Abstract: We look at the events surrounding the bitcoin price rally in June 2011 to $32 and the following temporary flash crash down to $0.01, on the MtGox exchange. We look at the incompetence of MtGox and examine the causes of the crash. We then look at the political battle and uncertainty which occurred in the aftermath of the crash.

Bitcoin price from May 2011 to 18 June 2011

(Source: YouTube, MtGox, BitMEX Research)

Overview

If one likes price volatility and scandals, the summer of 2011 was an exciting time for Bitcoin. Over the course of a few days, bitcoin plummeted in value from a peak of $32 to just $0.01 on the MtGox exchange, a trading platform based in Tokyo, which was dominant at the time. This was after a recent rally, with bitcoin trading at around $2 a couple of months earlier. The crash down to $0.01 is now a famous part of Bitcoin history.

In this piece, we look at the cause of the crash and its aftermath. Although the major exchange of the time, MtGox, was shown to the community to be largely negligent, which may not have been the best advertisement for Bitcoin. In our view the engaging nature of the events which occurred that summer, ironically made a significant contribution to the level of interest in the space.

MtGox security issues & the context of the event

There was significant uncertainty surrounding the hack at MtGox which caused the June 2011 price crash and the issues surrounding it were never fully explained. The Bitcoin community was riddled with rumours about whether MtGox was solvent and how much bitcoin was stolen.

Thanks to a report published in 2017 by Kim Nilsson, we now have a relatively strong understanding of what occurred in 2011 and the damage that this caused to MtGox.  Ironically, despite the huge impact on the market and the company’s reputation, in terms of MtGox’s solvency, this event was largely insignificant compared to other security incidents. For many however, a new window into MtGox was opened up, which illustrated a severe lack of monitoring systems, governance, controls and security measures.

The  table below lists some of the major security incidents at the MtGox exchange, with the June 2011 hack highlighted in green. This incident may have only directly cost the exchange 2,000 bitcoin, an inconsequential amount, compared to roughally 837,000 bitcoin of total losses.

List of known MtGox losses

(Source: Cracking MtGox, BitMEX Research)

Overview of the events in June 2011

In the weeks leading up to 19 June, many users of MtGox were reporting that their accounts had been hacked. At around the same time a database of MtGox users, including an MD5 hash of their passwords (with an unclear/inconsistent salt policy) was leaked and made available. Many passwords were identified. Some traders used the same credentials at the rival exchange, Tradehill, who also experienced security issues. Despite this, MtGox did not suspend trading, a decision which many traders questioned.

On 19th June 2011 (3am on 20th June Tokyo time), there were large sell orders on the exchange and the price crashed from around $17.50 to $0.01 and trading continued at this level for several minutes before recovering. This lead to a high degree of uncertainty, with some assuming there may be a problem with the Bitcoin network.

It now seems likely that what actually happened was that a hacker may have obtained access to the account of Jed McCaleb, the founder of MtGox who sold the exchange to Mark Karpeles around three months earlier. This account appears to have retained administrative rights to the database and therefore the hacker was able to manipulate account balances and grant themselves a large number of bitcoins on the MtGox system. The hacker is the likely to have begun selling some of these coins.

Due to the poor management of MtGox, in our view it is unlikely that the company were aware of this, even in the aftermath of the hack, and therefore the explanations provided at the time of the events were incomplete or inaccurate.

The withdrawal limits

At the time, MtGox had a daily withdrawal limit of US$1,000, this applied to both bitcoin and USD (via Dwolla). This meant that the hacker (or any others who benefited from the hack by buying bitcoin at low prices), would be unable to benefit by withdrawing the funds, except within the US$1,000 limit. However, the US$1,000 bitcoin limit was based on the market price of bitcoin on the platform and since the price fell to $0.01, in theory the maximum each user could withdraw was 100,000 bitcoin, certainly not a small amount.

Fortunately, however, MtGox appeared to also have a bitcoin based withdrawal limit, that many users were unaware of. As the Mark Karpeles said at the time:

2011-06-20 00:16:43 MagicalTux the btc withdrawal limit saved us

(Source: IRC, Note: MagicalTux is the CEO & owner of MtGox, Mark Karpeles)

Mark then mentioned that only 2,000 bitcoin were withdrawn in the aftermath of the event, which was a relatively positive result for MtGox.

Got about 2,000 BTC out

(Source: IRC)

There was widespread scepticism about this number at the time, with many believing much more was stolen. Ironically, this 2,000 bitcoin figure now seems about right, although MtGox had lost far more in other incidents. However, due to the price crash and suspension of trading, this incident was very public at the time and resulted in the the incompetence of the MtGox platform being exposed to the community.

The rollback debate

Many trades took place at the artificially low price of around $0.01 during the crash. Some traders & investors were unhappy at missing out on the price rally from around $1 to $32, and therefore had buy orders waiting in the system, all the way down the order book to $0.01. To them, this crash is exactly what they were waiting for. To the dismay of many of these traders, in the aftermath of the incident MtGox said they would reverse the trades which occurred during the crash:

The bitcoin will be back to around 17.5$/BTC after we rollback all trades that have happened after the huge Bitcoin sale that happened on June 20th near 3:00am (JST). One account with a lot of coins was compromised and whoever stole it (using a HK based IP to login) first sold all the coins in there, to buy those again just after, and then tried to withdraw the coins. The $1000/day withdraw limit was active for this account and the hacker could only get out with $1000 worth of coins. Apart from this no account was compromised, and nothing was lost. Due to the large impact this had on the Bitcoin market, we will rollback every trade which happened since the big sale, and ensure this account is secure before opening access again.

(Source: MtGox)

After this announcement there was significant debate in the community as to whether the rollback should occur. Obviously many participants in the debate had a financial interest in the outcome and this was no doubt effecting their views. In many ways, there were some parallels between this rollback and the 2016 DAO “rollback” on the Ethereum network, with some similar arguments being made.

