*I want to say thank you to Markus Sagebiel, @msgbi on Twitter, for drawing my attention to many of the following links and for great comments.

—–

After my recent bitcoin update, debates about the nature and chance of survival of the cryptocurrency were going on. Markets remain volatile and there were bad news again. One referred to Silk Road, the anonymous online market.

Willard Foxton from The Telegraph asked: “The Online Drug Marketplace Silk Road Is Collapsing – Did Hackers, Government Or Bitcoin Kill It?”

And Michael Fowlkes from the Market Intelligence Center wrote in Bitcoin Volatility Spikes Again As Silk Road Website Crashes:

 “While I have argued against buying into the Bitcoin rally on more than one occasion, I will be the first to admit that illegal drug purchases are far from their only use. Bitcoins do have a place in today’s world, but the wild price fluctuations are going to continue to occur until it matures and becomes more accepted by the mainstream.”

Other incidents included

-  the collapse of a bitcoin exchange partnership to manage operations in the U.S. and Canada as CoinLab filed a lawsuit against key Bitcoin exchange Mt. Gox alleging breach of contract in a deal to manage North America operations;

-  the closing of bank accounts of Bitcoin businesses in the U.S. and Canada;

-  the closing of Polish and German bank accounts of Bitcoin-24, the largest bitcoin exchange in Europe, on demand of the German prosecutor’s office in a fraud investigation.

Ian Steadman on Wired added to the bleak picture reporting of a study of the Bitcoin exchange industry which has found that 45 percent of exchanges fail, taking their users’ money with them:

“Computer scientists Tyler Moore (from the Southern Methodist University, Dallas) and Nicolas Christin (of Carnegie Mellon University) found 40 exchanges on the web which offered a service of changing bitcoins into other fiat currencies or back again. Of those 40, 18 have gone out of business — 13 closing without warning, and five closing after suffering security breaches that forced them to close.”

—–

As I mentioned before, regulators become growingly aware of the currency and related problems. Recently, the U.S. Commodity Futures Trading Commission (CFTC) announced to be examining the issue. Quoting Bart Chilton, one of its five commissioners, in the Financial Times:

“It’s not monopoly money we’re talking about here – real people can have real risk in these instruments, and we need to ensure that we protect markets and consumers, even in what at first blush appear to be ‘out there’ transactions.”

But, the FT authors also mentioned that as CFTC jurisdiction generally does not extend to cash markets unless exchanges list derivatives contracts based on them, Bitcoin would not become subject to CFTC jurisdiction unless it becomes the basis for a derivatives contract.

In Germany, according to heise online, Oliver Flaskämper from Bitcoin.de worried about an international legal prohibition.

(In Germany, bitcoin is still widely unknown, as BITCOM, the German Federal Association for Information Technology, Telecommunications and New Media found out. BITCOM is “the voice of the information technology, telecommunications and new media industry in Germany” representing more than 1,700 companies. According to a Forsa poll conducted for BITCOM, 85 per cent of Germans have never heard of the currency, but 20 percent could imagine using it some day.)

In a similar context, Max Keiser asked What If All Bitcoin Exchanges Were Shut Down By Various Governments?”

His conclusion was that

“mining of bitcoin would continue but spending them becomes a problem since there would be no quoted price. The bitcoin protocol is about mining bitcoin not pricing bitcoin. There is nothing in the protocol about establishing a market price for bitcoin; you need a market for that, but what if all the exchange markets are shut down?”

As a consequence, he proposed

“that some entity, possibly the Bitcoin Foundation (and this can be done on a non-profit basis), make a market in bitcoin and broadcast a current price for bitcoin (a peg)”.

Dan Kaminsky wrote on Wired in Let’s Cut Through The Bitcoin Hype: A Hacker-Entrepreneur’s Take that governments probably can’t kill Bitcoin, but:

“Don’t think, by the way, that a thing like Bitcoin can’t be co-opted by governments. A global public ledger is a very good system for everyone seeing if taxes are being paid or not. The network could literally reject transactions that don’t include a tax declaration, and directly pay to a bitcoin account controlled by taxation services. Everything can be subverted.”

Robert Wood, a tax lawyer, pointed to the consequences of reporting rules. In Sorry Bitcoin, IRS Gets Reports on Forbes he asked (the IRS or Internal Revenue Service is the U.S. government agency responsible for tax collection):

“are merchants and professionals that accept Bitcoin reporting them as income? I bet they are, and some people paying in Bitcoin must be deducting payments too. If you’re in business, don’t you almost have to?”

And he added:

“If you pay an employee in Bitcoin, you can’t withhold some of the Bitcoin and send it to the IRS. The IRS treats it as pay in kind, just as if you paid in groceries or anything else of value. You must value what’s provided, withhold income and employment taxes in cash and send the money to the IRS.”

According to CBC news, Revenue Canada Says BitCoins Aren’t Tax Exempt:

“… there are two separate tax rules that apply to the electronic currency, depending on whether they are used as money to buy things or if they were merely bought and sold for speculative purposes.

‘Barter transaction rules apply where BitCoins are used to purchase goods or services,’ Canada Revenue Agency spokesman Philippe Brideau said in an email.

Barter is the exchange of one good for another good without the use of cash, such as when a farmer who grows vegetables trades with another who raises chickens. Many Canadians don’t realize such exchanges are taxable, but they are.”

—–

Currently, worldwide more and more people are gathering experience with Bitcoin, both as producers and users.

Vocativ wrote:

 “The closest to a central bank committee for the world’s favorite new currency are the seven core developers of bitcoin”,

and made an interview with one of them: A Conversation With One oOf Bitcoin’s Inventors: ‘I’ve Given Away Over 15,000 Bitcoins’

Although most miners work in pools, Fernando Alfonso III on The Daily Dot drew the attention to people who

“have broken away from the pack and turned their homes inside out, investing in computers capable of solving thousands of mathematical problems at once.”

He wrote that some

“are building computer rigs so ridiculous they could literally burn a house down”

and included some photos to give you an idea.

Eric Limer on Gizmodo has more about Digital Drills: The Monster Machines That Mine Bitcoin, photos included. He remembered the beginnings:

“It all started so simply. Just after Bitcoin’s birth in 2009, and before its current surge of popularity, mining could be done by a run-of-the-mill CPU in just about any old computer. Back then—and still today—Bitcoins are mined by using computing power to solve a complex cryptographic equation. If your computer is lucky enough (or really, powerful enough) to get a right answer, you’ll create coins. So given enough time, a CPU can actually get some mining done. And back in the early days, if you could get free power to run it from your dorm room, library, or office, and the exchange rate was high enough (a buck or two), you could stand to make some spare pocket change.

So how did we get from there to giant rigs that consume $150,000 of electricity daily? It was inevitable, really. Especially after Bitcoins actually became worth something.”…

Sal Cangeloso asked on ExtremeTech One Bitcoin By The Numbers: Is There Still Profit To Be Made? and described his experience as a lonesome miner :

“Look on my works, ye Mighty, and despair! I have mined a Bitcoin. This was not much of an accomplishment a year or two ago, but in 2013, after the infamous early-April peak at $260, unearthing a Bitcoin is no easy task. Competition is on the rise and we are getting close to the end of the good ol’ days of Bitcoin; the time when a desktop computer or two have any real mining capabilities.”

And the result?

“Bitcoins earned: 1.00

Value today: $133.58

Total time: 14.5 days

Rigs operating: 2-3

Hours spent setting up and tinkering: 5

Current hashing rate: ~850Mh/s

Peak hash rate:  2700Mh/s

Average hash rate: 924 Mh/s

Minimum wattage: 700W

Peak wattage: 1440W

Current efficiency: 1.2Mh/W

Peak efficiency: 1.88Mh/W

Total power cost: ~$24.05 (@ $0.15/kWh)

Number of time pool went down: at least 2

Number of 502 errors encountered when checking 50btc.com: Countless”

On the consumer side, on May 1, Kashmir Hill from Forbes started her experiment of Living On Bitcoin For A Week, which makes a fascinating read:

“On Tuesday morning, I emptied my wallet of all of the cash and credit cards before I left my house. Many journalists have been writing about the mechanics of buying Bitcoin and the resulting heart palpitations as they watched the dramatic rises and falls in the digital currency’s worth over the last few weeks. But that’s just a story about gambling. My editor issued a different challenge to test the currency’s legitimacy: “Don’t just buy Bitcoin. Live on it for a week.” …

As I write this, it is day 5 of the week and Kashmir Hill has officially moved into a new home that accepts Bitcoin as rent.

In Bitcoin: The Berlin Streets Where You Can Shop With Virtual Money, Kate Connolly and Guy Grandjean from The Guardian have a video of  Kreuzberg, Berlin, where Bitcoin has expanded off the internet into the local economy. There you can see how paying with bitcoins in local stores works.

Mike “Mish” Shedlock discovered Bitcoinstore, which offers 500,000 electronic products for sale, include high-end digital cameras, and accepts only bitcoins as payment. Mish’s interview with the store owner, who is living in Japan and is also called the Bitcoin Jesus, is very interesting.

There is progress in other respects as well. In Bitcoin Is A Step Closer To Becoming A Part Of Your Web Browser, Christopher Mims, Quartz, describes on Business Insider how

“bitcoin has now passed the first round of approval required to become a standard for the web, alongside other familiar “schemes” which allow elements on a webpage to, for example, open your email application when you click on an email address on a webpage. This is the first time a payment system has ever been legitimized in this way.”

He gives an example:

“Imagine you’re buying socks or more likely, since this is bitcoin, assault rifles stuffed with heroin. On the checkout webpage, the “buy” button could use the “bitcoin:” link, which would automatically pop open your bitcoin wallet, which might reside in an external application, on another website, or even in your browser itself. In any event, it would make paying with bitcoin dead easy and absolutely universal.”

