Is it better to bribe Trump by purchasing his memecoin or his stock?

Noah Smith writes a provocative article about memecoins as a novel mechanism for bribery payments. A foreign dignitary looking to gain influence over Donald Trump would like to pay him a giant bribe, but doing so directly is prohibited by all sort of laws. Luckily, Trump has just issued his own memecoin, TRUMP, of which Trump owns 80% of all coins. So why not just buy the TRUMP token, thereby pushing its price up and gifting Trump with even more wealth, in return gaining a degree of influence over policy?

The best part is that no money actually changes hands, so it's probably less risky from a legal perspective. The dignitary can just plead "I thought it would go up!", says Noah.

Now, I'm not so sure that crypto is ushering in anything unique here. Consider that Donald Trump also owns shares of Trump Media & Technology Group Corp (DJT), which are NASDAQ-listed "tradfi" shares that predate crypto. Why not just buy DJT shares, pump their price higher, and collect favors from Trump? No crypto involved. 

In fact, a year before Noah wrote his article about memecoin bribery, Robert Maguire of Citizens for Responsibility and Ethics in Washington (CREW), worried about precisely such a scenario. Any entity wanting to "cozy up" to Trump need only buy a bunch of DJT shares on the NASDAQ, enough that they "get Trump’s attention, but low enough that it doesn’t break the five-percent threshold that triggers SEC disclosure."

Consider that Donald Trump and family members hold a 59% ownership stake in DJT equity, which isn't too different from the 80% of TRUMP that they own. Both assets have market caps of around $7 billion. So pushing up the price of DJT will certainly enrich Trump just as much as trying to nudge TRUMP higher. So here's my question: What's the best way to bribe the current President of the United States of America, by pumping the TRUMP memecoin or pumping old-school DJT shares?

Before answering it, I want to pause for a moment to reflect. The fact that I am even writing a blog post on the topic of bribing an American president shows how far along a certain dystopian financial timeline we have gone. Back to the timeline.

I see two reasons why the memecoin probably presents a better pseudo-bribery option than the tradfi stock. 

The first reason is that it's safer to pull off. DJT is listed on just one exchange; the NASDAQ. And the NASDAQ exists in the U.S., which has the most robustly-regulated and well-trusted securities markets in the world. One duty the government requires of NASDAQ is that it surveil transactions in real-time for abusive trading behaviour, so any sketchy DJT purchases could end up being reported by NASDAQ to the authorities. Furthermore, to get access to NASDAQ-listed shares, a brokerage account is required, and that'll require the would-be briber to pass through the brokerage's identity checks.  

On top of that, systems like the Consolidated Audit Trail, a government-mandated system tracking U.S. equity and options trades, gives regulators themselves a means to monitor market activity and investigate potential misconduct.

So a foreign dignitary is taking a bit of a risk if he or she goes the DJT route.

By contrast, the TRUMP memecoin is hosted on a blockchain, basically a borderless and open decentralized database, not a carefully-guarded database confined to the U.S. The result is that TRUMP can be listed anywhere, including on shady offshore crypto exchanges like ByBit or KuCoin, which surely aren't checking customers for pumps. To boot, these offshore exchanges perform only cursory identity checks, if any.

To further protect him or herself, a would-be briber can initiate the pump by sending funds from an offshore exchange, say KuCoin, to a decentralized exchange, or DEX, and only then push the price of TRUMP higher. DEXes are even more hands-off than offshore exchanges; they don't perform any surveillance or identity checks.

The riposte to this is that all blockchain transactions are public and observable, so a bribe conducted on a DEX could be traced. Ok, sure. But while blockchain transactions are visible, they aren’t directly tied to real-world identities. Blockchains are pseudonymous. It's a bit like going to a masked ball. Everyone can see who the dancers are, but as long as everyone has their mask on a degree of anonymity is preserved.     

So to safely get away with bribing Trump, it sure seems that his memecoin is the better option than NASDAQ-listed DJT.

Now for the second reason why the memecoin is better for bribery: it packs more punch per dollar.

A memecoin lacks what equity researchers refer to as fundamental value. Its price is solely a function of Sam's expectations of what future buyers like Jill will pay for it, with Jill's expectations conditioned on what she thinks Sam will pay. They are pure bundles of speculative energy. As I've referred to them in other posts, memecoins are decentralized ponzi games, zero-sum lotteries, or Keynesian beauty contests.

By contrast, DJT is a stock, and stocks provide their owners with a claim on the underlying firm's 1) profits and 2) its assets in case it is eventually wound-up. There is a "something" that buyers and sellers can coordinate on, so that unlike a memecoin, a stock is more than a pure nested expectation games. That's not to say that stocks don't have a big "meme" component (think Gamestop), but the degree to which this guessing game is played with stocks is unlikely to ever reach that of memecoins.

The existence of fundamentals makes pumps less effective. As a pump begins to drive the price of DJT higher, the underlying fundamentals will start to give certain existing investors a reason to sell (i.e. "it's now too expensive relative to earnings"), and that selling will dull the pump. Since there are no fundamentals for TRUMP memecoin buyers to latch on to – any price is as good as another – a memecoin pump never gets throttled by fundamental sellers.

To sum up, someone who has $10 million to bribe Donald Trump will want to demonstrate to the President that their purchases drove the price of the target asset higher: it'll be far easier to demonstrate this by pumping the frictionless memecoin than the burdened-by-fundamentals stock.

Now, if you've gotten this far and think this post is actually about how to bribe Trump, it's not. It's about the often fascinating differences (or not) between crypto and traditional finance. In my view, they aren't really so different. Crypto fans may think there's a financial revolution going on, but there's nothing new under the sun.

You might wonder: is the frictionlessness of a memecoin, its lack of fundamentals, and the ensuing incredible ease by which it can be bribe-pumped a new feature that crypto has brought to the table? Not really. There's no technical hurdle preventing the NASDAQ from listing a non-blockchain version of the TRUMP memecoin on its own old-fashioned Oracle database. People could buy and sell this NASDAQ-listed meme-thingy instead of that blockchain version of TRUMP. But securities law gets in the way. Listing an unadulterated ponzi game on a national stock market has never been legal, at least not in my lifetime. Why putting one up on a blockchain is legal is beyond me, but look over there, the President just did it.

At the speed the train is leaving sanity station and heading to financial silly land, I suspect listing pure ponzis on the NASDAQ will soon be an accepted thing. Memeassets everywhere! Bribes for everyone!

It's time to get rid of "crypto"

Call me a pedant, but I'm not a fan of the word "crypto". It may have been a serviceable category back in 2011 when there was only one type of crypto thingy – bitcoin. But it's ceased to be a meaningful term and, if anything, it causes a regression in understanding.

Source: Fidelity

Case in point is the above diagram from Fidelity, which suggests that clients should conservatively invest 40% of their wealth in "equity," 59% in "fixed income", and the other 1% in "crypto."

These categories are nonsensical because in many cases, crypto *is* equity. (And in other cases, crypto *is* fixed income.) Fidelity's buckets are not mutually exclusive.

For instance, take MKR tokens, which are inscribed on the Ethereum blockchain and are a top-100 asset listed on CoinGecko. MKR may sound like it deserves to fall in the crypto bucket, but hold on a sec. As a MKR holder, you enjoy a right to the earnings of MakerDAO, which is effectively an offshore bank. You enjoy buybacks, voting control, and a residual claim on assets after creditors in case of windup or bankruptcy. Guess what, folks. That's equity! Yep, buying MKR shares is economically equivalent to buying shares in Bank of America.

Likewise with Dai tokens, the payments instrument – aka stablecoin – that MakerDAO issues to customers on the Ethereum blockchain and the 25th largest asset on CoinGecko. Sounds like crypto, no? But along with being pegged to the U.S. dollar, Dai pays interest of 5%. That puts it firmly into the fixed income bucket, very much like an uninsured interest-yielding account at the Bank of America.

What exactly is crypto, then?

