By JP Koning
Thursday, February 21, 2013
Much of the conversation about bitcoin adoption focuses on its use in goods and services transactions. Breaking bitcoin news, for instance, draws attention to the fact that the Internet Archive
will be giving employees the option to be paid in bitcoin. This focus
on brick & mortar transactions means that the role that bitcoin
financial instruments—stocks, bonds, and derivatives—have to play in
promoting bitcoin adoption often gets overshadowed.
I'm currently reading Barry Eichengreen's Exorbitant Privilege
which goes into the mechanics of what it takes to create a truly
international currency. Eichengreen points out that prior to World War I
the dollar played a negligible role relative to the pound sterling in
world markets, but by the mid 1920s it was the dominant unit for
invoicing payments and denominating bonds. Eichengreen's theory is that the US dollar became the world's go-to currency because of the emergence of a very specific financial instrument—the banker's acceptance.
An acceptance is much like a bill of exchange, a financial instrument I explained in my last post.
Say a merchant decides to pay for a shipment of goods with a personal
IOU, or bill. If a bank first "accepts" the bill i.e. if it agrees to
vouch for the IOU, then this gives the bill more credibility. It is now a
According to Eichengreen, around 1908 or 1909, a concerted effort to
foster the growth of the US acceptance market began. Up till then, US
banks had been prohibited from dealing in acceptances and branching
abroad—both these limitations would be removed by new legislation. To
promote liquidity and backstop the acceptance market, the Federal
Reserve, established in 1914, was given authority to buy and sell
acceptances via open market operations. Furthermore, these acceptances
could legally "back", or collateralize, the Fed's note issue. This
feature was particularly helpful. Although the Fed was also legally
permitted to purchase government securities, government securities could
not "back" the note issue. Acceptances, therefore, became the more
flexible and preferred asset for Fed open market operations, at least
until 1932 when the limitations on government collateral were removed.
According to Eichengreen, the Fed was the largest investor in the
acceptance market and sometimes held the majority of outstanding issues
on its balance sheet.
By the mid-1920s foreign acceptances denominated in dollars exceeded
those denominated in sterling by a factor of 2:1 and more central banks
held US forex reserves than sterling. London was on the way out, and New
York on the way in. By 1929, the amount of outstanding foreign public
bonds denominated in dollars (excluding the Commonwealth) exceeded
sterling bonds. The lesson here is that a key step in the sequence of
internationalizing a currency is getting it to be used in financial
markets. This involves the development of deep, liquid, and accessible
markets in securities denominated in that currency.
What sort of financial deepening do we see in the bitcoin universe, and
how might we compare it to the dollar's emergence in the 1910s and 20s?
There are a number of healthy signs of financial deepening. I count five
competing bitcoin securities exchanges that provide a forum for trading
bitcoin-denominated stocks and bonds. These include Cryptostocks, BTCT, MPEx, Havelock, and Picostocks. A sixth, LTC-Global, provides a market in litecoin securities, a competing altchain.
Holders of bitcoin needn't cash out of the bitcoin universe in order to
get a better return. Instead, they can buy a bond or a stock listed on
any of these exchanges.
The largest publicly-traded company in the bitcoin universe is SatoshiDice, a bitcoin gambling website listed on MPEx.
With 100 million shares outstanding and a price of 0.006 BTC,
SatoshiDice's market cap is ~600,000 BTC which comes out to around $17
million. SatoshiDice IPOed
last year at 0.0032 BTC. With bitcoin only trading at $12 back then (it
is now worth $29), the entire company would have been worth $4 million.
Given today's $17 million valuation, SatoshiDice shareholders have seen
a nice return over a short amount of time—much of it provided by
While SatoshiDice certainly provides some depth to bitcoin financial
markets it has the potential to shallow them out too. Because MPEx
charges large fees to trade on its exchange, a few of the competing
exchanges have created what are called SatoshiDice "passthroughs". Much
like an ETF, a passthrough holds an underlying asset—in this case
SatoshiDice shares on MPEx—and flows through all dividends earned to
passthrough owners. As a result, investors can get exposure to
SatoshiDice without having to pay MPEx's expensive fees. BTCT, for
instance, lists two different SatoshiDice passthroughs (GSDPT and S.DICE-PT) which together account for more trading volume than all other stocks and bonds listed on BTCT.
SatoshiDice's sheer size is to some extent problematic since Bitcoin
financial markets are not as deep as they might appear. Should something
ever happen to SatoshiDice, a big part of the bitcoin financial
universe's liquidity will be wiped out, and this would ripple out across
the entire field of bitcoin securities. The same might have happened to
banker's acceptances in their day, except for one difference—the Fed
was willing to back the acceptance market up. In the bitcoin universe,
there's no buyer of of last resort to provide liquidity support to
Another impediment to deeper bitcoin markets is the hazy legality of the
bitcoin securities exchanges. The first major bitcoin securities
exchange, GLBSE, was closed in October 2012 with no prior warning. According to this
article, potential regulatory and tax liabilities convinced GLBSE's
founder to shut it down on his own behest. If any of the existing
bitcoin exchanges were to grow too noticeable, one could imagine the SEC
(or its equivalent) knocking on their door and forcing the
exchange-owner to pull the plug. This sort of regulatory uncertainty can
only dampen the liquidity and depth of bitcoin financial markets.
US authorities, on the other hand, didn't need to heed the rules when
they built the banker's acceptance market. They created the rules. If
financial deepening in the Bitcoin universe is to proceed it will happen
despite regulations and not because of them.
The last headwind to bitcoin financial deepening is bitcoin's
volatility. Eichengreen writes that the seesawing of the pound sterling
during the war period encouraged financial markets to search for a more
stable unit in which to express debts. The pound had always been
anchored to gold (or silver), but it was unpegged from its century's
long gold tether when the war broke out. Although it was repegged in
January 1916, this time to the dollar, this did not secure confidence in
the sterling's value since the peg was dependent on American support.
When this support was withdrawn at war's end, sterling fell by a third
within a year. Through all of this, the dollar continued to be defined
in terms of gold, a feature which no doubt attracted issuers.
Bitcoin, on the other hand, has more than doubled in just two months.
Back in June 2011, it fell by 50% in just two days. Like pound sterling
during the war, bitcoin's lack of stability will do little to promote
deeper financial markets.
Although I've stressed the difficulties that bitcoin markets face in
developing more depth, the sheer amount of financial innovation I'm
seeing from those involved in the various bitcoin securities exchanges
is impressive. I wish them the best. The more they build up bitcoin
securities markets, the better an alternative bitcoin presents to
competing currency units.
[Disclaimer: I am long SatoshiDice and several bitcoin mining stocks.]
Reprinted with permission.