—–

With rising popularity, demand for, and supply of, information is growing. Brett Scott (Suitpossum) described How To Explain Bitcoin To Your Grandmother:

“As anyone who doesn’t have a degree in advanced computer science knows, Bitcoin is conceptually tricky. Thus, when your grandmother is wanting to buy marijuana off the Silk Road and begins asking you to explain Bitcoin to her, what do you do? Ever since early 2012, when I asked the question ‘what the hell is Bitcoin?’, I’ve been trying to find ways to explain it to myself. Initially I used the example of the Borg from Star Trek, but more recently I’ve come to believe that one key to describing it is to start from normal currency, and to then describe Bitcoin in relation to that, rather than trying to describe it as a standalone phenomenon. I’m no Bitcoin expert, so this is still a work-in-progress (Warning!), but next time granny asks you, here’s a rough-and-ready way you might lay down the foundations (I’ve deliberately included a lot of repetition, because that’s important when learning). …”

For those who wish to start from the beginnings, and in greater detail, Khan Academy offers a video series on Bitcoin.

If you are interested in statistics, you may want to have a look at Blockchain whereyou find much information about activities, markets and prices including graphs and charts showing

Total Bitcoins In Circulation

Market Capitalization

Total Transaction Fees

Number Of Transactions

Number of transactions excluding popular addresses

Number Of Unique Bitcoin Addresses Used

Number of transactions per block

Total Output Volume

Estimated Transaction Volume

Estimated Transaction Volume

USD Exchange Trade Volume

Trade Volume vs Transaction Volume Ratio

Market Price (USD)

Cost % of transaction volume

Cost Per Transaction

Hash Rate

Miners Revenue

Mining Operating Margin

Average Transaction Confirmation Time

Bitcoin Days Destroyed Cumulative

Blockchain Size.

—–

Bitcoin is stimulating all sorts of discussions. Here are two examples:

In A Point Of View: Bitcoin’s Freedom Promise John Gray argued on BBC that this promise is an illusion:

“Believers in Bitcoin are confident that it can protect them not just from governments but also against humankind as a whole. Instead of relying on politicians and bankers, or the vagaries of democracy, Bitcoin’s users put their faith in the laws of mathematics.

For them the cyber-currency is governed by an incorruptible formula that – like the eternal forms envisioned by Plato, immaterial abstract ideas standing outside of time – is untouched by human error and folly.

The trouble is that unlike the tranquil spiritual ether imagined by the ancient Greek mystic, cyber-space is all too clearly a human artefact. A site of unceasing warfare – abounding in worms and viruses, vulnerable to attack and decay, and needing scarce resources and energy to operate – the virtual realm of the internet is a projection of the human world with all its conflicts.

A virtual currency can’t escape the dangers of actual societies. Cyber money may have many practical uses and provide an alternative to banks. It can’t be a way out from history’s intractable dilemmas.”

JP Koning wrote an interesting blog post about What Equity Markets Can Learn From Bitcoin And Ripple. It starts:

“This isn’t a bitcoin post. But it cribs some ideas from bitcoin and applies them to equity markets. Specifically, I’m going to play around with the idea that if equity markets were to adopt a bitcoin-style distributed ledger system, then some of the destabilizing effects of the so-called latency wars might be mitigated.

Historically, most databases and ledgers have been maintained at a central hub. In order to get access to this information, users have had to walk into the building that houses the records, or sign into a server that stores them. …

A centralized order book is hardly democratic since those closest to the hub can consistently use their informational advantage to game those who are furthest away. …

Which brings us back to bitcoin and the idea of a distributed ledger. Here we have a solution to the tiered nature of information reception from a central hub. Why not have a network of independent nodes store a stock’s order book, listen for new quotes and trades, verify the identities of traders, and update the distributed order book? The neat thing about storing data in a distributed fashion as opposed to a hub is that information is freed from geography. Rather than sitting on a computer in Mahwah, New Jersey, the order book is everywhere. This would help to mitigate the unfairness issue that plagues central order book markets.”

„Leute, die ernsthaft Bitcoins als Wertanlage in Betracht ziehen, sind Spekulanten unterster Klasse, die auf Nicht-Leistung und Voodoo Gewinne aufbauen wollen.“

Wie nachvollziehbar diese Sicht in jener Zeit auch gewesen sein mag: Spätestens mit den jüngsten Entwicklungen in der Eurokrise hat sie viel von ihrer Gültigkeit verloren.

…

More on CARTA

In the few days since I published my last article on parallel currencies, Bitcoin did not stop catching the headlines. Apparently, the “cryptocurrency” easily digested the disruptions caused by hack attacks on MTGox which had resulted in a temporary drop in value of one Bitcoin from over $140 to about $120. (Remember that when Bitcoin first started in January 2009, it was trading under one penny.) But, after a short respite, market turmoil started again.

See, for example, this note from Zerohedge from a turbulent night:

“Think the great BitCoin drama is over? After plunging by over 60% intraday, touching $100 from an all time high of $265 earlier, BitCoin was just getting started, posting a just as epic rebound to $200 in mere hours… before tumbling once more to $125… before rebounding again to $180… before sliding to $140… and so on.”

Or, to cite Joseph Weisenthal (@TheStalwart)‏ on Twitter in the heat of a moment:

“Bitcoin is totally forked. (No, really, seeing prices of $90, $170, and $225 at different sites)”

Events like these fuel discussions about the nature of the currency, and I would like to draw your attention to some exciting new contributions.

Izabella Kaminska continued her higly readable BitcoinMania series on FT Alphaville. Her latest article on A Cybernetic Ledger starts with an observation by Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis. He said that money may qualify as unit of exchange, store-of-value or unit of account, but “at its heart it is nothing more than the technological equivalent of a collective memory function” (I. Kaminska). In analogy, Bitcoin, which is “made up of pure computer code”, may be regarded as a cybernetic ledger:

“A publicly available deal sheet – forged, monitored and policed by its users and propagators, and encrypted in such a way that encourages best practice amongst its community members, consistent with the principles of game theory.”

—–

The system’s major flaw which has become apparent again during the recent turbulences is an inherent fundamental asymmetry between demand and supply. Peter Svensson of Associated Press writes:

“ … the supply of bitcoins increases only slowly, at a rate that’s coded into the system.

That’s a contrast to a regular paper currency like the dollar, whose supply is managed by a central bank like the Federal Reserve. The Fed engineers the dollar supply to increase slightly faster than the growth of the economy, which means that the value of the dollar falls slightly every year, in the phenomenon known as inflation.

New bitcoins are “mined” or generated by computers. They get harder to generate all the time, which means the inflow of fresh bitcoins keeps falling. There are about 8 million bitcoins in circulation today, and the maximum that can be generated is 21 million. By 2032, 99 percent of those will have been created.

Since the supply of bitcoins grows so slowly, any increase in demand leads to higher prices. That’s known as deflation, and it’s widely seen as a disaster when it happens to a real-world currency. As money becomes more valuable, our incentive is to hold onto the money instead of spending it — slowing down the economy.”

Deflation may not be a bad thing, as Jon Matonis argues in Forbes (more about this later). However, the current, more urgent problem is low market volume in  an endless series of speculative waves which may be typical for a market in its infancy, but which in the absence of major players or market makers, or an intervening ‘Bitcoin Central Bank’  (Christopher Vecchio), causes large price swings and extreme volatility.

—–

A lot has been written about how bitcoins are created and how the system works, which all seems very complicated. Matt Baxter-Reynolds has tested how it is done. In How to Buy and Sell Bitcoins he describes his experiences. The article comes in two parts. Part 1 is about some of the theory behind Bitcoin and Part 2 shows in detail how he actually bought and sold bitcoins, which to me appears a rather time-consuming and cumbersome process although the author concludes: “Once you get your head around it and set-up, working with Bitcoins is actually very easy.”

There are complaints that the system is not “idiot-proof”. But comparisons to other technologies indicate that procedures may become simpler and safer as soon as larger numbers of users get involved and incentives rise to work on easier solutions. One example is computers. To cite Timothy Lee in Forbes:

“The Bitcoin economy today looks a lot like the PC market circa 1978. Most people today look at Bitcoin and see an impractical curiosity. They’re happy with the banking services they’ve already got and can’t imagine why anyone would want to use an alternative currency”.

It is hard to imagine that in ten years from now the Bitcoin technology, or its successor, would look the same as today’s.

—–

Imagination plays an important role in many respects. To some observers, Bitcoin is only a speculative hype that will end in tears. Others see beyond the excesses of this new experimental market and think of it as a longer-term alternative to a failed monetary regime with morally doubtful and incapable institutions.

Many observers think of Bitcoin as “anarcho money”. Anonymous and unregulated financial markets tend to attract criminals. Bitcoin is no exception to the rule.

The best known example is Silk Road, where, as Gary Bryan writes, you can buy, and pay with bitcoins,

“anything from LSD to a custom-made Australian electricity bill (in case you ever need to, you know, fake proof of residency in Australia). There are even listings for trained assassins (which goes against Silk Road’s policy, but still).”

Or, to cite Jeremy Liew:

“The biggest six hacking, theft and fraud incidents involving Bitcoin exchanges, wallets, or investment vehicles have resulted in a total 1.2 million coins being stolen. This means that more than 10% of all Bitcoin in circulation has been stolen, and this does not include many smaller thefts and losses from individual wallets. There has been a great deal of malware in the wild, targeting individual wallets held on computers, and even hijacking computers into botnets to “mine” Bitcoin on the behalf of hackers.”

—–

Criminal activities, an increasing awareness that there is a fast-growing market circumventing banks and regulatory control, and the idea of a currency “that can’t be debased to political order” (John Naughton) did not escape the attention of governments and monetary auhorities. In my annotated list I already mentioned Jeffrey Sparshott’s article on the U.S. applying money-laundering rules to virtual currencies. There is another text by Evan Soltas of Bloomberg on the same subject titled Bitcoin Really Is an Existential Threat to the Modern Liberal State. He writes:

“The Financial Crimes Enforcement Network, the wing of the U.S. Treasury Department that investigates money laundering, said last month that it has the authority to regulate transactions involving both Bitcoin and U.S. dollars under the Bank Secrecy Act. These inter-currency exchanges appear to be the best foothold for regulation. Governments could require records of all purchases and sales of Bitcoin, for instance. But this approach has severe limits … (T)he usual mechanisms for detection and enforcement are very weak against Bitcoin.”

