when it comes to its practicality. Bitcoin first became a hot topic of conversation simply because we were in the midst of the European crisis, gold had more than doubled up since the 2008 crisis, interest rates were at 0%, and some smart people started to look for an alternative safe haven for personal use. (Not me…)

However, I never really got involved until late 2015 when I wrote a paper on the Blockchain. I remember when I first mentioned ‘blockchain’ in one of our regular office meetings. Literally no one had a clue what I was talking about. People had kind of heard of bitcoin, but not of blockchain. In banking circles, at least, the idea of the bitcoin was a complete anathema back then. No one of any reputation wanted his or her name associated with ‘Bitcoin’. And rightly so, because it was thought the ‘currency’ was used for nefarious deals on the dark net (and it probably was). Plus, a number of exchanges dealing with it had gone bust in mysterious circumstances.

Anyway, that paper was not on the bitcoin but on the blockchain. We explored how central banks can take the idea of the blockchain from the private sector and use it in a novel way to collect and analyze economic data which would help them conduct monetary policy in a much more efficient way. We advocated a sort of 100% reserve banking experiment.

Since the breakdown of the Bretton Woods System in 1971 and probably by the early 2000s, the private banks had done a fairly good job (with the use of the credit intermediation process) of creating just enough money supply to, more or less, match economic activity (MxV=PxT). However, as our economies gradually moved in the digital era, it became increasingly more difficult to capture that economic activity and match it up with enough mediums of exchange: in a sense, my position was, and still is, that because of its inherent lack of knowledge of economic activity our current monetary system does not produce enough money in order for the economy to work at its full potential.

GDP accounting, created in the ashes of the Great Depression, was more suited to an industrial economy, not so much to a service or, let alone, a digital version. The money created by the private banks, therefore, became increasingly more detached from the real economy. After the burst of the consumer debt bubble in 2008, there was very little demand for loans, so the banks could not create money even when it was most necessary. In addition, the increase in banking capital requirements thereafter, made it more difficult to extend loans and create money even if there was demand for that from the public or corporates.

Basically, it was a mess. Money supply had stopped working properly. So, we thought, what if the primary creation of the money went back to the state. The elegance of the blockchain process allowed for a decentralized, distributed ledger of (economic) data (the new GDP) which the central bank could use to govern the creation of money. This new technology provided for a big diversion from the old days when the state would misuse the creation of money (and which gave ‘helicopter money’ their bad rap).

In a sense, the blockchain offered a sensible alternative to the private-banks-run credit creation of money. In our example, however, the private banks would continue to create money but they would be constrained by a version of ‘100% reserve banking’. The blockchain, therefore, would allow the issuance of central bank digital currency (CBDC) accessible to the public at large (as opposed to a small number of depositor-taking institutions).

Central Bank Digital Currency

That was 2015. At that time, only Ecuador had begun experimenting with CBDC. Eventually, Ecuador became the first country to introduce its own digital cash after it had banned Bitcoin. “Electronic money will work as a payment method beyond the legal tender in circulation, and used with absolute trust by the entire citizenry…”(Source: Electronic Money, Banco Central del Ecuador).

Since then, pretty much all major central banks have embarked on the road of evaluating the feasibility of CBDC. None has, so far, done it.

In its One Bank Research Agenda (OBRA) from February 2015, the Bank of England posed the question of whether central banks should issue digital currencies. “Digital currencies, potentially combined with mobile technology, may reshape the mechanisms for making secure payments, allowing transactions to be made directly between participants. This has potentially profound implications for a financial system whose payments mechanism depends on bank deposits that need to be created through credit.” Since then the BoE has issued several papers on the viability of central bank digital currency. It is also partnering with UCL to practically explore the possibility of creating the so-called RSCoin.

The Riskbank (Sweden) is the oldest central bank in the world, the first to issue paper money in the 17th century, and the first one to move to negative interest rates. It could also be the first to issue CBDC. “The Riksbank is investigating whether it would be possible to issue a digital complement to cash, so-called e-kronas, and whether such a complement could support the Riksbank in the task of promoting a safe and efficient payment system.”

