Bitcoin, Regulation and Bitcoin’s Future

Is regulation the likely downfall of Bitcoin? Last week at the conference for the Association of Private Enterprise Education, a session included speakers with differing points of view about Bitcoin’s future. One speaker pretty clearly suggested that regulation would be the downfall of Bitcoin. Is that plausible?

I interpret regulation as being the setting of rules by administrative agencies which are not courts as commonly understood. The “not courts as commonly understood” here is somewhat convoluted, but many administrative agencies in the United States have branches which resolve disputes in some ways similar to resolution by the judges.

With this definition, contract law and other rules applied by courts are not regulation, even though they are very important. Most importantly, there have been few if any court cases alleging fraud in the Bitcoin community. While not rampant, there have been serious frauds. In addition, criminal law is not regulation. For example, theft – taking something of value from a rightful owner — is a crime in most (all?) countries. While there are well known instances of theft – summarized at Wikipedia – nothing much seems to have been done about bringing the thieves to justice.

It is quite likely that fraud and thefts will be pursued more seriously than in the past. Bitcoins are worth far more than in the recent past. 400 bitcoins are worth $20 at $.05 per bitcoin and $200,000 at $500 per bitcoin.

If someone steals 400 bitcoins when they are $.05 apiece, there is not much point in doing anything about it. Of course, there’s not much monetary gain from stealing them either. On the other hand, when bitcoin are worth $500, stealing 400 bitcoins is no small thing. Similarly, someone defrauded of $20 is not likely to do much about it other than learn from the mistake. $200,000 is quite another matter.

It’s hard to imagine that bitcoins will not be subject to much more legal oversight than in the past. This is not the same as regulation.

Examples of regulation include the application of specific laws before starting an exchange for digital currencies compared to laws which apply to any other exchange, for example for collectors’ postage stamps.

Financial regulations have their own nuances. Before starting a bank in the United States, the backers must show they have the skill and assets to successfully operate a bank. They also must show that there is enough demand for banking services to support existing banks and the new bank. This is far different than opening a new grocery store. Still, this arrangement is better than the situation in many other countries, in which there is no effective way to start a new bank.

No doubt there will be attempts to regulate bitcoins along the lines of other financial enterprises. It remains to be seen how effective that regulation will be. For example, if New York state requires a license before someone starts an exchange for digital currency, the only thing affected is the probability that an exchange will start in New York state. It will be zero. If the United States government requires a license before starting an exchange, the only thing affected is the probability that an exchange will start in the United States. It will be zero, although it is not particularly high anyway.

It strikes me as implausible that regulation will stifle digital currencies in a serious way. It is too easy to get around the regulations. For example, Satoshi Dice is said to block U.S. addresses. Even if they are blocked, it is not hard to use Tor to have an address apparently outside the United States.

Bitcoins probably have the greatest immediate potential in countries such as Argentina, which has serious inflation. Inflation generates revenue from the government at the expense of money holders. Bitcoin is an attractive alternative to Argentinian pesos. While U.S. dollars are attractive also, holding them is illegal and U.S. dollars are harder to conceal than bitcoins. Argentina has dollar-sniffing dogs, but a bitcoin has no smell or other physical presence besides a sequence of numbers and letters.

In short, bitcoins are a way to get around regulations. While that may sound nefarious or evil to some, it doesn’t to me. More to the point, it strikes me as a positive for bitcoin’s continued use.

 

The Federal Reserve and the Financial Crisis

This link below is to a talk about the financial crisis, and the Fed’s actions during the crisis and since. I gave it at the Heritage Foundation on Wednesday, March 19. The basic point is that the Federal Reserve’s liquidity actions were in the right direction during the financial crisis. Quantitative Easing is more akin to allocation of credit by the Federal Reserve, which is problematic on many levels.

http://www.youtube.com/watch?v=nZx9yZHEDw8&feature=player_embedded#t=3340

Larry White and George Selgin also gave quite interesting talks at the short meeting. Their talks precede mine in the video.

Why did Mt. Gox fail?

Rising U.S. dollar prices on the Mt. Gox exchange

The U.S. dollar prices of bitcoin on the Mt. Gox exchange rose dramatically, from $.05 at the start

It has been a big week for bitcoin. Newsweek claimed they found the creator of bitcoin, who went by the supposed pseudonym Satoshi Nakamoto but actually was born with the name Satoshi Nakamoto. Calls for regulation of bitcoin appeared all over the place, for example at an investment research firm Casey Research. A Canadian exchange dropped U.S. customers because of U.S. regulations already in place. The size of the loss at Mt. Gox became clear with a lot of speculation about how it happened.

How did Mt. Gox manage to lose half a billion dollars? A couple of guys with computers happened to be in Tokyo and half a billion dollars went missing (an observation made by a lawyer in a Wall Street Journal interview). It seems incredible.