The word "crypto" describes a database technology, not an asset class. Various asset classes – equity, bonds, options, and savings accounts (or various combinations of these) – can be recorded and stored on crypto databases, much like how MKR shares are served up on Ethereum, one of the most popular crypto database. These crypto databases fall in the same bucket as an Azure SQL database or an Oracle databases, both of which record assets but neither of which belongs itself to an asset class.

So now you can see why Fidelity counseling its customers to invest 99% in equity + fixed income and 1% in crypto is absurd. It's a category mistake, like if Fidelity advised folks to hold 99% in equity + fixed income and 1% in assets stored on Oracle databases.  

Telling customers to invest 1% of their wealth in generic assets stored in Oracle databases isn't just a category mistake; it's downright reckless. All sorts of wild financial stuff appears on Oracle databases, including sports bets and zero day options. Conservative investors have no business touching these. As for crypto databases, they are particularly notorious for holding financial fluff like ponzis and digital chain letters (i.e. litecoin, dogecoin, floki inu and their various ancestors and cousins); none of which Fidelity should be hocking to serious customers.

Crypto doesn't refer to an asset class, it describes the database technology on which assets appear. Better yet, let's just get rid of the word altogether. It's beyond repair.

Make bitcoin cheap again for cypherpunks!

[For CoinDesk's Tax Week, I wrote about taxing proof-of-work, the mechanism used to secure Bitcoin. I'm still not 100% sure how to design the tax. In my CoinDesk article I suggested a one-time tax on purchases made at regulated exchanges. Another option is a continual tax on holding bitcoin, like a property tax. Give it a read and tell me what you think.]

The Case for Taxing Proof-of-Work

Bitcoin is an energy-intensive protocol designed for serious cypherpunks. Alas, bitcoin has been mobbed by unserious speculators, pushing up its price and blowing up its electricity usage. It’s time to enact a tax on proof-of-work. The tax would drive the tourists away, bring proof-of-work consumption back to a balanced level and make bitcoin cheap again for cypherpunks.

The Bitcoin network provides bitcoin owners with a unique sort of security – proof-of-work. Proof-of-work, or PoW, is a method for securing a network in a decentralized manner. The process, however, is incredibly energy-intensive, requiring thousands of competing processors, or miners, to perform redundant calculations. Other forms of security, say that underlying instruments listed on the Nasdaq stock exchange, rely on cheaper centralized methods.

Think of bitcoin as an M1 Abrams tank. A Nasdaq-listed stock is a zippy little Toyota. Most of the time a cheap Toyota works fine. But there are times and places when an expensive M1 Abrams is needed.

There is a small community of cypherpunks – hobbyists and technologically informed individuals – who like to consume bitcoin's tank-like security. They make PoW-secured transactions and eschew non-PoW-secured transactions. These cypherpunks are well-versed in self-custody. They have a deep understanding of what bitcoin is and can clearly articulate why they prefer PoW-based security.

Then there is the great unwashed.

Most of the people buying bitcoin these days are not cypherpunks. They are casual users. These “tourists” don't particularly want to make peer-to-peer bitcoin payments. They don't care about the Bitcoin network's tank-like level of security. They are quite content to keep their bitcoins lodged at Coinbase or Binance. They couldn't write a lucid paragraph on PoW if their lives depended on it.

What these casual users are after is "number goes up" – they want to get rich. And it's because of this influx of speculators that a tax on proof-of-work could end up being necessary.

We can all agree that it'd be overkill to routinely drive an M1 Abrams tank to shop at the local corner store. The odds of getting held up just for one's butter and eggs just doesn't justify the costly security of an M1 Abrams. A Toyota will do just fine, thank you. The same goes for proof-of-work. For most people, consuming expensive proof-of-work security is akin to using an M1 Abrams to go shopping. It's unnecessary, even frivolous. A cheap Nasdaq penny stock should suffice.

The sheer physical cost of filling up an M1 Abrams with gas is a major impediment to casual tank usage. Alas, this "brake" doesn't operate with proof-of-work. Casual bitcoin users get to enjoy bitcoin’s tank-like security without incurring any out-of-pocket costs.

The reason that casual bitcoiners don't feel the immense expense of bitcoin security is because the mining bill is (mostly) paid for with new bitcoin. Every 10 minutes, 6.25 new bitcoins are created to compensate miners. Issuance of new bitcoins doesn't hurt the price of the bitcoin in tourists’ wallets. The timetable of new bitcoins was built into the price of bitcoin ages ago.

And so the casual bitcoin tourist gets bitcoin's gold-plated security without having to endure any associated costs. It's as if they get to drive an M1 Abrams tank to Walmart, for free. If you could drive an M1 Abrams to Walmart for free, wouldn’t you?

Proof-of-work should never have been more than a neat niche product used by cypherpunks and other associated outsiders. Thanks to an influx of casual buyers, the Bitcoin network now uses a massive 141 terawatt hours per year of electricity, about 0.63% of the world's electricity, according to the Cambridge Centre for Alternative Finance. That’s more electricity than many countries and industries.

Bitcoin’s energy consumption could grow to much larger proportions. Say that casual buyers push the price of bitcoin up to $380,000 in 2023. That's 10 times the current price, a move that bitcoin has done many times before. With bitcoin at $380,000, the total market value of all bitcoin ever mined would be $7.8 trillion, just a little less than the value of all gold ever mined.

As the price of bitcoin rises, the real value of the 6.25 BTC mining reward increases, attracting more miners that burn ever more electricity. With bitcoin's price at $380,000, the Bitcoin network would be consuming a whopping 1,400 terawatt hours or so of electricity, around 6% of the world's electricity (I'm using a simple linear interpolation from today's price and energy consumption.)

That would be a tragic mistake. We shouldn’t be sacrificing 6% of the world's energy to produce tank-like levels of security for speculators who don’t need that security. There are far better uses for scarce energy resources than pure price speculation.

That's where the tax comes in.

Sometime before bitcoin hits $380,000, a tax on bitcoin purchases should be implemented. It would apply at regulated venues like Coinbase and Kraken and on large professional actors, like hedge funds. Casual speculators would finally feel some of the burden of producing bitcoin's security. To avoid the tax, they would likely select other types of volatile instruments, ones with a much lower electricity requirements. They might, for instance, purchase proof-of-stake cryptocurrencies, Nasdaq penny stocks, three times-levered exchange-traded funds or out-of-the-money Tesla options.

The tax would make most people better off than before (or at least just as well-off).

Casual tourists would remove bitcoin from their menu of bets. But there are hundreds of thousands of speculative instruments offering wild price gyrations, and so the tourists are effectively no less well-off than before. They would get Nasdaq levels of security rather than Bitcoin-levels of security, but for casual bettors that's fine.

Cypherpunks are better off. By purchasing their bitcoin on unregulated venues like Bisq, they wouldn’t have to pay the tax. They would also benefit from casual buyers being pushed out of the bitcoin market, and the subsequent decline in the price of bitcoin. When copper or lead falls in price, users of these commodities benefit: They can consume more metal than before. Likewise for bitcoin. A tax-induced plunge in the price of bitcoin would allow cypherpunks to acquire and consume bitcoin-the-commodity at a far cheaper price than before.

Finally, the rest of the world would be better off. Pushing casual bitcoin tourists away from unnecessary consumption of PoW would free up huge amounts of electricity – both renewable and non-renewable – to be consumed by other industrial purposes. It’s win-win-win.

Buying coffee with Tesla shares

It's fascinating to see how brokerages these days are offering no-commission trades, fractional share ownership, and debit card-linked accounts. With this combination of features, maybe we're getting closer to the day when we can buy a $2.50 coffee with 0.007 Tesla shares.

Right now, a debit card purchase can only proceed if there are uninvested cash balances in the linked-to account. But what if the securities held in your brokerage account could also be debit-cardized?

Imagine going to Tim Hortons, ordering a double double, and paying with your RobinHood MasterCard debit card. Behind the scenes RobinHood, an online brokerage, checks your account. All you own is a few shares of Tesla. RobinHood won't actually transfer the shares to Tim Hortons. Instead, it quickly sells a small fraction of these—0.007 shares—for $2.50 cash.