Already in 2014, Danmarks National Bank (Denmark’s Central Bank) said that bitcoin is not money and [Bitcoins] ‘have no actual utility value, bearing closer resemblance to glass beads’. However, blockchain technology, or a variety of that, for example, would be an obvious model to use of virtual currency.

Canada’s Central Bank is running ‘Project Jasper’ which examines the feasibility of using distributed ledger technology (DLT), aka blockchain, to construct a wholesale payment system. This could eventually lead to the central bank issuing a digital currency of its own, called Cad-coin.

The Monetary Authority of Singapore (MAS) is running Project Ubin which uses DLT for inter-bank payments. In a speech (“Economic Possibilities of the Blockchain Technology”) at the Global Blockchain Business Conference this October, Mr. Ravi Menon, Managing Director of MAS asked: “…can we create a more efficient inter-bank payment and settlement system without MAS acting as the trusted party?”

The Central Bank of China could be considering the issuance of CBDC as a way to stabilize its own fiat currency while expressing concern of the inherent dangers of crypto currencies. According to this report, Yao Qian, the Director of the Digital Currency Institute under PBOC said, “it would be a disaster to recognize it [Bitcoin] as a real currency. And the lack of value anchoring inherently determines that bitcoin can never be a real one.”

Heavily burnt by the 2008 financial crisis, Iceland may be taking the most direct drastic measures. In a report commissioned by the Prime Minister, the suggestion is: “[I]n a Sovereign Money system, private banks do not create money. Instead this power is in the hands of the Central Bank, which is tasked with working in the interest of the economy and society as a whole. In the Sovereign Money system, all money, whether physical or electronic, is created by the Central Bank.”

In January 2017, the Reserve Bank of India (RBI) issued a white paper recommending the adoption of the blockchain. In September 2017, IDBRT, a research institute established by the RBI, announced plans for the launch of a blockchain platform.

The Central Bank of Russia (CBR) is moving fast towards the development of a national digital currency. In October 2016, CBR announced it had successfully developed a prototype blockchain called “Masterchain”.

In November 2016, Hong Kong Monetary Authority (HKMA) issued a white paper on the advantages and disadvantages of DLT. In October this year it issued a second white paper in which it stated clearly, “[A]part from the PoC projects, the HKMA has also commenced research on Central Bank Digital Currency (CBDC) with the aim of assessing the potential benefits, challenges and future implications of issuing CBDC. This is another example of the growing potential for the application of DLT.”

The European Central Bank (ECB) has issued several papers on DLT and its potential (the latest) without being explicit about the use of blockchain-based CBDC. Indeed, both the ECB and the Bank of Japan have said recently that they think “DLT like blockchain is not mature enough to power the world’s biggest payment systems, though it has the potential to improve system resilience”. However, Japan’s Financial Service Agency is developing a blockchain-powered platform that will enable Japanese consumers to instantly share their personal information at multiple banks and financial institutions.

Finally, the US Federal Reserve issued a white paper on the possible use of DLT in payments, clearing and settlement. However, recently elected new Fed Chairman Powel said in a speech in March this year, referring to the potential use of DLT or other technologies by central banks to issue a digital currency to the general public, that “[W]hile this is a fascinating idea, there are significant policy issues that need to be analyzed.”

The proliferation of cryptocurrencies

In a sense the developments described above stemmed from the period of central bank uncertainty post 2008. The uncertainty arose not because the central banks were not transparent enough (in fact, one could argue, they were too transparent), but because the policies they were adopting were unprecedented in modern times (post 1971). In addition, it was also a result of the advances in technology which allowed for a potential revamp of the money creation and transmission process. This naturally raised the issue of trust which, coupled with the lack of sufficient money circulation in the real economy, provided for a fertile ground for the development of a decentralized, distributed ledger-based cryptocurrencies that also offered a level of digital security never seen before.

