Forking Incentives

A month ago, we wrote about the bitcoin fork. We described the fork:

 

Picture a bank, the old-fashioned kind. Call it Acme (sorry, we watched too much Coyote and Road Runner growing up). A group of disgruntled employees leave. They take a copy of the book of accounts. They set up a new bank across the street, Wile E Bank. To win customers, they say if you had an account at Acme Bank, you now have an account at Wile, with the same balance!

 

BCH, son of Bitcoin, born by forking – down quite a bit from its highs, but still up 130% in the past month, and sporting the third-largest market cap in crypto-currency land. [PT] – click to enlarge.

 

This fork came about from a disagreement among the bitcoin miners, those who control the blockchain and hence the currency. The equivalent of the disgruntled Acme Bank group left to form bitcoin cash, the equivalent of Wile E. Bank. However, it has often been said that necessity is the mother of invention. Applied to bitcoin, that means that what happened due to irreconcilable differences in this case, could also occur deliberately later.

Why would someone do this deliberately? Well, as of this writing (Saturday afternoon), bitcoin cash is trading for $568.28. This copy of the original bank ledger is worth over fahv hunnert Benjahminns! Actually, not the ledger. Each record in the ledger. The ledger as a whole is worth $9.4 billion.

For anyone — or a cartel of someones — who can fork bitcoin, there are now 9.4 billion reasons to do so. Think about that. Take as long as you need.

Now, we don’t want to disparage anyone. We are absolutely certain that everyone who is speculating to get rich in bitcoin will turn away from forking. It just doesn’t feel right, and it couldn’t possibly be moral to create forks on purpose, to get richer quicker.

But if someone did wish to do it, there is a powerful incentive. Economics tells us that if a powerful incentive exists to do something, then someone will do it. For example, if the government subsidizes borrowers by pushing down the interest rate then there will be all sorts of borrowing that would otherwise not occur (to finance all sorts of activities that would otherwise make no sense). Or, if it subsidizes insurance for people who build in flood plains, then many people will build in flood plains.

We now live in a world where altcoins are proliferating. There is a crypto currency named for a set of Internet memes called Doge. There is Pot-Coin for the marijuana industry, and even Pepe-Cash and Putin-Coin. There is a coin named for the most popular four-letter word. By this standard, it makes sense to fork bitcoin as many times as one can. To fork and fork and fork until the marginal Fork-Coin has a value lower than the cost of forking.

 

And then there is of course Titcoin – currently ranked 603rd in market cap among the 1,101 altcoins currently in existence (at last count, that is – this is a figure that changes almost daily). [PT] – click to enlarge.

 

Snark aside, and in all seriousness, the point of our article a month ago is that the fork shows the contradiction in a ledger of liabilities unbacked by assets. By dispensing with the need for assets, the liabilities can proliferate — fork — and there can be any number of alt liabilities too.

Our point in this article is that this contradiction creates a powerful perverse incentive, that someone sooner or later will take up. We prefer the term “perverse incentive” to “unintended consequence”, because it puts the focus where it belongs. We look at what is profitable for someone to do, rather than the real or alleged intentions of the designers.

In some cases, the intention is obviously evil. For example, Obamacare was designed to destroy the insurers and drive America towards socialized medicine. In other cases, perhaps in bitcoin, the designer did not foresee much less intend the outcome.

However, here we are. Both the possibility to fork and the incentive are now obvious. We would not bet against it, as we would not bet against Boromir putting on the One Ring. In a Middle Earth minute.

We have not much focused on price, other than how rising price makes bitcoin unsuitable as money or how bitcoin does not have a firm bid. We do not subscribe to the view that bad means the price must go lower soon. However, let’s look at the price of an asset in a bubble starting with the dollar.

The dollar, it is often and loudly asserted, has value only because of faith. As soon as the faith is pricked, the air will rush out of the bubble. This partly explains why the gold bugs latch on to every story about gold repatriation to Germany or Treasury Secretary Steve Mnuchin visiting Fork Knox. Mnuchin said, “I assume the gold is still there,” and thus began quite a tempest in a tea pot.

The belief is that as soon as the one-awful-fact-they-don’t-want-you-to-know becomes known, the dollar will collapse. And gold will go to $65,000 (price measured in collapsed dollars). It’s a quest for the holy grail. Now, we enjoy tilting at windmills as much as Don Quixote, but this view is wrong. The dollar does not have value because of some fragile, collective faith.