The community appeared to be split on this issue, with some even favouring a vote to decide.

The trader who bought 260,000 bitcoins for US$2,622

The day after the incident, a trader called “Kevin”, claims to have purchased around 260,000 bitcoins during the crash and was arguing that he should be able to keep the coins. As he explained:

I had around $3,000 USD in my MtGox account, from earlier sales I’d made. I looked at the market stats, and realized that there were tons of orders to buy BTC at $0.01 that would likely eat up any remaining bitcoins this seller had on the order. I figured if I put a buy order in for $0.0101, my order would execute first and I could buy a huge amount of bitcoins

(Source: Bitcointalk)

Kevin posted what he claimed to be the trade confirmation:

06/19/11 17:51  Bought BTC 259684.77 for 0.0101

Kevin then went on to explain the likely reason behind the price crash, which was that the seller was trying to manipulate the price down so that they could withdraw more coins within the US$1,000 limit. In our view this part of Kevin’s story is likely to be an accurate explanation for the price crash. This logic contradicts the claim from MtGox that the person who conducted the hack was also the buyer of the bitcoin.

I could place a reasonably sized sell order for $0.001, crash the market again, and withdraw probably all of the bitcoins, since they’d be valued at $0.001 each and would fit under the $1,000 USD limit. I also decided against this, when I realized that whoever placed the gigantic sell order was probably doing so for the exact same reason

However, some have doubted the accuracy of Kevin’s story, claiming the volume of trades he claims is not consistent with the MtGox feed. The feed appeared to show trading volume of only 55,000 bitcoins during the crash past $0.0101 and only 238,000 bitcoins traded in the period. Only 3,000 bitcoin seem to have been traded at the $0.0101 price. These figures are lower than those implied by Kevin, although Kevin’s trades could have been excluded from this data for a variety of reasons. The feed was also notoriously unreliable and it was not clear if there was a precise definition of some for the information in the feed. In our view, there is no reason to believe the whole truth of any of the parties involved in this incident, but Kevin’s explanation for the crash itself seems plausible to us.

MtGox price feed during the crash

(Source: BitMEX Research, MtGox. Note: Volume in bitcoin)

The proof of reserves

The MtGox exchange was down for several weeks and many users were becoming anxious about the solvency of the platform. There was uncertainty over the amount of bitcoin which were lost and users were concerned about a run on MtGox, eventually leading to the exchange going into liquidation and users losing funds. In an attempt to reduce some of these concerns, as the chat log and bitcoin transaction show below, MtGox attempted to prove it had access to a significant quantity of bitcoin, by conducting an onchain transaction on 18th July 2011.

IRC Chat log – 18 July 2011

(Source: IRC Logs)

(Source: blockchain.info)

At the time, the above action seemed to settle the nerves of many of the traders.

Conclusion

A few weeks after these events, after many false starts, trading at MtGox eventually resumed and the bulk of the trades were reversed. However, to this day, as far as we are aware, MtGox has not been able to provide a coherent explanation for what occurred. The lack of a consistent narrative from MtGox lead many to believe that MtGox had poor monitoring and controls of its systems and that the company was run negligently. Many concluded “never to trust MtGox again”.

Unfortunately, however, MtGox somehow continued to dominate the exchange ecosystem for another three years. However one views the conduct and transparency of some of the platforms and players in the ecosystem today, we can at least conclude that things have  significantly improved from 2011.

Abstract: Following our earlier research pieces on Tether, financial information from Q1 2018 has been released by the financial regulators in Puerto Rico, providing more evidence of the impact of Tether. In addition to this, a source close to Tether has confirmed to us that the speculation in our initial report is correct.

After our earlier speculation that Noble Bank in Puetro Rico was Tether’s primary reserve bank, a few months later in May 2018 Bloomberg released an article further substantiating our claims. As Bloomberg put it:

According to three people with knowledge of the matter, Noble Bank International, based in San Juan, Puerto Rico, took over banking duties for Bitfinex last year.

In addition to the above, BitMEX Research has also now spoken to people close to Tether, who have also confirmed the reliability of most of the claims in our February 2018 report. Our initial discovery was based on the disclosure of data from the financial regulator in Puerto Rico, who have recently provided the latest update, for the quarter ended March 2018. In our view, the data continues to support our initial speculation.

New Financial Data for Q1 2018

Bank deposits in the International Financial Entities (IFE) category, which includes Noble Bank, were $3.5 billion, up 6.9% in the quarter. Total assets in the category were $4.1 billion, up 7% in the quarter. This moderate growth coincides with a the moderate increase in the volume of crypto-coin trading, which has likely resulted from the continued growth of the Tether balance and crypto-coin ecosystem, moderated by crashing crypto-coin prices in the quarter. In the quarter, the value of Tether in issue increased by 62.7% to $2.3 billion.

We have updated the chart below from the version in our earlier piece, which compares the Tether balance with the deposits in the banking category in Puerto Rico which contains Noble Bank.

Puerto Rico’s IFE aggregate deposits versus the Tether balance in millions of USD. (Source: IFE Accounts, BitMEX Research, Coinmarketcap)

Cash as a percentage of total assets (an indication of full-reserve banking) also increased in the quarter, from 85.8% to 91.0%. This also indicates crypto-coin or Tether-related activity, as we explained in the previous piece.

Puerto Rico’s IFE aggregate cash balance as a percentage of total assets. (Source: IFE Accounts, BitMEX Research)

In the quarter the regulator appears to have changed the name of the Tether balance, to “Deposits, money market investments and other interest-bearing balances” from “Cash in banks“. We do not view this as suspicious.

