Tuesday, December 19, 2017

Money as a generally-accepted medium for short selling

Jim Chanos, famous short seller. We are all Jim Chanos.


Most people find the idea of short-selling to be incomprehensible. Buy a stock and hold it, that's what one does. To the majority of us it's just down-right odd to do the reverse, borrow stock in order to sell.

At the same time, pretty much everyone in the world is a short seller, even if we don't realize it. The credit card debt we wrack up, the lines of credit, the pay day loans, the mortgages—they're all examples of us going short. We borrow a certain type of security—dollars or yen or other types of money, either in paper or digital format—and immediately sell it. And then after a little time passes we cover that short, buying the dollars or yen back and repaying the loan. We are all Jim Chanos, the world's most famous short seller, the only difference being we tend to short different instruments than Chanos does.

The only time I ever sold a stock short was back in 1999. I was still in university and probably a little bit reckless. What I didn't know at the time was that there was still a year or so left in the crazy late 1990s bull market. The price of the stock that I had shorted immediately began to move higher, and I got worried. The problem with short selling is that because a stock can keep rising forever, losses are theoretically infinite. After a month or two I bought the stock back to cover the loan, then got back to my studies.

While I've only sold stock short once, I've sold money short umpteen times. Borrow some Canadian dollars, sell it for things like groceries or a plane ticket or tuition, wait a while, repurchase the money, pay the loan back.

So why don't I finance my consumption by shorting things like Netflix or bitcoin? Why do I short dollars instead?

The nice thing about shorting money rather than Netflix shares or bitcoins is that I know exactly how much it'll cost me to repurchase the necessary securities to cover my short. Our labour is almost always priced in term of money, say $30 per hour. So if I've shorted three one-hundred dollar bills, I know ahead of time that I only need to sell ten hours of my time to buy that $300 back.

What's more, labour tends to stay sticky for months. This means I don't have to worry about my per-hour rate plunging temporarily to $15 next Wednesday, forcing me to spend twenty hours of time instead of just ten to cover my short. And since the central bank sets an inflation target of 2% or so a year, I already know far ahead of time that if I'm making $30 per hour this year, I'll be making ~$30.60 next year. So whereas one hour of my labour allowed me to cover a $30 short position in 2017, that same hour will allow me to cover a $30.60 short position in 2018. That sort of long-term certainty is a great feature.

Not so with bitcoin or Netflix. The big problem with using these instruments to finance consumption is that labour is never paid in terms of bitcoin or Netflix, but in yen or dollars or pounds. So while the sticky nature of labour means I know ahead of time that I'll be able to sell an hour of my time for $30, I don't know how many bitcoins or Netflix shares this $30 will allow me to repurchase to cover my bitcoin/Netflix shorts. This would be less of a problem if Netflix and bitcoin were fairly stable in price, but both are terrifically volatile, as I described here.

Consider a scenario in which I short one share of Netflix in order to fund my weekly supply of groceries (which costs ~$200)—or alternatively I short 0.01 bitcoins—and the price of either of these two assets doubles over the next few days. I'll end up having to pay $400 to cover the short, or fourteen hours of labour. If I had just shorted $200 dollars instead, I'd only owe seven hours ($200/$30).

A worst case scenario is one in which Netflix of bitcoin start to rise to infinity. If so, I'd have to work every waking hour of my life just to repurchase Netflix/bitcoin and cover my short. No thanks, I'll take the predictability of shorting money to pay for $200 worth of groceries. Central banks can create and cancel whatever amount of money they need to keep the purchasing power of money on a narrow path. I'll never have to worry about the nightmare of working every day for the rest of my life just to cover a tiny short position.

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Without the institution of short selling, society is made worse off. The timing of people's incomes do not always coincide with their consumption plans, and a short sale is a great way to bridge the gap.

And if short selling is a vital tool for bridging the gap between our incomes and consumption plans, it is important that the various media we use for shorting are capable of facilitating this process. When the future costs of covering a given short are difficult to predict, people will shy away from shorting to fund their spending needs, and the benefits of trying to bridge the gap between income and consumption plans will go unexploited. Society is made worse off.

The best media for this purpose—those most capable of providing a predictable price—will become society's generally-accepted media for shorting. So maybe money isn't just a medium of exchange, store of value, and unit of account; it's also a popular short-selling medium. That's why we see stable instruments like Federal Reserve dollars or Bank of Tokyo-Mitsubishi yen deposits or Barclays pound deposits serving as the world's most prolifically-shorted media. Sure, bitcoin and Netflix short sellers certainly exist, but this is a very niche sort of transaction undertaken by highly-trained financial practitioners or fools. They aren't generally-accepted short media.

