Robert Sams on rehypothecation, deflation, inelastic money supply and altcoins

The Bitcoin Foundation held a conference in Amsterdam back on May 15-17.  The video of the events was not uploaded until recently.  The one below covers the panel on economic theory.

Panel: Robert Sams (Founder, Cryptonomics) Robin Teigland (Associate Professor, Stockholm School of Economics) Peter Surda (Economist, Economicsofbitcoin.com) Konrad Graf (Author & Investment Research Translator) and moderator Jon Matonis (Executive director of the Bitcoin Foundation)

Over the past several months, Robert Sams has helped act as a non-partisan sounding board to discuss these issues as I did research on these topics.  He also recently launched a start-up in this space called Swiss Coin Group which acts as a liquidity counterparty (see also SCG’s announcement video from Coinsummit last month).

I finally had a chance to watch the panel on economic theory of Bitcoin (above) and below are some transcribed portions of comments by Robert Sams.

Regarding the ‘regression theorem‘:

The idea that something needs to have some underlying use value before it can gain liquidity and become a medium of exchange, first of all it has always struck me as not a derivation of logic and therefore not a theorem but an empirical hypothesis and one that I think that the very existence of Bitcoin has conclusively falsified.

On competing altcoins being sorted out:

I think eventually there is only room for a handful, 3, 4, 5, maybe ten competing cryptocurrencies.  Each filling a niche that satisfies some area of demand, some might have a richer scripting function for smart contracts, one might be embedded in a different kind of protocol.  So there is definitely room for multiple currencies but the very nature of hash-based proof of work, where the security of the network is arrived at by people literally burning money is one that can’t be evenly distributed over a large number of alternative cryptocurrencies.  It’s what you see, eventually most of the altcoins will fail and people will stop mining them, they won’t have any exchange value.  But there will still be room for quite a few.  And you already see it in the distribution of the market capitalization of these things, they follow a power law and I would expect that to continue.

What about altcoins in local communities?

That’s an interesting question.  I think the more local the currency becomes the harder I think it is to use hash-based proof of work as a solution.  Although other types of distributed consensus mechanisms could be used.  Because if as a community currency the overall monetary value of that thing is going to be much much lower, so the amount of seigniorage that comes from the mining award to reward the miners is much lower, so the amount of electricity that is spent securing it, it is something that will be alot easier for someone on the outside to attack it if they wanted to.  On the other hand, the incentive of attacking some small community currency might not be there, so not much of an issue.  So it’s an open question.

Thoughts on fractional reserve banking with bitcoin:

I don’t think it is actually possible to construct fractional reserve banking within Bitcoin.  Because fractional reserve banking, especially in the modern era, it’s one of the great scandals of modern finance is based on an illusion — this 1:1 fungibility between bank deposits and cash.  And you can do that in the conventional analog world because you have this whole institutional framework of deposit insurance, lender of last resort function of the central bank, you can bail out the banks if they fail in order to maintain this illusion that a loan to the bank — an unsecured loan to the bank which is basically what a bank deposit is — is the same thing as cash, and they are not.  And there is not anyway within the crypto space to express such an arrangement.  Sure there will be lending done in Bitcoin, I was talking to a guy last night who is doing just that, that’s fantastic.  But the relationship between the lender and the borrower isn’t one of “well I had some ownership of a pool of loans to people” — that’s something that has a floating net asset value.  It is not treated as a cash equivalent, I can’t use it as a medium of exchange or maybe I could but it would be a medium of exchange that trades like a credit instrument rather than risk free cash.  So I don’t think its even possible to express fractional reserve banking in bitcoin and I think that’s a good thing.

Konrad makes a really interesting point about trusted fourth parties and trusted fifth parties.  You know, it’s not just about being fractional reserve banking, the bank deposit versus cash, it’s about all assets within the financial system: the clearing banks, custodians — also play a fractional reserve-like role.  Most people don’t realize that.  Securities that are on deposit with a custodian bank can be lent out to those who want to sell them short; bonds, the same thing happens.  So that something that is called rehypothecation, these assets get lent and relent and relent, they multiply throughout the system.  So like some particular bond that’s in the system, there might be $2 billion of it outstanding, but the actual quantity of people who own that bond on their balance sheet is like a factor of 10 times that.  It’s just like the multiplication of base money in the banking system and the whole thing creates a systemic instability because the lack of clarity about this relationship between the guy who is entrusted his assets for safe keeping in some clearing bank and exactly do what that clearing bank can do with it.  Now the theory you think that it is governed by the law and the like but when Lehman bankrupt, there were a lot of fund managers and hedge fund managers who didn’t actually realize that their clients money which was supposed to be in a segregated client account was actually rehypothecated and they had to queue up in the bankruptcy courts in order to recover that money.  And one of the things that crypto does is make the sure technical nature of the transference being done by digital signature means that there is no way that you can create these rehypothecation arrangements without making them explicit.  And I think that is great.