Abstract: In this piece we look over the history of distributed stablecoins, focusing on two case studies, BitShares (BitUSD) and MakerDAO (Dai). We examine the efficacy of various design choices, such as the inclusion of price oracles and pooled collateral. We conclude that while a successful stablecoin is likely to represent the holy grail of financial technology, none of the systems we have examined so far appear robust enough to scale in a meaningful way. The coins we have looked at seem to rely on “why would it trade at any other price?” type logic, to enforce price stability to some extent, although dependence on this reasoning is decreasing as technology improves.

Overview

Distributed stablecoins aim to achieve both the characteristics of crypto-coins like Bitcoin (censorship resistant digital transactions) and the price stability of traditional financial assets, such as the US Dollar or gold. These systems are distinct from tokens such as Tether, where one entity controls a pool of US Dollar collateral, ultimately making the system centralised and thus susceptible to being shut down by the authorities.

Along with the somewhat related idea of distributed exchanges, distributed stablecoins have been referred to as the “holy grail” of financial technology, due to their very strong potential benefits. In our view the transformative nature of such a technology on society would be immense, perhaps far more significant than Bitcoin or Ethereum tokens with their floating exchange rates. Distributed stablecoins could have the advantages of Bitcoin (censorship resistance combined with the ability to transact electronically), without the difficulties of a volatile exchange rate and the challenge of encouraging users and merchants to adopt a new unknown token. Such a system is likely to be very successful and therefore it is no surprise that so many people have attempted to launch such projects:

List of stablecoin projects

The technical challenges involved in creating such systems are often underestimated. Indeed constructing a distributed stablecoin system, which is robust enough to withstand cycles or the turbulence and volatility linked to financial markets may be almost impossible. For instance perhaps most forms of fiat money, even the US Dollar itself, have not even achieved that, with credit cycles putting US Dollar bank deposits at risk. A stablecoin system which builds on top of the US Dollar is therefore never going to be more reliable than traditional banking, in our view.

In economics there is a concept of money supply, with risk and the potential inflationary impact increasing as the number of layers increase. One could add this stablecoin systems on top, as a new high risk layer:

• M0 – Notes & coins plus deposits at the central banks
• M1 – Money on deposit in a bank current account (including M0)
• M2 – Money on deposit in a bank savings account (including M1)
• M3 – Money in a money market account (including M2)
• MZM – Money in all financial assets redeemable on demand (including M3)
• MSC (Synthetic Crypto Money) – Money inside synthetic crypto stablecoin systems  (including MZM)

However advanced or sophisticated the distributed stablecoin technology is, we believe the token is likely to be less robust than the layers above it in the money supply tree.

In this piece we review some of the most prominent and interesting attempts at building these synthetic US Dollar type systems. BitUSD in 2014 and then a more recent project, MakerDAO (Dai).

Case study 1: BitShares (BitUSD) – 2014

The first stable coin we will discuss is BitUSD, a stablecoin on the BitShares platform. BitShares was a delegated proof of stake (DPOS) platform launched in 2014 by:

• Daniel Larimer (The primary architect behind EOS and Steem),
• Charles Hoskinson (the former Ethereum Foundation CEO & Cardano architect), and
• Stan Larimer (Daniel’s father).

BitShares is just one in a long line of decentralised autonomous corporation (DAC) type platforms released by Daniel Larimer, as the below image shows:

(Note: Daniel Larmier’s company Invictus Innovations launched a number of token/DAC platforms including Protoshares, Angelshares and BitShares. The black arrows represent Protoshares coin holders being granted tokens in the new chains, which Invictus Innovations promised to deliver on all new DAC platforms. Source: BitSharestalk)

BitUSD Marketing material

(Source: Introduction to BitShares Youtube video)

BitUSD System dynamics

Weaknesses

Exposure to a fall in the value of collateral – BitShares was a new, untested and low value asset, and therefore its value was volatile. If the value of the token falls by 50% sharply, in a period spanned by one of the loans used to create BitUSD, there may be insufficient collateral and the peg could fail.

Lack of a price oracle – In our view one of the most controversial aspects of this design is the absence of any price oracle mechanism, providing the system with real world exchange rates. However any price oracle system is challenging to implement and may introduce several weaknesses and avenues for manipulation. We will talk more about this in part 2. In our view, the only real way around this may be that any stablecoin system may require a price feed from a distributed exchange, which can in theory publish a distributed price feed from real world US Dollar transactions. The distributed exchange in BitShares did not allow “real USD”. A distributed exchange system like Bisq, without a central clearing could in theory allow “real USD” prices and provide a distributed price feed.   Therefore stablecoins may eventually be considered as a layer two technology on top of liquid and robust distributed exchange platforms, should these systems ever emerge.

Manipulation – Trading volume in the Bitshares vs BitUSD market on the distributed exchange platform was low, it was therefore possible for block producers to manipulate the market by causing the value of Bitshares to fall relative to BitUSD, enabling them to obtain Bitshares at a discount.

Lack of any price stability mechanism – The main weakness of the system is the lack of any mechanism to move the price towards $1, other than the “where else would it trade?” logic.

Daniel Larimer’s defence of the system

In Daniel’s view, the mechanism of BitUSD creation is analogous to how USD are created in the economy, in that financial institutions lend them into existence.

It’s the same way dollars are created in the regular banking system. Dollars are learnt into existence backed by collateral, in the case of the current banking system the collateral is your house. In the case of our system its shares in the DAC itself.

(Source: Lets talk Bitcoin episode 129)

In a way Daniel is correct here, however as we explained in the introduction to this piece, these synthetic dollars are far less reliable than those created by more traditional banks, and can be considered as a whole new layer of risk, as they are even further away from base money. In addition to this, when obtaining a bank loan, the bank typically has a legal obligation to provide the customer physical cash should they demand it. While such an outcome for BitUSD holder is possible, its not a legal obligation for the creators of BitUSD. Although obviously banks typically do not have the cash in reserve to pay back their deposits, we think the fact they have a legal obligation to do so is an important distinction to draw when comparing BitUSD to US Dollar banking deposits.

