Corporatization of Nations

Reliance Jio Infocomm Ltd, the telecom arm of India’s largest company by market cap (NSE:RELIANCE), plans to create its own cryptocurrency called JioCoin. Supply chain management logistics and loyalty payment with JioCoin are amongst the envisaged uses of JioCoin. Worldwide, many large corporates have already started launching their own private cryptocurrency.  KFC, Burger King and Kodak are the few well-known names that have hitched onto the bandwagon of this currency of the Internet.

Fast-food chain KFC has announced that it will accept  virtual currency for paying bills in its outlets in Canada with the launch of Bitcoin Bucket. A customer can buy this bucket with 0.0011564 BTC, equivalent of CAD $20, according to a company statement. Eastman Kodak has announced last week that it is going to launch its own cryptocurrency KodakCoin in partnership with WENN Digital. Burger King has launched its own cryptocurrency in Russia called ‘WhopperCoin. IBM recently partnered with Stellar and klickex to develop a blockchain-based cross-border payments solution. Stellar is a distributed hybrid Blockchain that facilitates cross-asset transfer of value including payments. Similar to Bitcoin, Lumen is the asset of value issued by Stellar.

This rush by multinational companies to get on board of the cryptocurrency mania camouflages a much larger issue and a potential threat to the current international political order. This threat can be analyzed from various perspectives including political, economic and technological.

Glenda Sluga, a Professor of International History, has written about  the possible unraveling of the current international order from a historical and political perspective: These days, the pulse of the world’s political health is running fast. The general prognosis is terminal, the end of the international world order, as we know it.(here)  Political headwinds which led to such prognosis are easily discernible- rise of “radical nationalism” in USA, “long the axis of modern international society” and, rise of “heteropolarity” in the international power structure.

Beyond this haze of political chaos, a much bigger threat to the existing international world order lies in emergence of private cryptocurrency and its adoption by multinationals. There is no gainsaying the fact the comity of nations defines the current world order. A nation state without its own currency is like the staging of Hamlet without the prince of Denmark. The power of a nation state to tax its citizens would stand highly diminished if large corporates can issue their own currency. Let us see how it would play out in reality.

Alice buys 1000 JioCoins (JC) by paying, say, 20000 Indian rupees. Alice pays 60 JC to Bob for as rent for the apartment she has leased from Bob. Bob buys monthly grocery from the supermarket run by Reliance. Bob uses 250 JC for this purpose.  Bob tops up his Jio mobile with 50 JC. Suppose, Bob works in Reliance Industries and receives 3000 JC every month. Bob pays 750 JC to Reliance Petroleum for purchase of gas for his car. He has purchased his car by taking loan from HSBC by paying EMI of 750 JC every month. This EMI payment is routed through a cryptocurrency exchange run by a Russian bank.  RIL pays IBM India monthly 100 million JC for maintaining its IT infrastructure. IBM may pay RIL is own cryptocurrency for using Jio mobile services in India. Gradually, a complete ecosystem of economic agents can emerge, who will use JC as their preferred currency for all their payment requirements.  It may be seen that the JC to Rupee exchange takes place only when Alice purchased JC. At a certain stage of development JC will acquire its own life, cutting its umbilical record with the fiat currency.

The above description of evolution of JC to encompass a significant slice of economic transactions in its country of incorporation, i.e. India, does not necessarily imply that JC would pose a threat to the  existence, or at least severely restrict usefulness,  of the sovereign currency INR as a fiat money. Initially, INR can continue to be the unit of account within the boundary of India. But if JC emerges as the people’s preferred medium of transactions and store of value, only raw state power can prevent rupee’s passage to oblivion. Be that as it may, the moot question is whether JC would severely dent the Indian state’s capability to tax the economic activities mediated through JC. Given the ability of a cryptocurrency to mask the identity of transactors, imposition of indirect taxes, like goods and service tax, might be a serious challenge for tax administration. If an Indian resident tax payer earns and spends only in JC, fixation of its tax liability would not be an easy task.

If all multinationals including RIL, IBM and others can agree on an exchange platform for conversion of their currencies then the nations of the world would find themselves divested of their defining power to tax and earn seigniorage.  The depth and reach of the large multinationals can be gauged from the fact that in 2016 the Fortune 500 companies had revenue of 27.7 trillion USD while the combined GDP of 198 countries was around 76 trillion USD. Using Output to GDP ratio for US economy, the share of Fortune 500 companies in the worlds’ GDP would work to around 21 percent.   So if these large corporates were to sign off from the current international order with their own currencies, their total GDP would be the second highest, next to USA only. They can usher into a new Bretton Wood regime for their private currencies and significantly reduce the cost of managing exchange rate risk.