In 2013 there were just 7 alternative digital currencies with a market cap of about $1.5Bn. Bitcoin was the largest amongst them (see Charts at the top).  By October 2017, the number of crypto currencies had risen to 1260 and their market cap to $201Bn. Bitcoin is still the largest but its share has fallen from 94% to 62%. However, the top three cryptocurrencies (Bitcoin, Ethereum and Ripple) still comprise 85% of the total market cap.

The proliferation of these private cryptocurrencies fills a void in the money supply which the central banks have not been able to fill despite the massive increase in their own digital reserves (i.e. the central bank balance sheets). The economy is lacking a medium of exchange (and the subsequent unit of account) in order to operate at its optimum level. The traditional income distribution model, Work=Job=Income, which has characterized the industrial economy so far, stopped working sometimes in the early 1980s with manufacturing finally giving way to services.

In the late 1990s, as the digital economy started gaining speed, consumers started making up for their lost income with debt ‘secured’ by real estate and engineered in the so-called shadow banking system: private ‘AAA-rated’ subprime mortgage pools acted as ‘mediums of exchange’ in a not-so-dissimilar manner to today’s cryptocurrencies. The end of the debt super cycle in 2008 put a stop to that, and with the central banks unable to do anything about it, cryptocurrencies came to the fore.

Despite the massive rise in cryptocurrencies’ market capitalization, they are still less than 1/6 of the subprime total market capitalization at the peak of the crisis in 2007. One could say that they are not, yet, in any way, shape, or form of a systematic significance to the financial system. The problem is that at the growth rate the cryptocurrencies’ market cap is rising, it will reach that critical level ($1.3Tn for subprime) in a couple of years or so. So, perhaps, we may be in 2005 or 2006 equivalent to the 2008 financial crisis?

In addition, however, there is the further danger that crypto currencies are a much more direct competitor to central bank legal tender than shadow banking money because of the ease at which they can be accepted as medium of exchange and unit of accounts in retail outlets. As more economic transactions go through private digital currencies, central bank monetary policy could become less relevant. If there is less need for final settlement in central bank reserves, this threatens the whole existence of the central bank. In addition, if the crypto currencies do not use the private banking system for payments, what is the role of the private banks?

Bitcoin’s major flaws

There is a lot of stake to the current monetary transmission mechanism and it is for this reason why the central banks are starting to react (see above). If history is any guide, they will not hesitate to outlaw any attempt which is aimed at taking over their privilege to govern the money creation process. But Bitcoin also has numerous flaws on its own (the below written from a non-technical, but rather functional, point of view as it pertains specifically to money creation and transmission).

Store of value vs medium of exchange and unit of account. Bitcoin is trying to be both as seen by the various jurisdictions coming with different classifications for it (asset vs currency). But NOTHING can be all these things together at the same time and to the same extent. Bitcoin is a store of value first and a medium of exchange/unit of account second. That is a is problem if it is trying to be a currency. For, if a currency is expected to increase in value it is much more likely to be hoarded than exchanged and thus it is very unlikely to ever become a unit of account. A normal currency’s value is a derivative of its medium of exchange/unit of account function, not the other way around as in the case of Bitcoin.

If Bitcoin, on the other hand, is an asset, then it cannot expect to be a medium of account and unit of exchange in the real economy. However, that puts into question the source of its value in the first place. Compare to gold which, similarly to Bitcoin, has been used as a store of value for centuries due to its pureness (difficult to forge), malleability (ease to transport) and scarcity (limited additional supply). But at least, when all else fails we use gold for decorations. In addition, and more importantly, the authorities gave a big stamp of approval to gold by using it as the core of their money creation process. And when they did not, they did not like us to do it either (confiscation of gold during the Great Depression).

Fixed-end supply. A total of 21m bitcoin can be created. Unless the protocol is changed, the last bitcoin will be “mined” in 2040. Moreover, the rate of bitcoin supply gradually decreases each year (current inflation rate of bitcoin supply is around 4%). By some estimates already 3 out of every 4 bitcoins ever to be created are already ‘mined’. Needless to say, that is why Bitcoin is considered valuable.