Some observers see the danger that Bitcoin exchanges are taken down by a patent lawsuit. On Twitter, Carta (@carta_) drew the attention to an article by Max Keiser who argues that

“as Bitcoin and the exchanges become more prevalent we’ll see Wall St. and the central banks challenge the exchanges on intellectual property grounds. They will argue the technology for trading in virtual securities with a virtual currency is a patented technology owned by Wall St. and that virtual market making is violating this patent (US pat. no. 5950176).“

Felix Salmon writes:

“… it’s far from clear that bitcoins are even legal. The FBI is on the record as saying that “it is a violation of federal law for individuals… to create private coin or currency systems to compete with the official coinage and currency of the United States”. And laws against operating an unlicensed money-transmitting business have been used against electronic currencies in the past, and would seem to apply equally to bitcoin.”

See also the New York Times article by Alan Feuer on Prison May Be the Next Stop on a Gold Currency Journey I mentioned elsewhere, which is on Bernard von NotHaus and the Liberty Dollar.

For all those who want to know more about Bitcoin’s legal status, Noam Cohen from the New York Times drew the attention to an academic paper by Reuben Grinberg on Bitcoin: An Innovative Alternative Digital Currency.

—–

Kim-Mai Cutler of TechCrunch describes how Bitcoin is increasingly  attracting venture firms. In Why I Take Bitcoin Seriously as a Venture Capitalist Jeremy Liew lists what, in his view, are the core attractions of Bitcoin:

Its value cannot be changed by the fiat of any single government or entity (unlike “fiat” currencies like the U.S. dollar controlled by the Federal Reserve Board)
It is nominally anonymous (or more accurately, pseudonymous) in that transactions are tied to wallets (essentially numbered accounts with passwords), not to people
It should be a “deflationary currency,” meaning that its buying power should theoretically always go up over time
Its transaction costs are zero (or close to zero)
Its transactions are irreversible (which is attractive to merchants)

Some of these advantages are real, others are part of the myths surrounding the cryptocurrency (as Jeremy Liew’s cautious formulations indicate, too). From what I have read so far, Bitcoin appears NOT, or at least not much longer, to be

- anonymous. There is widespread agreement that Bitcoin does not provide cash-like anonymity. As Jon Matonis argues,

“it is better described as user-defined anonymity because the decision to reveal identity and usage patterns resides solely with the bitcoin user. This is far superior to a situation where users of a currency are relegated to seeking permission for their financial privacy which is typically denied by the monetary and financial overlords.”

But, this may change. As Jeremy Liew writes:

“the “anonymity” of Bitcoin appears to be phantom as more research is done to tie Bitcoin wallets to individuals. This is anticipated to reduce the overall level of shady Bitcoin activity.”

See also Blogger Matthew Green about recent efforts and the resulting limits of privacy through pseudonymity offered by Bitcoin.

- Unregulated and uncontrollable.  Timothy B. Lee gives an example (ignore the technicalities, the argument will become clear in a moment):

“A few weeks ago, a node that had upgraded to version 0.8 of the client software generated a block that nodes running version 0.7 and earlier didn’t recognize as valid. This produced a “fork” in the network, with each half generating blocks the other half viewed as illegitimate. …

A core part of Bitcoin’s appeal is that it’s not under anyone’s control. Supposedly, nobody has the authority to change the Bitcoin money supply, cancel or reverse transactions, or otherwise change the attributes of the protocol. But in practice that’s not really true. In the wake of last month’s fork, the elites in the Bitcoin community effectively changed the rules in a matter of hours. In principle, there’s no reason those same elites couldn’t make other changes to the Bitcoin protocol.”

- A market without institutional players, “completely outside the professional traders and hedgies of Wall St. and City of London” (Max Keiser). This is already changing. As Nikolay Gertchev of the Ludwig von Mises Institute writes:

“The growing investment demand … spurred the development of intermediary dealers in bitcoins. There are a number of exchanges where bitcoins can be bought and sold against currencies. Specialized online storage, presumably with increased security, has also been made available. Intermediation, though open to free entry, is likely to remain rather monopolistic, given the very low margins associated with transacting in and with bitcoins.”

In addition, there are newly-forming markets for leveraging and shorting. Tim Worstall of Forbes reports about a soon-to-launch New York-based “leveraged forex trading platform” for Bitcoin, called Coinsetter. New ventures and players emerge. Cyrus Farivar of  Ars Technica gives the example of  ICBIT, currently “in process of incorporating in an offshore jurisdiction”, where investors can engage in a futures market, effectively betting on the upcoming exchange rate from bitcoins to dollars. And he draws the attention to a firm called Exante:

“Exante is likely the most bona fide of these operations as it is an official, licensed, Malta-based brokerage company with a real office, real employees, and the power of European Union regulators behind it. Earlier this year, its “Bitcoin Fund” became the world’s first bitcoin-based hedge fund and is based in Bermuda, a notorious offshore tax haven.”

—–

A crucial question is: Are bitcoins money?

Cullen Roche stresses:

“After all, anyone can create money, but the trouble is in getting others to accept it.  And since money’s primary purpose is in the means of exchange, just about anything can serve as money as long as it meets that primary purpose.  The thing is, there aren’t all that many things that meet that need on a broad level.  For instance, lots of people like to claim that gold is money (which it is), but gold isn’t accepted for payment in many places.  Therefore, … gold has a low level of moneyness …  Gold is money, but it’s just not a very good kind of money.  Bitcoin is actually very similar.  If you have Bitcoins you can buy certain things online that only a Bitcoin merchant will allow you to buy.  These merchants accept Bitcoins as a form of final payment.  To them, it’s a form of money with a very high level of moneyness. But to a company like Wal-Mart a Bitcoin is like a gold bar.  It doesn’t give you access to anything in their store therefore its moneyness is virtually nil in a Wal-Mart.  Most retailers around the world view Bitcoins similarly.”

Timothy B. Lee writes in Forbes:

“What gives money its value? One popular theory says that modern fiat currencies get their value by “government fiat”: the government declares a currency to be the official one, requires that currency be used to compute and pay taxes, and thereby confers value on what would otherwise be worthless slips of paper. Bitcoin is a clear challenge to that view. It has no “backing” from any government or other large institution, yet the stock of outstanding bitcoins is now worth more than $1 billion.”

Izabella Kaminska uses the term fiat above all

“to differentiate a faith-based non-collateral-backed currency system from a collateral-backed currency system. Bitcoin … is described as the “fiat of all fiats” due to its decentralised fiat nature and because its value lies in the mutual interests of its users rather than a collateral pool. It is, in that sense, a fiat that supersedes all other fiats, because it depends on an algorithmic self-dictated “law” for authority.”

But, she further argues:

“With Bitcoin … it’s the fact that the system cannot be mistaken for a credit system that classifies it as some form of fiat. There is, after all, no known reputable entity backing or guaranteeing any of the financial claims issued in its name. On the contrary, there is only a system of code. A memory. An arbitrary and faceless entity which glues the whole thing together.

Unlike government fiat, Bitcoin’s value doesn’t even represent a share in the collective equity of a nation.”

Lord Keynes has a similar argument:

“Bitcoins were obviously created to be “decentralized digital currency,” a type of money to be used as a medium of exchange and store of value. That is how the Bitcoin software was “advertised,” if you like. But a Bitcoin is not tied to some real commodity like gold at a fixed conversion rate. One wonders why any libertarian would get excited about it (as it turns out, most do not!).

A Bitcoin is backed by no commodity whatsoever: just like a stock or share, whose value is subjective and whose price is just determined by supply and demand on a stock market. The value of Bitcoins in goods or other currencies might crash tomorrow (and so might gold, but at least we have industrial uses for gold and uses in jewellery, etc.).”

Izabella Kaminska compares Bitcoin with other parallel currencies or free-banking initiatives stating that

“Bitcoin’s defining feature lies in the fact that it is redeemable against nothing. It is, as they say, completely uncollateralised.”

—–

Lack of redeemability and backing by a real commodity is one of the key arguments brought forward against Bitcoin referring to the arbitrariness of the money creation process. But, as Paul Ford argues in Business Week: “Bitcoin is no more arbitrary than derivatives or credit default swaps”.

Actually, bitcoin is no more arbitrary than any other currency. Money is a convention based on trust – in its value, in the sincereness of its creator, the soundness of intermediaries, the authority of rulers, the existence of a lender of last resort, the safety of deposit accounts or whatever.

To counter a common argument with an extreme example: If people, who are both currency users and voters, stop accepting the US dollar or the euro whenever possible, policymakers in need to win elections may soon decide to include acceptance of tax payments in bitcoins in their election programmes.

In what do holders of Bitcoin trust? Given the risks involved in this new experimental currency there is certainly a greater preparedness to lose money than in other monetary regimes. But this does not mean that users are willing to throw their money away for sentimental reasons. Kim-Mai Cutler reports that

“Jered Kenna, who just re-launched TradeHill, a Bitcoin exchange targeted at accredited investors and high-net worth individuals … says he’s had investors open accounts and individually send in more than $1 million to buy Bitcoin.”

Probably, these are not all nerds and dreamers. Bitcoin investors can be assumed to trust in the basic functioning of the system and, like any investor in any currency or other financial instrument, in their ability to cope with the risks. In the case of Bitcoin, this may be called overoptimistic or naïve, but users’ willingness to hold bitcoins, and engage in transactions using them, makes bitcoins money.

People in Europe just learn anew what a currency representing  “a share in the collective equity of a nation” is worth if the latter is deleted by a stroke of the pen. People in other parts of the world have made this experience, too. As Kim-Mai Cutler notes:

“Some Bitcoin founders are driven less by ideological passion and more by personal experience — especially if they grew up in countries with unstable currencies. They are keenly aware of how fragile faith in a government’s ability to repay its debts can be.”

