Unit 1 Lecture Notes

A frequently discussed topic in Bitcoin circles is whether Wall Street could manipulate bitcoin's price by generating bitcoin-backed financial assets that eat up much of the demand for bitcoin itself; The argument is that futures, ETFs, and other financial instruments offer exposure to Bitcoin's price, and that while Bitcoin itself may be strictly scarce, the amount of bitcoin-backed financial assets Wall street can generate is not. Thus, financialization will kill Bitcoin's scarcity, and a price ceiling will develop and prevent any further growth and success.

The same argument applies to suspected manipulation in the gold and silver markets, especially given how opaque official government policy is with regards to precious metals' monetary role. In particular, GATA is an organization that has spent decades arguing that large bullion banks (i.e. the market makers for precious metals) collaborate with central banks to use futures markets in order to suppress the price. If it can be done to gold and silver, can't it be done to Bitcoin?

Not quite. Financial instruments based on an asset are only bets on the underlying market dynamics of the asset itself, in terms of its supply and demand. For example, futures markets cannot themselves influence the spot market; The exception is when futures are physically settled/deliverable and real bitcoin switches hands, but this can hardly be called manipulation as it's equivalent to any other spot trade that moves the price.

In a free market, manipulation is extremely difficult due to the ‘burying the body problem': it's possible for a rich man to spend an enormous fortune buying gold, which raises its price and allows him to profit on previously placed gold futures bets. The problem is that after the bet settles, he now has an enormous amount of gold on hand, and should he try to sell this gold the price would come crashing down. The futures market bet is only profitable if he can move the underlying physical market, but that's not possible without a large position on the spot market (which ties up liquidity and involves even further exposure to market risk). It's quite possible that the price slippage even causes a net loss overall. In other words, it's possible to purchase a large amount of a monetary asset and increase its price, since the limited nature of the supply makes the price easy to raise, but it is not possible to keep the price high without continuing to hold on to the supply of the gold. And even then, the manipulator is exposed to significant risk that if the market moves in a different direction due to factors he cannot control, he would lose significantly.

But nobody suspects that precious metals are being manipulated upward, and central bank would have no interest in such a thing. The more interesting case is the manipulation of precious metals' prices downward, which is what GATA and many analysts conclude is the only reason preventing the return of precious metals to their natural monetary role. Here, the problem for manipulators is far more difficult. The only way to profit from manipulation of precious metals downward is to find a way to sell these metals on the physical markets, bringing the price down, and making your futures' contracts profitable. The tricky part about this is that you cannot sell them on the physical delivery market without buying them in the first place, which is likely to raise their price. In other words, this kind of manipulation is likely to be a wash-out in its impact on the price. If someone buys gold in massive quantities and brings the price up from $1,200 to $5,000 an ounce, they could then bring the price downward by selling their gold onto the market, and profiting on the futures' exchange markets. But they can only really manipulate the price downward to where they had started buying. Once their demand is removed from the market, the price should settle where it was previously, and they would be unable to bring the price further downward. So, manipulating price downward on a free market is only possible by selling, and is limited by how much the seller holds. You cannot after all, acquire more of something to sell without bidding up its price. Unless, of course, you are a violent government! And that is the punchline: gold manipulation only works because of government gold confiscation. What drives gold prices downward is not the manipulation of the futures' markets, it is the fact that governments have been able to accumulate a very large portion of the world's gold supply at very little cost, and can use that supply to suppress the price downward when needed. The futures' markets are just a way for banks and individuals to profit on betting on this price being held down by central banks holding so much confiscated gold; they are not what drives the price downward.

As fractional reserve banking started becoming more widespread in the late nineteenth century due to the centralization of banking clearance, central banks were created to help prevent bank runs. When the crash of 1929 happened, large-scale systemic defaults across various sectors of the economy put significant pressure on over leveraged banks. Instead of letting the discipline of the gold standard clear out that monetary mess, write-off losses, and let everyone begin anew, governments chose to sacrifice the gold standard to maintain the over leveraged fractional reserve banking system. From then on, it had a lender of last resort instituted as a matter of policy, in the shape of the FDIC. The key to the stability to the fractional reserve system since then has been the lender of last resort. And the key to the sustainability of this lender of last resort has been its ability to fall back on a money whose supply could be easily increased.

But the problem that this sort of system faces is in the sustainability of the monetary unit it uses. If the money supply is easy to increase, the free market would move to another money. If everything I said in my book on monetary competition has some merit, then people would choose to have more cash balances in harder forms of money, like gold, and that would in turn lead to a significant drop of the value of the dollar. How did the dollar not collapse next to gold, even after 85 years of the function of lender of last resort? The answer is that gold ownership was prohibited, and banks banned from dealing with it. Government confiscated banks' gold easily and was able to recapitalize the banking system with the extra dollars while not worrying about the dollar collapsing in price next to gold, since individuals could not return to a gold standard when all the banks and central banks were prohibited from dealing with gold.