The dollar has value because of the struggles of debtors. What are you willing to sell, in order to avoid foreclosure on your house, repossession of your car, or bankruptcy of your business? Your labor and the products of your effort. As much as you need to sell, in order to service your debts and avoid default.

However, there is no real borrowing in bitcoin. What holds up the value of bitcoin?

There is a risk that a series of forks could prick this bubble of faith.

 

Fundamental Developments

There were big moves in the metals markets last week. The price of gold was up $31 and that of silver $0.56. The price of gold hasn’t been this high in just about a year, which is another way of looking at the one-year low price of the dollar. From its high over 27.5mg gold in mid-December 2016, the dollar has dropped 11% to its current 23.5mg.

Will the dollar fall further? In the short term, anything is possible. Once speculators smell blood in the water (i.e. a strong looking chart pattern), they may enter bigger trades with leverage. We will, of course, see that as a rising basis which is a contrarian signal. In the longer term, prices cannot go up too far or remain high if there is no renewed demand to hold gold metal.

One possible driver of this is portfolio rebalancing by those who bought a small allocation of bitcoin or Ethereum which is now not-small. Will these folks sell their crypto-currencies, which are anti-dollar plays, to buy more dollars? Or will some of them buy real money? This remains to be seen.

As always, we are interested in the fundamentals of supply and demand as measured by the basis. We will show intraday basis charts this week as there are some interesting features.

But first, here are the charts of the prices of gold and silver, and the gold-silver ratio.

 

USD prices of gold and silver – click to enlarge.

 

Next, this is a graph of the gold price measured in silver, otherwise known as the gold to silver ratio. The ratio moved down.

 

In this graph, we show both bid and offer prices for the gold-silver ratio. If you were to sell gold on the bid and buy silver at the ask, that is the lower bid price. Conversely, if you sold silver on the bid and bought gold at the offer, that is the higher offer price.

 

Gold-silver ratio, bid and offer – click to enlarge.

 

 

For each metal, we will look at a graph of the basis and co-basis overlaid with the price of the dollar in terms of the respective metal. It will make it easier to provide brief commentary. The dollar will be represented in green, the basis in blue and co-basis in red.

 

Here is the gold graph (Dec contract), this time showing intraday resolution for the full week.

 

Gold price and gold basis, intra-day last week – click to enlarge.

 

We have posted many graphs showing basis correlating with price. That is, as price rises so does basis. Basis is the spread between futures and spot. A rising basis means futures are rising faster than spot, which occurs if the buying pressure is occurring in the futures market. If the buyers are mostly speculators.

Something should immediately leap out at you on this graph. This relationship broke down Thursday afternoon (GMT). First there is a minor sell off seen in the price move from about $1,307 to $1,305. The basis drops from about 1.17% to 1.12%. The basis begins to rise with rising price after that, but it trails. It recovers the 1.17% level but only when price is about $1,317 — ten bucks higher. Then as price keeps rising, basis is sideways until midnight.

Basis makes one more rally approaching 7am (GMT), then falls back sharply as price continues to rise. Especially late in the day. Even if we ignore the last part below 1.11% as liquidity is dropping with the rest of the world offline and only whatever trading volume remains in the US Friday afternoon before a major holiday weekend (Monday is Labor Day), we still see a falling basis with rising price.

Demand for gold metal has picked up, even at this higher relative price. One of gold’s unique properties is that demand can rise as price rises, without any particular limit (even if it hasn’t happened much in recent years).

To put this into perspective, we would not characterize the current market state as a gold shortage. Every contract is in contango (Sept. basis is over 0.5%). The continuous gold basis has been in a rising trend for two months. Gold is not exactly scarce, nor facing massive demand for physical metal and shortage. As our old buddy Aragorn would say, “today is not that day.”

 

Continuous gold basis, co-basis and the USD priced in milligrams of gold – click to enlarge.

 

However, the basis move is notable in contrast to the price move. The rise in basis has not been much, considering how much the price has risen — about $120 in two months. Now the December contract, which matures in under 120 days, has a basis below that of 3-month LIBOR (about 1.3%).

The calculated Monetary Metals gold fundamental price was up $25, to $1,355.

 

Near contract gold basis and co-basis and USD priced in milligrams of gold over the past three months (regular chart) – click to enlarge.

 

Fundamental vs. market gold price – late last week, the fundamental price increased more than the market price – click to enlarge.

 

Now let’s look at silver, with a similar graph of the week’s action.

 

Silver price and silver basis over the past week – click to enlarge.