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Bitcoin is a particularly awful medium for short selling because its lack of fundamental value leads to jaw-dropping volatility. Anyone who borrows one bitcoin (which currently trades at $19,000) and then sells it to finance a $19,000 purchase, say a car, could easily end up owing $190,000 two or three months down the road. That'd be a mere 10x price increase in the price of bitcoin, which is just a regular month or two in bitcoinland. A price move of this degree could easily bankrupt the car buyer.

Which in turn could bankrupt the person who lent to them. A bitcoin lender must account for the potentially lethal effect bitcoin's price spikes will have on his or her customer base by incorporating a premium into the interest rate charged to their customers. This means that the interest costs of borrowing and shorting $19,000 worth of bitcoin in order to buy a car will always be more than the costs of borrowing $19,000 worth of Federal Reserve banknotes. 

Because this volatility is inherent to bitcoin, it will always be bad at helping people build vital bridges between incomes and consumption plans. Don't expect it to ever become a generally-accepted medium for short selling.    

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What other features make for a good generally-accepted medium for shorting? When it comes time to cover one's shorts by buying back Netflix or bitcoin, there may not be enough of these instruments available, which can lead to a huge spike in their price. These are called short squeezes.

Money is different. The supply of modern money is tiered, with the public at the top, commercial banks in between, and a central bank at the bottom layer. When a spike in the public's demand for money occurs (otherwise known as a bank run), private banks will try to accommodate that spike until they can't, at which point they can turn to the central bank for help. The central bank can in turn manufacture whatever quantity of new money is necessary to meet that demand. So short squeezes will always be prevented by the central bank. That's a feature that neither Netflix nor bitcoin can offer.

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If the central banker's job is to maximize people's ability to bridge long gaps between income and spending by ensuring the predictability of the generally-accepted medium for shorting, might there be a better rule for managing things than inflation targeting?

Say that a recession hits and a large part of the population loses their jobs. If the central bank has an inflation target, those who have jobs can continue to easily cover the same quantity of dollars shorted by selling their labour whereas those without jobs will not be able to cover their shorts at all. Aggregating these two groups together, there is a net reduced capacity for short covering. So we might say that the central bank is failing at its job of providing a predictable medium for shorting.

If the central bank were to temporarily boost inflation to 4% when a negative shock occurs, it would be easier for the unemployed to cover their shorts than under a permanent 2% inflation targeting regime. For instance, with inflation at 4% rather than 2% an unemployed person would be able to sell their car or couch at a higher price than otherwise in order to cover a short position. For those on the flip side of the coin—those who make their living lending the medium for shorting—a temporary increase in inflation to 4% means their loans will be less valuable. But at the same time, the increase in the odds that the unemployed will be able to cover their shorts means that creditors needn't fret so much about the hazards of bankrupt customers.

So everyone wins. The converse could work too. When the economy is booming and jobs plentiful, the central bank could reduce inflation to 1% or so, thus making it slightly harder for people to cover their short positions. By using a rule that improves predictability in both regular times, downturns, and booms, the central bank provides a superior shorting medium for bridging gaps between incomes and consumption plans than under a flat inflation targeting regime. I suppose this is an argument for NGDP targeting over inflation targeting?

Friday, December 15, 2017

Electronic money will only save central banks from subjugation if it is anonymous

50 SEK banknote issued by the Riksbank in 1960

"Do we need an eKrona?" asks Stefan Ingves, the Governor of the Riksbank, Sweden's central bank. The Riksbank is probably the central bank that has advanced the furthest in discussions surrounding the introduction of a central bank-issued digital currency (CBDC)—a new form of risk-free digital money for use by the public. Canada, New Zealand, Australia, the ECB, and China are also dissecting the idea, with more central banks to come in 2018.

Sweden is approaching the issue from a unique angle, says Ingves. It is the only country in the world showing a consistent decline in cash and coin usage. I've written about this interesting pattern here, here, and here. Below is a chart:


Ingves floats two theories. Either the Swedish public no longer wants central bank money, or alternatively they do want central bank money but not the type that is "made of pieces of paper," preferring instead an as-yet non-existent digital alternative. If so, then it may be the Riksbank's duty to provide that alternative, says Ingves.

