Moneyness = 22?

Courtesy of Kerry Taylor's twitter feed, here is a chart which was presented during a recent investing conference in Toronto. Apparently bitcoin has a moneyness score of 22 while cowry shells ring the bell at 15, both of them exceeding the moneyness of U.S. dollars at 13. The presentation that contains the chart was created by angel investor Sean Walsh and is available here.

Since my blog is called moneyness, and I've written quite a lot on this topic, I feel somewhat obligated to chime in. Let's start with the good bits about the chart. Instead of classifying items as money-or-not, we can appraise objects by their degree of moneyness. Because every valuable object or instrument is exchangeable, some more easily than others, everything lies somewhere on the money spectrum. The diagram below illustrates this idea. This way of looking at things can provide some insights that we don't normally get when taking the money-or-not approach, and its nice to see that folks like Walsh are using it. (For a longer explanation of moneyness, go here).

Now the not-so-good bits. Let's go and see what Walsh means by the term moneyness. On page 14 he lists six characteristics of money including scarcity, durability, divisibility, recognizability, fungibility, and tranportability. Walsh compiles an instrument's moneyness score by assigning a value from 0-4 for each characteristic and then summing this up. The maximum score is 24, with bitcoin losing just a point on durability and fungibility. He gives no explanation for how or why some instrument might get a 3 for, say, recognizability instead of a 4, so I guess we'll just have to assume he has a consistent method for rewarding points.

There are two reasons why I disagree with this approach. First, even if we accept Walsh's definition of moneyness and his choice of rankings for each instrument, his list of attributes is incomplete. It is missing one of the most important ones: price stability. When people accumulate balances in anticipation of spending needs, they expect those balances to hold their value for a few days, maybe weeks. If the medium's purchasing power is volatile, then there is a risk that the stuff in their wallets won't allow them to meet tomorrow's spending requirements, which means it isn't doing a very good job as a medium of exchange. Bitcoin probably has the lowest stability of the instruments in the chart. 

My second and more important criticism has to do with the way that Walsh measures moneyness. In a hard science like chemistry or geology, ranking each objects' physical characteristics might pass muster. For instance, geologists use the Mohs Hardness Test, a scale from 1-10 for testing the resistance of a mineral to being scratched. Walsh is running something like the Mohs Hardness Test, except for monetary instruments.

But economics involves humans. And in economics, we are not interested in the physical characteristics of the goods and services people buy, say how hard a mineral is, or how cushy a couch is, or how fast a car can go. Rather, we are interested in the subjective evaluation economic actors place on those objects and the manifestation of these preferences in the form of market prices.

So the way to accurately measure moneyness isn't to design the equivalent of Mohs Hardness Test for monetary instruments, but rather to find out what price people actually put on that moneyness. One way to do this is by asking how much compensation people would expect to earn if they were to give up an object's moneyness for a period of time. More specifically, say you are offered a deal to buy one bitcoin but are prohibited from selling that bitcoin for one year. How much less would you be willing to pay for this locked-in bitcoin than a regular bitcoin that you will probably hold for at least one year anyways? If a locked-in bitcoin is worth, say, $500 less to you than a regular bitcoin, that means that you place $500 on a regular bitcoin's one-year tradeability, or its moneyness.     

We can also think about moneyness in terms of interest rates. What rate would you need to earn on a locked-in bitcoin to compensate you for the nuisance of giving up its ability to be used as an exchange medium? 10%? 5%? The extra interest you expect on locked-in bitcoin is the degree to which you value a regular bitcoin's tradeability, or moneyness, over that time-frame.

The price of a dollar's moneyness is easy to measure. Someone who will have a spare $10,000 on hand for the next year can hold it in a government-insured chequing account and earn 0% or they can lock that amount into an insured term deposit and earn around 0.85% (I'm using Canadian numbers for non-cashable 1-year GICs). By locking in the $10,000, an individual's ability to mobilize these dollars as a medium for making payments has been effectively destroyed for 365 days. They cannot buy stocks or bonds with it, nor convert it into cash, nor purchase peaches, tables, labour, travel, etc. Their dollar are inflexible; they have no moneyness.

People are willing to accept this burden but only if they are compensated to the tune of 0.85%. Put differently, the 0.85% rate represents a large enough carrot that marginal depositors are roughly indifferent between holding money in a chequing account for a year or locking it in. So if $10,000 in a term deposit provides a pecuniary return of $85, then $10,000 dollars held in a 0%-yielding chequing account provides around $85 in non-pecuniary monetary services, or moneyness, over the course of the year.