In response to the supposed weakness of a lack of a price peg, Larimer argues in favor of his “hypothesis that the price feed is unnecessary” as follows:

It implements automatic margin calls, such that if the price moves against someone who is effectively short, it forces them to cover and buy it back in the market and that creates a peg. The market peg works on the premise that all market participants buy and sell based on what they think market participants will be buying and selling in the future. The only rational choice is to assume that it’s going to trade based on the peg in the future. If you don’t believe that they you have to decide on which way it’s going to go, up or down. And if you don’t have a way of saying you abstain from the market. If you don’t think it works you sell the shares and get out, as the systems going to fail in the first place. So its a self reinforcing market peg, that causes the asset to always have the purchasing power of the dollar.

(Source: Lets talk Bitcoin episode 129)

In our view this idea that a price of $1 is the “only rational choice” is a weak argument. It is basically saying that if the price is not $1, then what will it be? This logic may hold true for some periods, but it is not sustainable and will not scale, in our view.

Conclusion

The volume of BitUSD in existence was a lot lower than many had hoped, in some periods there was only around $40,000 in issuance. At the same time liquidity was very low and the price stability was weak, as the below chart illustrates. The main architect of BitUSD went on to propose a new stablecoin SteemUSD in 2017, this time including a price feed system. Therefore we consider BitUSD as an interesting early experiment, it did not achieve what was hoped nor did it build a robust stablecoin.

(Source: Coinmarketcap)

Case Study 2: MakerDAO (Dai) – 2017

The next stablecoin we look at is Dai, which exists on the Ethereum platform. This system is highly complex, with four relevant pools of funds and six possible stability mechanisms. There are currently around $50 million worth of Dai in issuance and the peg seems to be holding up reasonably well.

System dynamics

Analysis of the core stability mechanism – Dai redemption

The primary stability mechanisms appear to be the ability of CDP owners to redeem if the price of Dai is too low and for people to create new Dai if the price is too high. For example if the price of Dai falls to 80 cent, CDP owners could purchase Dai in the market and redeem it, unlocking $1 worth of Ethereum and making a nice profit. This is how the system should work under normal circumstances.

The above appears to be a robust stability mechanism which should keep the price of Dai at or near $1. However, the theory may only work if CDP owners expect the price of Dai to correct back to $1. If the price of Dai has fallen to 80 cent, CDP owners may be reluctant to redeem if they expect the Dai price to fall further to 60 cent, as such a price would enable them to make even more profit. There is no guarantee that once the price reaches 80 cent, it won’t continue to fall.

Therefore the stability mechanism could depend somewhat on the power dynamics between two groups, Dai owners and CDP owners. These two groups are essentially trading against each other in the market, Dai owners are selling of Dai and CDP owners are the potential buyers. If the power balance shifts towards CDP owners, such that they are well capitalised, patient, collaborative and determined, this group could outmaneuver the Dai token holders, drive the price down, and then buy it back and make a large profit. This may seem unlikely, but in our view the stability mechanism may not work in all market scenarios. Although we consider Dai as superior to BitUSD, in some limited ways, the Dai peg relies on market psychology and investor expectations, in the same way as BitUSD. Therefore the Dai peg is also weak and unlikely to scale.

The global settlement system can mitigate the above risk. If CDP owners are successfully manipulating the price of Dai down too far, this could trigger global settlement. Dai holders would then get around $1 of Ethereum back. Therefore the threat of global settlement may keep the price of Dai up. However again the effectiveness of this threat depends on the determination of the various groups, the CDP owners, MakerDAO token holders and global settlement activators.

Conclusion

We consider Dai to be one of the most sophisticated and advanced stablecoins systems which has been produced so far. In our view, when digging into Dai’s stability mechanisms, there is no one powerful mechanism which ensures stability. Instead we have a complex network of systems, which to some extent reference each other and use circular logic.  One could claim this complexity was created to obfuscate the lack of a strong and clear stability mechanism, but it is more likely to be an indication of an experimental trial and error type approach to the design of the system.

Therefore the system is still reliant on investor expectations and psychology, although to a lesser extent than the BitUSD. While the stability systems in place could work, at least for a while, we think they are not robust enough to withstand market turmoil or some types of power imbalances between Dai holders and CDP owners. Therefore, the search for the holy grail continues.

Abstract

This report is the third in a three part piece on Bitcoin economics. In the first piece, we looked at common misconceptions with respect to how banks make loans and the implications this has on the ability of banks to expand the level of credit in the economy. We analysed the inherent properties of money which ensure that this is the case and evaluate the impact this could have on the business cycle. In part two, we considered why Bitcoin might have some unique combinations of characteristics, compared to traditional forms of money.  We explained the implications this could have on the ability of banks to engage in credit expansion. In this piece (part three), we examine the deflationary nature of Bitcoin and consider why this deflation may be necessary due to some of Bitcoin’s weaknesses. We also look at how Bitcoin could be more resilient to some of the traditional economic disadvantages of deflation than some of Bitcoin’s critics may think.

Click here to download the pdf version of this report

Bitcoin’s deflation problem

One of the most common critiques of Bitcoin and related crypto-coin systems, is the supply cap (in the case of Bitcoin 21 million) and the associated deflationary nature of the system, which could be damaging to the economy. Critics have argued that history has taught us that a finite monetary supply can be a poor economic policy, resulting in or exacerbating, economic crashes. Either because people are unwilling to spend appreciating money or because the real value of debt increases, resulting in a highly indebted economy. Bitcoin proponents are often called “economically naive”, for failing to have learnt these economic lessons of the past.

