Sunday, June 22, 2014

In Search of the Ideal Bitcoin Jurisdiction

By Jon Matonis
Tuesday, June 17, 2014

Jurisdictions embracing bitcoin and bitcoin-related businesses can dramatically improve their countries' economies in a multitude of ways. But, what exactly would a favorable bitcoin jurisdiction look like?

For starters, it would ideally have no VAT or capital gains tax on bitcoin transactions and would encourage an active two-way exchange market with national currencies.

Commercial banking partners would not be subject to costly and overbearing regulatory guidelines that threaten or impede innovation. Furthermore, wallet providers, merchants, and payment processors would be under no restrictions.

Isle of Man


As the bitcoin protocol expands globally, we are already witnessing some jurisdictions announce their intentions to become welcoming business hubs for bitcoin innovation.

Most recently, UK Crown dependency, the Isle of Man, outlined plans to provide an environment that enables companies operating within the bitcoin space to flourish and its government posted an informative Questions & Answers document.

Capitalizing on the inability of more bureaucratic jurisdictions to embrace bitcoin, group General Counsel for Counting House Services Paul Davis emphasized:
“They cannot come here to launder money, defraud the public, or damage the island’s reputation. But they can pitch their tent here, do their business, build their software and offer their services.”
Furthermore, the island’s Financial Supervision Commission, confirmed in March that a bitcoin exchange holding client funds with a licensed overseas payment service provider is not required to obtain a licence in the country for its activities.



Luxembourg also made headlines earlier in the year when it publicly advertised its intention to start an open dialogue with bitcoin businesses seeking a jurisdictional home.

Several teams of bitcoin industry experts have already met with Luxembourg officials. Michael Jackson, partner at Luxembourg-based Mangrove Capital Partners, characterized his conversations with the country’s regulators thus:
“[They're saying] we’re very open to people coming here and explaining their businesses. We don’t have any problem with a bitcoin business, as long as it does what it’s supposed to do and behaves properly.”
Jackson also expressed optimism that Luxembourg’s decision would carry weight in the broader European community, noting that it is a financial center of Europe.


Somewhat reluctantly, Gibraltar has recognised its leadership role in the electronic payments industry for e-gaming and what that means for bitcoin. The British Overseas Territory has hosted two conferences, one in 2011 and one in 2014, that highlighted the strong business benefits for taking a leadership role on bitcoin integration.

KPMG’s Archie Watt told New Statesman:
"Low cost, low hassle cryptocurrencies such as Bitcoin have the gaming world pricking up their ears."
Two operators in Gibraltar have expressed to me privately that senior members of the Gibraltar government want the jurisdiction to lead rather than follow and that the responsive framework is already in place to make that happen.

A question of costs

When discussing bitcoin's benefits for an economy, one must distinguish between the economic benefits of a jurisdiction making itself appealing to bitcoin business versus the jurisdiction adopting bitcoin as its territorial unit, which is an entirely different strategy (to be covered in a future analysis).

The economic benefits of the former can be seen as setting the stage for bitcoin jurisdictional arbitrage.

'Jurisdictional arbitrage' is defined as the practice of taking advantage of the discrepancies between competing legal jurisdictions. According to Wikipedia, it takes its name from arbitrage, the financial practice of purchasing a good at a lower price in one market and selling it at a higher price in another.

Patri Friedman, grandson of economist Milton Friedman, explains that, just as in financial arbitrage, the attractiveness of jurisdiction arbitrage depends largely on its transaction costs – in this case, the costs of switching legal service providers from one government to another.

Reaping the rewards

With respect to extreme economic benefits, a jurisdictional hub for bitcoin with an independent and functioning court system would immediately experience an influx of new capital and new businesses, thereby contributing to a growing GDP (Gross Domestic Product).
A forward-looking jurisdiction for bitcoin business would demonstrate strength and leadership for the new digital economy.
Due to bitcoin's inherent lack of a third-party intermediary, the leading financial service industries of today would gradually become dis-intermediated and this newly open jurisdiction would serve as the disruptors' laboratory.

New, disruptive operators geared towards building out the bitcoin mobile payments infrastructure, funds transfer business and asset management industry would flock to the region, spurring vigorous job growth and opportunity.

The hub would soon find itself a magnet for related advisory services, venture capital, and other professional support services seeking to capitalize on the bitcoin boom. Retail banks could be rejuvenated as demand increases for true bitcoin services, such as foreign exchange, transaction escrow services, and trusted safekeeping.