Duty is an admirable motivation, but let me propose another reason for why the Riksbank is exploring the idea of an eKrona—self preservation. I think Sweden's central bank is terrified that it will become powerless in the future. It is desperately casting around for solutions to resuscitate itself, one of these being an eKrona. This fear is rooted in the fact that declining cash usage has led to a collapse in the resources that the Riksbank believes that it needs to function.

These worries about powerlessness are shared by central bankers around the world, many of whom expect advances in private payments technology to lead them to the same cash-light situation that Sweden is currently experiencing. Their respective degrees of discomfort probably depend on how advanced their citizens are in the process of shifting away from cash. The Federal Reserve, which issues the world-renown $100 bill, is perhaps the farthest from having to worry, whereas central banks like the Norges Bank and Central Bank of Iceland are much closer to approaching peak cash.

What do I mean by a collapse in resources? Central banks have always been unique among government agencies for their self-sufficiency. Rather than depending on tax revenues to pay for their operations, they are capable of funding themselves internally. Central bankers have even made a habit of providing their masters in government with juicy dividends each year.

The magic behind this ability to self-fund is due to the central bank's monopoly on banknotes. Banknotes get into circulation when a central banker buys an asset, usually a government bond. Because the central bank doesn't have to pay any interest on the banknotes it issues whereas the bonds it holds yield 4% or so, it gets to collects the entire 4% margin for itself as revenue. Out of those revenues it pays its expenses, the remaining profit flowing back to the government as a dividend. 

These dependable and juicy margins, otherwise known as seigniorage, have afforded central bankers a number of luxuries. First, consider the creature comforts. These include large research departments, well-paid staff, good benefits, high status, nice new office buildings, museums with free admission, and plenty of international travel and conferences.

But seigniorage also serves a more important function; as fuck you money. Fuck you money (pardon the expletive, but its such a great phrase) can be thought of as any resource base that is large enough to allow an individual or institution to reject traditional hierarchies (i.e. one's boss) without fearing the consequences. The central bank's seigniorage—its fuck you money—finances a dividend that flows to the government, effectively buying central bankers a uniquely-large degree of autonomy from the vagaries of their political masters. This safe space allows folks like Ingves to pursue their most important task in peace, namely jigging the interest rate up and down in order to set the price level. A government department that must pass around the hat each year for funding would never be able to attain the same degree of independence.

At this point you may be able to see the Riksbank's problem. As the supply of krona banknotes in circulation withers, the Riksbank's seigniorage is getting smaller and smaller. This threatens not only the creature comforts that Swedish central bankers have gotten used to, but also the flows of fuck you money necessary to secure their sacred independence. If the popularity of kronor banknotes continues to drop, the perceived risks of political subjugation of the central banking machine will only grow.  

Let's take a look at some numbers. Below is a chart of Riksbank seigniorage going back to 2008.



The Riksbank calculates this number by taking the total earnings from its assets (both income and capital gains) and allocating an appropriate portion of this to the banknote component of its liabilities. The total costs of managing the bank note and coin system (printing, handling, salaries, designing etc) are deducted from this amount, leaving banknote seigniorage as the remainder.

Whereas Riksbank seigniorage clocked in at around SEK 5 billion in the late 2000s, it has plunged to SEK 560 million in 2016. If the rate of decline in banknote usage continues, my calculations show that seigniorage could fall to half that amount by 2018 and go into negative territory at some point in the early 2020s.

Falling global nominal interest rates are one important explanation for the decline in Riksbank seigniorage. As I said earlier, central bankers garner the margin between the supply of 0%-yielding banknotes in circulation and the interest payments they earn on bonds. If bond rates are declining, the margin shrinks and seigniorage suffers. But even if Swedish interest rates were to slowly recover over the next few years, this wouldn't halt the deterioration in Riksbank seigniorage. The constantly eroding base of banknotes on which the Riksbank relies for its profits would more-than-cancel out the effects of higher rates.

To shore up its flow of fuck you money, the Riksbank needs to find other sources of income. Which may be the true reason for Ingves's recent broaching of the idea of an eKrona. Given that a decline in banknotes in circulation is at the heart of the Riksbank's flagging seigniorage, then perhaps by developing a new 0%-yielding product and pushing it into circulation, the Riksbank can rebuild its once plentiful resources.

