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Category Archives: Decentralization

The multifaceted collapse of SBF and FTX

11 Friday Nov 2022

Posted by beyondoverton in blockchain, Decentralization

≈ Leave a comment

Tags

cryptocurrency

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:

The Corona virus will push us further into the digital medium

27 Thursday Feb 2020

Posted by beyondoverton in De-urbanization, Decentralization, Travel, VR

≈ 1 Comment

The facemask will become a feature of our daily life: it was already turning into a fashion symbol before the virus hit. In the near future, the face mask will be incorporated into the VR ‘goggles’, 

The Corona virus will only accelerate the shift towards the digital medium at the expense of the physical medium of human existence. Millennials have more or less embraced this change: apart from having to go to school they do not leave their bedrooms anymore (and I suspect, if the quarantine stays on longer, governments will start to consider settling up virtual classrooms). If you don’t have a teenager just have a cursory check on some of the comments on Tiktok to get an idea that the young generation does not consider the virus a big issue at all – it affects mostly the older generation, plus a quarantine allows the young to spend more time in the digital world of their bedrooms.

But, if the quarantines remain a feature in the developed world, the virus could also have a profound effect on the older generation in terms of travel and work preferences. For example, the trend decline in car sales globally will accelerate. Long distance vacation travel is also likely to slow down; physical social interaction, already massively in decline, as well. The older generations may be ‘forced’ into the digital medium for health and safety concerns, as well as to avoid increasing living costs.

Does that mean any physical infrastructure not directly linked to the new medium becomes obsolete? This is an important question for policy makers to consider especially now as the calls for fiscal action become louder and louder. In that sense, the thinking in the higher echelons of power in the West are either at level zero (a border wall), or level one (a bridge in the Irish sea, high speed rail). Instead, we need at least second level thinking here, for example, what is the new mobility landscape?

If Chevron’s London office staff working from home proves to be either non-disruptive or even possibly increase productivity, would that become the new normal? Outsourcing office space for free from your own employees, and saving massively on real estate costs, which company wouldn’t jump at the opportunity (note this is no different to getting consumer data for free in exchange for social media access, or booking your own travels in exchange for lower prices – it’s all part of the same trend)?

This means more de-urbanization. The concept of the city as a melting pot of ideas and people is also becoming obsolete. Moreover, this is again an existing trend: urbanization rates have been decreasing in the developed world independently as a feature of decentralization.

Will the supply chains shift as a result of all this? Yes. Again, a well-established trend already which started in earnest with the decision to Brexit in 2016, Trump’s de-globalization campaign and the ensuing US-China trade war. While China is the more obvious ‘loser’ here (though, not necessarily clear, as China was already moving up the value chain and this process may have only accelerated this, as well as its push to ‘own; the digital medium through the development of 5G), the beneficiaries are not clear. It is unlikely, though, to be any other emerging market countries, as that does not take care of the issue at hand (the start of this trend in 2016).

Though actual production is likely to come back to the developed world, this does not necessarily mean higher employment long term. There is yet another trend, which has already been in place for a few years, which will get a strong push here, that of automation of production. We haven’t seen the benefits of automation yet largely because it has either not been profitable enough, or because of politics (keep employment higher until we figure out what to do with people, and in return, we ‘let’ you book revenues in tax havens so you save on corporate taxes and have more cash for share buybacks!). But automation costs have been coming down as technology advances, while human costs have been perking up. Political developments, plus massively increasing federal budget deficits, have also put pressure on clamping down on tax havens. We can finally see the seeds of 3D printing and precision manufacturing bear fruit. This is very bullish companies in these two sectors.

With manufacturing supply chains practically disintegrated, the only ones that will matter in the digital medium are commodities supplies – this is very bullish commodity exporting countries.

Is that the new normal?

My flight from London to Rome on March 26 was practically empty

We are entering a ‘Ready Player One’ world. The trend-decline in physical infrastructure, in the developed world – decades long, will probably accelerate. It is too late to build the HS2. The trend-increase in alternative ‘realities’, on the other hand, whether we call them fake news, social bubbles, or whatever, will only accelerate. So, focus is shifting to building the foundation of the equivalent of the digital ‘Interstate Highway System’: 5G is the most important development in that regard at the moment, and the main reason the US-China trade war started in the first place. 