We can also go through this process with gold. Head over to Kitco and you can see that the 12-month lease rate is at 0.2%. Say you are hoarding $10,000 in gold under your mattress. If you are willing to forfeit the ability to make any transactions with your $10,000 stash for one year, a bank will compensate you with $20 ($10,000 x 0.2%) for your pains. Put differently, $20 is the amount that the bank needs to provide the marginal gold hoarder to tempt them into giving up the moneyness of gold. (The implied moneyness of $20 is far less than the $85 a Canadian chequing account offers, contrary to Walsh's chart, which ranks gold above dollars. Note that I am ignoring storage costs.)

To carry out this measurement for bitcoin, we'd have to determine what sort of rates a large international bank provides to bitcoin term depositors. I doubt this measurement can be made since reputable banks don't deal in bitcoins. So bitcoin's moneyness is not 22. We have no real idea what it is.

What gold's negative lease rate teaches us about the zero-lower bound

When people talk about gold, they usually talk about the gold price. But there are a few other key gold market metrics that often go unmentioned. The chart below stacks the gold price on top of the gold forward rate (GOFO), LIBOR, and the lease rate. The gold lease rate is an interest rate. Just as you can lend your cash to a bank at the bank's deposit rate, you can lend your physical gold to a bank at the lease rate.

Understanding GOFO and the lease rate is important not only for gold bugs, but for anyone who wants to get a good grasp of the phenomenon of interest rates. GOFO and the gold lease rate demonstrate that interest rates are not phenomena solely confined to paper assets. The ability for an investor to lease their gold and earn an interest return makes up part of gold's peculiar "own-rate". All commodities have own-rates. From our perspective as consumers, we rarely get to see these markets, but they do exist. I've illustrated them in the following chart:

Go to this scribd link for a high res version if you want to understand how GOFO, LIBOR, and the lease rate interact.

One thing you may have noticed from the chart is that gold's three month lease rate (at bottom) is negative. Back in November 2011 the one month lease rate fell to a record low of -0.5%. Now anyone familiar with the idea of the zero-lower bound may find this surprising. Interest rates aren't supposed to be able to fall below 0%. If they do, people will simply redeem the underlying 0% yielding asset and store it themselves. Why keep gold on loan to a bank only to pay a -0.5% penalty when you can withdraw it and keep it under the mattress for free? Yet the market was willing to bear negative lease rates.

The reason for this oddity is that as the yellow metal's price rises, it becomes ever more attractive to robbers. One ounce to a robber at $300 is tempting, but not as tempting as that same ounce at $1750. So it costs more to insure gold. Secondly, storing gold is somewhat costly. Do you hide it under granny's bed, or do you buy a home safe for it? At which point do you rent a vault at a bank? Anecdotal evidence suggests that banks specializing in gold storage have been running out of space over the last few years, implying rising storage costs.

In a nutshell, that's why people haven't withdrawn their gold as lease rates have turned negative. In keeping their gold on loan to the bank rather than bringing it at home, they avoid all the headaches of storage costs, insurance, and the fear of theft, yet still get exposure to gold price appreciation. The negative lease rate is the fee they pay in order to have someone else incur all these headaches.

Like the gold market, the currency market also has the capacity to bear a negative interest rate. If the rate on bank deposits falls to say -0.25%, depositors would likely keep their cash on loan to the bank since storing it at home or in a vault is costly. How low can deposit rates fall before people start to withdraw cash? -1%? -2%? Cash, after all, is thin and light, surely easier to store than gold. One way to prevent cash redemption at negative deposit rates is to make cash storage costly. If someone wants to withdraw $100,000 in cash, make them take it all in $5 bills. The high cost of storing low denomination bills will get anyone to reconsider withdrawal. I've discussed the idea of varying redemption denominations here.

So as the gold market shows, the zero-lower bound is a soft bound, not a hard one. As for all you gold bugs out there, I'll write more about negative lease rates sometime soon.

Interest rates and gold

Nick Rowe recently asked what the point of repoing an object was when you could just sell it, repurchasing it later. He could see three reasons. Firstly, you might repo a particluar thing because you hold it dear and want it back. It might not be available were you to simply try buying it back. Secondly, you might repo an asset because future liquidity might be an issue. Thirdly, you might repo an asset rather than sell it because future prices are uncertain. My comment used gold markets as an analogy:

Nick, I think for financial assets you are right about points 2 and 3. In gold markets, for instance, you'd rather lend or swap (ie. repo) your gold than sell it (upon the anticipation of buying it back at some future point) because you might fear that, come time to buy the gold back, the future price could be much higher, or that the gold market could be illiquid and you might not be able to buy.