In this third piece on Bitcoin economics, we explain that the situation may be more complex than these critics think, as Bitcoin is fundamentally different to the types of money that came before it. There may be unique characteristics about Bitcoin, which make it more suited to a deflationary policy. Alternatively, limitations or weaknesses in Bitcoin could exist, which mean that too much inflation could have negative consequences not applicable to traditional forms of money. In our view, these issues are often overlooked by some of Bitcoin’s economic critics.

A selection of quotes about Bitcoin’s inflation problem

The supply of central bank notes can easily expand and contract. For  a  positive  demand  shock  to  bank  notes  (shifting  from  consumption/investment  to money: i.e. it is a  deflationary  shock),  the  central  bank increases money  supply  by  buying  securities and  foreign  currencies.    For  a  negative  demand  shock  to  bank  notes,  the  central  bank absorbs money in circulation by selling securities and other assets.  In case of [Bitcoin], the latter operation is not included in its protocol. That is  to  say,  the  cryptocurrency  protocol  usually  includes  the  currency  supply  rule,  but  does  not  have  a  currency  absorption  or  write-off  protocol. Can we reduce this irreversibility?

– Mitsuru Iwamura (“Can We Stabilize the Price of a Cryptocurrency?: Understanding the Design of Bitcoin and Its Potential to Compete with Central Bank Money”) – 2014

The point is that by not building in an inflation, of say 2% per annum in the global supply of Bitcoins, you almost doom it as a currency, because people will start hoarding it, knowing that it’s going to be worth more next year than it is this year

 –  David Webb (51 minutes into the video) – 2014

More broadly, a hard supply cap or built-in deflation is not an inherent strength for a would-be money. A money’s strength is in its ability to meet society’s needs. From my perspective, Bitcoin’s built-in deflation means that it does a poorer job than it might at meeting society’s needs. Maybe I will be proven wrong. We shall see.

 –  The Economist (“Bitcoin’s Deflation Problem”) – 2014

The currency’s “money supply” will eventually be capped at 21m units. To Bitcoin’s libertarian disciples, that is a neat way to preclude the inflationary central-bank meddling to which most currencies are prone. Yet modern central banks favour low but positive inflation for good reason. In the real world wages are “sticky”: firms find it difficult to cut their employees’ pay. A modicum of inflation greases the system by, in effect, cutting the wages of workers whose pay cheques fail to keep pace with inflation. If the money supply grows too slowly, then prices fall and workers with sticky wages become more costly. Unemployment tends to rise as a result. If employed workers hoard cash in expectation of further price reductions, the downturn gathers momentum.

 – The Economist (“Money from Nothing”) – 2014

Our current global system is pretty crap, but I submit that Bitcoin is worst.  For starters, BtC is inherently deflationary. There is an upper limit on the number of bitcoins that can ever be created (‘mined’, in the jargon: new bitcoins are created by carrying out mathematical operations which become progressively harder as the bitcoin space is explored—like calculating ever-larger prime numbers, they get further apart). This means the cost of generating new Bitcoins rises over time, so that the value of Bitcoins rise relative to the available goods and services in the market. Less money chasing stuff; less cash for everybody to spend (as the supply of stuff out-grows the supply of money).

 –  Charlie Stross (“Why I want Bitcoin to die in a fire”) – 2013

Nevertheless, there is still the 21m limit issue. If the limit is reached, the future of Bitcoin supply has to go down the path of fractional reserve banking, since only re-lending existing coin, or lending on the basis that settlement can one day be made in Bitcoin — a la conventional banking practice — can overcome the lack of supply

 – Izabella Kaminska – Financial Times (“The problem with Bitcoin”) – 2013

 

So to the extent that the experiment [Bitcoin] tells us anything about monetary regimes, it reinforces the case against anything like a new gold standard – because it shows just how vulnerable such a standard would be to money-hoarding, deflation, and depression.

–  Paul Krugman (“Golden Cyberfetters”) – 2011

While Bitcoin has managed to bootstrap itself on a limited scale, it lacks any mechanism for dealing with fluctuations in demand. Increasing demand for Bitcoin will cause prices in terms of Bitcoin to drop (deflation), while decreasing demand will cause them to rise (inflation). What happens in each of these cases? Let’s start with deflation, because right now demand for Bitcoin is on the rise. What do people do when they think something’s value will be higher tomorrow than it is today? Well, they acquire and hold on to it! Who wants to give up money that’s constantly rising in value? In other words, rising demand causes demand to rise further. Irrational exuberance at its finest. Deflation begets deflation, ad infinitum, or at least until something breaks.

– The Underground Economist (“Why Bitcoin can’t be a currency”) – 2010

Deflation and the deflationary debt spiral

Many economists have been debating the advantages and disadvantages of inflation for decades. Nevertheless, this primary point of contention is one of theory; economists, from differing schools of thought have a variety of views on the topic.  It is fair to say that the current economic consensus is that deflation is an undesirable economic phenomenon, while moderate inflation of around 2% per annum is desired. Those with Austrian school leanings, who oppose centrally managing inflation towards a certain positive target, tend disproportionality to support Bitcoin and gold’s somewhat deflationary nature.

One of the primary drivers for the negative view on deflation appears to be the 1929 great depression and the idea of a deflationary debt spiral. The theory is that during a period of economic recession and deflation, the real value of debt increases. Such an increase compounds the misfortunes of an already weak economy. Economist Irving Fisher is often credited with formulating this theory, as a response the financial crises of 1837, 1873 and the 1929 great depression.