 

At the risk of turning these charts into Rorschach Tests, this one does not look the same to us at all. The silver basis tracks the silver price, though a skew occurred on Wednesday and widened on Thursday. The movement of both traces were a close fit on Thu and Fri. Note the spike down in the basis at the end of the day on Friday (as in gold, though gold had been falling all during the London day through the US day).

 

Silver basis and co-basis and the USD priced in grams of silver. N.b.: the fundamental and market price ended last week very close to each other – click to enlarge.

 

Our calculated Monetary Metals silver fundamental price increased $0.46. And, though our calculated Monetary Metals gold:silver ratio fundamental price has dropped a bit, it was rising the last three days of the week.

 

© 2017 Monetary Metals

 

Charts by: Crypto-Compare, CoinMarketCap, Monetary Metals

 

Chart and image captions by PT

 

Dr. Keith Weiner is the president of the Gold Standard Institute USA, and CEO of Monetary Metals. Keith is a leading authority in the areas of gold, money, and credit and has made important contributions to the development of trading techniques founded upon the analysis of bid-ask spreads. Keith is a sought after speaker and regularly writes on economics. He is an Objectivist, and has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona.

 

 

 

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13 Responses to “The Forking Paradise – Precious Metals Supply and Demand Report”

  • VB:

    1) Bitcoin Cash was not created by a disgruntled group that decided to fork the coin. Just the opposite. Bitcoin was modified (to implement some new features that are supposed to increase the transaction rate but will fail) in a way that made it incompatible with the previous protocol. The “original” Bitcoin was renamed “Bitcoin Cash” and the “new” Bitcoin was named “Bitcoin”. The “disgruntled group” are simply people who disagree with the modification and want to keep using the “original” Bitcoin. I am putting “original” in quotes, because that’s not really the original Bitcoin that Satoshi created. It has already forked 3-4 times in the past, but each it it was in order to fix some problem that everyone agreed was obvious and needed fixing in the hurry; that’s why these old versions aren’t still around.

    2) What many people fail to realize is that Bitcoin’s supposed hard cap of 21 million units is not written in stone. If enough miners (51% in theory, but in practice it would take more than that) decide to raise the cap, they can certainly fork the coin and do so. And why wouldn’t they? Miners get the vast majority of their profit from the mining reward – the profit from the transaction fees is just a few percentage points. As the number of mined Bitcoins approaches the limit, the reward decreases exponentially, halving every few years. As the miners see their profits drop, they will either stop mining, or will do something to ensure that they keep running a profit – like, increase the cap, increase the reward, or whatever. If the currency is still in use and has any price by then, of course.

    3) Somebody asked what will make me admit that I’m wrong on Bitcoin. Nothing, because I am right. It doesn’t matter what its speculative price is. The only thing that would make me take a crypto currency seriously, is if I see an economy behind it. None of the existing ones is that. They are all nothing more than value transfer protocols (although Ethereum has some interesting additional properties). They are used to transfer value from one point to another. At these points they are converted back to Actual Money – i.e., fiat currency. Sever the link to Actual Money (e.g., close down the exchanges) and Bitcoin will collapse under its own weight. Nobody produces goods in exchange of Bitcoin, and nobody buys things with Bitcoin. Yes, I said nobody. Those who claim to “accept Bitcoin” actually immediately sell it for Actual Money. It is just used to transfer value in those cases when using Actual Money is more inconvenient, dangerous, or illegal – like buying drugs, evading taxes and capital controls, paying ransoms, and so on. A real currency needs a real economy behind it and it must not depend on the ability to exchange it for another currency. Oh, yes, and it needs to handle hundreds of thousands of transactions per second, instead of 3-4, like Bitcoin does. And, ideally, it doesn’t need to waste the electrical output of Ireland, in order to achieve that. As it currently is, even a single supermarket chain won’t be able to operate based on Bitcoin, let alone whole countries. It would be nice if the currency were as anonymous as cash too, of course – which Bitcoin most definitely isn’t. (There are other crypto currencies that are – Monero, ZCash – but they aren’t that popular.)

  • numeflua:

    There is a simple reason why altcoins are not inflationary: in inflation, you lose your fractional ownership of that asset. When dollars are printed, your own dollars are now part of a larger supply and so you own a smaller percentage of the total number of dollars.

    When a coin forks, you still own the same fractional percentage of each post-fork coin’s total supply.