But as seen in the preceding paragraphs, if this also destroys the purpose of bitcoin’s use (and assuming there are no other reasons why anybody would want to hold bitcoins), then it also degrades its value. The actual supply of bitcoin can be both much smaller than 21m (miner underplay and other technical peculiarities, loss/destruction of bitcoins) and larger (protocol is changed or the idea of ‘fractional reserve bit-coining’ is practiced).

High energy costs. I already touched on this issue here. More knowledgeable people have written extensively on the technicalities of energy usage in bitcoin ‘mining’ (see, for example, this, “One bitcoin transaction uses as much energy as your house in a week”) so I am not going to spend more time on this.

Transaction processing speed. Bitcoin’s blockchain can process low single digits to low double digits transactions per second. This is much lower compared to traditional payment system providers (Visa, MasterCard, PayPal, etc.) which can process thousands of transactions per second. There is thus a big question to the scalability of the bitcoin as a medium of exchange in the payment mechanism.

Of course, as the technology advances, more progress is expected in this regard (for example, see “Bitcoin Lightening Network: Scalable Off-Chain Instant Payments”, J. Poon, T. Dryja, January 2016). However, the speed of processing, the energy usage and the security (see below) can be increased several-fold if the blockchain process is designed to be ‘permissioned’ (Bitcoin is ‘permission-less’) as in when governed by a central bank, for example, in the case of CBDC.

Security and privacy risk. Without a ‘central authority of last resort’, there is a bigger risk of losing bitcoins than cash deposits, for example. If you lose your private key, or the hard drive gets corrupted, there is no one you can turn to help you retrieve your bitcoins (this is the equivalent of losing your physical cash). The same holds true for the possibility of reversing a bitcoin transaction, if, for example, it is done by mistake – it is not possible (there is a technical solution called ‘multiverse transactions’ but it cannot be done in a decentralized system like the blockchain as it involves a third party).

In addition, it is possible in theory for a major ‘miner’ with enough computational power to ‘fork’ the bitcoin blockchain for his/her own gain. This also opens up the system for potential fraud by altering past records. If the blockchain is permission-less, as in the case of Bitcoin, nothing stops a ‘miner’ to eventually gain this computational power (including collusions amongst miners – how many people trading currently bitcoin, for example, can understand exactly the permutations behind the most recent fork in the Bitcoin blockchain and why really this was done).

Finally, there is also the issue of hacking, whether the bitcoin is stored in an e-wallet on the internet, or with a centralized exchange, it does not matter (understanding the security of a physical bank is one thing; getting your head around cybersecurity is totally another).

Conclusion: Bitcoin and all other cryptocurrencies are a natural development of the money creation process. They are a result of the free market’s response to the breakdown of the traditional income generation model, which had been in existence since the Industrial Revolution, and the authorities’ inability, or rather, refusal, to address it by creating additional mediums of exchange and distributing them among the population.

The cryptocurrencies, however, are an imperfect solution, at best, to our money problem. Taken to the extreme, they could threaten the existence of the central bank and the banking model, in general. However, the technology inherent in them, the blockchain, used in accordance to the regulatory framework of a central bank and without much change to the current banking system, could shape the new money system which fits better our modern digital economy.

‘Mining’ for money is a ridiculous idea

03 Friday Nov 2017

Posted by in blockchain, Debt, Monetary Policy

≈ 2 Comments

Martin Walker (FT Alphaville) touches upon an important aspect of the modern crypto money creation process: the ridiculous costs and unnecessary side effects of digital ‘mining’.

Bitcoin exemplifies our bizarre relationship with money through the ages stemming from our lack of understanding of what it is. It’s as if we are cursed to never come to terms with money’s functions and how they help us progress. Our problems started with us prioritizing the ‘store of value’ of value function of money over ‘medium of exchange’ and ‘unit of account’. For if money is expected to increase in value, it is much more likely to be hoarded than exchanged and thus it will eventually cease to be a reliable unit of account.  

From the very beginning of humankind, it has indeed been a constant one step forward, two steps back kind of dance with our faithful companion. Money originated as a ‘gift’= a debt of gratitude to our fellow tribal members who shared their luck of finding more food than they needed. When our memory (of ‘how much’ we owe whom) failed and disagreements became common, we created the first money ledger run by the first central authority (the tribe leader): lines in the sand of who ‘owes’ who.