Would you take out a 5 year loan in bitcoin knowing you had to pay it back in bitcoin?

No.  Well, it depends, I guess if I were selling it short.  But no.  If there was a lending market in bitcoin its most likely to flourish initially as being something that’s denominated in fiat money rather than nominal bitcoin.  Unless the borrower is using it as a vehicle to speculate on a climb in the exchange rate.

On deflation:

I think the deflation criticism of Bitcoin is usually misguided, it usually comes from the economics profession.  The arguments that are made don’t really apply because, the arguments about sticky prices (good’s prices fall faster than wages), about balance sheet effects of debtors being punished because an increase in the purchasing power, none of those really apply in Bitcoin because bitcoin isn’t yet a unit of account.  Contracts and prices are still priced in the fiat currency and expressed in bitcoin by reference to some exchange rate.  So the traditional arguments like, “is deflation is a bad thing” don’t really apply in a bitcoin world.

There is a different reason for why we maybe should be concerned about the appreciation of the exchange rate because whenever you have an economy where the expected return on the medium of exchange is greater than the expected return of the underlying economy you get this scenario, kind of like what you have in Bitcoin.  Where there is underinvestment in the actual trade in goods and services.  For example, I don’t know exactly how much of bitcoin is being held as “savings” in cold storage wallets but the number is probably around $5 billion or more, many multiples greater than the amount of venture capital investment that has gone into the Bitcoin space.  Wouldn’t it be a lot better if we had an economy, where instead of people hoarding the bitcoin, were buying bitshares and bitbonds.  The savings were actually in investments that went into the economy to fund startups, to pay programmers, to build really cool stuff, instead of just sitting on coin.  I think one of the reasons why that organic endogenous growth and investment in the community isn’t there is because of this deflationary nature of bitcoin.  And instead what we get is our investment coming from the traditional analogue economy, of venture capitalists.  It’s like an economy where the investment is coming from some external country where Silicon Valley becomes like the Bitcoin equivalent of People’s Bank of China.  And I would much prefer to see more organic investment within the cryptocurrency space.  And I think the deflationary nature of bitcoin does discourage that.

What about issuing coins after 21 million limit, that would be called Keynes coin?

I wouldn’t call it Keynes coin, not just because of the marketing but conceptually I don’t think it would be either.  This is controversial and difficult.  There are algorithmic, distributed ways of working within cryptocurrency protocol to change the money supply in proportion to the change in its exchange value.  And that can be done, it doesn’t require a central bank, it doesn’t require some cabal of guys deciding what the monetary policy can be, it can be done completely anarchic and distributed way and it would have the property of stabilizing the price of cryptocurrency.

I think the issue if should you have more elastic supply or not it just really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price.  And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices.  And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account.  And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies.  So I do think the issue does need to be addressed.

Audience question on 100% reserve versus fractional banking:

There is a movement underway in the economics profession called limited purpose banking or 100% reserve banking.  It’s not just in the cryptocurrency world that we criticize fractional reserve.  Even Mervyn King before he left his chairmanship with the Bank of England he suggested that this is something that we should look into.  So yes, it is quite possible, there could be consensus — broad base consensus — around taking away the banks ability to create private money.  What do we use to replace that, one side of the argument is going to be that the banks should take the role of issuing the currency they just have to have 100% reserves and ‘gosh those things should be risk free government bonds.’  I think there is an alternative argument that can be made from the cryptocurrency space is that we don’t actually need the banking system to fulfill those functions at all.  And the demand for some medium of exchange in the absence of bank created money will be met spontaneously within the cryptocurrency space.

Audience question, does buying bitcoin and holding them benefit the community?

It’s an interesting question.  I don’t think so.  You could argue indirectly the fact that people buy and hold bitcoin, the price goes up and that attracts all the interest into this space and to some extent that’s true.  So yes, it does provide some investment.  But I think it doesn’t provide as much investment as would be the case in the alternative world where Satoshi implemented the exact same thing but had a different money supply rule.  My view counterfactual is that we would actually see a lot more underlying economic activity in the cryptocurrency space and a lot more investment.

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One thought on “Robert Sams on rehypothecation, deflation, inelastic money supply and altcoins

  1. The reason that those that buy and hold are benefiting Bitcoin is because Bitcoin entrepreneurs are often the early investors. So these early investors see gains as a result of those who buy and hold and as a result are able to self-fund their endeavors — many of which are Bitcoin-related.

    So that’s one example of how those that buy & hold bitcoins are helping.

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