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Bitcoins for Sovereigns and Children

Bitcoin markets have been very volatile in the past few days with the UK based Intersango price peaking at 10.06 on the 17th August 2012 before dropping to just over 7.5 and now setting back to around 8.2 as I write this on the 18th.

I’ve been dabbling in the market for around 2 months making a few trades with the same amount of cash (around 70 GBP) and here are my perceptions:

  • even on the Intersango GBP market which is much smaller than the USD or EUR markets and a bit less then the mtGOX there is sufficient liquidity to fill orders for single digits of bitcoins with no delays and with less than 2% spread. Remember we’re dealing with small amounts of money here – if you wanted to send someone 5 GBP anonymously then the cheapest is cash by hand and by post it would cost you a stamp so about 10%  in costs. But as bitcoins your charges would be overall less than 5% excluding exchange risks.
  • the different markets do not yet seem to be efficient with differences in prices between them. Basically the markets are not yet smoothed by arbitragers. In time this should change.
  • I know of no simple means of automated trading systems(1). The exchanges have APIs but no  one has brought this together with existing low-cost or free technical analysis packages.
  • I know of few means to short coins in that there are only informal peer to peer bitcoin lenders(2)(3). There is no reason why there cannot be a more formal bitcoin lenders. With a suitable legal framework someone with bitcoins could lend these so a trader could short bitcoins if they think the market will be bearish. There is a default risk but in the end the stock lender was given e.g. dollars so on default the lender is stuck with long dollars and short the bitcoins that the trader defaulted and has loss the unrealised gains of the bull market that the trader was betting against. There do seem to be a number of “investment vehicles” but these are only for money or coins that you don’t mind losing (4)(5).
  • I know of few bitcoin options market makers. So no simple access to put, calls options or futures. There is no reason why this cannot happen. The perfect storm is efficient markets with automatic trading across exchanges to smooth differences and then stock lending. With sufficient liquidity in an efficient market then a market maker could write covered options.
  • Market entry is trivial. You need a UK bank account to get money and you can only send money back to that same bank account. You can get bitcoins into the system from any coin address and out to any coin address. Other exchanges may be different but I suspect most will have a similar anti-money laundering mechanism.

Don’t think bitcoin trades are done in secret. Contrary to what people think about bitcoins the level of publicly visible transactions is phenomenal compared to existing money markets or even cash. I can hand someone cash and no one will ever know about this transaction but if I send someone some bitcoins then if the police know my IP address or bitcoin address they can trivially work out every bitcoin transaction I do. They may not know to whom but they have the precise record unless I plan ahead and make my IP footprint anonymous e.g. TOR or VPN.

On this basis I suspect that Governments will have a problem restricting bitcoins simply because it already has a level of reporting that cash transactions don’t. Couple ISP IP records with block chain reporting of IP addresses and anonymity of bitcoin is eroded. Sure you can use bitcoin anonymously but you have to plan ahead. Hey that’s true for all security !?

There will come a time when fiat money issuing governments will sit down and try and work out what they can do with bitcoins. They just can’t ignore the system as it has some features that puts their own money to shame. Their approach to date has been to try and say that bitcoins are used for illegal trade or money laundering. That is disingenuous given most of the world’s illegal trade is done in money that they issue.

With no counterfeiting and no quantitative easing i.e. a fixed money supply it throws a spanner in the works of both seigniorage and existing poorly implemented fractional reserve banking systems. So what can they do ?

  • market interventions – print money as normal and buy up bitcoins over time and horde them.  With poor liquidity the remaining coins become collector items with no purpose that supplants the fiat cash. Coupled with Gresham’s law people will use the lower valued money rather than the high-valued bitcoins (which would be ironic).
  • Sovereign countries could just gain 50% of the network’s computing power and do changes that make an utter mess of the whole of the bitcoin network.This could irreversibly damage the reputation of the system. A typical gang of sovereigns could do this as often as they like and hide behind sovereign immunity.
  • central banks could roll their own bitcoin system by pre-building coins using in-house mining. They could then release these like they do existing cash i.e. just make the coins available on an exchange. They could do this as many times as they like.
  • simply make the possession illegal. If it works for drugs and guns then why not bitcoins ? The coins have to be in a electronic wallet or on an exchange so make this illegal. This would dry up liquidity overnight.
  • make anyone who confirms transaction blocks register with a central authority.
  • implement a bitcoin bank and kickstart fractional reserve banking in bitcoins.  This would require very good fiscal discipline on capital adequacy which few governments can provide given lack of ability to issue new money because the total number of bitcoins would always be  fixed.

Bitcoins are going to be one hell of a Sovereign nightmare and I think they’ll just variously make them illegal or restrict their use in ever bizarre ways through regulations that make the widespread use as a stored value more or less impossible or meaningless.

On a more hopeful note compared to the central banks the market is ideal for children to trade in. The market dynamics are similar to any FOREX exchange and so kids can,

  • Watch charts and technical analysis indicators
  • make decisions on if the market will be bull or bear against a specific (fiat) currency and make the correct trade to profit from that,
  • observing the price triangulations between different currencies and bitcoins,
  • performing different buy or sell trades (fill or kill, good until cancelled) and closing out their unfilled orders,
  •  transferring monies or bitcoins, confirming transfers have taken place,
  • sticking to strategy by closing positions when they have agreed to,
  • suffering wins and loses and calculating the maths on their net worth.

I recommend any parent to try and see if they find if your child has interest in this type of trading. At the very least they’ll be equipped with the terminology to understand the more liquid forex market.

Notes:

1. There are obviously some robotic trading systems but these have not yet been integrated into commonly available technical analysis packages as far as I can see so you still need two screens up –  the analytic screen with your buy/sell indicators and the exchange orderbook.

2 . There is an informal market in loans as a peer to peer market. Some are legitimate such as coin miners who want coins now (probably to sell on the spot market for cash) and are in effect short selling their future mined coins. This is not that much different from physical ore miners (such as gold or silver or even oil) selling forward contracts but the costs are far higher than the usual risk free rate of return used to price forward contracts.

3. There are unsecured loans on a peer to peer basis. Credit rating is managed by the lender based on traditional credit searches plus community based reputation. There is default risk and interest rates are high. This is not a retail market place and if you are interested in microlending then there are other more reputable platforms.

4. The high interest borrowers (i.e. where “bonds” are issued) has only two possibilities that make sense: the first is that they have all the hallmarks of a ponzi scheme. They all seem to have high returns that are divorced from the risk free rate of returns of fiat money that you would expect if the bitcoins were turned into cash. The only “legitimate” reason to pay such high returns is if the bitcoins are being used to trade high margin items on markets that only take bitcoins and that seems to be illegal goods. But then most of the world’s illegal trade is done in fiat money and not bitcoins.

5. If someone is advertising a fool-proof trading system that offers a couple of percent per week for a “bitcoin” deposit then as bitcoins are convertible to fiat money this would imply that you could use bitcoins as a carry currency, e.g. swap say USD to bitcoins, earn loads of bitcoins in interest, and then convert back and keep doing this. No way – anything that advertises this is hooking you with muppet bait. On the other hand if they are talking of low single digit percentage per month or double digits per annum and have a business plan other than pass-through to other dubious deposit taking schemes then they could be an interesting bet.

I’ll write a note later on the few legitimate exchange systems for bitcoins and how kids (or parents) could trade in these and learn the dynamics and terminology.

Investment interest ethics: I have 10 bitcoins as I write this.

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