    • VB:

      Nonsense. The proper definition of inflation is the increase of the money supply. The supply of Bitcoins (although theoretically capped at 21 million) still increases (due to mining) at a rate higher than many stable mainstream currencies. So, even if we don’t consider the inflation caused by hundreds of other copycat crypto currencies, Bitcoin itself still inflates rather fast.

  • numeflua:

    Question for Keith and other Bitcoin skeptics:

    At what point will you admit that your views are wrong? What needs to happen. Bitcoin has a $70 billion “market cap”. If that grows to $500 billion, will you admit you were wrong? Or will that simply be evidence that a bubble’s irrationality knows no bounds. How about $1 trillion (making it 1/7th of gold’s value)? What if it exceeds gold’s value?

    The Tulip Bubble lasted what… 3 years max? NASDAQ bubble lasted from 98-00 – 3 years max. Maybe 4 if you really stretch the definition. The last gold bubble nuttiness lasted a couple of years.

    What if Bitcoin still has at least $70 billion valuation 5 years from now? It’s already been around for 8 years.

    What price, what time frame, what events would cause you to say, “I was wrong. This is something new to the world I didn’t see coming”?

  • No6:

    ‘They’ are not coins
    ‘They’ are not currency
    And ‘they’ most definitely are not money

    What we do have is another internet speculative bubble.

  • jks:

    Keith worries that all the alt-coins are inflationary. They aren’t because the vast majority of them will never get traction as money. A few of them may get traction as money and that’s good because we all like choice, but it’s still not inflationary. To acquire one coin, you must trade another for it. The purchasing power of the money you gave up decreased by the same amount the purchasing power of the coin you acquired gained. That’s not inflationary.

    Keith worries that the bitcoin fork was inflationary. I believe that it was inflationary. When a stock splits 2 for 1 that’s inflationary. The value of your stock suddenly decreased by half. Do you care? No. Because you now have twice as much stock. A similar thing has occurred with the Bitcoin fork. The analogy breaks down because with the Bitcoin fork you have a new and different currency with unknown value, Bitcoin Cash. There are a number of scenarios that can happen, BTC Cash can go to zero and never gain any traction as money. Or everybody could dump their BTC and jump to BTC Cash in which case BTC would go to zero. Finally, both currencies could get traction as money and both have value. In any scenario, is the holder of BTC hurt? Not from an inflationary standpoint. From a mining standpoint, yes. Hashing power was taken away from BTC to support BTC Cash. In any case, if the users of Bitcoin become unhappy with the way their money is managed, they can vote with their feet and move to a competing money that’s better managed.

    Keith, and a number of others, contend that cryptocurrencies have no intrinsic value; no “bid”. Not true. Databases have intrinsic value. Just ask Oracle. Possession of bitcoin represents permission to write to the Bitcoin blockchain database.

    • VB:

      Nothing has intrinsic value – not bitcoins, not dollars, not gold. Value is not a property that can be intrinsic to objects. Value is subjective; it is in the eye of the beholder.

      Obviously, a large number of morons at the moment think that bitcoins are valuable. The rest of us disagree. Time will show whose reasoning was more correct.

  • Treepower:

    Two questions:

    In what way is the supply of cryptos constrained by blockchain if the number of crypto mines is effectively limitless?

    Could the proliferation of cryptos and their increasingly mainstream acceptance be construed as the initial stages of repudiation of the global fiat scrip?

    • sufganiyah:

      Not sure what you are trying to say, but the number of miners doesn’t affect the supply of new bitcoins.

      • Treepower:

        Not miners, mines. First Bitcoin, then Ethereum, now Bitcoin Cash + 1000 new cryptos and counting. What does it matter that each one is limited in supply when the total supply of cryptos clearly is not? Just open another mine, and another.

        • sufganiyah:

          Nobody cares about most of the other “mines”.

          Ethereum is different though. I suggest that you read up on it, because it’s a lot more than a cryptocurrency. I can guarantee you that it has a great future ahead.

        • jks:

          Imagine a world with only 1 currency. There are 21 million units of this currency for all the people to use to buy all the things. Suddenly, someone offers another currency also with 21 million units. Nobody wants to use the new currency. Is that inflationary? No.

          What if everyone wants to use the new currency and no longer wants the old currency. They use their old currency to buy units of the new currency till the old currency becomes worthless. Is that inflationary? No.

          What if people want to use both currencies. They spend half their money to buy the new currency. Is that inflationary? No. They now have the same total number of units with the same buying power.

          In each case, people have to spend their old currency to buy the new. The buying power of the old currency decreases by the same amount the new currency increases. There’s no inflation in any scenario.

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