Monday, February 25, 2013

Bitcoin liquidity revisited - Save Bernankestan


Recently I wrote about how the viability of bitcoin was limited by the risk of total, sudden liquidity collapse . The argument can be summarized as saying that without institutions whose business is transacted in it, bitcoin suffers from a bootstrapping problem whereby a crack in the crypto scheme would create an instant wave of counterfeit and debasement. Since there is no entity to restore trust in the currency with a guarantee, e.g. no central bank or government to offer a sovereign guarantee, a crack would make bitcoin illiquid and worthless. 

I said that bitcoin would only ever be useful on the black market, since without legitimacy from legal institutions, the only commodity of last resort it may ever be readily exchanged for will be drugs or other contraband.  

Circumstances have changed since I argued that point, as a number of online gambling sites are beginning to take in and pay out bets in bitcoin. It is a game changer since, more than blackmarket commodities, now bitcoins may be traded for _risk_.

Consider that legit banks with legit currencies only hold about %3-%6 of their customers' deposits in actual cash equivalents. This means that the other %95 of assets are tied up in contracts, loans securities and other abstractions that all represent...(wait for it)....risk.

At its most basic level, a casino manufactures (or synthesizes) risk and sells it to punters. The quality of risk they create is lopsided odds with asymmetric payouts (e.g. low chances of winning a lot of money). Their machines essentially conjure the risk and provide a witness to the contract between the punter and the institution. For a currency, the liquidity is a pretty valuable service.

What's interesting about it is that since it does not create or destroy money, a casino can just leave the machine on and trade risk for money ad infinitum. Students of Douglas Adams' "bistromaths," "powering an infinite improbability drive" should feel a tug at their intuition. While a casino game does not truly make or create anything (other than sensation, perhaps), or provide a value added service, so long as there are players, a casino can provide infinite liquidity to a given currency.

This may also imply some surprising economic utility for casinos, the game of chance may act as a consumer of last resort for currency that has nowhere else to go. Securities provide this function in finance now, where otherwise idle cash is made productive by keeping it moving by converting it to contracts for risk. If you have a wallet full of bitcoin that is no longer enough to buy anything on Silk Road or some other future dark markets; or a bitcoin crack has made everyone stop accepting it because they think it may be counterfeit; it would seem to be intrinsically worthless - except if you could go into a casino and put it all on red.

The fact that we can now gamble with bitcoins is a powerful conceptual leap that may have significant implications for the viability of alternative currencies. Most of the arguments against casinos have to do with moral ideas about addiction, poverty and waste, but in a pure and abstract form, they are the same as the modern financial economy. Casinos and banks are each systems of structured, risk-based games. It's just a matter of who deals the cards and who operates the tables, and what the the rules and payouts are for a given game.

In a world of arbitrary "fiat" currencies, it may be worth the while of mathematicians to investigate whether there is a class of game that might provide the sort of infinite liquidity required to sustain a relatively desirable society. (Save Bernankestan!) EDIT: The main value provided by a casino is that by exchanging a given currency for risk, the currency is imbued with an explicit non-zero spot value - so long as a bet can be made or paid in it.

In terms of the problem of institutional backing for bitcoin, the potential of guaranteed liquidity via casinos may be the fount of honor these alternative currencies need. So far, niche currency systems like casino chips, Chuck-E-Cheez tokens and even Airmiles, have been constrained mainly by rules that restrict their use and administration to individual, tightly controlled and monitored institutions. The idea is that they cannot be "real," generalized and fungible currencies; they only represent a local convention for a specific kind of system.

Casinos, or another future system of risk-based games (legal or not), may provide the missing block that will make bitcoin a fully autonomous currency. If this is true, expect the reaction from established currency administrators (e.g. the governments of developed countries) to be swift, ruthless and possibly violent.

Given the tremendous power and autonomy that casinos could imbue bitcoin with, such a reaction may even be commensurate.

3 comments:

  1. Good post. The only point that I would make is that if the cryptography behind Bitcoin were broken, it would not be accepted anywhere.

    As it stands, there would have to be several forms of encryption cracked to truly threaten the network - Bitcoin should be quite safe for the foreseeable future.

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