Central Bank Digital Currency

I am providing a link below to the latest version of my paper. The Reserve Bank of India has declared that it will start a pilot project on the issuance of CBDC. The former Governor Subbarao has strongly cautioned RBI against any interest payment on account-based CBDC. Please see my detailed discussion on various issues related to this subject.

The key takeaways from my paper:

  1. CBDC should not be a mutated version of Bitcoin type digital coin.
  2. CBDC must possess three properies of paper currency fully and comprehesnively: No third party verification is required to transfer digital currency from a holder to a recipent.
  3. No account balance concept is introduced and therefore no double spending is possible.
  4. A holder is a legal owner unless proved otherwise.
  5. All digital currency are of a certain denomination and every transfer is legitimate as long as wallets are genuine. A proper application of public key cryptography and hash function allows a digital currency to mimic it’s paper based counterpart.
  6. The only difference with paper curreency is that transactions based on digital currency are not competely anonymous. But investigation of audit trail of a particular digital note would be very complex and costly. So it would not be easy.
  7. Double spending is prevented because notes are automatically modified in the wallet of the sender which will not be accepted by another receiver’s wallet. No internet is required for a transaction to take place and notes cannot be sent through internet.
  8. No requirement of a blockchain database.
  9. It is neither an account-based nor a token based payment system.
  10. Notes can travel back to issuer- the central bank- and get destroyed by the central bank.

https://docs.google.com/document/d/1b9L8OGBUy7rVjvMVdFmnvP_9q1uNAG1i/edit?usp=sharing&ouid=109936802430456407164&rtpof=true&sd=true

Central Bank Digital Currency

In December 16 2019, I wrote this letter to RBI Governor

To

The Governor

Reserve Bank of India

Mumbai

Sub: Possibility of introducing Central Bank Digital Currency in India- a Technical Blueprint

Respected Sir,

Many countries in the world including China are experimenting to introduce Central Bank Digital Currency (CBDC). I have worked out a blueprint for developing such a CBDC for India. I would like to point out that such a CBDC, although based on the principle of cryptography, is not designed on the Distributed Ledger concept. It also does not require Third Party Verification based Consensus schema that drives current Bitcoin and similar cryptocurrencies. According to me a CBDC must mimic the basic characteristics of paper currency which are anonymity (to a reasonable extent, as any digital asset is finally traceable) of transactors, bearer as legal owner and a legal tender if the both transactors agree on this mode of transaction. Furthermore, at the unit level each CBDC would have distinct denominational identity and cannot be sub-divided.

If this proposal appears to be- prima facie- feasible and fits into the RBI’s overall scheme for currency management, I would be ready to provide the underlying distributed database structure etc.  Finally, I would humbly state that my proposal is only a proposal and needs extensive discussion amongst all stakeholders to make it a proper working solution.  

Best regards

Ashok Kumar Nag

Former Adviser`

Department of Statistics and Information Management

Reserve Bank of India

Now that RBI is preparing to introduce digital currency, I feel that I need to put in public domain the blueprint for a digital currency that I had proposed.

eRupiah: RBI’s Virtual Cash  

Introduction:

No currency has ever been used in the human history which did not have the stamp of an authority. Bitcoin is a medium of payment but it is not money for the same reason. As long as, a citizen of a country cannot pay taxes with Bitcoin, it cannot be called a legal tender. Nonetheless, the technology underlying Bitcoin is a significant one with great potential. A central bank, issuer of paper currency, can use some selected components of Bitcoin technology to replace paper currency with virtual currency, retaining all the important features of paper currency. The most important of them is that a central bank note is a freely negotiable bearer bond and a legal tender in the hand of its holder. It does not require any third party verification. Counterfeiting a central bank note is not impossible but difficult and costly. The central bank neither authenticates any transaction made with that particular note nor does it keep any record of that transaction. The note remains as a liability on the book of the central bank till it comes back to it, either for reissue or its destruction. The physical nature of the note ensures that no double spending is possible with the same note by its current holder. In case of digital cash, the main issue that a central bank has to resolve is the issue of double spending without depending on third party verification of the same. What follows hereunder is an outline of a system that any central bank can implement to issue its own currency retaining most, if not all, of the desired properties of a paper currency.