So when conspiracy theorists decry financial market manipulation of gold prices downward, they are likely fixating on the symptom, not the cause. The financial manipulation is largely due to the fact that central banks have confiscated large supplies of gold across the world from the 1910's onward. As discussed in The Bitcoin Standard, central banks in the twentieth century held many multiples of times more gold than they held in the nineteenth century. In the nineteenth century, with their currency largely backed by gold, they held gold for purposes of clearance among one another, and among banks in their respective economies. In the twentieth century, governments hoarded gold in obscene quantities to prevent the emergence of a free market and banking system based around it.

The story of how central banks have managed to maintain their currencies in operation is inseparable from their ownership of large quantities of gold. Ferdinand Lips' Gold Wars has an excellent discussion of this. To go back to our parable on manipulation, it is not possible to manipulate the price of something downward except by selling it, which, on average will mean no more than being able to bring it to the price at which it would be without you having bought it in the first place. But if a government is able to coercively ban the trading of gold, and prevent its clearance through the banking system, gold's monetary role is severely crippled in a modern economy where trade happens over large global market networks.

Central banks have consistently sold gold into the market when the prices have risen. Given central banks' massive reserves, such sales act as an inflation of the supply, bringing the market price down in national currencies, and making gold less attractive as a store of value. Examples of these sales are plenty, but the most famous might be the Central Bank Gold Agreement and its sales of thousands of tons throughout the 90s and early 2000s.

Another example of the ways in which central banks can prevent the reemergence of mass use of gold is to prevent free market alternatives for the settlement of gold from emerging. The example of e-gold is instructive. E-gold was a business that allowed digital payments backed by a physical safe full of gold. When you as a consumer would send a sum of US Dollars to e-gold, they would purchase a corresponding quantity of physical gold for you, and give you an account at the institution. You are then able to perform digital payments through their system, paying anyone on the network with the gold you own in their facility. It was, effectively, a centralized Bitcoin with a physical gold safe instead of digital coins. E-gold was successfully growing in the 1990s, and arguably was a cheaper more convenient and simpler way of achieving Bitcoin's goals. But it had one fatal flaw: the government could easily shut down their safe and their infrastructure and prevent them from continuing to operate. This is exactly what happened in 2008, with e-gold forced to shut down even though the judge had ruled they had no intent to engage in criminal activity, and that there is no reason to shut them down. If government had opened the door for E-gold to continue operating, and other similar businesses emerged worldwide, the use of gold as money could have spread worldwide, raising the value of gold compared to national currencies. As many businesses have tried this model and come across an iron wall of regulatory barriers, most notably, the fact that gold faces capital gains tax, which makes its use as a daily money highly complicated. The pressing need for gold to have physical settlement and the economies of scale from centralization of its reserves continue to make it vulnerable to government capture.

Therefore, it is not the futures' markets and rehypothecation that allows for the manipulation of gold price downward. It is government confiscation of large amounts of gold, estimated at around a sixth of global stockpiles, and its monopoly over settlement institutions. It is this banning of monetary competition that allows for the survival of governments' inferior currencies as they engage in being the lender of last resort for fractionally-reserved banks. Commodities other than gold, which are consumed in large quantities, have live liquid markets where large supplies are moved very quickly. It is possible for short-term manipulation of these assets to happen, but it cannot deviate too much from the realities of the market dynamics of millions of people supplying and demanding it. With these commodities, like with securities, the shadow banking system is able to create more claims on the assets that they have, and effectively monetize the increase in their supply, primarily because they have liquid markets settled in US dollars, and the shadow banking system has a lender of last resort who can print these dollars. As Nassim Taleb explains, the presence of a central bank guarantee behind a financial institution is a free option, with a positive expected value. All losses are written-off to the central bank's printing press, while all gains remain private. In this kind of arrangement, as all securities are settled in dollars, it becomes possible for fractional reserve banking to thrive.

This will lead us to a deeper appreciation of the astonishing potential of Bitcoin, and what it could do. By being built on an entirely decentralized basis, by having no single point of failure, no indispensable individuals or organizations, and no critical physical infrastructure, Bitcoin is very hard to shut down like E-gold. By being digital, Bitcoin settlements allow for at least half a million daily transactions that settle across the world in under an hour, which makes the final layer of settlement far more decentralized than gold's, which makes it much harder to capture and control. By being non physical, Bitcoin is also far easier to move around the world, to escape from places seeking to confiscate or destroy it. And this is why Bitcoin matters: it improves on gold in all the ways in which gold is vulnerable to capture by government. Only time will tell whether this is enough for it to continue to grow and succeed, of course, but it seems to have a better chance at resisting gold's fate than gold did.