Most significantly though, a forward-looking jurisdiction for bitcoin business would demonstrate strength and leadership for the new digital economy, catapulting the country and its people to the world stage.

Much like Gibraltar became the worldwide hub for e-gaming in 2004 and Zurich became the world's gold trading hub in 1968 due to the collapse of the London Gold Pool, a jurisdictional bitcoin haven would make history.

Thursday, June 5, 2014

DISH, Overstock, and Bootstrapping a New Currency

By Jon Matonis
Saturday, May 31, 2014

On the heels of the recent Dish Network announcement to begin accepting bitcoin payments, we saw the same clueless chorus of naysayers and payment newbies come out claiming that Dish doesn't really accept bitcoin because they actually end up with US dollars.

It would be just as ridiculous to say that a hotel in Barbados doesn't accept US dollars because, after the VISA credit card transaction, the hotel ends up with Barbados dollars.

Dish Network selected bitcoin payment processor Coinbase to manage the foreign exchange conversion risk in the same way that other international merchants select credit card processors. It matters not what the merchant's native currency is, but what they permit consumers to use when purchasing.

As with Overstock's decision to begin accepting bitcoin payments, the Dish announcement is significant because it adds yet another payment outlet for holders of bitcoin and it brings another large merchant into the ecosystem of processing bitcoin transactions.

Dish's executive vice president and chief operating officer Bernie Han said that Dish sees its new payment option as a way to boost customer service:
“We always want to deliver choice and convenience for our customers and that includes the method they use to pay their bills.”
One cannot overlook the fact that something as mundane as a payment option is also being strategically deployed as a competitive wedge in a branding and messaging campaign. However, this residual bonus has a diminishing impact as more companies announce their intention to embrace bitcoin and we move past its early adopter phase.

The monetary transition process

While some analysts observe that new merchant acceptance has the effect of creating downward price pressure for bitcoin, since processors immediately convert into national currency for their clients, I maintain that the entire process is simply part of bootstrapping a new currency.

And yes, selling pressure from new merchants converting out of bitcoin may not always be replaced by new buying. Bitcoin is barely in the early stages of this monetary transition process.

That process includes price discovery on liquid exchanges, creation of closed-loop systems to both receive and spend bitcoin, and finally, pricing of goods and services in the new numéraire.

The trend towards global participation

In an important but somewhat pessimistic paper, "Cryptocurrencies, Network Effects, and Switching Costs," William Luther observes that there is a systemic bias against monetary transition. His research concludes that despite the inferiority of the prevailing currency and due to both network effects and switching costs, "cryptocurrencies like bitcoin are unlikely to generate widespread acceptance in the absence of either significant monetary instability or government support".

As an economist, I disagree with this thesis because it fails to consider global usage and the potential for bypassing capital controls. Luther's cited monetary instability or government support are both conditions relevant only within the restricted political borders of a monetary regime. They may serve as great litmus tests in a confined jurisdiction, but they are utterly useless in considering cross-border transactions.

The trend towards global merchants participating in a global economy will only serve to strengthen this dynamic. We are witnessing it today with at least 60 countries blocked out of the current prevailing payment systems, and hence unaware of the switching costs and network effects of Luther's incumbent monies.

Quoting bitcoin prices

Beyond the network effect of incumbents, I do agree that the holy grail for bitcoin is having prices quoted and displayed in bitcoin rather than mentally going through a conversion process. This step completes the process for monetary transition and it is difficult to predict how that specific step occurs.

In "The Origin, Classification and Utility of Bitcoin," Peter Šurda correctly states:
“Even though not money, bitcoin is a medium of exchange ... While it is true that economic calculation is beneficial, this is merely one of the relevant aspects of media of exchange. Economic calculation depends on the unit of account, and while bitcoin is not used as a unit of account to any apparent degree, it may happen in the future, and its utility would increase even more in such a case.”
Redditor ISkiAtAlta makes an interesting observation on why it's not easier or more beneficial to (re)obtain bitcoin than it is to obtain or use fiat, claiming that we're not there yet because the barrier to obtaining bitcoin is too high and the perceived benefits have not yet been internalized – particularly for new users.

That above rationale addresses the issue of monetary switching costs, but I think it applies equally to the establishment of a numéraire, or favored unit of account.