Then we may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress setting and to
2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes
3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be
4. A still greater fall in the net worths of business, precipitating bankruptcies and
5. A like fall in profits, which in a “capitalistic,” that is, a private-profit society, leads the concerns which are running at a loss to make
6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies, and unemployment, lead to
7. Pessimism and loss of confidence, which in turn lead to
8. Hoarding and slowing down still more the velocity of circulation. The above eight changes cause
9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way

 – Irving Fisher (1933)

Is deflation as bad as these critics claim?

To the extent that critics accuse Bitcoin supporters of being economically naive, they may not always be entirely correct or they could be missing some nuances. Firstly, one does not need to be an Austrian economist to question whether deflation (supply cap) is always undesirable. Deflation could be bad in some circumstances, but it may depend on the characteristics of the economy and the type of money used in society. The social sciences are not like maths or computer science, nobody really knows the right answer to a high degree of certainty and opinions in the academic community change over time. Furthermore, economic circumstances can change over time, which can result in a different set of dynamics, where different inflation policies are optimal. Therefore a hard rule, fixed for all time, such as “deflation is always bad”, may not be the correct philosophy. For example, maybe Fisher’s view on inflation was correct for the economy in the 20^th century, however by 2150 technology may have fundamentally changed to such an extent, such that another inflation policy may be more appropriate for society.

Bitcoin has different characteristics and the deflationary debt spiral argument may be less relevant

As we explained in part 1 and part 2 of this piece, Bitcoin possesses properties which are fundamentally different to the traditional money used in the economy such as the US Dollar or gold backed systems. Traditional money, such as the US Dollar are based on debt, which is an inherent property of fiat money. Alternatively Bitcoin may have properties which make it resilient to credit expansionary forces, such that the money is not inherently linked to debt. Therefore in the event of an economic crash and deflation, in a Bitcoin based economy, the impact of increases in the real value of debt could be less significant than one may think. This could make the deflationary debt spiral argument less relevant in a Bitcoin based economy.  In our view, it is likely that many of the Bitcoin critics may have overlooked this point when evaluating the disadvantages of Bitcoin’s deflationary monetary policy.

Disadvantages of inflation unique to Bitcoin

In addition to Bitcoin having some potential advantages, which could make it more resilient to the disadvantages of deflation, Bitcoin’s critics may also have overlooked some of Bitcoin’s weaknesses, which may make it more vulnerable to inflation:

• Arbitrary environmental damage – Another common criticism of Bitcoin is the environmental damage caused by the energy intensive mining process. Although as we explained in the second part in our series on mining incentives, this issue could be overestimated since miners have a uniquely high level of choice with respect to the geographic location of their mining operations. This flexibility could reduce environmental damage as miners may use failed energy projects rather than investing in new ones.  However, it is still important to note that, the negative environmental damage caused by Bitcoin does seem to be a significant negative externality.  Mining incentives are made up of transaction fees and the block reward (inflation). Therefore increasing inflation increases the level of environmental damage and increases the negative externality. If a 2% inflation policy is decided upon, this could mean at least 2% of the value of the system is spent “damaging” the environment per annum. The inflation policy decision is somewhat arbitrary and the more inflation is selected the greater the extent of environmental damage. There may even be parallels here with the existing financial system. The policy of central banks to stimulate the economy, to achieve their inflation targets, could also be said to cause an arbitrarily high level of environmental damage, at least in the eyes of some critics. Although the link between inflation and environmental damage in a Bitcoin based system is more direct and measurable.  Instead of continued inflation, in Bitcoin the block reward halves every four years until mining incentives are driven entirely by transaction fees. This means that the level of environmental damage will be driven by the market, in that it could represent the amount that users are willing to pay for security, rather than an arbitrarily high level of environmental damage which would be the result of an inflationary monetary policy.
• Aligning the interests of miners and users – Miners are currently primarily incentivised by the block reward rather than transaction fees. This results in a number of potential problems in the ecosystem, for example perhaps the interests of miners and users are not well aligned. Miners could, for example, exclude transactions from blocks, against the interests of users. Miners may be less likely to take this kind of action if they are primarily incentivised by transaction fees, something Bitcoin’s deflationary policy ensures will eventually become reality.
• Inability to generate coin value – The supply cap can be considered as a key selling point of Bitcoin for investors and is likely to have helped generate investor interest which may have been necessary to bootstrap the system. If a perpetual inflationary policy was chosen, Bitcoin may not have been able to succeed to the extent it has, even if the deflationary policy is inferior from an economic perspective.

The irony of this debate – economic criticisms are only relevant if Bitcoin is a tremendous success

Much of this discussion focuses on the economics of Bitcoin, assuming Bitcoin is widely adopted, such that the inflationary dynamics have an impact on society. In our view this is an unlikely outcome and perhaps should be considered even more unlikely by Bitcoin’s critics. In our view, Bitcoin may satisfy a useful niche, that of making both censorship resistant and digital payments, but it’s unlikely to become the main currency in the economy. Therefore the debate about Bitcoin’s deflationary nature should be considered as largely irrelevant anyway. Hence it is therefore somewhat odd that some critics use this as an argument against Bitcoin.

This point is similar to one Paul Krugman made in his 2013 “Bitcoin is Evil” piece. Although Mr Krugman is widely derided in the Bitcoin community, most notably for his 1998 comment that “by 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s”, we consider the distinction he draws in the quote below as both accurate and sensible:

So let’s talk both about whether BitCoin is a bubble and whether it’s a good thing — in part to make sure that we don’t confuse these questions with each other.

– Paul Krugman – “Bitcoin is Evil” – 2013

Perhaps Satoshi thought that having a finite supply cap and a deflationary bias, may help the system succeed, even if from society’s point of view, moderate inflation would be more utilitarian. From a system design perspective, producing a working payment system should be the priority, since a system which does not succeed, even if it’s hypothetically beneficial to society, is ultimately useless.