In my view, what matters – in analogy to national currencies which are valued by their purchasing power – is the range or basket of goods and services bitcoins can buy, and of economic activity they may serve to finance. 50 years after the Euromarkets rang in the era of financial globalisation, Bitcoin became the first truly global monetary phenomenon not tied to a national or regional jurisdiction. And just as the value of the Eurodollar, and later of other Eurocurrencies, was determined by developments in and outside national territories, bitcoins must be valued accordingly. Noam Cohen from the New York Times mentions a similar idea:

“Some observers and investors also make the case that bitcoins are in fact undervalued. Their argument goes like this. The total value of the world’s economic activity is enormous. There are certain transactions that are ideal for bitcoins because the currency is relatively anonymous and does not need to be processed by a financial organization or a government.

If  bitcoins become the dominant currency in some small niche of the world economy — that is, those people who do not want their transactions easily tracked or who want to send money back home from abroad — then they will become quite valuable indeed.”

Eventually, the range of bitcoin uses determines its value.

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The second key argument against Bitcoin already mentioned is limited supply.

The Unconventionial Economist describes how the algorithm behind Bitcoin is restricting currency supply. Starting from 2009 the number of Bitcoins generated every 10 minutes was roughly 50. Every 210,000 generations (approximately 4 years) the creation rate drops in half (50, 25, 12.5, etc), until the said limit of 21 million bitcoins is reached.

According to some commentators, the consequences may be devastating. To cite Felix Salmon once again:

“The biggest problem with bitcoins … is conceptual: if they succeed, they fail.

If millions of people started using bitcoins on a regular basis, the soaring value of bitcoins would actually be disastrous. You’ve heard of hyperinflation: this would be hyperdeflation. Take a gold bar valued at $600,000. At $60 per bitcoin, the value of that bar is 10,000 BTC. But then assume that bitcoins rise in value to $600 apiece, and then to $6,000, and then to $60,000 — as would have to happen if the fixed number of bitcoins was being used to store hundreds of billions of dollars in value. Then the value of the gold bar would plunge, in bitcoin terms — to 1,000 BTC and then 100 BTC and finally just 10 BTC. The same thing would happen to all other goods and services in the world, including your own salary. Everything would be constantly going down in price, if you thought in bitcoin terms.

Inflation is bad, but deflation is worse. The reason is that in a deflationary environment, no one spends money — because whatever you want to buy is sure to become cheaper in a few days or weeks. People hoard their cash, and spend it only begrudgingly, on absolute necessities. And they certainly don’t spend it on hiring people — no matter how productive their employees might be, they’d still be better off just holding on to that money and not paying anybody anything.

The result is an economy which would simply grind to a halt, with massive unemployment and almost no economic activity. In a word, it would be a Depression. In order to have economic growth, you need monetary growth as well — and that’s something which is impossible to achieve in a bitcoin-based system. Currencies such as the dollar, with a central bank which can print money at will, have succeeded for a reason. As economies grow, the money supply has to be able to grow with them. And that’s why bitcoin can never really succeed over the long term.”

Jon Matoni presents the counterargument to this scenario of money-hoarding, deflation, and depression, citing Doug Casey:

“Deflation is actually a good thing, because in a deflation prices drop and money becomes more valuable, so deflation encourages people to save money. Deflation rewards the prudent saver and punishes the profligate borrower. The way a society, like an individual, becomes wealthy is by producing more than it consumes. In other words, by saving, not borrowing. And during a deflation, when money becomes more valuable, everybody wants money. They want to save. Whereas during an inflation, you want to get rid of the money. You want to consume. You want to spend. But you don’t become wealthy by spending and consuming; you become wealthy by producing and saving.”

As so often in economics, the expected outcome depends on the assumptions made. In a highly developed, saturated economy, for instance, sinking prices may well result in higher savings as described. In an economy in an earlier stage of development, in deep recession or enduring austerity, however, the propensity to spend may not decline to the same extent as prices. Similar arguments hold for the answer to the question whether investment will rise or fall under a Bitcoin regime.

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Another question is whether bitcoin supply is indeed limited.

On closer inspection, the 21 million may turn out to be one of the myths Bitcoin proponents nourish. In his article on Bitcoin’s Collusion Problem Timothy B Lee argues that the promise that the number of Bitcoins issued will never exceed 21 million is not credible. To follow his argument would require delving deeply into the process of bitcoin creation. But the following excerpt may give you an idea and provide an incentive to read the whole article:

“(T)he question is whether it would be possible for a critical mass of nodes [of the network running Bitcoin] to collude to change the rules. And I think the obvious answer to this question is yes, for two reasons. First, the Bitcoin software itself offers a convenient collusion mechanism. If the Bitcoin protocol is anything like other network protocols, a handful of clients is likely to account for the overwhelming majority of nodes at any given time. That means that convincing the creators of the top two or three Bitcoin clients to change their implementations would be enough to effectively change the protocol.

Second, collusion will grow easier as the network grows and becomes more professionalized. Bitcoin supporters are quick to point out that their system wouldn’t require ordinary consumers to run their own Bitcoin nodes. They predict that as the network grew and the resources required to run a node increased, that nodes would increasingly be run by commercialized entities who made money by providing “eWallet” services to ordinary Bitcoin users.

We might call organizations that are in the business of running Bitcoin nodes and processing Bitcoin transactions “banks.” And we could imagine these banks forming a membership organization whose primary function is to control the size of the Bitcoin money supply. It would announce changes to the Bitcoin protocol that expand the supply of Bitcoins at the desired rate. Member banks would agree to change their software accordingly. We could call this entity a “central bank.””

The history of money and finance shows that there is always a loophole to overcome obstacles and circumvent restrictions, and Bitcoin may be no exception.

Furthermore, change may also come from outside. As Prof. Steve Hanke ‏(@steve_hanke) wrote on Twitter:

“#Bitcoin is vulnerable 2 currency competition (like all others). Just bc Nakamoto came up w/ a great algorithm doesnt mean someone else cant”

There are already alternatives. As the Economist writes: “Bitcoin is not the only digital currency, nor the only successful one.” There are variants which to some observers already appear more attractive. Felix Salmon’s article about The Promise of Ripple is one example

Eventually, Bitcoin’s fate will be decided by how it fares in this competition. coɴsτ∀ɴτιɴε (@kkoolook) is right remarking on Twitter amid the highest turmoil:

“The real value of #Bitcoin is not its price but its technology.”

Does a similar law also hold for paper money, bank loans and virtual currencies? Apparently not, because otherwise the following examples of parallel currencies would not exist. The reasons why they survive, and thrive, and why, on the other side, they do not entirely replace their rivals, are an interesting topic for future research.

Here comes my collection of samples.

Local and regional currencies

Why do local currencies exist? In Shareable: Can Local Currencies be the Foundation for the Sharing Economy?  John Boik, founder of the Principled Societies Project, writes that at the moment, most local currencies are essentially “buy local” programs which encourage residents to purchase goods and services within their communities. But a more advanced form could serve as the financial underpinning of an expanded sharing economy.

There are countless variants of parallel currencies:

See a sample of the Boston Bean in the U.S.

In Japan, one example is the “r” or Earth Day Money.

Another country-wide alternative currency, which has a long tradition, is the WIR in Switzerland.

Bristol businesses queuing up to join local currency scheme  This Telegraph article describes how, as Britain loses faith in its banks and feels shockwaves from the euro crisis, one city is trying to keep local wealth in local pockets with the launch of its own currency: the Bristol pound, modeled after the Chiemgauer (see below).

Wer will schon Euro, wenn er Chiemgauer haben kann The first of a series of articles on Süddeutsche.de on the development and circulation of regional currencies.

German law rules that regional currencies are not allowed to look like official bills (not „banknoteneigentümlich“). See pictures of

a twenty-Chiemgauer bill (districts of Rosenheim and Traunstein, initially established as a school project in 2003),

Eder Taler bills (in the regions of Waldeck-Frankenberg and Schwalm-Eder),

Regio bills (Bavaria, issued by a monastery,  Kloster Irsee) ,

twenty Carlo (Karlsruhe),

a  twenty-BürgerBlüte bill (Kassel, Blüte (blossom) is German slang for bogus bills),

Ammerlechtaler bills (Ammersee region, Bavaria) and

the Roland (Bremen, the first regional currency in Germany, introduced in 2001).

Another example is Kohle von der Schwarzbank, a temporary project of a regional currency called “Kohle” (coal, in German is a slang expression for cash) in the German city of Oberhausen.

All in all, the Online Database of Complementary Currencies Worldwide complementarycurrency.org lists currently 249 complementary currency systems (of which 107 are in Europe). Bitcoin is one of them:

Bitcoin

There are countless articles about bitcoin. Here is a somewhat arbitrary selection.

What is Bitcoin? A short video and first informations on weusecoins.com on how to use bitcoin.

What Is Bitcoin and What Can I Do With It? Lifehacker answers this question.

Bitcoin – How it works is also very briefly explained on Andrew Grumet’s Weblog.

What is known about Satoshi Nakamoto, the person who invented bitcoin? In The Rise and Fall of Bitcoin in Wired Benjamin Wallace tries to find an answer.

There are physical bitcoins as well.

Programmer Robert McNally Put Together An Awesome Presentation On What Bitcoin Really Is presented by Business Insider and beginning with the Question: What is Money? Followed by: What is Cryptocurrency?

“Unless you are a computer geek, an MIT grad or an algorithmic genius, it’s unlikely you will ever really understand.” But Izabella Kaminska masterfully manages to make us understand at least some bits in: When memory becomes money; the story of Bitcoin so far on FT Alphaville.

In Lessons From the Newest Electronic Money – Bitcoin on Pragmatic Capitalism, Cullen Roche, the Founder of Orcam Financial Group, LCC asks whether bitcoin is money – and gets a long list of interesting comments!

Here is Jon Matonis on Bitcoin and crypto-currencies In this podcast, GoldMoney’s Andy Duncan and Jon Matonis of the Bitcoin Foundation discuss whether crypto-currencies are a credible alternative as a medium of exchange.

There is a bitcoin wiki available in eight languages containing more than 600 articles.

This is Wikipedia on bitcoin.