Or maybe not?

It is easy to forget how large the increase in the price of bitcoin is over a couple of years. The adjoining chart shows the price of bitcoin in dollars on Mt. Gox from the start of trading in 2010 until the day before trading ended. The first trades were at $.05 per bitcoin. Now bitcoins are trading at about $600 (on other exchanges of course).

Mt. Gox appears to have a loss of about 850,000 bitcoins. Valued at $600 per bitcoin, this is half a billion dollars. Valued at five cents per bitcoin, this is $42,500. The loss changes from huge to smaller than most personal bankruptcies in the United States, depending on the price of bitcoin. It’s the loss in dollars that matters in most ways. Is this small loss at another price just an interesting tidbit?

No, it is an important piece of the puzzle of where the half billion dollars went.

I will suppose that Mark Karpeles did not intend to defraud anyone. I seriously doubt he is the Bernie Madoff of bitcoin. (He’s not as successful for as long; that’s for sure.) It’s more likely that he is what he seems: a programmer who became interested in bitcoin and got involved in exciting developments by running an exchange.

Software issues and fraud by some customers probably did contribute to Mt. Gox’s failure, although it is hard to explain the magnitude of the loss by them alone, a point made by Emin Sirer. Mismanagement probably also played a role.

Based on many episodes in the past, there is a relatively simple and plausible explanation.

Mt. Gox was a startup in 2010. The available evidence indicates it had relatively little capital. In some ways, the whole thing may have been more like a lark than the start of a very big business. Initially there were not all that many trades and negative cash flow was likely. How to pay the bills?

It would be easy and seem harmless to take a small part of the inflow of bitcoins from customers and use them to pay bills. You might think this is fraud or otherwise evil, but I found no promise by Mt. Gox that it would keep customers’ funds separate from the exchange’s funds when I was thinking about using Mt. Gox to buy bitcoins. To a programmer, as opposed to a financial economist, I can see why this would not seem like a big deal.

The implications of this are large though. Mt. Gox now is short bitcoins early on. Being short bitcoins is similar to being short stock. Going short is the same as selling now and buying them back later. If the price goes down, this is selling high and buying low. If the price goes up, this is selling low and buying high. An increase from $.05 to $600 is huge. A debt of $2.00 to cover the cost of a cup of coffee – 40 bitcoins – becomes a debt of $24,000. A couple of cups of coffee and suddenly it is serious money!

Losses due to fraudulent withdrawals may well have contributed to the large loss. Especially if the losses due to fraud by customers happened when the price was lower, for example $100 just a year ago, that loss of a $100 bitcoin becomes the loss of a $600 bitcoin today.

How does an initially small and later larger debt get translated into losing 850,000 bitcoins and having little cash? Redemptions on Mt. Gox in the last eight months or so were in bitcoins, not dollars. Starting in 2013 and especially in Summer 2013, Mt. Gox was having trouble transferring funds to U.S. customers. The price of bitcoins in dollars was higher on Mt. Gox than elsewhere, consistent with a difficulty of redeeming in dollars. A U.S. customer would redeem in bitcoins, not dollars. Instead of a constant inflow of bitcoins and dollars, there was a constant outflow of bitcoins because of Mt. Gox’s difficulties. Mt. Gox redeemed and bitcoins went away. At the same time, there were not that many dollars because the small initial short position became a very large loss.

Is this likely to be all the story? History suggests not. When people get into difficulties, they do things that seem mysterious, goofy or even stupid in hindsight. It would be surprising if nothing like that happened.

Still, Mt. Gox is likely to have been in the wrong place at the wrong time, experiencing the opposite of some others’ good fortune. One graduate student bought $27 worth of bitcoins and later cashed in a fifth of them to buy a nice apartment. Mt. Gox likely had the bad luck, borrowing a small amount, maybe losing a small amount other ways, and ending up short bitcoins early on. The small debt became a very large one and the drain of bitcoins made the magnitude of the loss evident.

The drumbeat for regulation of bitcoin after Mt. Gox’s failure has begun, with an op-ed in the Wall Street Journal by Ezra Galston claiming that

In the near term, the bitcoin community must embrace external regulation to ensure that credible vendors may participate in payment processing. A “BitLicense,” proposed by the New York State Department of Financial Services, is a good start, but transmitter laws that differ by state may leave payment processors just as hesitant.

This is reminiscent of the call by Ben Lawsky for “smart” regulation by New York State. He takes it for granted that U.S. citizens would be better off dealing with a U.S. exchange – Lawsky hopes in New York state – instead of using an exchange in a foreign country.

Mt. Gox and similar exchanges are a remarkable development. At Mt. Gox, a customer could transmit an order to the exchange to trade bitcoins for currencies or currencies for bitcoins. The order could be submitted 24/7 and it could be executed 24/7. Mt. Gox did not limit trading by hour of the day or day of the week. No broker received a payment when the order was submitted; the trade was submitted online by the owner of bitcoins or currency.

