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Post by Dan Hoglund on Dec 16, 2017 14:03:54 GMT
Lets start with a disclaimer to avoid confusion later on. As you can probably tell within a short matter of time I'm just a happy amateur on monetary matters. I thought I'd try my luck with a question for anyone interested. By reading this blog I get the idea that just about any asset can be decomposed into a "fundamental" component and a liquidity component. The liquidity component is the premium on top of fundamental value that arises entirely from the owner's ability to sell the asset to another person. So here comes Bitcoin and it's made up, it seems, almost entirely by liquidity value. The multi trillion dollar question now is: How sustainable is it? According to the blogger Mencius Moldbug an asset with a huge liquidity premium barring any critical external event can produce a feedback loop, attracting ever more capital until it becomes the dominant medium for savings. Savers will seek the best asset to maximize their savings and by doing so they will collectively gravitate towards the same asset as it keeps appreciating in price. He calls it the bubble theory of money: unqualified-reservations.blogspot.se/2013/04/bitcoin-is-money-bitcoin-is-bubble.htmlBut according to what I've picked up from JP Koning and Mike Sproul this should not happen. The forces of capital attracting more capital in an ever growing liquidity premium will be offset by other forces. I hope I'm not distorting any of their views but as I understand them when the liquidity premium grows so does the opportunity to profit by short selling the overvalued asset. Of course there must be a way to short sell. But if there is and if the short sale can produce an asset that can also be traded it can then compete with the demand for the original asset, thereby driving the price down. So, do you see the newly created futures market for Bitcoin as an example of that? Can we now expect this to put downward pressure on Bitcoins liquidity premium? I can now as an investor choose between Bitcoin and Bitcoin futures. My buying of Bitcoin futures will not drive the price up as it would if I bought Bitcoins directly but the futures are competing with Bitcoin for my investment money. Or does this not apply? Clearly the futures trading and regular short selling is a bit different. And what about gold, why can it stay "levitated" in price for such long periods of time? Surely the gold producers would not be able to sell at the current price without investment demand so there should be a considarable liquidity premium on gold even today but at the same time there are no limitations to short selling, to my knowledge.
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Post by JP (admin) on Dec 18, 2017 15:37:47 GMT
Hi Dan, good questions. Here are my initial thoughts. In the case of gold, as fractionally-backed gold-denominated IOUs begin to be listed the speculative demand for gold will start to be absorbed by a much wider base of gold ounces, both real and pseudo. This should pressure prices down. But at some point physical demand for the yellow metal establishes a lower bound to the price thanks to the presence in the market of those who withdraw real gold ounces from the market because they value the metal in various industrial processes and consumer purposes.
In the case of bitcoin, things like ETFs, the Grayscale BTC trust, and futures are not fractionally-backed. (Futures are tricky, we can debate that point). So even as the speculative demand for bitcoin is beginning to be absorbed by a much wider base of pseudo bitcoins, real bitcoins are being withdrawn from supply by those running these schemes. So I believe the net effect is neutral. We'd need to see the introduction of fractionally-backed bitcoins to get an effect on price. And of course, there is no real bitcoin equivalent to manufacturers who put gold in circuit boards... which means no theoretical floor to bitcoin's price.
Anyways, I emailed Mike Sproul, hopefully he'll chime in as I'm sure he has some interesting things to say.
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Post by Mike Sproul on Dec 18, 2017 17:06:31 GMT
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.
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Post by JP (admin) on Dec 18, 2017 17:14:38 GMT
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. Hah, looking forward to your response, Mike.
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Post by Mike Sproul on Dec 18, 2017 22:24:41 GMT
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.
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Post by Dan Hoglund on Dec 19, 2017 12:24:14 GMT
Hi JP and Mike, thanks for the answers!
I think there's some confusion here on my part regarding some terms I see you use. Should I see "liquidity premium" and "liquidity value" as the same? And is it simply a term for the market value minus "fundamental" value. Or is it the extra benefit the owner gets based on how EASILY an asset can be sold?
JP, if the Bitcoin futures market is settled in cash is it withdrawing any real Bitcoins from the supply?
Mike, does it really matter if the futures or short products get circulated as "money" for them to have an impact on the price of the underlying asset? Isn't it enough that futures now compete with the real assets for the same investment demand?
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Post by Mike Sproul on Dec 19, 2017 15:07:21 GMT
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.
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Post by Dan Hoglund on Dec 19, 2017 16:37:42 GMT
Thanks Mike, this is interesting stuff.
I take it liquidity demand is also the same as investment demand? So I assume that Bitcoin by that terminology has close to 100% liquidity value.
If the underlying asset is already made up of 100% liquidity value as in Bitcoins case the futures will then also have 100% liquidity value from the get go. There is no fundamental value in either the underlying asset or the derivative. 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"?
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Post by JP (admin) on Dec 19, 2017 17:48:15 GMT
Hi JP and Mike, thanks for the answers! I think there's some confusion here on my part regarding some terms I see you use. Should I see "liquidity premium" and "liquidity value" as the same? And is it simply a term for the market value minus "fundamental" value. Or is it the extra benefit the owner gets based on how EASILY an asset can be sold? JP, if the Bitcoin futures market is settled in cash is it withdrawing any real Bitcoins from the supply? Mike, does it really matter if the futures or short products get circulated as "money" for them to have an impact on the price of the underlying asset? Isn't it enough that futures now compete with the real assets for the same investment demand? 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.
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Post by Dan Hoglund on Dec 19, 2017 18:38:57 GMT
JP, right ok but that assumes they're 100% hedged. Considering the size of the contract (5 Bitcoins) and the nature of the underlying I guess that's possible.
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Post by Mike Sproul on Dec 19, 2017 18:51:28 GMT
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.
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Post by JP (admin) on Dec 20, 2017 5:47:29 GMT
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. True. But he'd have to be pretty sure that the promise was risk-free, at least as good as holding the bitcoin's himself. As for the second person, in issuing the bitcoin-denominated promise they'd be taking on an incredible amount of risk, since the price of bitcoin could quadruple or quintuple, forcing them into bankruptcy. Is there a large enough population of serious investors actually willing to play Russian roulette by shorting bitcoin?
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Post by Antti Jokinen on Dec 20, 2017 13:25:36 GMT
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.
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Post by Dan Hoglund on Dec 21, 2017 20:55:20 GMT
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. Thanks for the clarifiction. The Bitcoin market seems to agree lately as well. Still early though. I have to say I really like the "IOU"- dillution argument, or what I should call it. It's clear when I read Moldbugs stuff (the blogger I read that got me to post these questions), and he wrote at least 4-5 lengthy posts, that nowhere does he acknowledge that argument and counter it. It's just missing from his analysis. I also liked the post on this blog about the short squeeze on Volkswagen that you wrote long ago. It fits well to this subject and helped my understanding of the argument.
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Post by JP (admin) on Dec 22, 2017 14:12:45 GMT
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. Sure, you could use stop losses. Same on the buying side of things. But if you're consistently trying to short the market you could be putting on an infinite number of these stopped-out orders, whereas if you're trying to buy the market the price of $0 limits the number of stopped-out buys you have to do.
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