Bitcoin was forged in opposition to the financial system. In the very first block that Satoshi Nakamoto mined back in 2009, the following text appeared: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks…”
Since then, bitcoin has become increasingly intertwined with Wall Street. Two traditional exchanges, the Cboe Futures Exchange and the Chicago Mercantile Exchange, have launched cash-settled futures contracts, with the Intercontinental Exchange’s Bakkt platform about to debut a futures contract settled in actual bitcoin. A bitcoin exchange-traded fund (ETF) could be just around the corner.
Will this flirtation with Wall Street be good for bitcoin’s price? Many commentators seem to think so. I’m not so sure. One way to make sense of the financialization of bitcoin (“financialization” refers to how assets can be exchanged through secondary financial instruments) is to look at how gold’s long dalliance with finance has played out. The comparison is an apt one, since bitcoin is often described as digital gold.
Most of the world’s gold trade is conducted on the London Gold Market, a collection of dealers who transact over-the counter, or bilaterally, with each other. The London Bullion Market Association (LBMA) provides statistics on the London market, which were recently collated by gold analyst Ronan Manly.
If these bitcoin bankers can create, say, 100 million screen bitcoins by leveraging just a million real ones, then there goes bitcoin’s vaunted 21 million coin limit.
About 1.45 million metric tons of gold per year are traded in London. But only 0.19 million tons of the yellow metal have been mined since the dawn of time, according to the World Gold Council. So, each year London trades 11-times the amount of gold ever brought out of the ground.
This impressive feat doesn’t involve the transfer of actual gold ounces. Most of the gold that trades in London is in the form of what Manly describes as screen gold. This peculiar form of gold cannot be touched or weighed. It exists merely as a digital IOU, the price of which floats and bobs on trading screens across the world. Bullion banks are responsible for the creation of these gold IOUs—think JP Morgan and HSBC.
The screen gold that the bullion bankers create is not fully backed. For each $1000 in gold IOUs that they issue, bullion bankers generally keep a much smaller chunk of gold in reserve, say $10 or $20 worth. The maintenance of a fractional reserve allows London’s bullion bankers to create incredible amounts of screen gold on top of a thin stack of the real stuff. Manly calculates that the bullion banks keep just 998 tons of gold in London vaults. They leverage this minuscule amount of yellow metal to generate 5,880 tons of trade per day, or 1.45 million tons per year, the majority of which is in screen gold.
When finance eventually melds with bitcoin, this same multiplicative power could be wielded by a newly emergent class of bitcoin bankers. If these bitcoin bankers can create, say, 100 million screen bitcoins by leveraging just a million real ones, then there goes bitcoin’s vaunted 21 million coin limit.
Caitlin Long, a blockchain enthusiast and Wall Street veteran, recently made this same point. “Bitcoin has algorithmically-enforced scarcity, and that’s a big part of what gives it value,” she writes. But this scarcity will be offset if “Wall Street begins to create claims to bitcoin out of thin air, unbacked by actual bitcoin.” As an example of this propensity to create copies of the real thing, Long brings up the transaction that took Dole Foods private in 2013. A judge subsequently ruled that Dole shareholders were underpaid. But when it came time to get restitution, 49.2 million valid claims were filed even though Dole had only 36.8 million shares outstanding. Thanks to the practice of equity lending, 33 percent more claims to Dole Food shares had been created than actually existed.
To understand the implications of financialization for the price of bitcoin, the gold market provides some hints. Financialization of gold goes far back to the 1600s, when bankers first began to issue gold-denominated banknotes. A banknote typically promised its holder the ability to redeem one ounce of gold. Thanks to the rarity of customer redemptions, however, bankers soon discovered that they only needed to keep a fraction of that amount in reserve. Consumers were more than happy to hold these banknotes in place of coins. Even though notes were riskier than the actual metal, they were lighter and didn’t suffer from wear and clipping.
The displacement of real bitcoins with bitcoin IOUs could do very serious damage to bitcoin’s price.
How might the substitution of real gold with paper gold have affected the price of the yellow metal? Monetary economist George Selgin has written a classic blog post on this very subject. As fractionally-backed notes replaced gold coins, society didn’t need as much gold as it once did. With the demand for gold declining, the value of gold would have declined with it, notes Selgin.
This same “inflation” could play out if bitcoin were to merge with Wall Street. A large chunk of the current crop of bitcoin speculators would probably prefer a bitcoin banker’s IOU to the actual thing. More bitcoin in circulation (“liquidity”) means more trading opportunities. A synthetic bitcoin would provide speculators with exposure to the price of bitcoin, but without all the hassles of storage, security, and insurance. Unlike an actual bitcoin, these IOUs would be held as a book entry on a bullion banker’s books and thus would be non-transferable. But since so few people are using bitcoin as money anyways, this would be a small price to pay.
How much would bitcoin’s price fall? In gold’s case, Selgin points out that the financialization of gold didn’t reduce the demand for gold to zero. Banks still had to hold some reserves in their vaults to allow for note redemptions. And people still wanted to hold physical gold for religious reasons and because it was pretty.
But bitcoin doesn’t possess anything analogous to gold’s use value. The price of bitcoin is literally held up by its boot straps. Without this bedrock demand, the displacement of real bitcoins with bitcoin IOUs could do very serious damage to bitcoin’s price.
Author: JP Koning