The main features of a paper currency are:

It is a legal tender; transfer between two transactors can happen only through face-to-face encounter; double spending is not physically possible; no third party verification required; counterfeiting is possible but costly and detected by physical examination; each note has a unique identity; gets destroyed when unusable, liability of a central bank, in general.

I am presenting below a system based on digital currency on a mobile phone. There is no compelling reason to believe that the same system cannot be implemented on a specially designed smart card with embedded chip. The system outlined below is described within the currency management framework of the Reserve bank of India (RBI). With little tweaking the same can be customized by any central bank.

RBI Currency Management Framework:

RBI carries out its currency management function through its 19 Issue Offices located across the country. There is a network of 4281 currency chests and 4044 small coin depots in selected commercial bank branches. These chests store currency notes and rupee coins on behalf of RBI.  The note distribution mechanism is summarized in the following diagram.

For issuance of digital currency, each currency chest would function as a data center for hosting the ledger book of notes issued from it.   Similarly each issue office of RBI would have a copy of the entire ledger book of notes. A folio would be opened in the note ledger book when the first time a specific note is issued.  Each data center will have complete inventory of wallets issued by RBI.  An wallet could be a mobile app downloaded on a person’s mobile phone or it could be  a smart card to be issued by RBI. The details are given below.

Every bank branch would have a digital cash dispenser. Any wallet holder would be able to replenish her wallet with digital currency by pairing it with the dispenser via Bluetooth or NFC communication channel.  Similarly every ATM would have similar facility. At the time of cash dispensation from bank branch or ATM would require Aadhaar based biometric verification of wallet.  For cash transfer between wallets of two individuals this verification is not a necessary requirement.