Since RobinHood doesn't charge commissions, selling the shares costs you nothing. MasterCard signs off on the transaction and presto, you've got your coffee. You own 0.007 fewer Tesla shares while Tim Horton's will soon get $2.50 in cash from RobinHood.

Stock markets aren't open on the weekend. So what happens if you want to buy groceries on Sunday? Maybe you've got 2.1 shares of Tesla in your RobinHood account. They were worth around $825 at Friday close. Something catastrophic could occur over the what remains of Sunday, but RobinHood is pretty sure that come Monday morning, those shares probably won't be worth less than $500. And so it will allow you up to $500 in weekend debit card payments. When the market opens on Monday it sells whatever Tesla shares are necessary to settle up your grocery purchase.      

If the option of paying with volatile assets like Tesla were to be widely adopted, you'd expect traditional banks to get into the game. Right now banks offer deposits denominated in fiat units like dollars or yen or pounds. But there's no reason they couldn't provide Tesla-denominated checking deposits. The fact that banks don't do this is a good tip-off that there isn't a very big demand to make transactions using volatile instruments.

Why do people prefer to pay for things using stable instruments rather than volatile ones like Tesla shares? My guess is that it has something to do with FOMO.

Given a choice between paying with their regular bank debit card or a RobinHood card, most people will choose their regular card. Spending away Tesla shares could mean that they miss out on a potentially big jump in price. But spending away fiat-denominated deposits doesn't produce any negative emotions, since deposits can always be replaced at the exact same price come next week's paycheck.

(As I suggested last year, this is a weird example of Gresham's law, where lottery-type instruments like Tesla don't get recruited as money because the market puts less value on them than a hopeful individual does.)

If no one wants to use Tesla shares to buy coffee, they might prefer to set up their RobinHood debit card to sell lower-risk securities. For example, a RobinHood customer could have their card draw down on a bond ETF like the iShares Short Treasury Bond ETF (SHV), which primarily invests in US Treasury bills.

Since SHV's price hardly fluctuates, anyone who uses SHV units to buy coffee needn't fear missing out on a big payday.

At the same time, they'd earn far more than they would on checking account. SHV currently pays around 1.68%, which after a 0.15% management fee comes out to around 1.53%. That's about the rate you could get on a high-interest saving account, which aren't usually designed for everyday spending.

Will this sort of debit-cardization of stocks & ETFs ever happen? I don't know. There could be regulations that prevent the practice, or maybe some sort of hidden cost that makes it too expensive. On the other hand, cryptocurrencies and gold have already been debit-cardized, the gold and bitcoins being sold the moment that a card purchase is initiated. I don't see why it wouldn't be technically possible to do the same with other exchange-traded liquid assets like stocks.

Crypto-linked cards haven't been very successful, probably due to the FOMO problem I mentioned earlier. (Last year, Coinbase shut down its Shift crypto card). Tesla shares would probably suffer from the same. But a low-risk ETF held in a Robinhood account wouldn't be quite so hobbled. 

Classifying cryptocurrencies

Whenever biologists stumble on a strange specimen, they first try to see if it fits into the existing taxonomy. If it doesn't fall within any of the pre-existing categories, they sketch out a new one for it.

For people like myself who are interested in monetary phenomena and finance, Bitcoin and other cryptocurrencies like Dogecoin and Litecoin have presented us with the same challenge. How can we classify these strange new instruments?

Because they have the word 'currency' in them, the knee-jerk reaction has been to put cryptocurrencies in the same bucket as so-called fiat money, i.e. instruments like bank deposits and banknotes. But this is wrong. Bitcoin, Dogecoin, and other cryptocurrencies are fundamentally different from $100 bills or Citibank deposits. 

To see why, here is a chart I published last year at Sound Money Project:

I've located cryptocurrencies in the zero-sum outcome family. Banknotes and deposits are in a different family, win-win opportunities. The property that binds all zero-sum games together is that the amount of resources contributed to the pot is precisely equal to the amount that is paid out of the pot. Jack's ability to profit from his cryptocurrency is entirely dependent on the next player, Jill, stepping forward and taking them off him at a higher price. Likewise, the amount Jack wins from the lottery is a function of how much Jill and other players have contributed to the pot.

Compare this to a stock or a bond. As long as the firm’s managers deploy the money in the pot wisely, the firm can throw off more resources than the amount that shareholders and bondholders originally contributed.

People have been asking me to extend this classification to other assets. Below I've made a more extensive chart:

Similar to the first chart, I've put Bitcoin, Dogecoin, and other cryptocurrencies in the bets & hedges category along with insurance, futures & options, and various gambles such as lotteries. I describe the members of this family as sterile uses of wealth. Unlike more productive uses of wealth, which increase society's resources, bets and hedges transfer existing resources from one person to another.

I disagree with you, JP

No doubt others will disagree with my classification scheme. For instance, why not put cryptocurrencies in the consumer goods section? After all, aren't cryptocurrencies sort of like collectibles? Don't people primarily collect sports cards, old coins, and crocheted doilies because they expect these objects to rise in value, just like the people who buy cryptocurrencies?

Collectibles and other knick-knacks have sentimental, symbolic, ornamental, and ceremonial value. Even if they can't be sold (most knick-knacks can't), they are still valuable for the above reasons. Not so Bitcoin, Dogecoin, and Litecoin. Cryptocurrencies are pure bets on subsequent people accepting or buying them. If no one steps up, the tokens don't have any other redeeming features that can salvage their value.

Are cryptocurrencies like art? Leonardo da Vinci's Salvator Mundi sold for $450 million to a Saudi prince in 2017. Surely Salvator Mundi's consumption value isn't that high. It would seem that its value is entirely predicated on what the next aesthete will pay, in the same way that bitcoin's value hinges on whether another bitcoiner arrives.

Perhaps. But most art pieces aren't Leonardo's Salvator Mundi. The great mass of paintings that have been created over time are relatively cheap. Secondly, prices in high-end art markets may seem to be disconnected from the consumption value they provide, but that's only because these prices are being drive by the preferences and tastes of consumers who are far richer than most of us. It is this ability to consume the beauty and meaning of art that separates it from cryptocurrency.

What about categorizing cryptocurrencies as commodities? For instance, Bitcoin is often described as digital gold. Or consider George Selgin's reference to bitcoin as a synthetic commodity. Selgin's argument is that cryptocurrencies are commodity-like because they are scarce. And they are synthetic because, unlike commodities, they have no value apart from what other people will pay for them (i.e. they have no nonmonetary value).

I agree with Selgin's analysis. But because cryptocurrencies are synthetic—i.e. their purchasing power is entirely predicated on another person entering the game—I've put them in the bets & hedges category along with other zero-sum games, not the commodity family. Sure, the supply of cryptocurrencies is fixed, say like copper. But that only makes it a very special type of bet, not a commodity.

Blurred lines

The categories in my classification scheme do sometimes blur. At times the stock market becomes incredibly speculative. People start buying shares not because they expect the underlying business to produce higher cash flows, but because they expect others to buy those shares at a higher price, these buyers in turn expecting others to purchase it at a higher price. Thus buying stocks becomes for like betting on a zero-sum game than an effort to appraise the earnings potential of an underlying business.

The same applies to gold:

I'd argue that gold's price can be decomposed into two components 1) its value as a commodity and 2) the value of the lottery-like zero-sum game being played on top of its commodity value. Bitcoin lacks 1), it is purely 2). So it is sort-of like gold, but exactly like a lottery.

— JP Koning (@jp_koning) September 8, 2018

There is another type of blurriness. Notice that neither chart has a category for money. That's because I prefer to think of money as an adjective, not a category. More specifically, moneyness is a characteristic that attaches itself by varying degrees to all of the instruments in the chart above. A more money-like instrument is relatively more tradeable, or marketable, than a less money-like instrument.

So we can have money-like commodities, bonds with high degrees of moneyness, and heck, money-like lottery tickets. Even some types of banknotes will be more money-like than others. For example, you'll have much better luck spending fifty C$20 bills than you will one C$1000 banknote. Or take the example of choice urban land, which is a lot more saleable than property in the middle of nowhere. Lastly, spending bitcoins is probably much easier to do than spending Dogecoins.