I have found no evidence in Mt. Gox’s trade data of any lull in trading at any regular hours or any regular days of the week. To some extent, this probably is true because many holders of bitcoins are hackers (in the good sense) and they famously keep irregular hours. It also probably is true because Mt. Gox’s customers were located in many different time zones. Indeed, my purchase of a bitcoin might be a purchase from someone living on the other side of the planet.

None of this is true of regulated exchanges in the United States. Hours are limited. Orders are submitted through a firm that is a member of the exchange and a payment is made to the member for submitting the order. Some trades cannot occur without human intervention because of exchange rules. At least for American citizens, it is no small thing to open an account at established exchanges in other parts of the world. (We have the U.S. government to thank for that.)

Regulation to make bitcoin exchanges more similar to U.S. exchanges will not make trading better from customers’ point of view.

Mt. Gox halted trading in Bitcoin on its exchange late yesterday (February 24), after suspending payments to customers on February 7. This morning (February 25 Eastern Time) their website is down except for the silly message

 Dear MtGox Customers,

In the event of recent news reports and the potential repercussions on Mt Gox’s operations and the market, a decision was taken to close all transactions for the time being in order to protect the site and our users. We will be closely monitoring the situation and will react accordingly.

Best regards,
MtGox Team

Why is this silly? Coindesk (a bitcoin news source) reports on a document suggesting that Mt. Gox has large losses, on the order of 750,000 bitcoins. This is about $370 million U.S. dollars at a price of $500. If the losses are anywhere near this big, Mt. Gox is gone. It would do well to be working out its insolvency and making the insolvency clear to customers with accounts. Instead, the document, which supposedly is a plan for resurrection, is wildly unrealistic about the options at an insolvent financial firm.

Bitstamp – the largest exchange by number of trades recently – recovered from the software issue in days and began trading again. The long suspension of payments indicates that the problem is serious.

Mt. Gox suspended payments almost three weeks ago and has been issuing nothing but rare, cryptic messages since. There is no evidence the losses aren’t very substantial and all efforts should be devoted to winding down the operation, not supposedly protecting “the site and our users.”

Fraud by Mt. Gox is not necessary to get to this sad end for the exchange. Instead, naiveté is sufficient to explain it. Some of it was on display in Wired in November when they used the prescient title “The Rise and Fall of the World’s Largest Bitcoin Exchange.”

The bankruptcy rules in Japan will have a big effect on the resolution for Mt. Gox’s customers. I know nothing about whether Japan even has “bankruptcy” laws as the U.S. does. Arrangements for insolvent firms and people are very different even in the United States and European countries. Japan may not be so different if General McArthur’s staff wrote the first version at the end of World War II but even that is not necessarily what is in force now.

The history of non-governmental currency indicates that the hit on bitcoin’s reputation is likely to be substantial. Some people have lost quite a bit of money. The Coindesk article says that one person had 550 bitcoins at Mt. Gox, which is a rather startling amount: $275,000 at $500 U.S. dollars per bitcoin. I would think twice before having that much deposited at my credit union, let alone at a startup operation in Japan. This person says that he has no one to blame but himself, which is admirable.

Unfortunately, many others are likely to want the government to protect them in the future and politicians will be happy to oblige. New York State already was floating the notion of BitLicenses.

Currency union and Scottish independence

Scotland is having a referendum on leaving the United Kingdom. For someone whose ancestors include mostly Irish people, this seems unexceptional. I can see points pro and con.

The odd thing was an article in the Wall Street Journal on currency union between the rest of the United Kingdom and Scotland if Scotland left the United Kingdom. There was an article by the BBC as well. Why would the United Kingdom – with about 59 million people – form a currency union with Scotland which has about 5 million people? What does the rest of the United Kingdom stand to gain from a currency union with Scotland?

It is similar in some ways to a petition by Puerto Rico to form a currency union with the United States if it became independent. Puerto Rico uses U.S. dollars and the U.S. government would have no problems with that continuing. The U.S. has no obvious incentive to share any seigniorage from money held by Puerto Ricans any more than it shares seigniorage with Panama, which uses U.S. dollars. The U.S. government also treats Panamanian banks the same as other foreign banks, at least as far as I know. Scotland would be in the same position.

Bottom line: The United Kingdom has no incentive to form a currency union with an independent Scotland. If Scotland leaves the United Kingdom, the Scottish government can attempt to choose a currency but I would be surprised if U.K. pounds did not prevail unless there were serious legal penalties. Apparently this is evident to Scottish politicians as well. They’d just rather have some of the seigniorage and probably don’t like the image of using foreign currency after becoming independent.