From there on, it all went downhill for different reasons: huge, cumbersome stones; other stupid object; precious metals… There were some interruptions to this craziness: the time of the Roman republic, the first fiat money in China, the Italian city states creating the first modern ledger during the Renaissance. But generally speaking the crazy money mist always came back and deluded us in going to extremes (mining foreign lands, killing indigenous people, etc.) to obtain shiny objects and call them money.

Until it all ended in 1971 when Nixon pulled the US out of the Bretton Woods Agreement and fiat money became the norm globally. And now, in 2017, having reached an extraordinary level of human progress, once again the mist is descending in front of our eyes and we are thinking about going back to ‘mining’ for money?  

Plenty of liquidity but scarce money

05 Thursday Oct 2017

Posted by in blockchain, Debt, Monetary Policy, UBI

≈ 3 Comments

“All the perplexities, confusion, and distress in America arise…from downright ignorance of the nature of coin, credit and circulation” John Adams in a letter to  Thomas Jefferson

1)We should have never ‘put together’ “store of value” and “medium of exchange”.    

2) If something has intrinsic value which is expected to go up in time, it will be hoarded and exchanged less often.

3)’Money’ is a “unit of account” which we ‘exchange’, in order to efficiently get the things we really need and want in life.

4)Inflation/Deflation are simply measures of whether ‘money’ is abundant or scarce relative to the economic activity we desire.

5)In the economic system we have created, purchasing power is gained either through paid work or through credit.

7)As long as companies earn a profit, they retain more ‘money’ than they distribute in wages and other payments, thus there is insufficient medium of exchange to meet the supply of goods.

7)Even if companies invest the profit in new projects, this only adds to the previous supply-demand imbalance unless new medium of exchange is added endogenously in the form of credit.

8)Advances in technology make the old paradigm of Work=Job=Income obsolete; purchasing power is lost.

9)Credit only makes the scarcity of ‘money’ more acute because new medium of exchange needs to be added just to pay the interest on the debt; a vicious cycle develops.

10)This credit/debt cycle also eventually comes to a natural end (2008); no more purchasing power can be added even endogenously.

11)If we want to keep the current economic system going, we need to find a new way of generating ‘purchasing power’.

12)But if the paradigm has shifted, normalization is meaningless; instead of going back to something that does not work, let’s look forward.

12)’Helicopter money’ has an, unjustifiably, bad reputation historically.

13)UBI is politically unfeasible to implement in a large country with open borders.

14)The problem with them in the past has been our lack of knowledge of existing economic activity, and thus our inability to disburse the right amount of purchasing power needed.

15)M≠PxT, so we invent V, in order to MxV=PxT

16) Both of them, however, are great ideas which need to be put in the context of our existing institutional framework.

17)The central bank opening its balance sheet (CBDC) to the public at large is the next step in monetary/fiscal policy.

18)Blockchain, as in a large, open, decentralized, distributed, real-time database of all economic transactions, is the digital equivalent of ‘GDP’ of the industrial era.

19)The Fisher’s equation above then takes the form of CBDC=Blockchain, ‘money’ matches economic activity.

What if central banks gave the QE money to the people?

03 Tuesday Oct 2017

Posted by in blockchain, Debt, Monetary Policy, Questions, UBI

≈ Leave a comment

I would not be blindfolded by the fact that the US is trying to go back to ‘normal’ with the Fed on a rate-raising spree. ‘Normal’ changed a long time before 2008. You cannot go back to ‘normal’ with a broken monetary transmission mechanism. We can create all the money in the world but if it goes in the hands of the few, if it is subsequently ‘hoarded’ and if it cannot  reach the end consumer because Work≠Job≠Income (whether that is because of technology, globalization or whatever) or because the credit channel is closed (the end of the private debt super-cycle in 2008), the economy is not going to go anywhere. And if there is little demand because there are not enough mediums of exchange, aka money, circulating in the economy, optimizing production is a waste of time and resources.