Bitcoin: the fastest growing currency in the world – video Bitcoin is an unregulated, uncontrolled online currency. It can be used to buy drugs, move money across the world, or get rich quick. People behind Bitcoin speak to the Guardian’s James Ball at their home in a squat in central London.

The Demographics Of Bitcoin presents results of a survey via Space Druid on Zerohedge. Here are some highlights:

The average user is a 32.7 year old libertarian male.

Top motivators for new users are curiosity, profit, and politics.

Bitcointalk.org is the dominant community platform.

Far more people have used Bitcoin to make donations than to buy narcotics.

39% of users do not drink, smoke, gamble, or take drugs.

How Bitcoin could destroy the state (and perhaps make me a bit of money) In the Spectator, Hugo Rifkind describes what he learned about bitcoin. Impressive: “… in 2010 somebody spent 10,000 of them on a pizza, a sum which would today make that pizza worth £465,368”

Bitcoin Goes Parabolic: My Updated Thoughts  Michael Krieger describes himself as a recovering Wall Street employee. He presents a “parabolic chart” of bitcoin development and compares the currency with gold and silver.

Bitcoin Hits $1 Billion When the total worth of the virtual currency reached a new high economists were mystified as to why, writes Morgen E. Peck, taking as an example the reactions in Cyprus after government announced a bank holiday in March.

I’m Raising My Bitcoin Price Target To $400 jokes Henry Blodget and explains why bitcoin “has all the elements required to become a massive speculative bubble … along with the additional attribute of not being constrained by any “fundamental” value whatsoever”, and the resulting consequences.

Is the Cyprus crisis a boon for Bitcoin? asks David Glance, Director, Centre for Software Practice at University of Western Australia

Spain turns to Bitcoin, prompting incoherent discussion on Today writes Alex Hern in the New Statesman. It’s not only Cyprus …

Bitcoin interest spikes in Spain as Cyprus financial crisis grows writes Ian Steadman on Wired.

Bitcoin Bubble or New Virtual Currency? From the Unconventional Economist, via Bullion Barron and MacroBusiness on Naked Capitalism, with many interesting comments.

Bitcoin ‘Glitch’ Sparks 23% Flash Crash This is Tyler Durden on Zerohedge.

The growing demand for larger and smaller monetary units JP Koning writes: “In financial markets, we’re starting to see stock quotes in sub-penny amounts. This is a massive change from a few decades ago when stock was typically quoted in eighths of a dollar. … Cryptocurrencies like bitcoin are particularly interesting in this respect because they are divisible to 8 decimal places. I found myself in a novel place last week when I was offering to sell a bitcoin-denominated stock for 2.99999, and someone undercut me by offering 2.99998.”

Four Reasons You Shouldn’t Buy Bitcoins Forbes author Timothy D. Lee explains why “anyone thinking about investing (in bitcoins) should understand that it’s an extremely risky proposition.”

On the other side: Bitcoin May Be the Global Economy’s Last Safe Haven  as Paul Ford argues in Businessweek.

But today (April 4) we learn from BBC that Hack attacks hit Bitcoin exchange rates.

In The Bitcoin Bubble and the Future of Currency, a rather lengthy but highly readable article, Felix Salmon looks behind the bitcoin bubble. He writes “… for the time being, bitcoin is in many ways the best and cleanest payments mechanism the world has ever seen. So if we’re ever going to create something better, we’re going to have to learn from what bitcoin does right – as well as what it does wrong.”

Why bitcoin’s rise is nothing to celebrate is a shorter version of the Felix Salmon Article mentioned above.

Bitcoin miners hit back at cyber-thieves is an interesting report by BBC’s Mark Ward about how thieves running networks of hijacked PCs are increasingly using these machines to create or “mine” the coins.

Does the Internet Depend on the Survival of Bitcoin?  asks Max Keiser in the Huffington Post.

Bitcoin getting big enough to attract regulatory repression writes Bruce Sterling on Wired.

Silk Road: the online drug marketplace that officials seem powerless to stop  writes James Ball in the Guardian. Where there is light, there is also shadow …

Web Money Gets Laundering Rule The U.S. is applying money-laundering rules to “virtual currencies,” amid growing concern that new forms of cash bought on the Internet are being used to fund illicit activities. By Jeffrey Sparshott, Wall Street Journal.

Others

Bitcoin beware. Alternative currencies are not always tolerated. Prison May Be the Next Stop on a Gold Currency Journey  is a New York Times article about Bernard von NotHaus, found guilty of counterfeiting charges for minting and distributing a form of private money called the Liberty Dollar.

What are NORFED Liberty Dollar Coins? This is a related report about a consumer advisory issued by the U.S. Mint warning people that the Liberty Dollars might be confusing to consumers and explaining why it is illegal to use them to conduct any commerce in the United States.

In Why central banks should take charge of their digital currencies Izabella Kaminska mentions several other variants of mobile money or virtual currencies:

M-pesa “(M for mobile, pesa is Swahili for money) is a mobile-phone based money transfer and microfinancing service for Safaricom and vodacom, the largest mobile network operators in Kenya and Tanzania.” (Wikipedia)

Square ”The fast, easy way to pay with your phone”.

Paypal the online money transfers system.

Dwolla another payment system that allows to send, request and accept money.

Ven the “global, digital currency for everyone”, used among a local community of networked users.

Mobino which offers an infrastructure to manage the circulation of e-money where people can have an account directly linked to their phone number.

With respect to the latter, Izabella Kaminska writes: “Before you start thinking this is going to be another boring “mobile money is the future” post, we should point out two important things. First, there’s Groff [the "father" of the Mobino] himself. He comes to mobile payments by way of telecoms, by way of French military service at CERN, by way of working with Tim Berners-Lee, by way of writing important elements of that small project known as the world wide web, by way of working with Steve Jobs on the European side of NeXT, and so on… So, credentials — he has more than a few. But if you’re thinking, well, it’s not like the space is lacking big software entrepreneur names, then the next point should be of more interest. Groff’s key aim with Mobino unsurprisingly is digitising money. As he noted to us:

Over the last 20 years we’ve managed to digitise everything; the press, shopping, even love… Money is the most intangible thing, and yet it’s the last to be properly digitised.

Yet, when Groff talks about digitising money, he doesn’t mean it in the M-pesa or Bitcoin sense. What he wants is a fully democratised, honest and harmonised digital currency structure. One that works with the government, not against it, whilst all the time empowering citizens.”

My last link in this category is a report by the European Central Bank on the growth and impact of virtual currency, including case studies of bitcoin and Second Life, the virtual community using the Linden Dollar.

Euro crisis

Some observers see parallel currencies as a solution for the euro crisis. Here are some examples:

From the failed idea of an optimum currency area to a regime of multiple currencies? As Thomas Mayer, former Chief Economist of Deutsche Bank Group and Head of DB Research, and now a senior fellow at the Center for Financial Studies at Goethe University Frankfurt  and external adviser to Deutsche Bank, mentioned: Parallel currencies emerge when official currencies fail to meet the needs and preferences of their populations.

Forget Euro Breakup—Think Euro Mutation In this article in the Wall Street Journal, Thomas Mayer recycles his idea of a future currency regime in Europe which he considers a more likely outcome than the current monetary arrangement or a total euro breakup. He is expecting what he calls a euro mutation, that is “the emergence of two new currencies that will operate alongside the euro, creating a three-tier monetary union”. In his words, “a three-tier euro zone would emerge. Countries like France, Italy and Spain would become the “core” countries, where the euro would be used both as a medium for transactions and a store of value. Germany, the Netherlands, Finland and its peers would constitute the “upper tier,” where the euro is a means of transaction but not a store of value. Countries such as Greece, Cyprus and Portugal would compose the “lower tier,” where the euro is a store of value but not a means of transaction.”

German bank tables plan for parallel Greek euro presents Deutsche Bank’s proposal for a a “geuro” – a parallel currency allowing Greece to devaluate while staying in the eurozone.

List of parallel currency proposals for Greece and the EMU by author(s) is a rather eclectic, but nonetheless interesting, collection of German and English language texts, compiled by the Money Network Alliance.

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Do you know other examples of parallel currencies? Tell us in your comment!

Bundesbank already printing D-Mark to prepare for breakup,

euro breakup into smaller currency unions,

Italy already de facto out of the euro,

Grexit,

contagion from Cyprus.

fears of Spain’s euro exit,

considerations of France leaving the euro to regain monetary sovereignty,

repatriation of German gold reserves as sign of an impending collapse of the monetary union,

the immediate success of a German initiative to abandon the euro,

and an overall rapidly waning confidence in the future of European monetary policy.

—  Considering the headlines, Europe seems to be in standby mode with flight instincts growing every day.

In this situation, anger, frustration and  fear seem to leave no room to develop a constructive European-wide approach to future monetary policy cooperation. But this is exactly what is currently needed most urgently. The euro experiment has failed, and a more or less orderly retreat which allows to contain the damage to the process of European integration requires a clear signal that lessons have been learned and a less ambitious, but viable system will be established paving the way for Europe’s return to “normality”.

Shrinking the union?

Given the often prophesied enormous cost of a return to national currencies, to many observers the most preferable alternative to the status quo would be to maintain the concept but shrink the current euro area to a smaller union of “like-minded” nations. There are at least three reasons why this is not a good idea:

(1)   The first is a practical one. This solution would require a solid and sustainable definition of “like-minded”. Considering the candidates for euro “ins” and “outs”, which in public debates vary almost daily, there is no such definition. One day, France is among the “core” countries, the next day, its economic data makes it an exit candidate in the eyes of commentators.

(2)   One reason for this uncertainty is an underlying conceptual weakness. In general, proponents of a currency union have a vague idea of an “optimum currency area” (OCA) based on similar economies and trade relations. But, we live in a world where markets for goods and services are dwarfed by financial market size. In order to decide whether a group of countries falls in the OCA category, the underlying concept or theory must take into account both financial and “real” influences.

The introduction of the euro was thought to once-and-for-all end the problem of individual countries being targeted by financial speculation. But even under the common currency, markets have found ways to discriminate between members, and to bet on them. There is no theory taking account of this. As I argued elsewhere, under these circumstances monetary unification without a true and full financial and fiscal integration (not meaning eurobonds) must be doomed to fail, and a smaller currency union would only prolong the sufferings.