To come back to the question of the manipulation of Bitcoin. The way I would understand it is that the manipulation of Bitcoin through the creation of financial instruments is not sustainable without a lender of last resort who can print bitcoin, or as was the case with gold, who can print receipts for bitcoin and force their acceptance as if they were bitcoin. Any financial institution that engages in fractional reserve banking, rehypothecation, or maturity mismatching with its bitcoin assets and liabilities is always in danger of being subject to a bank run.

With Bitcoin being digital and its ledger far easier to audit, it becomes easier for customers and speculators to notice discrepancies in a bank's balance sheet, and so they are more likely to notice discrepancies between bank obligations and assets, and more likely to demand their assets quickly. There are little barriers to entry when it comes to operating bitcoin, or moving from one service to another, and therefore, the cost of demanding deposits from a bank are likely far smaller than the government-protected monopolies were fractional reserves flourish. The most likely outcome from any bank engaging in maturity-mismatching is that its own notes will be discounted on the market. Whereas in a fractional reserve banking system, a bank creating new liabilities is able to effectively divide the cost by the holders of all the currency whose value is being reduced by inflation, in a free market with a hard money, the only people whose holdings will be devalued are those who choose to hold assets that are liabilities of the bank. Since they cannot force acceptance of their version of bitcoin to others, since they cannot demand that their partially-backed bitcoin assets are accepted at par, the rest of the market will likely discount their bills to the ratio at which they are backed. This does not need any central body to regulate or decide; the simple supply and demand dynamics of an increasing number of bitcoin-backed assets from the bank circulating and being cleared on the market will cause their price to drop compared to other forms of assets fully-backed by bitcoin.

More pressingly, there is a specific operational mechanism for free liquid markets to bankrupt anybody who engages in fractional reserve banking, and that is through what I like to call "liquidity vulture attack". A large speculator could short-sell a bank's stock price, and then make a large demand deposit in the same bank. Should the bank be engaged in fractional reserve lending, they would then proceed to lend out part of the speculator's deposit. The speculator then demands their entire deposit back. The bank would be unable to meet his demand for withdrawing his deposit, and instead would scramble to offload illiquid loans in exchange for liquid cash to settle with the depositor. But this liquidity crunch only makes cash more expensive for the bank as its long-term liabilities are discounted heavily, and instead, the bank's increasingly precarious position is likely to lead to more depositors asking for their deposits back. The bank's stock price would likely collapse as it goes bankrupt, and the depositor, even if they fail to get all their deposit back, would likely profit from the collapse of the price of the stock.

All of these reasons lead me to believe it is unlikely that fractional reserve banking would develop atop Bitcoin, and that all forms of financialization can only succeed in the long-term if practicing strict and full reserve backing of their instruments with Bitcoin. Bitcoin's liquidity and hardness mean that markets will be ruthless in punishing any financial institution that tries to sell obligations to bitcoins it does not own. And unlike gold, which governments could confiscate and control and prevent from developing its own settlement market,Bitcoin is much harder to confiscate, monopolize, or centralize. This does not mean that we will not see financial institutions attempt unbacked bitcoin financial products, but that when we do, the most likely outcome is an edifying lesson in the harsh realities of hard money on free markets. In fact, the real implications of a hard asset will likely only begin to dawn on most financial professionals after such an episode and lesson. Perhaps a large financial institution will assume that its large fiat based assets can allow it a large room for maneuver in rehypothicating Bitcoin holdings. But a large swing in price upward and some speculative bets against the institution could leafd to it becoming illiquid and needing injections of Bitcoins to survive. Since Bitcoin cannot be printed, it would need to be buying on the open market, but its own shady finances mean it will be buying as the price is rising fast. The institution would then require a large amount of dollar liquidity to stay solvent and buy more Bitcoins. Regulators would then be in a serious bind: Bail the institution out, and they are essentially directly printing more dollars to use to buy Bitcoin and raise the Bitcoin price further, making it appear more attractive for potential holders. Refuse to bail out the financial institution, and then it and the many counterparties to which it is exposed are in trouble, possibly causing a systemic crisis.

Generations of bankers and financiers reared on the soft ill-discipline of easy money and the unlimited generosity of central banks' subsidized low interest rates may struggle to understand these implications of hard money, and I find it hard to imagine that they would all refrain from engaging in the lending of deposits. Surely, some institutions will try, and that may just be the lesson that wakes people up to the hard realities of hard money.

In conclusion, I see the threat of fractional reserve banking in Bitcoin as a threat to those who engage in it, and not a threat to Bitcoin itself. I expect that whatever attempts at fractionally-backed Bitcoin are introduced, they will likely fail the market test and cause losses to those who engage in them. The bitcoin holder who remains in control of their private keys is not affected by this in the long-run, and the long-run is what primarily concerns a long term bitcoin holder.