For the last few centuries, the most money-like instruments have tended to be in the debt category. There are many reasons for this. Debt instruments are stable, they are light and thus convenient for transporting, they can be digitized and used remotely, they are fungible, they are difficult to counterfeit, and they can be efficiently produced.

All of you folks with some spare funds who are mulling a big cryptocurrency purchase: be careful. There are plenty of people on the internet who are aggressively marketing crypto as some sort of new society-transforming elixir, or tomorrow's money. But much of their marketing is unfounded. It is unlikely that Bitcoin or Dogecoin will ever attract the same degree of moneyness as the most popular debt instruments. Their zero-sum game nature will always interfere with their ability to attract usage as a medium of exchange. But I could be wrong.

While there are elements of cryptocurrencies that are really neat, they aren't fundamentally new. Rather, they fit quite nicely in the traditional 'bets and hedges' category. If you wouldn't bet all your savings in a zero-sum game like poker, neither should you do the same with cryptocurrencies. A bond or equity ETF is naturally productive, as is an investment in human capital. Consider them first.

Norbert's gambit

I executed one of the oddest financial transactions of my life earlier this week. I did Norbert's Gambit.

These days a big chunk of my income is in U.S. dollars. But since I live in Quebec, my expenses are all in Canadian dollars. To pay my bills, I need to convert this flow of U.S. dollars accumulating in my account to Canadian dollars.

Outsiders may not realize how dollarized Canada is. Many of us Canadians maintain U.S. dollar bank accounts or carry around U.S. dollar credit cards. There are special ATMs that dispense greenbacks. Canadian firms will often quote prices in U.S. dollars or keep their accounting books in it. I suppose this is one of the day-to-day quirks of living next to the world's reigning monetary superpower: one must have some degree of fluency with their money.

Anyways, the first time I swapped my U.S. dollar income for loonies I did it at my bank. Big mistake. Later, when I reconciled the exchange rate that the bank teller had given me with the actual market rate, I realized that she had charged me the standard, but massive, 3-4% fee. In an age where the equivalent fee on a retail financial transaction like buying stocks amounts to a minuscule $20, maybe 0.3%, a 3-4% fee is just astounding. But Canadian banks are an oligopoly, so no surprise that they can successfully fleece their customers.

So this time I did some research on how to pull off Norbert's gambit, one of the most popular work-a rounds for Canadians who need to buy or sell U.S. dollars. From a moneyness perspective, Norbert's gambit is a fascinating transaction because it shows how instruments that we don't traditionally conceive as money can be recruited to that cause. The gambit involves using securities listed on the stock market as a bridging asset, or a medium of exchange. More specifically, since the direct circuit (M-M) between U.S. money and Canadian money is so fraught with fees, a new medium--a stock--is introduced into the circuit (like so: M-S-M) to reduce the financial damage.

To execute Norbert's gambit, you need to move your U.S. dollars into your discount brokerage account and buy the American-listed shares of a company that also happens to be listed in Canada. For instance, Royal Bank is listed on both the Toronto Stock Exchange and the New York Stock Exchange. After you've bought Royal Bank's New York-listed shares, have your broker immediately transfer those shares over to the Canadian side of your account and sell them in Toronto for Canadian dollars. Voila, you've used Royal Bank shares as a bridging medium between U.S. dollar balances and Canadian ones.

These days, Norbert's gambit no longer requires a New York leg. Because the Toronto Stock Exchange conveniently lists a wide variety of U.S dollar-denominated securities, one can execute the gambit while staying entirely within the Canadian market. In my case, I used a fairly liquid Toronto-listed ETF as my temporary medium of exchange, the Horizon's U.S. dollar ETF, or DLR. I bought the ETF units with my excess U.S. dollars and sold them the very next moment for Canadian dollars.

Below I compare how much Norbert's gambit saved me relative to using my bank:

Using the ETF as a bridging asset, I converted US$5005 into C$6465, paid $19.90 in commissions, for a net inflow of $6,445.10 Canadian dollars into my account. Had I used my bank, I would have ended up with just $6265, a full $180 less than Norbert's gambit. That's a big chunk of change!

What is occurring under the hood? Norbert's gambit is providing a retail customer like myself with the same exchange rate that large institutions and corporations typically get i.e. the wholesale rate. Because there is a market for the DLR ETF in both U.S. dollar and Canadian dollar terms, an implicit exchange rate between the two currencies has been established. Call it the "Norbert rate". Large traders with access to wholesale foreign exchange rates set the Norbert rate by buying and selling the DLR ETF on both the U.S. and Canadian dollar side. If any deviation between the Norbert rate and the wholesale exchange rate emerges, they will arbitrage it away. Small fish like myself are thus able to swim with the big fish and avoid the awful retail exchange rate offered by Canadian banks.

This workaround is called Norbert's gambit after Norbert Schlenker, a B.C-based investment advisor who it to help his clients cut costs. Says Schlenker in a Globe & Mail profile:

"In 1986 I moved down to the States, and while I was there I needed to be able to change funds from U.S. dollars to Canadian and vice-versa, and I had a brokerage account in Canada. It came to me that I could use interlisted stocks to do this."

Thanks, Norbert!

But using stock as money isn't just a strange Canadianism. Back in 2014, I wrote about other instances of stocks serving as a useful medium-of-exchange. During the hyperinflation, Zimbabweans used the interlisted shares of Old Mutual to evade exchange controls, lifting them from the Zimbabwe Stock Exchange to London. Earlier, Argentineans used stocks (specifically American Depository Receipts) in 2001 to dodge the "corralito". But I never imagined I'd use this technique myself to skirt around Canada's banking oligopoly!

Store of value

LSD tabs like these ones have an incredibly high value-to-weight ratio

When bitcoin first appeared, it was supposed to be used to buy stuff online. In his 2008 whitepaper, Satoshi Nakamoto even referred to his creation as an electronic cash system. But the stuff never caught on as a medium-of-exchange: it was too volatile, fees were too high, and scaling problems resulted in sluggish speeds. Despite losing its motivating purpose, bitcoin's price kept rising. The bitcoin cognoscenti began to cast around for a new raison d'etre. Invoking whatever they must have remembered from their old economics classes, they rechristened bitcoin as the world's best store of value.

Store of value is one of the three classic functions of money that we all learn about in Money and Banking 101: money serves a role as a medium of exchange, unit of account, and store of value. So presumably if bitcoin wasn't going to be a medium of exchange (and certainly not a unit of account thanks to its volatility), at least some claim to money-ishness could be retained by having it fill the store of value role.

In his 1867 Money and the Mechanism of Exchange, political economist William Stanley Jevons formally introduced the term store-of-value into monetary economics (although Nathan Tankus tells me that Marx may have originated the idea albeit with different terminology, and Daniel Plante tips Aristotle):

William Stanley Jevons (1867) was probably the first economist to introduce the 'store of value' function of money https://t.co/xqIs3Fym3a pic.twitter.com/dRcfLfMUya

— JP Koning (@jp_koning) October 8, 2017

Jevons's store of value function refers to the process of preserving value across both time and space. Now in one sense, every good that has ever existed has been a store of value, as Nick Rowe once pointed out. If a good isn't capable of storing value, we'd be incapable of handling and consuming it. Even an ice-cream cone needs to exist long enough for value to be transferred from tub to mouth.

What Jevons was implying in the above passage is that some goods are better than others at condensing value. Goods with the low bulk and weight, including the "current money of the land" (i.e. banknotes), are the best condensers. Below is a list of items ranked according to price per pound, which I get from Evilmadscientist (beware, these are 2008 prices). While all-purpose flour can store value, a $100 bill is better at the task, and while both are surpassed by championship thoroughbred semen, nothing does the job better than LSD.

To condense value over time and space, a store of value will need to be durable. Saffron has a fairly high value-to-weight ratio, but its quality depreciates much quicker than a dollar bill, thus compromising its ability to store value through time. Same with copper and silver, both of which will steadily corrode whereas gold does not. It also helps to have low storage costs. Oxen may have been a great way to store value across space, yet feeding and sheltering them over long periods of time would have been quite expensive. 