In terms of design, one option the Riksbank is putting forward is to allow Swedes to keep accounts directly at the central bank. It refers to this option as register-based eKrona. I'm afraid that register-based eKrona is destined to be a dud. Private banks have decades worth of experience in providing accounts to the public. A central bank account will always be a poor competitor. Former New Zealand central banker Michael Reddell recently blogged on the topic of an eNZD, recalling the days when his employer offered accounts to employees:
Central banks almost inevitably would lag behind commercial banks in their technology anyway, which wouldn’t make a central bank transactions account product particularly attractive... Frankly, I’d be a bit surprised if there was much (normal times) demand at all (and I think back to the days –  decades ago –  when the Reserve Bank offered –  in direct competition with the private banks –  cheque accounts to its own staff; perhaps some people used theirs extensively,  but I used it hardly at all).
As for the supposed superior credit risk of a central bank account, I just don't see it. Sweden already insures private bank accounts for up to 950,000 kronor ($112,500) and even up to 5 million kronor in special circumstances. A central bank account could only be the superior alternative for amounts north of $112,500, but how many members of the public really keep that much in deposits?

Types of eKrona compared to cash and bank account money (source)

Given that register-based eKrona would fail miserably in securing the Riksbank a new stream of fuck-you money, Ingves and his research staff should probably be focusing entirely on the alternative form for eKrona: electronic banknotes. The Riksbank refers to this option as value-based eKrona. Unlike register-based eKrona, a value-based eKrona would possess a very special feature; anonymity. Like physical banknotes, they would be untraceable, only they would be superior to their physical forbears since they would be transferable not only face-to-face but also over the internet. The Swedish public's desire for online economic privacy would be sufficient to generate a positive demand for the lone product providing said services, the eKrona, thus restoring at least some part of the Riksbank's lost seigniorage.

In his recent speech, Ingves seems tepid on the idea of privacy for the eKrona, blithely writing that "perhaps it could contain some element of anonymity." Here's a message for him (and all those other central bankers who will eventually be in Ingves's position). "Perhaps" isn't good enough. Without a differentiating feature like anonymity, eKrona will never gain any acceptance among a public that already has decent private bank digital money. And so the Riksbank will only continue on its path to losing its wellspring of fuck you money and the independence it buys. Anonymous digital money or bust.

Wednesday, December 6, 2017

Store of value

LSD tabs like these ones have an incredibly high value-to-weight ratio


When bitcoin first appeared, it was supposed to be used to buy stuff online. In his 2008 whitepaper, Satoshi Nakamoto even referred to his creation as an electronic cash system. But the stuff never caught on as a medium-of-exchange: it was too volatile, fees were too high, and scaling problems resulted in sluggish speeds. Despite losing its motivating purpose, bitcoin's price kept rising. The bitcoin cognoscenti began to cast around for a new raison d'etre. Invoking whatever they must have remembered from their old economics classes, they rechristened bitcoin as the world's best store of value.

Store of value is one of the three classic functions of money that we all learn about in Money and Banking 101: money serves a role as a medium of exchange, unit of account, and store of value. So presumably if bitcoin wasn't going to be a medium of exchange (and certainly not a unit of account thanks to its volatility), at least some claim to money-ishness could be retained by having it fill the store of value role.

In his 1867 Money and the Mechanism of Exchange, political economist William Stanley Jevons formally introduced the term store-of-value into monetary economics (although Nathan Tankus tells me that Marx may have originated the idea albeit with different terminology, and Daniel Plante tips Aristotle):

Jevons's store of value function refers to the process of preserving value across both time and space. Now in one sense, every good that has ever existed has been a store of value, as Nick Rowe once pointed out. If a good isn't capable of storing value, we'd be incapable of handling and consuming it. Even an ice-cream cone needs to exist long enough for value to be transferred from tub to mouth.

What Jevons was implying in the above passage is that some goods are better than others at condensing value. Goods with the low bulk and weight, including the "current money of the land" (i.e. banknotes), are the best condensers. Below is a list of items ranked according to price per pound, which I get from Evilmadscientist (beware, these are 2008 prices). While all-purpose flour can store value, a $100 bill is better at the task, and while both are surpassed by championship thoroughbred semen, nothing does the job better than LSD.


To condense value over time and space, a store of value will need to be durable. Saffron has a fairly high value-to-weight ratio, but its quality depreciates much quicker than a dollar bill, thus compromising its ability to store value through time. Same with copper and silver, both of which will steadily corrode whereas gold does not. It also helps to have low storage costs. Oxen may have been a great way to store value across space, yet feeding and sheltering them over long periods of time would have been quite expensive. 