Framing it as an issue of timing, ISkiAtAlta offers three items that must be present for motivating consumers to go through the trouble of transacting in bitcoin: (1) it has to become easier to obtain bitcoin, (2) people must see the value of holding their savings in bitcoin, and (3) merchants must offer discounts for bitcoin transactions.

I would add that consumers must have more user-friendly applications and that merchants must also see the value of holding balances in bitcoin which becomes reinforced by expenses and liabilities – expressed in bitcoin through supply chain vendor demand or employee demand. It becomes infinitely easier to maintain bitcoin balances if a merchant or company knows that risk can be reasonably hedged and that others will also accept settlement in bitcoin.

Bootstrapping a new currency is always a chicken-and-egg dilemma, but when it comes to volatility, original perspective can be helpful too. Perhaps it's not bitcoin that is volatile against the US dollar, but it's the US dollar that is volatile against the future store-of-value bitcoin.

Sunday, June 1, 2014

Inching Towards Bitcoin Derivatives

By Jon Matonis
Tuesday, May 27, 2014

Bitcoin derivatives are more in demand than ever, as bitcoin company executives seek a way to hedge balance sheet risk. A liquid futures and options exchange for bitcoin will provide commercial hedging opportunities as well as increase overall price stability. This is not disputed.

What will be contentious, however, are the paths and methods necessary to get there. In this article, I examine exchange structure, exchange jurisdiction, the practicality of various contracts, and existing bitcoin futures markets.

What are derivatives?

Derivatives obtain their name from the fact that they are instruments derived from an underlying spot commodity or index.

In theory, the spot price of the physical commodity underlies and provides the basis for pricing in the futures market due to the explicit option for physical delivery. In the case of an index, cash settlements are typically the norm.

‘Call options’ and ‘put options’ based on the futures contract can also be offered. Exchange-traded products differ from customized over-the-counter products in that they are standardized, easily traded and underwritten by the pooled collateral of exchange members.

In the recent working paper from the Mercatus Center, authors Jerry Brito, Houman Shadab, and Andrea Castillo evaluate the emergence of derivatives in the context of bitcoin.

As the most detailed analysis to date concerning bitcoin securities and derivatives regulation, the paper argues that “financial regulators should consider exempting or excluding certain financial transactions denominated in bitcoin from the full scope of their regulations, much like private securities offerings and forward contracts are treated”.

The authors also anticipate what form the second wave of bitcoin regulation, mostly in the US, might take. I extend that thinking into the rationale for multi-jurisdictional exchanges and the free market emergence of bitcoin clearing houses to address counterparty risk.

Exchange structure

Any new bitcoin derivatives exchange will have to be electronic with 24/7 availability in order to mirror the existing spot markets for bitcoin trading. Just as with commodity exchanges that trade gold, silver, wheat and soybeans, warehousing partners will need to be established to accommodate the safe storage of bitcoin necessary for exchange integrity.

Ideally, the broker-dealer community will go through one of several wholesale clearing members to access the exchange for their clients, and these clearing members will underwrite the performance risk of their clients.

Posted collateral from the clearing members can take the form of cash, bonds or other liquid instruments determined by the exchange.

Furthermore, reasonable margin rules and position limits will have to be enforced to insulate the exchange and its clearing members during periods of extreme volatility.

Exchange jurisdiction

As evidenced by the likely manipulation in the precious metals markets and the MF Global debacle, government oversight of an exchange is no panacea for mischievous operators because the regulators themselves have been complicit for years.

Obviously, jurisdiction is important for the enforcement of contract performance, but exchanges would not require direct regulation for legitimacy.

Properly structured exchanges could easily facilitate and apply best practices for price discovery, trade clearing and trade settlement. Luxembourg and Gibraltar would be favourable early selections for such an exchange.

Also, multiple jurisdictions would be preferred for bitcoin derivatives exchanges in order to prevent a single jurisdiction, like the US, from exerting too much influence on an exchange that is vital to the bitcoin ecosystem.

Moreover, as bitcoin absorbs a greater and greater portion of overall economic activity, it could become tempting for certain jurisdictions to interfere in the price-discovery mechanism by participating in or encouraging naked short sales.

Former US Secretary of the Treasury Lawrence Summers clearly understood the importance of managing investor expectations by suppressing gold prices as he was one of its principal architects.