(3)   Fears of the consequences of a drastic change are no excuse for an ineffectual solution, in particular, if these fears appear exaggerated. Despite all prophesies, probably no one has the slightest idea of how much the termination of this historically unique experiment will cost in comparison to its continuation. To cite one of my earlier articles:

“These arguments neglect the cost the current situation is imposing on the world, eurozone members and nonmembers alike. Many commentators conjure doomsday scenarios. To cite Nouriel Roubini: “ … such a disorderly eurozone break-up would be as severe a shock as the collapse of Lehman brothers in 2008, if not worse.”

How can he know? This statement contradicts all textbook wisdom. In contrast to the Lehman collapse, the euro break-up has long been a foreseeable event with a growing probability of entry (Roubini prides himself to have foreseen a break-up after five years as early as 2006. Had the US authorities had even the slightest suspicion of the Lehman crisis and its possible extent in 2003 presumably it would have passed with much less noise and damage). These days, in Europe business firms are increasingly writing currency clauses into new contracts. … Many banks have written down “toxic” debt … ”

The transition to a new currency regime may be smoother than expected.

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Other options

The alternative to a currency union is a return to national currencies under one of the following regimes which differ with respect to the extent to which those currencies are tied to one another:

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Source: Reszat 2005.

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One extreme is the clean float where authorities abstain from any form of influence on the exchange rate. In practice, this is a highly unlikely scenario.

The next loosest variant of a currency regime is the managed float: Exchange rates are generally allowed to fluctuate freely but governments or central banks exert a discretionary influence. Relations between the world’s major currencies are managed floats.

There are other, stricter arrangements such as a unilateral peg of one currency to another, or to a basket of currencies. The exchange rate can be fixed once and for all or take the form of  a crawling peg with adjustments made in regular or irregular intervals. (As Steve Hanke emphasised, Milton Friedman further distinguished between fixed and pegged exchange rates with monetary authorities aiming for more than one target at a time under the latter.)

Again, there is a conceptual problem: Setting parities and fluctuation margins requires some ideas about the short- and longer-term influences determining the exchange rate. Traditionally, the focus is on economic indicators such as foreign trade, price and non-price competitiveness and inflation differentials. But the greater the influence of financial markets, and the greater the use of currencies in foreign exchange markets independent of trade relations, the less sustainable are respective arrangements.

The predecessors of monetary union in Europe were multilateral systems of fixed but adjustable exchange rates, first the “snake in the tunnel” – a system of narrow fluctuation limits within the wider exchange-rate bands of the Bretton Woods system established in 1972 – and later the European Monetary System (EMS). Eventually, they proved unsustainable which was one reason why European countries sought to eliminate the possibility of exchange-rate fluctuations once-and-for-all. The timeline of the EMS crisis, which I published earlier, and which I add once again at the end of this article, gives an impression of the struggles involved.

Lessons

With over 40 years of instutionalised monetary policy cooperation, Europe’s experience in this field is outstanding and, at the same time, shattering. Sticking to a failed regime far too long, even after its weaknesses have become apparent, has brought poverty and discord to member countries and jeopardised the achievements reached in other areas and the overall integration process.

Two lessons can be learned from this experience.

(1)   The exchange rate is no policy instrument.

The way the foreign exchange market functions differs fundamentally from the ideas of policy makers and most economists advising them. This is largely a wholesale market, a huge money market in foreign currency, which is only loosely related to international trade, developments of national economies and markets for goods and services. It is the biggest of all international financial markets with an estimated daily turnover of 3,981 billion US dollar in April 2010. By comparison: World annual exports in 2010 were $14,950 billion. The stock of foreign exchange reserves worldwide was $10,791 billion at the end of 2010.

With luck, central bankers and policy leaders may manage to impress this market transitorily. But they are competing with many other, more spectacular influences and their coffers are never big enough to enforce their intentions lastingly.

(2)   Currencies are unsuitable means of integration policy.

Both fixed exchange rates and a common currency require a high degree of economic and political integration. Their establishment can only stand at the end of a successful integration process, including both goods and financial markets, not at its beginning. True, European economies benefited from periods of low exchange-rate variability in earlier years, and a common currency later on, but these advantages came at a high price.

—–

After 40 years experience with regional currency regimes, which eventually all failed, maybe the time has come for European monetary policy to choose a minimalist approach returning to national currencies and focusing on sporadic coordinated discretionary measures to influence market conditions and expectations, and to content themselves with being one stabilising element among others in times of turbulence. Mitigating transition effects, regaining flexibility, and slowly and patiently restoring credibility and trust in European institutions and processes, taking along all member countries on an equal footing, should be the primary objective. Over 60 years of successful European economic and political integration would be worth it.

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-  the New York Foreign Exchange Committee,

-  the Singapore Foreign Exchange Market Committee,

-  the Tokyo Foreign Exchange Market Committee,

-  the Canadian Foreign Exchange Committee,

-  and the Australian Foreign Exchange Committee.

The following table presents an overview of volumes and annual changes:

Two aspects are remarkable. One is the clear, and partly massive, overall decline of trading volumes in spot markets. Secondly, this decline is not matched by developments in foreign exchange swap markets. There were modest reductions in swap trading in the US and the UK (possibly reflecting banks’ cutback of proprietary trading in reaction to the financial crisis and in face of looming financial regulations). But elsewhere, swap volumes have risen – in Canada and Japan even by over 20 per cent.

In all leading places, except New York, swaps have long outweighed spot trading. One possible explanation is a rising demand for hedging against adverse market movements in times of increased financial turbulence. Another, in my view more plausible one in this interbank wholesale market, is search of profits. In times of meagre returns elsewhere, and growing public criticism, this very traditional, straightforward market segment outside the limelight which, as I argued elsewhere, is characterised by high concentration, flexibility and volatility and, accordingly, high prospective returns, is a lucrative niche for big players.

These developments raise the question what will be won by recent regulations in the United States and Europe. In both parts of the world, new rules for foreign exchange trading are in course of implementation – in the US they come as part of the 2010 Dodd-Frank financial reform, and in the European Union they are included in the concept of the financial transaction tax (FTT). In both cases, some foreign exchange market segments have been exempted for various reasons – with possibly unintended consequences for financial market stability.

In the EU, the financial transaction tax will come into force in January 2014. Participating countries are Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia and Spain.

According to the 2011 draft Directive – the basis upon which the countries wished to proceed – spot trading will be exempt from the FTT. Foreign exchange swaps and forwards will be included as cash products, with a minimum tax level of 0.1 percent, and forex options will be treated as derivatives (with a minimum tax of 0.01 percent on notional value). As for foreign exchange swaps, only the forward leg will be taxed.

In the United States, on November 16, 2012, the Department of the Treasury confirmed that both foreign exchange swaps and forwards should be exempted from certain requirements of the Dodd Frank Wall Street Reform and Consumer Protection Act such as the trade execution, mandatory clearing and margin requirements. But, they are still subject to Dodd-Frank’s reporting requirements and business conduct standards. Furthermore, the exemption does not apply to foreign-exchange options, currency swaps and non-deliverable forwards. Foreign exchange spot trades, on the other side, are not swaps under the Dodd-Frank definition and will not be regulated at all.

In both cases, the explanations given for the special treatments do not live up to market reality.

According to the European Commission:

“Through the FTT, the financial sector will properly participate in the cost of re-building Europe’s economies and bolstering public finances. The proposed tax will generate significant revenues and help to ensure greater stability (my emphasis) of financial markets, without posing undue risk to EU competitiveness.”

The tax will apply to financial transactions with at least one of the parties being established in a participating EU member state and either or both parties being a financial institution. Beside foreign exchange spot transactions omissions include loans, deposits, emissions, credits and commodities (except commodity derivatives). Excluded are also most consumer financial products such as insurance contracts, mortgage lending and consumer credit.

Apparently, the idea behind these exemptions is to spare end users, consumers and nonfinancial firms as much as possible with the aim not to unduly hurt the “real” economy while skimming off profits made in the financial industry, and, at the same time, making the financial system more stable.

The aim of Dodd Frank, too, is market safety and stability. The framework was developed in reaction to the financial crisis of 2007-2010. Pete Karabatos summarises its major components:

-  Consolidation of regulatory agencies, new oversight council,

-  regulation of the financial markets, increased transparency,

-  strengthened investor protection,

-  new crisis resolution tools including the ability to wind down bankrupt firms,

-  additional measures for adopting international standards and for accounting and tightened regulation of ratings agencies,

-  separation of proprietary trading activities from banking activities, and

-  new regulation for cross-border electronic transfers.

Title VII of Dodd-Frank deals with “Wall Street Transparency And Accountability” and regulates all those Over-the-Counter (OTC) derivatives the law is defining as “swaps”. Foreign-exchange swaps and forwards are not in this category as, according to the U.S. Treasury Department, they “already have high-levels of transparency and risk management” (Brush). Furthermore, the fact that about 41 per cent of forex swaps and 72 per cent of forex forwards in the US trade on electronic platforms is said to ensure a “high level of pre- and post-trade transparency” (Nasiripour and Ross).

Here we have the phenomenon that in the two regions with the biggest global centres of foreign exchange trading views apparently differ about the nature of the products traded – which is all the more remarkable as these are among the oldest, plainest and most standardised financial products worldwide.

There seems to be unanimity about spot trading which is exempt in both cases. Obviously, this is seen as a lesser threat to financial market stability than forwards and swaps. (Foreign exchange spots are also outside the scope of direct regulation by the FSA in the UK and the European Union’s MiFID.)

The focus of Dodd Frank and the European FTT is on longer maturities and their inherent speculative potential. Foreign exchange forwards and swaps are met with distrust in both parts of the world. But in the official US view they are harmless compared to other derivatives where markets are regarded as less transparent and risks less well-managed, and regulators settle for reporting requirements for better financial supervision.