Discretionary Monetary Policy and the Stability of a Money’s Value

George Selgin has a very nice blog about an FT op-ed on Bitcoin. He didn’t say all that might be said though.

The conclusion of the FT article is:

“Governments should be wary of allowing any virtual currency, unless they first find a way of putting central bankers back in charge.”

I couldn’t help but smile reading this.

So ends a profoundly uninformative piece on Bitcoin in the Financial Times no less.

The author of the article is Mark Williams “a former Federal Reserve risk examiner….” I guess this affiliation is supposed to suggest some sort of expertise concerning monetary policy. Unfortunately for the FT and we poor readers, the article is more a rant than a thoughtful piece.

The premise of the article is: “Keeping money stable and trustworthy has traditionally been a function of national governments.”

This premise assumes a great deal. It is fair to say that governments typically, although certainly not always, have been involved in defining the unit of account and money used by most people in the government’s area. Whether that money typically has been stable or trustworthy is quite another question. Probably the best answer is: “Sometimes yes, sometimes no.”

In the main part of the article, the loss of discretionary monetary policy determined by central banks is the big loss if private currency is allowed to exist. According to the author, central banks do a good job of executing the “enormous job” of adjusting monetary policy to the current state of the economy.

Williams assumes that Bitcoin and similar currencies will become sufficiently popular that they will make discretionary monetary policy less effective. A new currency faces a lot of hurdles to being adopted in place of an incumbent currency that is legal tender. If private currencies become widely held, it is hard to see how this can happen unless private currencies become a more reliable store of value than government currencies.

For private digital currencies to become a more reliable store of value and popular, there must be a trade-off of discretionary monetary policy and instability of money as a store of value. The desirable discretionary policy must make the money’s value less stable, or else digital currency is very unlikely to be widely adopted.

This whole line of argument seems more like an argument against discretionary monetary policy than an argument for it.

 

Mt. Gox’s suspension and software problems

On Monday, Mt. Gox announced that the suspension of payments would continue because of a software problem. This will not inspire confidence by Bitcoin newbies. The dollar price of a bitcoin at Mt. Gox fell below $600 on February 11. Long term though, such difficulties and responses are inevitable. Protocols in other contexts have these problems, including theft of information on millions of credit cards.

Smart regulation of bitcoins?

Mt. Gox has suspended payments, at least until Monday, February 10. A suspension of payments means that it is not possible to withdraw funds from Mt. Gox. This is not a problem at a small outfit. Mt. Gox was the by far largest exchange for bitcoins at least until the last few months. Mt. Gox seems to have had difficulties redeeming accounts for some time. The problems started about the same time that the Financial Crimes Enforcement Network in the United States started treating Bitcoin firms as money transmitters and reportedly seized accounts in the United States related to Mt. Gox.

It is odd to read a spokesman for the Bitcoin Foundation — Jinyoung Lee Englund — say that the United States has a “smart regulation approach” at the same time this problem occurs.

But then again, maybe creating substantial difficulties for firms dealing in bitcoins is smarter than trying to ban them? The Russian government has announced that bitoins are banned in Russia.

Trying to ban bitcoins is not particularly bright. It shows a lack of knowledge, imagination or both. Bitcoins can be transferred around the world trivially by parties who completely trust each other. Anyone who has bitcoins in Russia can transfer funds abroad if they have someone they trust outside the country. It is equally easy to make the reverse transaction, bringing bitcoins into the country. Maybe bitcoins would be brought into Russia to sell? An institution such as Mt. Gox is not necessary.

 

 

Bitcoin and other digital currencies

Bitcoin has been much in the news lately. I have written a draft of a paper on “The Economics of Private Digital Currencies”. The paper uses Bitcoin to concretely summarize how private digital currencies work.

There are two major innovations associated with recent private digital currencies such as Bitcoin. The first is the settling of transactions by a peer-to-peer network. Instead of settling transactions on the books of a single institution such as the Federal Reserve in the United States, transactions are settled on a network in which no link inherently has more standing than any other link. More concretely, transactions are settled by agreement among participants in the network, for example Bitcoin’s network. The paper goes somewhat into the details without, I hope, becoming tedious for non-programmers.

The second innovation is the creation of exchanges in which buyers and sellers of Bitcoins are “end users” – people how hold bitcoins or want to buy bitcoins instead of agents such as brokers – and the trading is computerized without human intervention. This has resulted in 24/7 trading, which is quite different than trading on organized exchanges. It is more similar to Ebay than the New York Stock Exchange.

Whether Bitcoin or any other digital currency will exist in a couple of years is an open question. A close examination of Bitcoin reveals no inherent design flaws indicating that it will ultimately fail. The question is whether it will be useful. As with many other innovations, this is hard to tell.

The paper is available at http://www.jerrydwyer.com/pdf/digitalcurrency.pdf.