The protocol for issue of eRupiah

  1. RBI would maintain ledgers of each currency note in a distributed database.
  2. Currently RBI issues notes through its Issue offices. The distributed database will be created according to issue departments of RBI. Each Issue office of RBI will be able to issue new digital currency and destroy old digital currency. Destruction of old digital currency would help RBI to keep the number of entries in the ledger folio of a particular note within a limit. Every Issue offices would maintain record of all notes issued by it as well as copies of corresponding records of 3 neighboring Issue offices.
  3. Each currency chest will have a database of notes received by it from RBI’s Issue department.
  4. Each currency chest will also have replicated database of its three nearest neighbor
  5. The system will issue new digital currency when an account holder wants to withdraw cash from its account with RBI. It would be optional, to start with. An account holder can withdraw cash or digital currency according to her discretion.
  6. The account holder would specify how much of its cash withdrawal would be in digital form. This facility would be provided for an interim period when both forms of currency would be in circulation.
  7. To incentivize issue of digital cash, RBI may reward with a fixed amount that could be related to the cost of producing physical cash.
  8. RBI is banker to the Central and State Governments. It also functions as banker to the banks and thus enables settling of inter-bank obligations. These large account holders of RBI would get digital cash in their Jumbo Wallet which would be a server in the account holder’s custody. It would be like a till holding cash. An authorized person can withdraw e-Rupiah from the till as and when required.
  9. The RBI’s Note ledger would comprise ledger folios of each currency notes issued.
  10. Each record in the Note ledger would comprise the following attributes: (1) a sequential no, (2) unique identity / sr no of a note, (3)  hashed value of the note serial no, (4) identity of the issue department, (5) denomination, , (6) time stamp of transaction, (7) hashed value of identity of paying wallet (first time payer would be RBI), (8) hashed value of identity of receiver wallet, (9) active flag,   (10) hashed value of first 9  attributes , (11) hash value of the first 9 attributes of earlier transaction record of the same note. The identity of a wallet is described below.
  11. RBI will also maintain database of each wallet downloaded from its website.
  12. The wallet database will have a header record with the following attributes (1) IMEI no of each phone, (2) Aadhaar No of the phone owner, (3) timestamp of successful downloading of the wallet, (4) the GPS location of the phone at the time of downloading of the wallet, (5) a unique private key generated for each wallet and (6) the corresponding unique public key generated for each wallet. This data would also be hashed and encrypted with RBI’s private key and will be part of the header record. RBI’s public key would also form a part of the header record. The private and public key of each wallet would be generated by RBI at the runtime. The hashed value of attributes 1 to 6 would be the identity of each wallet.
  13. Each wallet will have its own database of transactions. Each record in the transaction database will represent a note that has been loaded into the wallet. Each record will have the following attributes: (1) unique identity of the note, (2) note denomination, (3) digitally signed (with the private key of the paying wallet) hashed value of the concatenated string of serial no and denomination, (4) digitally signed ( with the private key of the paying wallet) hash value of concatenated string of attributes 1 and 2 of the header record with private key of payer wallet, (7) public key of the paying wallet, (8) timestamp of last transaction( i.e. timestamp of receipt of the note , (9) timestamp of the payment transaction, (10) payment status (paid or unpaid), (10) hashed value of the earlier transaction of the note(attributes 1,2,3,4,5).
  14. A transaction between two wallets would involve “note data” transfer from the paying wallet to receiving wallet. [A separate note is given to explain how such transfer can happen with QR codes}. Every note that gets transferred from the payer’s wallet to the recipient’s wallet would essentially mean transfer of the entire record from the former to the latter. In the process of data transfer two insert / update activities take place in the receiver’s and payer’s wallet respectively. The receiver’s wallet inserts a new note record while the payer’s wallet updates the concerned note’s existing record.
  15. Once the receiving wallet gets a new e_Rupiah note, it checks the authenticity of the note by calculating hash value of the concatenated string of attribute 1 and 2 of step at 13. In the payer’s wallet the status flag would get changed to “paid” while in the receiver’s wallet it would continue to have the status flag as “unpaid”.
  16. Any wallet would have a limit in terms of number of records / notes. When the database has reached its limit then the wallet would have to be uploaded to RBI and a new wallet has to be downloaded.
  17. At any point of time a single wallet would be subject to 2 limits- holding limit of no of transactional records and total value of a single transaction. For a high value transaction two factor authentications would be required. (say above one lac). Both paying wallet as well as receiving wallet has to simultaneously establish connection with RBI and get their credential verified.         
  18. As and when no of records in a wallet’s transactional database reaches its limit, the database has to be downloaded in an ATM or at a bank branch.  The wallet would be purged of the all transaction records with status as “paid”. The wallet holder then can download more E_Rupiah from an ATM or from a bank brunch. RBI will update its ledger book of individual notes thus uploaded from each wallet.
  19. Any fraudulent transactions identified in the process of uploading would get notified and thorough automated forensic audit perpetrator of fraud would get identified.  Downloading of Wallet:
  1. The user sends a sms to a designated no with the Aadhaar no of the sender. Each sms would cost the user 1 INR. RBI would send a link to the phone and clicking on the same the app would be automatically downloaded. To activate the app, the user has to sign-in with his/her Aadhaar no. For additional security one may think of incorporating biometric signature of the wallet holder as another feature of the wallet; every use of the downloaded wallet would require signing in biometrically by the wallet holder.

2. The wallet will have the following features:It will recognize another wallet in its vicinity using NFC technology. Alternatively Bluetooth technology for pairing two cell phones can be also used. Both the wallets would then exchange their digital identity and verify them with public keys of both and RBI’s public key. After two wallets have been paired, the payer’s / payee’s wallets would prompt the respective wallet owners to initiate the intended actions on their part. The payer will have to initiate payment action and would type in amount of money to be paid. The wallet would automatically prompt for denominations – a built in program would provide the best possible composition nearest to the amount indicated by the payer. The payer would have the right to change the composition and the resulting total value.

3. Once the payer approves payment the required data transfer takes place without seeking any third party verification at that time. For a transaction above a certain threshold value, at the discretion of the transactors, the receiver’s wallet may be connected with Aadhaar database and a biometric confirmation of the payer’s bonafide may be authenticated.

4. If any wallet holder commits a fraud by hacking the wallet’s database and changing the header record, it would be considered as an act of counterfeiting of notes. As and when any receiver uploads data to RBI website, the same would get immediately detected when RBI updates its ledger folio of notes involved. The concerned wallet holder would be notified with the fraudulent transactions and details thereof. It would be a matter of time to nab the fraudster. 