In contrast, in Europe, forex forwards and swaps are treated even harsher than other derivatives which have a much lower tax rate. The motives are not clear. The wish to maximise tax revenues may play a role. As I argued elsewhere, the alleged aim to throw sand into the wheels of financial speculation has not much credibility in times of empty public coffers.

Attitudes of both sides are questionable. In order to see what is wrong with these arguments we have to recall how markets work. Let us start with definitions.*

*  Those who are familiar with my earlier article on Financial Regulation of Forex Forwards and Swaps may wish to skip the following.

A foreign exchange spot transaction is an exchange of two currencies for settlement within two business days. This includes intraday settlement as well as overnight trading and tom next.

An outright foreign exchange forward transaction is an exchange for more than two business days. The counterparties agree on periods stretching days or months or even years into the future with the exchange rate fixed at the time the transaction is agreed.

A foreign exchange swap is an exchange of two currencies for a specific period with a reversal of that exchange at the end of the period. A foreign exchange swap consists either of a combination of a spot and a forward leg or of two forward or spot trades with different maturities.

The foreign exchange market is largely a wholesale market, a money market in foreign currency.  As a rule, as in national money markets trades are highly standardised. The market is highly liquid and transactions are very large with traders buying and selling the equivalent of millions of US dollars in a few seconds.

In principle, foreign exchange forwards do not differ from spots. If a derivative is defined as an asset that derives its value from another asset, then both spot and forward trades are in this category. The difference is between short and long-dated trades and is a market convention.

Both spots and forwards are leveraged instruments. The potential return of trades is not on notional amounts but on margins. Due to established customs, when a currency is bought or sold spot or forward, no accounts are debited or credited, that is no money actually changes hands, until settlement, and it is only the difference, i.e. the gain or loss, that has to be paid and settled.

In combination with forex swaps both instruments offer a high degree of flexibility and profitability in taking positions which is one explanation for market size:

Dealers wanting to hold an open position for an undefined short time period buy or sell the currency spot or forward and then, when expectations do not fulfill in time or prospects continue to look favourable, prolong the position by a swap. As the Bank for International Settlement once put it:

“...foreign exchange swaps are often initiated to move the delivery date of foreign currency originating from spot or outright forward transactions to a more optimal point in time.”

By keeping maturities very short and renewing swaps continuously, traders are highly flexible in reacting to market events.

In contrast to a widespread view, foreign exchange forward and swap markets are not transparent. The foreign exchange market is largely an unknown quantity. There is no way to state how much bigger it is than other markets for financial derivatives. The only coherent source of information on market volumes is a survey conducted in April every three years by central banks and monetary authorities of countries with large and medium-sized foreign exchange markets under the auspices of the Bank for International Settlements. The above-mentioned regional surveys which are conducted more often differ in methodology and results. All those represent only a fraction of total foreign exchange business worldwide and allow only a momentary glimpse at a market which is permanently in motion and where actors, amounts, and types of transactions can vary considerably from month to month.

Will the new regulations increase transparency? So far, for the central bank surveys participants are asked to report all arm’s-length trades which means trades in which the dealer is indifferent as to the counterparty. For example, not included are in-house deals and deals with other offices of the same institution. Excluded are also deals of large globally operating firms within private corporate networks “bypassing” banks.

Under the new regulations there will be both more and less information. On the one hand, both Dodd-Frank reporting requirements and the EU tax exclude spot trades. They will remain largely intransparent. On the other hand, in principle, both concepts seem not to refer to the “nearness” of counterparties. Leaving problems of practical compliance aside, this could bring an increase of transparency.

Under Dodd-Frank, so far 65 entities were required to register as swap dealers with the supervisory authority, the US Commodity Futures Trading Commission (CFTC), representing nearly 40 banks. There is a $8bn notional threshold requiring registration which the 65 entities crossed in less than three weeks after implementation. Foreign exchange reporting will start in the coming months. Beside banks, other businesses will have to register as well as soon as they cross the threshold. Examples are Cargill, BP and Royal Dutch Shell (Nasiripour and Meyer).

In contrast, the European FTT will be restricted to financial transactions where at least one of the parties is a financial institution. Trades of nonbank businesses without involvement of a reporting financial institution will remain excluded.

Will the new rules for foreign exchange trading and reporting contribute to greater financial stability?  More information may improve the conditions for financial supervision. But, given that in both cases important market segments and actors are excluded the effect may be limited.

Forwards and swaps cannot be regarded isolated from spots.  The question whether trade will slow down as a consequence of recent regulations, for example, will largely depend on their effect on spot markets. In principle, as mentioned before, the distinction between spots and forward trades is a market convention. It may not pay, as Oliver Wyman found out, to replicate a seven day swap with a series of spot transactions. But both instruments allow forward-looking trades, and if one of them faces obstacles such as a tax, or only reporting requirements, market participants’ focus may shorten and activities may shift to the other.

As the following figure shows, the bulk of global foreign exchange trading is already of very short-term nature. Regrettably, the statistics do not provide a breakdown of the shortest interval of up to seven days giving no information about the presumably substantial share of spot and intraday trades.

As financial institutions make efforts to avoid taxation, the European FTT may in particular cause a shortening of maturities within this interval, thereby shifting the weight to the least transparent and least regulated market segment. Whether the Dodd Frank reporting requirements are a great enough deterrent to reinforce this tendency remains to be seen.  Contrary to the legislators’ intentions, the result may be not a deceleration, but an acceleration of market activity. At a time of major disruptions, when in Europe the experiment of a common currency is about to fail, the Chinese yuan is challenging the dominance of the traditional leading currencies and worldwide a currency war is looming this prospect is rather worrying.

]]> http://reszatonline.wordpress.com/2013/02/10/ftt-dodd-frank-and-forex-stability/feed/ 0 reszatonline fxswap_table1 fxswap_table3a fxswap_table2 fxswap_table4 http://reszatonline.wordpress.com/2013/01/27/central-bank-independence-in-japan-not-what-you-would-expect/ http://reszatonline.wordpress.com/2013/01/27/central-bank-independence-in-japan-not-what-you-would-expect/#comments Sun, 27 Jan 2013 09:12:09 +0000 reszatonline http://reszatonline.wordpress.com/?p=5436 ]]> *The author was Visiting Scholar, Bank of Japan, Institute for Monetary and Economic Studies (IMES), Tokyo (1994), and Visiting Scholar, Economic Planning Agency, Tokyo (1995).

——-

Currently, partly in reaction to earlier threats by Japan’s premier Shinzo Abe to curtail the independence of the Bank of Japan (BOJ), a big fuss is made in the news and in public debates about an increased “politicisation of exchange rates”and a potential “devaluation competition”: To observers’ bewilderment, talk about a currency war dominated discussions at Davos and elsewhere.  Policymakers and central bankers are expressing their growing concerns. One example is Jens Weidmann, president of the Bundesbank, who said in a speech in Frankfurt:

„Schon jetzt lassen sich bedenkliche Übergriffe beobachten, zum Beispiel in Ungarn oder in Japan, wo sich die neue Regierung massiv in die Angelegenheiten der Notenbank einmischt, mit Nachdruck eine (noch) aggressivere Geldpolitik fordert und mit dem Ende der Notenbankautonomie droht.“

“Already alarming violations can be observed, for example in Hungary or Japan, where the new government is interfering massively in the business of the central bank with pressure for a more aggressive monetary policy and threatening an end to central bank autonomy.” (Cited by Reuters)

The argument is insofar misleading as central bank independence in Japan differs from central bank independence in the euro area. If the Japanese government wishes to influence the Japanese currency, for instance, it is perfectly able to do so without touching the legal rights of the Bank of Japan.

In Japan and worldwide, central bank independence is a recent phenomenon. As Neil Irwin of the Washington Post wrote:

“The Bank of England gained legal independence in 1997; the central banks of France, Italy and many other Western European nations that aren’t Germany weren’t truly independent as late as the 1990s, when there began a push to create the ECB. The Federal Reserve gained independence in the 1951 Treasury-Fed accord, but sure didn’t act like it in the 1970s, when the Nixon administration used all manner of tools to encourage easy money policies out of the central bank (and resulting high inflation). It was Fed chief Paul Volcker’s willful leadership, serving in the Carter and Reagan administrations, that brought independence to the Fed in practice, if not in law.”

The Bank of Japan became “independent” with the 1997 revision of the Bank of Japan Act. Monetary policy is set by a nine-person policy board. Government officials are able to attend the meetings and submit proposals, but have no voting rights.

The duties of the Policy Board include:

-       setting the discount and loan rates;

-       setting out the reserve requirement for banks;

-       conducting open market operations;

-       making loans to financial institutions as needed;

-       initiating transactions with other central banks, and buying and selling foreign exchange in the forex market (currency interventions).

At first glance the reform seemed great progress. Traditionally, the degree of formal dependence of the Bank of Japan had been very low as various studies documented (Reszat 1997, Chapter 9). As one scholar wrote:

“The Bank of Japan is closely tied to the Ministry of Finance in ways that would normally appear to give the Bank little independence … In fact, one of the most commonly used measures of central bank independence, that of Cukierman, Webb, and Neyapti(1992), ranks only Norway below Japan among industrialized countries.” (Walsh 1997)

A Bank of Japan study by Fujiki 1996 also referring to this CWN index sketched how the index was constructed taking into account four groups of criteria:

-       variables related to the appointment and tenure of the chief executive;

-       to policy initiatives of the central bank in the decision making process;

-       the policy objectives of the central bank and

-       the conditions attached to central bank credit to the government.

When the reform was implemented, critics regarded it only as a modest reduction in the  power of the Ministry of Finance as the Bank of Japan is legally free to set interest rates (which was more or less a confirmation of the prevailing practice) but still has to cooperate closely with the Ministry. Article 4 of the Bank of Japan Act says:

“The Bank of Japan shall, taking into account the fact that currency and monetary control is a component of overall economic policy, always maintain close contact with the government and exchange views sufficiently, so that its currency and monetary control and the basic stance of the government’s economic policy shall be mutually compatible.”