Instead of focusing on going back to a ‘normal’ interest rate policy, a forward-looking central bank would be looking into the opportunity presented by the rise of the blockchain technology and the subsequent spread of digital cryptocurrencies. The latter are a direct response to the broken down monetary transmission mechanism: if the traditional mediums of exchange do not circulate in the economy, people are devising their own ways of exchanging goods and services.

The interest-rate cycle is something of the past now. If the financial crisis of 2008 did not make it obvious, perhaps, we have to wait for the next one, which would be here like clockwork as policy makers embark on the policy of ‘normalization’. But there is some hope that some central banks are looking into ways to introduce a digital currency of their own and opening their balance sheet to the public at large.

Back of the envelope calculation shows that if the money spent on buying financial  assets by the central banks of UK, US and Japan, was instead disbursed directly to the people, working wages would have risen substantially.

Between 2008 and 2016, central banks’ balance sheets have risen by 360% in the UK, 99% in the US and 280% in Japan.

Source: Bank of England, US Federal Reserve, Bank of Japan

At the same time, over this period, nominal wages have risen by only 14.8% in the UK, 18.4% in the US and actually fallen by 2.9% in Japan! In 2016, the average annual wage in the UK was GBP 34,142, in the US – USD 60,154 and in Japan – Yen 4,425,380.

Source: OECD

Japan is peculiar also because its working age population declined by 7.4%, while US’ and UK’s rose by 4.5% and 2.7%, respectively, during this period.

Source: OECD

I took the actual change in central bank balance sheets and divided it over the average working age population between 2008 and 2016. If this money could have been disbursed directly to the people, workers would have received a lump sum of GBP8,574, USD10,997, Yen4,430,424 over the period.

Let’s imagine that this lump sum was disbursed to the working age population at the end of 2016. Compared to 2008, their wages in 2016 would then have been higher by 44% (UK), 40% (US), 98% (Japan)!

If wages could indeed ‘miraculously’ rise by almost half in the UK and US and almost double in Japan over this 8 year period, what are the chances that we would still be stuck around 2% inflation in the US and UK and around 0% in Japan? Where would GDP be?

This is a very simple exercise. Undoubtedly real life is much more complicated that this and it is rarely black and white. Moreover, this would have been a lump sum disbursement, a one-off boost to income, and not a permanent rise in wages. Consumer behavior in this case, Ricardian equivalence, etc., would have been very different from a situation with a permanent rise in wages.

However, instead of patting ourselves on the back that things could have been much worse had the central banks not backstopped the financial system by buying financial  assets, can we not also think how they could  have also been much better if we found a better use for the money miraculously created out of thin air? If we could create money out of thin air to boost financial asset prices, is it really not possible to devise a way whereby the consumer also gets a permanent rise in income? Can we have an adult conversation about the effects of such an experiment without resorting to the taboos of the past? Can we include people other than economists in this conversation?

The free market may be the best and most efficient optimization model available so far to us, but what if we are optimizing the wrong variable?

China’s belated move to ban ICOs could actually push token prices higher…

05 Tuesday Sep 2017

Posted by in blockchain, Monetary Policy

≈ Leave a comment

…in the short term as the supply of new tokens becomes restricted, and if demand stays the same. However, further regulations are more likely to take prices lower. Down the line, I would not be surprised if some tokens disappear completely.

To a certain extent, the crypto-mania now reminds me of the dotcom mania in the late 1990s. Both of them have an underlying cause that justifies their rise. In the case of dotcom it was the beginning of the digitalization of society (new ways to connect, work and entertain) and the promise of the commercial internet (new way to shop!). In the current crypto-currencies craze, the underlying cause is the scarcity of money, stemming from the rise of inequality on the back of the breakdown of the Work=Job=Income model, and the following promise of creating the new medium of exchange using a totally different framework (i.e. if we cannot get  the medium of  exchange by having a job, and it the central banks would not print the medium of exchange and  distribute it to the population at large, the population at large will create its own medium of exchange).