In dissecting the methods of manipulation, Paul Craig Roberts, former Assistant Secretary of the Treasury for Economic Policy, and investment expert Dave Kranzler conclude that the global volume concentration with just one exchange creates a single point of manipulation.

From their January 2014 paper, Roberts and Kranzler summarize the process:
“When gold hit $1,900 per ounce in 2011, the Federal Reserve realized that $2,000 per ounce could have a psychological impact that would spread into the dollar’s exchange rate with other currencies, resulting in a run on the dollar as both foreign and domestic holders sold dollars to avoid the fall in value. Once this realization hit, the manipulation of the gold price moved beyond central bank leasing of gold to bullion dealers in order to create an artificial market supply to absorb demand that otherwise would have pushed gold prices higher. The manipulation consists of the Fed using bullion banks as its agents to sell naked gold shorts in the New York Comex futures market. Short selling drives down the gold price, triggers stop-loss orders and margin calls, and scares participants out of the gold trusts.”
As a Fed bullion bank through the acquisition of Bear Stearns, JP Morgan has held aggregated positions in gold and silver far in excess of CME Group position limits, frequently relying on hedger exemptions and waivers.

With digital commodity bitcoin, such brazen price suppression from the authorities may prove to be the “last resort” option and the only viable method for desperate governments seeking to maintain their unfair legal tender monopoly.

Printing paper money to underwrite massive naked short selling on bitcoin exchanges is the greatest single threat to bitcoin’s long-term dominance as free market money. Multiple worldwide competitive exchanges would mitigate the impact of such a grim scenario.

Practicality of contracts

From the balance sheet perspective, bitcoin futures contracts would more logically adhere to the standards already in place for currency futures contracts. Therefore, typical contract specifications for bitcoin would include the following currency pairs: XBT/USD, XBT/EUR, XBT/GBP and XBT/CNY (all currently tracked by CoinDesk’s BPI).
Cryptocurrency futures markets seem poised to transform currency risk management again in the post-legal tender era.
Contract months would be quarterly in March, June, September and December, with the last trading day being the 15th of each settlement month.

Contract sizes would vary based on bitcoin valuation and growth, but it is logical to assume that 100-bitcoin and 250-bitcoin contracts would be the early norm. Initially, the minimum trading interval (or tick) would be 0.01 bitcoin.

Proposed margin requirements for the 100-bitcoin contract could be structured at 10.00 bitcoin for initial margin deposit and 8.00 bitcoin for maintenance margin deposit.

Accounts would be marked-to-market at the close of trading day for purposes of determining new margin capital or forced liquidation. For overall integrity, each exchange should also publish and adhere to aggregated position limits.

As pointed out by the Mercatus study, an alternative would be to denominate contract prices in bitcoin and hold margin funds in bitcoin, thereby eliminating the need for traditional bank or financial institution accounts. This would be possible if the contract was cash settled in bitcoin and the exchange maintained bitcoin warehousing requirements.

Existing bitcoin futures markets

Expect the terrain to shift dramatically in the coming months, but currently the largest and most significant bitcoin futures market is operated by Alex Stukalov. The company is in the process of registering in an offshore jurisdiction and facilitated more than $15m-worth of bitcoin futures trading during the last 30 days.

Romanian-based MPEx operated by Mircea Popescu displays BTC/EUR futures with settlement each month and displays contracts in the standard calendar months for bitcoin “network difficulty” futures, however, it remains to be seen whether sufficient and tradeable liquidity exists. Indeed, MPEx/MPOE shuttered its BTC/USD options trading in February 2014 due to lack of a robust pricing feed.

We can learn a lot about bitcoin futures exchanges by studying these predecessors, especially in the areas of customer support, liquidity and counterparty risk. Neither nor MPEx serve as a clearinghouse for their customers’ trades, which is an essential element of a formal futures exchange. Furthermore, verifiable volume reporting will be critical as these futures exchanges will most likely play an important role for bitcoin price discovery.

The other operators claiming to be in the derivatives and hedging business are actually offering non-standardized margin trading by offering interest rates on borrowed funds. Notable entrants for margin trading include BitFinex,, Bit4x and still-in-beta Coinsetter.

After the unwinding of the Bretton Woods currency arrangement in the 1970s, the gun-slinging traders of the Chicago pits transformed financial futures with various products designed to manage floating currency risk.

Now, nearly 45 years later, cryptocurrency futures markets seem poised to transform currency risk management again in the post-legal tender era.