Shorting away liquidity premium

Hi guys. My wife is currrently buying shoes online. I am assured that they are totally adorable, and vastly more important than any silly old blog post. Accordingly, it will be an hour or so before I get access to my desktop, which is much more efficient than typing on my iPad.

I just underestimated my wife's shopping time by a factor of 4, so keep that in mind when you read what follows.

1) Normally, the price of gold would consist of a fundamental value (jewelry and manufacturing) plus a liquidity value. As people switch from gold to paper money, gold loses its liquidity value and is pushed down to its fundamental value. A shopper who buys groceries on credit and issues an IOU that says “IOU 1 oz” is going short in gold, while the grocer takes an offsetting long position.
Note that fractional reserve banks are not an integral part of this process. The bank is just an intermediary that might add its name to the shopper’s IOU and help it to circulate more easily. The bank both lends and borrows dollars, so on net it is neither short nor long in dollars.

2) Bitcoin seems to have replaced fundamental value with bubble value, and it also seems to have considerable liquidity value. So suppose people start shorting bitcoins, and this creates a bunch of what I call "derivative bitcoins", which are just IOU's for actual bitcoin. I think the creation of derivative bitcoins would reduce liquidity value, and potentially push bitcoin all the way down to its bubble value.
As for bitcoin’s bubble value, that is something that breaks a lot of the rules of finance, so I have much less confidence when speaking of it. But I can say that bubbles must burst sometime before they engross the entire wealth of the world, and this point will be reached sooner when there are both genuine bitcoins and derivative bitcoins in existence. So I think a market for derivative bitcoins would hasten the day when bitcoin loses its value.

3) As for futures and forward markets: A farmer promises to deliver 1 ton of wheat to a miller for $200, payable in 3 months. The miller writes an IOU that says “IOU $200 in 3 months”, while the farmer writes and IOU that says “IOU 1 ton of wheat in 3 months”. This is a forward trade, with the farmer going short in wheat and the miller going long. If the price of wheat rises by $1, the farmer loses $1 and the miller gains $1.
A futures trade changes things very little: The miller’s IOU now says “If the price of wheat falls by $1, IOU $1”, while the farmer’s IOU says “If the price of wheat rises by $1, IOU $1”. Both the miller and farmer are in the same win/loss positions as with the forward trade, so it doesn’t matter whether the trade was a forward trade or a futures trade.
Now, here’s a bit of a stretch, but I think it’s right: Both kinds of IOU’s are usable as money, or could easily be made usable by a financial intermediary like a bank. So whether the exchanges start to offer bitcoin futures, forwards, or whatever, the effect would be to drive bitcoin down to its bubble value, and to drive that bubble value down to zero.

Hi Dan:

Yes, liquidity value=liquidity premium. What I have in mind is a supply and demand diagram for gold, where total demand for gold is the sum of "use demand" (jewelry & industrial uses) plus "liquidity demand" (gold held as money). If a superior rival money is introduced and people stop holding gold as money, then the value of gold will drop to the point where supply=use demand.

As for the question you asked of JP, I'd answer that cash settlement makes it possible (probable) to trade bitcoins without ever holding bitcoins.

For your last question to me, I'd answer that supply and demand is a fine model for apples and oranges, but not for financial securities. I know everyone speaks (carelessly, I think) of "Increased demand for stocks driving up their price", but the price of stocks, like every other security, is determined by the assets and liabilities of the issuer, not by supply and demand.

Having said that, there will be times when incomplete information about the issuer's assets and liabilities will force traders to trade based on guesswork, so there can be a small range where the price of the security is driven by forces that could be called "supply and demand", but it's not the same thing that econ texts talk about under the heading of supply and demand. Those textbook curves are made for actual goods that are actually produced using scarce resources, and which actually satisfy consumer desires. Financial securities don't fit that model.

So, back to your question: If gold is partly demanded as money, and if derivative gold circulates as money, then this can reduce the value of gold to its fundamental value, but no further. If gold does not circulate as money, and its value is already at fundamental value, then the issuance of derivative gold will not affect that fundamental value. So yes, I think the short/futures products have to circulate as money in order to affect the price of gold.

The reason I think that bitcoins are withdrawn from supply in the case of futures is that if someone goes long a futures contract, the person taking the other side will be hedger who locks in a profit by immediately buying an equivalent amount of bitcoin and holding it until the contract expires. So the bitcoins are frozen. It doesn't make a difference whether the contract is cash or physically settled, since either way the hedger will have to hold on to the bitcoins to be guaranteed a profit. In the case of physical delivery he'll deliver the actual coins, in the case of cash delivery he'll sell the BTC at expiry and deliver cash.

A good time to set some definitions straight:
1) liquidity demand=monetary demand=the amount of something that people hold just to buy stuff.
2) Bubble demand=the amount of something held in the expectation that a greater fool will be along shortly, and will pay even more.
3) Investment demand= Not sure. I'll leave this one to you, Dan.
4) Use demand=the amount held for jewelry/industrial/consumption uses

"Shouldn't the derivatives in that case put downward pressure on the underlying simply by being issued? The fact that the derivatives are issued by someone and bought by someone else does that not count as "circulate as money"?"
Agreed.

"the person taking the other side will be hedger who locks in a profit by immediately buying an equivalent amount of bitcoin and holding it until the contract expires"
But he doesn't have to hold bitcoin. He could, for example, hold someone's promise to deliver the cash equivalent of so much bitcoin.

JP, what about stop loss orders? I could short Bitcoin at 19K through a futures contract and put in an order on one of the exchanges to buy it if it breaks 20K, say at 20.500. There are of course risks related to unreliable trading systems.