Conclusion

We conclude that rather than being driven by economic naivety, some Bitcoin supporters may have had a more nuanced understanding of the relationship between debt, deflation, the properties of money and credit expansion than the critics think. In contrast one could argue it’s the economic mainstream’s lack of understanding of the relationship between money and debt, and the potential ability of Bitcoin to somewhat decouple the two, which is the most prevalent misunderstanding. Indeed to many, Bitcoin’s ability to decouple debt from money and thereby result in a deflationary climate without the deflationary debt spiral problem is the point, rather than a bug.

However, even if Bitcoin has solved this economic problem, perhaps it’s naive to think Bitcoin would result in a more prosperous economic system. Bitcoin is a new and unique system, which is likely to cause more economic problems, perhaps unexpected or new ones. After all there is no perfect money. It just may not be correct to apply the traditional economic problems of the past, to this new type of money. Although it may be more difficult, identifying Bitcoin’s potential economic problems may require more analysis and a stronger understanding of the underlying technology.

Ironically, if one thinks these economic problems associated with deflation have a remote chance of being relevant, like the critics indirectly imply, that would mean Bitcoin has a significant chance of becoming widely adopted and hugely successful. In that case, perhaps the sensible thing to do is buy and “HODL”.

Abstract: Although in 2018 Bitcoin may have somewhat moved on beyond this issue, in this sixth piece on consensus forks and chainsplits, we provide a list of 44 tokens which seem to have forked away from Bitcoin since the Bitcoin Cash split.

(Source: gryb25)

From late 2015 to the end of 2017, there was significant focus and analysis in the Bitcoin community about a chainsplits, finally resulting in the launch of Bitcoin Cash and then a plethora of other tokens. We have already covered some of topics related to these splits, in the five articles below:

• Bitcoin Cash: Potential Price Implications of Investment Flow Data
• The SegWit2x (B2X) Hardfork – Protecting Yourself and Your Coins, Part 1: Coin Splitting
• The SegWit2x (B2X) Hardfork – Protecting Yourself and Your Coins, Part 2: Investment Strategies
• The Bitfinex chain split tokens
• A complete history of Bitcoin’s consensus forks

In this sixth piece we list 44 Bitcoin forked tokens.

List of Bitcoin forked coins since Bitcoin Cash

(Source: BitMEX Research, Forked coin websites, findmycoins.ninja)

Please note it is very important to handle these new fork tokens with caution. In particular, we would strongly advise you not to import your Bitcoin private key into any new fork token wallets without first spending the Bitcoin to a new output associated with a different private key after the token snapshot point, so that your Bitcoin is not at risk.

Abstract

We look at Bitmain’s new Ethereum miner and notice that it may be less energy efficient than one might expect for an ASIC. We explore the possibility that this miner contains a new more advanced form of technology, which is less efficient than ASICs, but potentially partially immune to PoW algorithm changes. We then conclude that whether this particular Ethereum chip is capable of this or not, this type of technology may eventually end the era of anti-ASIC PoW changes designed to improve decentralisation, such that crypto-coin communities may have to accept the inevitability of ASICs.

Overview

Bitmain have recently launched a new Ethereum miner, widely believed to be an ASIC, and it is expected to ship in late July 2018. However, many in the Ethereum community oppose ASICs and prefer GPU mining, since GPU companies are primarily concerned with gaming rather than crypto-coins, which should mean that the hardware is distributed more widely and fairly, improving decentralisation. Therefore a risk to Bitmain could be that the Ethereum community decide to hardfork to change the PoW algorithm, which could devalue the Bitmain machines and result in a large wasted investment.

In this report, we speculate that Bitmain may already be one step ahead of the Ethereum community. Bitmain may have already learnt a lesson with Monero, two coins which recently conducted PoW changes, potentially resulting in large devaluations of Bitmain’s ASIC chips. Developing a custom chip requires a considerable financial investment and therefore we think Bitmain may have taken some countermeasures to avoid another loss. Bitmain could have designed a new type of mining chip, less efficient that ASICs, but immune to PoW changes. This could make an Ethereum hardfork PoW change mostly pointless.

The recent Monero anti-ASIC PoW change

At the start of April 2018 the Monero community decided to hardfork and change the PoW algorithm, in an attempt to “brick” ASICs and make Monero more GPU-friendly. Due to sharp increases in hashrate, illustrated by Figure 1 and 2 below, the Monero community believed that ASIC manufacturers had developed Monero ASICs, in secret, and were mining the coin.

As Figure 2 shows below, the rolling 90-day hashrate growth rate reached c. 300% in the early part of 2018 (based on 7-day rolling averages). Even after factoring in the sharp increase in value of the Monero coin, this is an extraordinary growth rate. After Monero developers announced plans for a hardfork, Bitmain began to sell Monero ASICs on their website, indicating that they could indeed have been mining in secret. After the PoW change, as Figure 1 shows, the Monero hashrate dropped off significantly.

After the hardfork, the Monero chain split into two, with the original rules coin being called Monero Original (XMO). Although this coin had a lower value than Monero, it had a higher hashrate, since there was little else for the Monero ASICs to mine. There was no replay protection implemented for the split, however Monero increased the ring signature limit, therefore one can split Monero and Monero Original by first initiating a transaction on the Monero Original chain with fewer ring signatures than are allowed on Monero (less than 7).

