The Coming Speculative Attack

I was reading Pierre Rochard’s article over at SNI and i noticed something very interesting. (Bold at bottom-mine)

Slow bleed leads to currency crisis as the expected value of bitcoins solidifies in people’s minds. At first they are conservative, they invest “what they can afford to lose”. After 12-18 months, their small stash of bitcoins has dramatically increased in value. They see no reason why this long term trend should reverse: the fundamentals have improved and yet adoption remains low. Their confidence increases. They buy more bitcoins. They rationalize: “well, it’s only [1 -5%] of my investments”. They see the price crash a few times, due to bubbles bursting or just garden-variety panic sales – it entices them to buy more, “a bargain”. Bitcoin grows on the asset side of their balance sheet.

On the liability side of the Bitcoiner’s balance sheet there are mortgages, student loans, car loans, credit cards, etc. Everyone admonishes people to not borrow in order to buy bitcoins. The reality is that money is fungible: if you buy bitcoins instead of paying down your mortgage’s principal, you are a leveraged bitcoin investor. Almost everyone is a leveraged bitcoin investor, because it makes economic sense (within reason). The cost of borrowing (annualized interest rates ranging from 0% to 25%) is lower than the expected return of owning bitcoins.

How leveraged someone’s balance sheet is depends on the ratio between assets and liabilities. The appeal of leveraging up increases if people believe that fiat-denominated liabilities are going to decrease in real terms, i.e. if they expect inflation to be greater than the interest rate they pay. At that point it becomes a no-brainer to borrow the weak local currency using whatever collateral a bank will accept, invest in a strong foreign currency, and pay back the loan later with realized gains. In this process, banks create more weak currency, amplifying the problem.

The effect of people, businesses, or financial institutions borrowing their local currency to buy bitcoins is that the bitcoin price in that currency would go up relative to other currencies. To illustrate, let’s say that middle-class Indians trickle into bitcoin. Thousands of buyers turns into hundreds of thousands of buyers. They borrow Indian Rupees using whatever unencumbered collateral they have – homes, businesses, gold jewelry, etc. They use these Rupees to buy bitcoins. The price of bitcoins in Indian Rupees goes up, a premium develops relative to other currency pairs. A bitcoin in India might be worth $600, while in the U.S. it trades at $500. Traders would buy bitcoins in the U.S. and sell them in India to net a $100 gain. They would then sell their Indian Rupees for dollars. This would weaken the Indian Rupee, causing import inflation and losses for foreign investors. The Indian central bank would have to either increase interest rates to break the cycle, impose capital controls, or spend their foreign currency reserves trying to prop up the Rupee’s exchange rate. Only raising interest rates would be a sustainable solution, though it would throw the country into a recession.

There’s a huge problem with the Indian central bank raising interest rates: bitcoin’s historical return is ~500% per year. Even if investors expected future return is 1/10th of that, the central bank would have to increase interest rates to unconscionable levels to break the attack. The result is evident: everyone would flee the Rupee and adopt bitcoins, due to economic duress rather than technological enlightenment. This example is purely illustrative, it could happen in a small country at first, or it could happen simultaneously around the world. Who leverages their balance sheet and how is impossible to predict, and it will be impossible to stop when the dam cracks.

Which countries are most vulnerable to a currency crisis? Business Insider provides a helpful list here. Bitcoins will have to reach certain threshold of liquidity, indicated by a solid exchange in every financial center and a real money supply – i.e. market cap – of at least $50 billion, before they can be used as an instrument in a speculative attack. This will either coincide with or cause a currency crisis.

End of Article

I think things are going to get very interesting when the next self-imposed government currency crisis hits a country. As this article predicted, Bitcoin has grown and is now big enough to start eating small governments.

http://nakamotoinstitute.org/mempool/speculative-attack/

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