5. For merchants, wallets can function like mPOS (mobile point of sales) machine. A merchant’s wallet would authenticate the payer’s wallet and notes therein by directly connecting to RBI’s ledger of notes.

How the system will function:

Alice downloads the mobile app/wallet from RBI website. Alice visits it nearest ATM or bank branch and loads its wallet with required e-Rupiah. On a single day Alice would not be allowed to load her wallet with more than, say, fifty thousand value of e-Rupiah. The cash dispenser, say ATM, would be configured accordingly.

Alice wants to pay, say one thousand rupees, to Bob; the Alice keeps her wallet bearing mobile to Bob’s wallet and taps the application on her mobile. The respective apps recognize each other and Alice keys in the amount to be disbursed to Bob. If Alice has necessary denominations then the application would give nearest amount higher than that amount and which can be transacted. The balance can be paid back by Bob.

Loss of Wallet

In case of loss of a wallet, the holder of the wallet would be required to register the loss with RBI and provide its mobile number and Aadhaar number. RBI would broadcast the IMEI no of the wallet to all mobile service providers, thus blocking any further use of the mobile.  In due course, the stolen wallet can be traced and, in case of theft, required action by law enforcing agencies can be initiated. If a fraudster wants to use a stolen wallet by replacing the original header record, it would need to replace all unpaid notes’ records with values consistent with corresponding values of the new fraudulent header record. This would be very costly and may not be worthwhile. Furthermore, it would not be possible to download any further notes from an ATM or a bank branch.

 Cost of Issuing E-Rupiah

As on end March 2017, around 201 billion pieces of notes including coins (one rupee and above) were in circulation.  In that year, India’s adult population (15 years and above) was estimated to be around 916 million. If all adults hold one wallet each, the estimated size of all header records would be around 320 GB, not a very big number by any yardstick.  The size of transaction database, assuming 1000 transaction for each note during its lifetime, would be around 71 petabyte or .07 Exabyte. Amazon Redshift Spectrum Query service charges $5 per Terabyte of Query. If in the extreme case we assume that all notes are transacted once every day of one year, then the cost would be around 132 million US dollar or 862 crore of Indian rupees.  Taking storage cost, it would be well below the cost of printing notes that RBI incurs today.

Digital Currency and Corruption With digital currency it would be very difficult for anybody to make huge cash transaction for drug trafficking, bribing and other illegal purposes. In the Netflix original TV serial Narcos, the Columbian drug cartels are seen to carry out most of their transactions in cash. So much so, they had to store cash buried in fields.  Central Bank Digital Currency would be the most effective antidote to cash mediated corruption and illegal transactions. 

More on the e-Rupiah process

The following paragraphs describes the process of connecting and validating users in proposed p2p e-cash transfer.

The scenario has two users with devices – device A which will send the money (will be called as consumer hereafter) and device B which is a merchant and will receive the money.

The app will require any user to sign up first using the government issued ID card such as aadhaar card. Once the sign up is done, app will connect to RBI server and download a key pair on the phone.

  1. Merchant will start the app and enter the amount it wants to receive.
  2. Once the amount and details are entered the app will create a barcode of the same. At the same time, app will start a hotspot.
  3. The consumer will start the app and scan the barcode using the send button.
  4. The barcode shall contain basic information such as some validation message, network name (hotspot) and network key.
  5. Using the scanned information, the consumer’s app will connect directly to the hotspot started by merchants app. All the basic network validation will be done internally.
  6. Once the two devices are connected, the main process of validation will start.
  7. Both devices will exchange public key of each other.
  8. Once done, both the devices will exchange basic data in form of encrypted packet. The packet shall contain data such as user info and some other validations related data if and as necessary. The packet will be encrypted with the respective users’ public key. For example, consumer will encrypt packet using merchants’ public key.
  9. The merchant’s device will decrypt package received from consumer’s device using its private key and verify the data.
  10. Once verification is done, the consumer shall send the money requested by merchant and will deduct it from app’s database pending upload to RBI server.
  11. Once the transfer is done successfully, the hotspot will be shut down by app.

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