Jevons was writing before computers and the internet had emerged. Nowadays, billions of dollars in value are represented digitally. These digital tokens—stocks, bonds, deposits, credit, bitcoin, and whatnot—are weightless and volumeless. Which means they far exceed the ability of any physical item to condense value over time and space.

How does bitcoin rank relative to other digital stores of value? Let's say you needed to condense a certain amount of value and had a choice between either holding bitcoin or Netflix stock. (I choose Netflix because its market cap is close to the market value of all bitcoins ever mined, and because both their prices have done exceptionally well over the last six years). Bitcoin is great for conveying value across space, especially if it involves crossing national borders. All you have to do is remember your private key and you can access your funds no matter where you are. Netflix isn't quite so fluid. While you can certainly access your online brokerage account when you are in Vietnam on holiday, you can't actually sell Netflix stock in Vietnam (as you presumably could with bitcoin). Instead, you'd have to sell the stock and transfer the proceeds to a bank account in Vietnam via the correspondent banking system. That could take a few days and you might run into some hassles.

What about for storing value across time? Bitcoin has a few neat features, including censorship resistance. Since bitcoin isn't centrally managed, there is no way for an administrator to censor you, i.e. erase your bitcoins. With Netflix (or any other centrally-housed digital asset), however, if you are a considered to be a bad actor by those who control the system, presumably your shares can be frozen or confiscated. Counterbalancing this, bitcoins are notoriously susceptible to being stolen. But I've never heard of a thief getting away with someone's shares. There's a bit of give and take.

But in general, I'd argue that bitcoin and Netflix stock are both pretty bad for temporally storing value, although bitcoin is particularly bad. For an asset to do a good job condensing property over time it has to provide its owner with predictable access to a future basket of consumption goods. Assets with prices that have gone parabolic do not fulfill this requirement. After all, there is no reason that the price won't reverse and start to plunge, thus compromising that instrument's ability to store predictable amounts of consumption through time. Anything with a highly stable price across all time frames (minute-by-minute and year-to-year) provide the requisite predictability. Assets that gyrate do not.

The chart below shows the relative variability of the prices of bitcoin, Netflix, and gold since 2011.

Specifically, the chart measures each assets' median change in price over a given month. For instance, in November 2017 bitcoin had the tendency to close up or down by around 3.2% each day, Netflix by 0.8%, and gold by 0.3%. Averaging out all months since 2011, gold's variability comes in at 0.5%, Netflix at 1.5% and bitcoin at 2.2% (see dashed lines above), which means the yellow metal has done a much more predictable job of storing value over time than the other two assets, and Netflix is more up to the task than its digital counterpart. 

In late 2016 bitcoin's volatility seemed to have fallen permanently below Netflix levels and—for a month or two—approached that of gold. The digital stuff had become a mature asset! That wasn't to be, however, and bitcoin volatility has since reverted to levels significantly above its long term average.

I'd argue that bitcoin's high volatility is inherent to its nature. As such, it will always do a fairly bad job of storing value over time. The problem, as I outlined in my recent BullionStar article, is that bitcoin is a pure Keynesian beauty contest asset. People only buy bitcoins because they expect others to buy them at a higher price. The markets for gold and Netflix, on the other hand, are populated by a second set of participants who value those assets for reasons apart from whether others will buy them later. In the case of gold, industrial buyers step up whereas with Netflix it is value investors. The buying and selling of this second set of participants has a calming effect on prices.

The most predictable way to condense value through time is a U.S. dollar deposit. Anyone who has $100 in their account knows with a high degree of accuracy what they'll be able to buy next week. This stems from the fact that consumer good prices are measured in terms of the units issued by the central bank, and retailers keep these prices fairly rigid over the short term. For longer time periods, say one year out, the U.S. dollar will have naturally suffered from some inflation. But this decline in purchasing power is a known quantity. The Federal Reserve has an inflation target of 2%. So it's a safe bet that $100 will be worth $98, not $92, or $84, or $104. That's pretty good predictability. Interest earned on the deposits will make up for the lost purchasing power.

So is bitcoin a store of value? Sure, everything is to some degree... and bitcoin certainly does a good job of condensing value across distances. But relative to other assets, in particular U.S. dollar deposits, it does a poor job storing value across time. I don't think this is going to change, but I could be wrong.

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P.S: In the interest of full disclosure, I still own some bitcoin and XRP, not much though. Own some gold too, but no Netflix.
P.P.S: Here is a rewrite of Satoshi's whitpaper, substituting in store of value system for electronic cash system:

The siren call of T+0, or real-time settlement

The NYSE's clearinghouse in 1898, six years after its founding

Traditional financial systems often get mocked for being slow. In North America, for instance, securities markets have recently switched from T+3 to T+2 settlement. Before, if you sold a stock the cash would only appear in your account three days after the trade—now settlement has been moved to a blazing fast two days. In an age where mail is transmitted in milliseconds, this delay seems terribly old fashioned. Or take automatic clearing house (ACH) payments in the U.S. Earlier this month the ability to make same-day ACH debit payments was rolled out, an improvement over the three or four days they used to take, but still no where near immediate.

The snail-like pace of securities and ACH settlement is often contrasted to real-time settlement, say like how payments using banknotes, coins, or bitcoins are finalized the moment the token leaves ones wallet and enters the destination wallet. Or take real-time gross settlement systems operated by central banks, over which a transfer of balances from one account to the other occurs instantaneously and is irrevocable. In the case of securities settlement, why only go from T+3 to T+2? Why not go straight to T+0?

Don't be beguiled by settlement speed. Slow isn't necessarily a bug—it's often a feature. Imagine the following scenario. You and your friends play poker every day at a cafe. To buy into the game, cash or bitcoins are required. And at the end of each game, cash or bitcoin is paid out to the winners. The problem with this system is that each day all players have to lug a transactions medium to the cafe and back from it—and this involves a sacrifice. Banknotes and coins take up lots of space and can be easily stolen. Like bitcoin, they don't yield interest—so a stream of interest income is being foregone to play poker. Once the game is done, the laborious process of counting out cash and banknotes occurs. In the case of bitcoin, the payouts are costly since each one involves incurring a fee to send bitcoins from one wallet to another.

Participants in financial markets have adopted a time-tested strategy to avoid much of the work involved in repetitive use of transactions media like cash: substitute them with IOUs that are only settled from time-to-time. Returning to the poker example, rather than stumping up cash each game players can buy-in using IOUs denominated in cash or bitcoin. These IOUs are recorded in a ledger. Rather than cashing out at the end of the game each player's balance is held over to the next day, only to be updated subject to that day's results. These ledger balances continue to be updated at the close of each game until after (say) the tenth game, everyone finally decides to settle their accounts, upon which all debtors, or losers, bring cash and/or bitcoin to the cafe to pay off winners, or creditors. The system has settled—not in real-time—but T+10.

The advantage of delayed settlement is that quid pro quo is achieved with one set of transactions conducted at the end of the 10-game cycle rather than a set of transaction for each game. No more tedious counting out coins each day or daily bitcoin fees. Because the obligation to carry around cash is kept to a minimum, interest income needn't be sacrificed by players. Nor are there any nuisances of storing cash.

While slowing down the system reduces the amount of work that must be done, it comes at the expense of flexibility and safety. One of the benefits of a cash payment is that transactions media are immediately available for use in subsequent transactions. If a player can only get cash out of the game after ten games, they will have to be sure that they don't need that cash for other payments in the interim. Slowing down the system also introduces credit risk into the system. Players may be unable or unwilling to honor their IOUs at the end of the cycle. Lengthening the cycle only increases the odds of settlement failure due to insolvency or bankruptcy.

If the benefits that your friends expect to harvest from delaying poker settlement—the reduction in work and fees—outweigh the aforementioned costs, then a T+10 system makes a lot of sense. Keep this in mind whenever you encounter a real-life financial transaction like an ACH payment that takes a long time to settle. The system's sluggishness may be designed that way because the conservation of work and transactions costs outweighs the inconveniences of not having immediate availability of transactions media and exposure to credit risk.