Figure 1 – Monero hashrate compared to Monero price

Source: Coinmarketcap, BitMEX Research

Figure 2 – Monero hashrate compared to Monero price – Rolling 90-day percentage growth of 7-day moving average

Source: Coinmarketcap, BitMEX Research

Note: In the 7 days following the PoW hardfork, the hashrate rolling average excludes the period prior to the hardfork

Bitmain’s new Ethash miner

As we mentioned above, Bitmain has recently launched a new Ethereum miner, which is expected to ship around late July 2018. Given the history with Monero and the fact that many in the Ethereum community, including those mining Ethereum at home on GPUs, are likely to be unhappy at a new Bitmain product, Bitmain may be concerned. One downside to the new miner could be increased miner centralization, but in addition to this, the product may also receive hostility from some in the Ethereum community due to their financial interests in the existing Ethereum miners, GPUs. Bitmain’s management is not stupid, and therefore in our view the company is likely to act with caution and may have taken measures to mitigate against some of these risks.

Figure 3 – Bitmain’s new Ethereum miner: the Antminer E3

Specifications:

• Power consumption: 800W
• Hashrate: 180MH/s

Source: Bitmain

The advertised specification of the product is disclosed above. As the table below illustrates, a back -of-the-envelope calculation could imply this new Ethereum miner is less efficient than one would expect if it was an ASIC, based on comparisons with the efficiency gain measured on some of the other ASICs related to other coins. For instance a Bitcoin ASIC is c. 521x more efficient than an FPGA, while the Monero ASIC is c. 88x more efficient than a GPU. In contrast the new Ethereum miner is only c. 1.4x more efficient than a GPU. This could indicate that the new Ethereum miner is not an ASIC at all, but merely a new device more efficient than the existing GPU miners. However, we appreciate that the below table is a crude approximation which ignores many crucial variables and factors, such as the memory-intensive nature of the Ethereum mining algorithm. But although the calculation is inaccurate, the figures can still potentially illustrate a point:

Figure 4 – Approximate miner efficiency calculations

Source: BitMEX Research, Bitmain
Note: Figures are approximations

Mining chip types & Vector processors (VPs)

As Figure 5 below illustrates, when Bitcoin launched in 2009, mining was conducted using CPUs. However, the architectures of GPUs and FPGAs are more efficient at processing repetitive hash operations. Therefore the network shifted, first to GPUs and then to FGPAs. In 2013, ASICs designed for specific hash functions emerged. Compared to CPUs, GPUs and FPGAs, ASICs are far more efficient at running a particular algorithm, however excluding this, ASICs are far less efficient or actually totally useless.

Figure 5 – Crypto-coin chip type timeline

Source: BitMEX Research
Note: The inclusion of Vector Processors (VPs) towards the end of 2018 is speculative

It might be possible that Bitmain has developed a new type of chip, a Vector Processor. The architecture of this chip could be designed for PoW hash functions in general, but not for a specific hash function. These chips could then be more efficient than GPUs and FPGAs, but less efficient than ASICs. The advantage over ASICs is that they could be, in some respects, immune to PoW changes. It is possible that the new Ethereum miner falls into this category of chip, although this is mostly speculation on our part.

Figure 6 – The evolution of crypto-coin chip types

Higher efficiency

It is possible that Bitmain’s new Ethereum miner is tailored for Ethash, in that the components inside the miner such as the electric circuits, power control devices, memory and control modules could all be specifically calibrated for mining Ethereum. However the chip itself, which is the area that requires by far the most financial investment, could be more general and not specifically designed for Ethereum. Therefore if Ethereum conducts a PoW change, it could be possible to direct the chips into a new device as they leave the foundry or perhaps even recover the chips from the old device put them into a new Ethereum miner. Although again, at this point we are speculating.

Artificial Intelligence (AI) technology

At TSMC’s latest set of quarterly results on 19th April 2018, Co-CEO Mark Lie said the following:

[Bitmain] is doing a lot of things on blockchain technology, like AI. They are doing very well. We expect them to slowly move to the AI area.

Source: Q1 2018 earnings call

“AI” is a term with many meanings. Although at this point the situation is unclear, it is possible that any new Vector Processor chips could be what TSMC mean by AI technology. Since any such chip may be able to switch between hashing algorithms, at a stretch, one could argue this falls within the scope of AI. It remains to be seen if the chip is merely programmable, like modern GPUs, or if there is a trick up its sleeve that could give it an efficiency gain vs. GPUs in most cases. If present, this advanced technological capability is likely to be seen as a major achievement for Bitmain. Such technology may also be even more expensive to develop and more specialised than the technology in ASICs, which could make the decentralisation problem even worse.

Ethereum hashrate growth – No evidence of deployment of the new chips

Despite the above, we have not yet seen any strong indications of the deployment of the new chips on the Ethereum network. As Figures 7 and 8 below indicate, Ethereum’s hashrate appears, broadly speaking, to be following a normal trend given the price volatility.

Figure 7 – Ethereum hashrate compared to Ethereum price and NVidia GPU sales

Source: Bloomberg, Etherscan.io, Coinmarketcap, Nvidia, BitMEX Research

Figure 8 – Ethereum hashrate compared to Ethereum price – Rolling 90-day percentage growth of 7-day moving average

Source: Bloomberg, Etherscan.io, Coinmarketcap, BitMEX Research

Conclusion

When discussing the possibility that Bitmain’s new Ethereum miner isn’t an ASIC and that the new chip may be somewhat immune to PoW changes, Vitalik Buterin told us:

I have a very similar impression myself

Despite what we have said above, most of the content in this article should be considered guesswork. However, even if we are wrong about this particular chip, we still think it is reasonably likely that at some point in the future, Bitmain or another company, will develop a general-purpose hashing chip, which is more efficient than GPUs for almost all hashing algorithms. At this point the era of anti-ASIC PoW changes could be over, with crypto-coin communities having to make a choice between two potentially unfavourable outcomes:

1. Allowing ASICs, or,
2. Allowing general purpose hashing chips, where technologies and production capabilities could be even more concentrated.

Unless of course proof-of-stake systems prove robust enough.

Disclaimer

Whilst many claims made in this note are cited, we do not guarantee accuracy. We welcome corrections.