Incidentally, you can also sell your gold and buy a futures contract. Selling spot and buying a futures contract is financially equivalent to swapping (repoing) gold - in both transactions you'll lock in a guaranteed price and will avoid the risk of illiquidity. So your question: why repo? is similar to the question: should I sell some asset and simultaneously buy a futures contract or sell it and take the risk of buying back at spot at some future point in time.

Some people might recognize these various gold transactions. A gold swap — a temporary exchange of gold for cash — is transacted at the GOFO (gold forward) rate. A gold loan, which is an unsecured and temporary exchange of gold for nothing but a promise to repay, is transacted at the gold lease rate.

You can actually conceptualize both transactions as swaps. In the first, gold is temporarily swapped for a liquid and safe financial promise (cash). In the second, gold is temporarily swapped for an illiquid and safe financial promise (a promise to repay the gold ie. "paper gold"). Lingo-wise a swap is no more than a repo.

The different rates at which these two swaps are conducted — GOFO and the lease rate — will be determined by the relative subjective value gold owners place on the swapped-for assets. Because liquid financial promises provide more services to their holders than illiquid promises, anyone swapping away gold will prefer the former to the latter. That's why the gold lease rate — the rate paid by the person taking the gold to the person foregoing that gold - has always been higher than GOFO. After all, the party swapping away gold needs some increased financial incentive to take the illiquid "paper gold" asset rather than the liquid cash.

Indeed, liquid and safe financial assets are so valued, and so easily storable, that in general, anyone swapping away their gold will not receive a fee for foregoing the metal. Rather, they will pay a fee for the advantages of getting cash. This fee is what GOFO represents.

These ideas can be tough to conceptualize. A while ago I caught the folks at FT Alphaville mixing them up. For instance, the author maintained that a dearth of cash in markets now meant that

since their cash had become more valuable to the market than their gold, they could now make a return from lending cash against gold, as opposed to gold against cash.

The above comment implies that the gold swap rate — cash for gold, or GOFO rate — has somehow switched. But in actuality, those swapping away cash for someone else's gold always earn a return (GOFO). This is because they are foregoing liquidity. The gold lease rate has switched, but that is a different rate, and a different story altogether.

On the topic of gold, David Glasner asks why gold markets are rising due to hyperinflation fears but bond markets aren't:

Now my question — and it’s primarily directed to all those believers in the efficient market hypothesis out there — is how does one explain the apparently inconsistent expectations underlying the bond markets and the gold markets. Should there not be a profitable trading strategy out there that would enable one to arbitrage the inconsistent expectations of the gold markets and the bond markets?

I don't think there is any discordance to explain:

I think gold prices and bond prices have been rising over the last three years for similar reasons. In general, the economy-wide expected rate of return has been falling (towards zero, perhaps below it) as investors grow fearful of the future. This pushes people into safe bonds. It also pushes them into assets like gold that have very low storage costs, since buying some easily-storable durable asset and holding it over time provides a 0% return, better than most risky alternatives which are expected to fall.

So I don’t think there are segmented expectations in these two markets, nor do I think it is worthwhile trying to arbitrage them.

Returning to the discussion of GOFO, if today's gold markets were actually dominated by those who believed in the inevitability of hyperinflation rather than (fairly) rational actors, then GOFO would be inverted... in essence, anyone who swapped away their gold for cash would expect to receive the GOFO rate rather than pay it. The current practice, as I pointed out above, is to pay that rate, not receive it. The reason for the inversion would be because the destiny of cash in a hyperinflation is demonetization and, as a result, it will lose all of its liquidity premium, whereas gold's destiny is to be remonetized and gain a relative liquidity premium. As a result, any gold-for-cash swap based on a universal expectation of hyperinflation would require whoever foregoes the benefits of gold's inevitable superior liquidity to be compensated by a return. Needless to say, GOFO has not inverted. Those foregoing  their gold still pay up to those foregoing cash.

Gold lease rates

More on the phenomenon of negative gold lease rates at Gold Chat.

The points are similar to here.

Gold lease rates, GOFO, gold

FT Alphaville commented on gold lease rates in Make your own (collateralised) gold standard.

My comment pointed to the fact that much of the conversation on negative lease rates is not considering the fact that storage costs are rising. These rising costs encourage gold owners to lend gold out temporarily so they save themselves the hassle of footing a hefty storage bill, and they may be so eager to avoid this bill that they are willing to pay others a fee to take on the burden. Thus negative interest rates.

Relavent links:

See Negative Lease Rates at Gold Chat