Technologically, these large corporates could not but continue to be part of one country or other, at least formally, the emergence of cryptocurrency can unshackle them from this tether of fiat currency and its in-built inflationary bias. If the world economic order get re- arranged on this line, what would happen to the multitude of people who would continue to remain outside the charmed circle of digital economy, can only be a matter of speculation and not an informed guess.

Trading or Investing in Bitcoin is Injurious to your Financial Health.

One of the fundamental lessons of all financial scams is that there always exists enough number of gullible people to be conned by merchants of dream. For example, the people of 17th century Amsterdam started believing that prices of a bunch of tulip bulbs could rise to a level higher than the value of a furnished luxury house. It also happened during the dotcom bubble of late 1990s. Presently such a bubble is unfolding before our own eyes and the sad part of it is that some financial sector regulators are actively encouraging formation of this bubble in the name of financial innovation. It would be apposite here to recall the scathing criticism that the Financial Crisis Inquiry Commission of US Congress made of the regulatory failure leading to the sub-prime financial crisis:  We conclude widespread failures in financial regulation and supervision proved devastating to the stability of the nation’s financial markets.

U.S. financial firms CME Group and CBOE are going to launch Bitcoin futures on December 18, followed by launch of binary options on Bitcoin by Cantor Fitzgerald. The US regulator for futures market, Commodity Futures Trading Commission (CFTC), has allowed introduction of these new products by these exchange platforms on the basis of self-certification submitted by them. The Commodity Exchange Act of USA allows such exchanges called Designated Contract Markets (DCM) to introduce new contracts by submitting a written self-certification to the CFTC that the contract complies with the Commodity Exchange Act (CEA) and CFTC regulations. It is the responsibility of DCMs to determine that the offering complies with the CEA and Commission regulations.

The CFTC in its press release of 1st December has referred to the IRS characterization of Bitcoin as a virtual “currency”. More than that, IRS has referred it as “convertible virtual currency”. I have already explained in my earlier blog why Bitcoin cannot be called a currency. In 2015, CFTC declared Bitcoin as a “commodity” by referring to the CEA act that includes “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.” in the definitional boundary  of commodity. The press release clarifies that “Bitcoin and other virtual currencies are encompassed in the definition and properly defined as commodities”.  Under CEA commodities are classified into three categories-

(1) Agricultural commodities

(2) Excluded commodities which include, inter alia, an interest rate, exchange rate, currency, security, security index, credit risk or measure, debt or equity instrument, index or measure of inflation, or other macroeconomic index or measures

(3) Exempt Commodity which means a commodity that is not an excluded commodity or an agricultural commodity.

Prof.  Shadab of New York Law School has argued in his written statement submitted to the CFTC that Bitcoin should be classified as “exempt commodities and not as excluded (currency) commodities “.

Each Bitcoin future contract on CME would be composed of 5 Bitcoins. The tick size (the minimum fluctuation) has been fixed at $5 per bitcoin, amounting to $25 per contract. Per person open position limit has been set at 1000 contracts. The daily price fluctuation of a Bitcoin future is limited to a 20% band above or below the prior settlement price.  The settlement price will be Bitcoin Reference Rate (BRR). BRR is calculated by UK based crypto currency trading platform -Crypto Facilities Ltd, in partnership with CME.  BRR is calculated by taking traded price and volume data from a few selected exchanges involved in spot Bitcoin trading.   Price and volume data are obtained for 12 periods of 5 minutes each   in the last hour of trading. For each time interval, a volume weighted median price is calculated. The overall price is average of these 12 prices.

So, purely from methodological perspective, construction of reference price cannot be faulted. Since BRR is based on observed prices of Bitcoins traded on mostly unregulated exchanges, these prices are always subject to manipulation.  The extent of volatility that can happen on these exchanges can be understood from the movement of bitcoin price on December 7. On this day, the price of 1 Bitcoin fluctuated from a high of USD 19,000 to a low of USD 4,000.  If the price volatility is considered in conjunction with volume volatility (see the graphs below), Bitcoin may turn out to be Twenty First century’s first virtual Tulip.