Even the bitcoin ecosystem has adopted various forms of delayed settlement. Thanks to high fees and long wait times, Bitcoin companies have been avoiding direct exchanges of bitcoins among each other in favor of netting out bitcoin-denominated IOUs, says Izabella Kaminska, only settling net amounts after some time has passed. And Bitcoin developers are working towards introducing something called the Lightning Network, which will allow users to make payments using fully-backed bitcoin depository receipts rather than having to settle trades directly on the blockchain using regular (and peskily-slow) bitcoins. 

Let's finish off by revisiting the recent shift from T+3 to T+2 securities settlement in the US and Canada. Interestingly, if you zoom out you'll see that over time the New York Stock Exchange shows a predominant tendency to lengthen the settlement cycle, not shorten it. The recent move to T+2 only brings the exchange back to the same settlement speed at which it operated at from 1933 to 1952. Prior to 1933, next-day settlement, or T+1, had been standard.

The lengthening of the cycle to T+2 in 1933, which corresponded with an increase in stock trading volumes, was implemented to "ease the work" of brokerage clerks. Back then all securities were recorded in physical form, so settlement required the transportation by hand of certificates from one office to another by an army of runners. In the face of growing trade volumes, the only way to maintain T+1 settlement would have been to do much more work, which meant hiring more clerks and runners—costs that would be offloaded onto clients. Slowing down the system to T+2 from T+1 presumably would have kept things cheap.

The 1968 switch to T+5 settlement was an effort to cope with the famous "back office crisis." Investors who were too young to remember the Great Depression had begun to arrive in droves to equity markets in the early-60s. Back office clerks could not keep up with amount of work required to settle trades. At one point the NYSE even closed on Wednesdays to help deal with the backlog.

The recent move back to T+2 means that cash will appear in investors' accounts 24 hours earlier, making it easier for them to meet subsequent payments deadlines. Credit risk is reduced too. Brokers conduct trades with other brokers on behalf of their clients, building up credit and debits over the settlement cycle. The shorter the cycle, the quicker these debts will be unwound by transfers of stock and cash, the resulting savings hopefully flowing through to customers.

Why not go straight to real-time, or T+0? The move from T+3 to T+2 means one less day over which brokers can 'net out' their respective debits and credits so as to conserve on transactions costs. T+0 means no netting-out window whatsoever—and that would impose a terrific amount of work on the system. Like I say, it's a trade-off. Real-time settlement is no panacea.

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P.S. Here's a great article on the history of securities clearing and settlement: Was Trade Settlement Always on T+3? A History of Clearing and Settlement Changes, by Kenneth Levine (1996)

When a rising stock market is a bad thing

If the world had a single cauldron for mixing various monetary phenomena, it would be Zimbabwe. Over the last two decades, it has experienced pretty much everything that can happen to money, from hyperinflation to deflation, demonetization to remonetization, dollarization and de-dollarization, bank runs, bank walks, and more.

Adding to this mix, the Zimbabwe Industrial Index—an indicator of local stock prices—has recently gone parabolic, having more than tripled over the last twelve months. That's a good sign, right? Beware, these gains aren't real. As is often the case in Zimbabwe, the rise in stock prices is a purely monetary phenomenon.

Ever since the great Zimbabwean hyperinflation led to the domestic currency becoming worthless in 2008, U.S. dollars have served as the nation's currency and unit of account. However, Zimbabwe's central bank, the Reserve Bank of Zimbabwe (RBZ), has spent much of the last two or so years surreptitiously bringing a new parallel monetary unit into circulation. These new units, informally referred to as RTGS dollars, are a digital form of money, specifically a deposit held at the central bank. (I described them here).

At the outset, RTGS dollars were denominated in U.S. dollars and supposedly convertible into genuine U.S. banknotes. We now know these units were only masquerading as U.S. dollars. By early 2016, huge lineups began to appear outside banks as Zimbabweans unsuccessfully tried to convert their deposits into real U.S. cash. When conversions finally became possible it was only because the RBZ had introduced its own paper currency, a 'bond note', in late 2016. These bond notes were themselves supposed to be fully fungible with U.S. dollars thanks to a promise of 1:1 convertibility, at least if you believed the nation's central banker, but this has never been the case.   

Over the last year a great redenomination has been occurring as all Zimbabwean prices—including that of ZSE-listed stocks—are shifted over from a genuine U.S. dollar standard to an RTGS dollars/bond note standard. Prior to 2016, if you sold a stock or received a dividend, you'd get U.S. dollars, or at least a pretty decent claim on the real thing. Now, you get RTGS dollars—which can only be cashed out into an equally dodgy parallel currency, bond notes.

The incredible 300% rise in the Zimbabwe Industrial Index is a reflection of the redenomination of stocks into an inferior monetary unit and that unit's continued deterioration. For instance, if you were willing to sell your shares of Delta Brewing for $10 prior to the redenomination, you'd only be willing to sell them at a much higher level post-redenomination, say $15, in order to adjust for the diminished purchasing power of the money you'll receive upon sale. RTGS dollars are not U.S. dollars. After adjusting the Zimbabwe Industrial Index for the decline in the value of the money in which stocks are denominated, things certainly wouldn't look as bullish as the chart above indicates.

What is the actual exchange rate between RTGS dollars/bond notes? We can get a pretty good idea by looking at the prices of dual-listed shares. The shares of Old Mutual, a global financial company, trade in both Harare and on the London Stock Exchange. See chart below, courtesy of Gareth on Twitter.

Old Mutual investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other. Arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse.

The ratio of the two Old Mutual listings (the green line above) provides us with the implicit exchange rate between genuine U.S. dollars and dollars held in Zimbabwe. In 2009 the two listings traded close to parity (i.e. around $2 each), which makes sense because Zimbabwe had dollarized by then, and dollars-in-Zimbabwe were fungible with regular dollars. From 2010 to 2016 the dollar-denominated price in London was above the price in Zimbabwe. This discrepancy may be due in part to the fact that Harare-listed Old Mutual shares aren't very liquid, so they suffer a liquidity discount. Another reason is that the authorities place a ceiling (i.e. fungibility limits) on the number of Old Mutual shares that can be deregistered from the Harare market and dropshipped into London. With all of the space under the ceiling having presumably been used up, it would have been impossible to arbitrage the difference between the two prices, the Harare counter falling to a permanent discount.

So the Old Mutual ratio was probably not a good indicator of the implicit exchange rate between 2010 and 2016. However, in June 2016 this ceiling was raised, at which point arbitrage would have once again been possible. As such, the ratio would have probably returned to providing a decent indicator of the exchange rate between a dollar-in-Zimbabwe and a genuine dollar. 

You can see that Old Mutual is currently valued at $5.80 in Zimbabwe whereas it only trades in London for around $2.66 per share (after converting from pounds into US dollars). This means that Zimbabweans are willing to put $5.80 in one end of the sausage maker in order to get $2.66 out from the other. So a dollar-in-Zimbabwe, which was trading at par to U.S. dollars just two years ago, is now worth just 46 cents. That's quite the inflation rate. I don't see things slowing down, either.

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P.S.: Some investors will no doubt want to say the same thing is going on with the US and Europe with loose monetary policy creating so-called asset price inflation. I disagree.

P.P.S: Gareth has provided another chart. It shows the implied exchange rate between dollars-in-Zimbabwe and genuine U.S. dollars using the only other fully transferable dual-listed counter, PPC, a cement company that is also listed in Johannesburg. Note how close the PPC rate follows the Old Mutual rate.

A modern example of Gresham's Law

Sir Thomas Gresham

Anyone who makes an effort to study monetary economics quickly encounters the concept of Gresham's law, or the idea that bad money can often chase out good. Gresham's law is usually used to explain the failures of bygone monetary systems like bimetallic and coin standards. But the phenomenon isn't confined to ancient times. I'd argue that a modern incarnation of Gresham's law is occurring right now in Zimbabwe.