Planning vs trial and error

13 Monday Jan 2020

Posted by beyondoverton in AI, China, Decentralization, Politics

≈ Leave a comment

Tags

blockchain, China, Russia

What’s the best model of resource optimization?

The market has been predicting the coming collapse of China ever since it joined the WTO in the early 2000s and people started paying attention to it*. The logic being, with the collapse of the Soviet Union in 1989, China would be next: the free market must surely assure the best societal outcome. But with the re-emergence of China thereafter, and, especially, that it is still ‘going strong’ now, on top of the slowdown (‘secular stagnation’ or whatever you want to call it) of the developed world, I think the verdict of what the best model of resource optimization is, is still out. 

The Soviet models of resource optimization in the 1960s and 1970s were very sophisticated for their time (and even ours): In the late 1950s, Kitov proposed the first ever national computer network for civilians; in the early 1960s, Kantorovich invented linear programming (and got the Nobel prize in Economics); shortly after Glushkov introduced cybernetics. 

Kitov’s idea was for civilian organizations to use functioning military computer ‘complexes’ for economic planning (whenever the latter are idle, for example during the night). Kantorovich brought in linear programming which substantially improved the efficiency of some industries (he is the central character in a very well written book about the Soviet planning system called ‘Red Plenty’). Glushkov combined these two ideas and his OGAS (The All-State Automated System for the Gathering and Processing of Information for the Accounting, Planning and Governance of the National Economy) was intended to become a real-time, decentralized, computer network of Soviet factories. The idea was very similar to a version of today’s permissioned blockchain: the central computer in Moscow would grant authorizations but users could then contact each other without going through Moscow.

The Soviet planning system failed not necessarily because it would not work (limited, though, as it was in terms of computational power and availability of data) but because of politics: Khruschev, who had taken over after WW2 and denounced the brutality of Stalin, was ousted by Brezhnev. The early researchers were pushed aside (in fact, those Brezhnev years were characterized by fierce competition among scientists for preferential political treatment). One could say, the Soviets’ model of resource optimization failed because it was not socialist enough (compared to how the Internet took root in the US on the back of well-regulated state funding and collaboration amongst researchers). In other words, the 1970s Soviet Union was a political rather than a technical failure. 

I should know, I guess. I grew up in one of the Soviet satellites. My father was in charge of a Glushkov-style information data centre within a large fertilizer factory. When we were kids, we used to build paper houses with the square punched cards he would sometimes bring home from work. Later on, when I became a teenager, my father would teach computer programming as an extracurricular activity in my local school (I never learned how to program – I preferred to spend my time playing Pacman instead!). At that time, Bulgaria used to produce the PC, Pravetz (a clone of Apple II), which was instrumental in the economy of all the countries within the Soviet sphere of influence.

By the time I was graduating from high school, though, things had begun deteriorating significantly: even though everyone had a job, ‘no one was working’ and there was not much to buy as the shops lacked even the essentials. Upon graduation and shortly after the ‘Iron Curtain’ fell down, I left to study in America. 

Eventually, I ended up spending much more time in the ‘trial and error’ economy of the developed world, working at the heart of the ‘free market’ in New York and London. I am certainly not unique in that sense as many people have done this exact same thing, but it does allow me to make an observation about the merits of the planned economy vs the free market.

My point is the following. The problem of the planned economy was not so much technical misallocation of resources, but, ironically, one of proper distribution of the surplus. The Soviet system did not exactly create an extreme inequality, like the one there is now in America (even though some people at the top of the Party did get exorbitantly rich) but instead of using the production surplus for the betterment of the life of the population NOW, politicians continued to be obsessed with further re-investment for the future. There was perhaps a justification for that but it was purely ideological, a military industrial competition with America, nothing to do with reality on the ground.