 

 

 

 

 

 

 

Data source- here

Given this “insane volatility” ( as described by the chairman of BBCBS committee) of spot prices of a traded asset, the CFTC’s move  in allowing derivative products  on such an asset can be highly counterproductive. Apparently the CFTC believes that by bringing Bitcoin on a regulated platform it would be able to contain the speculative excess.  The high margin requirement is expected to dissuade small investors to take positions in the Futures market, leaving the field open for play by institutional investors. More than 100 hedge funds have been created in the last one year to trade in digital currency only. It is reported that there is $10B of institutional money waiting on the sidelines to invest in digital currency today. To meet the requirements of these institutional investors, Coinbase, the US based Bitcoin exchange, has launched a new company to store securely their digital assets (see here). The company has claimed that it is already holding $9 billion of digital currency on behalf of its customers.

It should be a matter of regulatory concern about the source of Bitcoin’s price volatility. Apart from alleged price manipulation the most plausible explanation would be the intrinsic unbridgeable gap between demand and supply of Bitcoin. New supply of Bitcoin is largely a result of mining activities and the maximum supply of Bitcoin is a known figure. Against the back drop of a largely inelastic supply curve, the demand curve is driven by enthusiasts of cryptocurrency- a fast growing tribe. The fundamental inelasticity of the supply curve is getting reflected in higher and higher cost of Bitcoin based transactions.   The following two graphs show how running Bitcoin network becoming costlier and costlier.

 

 

 

 

 

 

Given its inherent supply constraint, there is no possibility of Bitcoin becoming a global currency in its current form. Since Bitcoin is a highly sophisticated technological product, it attraction to young people is immense, like marijuana once was. But it should be the job of central banks to proclaim from the rooftop with as much force as it can command that: Trading and or Investing in Bitcoin is injurious to your financial health.

Bitcoin- Comment on Aswath Damodaran’s Post

Prof Aswath Damodaran (AD, henceforth) is a well-known name in the field of corporate finance and valuation of financial products. It is unfortunate that despite his formidable reputation in valuation of financial products, his latest “Musing on market” is a complete let down (You can read complete post here). He starts the blog by classifying investment assets into four categories. These are: Cash generating assets, Commodity, Currency and Collectibles. The first three categories do not need any clarification. But what about Collectibles? Picasso’s paintings fall into this category because they do not generate cash and, therefore, cannot be valued but it has a price. So, according to AD, something may have price but no value. For him “value” is synonymous with discounted future cash flow that an asset generates. So if an asset does not generate future cash flow, then it has no computable “present value” or “value”.  This definition of value is a highly myopic interpretation of notion of “value” that has been debated from the time of Adam smith to Gerard Debreu. This apparent distinction between price and value leads him to differentiate between trading and investing. The only difference between a trader and an investor is that they make different intertemporal choices.  An investor in collectibles has a choice to sell it immediately or sometimes in future. It follows logically that he finds that it is worthwhile to wait to get a higher price in future. Or he may get more pleasure holding it for a long time to come. The DCF valuation that financial instruments are subjected to, can be looked upon an estimate of the future market price. That is why; there is a market of financial instruments. If DCF is a correct estimate of “value” of any financial instrument then there is no reason why every dealer of a treasury would not have the same opinion about the intrinsic value of that instrument. If every trader has the same opinion would the market exist? According to him, traders do not bother about value but they only concerned about price. This begs the question – how price is determined in financial market?

Although we are really not concerned about the distinction between value and price, the issue becomes relevant in the context of Bitcoin- the subject matter of AD’s blog. Per force, AD has to categorize Bitcoin per his own classification scheme. Bitcoin does not generate cash; it is not a commodity too. So we are left with only two categories for Bitcoin to be slotted. AD now considers the definitional attributes of a currency.   These are well accepted and standard- unit of account, medium of exchange and store of value. Surprisingly AD finds that Bitcoin satisfies all the criteria to be designated as currency.  According to AD, anything which is fungible, divisible and countable can qualify to be a candidate “unit of account”.  If this is true, then theoretically any currency in any jurisdiction can function as currency. In fact, in some African countries, many small shops quote their merchandise in USD terms. But their balance sheets have to be prepared in terms of domestic currencies as per the law of the country. The acid test of anything to qualify as currency is that whether one can pay tax with that thing or not. AD gives three reasons for Bitcoin’s failure to take off as the preferred currency for majority of people. These are: – inertia, price volatility and competing crypto currency. He fails to note the most important reason- no sovereign backing. We have heard of dollarization of many domestic currencies because of people’s lack of trust on the domestic sovereign’s ability to preserve the purchasing power of that currency. But we must note that in no case people of such country start using the neighboring country’s currency, which could be as inflation prone as the former. In other words, backing of a powerful and trustworthy sovereign engenders the trust that is required for something to function of currency. The properties “medium of exchange “and the “store of value” neither jointly nor severally can make anything – real or virtual- a unit of account.