I know bitcoin, for example, is down 12% from the announcement of the ban on ICOs. That’s still less than the last time, in March this year, when PBOC also announced it was looking into tightening regulations on bitcoin trading. But that’s beside the point. One could say the most recent news is, actually, more important.

And it is indeed more likely that as the authorities start introducing even more regulations on crypto-currencies, their prices will become … less volatile but also settle down in a lower range. After all, without regulations, and without an underlying businesses per se, crypto-currencies currently do have an advantage over other regulated asset classes. But, strictly speaking, from a flow perspective, restricting the supply of an asset, should make its price go up, if demand is unchanged. The fact that new ICOs are not allowed should make the existing tokens more valuable.

Of course, that is only a short-term view, which does not take into account the possibility of further regulatory actions. It is surprising to me that it has taken such a long time for authorities to start looking into these ICOs and also, in general, into the spread of crypto-currencies, given that the latter are a direct threat to their own legal tender. In fact, there is confusion globally as to what indeed those crypto-currencies are. Are they an asset, a currency, or legal tender? Not only different countries have different definitions but in some countries the definitions vary depending on the regulatory authority even!

For the current crypto-mania to subside we do need to see central banks introducing their own digital legal tender accessible to everyone in society (and not just to banks and other select financial institutions as is the case now with central bank reserves). In other words, authorities need to address the underlying cause of the spread of the crypto-currencies. All other measures would most likely only temporarily slow-down their rise.

 

It should be abundantly clear by now, but let me state it here, that this blog does not constitute an investment advice. And I have no positions in any crypto-currencies/tokens.

Blockchain as a trust bearer: from evolution in the developed world to revolution in emerging markets

03 Thursday Aug 2017

Posted by in blockchain

≈ 1 Comment

Trust is at the core of human relationships. If we do not trust each other, it makes it difficult for us to cooperate and ‘build’ something together. Thus, progress does not happen (or it takes much longer for it to materialize). In the context of economic transactions, maintaining trust takes time and is costly as it requires the build-up a complex system of ‘middlemen’. By creating a secure, digital, distributed and decentralized database, blockchain is simply the latest, and most efficient, bearer of trust in an evolutionary cycle.

In the past when humans lived in small communities, trust was ‘easier’ to maintain as people knew each other well. For example, if I was luckier hunting than you one day, I could ‘afford’ to give some of my kill to your family trusting that you would do the same when a similar opportunity arises another time.

(Moreover, there was no upside to keep it all for oneself as, most likely, it would have rotten. In a sense, amidst the scarcity prevalent in these primitive societies, there was a momentary ‘lapse’ of abundance which possibly was at the base of people being so generous and cooperative in the first place. This simple observation raises profound questions about our human nature but this is not the time for such a philosophical diversion).

In this transaction, there was an exchange of real goods against the ‘unwritten’ promise of the opposite transaction at some point in the future. In essence, the lucky hunter was ‘gifting’ his unused part of the kill to the other party. Trust in this case worked because 1) we, cumulatively, remembered about the past transaction; 2) there was a huge cost of no-cooperation and thus loss of trust.

As the tribe expanded, these two conditions could easily be broken as our memory is fragile by nature. If in the past, the transaction simply took place between two people, now that was not possible without a third party, a middleman, ‘guaranteeing’ its credibility. The chief of tribe, for example, by the mere existence of his (it was mostly a male!) status was such a trust holder/verifier in those early days. But he could also forget and he could also intentionally misrepresent the past (scarcity of resources opened up the possibility of corruption).

One way around that was to start keeping track of the past transactions, the original ledger: that could be done either in physical format (sticks in a corner) or ‘written’ format (tallies in the dirt). This process did not last long as people, of course, figured ways to tamper with these early ledgers. The next natural step, therefore, was to find a more solid ‘ledger’, one which was more difficult to alter: what if we use very heavy, unmovable/undeletable objects instead? The Yap stones are a good example of this early form of trust.