So, while the Soviets were perhaps winning that competition (Sputnik, Gagarin, Mir, etc.), the plight of the common people was not getting better. And while they ‘couldn’t’ simply go in the street and protest or vote the ruling party out, they expressed their anger by simply pretending to work. Of course, that eventually hurt them more as the surplus naturally started dwindling, productivity collapsed and the quality of the finished products deteriorated. The question is, given a chance, would the planned optimization process have worked? If Glushkov’s decentralized network with minimum input from humans had been developed further, would the outcome now be different?

There is a lesson here somewhere not just for China but also America. Both have created massive surpluses using the two opposing optimization solutions. And both are running the risk of squandering that surplus, in a similar fashion to the Soviet Union of the 1980s, if they don’t start distributing it to the population at large for general consumption. In both cases this means transferring more income to ‘labour’: in China away from the state (corporates), in America away from the capital (owners). But because the differences at the core of the two systems, it is easier for China to do this consciously; in America, the optimization process of the free market, unfortunately, ensures that the capital vs labour inequality goes further to the extreme.

So, can China then pull it off? 

While I am not privy to the intricacies of their ‘planned’ resource optimization model, just like in the Soviet Union, the risks there seem more political. But after an additional 50 years of Moore’s law providing computational power and after digitalization has allowed access to data the Soviets could never even dream of, China stands a much better chance of making it than the Soviet Union ever did.


*I actually use “The Coming Collapse of China”, Gordon Chang, 2001 as a reference point

The jeepney: decentralized trust in practice

21 Thursday Feb 2019

Posted by beyondoverton in Decentralization, EM

≈ 1 Comment

Have you ever ridden in a jeepney? Chances are that you haven’t, for even if you have visited the Philippines, unless you are a backpacker, you would have stuck to taxis. In our travels, we met expats who had lived there for years but had never been in a jeepney.

Well, you are missing on a practical lesson how decentralized trust works.

The jeepney is actually the most popular public means of transportation in the Philippines. It was originally made from the American jeeps left over from WWII. It is also the cheapest way to travel because of its open rear door design, the jeepney can pick up and drop off passengers anywhere. Having said that, it is not the safest way of transport, either mechanically (too old), or because of its seating configuration (a long bench with no seat belts, very low ceiling, combined with constant and sudden stopping).

What was fascinating for me was actually how its payment system works: it is all based on trust. Decentralized trust in fact. As it is not optimal to have a ticket collector, the jeepney driver is also tasked with collecting the money for the trip. The problem is that the entrance is all the way in the back. Not only the driver cannot collect the fare in advance, but he has to rely on other passengers to pass on the money to him. Many times he has to pass back change. The fare also depends on the destination which is shouted as the money changes hands, which adds an additional variable to keep track of. All this while driving, so obviously the driver cannot possibly follow up on all this!

But the system works. Passengers can see who has paid and who has not and they have an interest to keep its integrity in check not because of a fear of a fine (light regulation with minimal monitoring) but the realization that if it breaks, it means everyone has to take the more expensive and less convenient bus. Of course the system can also be ‘gamed’: if ‘majority’ of the passengers agree to cheat but the level/cost of cooperation is too high.

As societies become more complex it is basically suboptimal to rely on a centralized authority. An additional complication is if those societies do not have a strong institutional infrastructure, like in most of EM, or the traditional sources of authority start to be mistrusted, like in a lot of the developed world.  Decentralized trust then becomes a necessity and a prerequisite for maintaining the proper functioning of society. It seems to me that EM has the first mover advantage here and is likely to leapfrog the developed world.

Bitcoin is not the future of money

06 Monday Nov 2017

Posted by beyondoverton 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.

Will decentralization lead to de-urbanization?

27 Thursday Jul 2017

Posted by beyondoverton in Decentralization, Questions

≈ 1 Comment

Tags

De-urbanization, Decentralization

Army (3500 BC): walled city -> Navy (1210 BC): walled city -> Air Force (early 20th century): walls provide no security; in fact, institutional and physical infrastructure concentration reduces security rather than increases it -> Cybersecurity (early 21st century): decentralized security essential as centralization runs the risk of total destruction. Will the trend of decentralization spurred by the advances of technologies like the blockchain, for example, speed up the process of de-urbanization in the developed world? Can technology also start to reverse the developing world urbanization?

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