Zimbabwe's stock market has blown away all other stock markets by rising 30% in the last month-and-a-half. The chart below compares the Zimbabwe Industrial index to the U.S. S&P 500, both of which are denominated in U.S. dollars. I'd argue that the extraordinary performance of Zimbabwean stock is an instance of Gresham's law. With the imminent arrival of newly printed Zimbabwean paper money, known as bond notes, "bad" paper money is poised to chase out "good" money, stocks being one of the few places where Zimbabweans can protect their savings.

What follows is a quick summary of bond notes (alternatively, read my two earlier posts). The Mugabe government, which began discussing the idea of a new paper currency earlier this year, says that it will issue low denomination bond notes into circulation before the end of the November. Recall that Zimbabwe has been using U.S. dollars since 2008 after a brutal hyperinflation destroyed the value of the local currency. The regime claims that a $1 bond note will be worth the same as a regular $1 Federal Reserve note. It says it has received a U.S. dollar line of credit from the African Export-Import Bank that will guarantee the peg.

Enter Gresham's law, which says that if two different media circulate, and the government dictates that citizens are to accept the two instruments at a fixed ratio—say via legal tender laws—then the undervalued medium will disappear leaving only the overvalued one to circulate. So called bad money drives out good.

Medieval coinage systems were often crippled by Gresham's law. For instance, say a new debased silver penny was introduced into circulation along with existing pennies. Because it contained a smaller amount of silver, the new penny was worth less than the old. However, legal tender laws required that all pennies be accepted without discrimination in the settlement of debts. Medieval debtors would thus always prefer to discharge debts with new pennies rather than old ones since they would be giving up less silver. The result was that only "bad money," or debased coinage, circulated. Because "good money," or undebased coinage, was undervalued, people either hoarded it, sent it overseas, exchanged it on the black market at its true value, or melted it down.

The same conditions that created Gresham effects in medieval times are emerging in modern day Zimbabwe. Rather than two different medieval coins, we've got two different types of dollars; bond notes and regular U.S. cash. The next ingredient for Gresham's law is a decree that dictates the rate at which people are to accept the two instruments. In Zimbabwe's case, the government has already declared that bond notes (once they appear) are to be legal tender along with U.S. Federal Reserve notes, which means that Zimbabwean creditors will have to accept bond notes at par as a means of discharging all debts, even if they'd prefer the genuine thing.

Since a chequing deposit is a debt incurred by a bank to a depositor, this means that Zimbabwean banks can—in theory at least—meet depositors' demands for redemption by providing bond notes. So a Zimbabwean bank deposit is no longer just a claim on actual dollars, but a claim on some mysterious as-yet unissued Zimbabwean government liability.

The last ingredient for Gresham's law is an overvaluation of one of the two media. In Zimbabwe, this will most likely occur as the market value of bond notes falls below that of genuine U.S. dollars. While many countries maintain successful currency pegs to the U.S. dollar, they have the resources to do so. I'm skeptical that the isolated and corrupt Mugabe regime has the resources to pull a peg off.

Bond notes have yet to be issued, but because existing bank deposits—or electronic dollars—are likely to be payable in this new paper currency, we can think of deposits as a surrogate for the bond note. The first bit of evidence that Zimbabwe has run into Gresham's law is that physical U.S. dollars are beginning to disappear from circulation, replaced entirely by electronic dollars. Why might this be happening? Start with the assumption that Zimbabwean bank deposits have become "bad," meaning they are worth less than actual physical dollars. If a Zimbabwean citizen needs to buy $100 in groceries, and the grocer is required by law to accept deposits and cash at the same rate, our citizen will naturally spend only overvalued deposits and hoard "good" and undervalued cash.

In fact, we have direct evidence that deposits have become "bad". In the black market, dealers will only sell physical cash at a premium. I've seen anywhere from 5% to 20% mentioned.

More evidence is provided from the stock market. The shares of Old Mutual, a global financial company, trade on both the Zimbabwe Stock Exchange (ZSE) and the London Stock Exchange (LSE). Because investors have the ability to deregister their shares from one exchange and transfer them for re-registration on the other, arbitrage should keep the prices of each listing in line. After all, if the price in London is too high, then investors need only buy the shares in Zimbabwe, transfer them to London, sell, and repurchase in Zimbabwe, earning risk-free profits. If the price in Zimbabwe is too high, just do the reverse

Oddly, Old Mutual trades in London for around $2.30 per share (after converting into US dollars) whereas it is valued at $3.20 in Zimbabwe. Here's the article that first tipped me off to this. As the chart below shows, this rather large gap has progressively emerged as the introduction of bond notes becomes more likely. Why is no one arbitraging the difference by purchasing Old Mutual in London for $2.30, then transferring it to Zimbabwe to be sold for $3.20? The large discrepancy likely reflects the growing risk that any dollar sent to Zimbabwe is likely to be trapped and re-denominated into a bond note.

The ratio of the two Old Mutual listings implies that the exchange rate between genuine U.S. dollars and dollars held in Zimbabwe is around 0.72:1, i.e. one Zimbabwean U.S. dollar deposit is only worth 72 cents in genuine U.S. dollars. While transaction costs and other frictions may explain part of the gap, this is still an incredibly wide discount.

Those with long memories will remember that during Zimbabwe's last hyperinflation, the cross-rate between Old Mutual listings was a popular way to measure the true exchange rate between the hyperinflating Zimbabwe dollar and the U.S. dollar. The official rate maintained by the Reserve Bank of Zimbabwe was not the true rate as it dramatically overvalued the Zimbabwe dollar. In the chart below of the hyperinflation, pinched from a paper by Steve Hanke, the Old Mutual Implied Rate—or OMIR—appears along with the black market rate for U.S. dollars. (I once discussed the OMIR here. The same trick was used in Venezuela using ADRs.)

From Hanke and Kwok

Once all the ingredients for Gresham's law are in place, inflation is never far behind. Because U.S. dollars are being undervalued, Zimbabweans will refuse to buy stuff with anything other than overvalued deposits. If they don't update their sticker prices, retailers will soon discover that they are receiving fewer real dollars than before. To maintain the real value of their revenues, they will have to mark up their prices, thus compensating for the fact that only "bad" money is flowing into their tills.

While retail prices are usually sticky, financial prices are not. And that may be why we've seen such a huge jump in Zimbabwean stock prices but little movement in Zimbabwean consumer price inflation. With Gresham's law beginning to push good money out of circulation, nimble owners of Zimbabwean shares are demanding a higher share price from potential share buyers in order to compensate for the risk of holding soon-to-be issued bond notes. Less nimble retailers have yet to demand this same compensation from their customers. Don't expect this to last; consumer price inflation can't be too far behind asset price inflation.

The strange mania for Swiss National Bank shares

The shares of the Swiss National Bank (SNB), Switzerland's central bank, have almost doubled since July, despite there being no real news. Yep, you read that right, the SNB is listed on the stock market. There are four other central banks with listed shares: Belgium, Japan, Greece, and South Africa. I discussed this odd group back in 2013.

Why are SNB shares catapulting higher? This is a staid central bank, after all, not a penny stock.

Let's look at the fine print. Swiss National Bank shares aren't regular shares. To begin with, the dividend is capped at 6% of the company's share capital. The SNB was originally capitalized back in 1907 with 25 million Swiss francs, an amount that hasn't changed in 109 years. Which means that the dividend is, and always has been, limited in aggregate to a minuscule 1.5 million francs per year (about US$1.5 million). Because this amount must be divvied among the 100,000 shares, each share gets just 15 francs per year.

The SNB has faithfully paid this 15 franc dividend since its founding (apart from 2013, when it was omitted due to massive capital loss on its gold holdings). For instance, here it is paying the dividend throughout the 1980s:

Once the 1.5 million franc dividend is paid, Swiss law dictates that all remaining profits get sent to the Swiss central government and the cantonal governments. It further stipulates that if the SNB is to be liquidated, shareholders will only receive a cash payment equal to the nominal value of their shares. This means that if shares are trading for 1025 Fr, but there is residual firm value (after paying debtors) of 10,000 francs per share, well too bad—shareholders only get 1025 Fr.