Furthermore, the Bank of Japan is still lacking the autonomy to influence the yen exchange rate: Whenever it is intervening in the foreign exchange market it is acting on behalf of the Ministry of Finance. The Bank of Japan explains:

“When the yen becomes unstable in the foreign exchange market, the Japanese government (Finance Minister) may instruct the Bank of Japan, its agent, to conduct foreign exchange intervention by buying or selling yen against foreign currencies as needed.    

When the Bank intervenes, it uses government funds, and specifically those in the Foreign Exchange Fund Special Account (FEFSA). [N.b. Manfred J.M. Neumann once studied the nature and composition of this account in detail.] … The government’s foreign-currency assets held in the FEFSA, together with other foreign-currency assets held by the Bank, make up Japan’s foreign exchange reserves, the balance of which at the end of each month is released by the government (MOF).”

How does the cooperation between BOJ and MOF take place in practice? Again, the Bank of Japan explains:

When the government (Finance Minister) deems it necessary to intervene in the foreign exchange market …, the government (MOF) instructs the Bank to intervene. The Bank provides the government (MOF) with the latest market information relevant for making decisions on intervention. Based on this information, the government (MOF) gives the Bank specific instructions for the intervention. The Bank then conducts operations by concluding, through its dealers, foreign exchange trade agreements with major participants in the interbank market, such as financial institutions and foreign exchange brokers. If intervention is required during nighttime hours in Japan, the Bank usually entrusts the operation to the central bank of the region with the most active trading in its foreign exchange market at that time of the day.”

The first time I heard about a bad bank in Japan in the early 1990s. I have described elsewhere the dramatic consequences of the burst of the speculative bubble which had seized the Japanese economy in the 1980s and the resulting financial sector restructuring. One element of this process was the establishment of a bad bank, the Cooperative Credit Purchasing Company (CCPC).

Founded in January 1993 by 162 banks on the initiative of the Japanese Ministry of Finance, but without direct government participation, the CCPC was a private institution intended to “clean” banks’ balance sheets by buying nonperforming loans from banks and recovering them by selling the property which served as collateral.

The CCPC financed the purchases of the loans by borrowing from the selling banks. The latter received no interest and only got their money back when, and to the extent that, the CCPC managed to sell the underlying collateral. As a consequence, the credit risk stayed with the banks: “If the CCPC incurred a loss when a loan was sold, the original bank was supposed to pay for the additional loss.” (Hoshi 2008)

The incentive for the banks to participate in the scheme was tax relief. In general, Japanese banks were not allowed to deduct loan losses from taxable incomes as long as the borrower had not been officially declared bankrupt. But if the loans were transferred to the CCPC, the banks were allowed to deduct the difference between the book value and the sale price. The latter was supposed to reflect a fair market value. But there was an agreement that the final price of a transaction was determined only after the CCPC had managed to sell the loan. (Kanaya and Woo 2000)

It did not work. All in all, the CCPC bought loans of ¥15.4 trillion (about $146 billion) in face value. This was a small share of nonperforming loans in the system. In the mid-1990s outstanding loans in the Japanese economy amounted to over ¥500 trillion, exceeding nominal GDP (Okina 2009), and there were (conservative) estimates that the share of nonperforming loans was about ¥46 trillion or 10 percent of GDP.

One obstacle was that the banks could not be forced to sell to the CCPC, and many were reluctant to disclose the amount of problem loans they held. Mostly big banks took the opportunity. Up to 1998, the participating banks enjoyed an estimated ¥4.6 trillion of tax benefits. In comparison: At the same time, tax payments of the main banks were about ¥2 trillion. (Patrick Welter 2009)

Asset recovery was slow since real estate prices continued to decline. “Until the late 1990s, the CCPC just warehoused these bad loans without restructuring or selling those.” (Hoshi 2008) The CCPC continued to buy loans until March 2001 and eventually was dissolved in March 2004.

But this was not the only approach to free Japanese banks from the bad loans in their balance sheets. When in December 1994 two credit unions Tokyo Kyowa Credit Union and Anzen Credit Union, failed in Tokyo, an asset management company, Tokyo Kyodo Bank, was set up to deal with their remaining assets (later it also absorbed other failed credit unions). In 1996, Tokyo Kyodo Bank changed its name to Resolution and Collection Bank, RCB (Hoshi and Kashyap 2004).

At about the same time, the Housing Loan Administration Corporation (HLAC) was established. Its task was to collect loans of failed jusen. As Hoshi 2008 explains:

“Jusen companies were mortgage lending institutions created by Japanese banks in the early 1970s with strong encouragement from the Ministry of Finance (MOF) that saw growing importance of financing housing for increased urban population. Increased competition in the financial industry following the deregulation in the late 1980s drove jusen companies to shift away from mortgage financing (where they often had to compete with their parent banks) to more risky loans to real estate developers. The banks often “introduced” very high-risk projects that they were reluctant to finance to the jusen for “finder’s fees.” In this sense, the jusen then resembles the bank affiliated SIVs (structured investment vehicles) of the U.S. banks that invest in securitized sub-prime loans.

Large exposure to the real estate sector made the jusen the first casualty of the collapse of land prices. In 1991, the MOF put together a rescue attempt that included loan forgiveness and interest concessions by founder banks to help the jusen, their borrowers, and agricultural coops, which were their important lenders. The financial situation of the jusen, however, did not improve, and the MOF put together the second rescue plan in 1993. Both of these plans were based on the assumption that land prices in Japan would recover soon. The MOF hoped the financial assistance would allow jusen to survive the temporary shock without resorting to fire sales of the properties that backed their loans and without imposing losses to agricultural coops. The land prices did not recover. By 1995, when the jusen were finally closed, the total write-offs were … much larger than the estimated amount of total non-performing loans in 1991 …”

In April 1999, the RCB and the HLAC merged into a new entity, the Resolution and Collection Corporation (RCC):

The RCC was a subsidiary of the Deposit Insurance Corporation of Japan (DICJ), an authorised corporation of the Japanese government. In contrast to RCB and HLAC, the RCC was allowed to buy nonperforming loans from both failed and solvent banks (as well as from failed insurance companies and agricultural cooperations). Compared to the CCPC, the RCC was quite successful. Hoshi and Kashyap 2004 wrote:

 “Unlike the CCPC, the RCC does not have recourse against originator banks for losses incurred when selling any collateral associated with a loan. As of the end of March 2004, the RCC had acquired ¥9.311 trillion of loans (appraised value) from failed financial institutions (including those inherited from RCB and HLAC), of which ¥6.892 trillion (74%) were collected. The RCC has also purchased ¥327 billion of non-performing loans (appraised value) from solvent banks, of which ¥222 billion (68%) have been collected.”

The following table shows the results as of March 2009. Two aspects are worth mentioning. The first is the gain the RCC made from cumulative recoveries. The second is bulk of loans which were still purchased from failed institutions. As Richard Koo, Chief Economist at the Nomura Research Institute, and co-author Masaya Sasaki note: “This serves as a reminder of how easy it is to remove bad assets from the balance sheets of failed financial institutions and how difficult it is to remove assets on which large losses must be booked from the balance sheets of healthy institutions.” (Koo and Sasaki 2010)

The RCC still exists. As of September 2011 (the latest publicly available data I found), the purchase of assets from failed institutions had risen to ¥6,535.1 billion with cumulative recoveries amounting to ¥7,488.3 billion. From sound institutions the amount was an unchanged ¥353.3 billion, with cumulative recoveries risen to ¥681.2 billion (DICJ).

A comparison of the private (CCPC) and public (RCC) solutions might suggest that the public variant is the superior one calling for vigorous government intervention elsewhere, too. But this conclusion would appear premature.

First of all, given the estimated combined initial amounts of bad loans of banks and jusen in the Japanese system, the RCC, too, apparently still covers only a small share. Furthermore, the Japanese bad-bank approach is only one instrument among a wide variety of measures to digest the aftereffects of the bubble, and regarding it isolated does not make much sense.

But, above all, too many special influences stand against a direct comparison of countries: The uniqueness of Japan’s bubble economy and the following dramatic economic decline, the structure and characteristics of the Japanese financial system, the historically grown links between banks and industrial conglomerates in Japan – and between industry, administration and policy –  with the resulting special advantages and obligations, and the long tradition of “administrative guidance” (Reszat 1997) opening channels of influence that do not exist in this way elsewhere. On the other side, there are also similarities. Sorting out the differences and discovering the common features in order to learn from the Japanese experience might be worth the effort.

References

Takeo Hoshi has written several blog posts comparing the Japanese and the US experience on EconoMonitor. One example cited here is: TARP (US, 2008) = CCPC (Japan, 1992)

The paper by Takeo Hoshi and Anil K Kashyap of  2004 is on Solutions to Japan’s Banking Problems: What might work and what definitely will fail

An early evaluation of the Japanese experience is the IMF Working Paper by Akihiro Kanaya and David Woo on The Japanese Banking Crisis of the 1990s: Sources and Lessons of January 2000.

An in-depth general discussion of variants of private and official bad-bank solutions can be found in a McKinsey study of 2009 on Bad Banks: Finding The Right Exit From The Financial Crisis.

I once analysed the extent of the crisis in Japan and related early policy strategies in this German-language report of 1995: Japan’s Banken in der Krise.

Patrick Welter described the mixed experiences of Japan with the bad bank concept for Frankfurter Allgemeine Zeitung in 2009: Gemischte Erfahrungen mit der „Bad Bank“

Another interesting paper is A Proposal for The Japanese Non-Performing Loans Problem: Securitization as a Solution by Kay Ellen Herr and Goe Miyazaki.

There was some overlap between the activities of the RCC and the Industrial Revitalization Corporation of Japan (IRCJ). See for the latter Yuri Okina (2009): Activity of IRCJ and Banking Crisis in Japan

The paper by Richard Koo and Masaya Sasaki (2010) is on Japan’s disposal of bad loans: failure or success?

Data and information about the DICJ and the RCC can be found on the DICJ site.

Finally I would like to draw your attention to two earlier posts on this blog on Japan’s banking structure and on Fukushima – the burdens of Japan’s financial system.