Monthly Archives: October 2013

A pugnaciously persistent meme, even among educated people and policymakers who should know better, is that governments at times “manipulate” the interest or exchange rates. By that it is meant that they move the rates away from some mythical “natural” value that they would be at in the absence of the alleged manipulation.

There is no natural rate. A governments is a monopoly supplier of its own government paper and while there are several suppliers of such paper, they’re not direct substitutes for each other. If you want USD cash or bonds, there’s only one shop in town, this is the US government’s (we here consider the central bank and the treasury as one entity given that they both manage the whole stock of government paper, central bank cash is just essentially a very short duration government bond).

Thus, the government is like any monopoly supplier of an exclusive product which has no directly fungible substitute, a price setter — unlike suppliers of fungible commodities who are individually price takers. So, like any monopoly supplier, while they cannot control external demand, they can choose the point on the demand curve, through setting either the quantity (how many bonds or cash they make available) or the price (the interest rate). They might practically set one or the other, but in all case they are choosing a point on the demand curve and which of the axes you use for that setting is a not very interesting technicality.

Not only they choose that, but they cannot opt not to choose. There is no “natural” point on the demand curve. The treasury cannot say they will issue “some” bonds at “some” price and not specify any price or quantity. Buyers of bonds cannot get not-a-number of bonds and receive not-a-number interest on it. Therefore the government is, like all monopoly suppliers of non fungible products, “manipulating” the interest rate at all times. It cannot not manipulate. And there’s nothing wrong with it for there exist no possible state of non-manipulation. Monopoly suppliers are price setters, this is just a fact of life. Buy the product if you like the offer, move on if you don’t.

The same apply to exchange rates, which is just the relative price and directly depends on supply which is just a consequence of setting a point on the demand curve, which in aggregate includes international demand. Exchange controls or the lack thereof doesn’t change that, they just make the currency more or less fungible which is just a quirky way to set quantity. Adding or removing price controls doesn’t change that governments are in full control of their position on the demand curve and have no way to relinquish that control.


I incidentally had a wander around the Bitcoin ecosystem in the past few days and there are a number of entertaining phenomenons to observe.

MtGox: a slow train crash

Looking at comparative exchange rates between Bitcoins and fiat currencies, one can’t help notice that BTC are 10% more expensive at MtGox, the highest volume Bitcoin exchange, than at every other exchange. The reason is not hard to find: MtGox has problems with their banking partners so that they have limited capacity to process withdrawals, and have thus set up a rate-limiting (both time and size) queue system. So basically it takes weeks to get money out of MtGox, making the obvious arbitrage opportunity of buying cheap bitcoin from any other exchange and getting back your original capital + 10% by selling it on MtGox and withdrawing it much harder (or for people who are BTC-based, the mirror strategy of buying fiat temporarily and converting it back into Bitcoin via cheaper exchanges). Of course the arbitrage is less interesting when (1) it takes weeks, (2) is limited in size, (3) MtGox might not be there by the time your withdrawal is due.

Interestingly MtGox remains the highest volume exchange despite being functionally insolvent — any old school bank sitting on funds for a month would be put in resolution by their regulator and counterparties would run away from it as fast as possible. It would be interesting to know how much of the remaining volume is the arbitrage trade and how much is people actually needing a transfer for non speculative reasons. Some inertia might be due to the difficulty of being validated on other exchanges.

Bitcoin exchanges: a flawed idea

MtGox problems are I think revealing a more fundamental problem. The entire modern banking system is oriented towards traceability and, to a degree, reversibility. Interestingly MtGox’s euro bank sits on incoming electronic transfers for 7-10 days, presumably to cope with reversals. Any transaction chain that gets out of regular banking and back in again via Bitcoin is in principle a loophole in the world banking system (let’s assume for a moment that Bitcoin is as anonymous as its proponents claim).

The way it seems to work is that while a new Bitcoin exchange is small enough to be under the radar it’s left alone until it becomes big enough to trigger compliance problems and then loses its interface with the regular regulated money world. I don’t think that’s going to get any better, limiting the potential for Bitcoin to gain wide acceptance. It can still work as an underground currency by using bridge goods for exchange, or peer-to-peer exchange, likeĀ LocalBitcoins, which basically works around the regulations by turning private individuals into unlicensed money changers, probably breaking some rule or other but possibly escaping it as long as individual members operate on an amateur scale.

ICBIT futures contango

Another arbitrageable anomaly is the contango curve for BTC/USD futures on theĀ ICBIT futures exchange. Liquid things normally have a flat term structure, because you can construct a market neutral position with the underlying and the future and gain the difference in a risk free manner.

Some possible explanation for this contango:

  • innumeracy may dominate, if more people believe that the future prices for liquid assets are bets about prices at expiration than there are people prepared to arbitrage this basic error.
  • the icbit exchange is too small to be worth bothering (the open interest on the BTC/USD futures is less than $400k nominal).
  • an arbitrage position that is short is subject to infinite risk if the price on icbit spikes before converging at maturity.
  • an arbitrage position is exposed to counterparty risk: the exchange, like many bitcoin ventures, is probably a one-man shop who can at any time disappear with the margin account or get it hacked/stolen.

Fees: even more expensive than regular finance

One striking thing is that bitcoin exchanges, and other bitcoin-based financial websites, despite skipping the full regulation of the regulated world, charge fees that are can be higher than the regular regulated financial industry, for example an arbitrage transaction getting euros in via Bitstamp and out via MtGox would cost:

  • Bitstamp deposit: unspecified USD/EUR cost
  • Bitstamp exchange fee: 20-50 bps (volume dependent)
  • MtGox exchange fee: 25-60 bps (volume dependent)
  • MtGox withdrawal fee: 100 bps

A speculative forex round trip with a competitive regulated money solution is much cheaper than that.

These services are just a bit of software, with a supporting geek community, it’s surprising cooperative services that don’t charge fees haven’t appeared.

Another look at fees is the cost per transaction shown on which seems to oscillate around 2-3% which seems pretty steep to me for transactions within a purely electronic currency with no services attached. I understand this includes the block fee from BTC created and given to miners, which are not paid directly as part of the transactions, but are fair to include given that they increase market cap and thus, everything else being equal, devalue existing bitcoins.

The US government will probably partially shutdown tonight, which as such isn’t that bad for a short while, but Congress seems set for a conflict about the debt ceiling, which could be really bad if they really defaulted, however pointless a technicality it is.

Alley flanked by trees with low-level branches

Low ceiling (credit: Swiv on flickr)

The market is basically pricing in a deal and hasn’t panicked yet. There will probably be a deal in the end, but I feel it does require a market panic (at least a small short one) to progress. I see things (possibly) happening that way:

  1. Markets stay calm for a few more days, while the deadline approaches
  2. The calm markets reinforce radical Republicans’ intransigence
  3. The market panics more convincingly (via volatility and/or actual dollar/stock falls) when a significant deadline gets too dangerously close
  4. Radical Republicans see the market panic in their brokerage account and surrender in a disorderly manner
  5. Problem solved, markets come back to where they are now, after a few days or at most a couple of weeks

The logic of the institutions seems to imply this, along with Obama being a much better strategist than radical Republicans — I don’t see why he would surrender first. That way he gets his way on the healthcare reforms, and scores political points in the process.

This is eerily like the Eurozone, without the structural reasons. Not silly at all.

Disclosure: long VIX, VSTOXX via derivatives.