Given these peculiar details, an SNB share isn't really equity; it's best thought of as a perpetual government bond with a 6% coupon, sometimes known as a consol. It throws off 15 francs per year for the rest of time. With the SNB as issuer, these securities are pretty much risk-free.

The math behind SNB shares is straightforward. Just use the Finance 101 formula for a perpetual bond, PV=c/r, or present value (PV) equals yearly cash flow (c) divided by yield (r). With annual interest payments of 15 francs and SNB shares trading at 2000 Fr, the yield comes out to 0.75%.

Here's what I think explains the rise in SNB shares. In July, an odd thing happened. The yield on the Swiss 50-year bond, the closest instrument in Switzerland to a perpetual government bond, fell below 0%. SNB shares (i.e. perpetual bonds) were themselves trading at around 1000 francs at that point for a yield of 1.5%. A few large investors probably began to ask themselves: Why the devil are we accepting a negative nominal return on our ultra long-term government bond portfolio if these other government bonds, which happen to be issued by the central bank and masquerade as shares, still have a positive yield? And so they started to buy SNB shares in quantity, driving the price up and the yield down.

This sort of thinking explains why SNB shares have risen, but not necessarily the explosive nature of the move. The shares haven't just risen by a few bucks, after all. They've almost doubled!

Let's take a closer look at the perpetual bond formula. If nominal interest rates fall from 1.5% to 0.5%, a fifty-year bond with a par value of 1000 francs and a 15 franc yearly coupon will rise from 1000 to 1,441 francs. Not bad, but compare that to a perpetual. For the same decline in rates, SNB shares will double in value from 1000 to 2000 francs. As rates continue to fall towards zero percent, the price of a perpetual goes parabolic. At 0.25%, the perpetual will be worth 6000 Fr, at 0.1% it trades at 15,000 Fr, and at 0.01% it sells for 150,000 francs. At 0.001%, they'd be valued at 1,500,000 francs each!

In the table below, I've illustrated the relative dynamic of a 50-year bond and a perpetual as rates fall to zero.

Price of a 50-year bond and perpetual at various interest rates

At the limit of 0%, SNB shares will have an infinite price. If all existing and yet-to-be-issued government fixed term bonds are guaranteed to lose money over the course of their existence, but there exists a government security that is guaranteed to perpetually offer a positive cash flow, then an investor will pay *any* amount of money to own those cash flows. There is no price to which SNB perpetual bond can rise that chokes off their demand.

The behavior of perpetual bonds at low interest rates *might* explain why SNB shares have gone hyperbolic. It also means that if Swiss rates continue to fall, the shares could have another double or two in the tank. So much for staid Swiss central banking.

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Hat tip to Leon Oudejans for alerting me to the recent rise in SNB shares.

P.S. Does anyone know how rare perpetuals are, specifically perpetuals like SNB shares that don't provide the issuer with the option to call it? My understanding is that this sort of security just isn't issued anymore, at least not since British consols.

What the difference between an SNB share and a 1000 Swiss banknote? Not much, right? They're both perpetual bonds, one paying 15 francs a year, the other paying zero francs per year. If you were to write the number 1000 on an SNB bearer share, and 500 on a half share, and 100 on a fifth share, etc you'd have the entire series of Swiss banknotes. Cut the dividend on shares to zero, and won't banknotes and shares be exactly the same?

Here's a chart of the Bank of Japan, which is also a perpetual bond underneath the hood.

The French shareholder revolution

I recently stumbled on a new and innovative capital structure that, as far as I can tell, only exists in France.

Since 2011, French beauty giant L'Oréal has been rewarding long-term investors with a loyalty bonus. It goes like this: if you buy L'Oréal shares, register them before the end of 2016, and hold them till 2019, you'll start to enjoy a 10% dividend bonus come January 1, 2019. So if L'Oréal declares a dividend of €1.00 in 2019, anyone who has held since 2016 gets €1.10. Not bad, eh?

Think of this as an obligatory transfer payment from short-term L'Oréal shareholders to long-term ones. Put differently, if you want to speculate in L'Oréal shares, expect to pay investors a fee, or tax, for that luxury. Unlike most taxes, this one hasn't been instituted by the government. Rather, it's the corporation that is decreeing this particular redistribution of income.

How big is the tax? Let's imagine an investment of $10,000 in the shares of a company that consistently appreciates 5% each year and increases its dividend by 5%. The dividend yield is 2% and all dividends are re-invested.

Fig 1: Comparative return from investing $10,000 in a firm that offers a loyalty bonus program

Assuming no loyalty dividend, the initial stake will be worth $79,851 upon retirement thirty years later. However, if the shares are registered in the 10% loyalty program for the entire period then the stake grows to $84,851. See figure above. The patient investor who takes the second option is 6.3% richer thanks to the premium. Tens of thousands of impatient speculators over that thirty year period will have effectively provided the patient investor with this boost to their wealth, most of these speculators probably not even aware of the subsidy they are providing. That's the magic of compound loyalty dividends! Note: By playing with the assumptions, say by making dividends grow at a faster rate (7%) than the share price (3%), the final wealth differential can be as high as 11.8%.  

The loyalty dividend structure, otherwise known as prime de fidélité in French, goes back to 1993 when Groupe SEB, a French appliance manufacturer, adopted it. That same year it was copied by industrial gas giant Air Liquide, Siparex, and De Dietrich (which went private in the early 2000s). Despite ensuing controversy in the French legislature over the fairness of elevating one class of shareholder above the rest, the ability to provide prime de fidélité was enshrined in French law in 1994, with several limits.

These limits include: 1) Shareholders must hold for at least two years; 2) The bonus cannot exceed 10% i.e. if the regular dividend is €1.00, nothing over €1.10 can be paid, and; 3) If a given shareholder owns, say, 10% of the company, they can only earn a bonus on the first 0.5% of that, the other 9.5% qualifying for the regular dividend.

After the first wave of adoption, the prime de fidélité structure was largely ignored by French firms, the exception being concrete giant Lafarge which began paying a loyalty dividend in 1999. But post credit-crisis, the idea has found a second wind. L'Oreal votde to institute a prime de fidélité in 2009; Credit Agricole, Energie de France, and Sodexo did so in 2011; and GDF Suez and Albioma in 2014. These are not small companies. Five of them—Lafarge, GDF, EDF, Credit Agricole, and Lafarge—are in the CAC 40, France's bellwether equity index.

I'm a fan of the prime de fidélité structure. If firms want to encourage an investing mentality among their shareholder base, setting up an an incentive mechanism like a loyalty bonus scheme seems a good way to go about it. Shareholders who are incentivized to think in terms of the long game will be more likely to elect a board of directors with that same mindset, the board in turn exerting pressure on management to adopt long-term goals. Even better would be a version of this program that allows investors to begin enjoying loyalty dividends from the moment they buy shares, say by giving new shareholders the option to lock-up their shares for a fixed two year term in return for a reward.

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Addendum: All of this ties into a favorite topic of mine. The world is missing a key financial product that I like to call the equity deposit. Indexed ETFs and mutual funds allow for immediate or end of day redemption, but this sort of uber-liquidity simply isn't required by the large population of passive equity investors who expect to hold till retirement.

To buy these indexed equity deposits, investors would be required to lock-in their investment for, say, ten years, with redemption only possible upon maturity. With captive funds in hand, the manager of the equity deposit scheme would be able to move a large percentage of the fund's assets out of unregistered shares and into registered loyalty programs. Mutual funds and ETFs, which offer instant or end of day redemption, need to stay relatively liquid in order to meet potential redemption requests. Putting shares into registered share programs like L'Oréal's would introduce liquidity risk, so mutual funds and ETFs would probably only be able to make limited usage of loyalty programs.

Equity deposits would thus be able to lever the magic of compound loyalty dividends to provide those with long-term goals a higher return than an equivalent index mutual fund or ETF. After all, if your plan is to buy once in your thirties and sell once in your sixties, why waste money paying for all the liquidity services that come in between?