As ‘society’ evolved, people branched out of their tribes and encountered others from foreign places with whom they wanted to interact. It was increasingly more difficult, however, to establish and maintain trust between two strangers: the transaction ‘ledgers’ they kept could have been different; the heavy, unmovable objects they could have used to record/‘verify’ their transaction, hugely impractical for people on the move. That is probably how the concept of ‘money’ as an exchange first appeared: when strangers meet and the risk of lost trust is great, we needed a revamp of the traditional exchange system. Debt and gifts require reciprocity which is not easy with strangers.

To paraphrase, it is much more pertinent to think of ‘evil’ as the source of all money, rather than the other way around.

Thus, the need for standardization arose as the concept of value became much more subjective. It was at this point that precious metals picked up the baton of trust holders/ledger keepers. “Precious” as in the sense of scarce, difficult or impossible to forge and easy to carry around. This gold system lasted for centuries supported by a framework of trust bearers, the kings and queens, breaking only temporarily a few times in history (i.e. under the Roman Republic and the Ming dynasty in China). Noteworthy is the set-up experimented in a few Italian city states during the Renaissance, which put in place the beginnings of the modern accounting system and the possibility of trust resting entirely on an institutional framework devoid of gold. This became a permanent feature, eventually, in the 1970s after the break-up of the Bretton Woods system.

Thereafter, economic trust has been maintained entirely by institutions like central banks. This trust was put in question after the 2008 financial crisis. This is when blockchain came into existence and has since slowly been establishing itself as the next bearer of trust in the cycle. Therefore, we could say, it is less revolutionary than evolutionary. By converting dispersed analogue information in a ‘all-in’ digital format, blockchain allows for the creation of a massive encrypted and secure database. Blockchain increases the efficiency of the trust system disproportionally to any other previous set-up.

At the moment, we may not trust the data we have been presented with in a transaction and would need middlemen to verify it by double-checking existing information. By storing all previous transactions, and the data that goes with them, in a distributed and decentralized database (without a central authority, tampering with it becomes more complicated), the blockchain mechanism, in effect, gets rid of these middlemen. For example, once all the information on a house is on the blockchain (has been verified once), it does not need to be verified every single time the house is sold/bought in the future. In addition, only new, incremental information needs to be verified.

Blockchain standardizes trust. It is interesting how recent commentators have compared Bitcoin with gold. Indeed, they both carry ‘information’ we can trust without question (especially when we transact with ‘strangers’ – which is now everybody in this time and age). Yes, blockchain is the same as the gold of the past – easy to ‘carry on’ and secure to exchange between two strangers from different ‘tribes’. Unlike gold, though, this trust is based not on physical properties (scarce, unmalleable, etc.) but on the evolution of our institutions which have allowed the technological progress we have experienced.

The digital world has no boundaries (for now). While we are questioning the merits of globalization at the moment, and whether this process is in reversal, such digital standardization in one country can easily spread across the world. Blockchain could thus actually speed up globalization and, therefore, substantially improve the prospects of some developing countries. Emerging markets assets have generally traded at a discount to their equivalents in the developed world, partially because of the huge institutional gap between the two.

Intrinsic value is indeed subjective but given certain assumptions can be modelled. The issue is that in emerging markets the assumptions can change literally overnight. In addition, there is the question of legal ownership, etc. For example, engaging in an exchange in a country with inadequate legal or executive system, where information is not readily available or cannot be trusted, is prone to be much more difficult and thus would require a substantial margin of safety. If indeed blockchain transforms the institutional framework of the emerging market world, it would not only raise asset prices there but, in the process, it could also accomplish what numerous NGOs and millions of financial aid money have failed to do in the past: make people accountable and subsequently raise everyone’s living standards.

Moreover, the lack of such trust legacy systems (fewer vested interests) in those countries may actually prove to be a positive development, as it could make it easier for some emerging markets to adopt the blockchain faster than developed markets. After all, there are plenty of examples where some developing countries leapfrog the developed world in adopting new technologies (i.e. skipping the evolutionary cycle completely – for example, mobile phones without first going through fixed phone lines; mobile banking without a bank account, etc.). In this sense, while in the developed world the trust system is slowly being updated through blockchain, this same process could be truly revolutionary in the developing world.