The problem with the ongoing effort to declare Bitcoin as currency is rooted in this historically untenable proposition that money originated from the act of barter. There is enough anthropological and numismatic evidence to the contrary. The renowned numismatist P. Grierson gave the simplest definition of money – ‘all money that is not coin or, like modern paper money, a derivative of coin’.  Historically, coins were always associated with an issuing authority. Thus sovereign backing is a prerequisite for something to become money in a specific jurisdiction.

So Bitcoin is not a currency or money proper. Of course, we can argue that the community of Bitcoin coin users can be considered as forming a “jurisdiction”. The “Bitcoin” is a currency of that virtual jurisdiction. But then Bitcoin can be considered as a currency of only that country. Then, the population size of that country would be smaller than Democratic Republic of São Tomé and Príncipe (200K) of West Africa.  The currency of that country, Dobra, suffered so much depreciation that the government had to issue a new Dobra in exchange of 1000 earlier Dobra. No foreign exchange trader has ever considered Dobra as a tradeable instrument. Bitcoin is experiencing appreciation of similar magnitude and, therefore, people are considering it as a lucrative financial asset. But to consider Bitcoin as a tradeable instrument would be blasphemous in the rarefied group of forex traders. AD, of course, suggests exactly the same in regard to Bitcoin.

It might be fashionable to hold an extreme libertarian view in the current dispensation of USA. In that environment, as the then Citigroup Chief Chuck Prince told in an interview, just when sub-prime crisis was knocking at the door of wall Street – “when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. This was on July 10, 2007. On October 5, Merrill Lynch announced a US$5.5 billion loss, revised it to $8.4 billion on October 24. We hope that gullible investors awash with liquidity do understand that music is bound to stop sometime and who knows who would be standing without a chair then.

 

Digital Currency- Hype or Future

This is an abstract of the talk that I gave to students of IIM , Indore on 5th October.

The ability of central banks to maintain the value of fiat money came under a cloud in the wake of the financial crisis that hit the developed economies in 2007/08. A libertarian view about privately issued money that always remained in the fringe of mainstream view of money started gaining currency. The computer geeks who hate any centralized authority started toying with the idea of digital currency that could have all the properties of physical cash and could be used as an efficient medium of exchange of values but without the backing of any central authority. A number of attempts to introduce a digital currency backed by cryptography were made before the dominant digital currency of today- Bitcoin- came into existence. Notable amongst them was Digicash invented by David Chaum in 1990. The experiment failed miserably and the eponymous company filed for bankruptcy in 1998.

In October 2008, an unknown programmer, or a group of programmers, under the name Satoshi Nakamoto published a paper titled Bitcoin on a cryptography mailing list and released as open-source software in 2009. The most critical issue that Bitcoin protocol successfully addressed is the problem of double-spending.

The technology as well as philosophy underlying the Bitcoin system traces its root to 3 different disciplines.

Firstly, it is meditated through a particular view of money- money being primarily a medium of exchange. From a monetary perspective, this aspect of Bitcoin makes it a trustworthy and relatively cheap decentralized payment system without any centralized settlement mechanism.

Secondly, it intelligently adapts certain well known features of distributed computing and information systems. Any distributed system has to resolve the problem coordination so that all the system can continue to function as  expected even if one or more nodes fail or start behaving arbitrarily. This issue is also looked upon from another perspective which is known as “state replication”.  A related problem germane to any distributed computing and information system is the Byzantine problem. The problem statement is- how to arrive at a consensus about an input value vi started by a node i, when a maximum of   f nodes have crashed. The proof-of-work mechanism has also originated in the distributed computation and information management area. This mechanism has also been made an integral part of Bitcoin protocol for validation and authenticity of transactions in Bitcoin network

The last and the most important building block of Bitcoin are the methods and tools of Cryptography. At the heart of Bitcoin lies one way function, hashing function, modulo arithmetic, public-private key, digital signature and maintenance of a public ledger of all validated transactions.

This talk would introduce all the building blocks of Bitcoin in a largely non-technical way. It would also highlight the potential fault lines of Bitcoin and why such a technology cannot become a currency proper. The presenter would argue that Central Bank Digital Currency based on the underlying technology of Bitcoin is very much possible. This is the most desirable and probably inevitable future of paper currency