Jevons was writing before computers and the internet had emerged. Nowadays, billions of dollars in value are represented digitally. These digital tokens—stocks, bonds, deposits, credit, bitcoin, and whatnot—are weightless and volumeless. Which means they far exceed the ability of any physical item to condense value over time and space.

How does bitcoin rank relative to other digital stores of value? Let's say you needed to condense a certain amount of value and had a choice between either holding bitcoin or Netflix stock. (I choose Netflix because its market cap is close to the market value of all bitcoins ever mined, and because both their prices have done exceptionally well over the last six years). Bitcoin is great for conveying value across space, especially if it involves crossing national borders. All you have to do is remember your private key and you can access your funds no matter where you are. Netflix isn't quite so fluid. While you can certainly access your online brokerage account when you are in Vietnam on holiday, you can't actually sell Netflix stock in Vietnam (as you presumably could with bitcoin). Instead, you'd have to sell the stock and transfer the proceeds to a bank account in Vietnam via the correspondent banking system. That could take a few days and you might run into some hassles.

What about for storing value across time? Bitcoin has a few neat features, including censorship resistance. Since bitcoin isn't centrally managed, there is no way for an administrator to censor you, i.e. erase your bitcoins. With Netflix (or any other centrally-housed digital asset), however, if you are a considered to be a bad actor by those who control the system, presumably your shares can be frozen or confiscated. Counterbalancing this, bitcoins are notoriously susceptible to being stolen. But I've never heard of a thief getting away with someone's shares. There's a bit of give and take.

But in general, I'd argue that bitcoin and Netflix stock are both pretty bad for temporally storing value, although bitcoin is particularly bad. For an asset to do a good job condensing property over time it has to provide its owner with predictable access to a future basket of consumption goods. Assets with prices that have gone parabolic do not fulfill this requirement. After all, there is no reason that the price won't reverse and start to plunge, thus compromising that instrument's ability to store predictable amounts of consumption through time. Anything with a highly stable price across all time frames (minute-by-minute and year-to-year) provide the requisite predictability. Assets that gyrate do not.

The chart below shows the relative variability of the prices of bitcoin, Netflix, and gold since 2011.


Specifically, the chart measures each assets' median change in price over a given month. For instance, in November 2017 bitcoin had the tendency to close up or down by around 3.2% each day, Netflix by 0.8%, and gold by 0.3%. Averaging out all months since 2011, gold's variability comes in at 0.5%, Netflix at 1.5% and bitcoin at 2.2% (see dashed lines above), which means the yellow metal has done a much more predictable job of storing value over time than the other two assets, and Netflix is more up to the task than its digital counterpart. 

In late 2016 bitcoin's volatility seemed to have fallen permanently below Netflix levels and—for a month or two—approached that of gold. The digital stuff had become a mature asset! That wasn't to be, however, and bitcoin volatility has since reverted to levels significantly above its long term average.

I'd argue that bitcoin's high volatility is inherent to its nature. As such, it will always do a fairly bad job of storing value over time. The problem, as I outlined in my recent BullionStar article, is that bitcoin is a pure Keynesian beauty contest asset. People only buy bitcoins because they expect others to buy them at a higher price. The markets for gold and Netflix, on the other hand, are populated by a second set of participants who value those assets for reasons apart from whether others will buy them later. In the case of gold, industrial buyers step up whereas with Netflix it is value investors. The buying and selling of this second set of participants has a calming effect on prices.

The most predictable way to condense value through time is a U.S. dollar deposit. Anyone who has $100 in their account knows with a high degree of accuracy what they'll be able to buy next week. This stems from the fact that consumer good prices are measured in terms of the units issued by the central bank, and retailers keep these prices fairly rigid over the short term. For longer time periods, say one year out, the U.S. dollar will have naturally suffered from some inflation. But this decline in purchasing power is a known quantity. The Federal Reserve has an inflation target of 2%. So it's a safe bet that $100 will be worth $98, not $92, or $84, or $104. That's pretty good predictability. Interest earned on the deposits will make up for the lost purchasing power.

So is bitcoin a store of value? Sure, everything is to some degree... and bitcoin certainly does a good job of condensing value across distances. But relative to other assets, in particular U.S. dollar deposits, it does a poor job storing value across time. I don't think this is going to change, but I could be wrong.



P.S: In the interest of full disclosure, I still own some bitcoin and XRP, not much though. Own some gold too, but no Netflix.
P.P.S: Here is a rewrite of Satoshi's whitpaper, substituting in store of value system for electronic cash system: