Is the Bitcoin Enhanced Approach to Value Really so Radical?
There has been a lot of noise in the crypto space during 2018 with the collapse of Bitcoin prices, a rash of new “stable coins” and the loudly heralded advent of security tokens. Through most of this time, a New Zealand based project has been quietly preparing its own revolution. But is it revolutionary at all?
Bitcoin Enhanced is two blockchain tokens tracking a long/short Bitcoin strategy that enable people to diversify outside of the risks of the financial system. The tokens stay outside the financial system because, unlike traditional hedge funds, they do not hold underlying assets.
Instead, the website publishes a Target Price which represents the returns of a simulated strategy, as if Bitcoin and Bitcoin futures were being traded. It is then up to the token holders to trade at this price on the Waves decentralised exchange (DEX).
The Bitcoin Enhanced Target Price is now at an 88% premium to Bitcoin. Throughout the year the project’s Phi Algorithm had demonstrated its ability to forecast times when Bitcoin prices are falling. But this success is not what makes the project different.
No Underlying Assets
A far more disruptive element is not to hold underlying assets. Without Bitcoin and Bitcoin futures how does the project expect to maintain the value of its tokens at the Target Price of its simulated strategy?
The short answer is that it doesn’t.
Instead it expects token holders to do the work.
The rationale goes something like this:
- Every person buying a token knows that the purpose of the Token is to trade at the Target Price of the simulated Bitcoin strategy published on the website.
- Because token holders know this each has the incentive to trade at this value as this is the only reason for buying the token in the first place.
In one way this is business as usual — let the market decide the price through the interaction of buyers and sellers. Bitcoin Enhanced is delaying its launch until 1st September 2019 in order to ensure there are sufficient tokens sold so that this price discovery can actually take place on the Waves exchange.
But in another way the approach appears completely radical. What makes the project think that people are able to maintain the tokens at a stated price? After all, George Soros in his famous bet against the Bank of England showed that even governments can’t achieve this.
By way of an answer the project goes back to a very basic question: what gives anything monetary value in the first place? Ultimately the only answer is people themselves.  Currencies, commodities and property have value because people believe they have value. Even the value of asset-based instruments such as shares in a hedge fund or a futures contract ultimately depend on instruments where value is determined by people’s belief.
So far so good. But why does the project think that people can keep a token at a specific specified price, in this case, the Target Price?
The Tether Experience
The response is because they can. Stable coin Tether is the most recent example of this happening. The sole purpose of Tether is to be a crypto coin whose value stays on par with the US dollar. Officially this parity is the result of each coin being backed by a US dollar that it can be redeemed for at any time.
In practise, Tether is highly unlikely to have dollars backing all its coins.  But if it is not underlying assets that maintain parity what does? The obvious answer is people’s desire for it to be so. Tether’s utility depends upon this parity. Therefore there is parity, as least while people still believe in the coin and have no other alternative.
The Gold Standard
But is Tether a single isolated case of people being able to maintain a specified value? Not at all. During the 19th century while Britain was on the gold standard, the pound was never backed one for one with gold. Nathan Lewis, author of the New World Economics blog did some primary research and went to the Bank of England to look up their records of currency and bullion during the century. He found:
“There was never any “100% reserve.” The “reserve ratio” (bullion to banknotes ratio) varies wildly during this time.”
In other words, the stability of the Pound was guaranteed by the expectations of users, not by underlying assets, long before Tether appeared on the scene.
A Deeply Conservative Approach
This means that Bitcoin Enhanced with its explicit use of the expectations of users to hold the tokens at its Target Price may not be so much revolutionary as deeply conservative. In the past the value of the Pound, the US dollar and commodities have had a long and enviable stability because people believed in and valued this stability. Prices stayed largely the same, not because, for example, the Bank of England held gold for every Pound issued, but because of the utility that stability gave. As Lewis puts it:
“For most of U.S. history, people adhered to the idea of Stable Money. Money should be as stable in value as possible.”
It is the “idea” of stability that made it so.
The Stability of Gold
Lewis also conducted an analysis to determine how stable the value of gold was. This was a little more difficult than it appears at first sight. What is one to compare gold with? Lewis found that changes in the price of gold were in fact changes in the value of the currency not vice versa. Given the stability of gold’s value against multiple currencies in multiple regions, as well as its stability against commodity prices during the 18th and 19th centuries he concludes that gold was indeed the source of stability for that era.
“The basic premise of a gold standard system is, first, that a currency that is stable in value is an important and desirable thing. Second, gold is stable in value. Thus, if you make the value of your currency the same as gold, then your currency will be stable in value.
“That’s pretty much all there is to it, although it seems like even this kindergarten stuff isn’t well understood these days. A lot of people seem to think that the purpose of a gold standard is to make the quantity of money stable because it is hard to mine gold. Actually, gold standard systems in operation during the 19th century had rather dramatic changes in base money outstanding, which was no problem and just part of the normal operations of the mechanism that kept the value pegged to gold.”
What Made Gold so Stable?
Lewis’ analysis begs the million dollar question: if it is gold that was stable, why? In Norway, silver played the same role where “Price stability has been the norm over the past 500 years”. What most people overlook, but Bitcoin Enhanced has not, is that the reason why the value of gold was stable is because people wanted it to be. There was utility in stability and thus it was so.
The point is not about stability per se but the fact people’s expectations where the method by which the price of gold stayed constant.
The Return to What Works
Seeing people’s expectations maintain a fixed price for gold and silver for hundreds of years casts the Bitcoin Enhanced approach in a very traditional light. It looks like the project is simply returning to a well-tested mechanism to maintain a given value. The purpose for which the mechanism is being used has changed. People kept gold at a constant price. The Target price changes depending on Bitcoin’s price and the success of the Phi Algorithm forecasts. Yet the mechanism is exactly the same and has been bedrock of the financial system for as far back as we have adequate records.
This appreciation of the enduring nature of the Bitcoin Enhanced approach to value begs another question: how is it that the way Bitcoin Enhanced establishes the value of its tokens can look so radical when it is simply using something that has worked so well for so long?
The answer lies in the current state of the financial system.
When Lehman Brothers collapsed on 15th September 2008 the reason why governments around the world had to step in with massive bailouts and the guarantee of bank deposits was because the financial system itself was in danger of collapse. How could this be? Why would the failure of one bank cause such concern?
A Fragile System of Dependencies
The reason is because the overwhelming majority of today’s financial instruments are derivatives in the sense that their value depends upon the value of another, underlying asset. When banks, insurance companies and other institutions trade these derivative instruments with each other they set up a system of dependencies where the value of one institution now depends on the value of others. This is because, the value of the instrument they hold depends upon a counterparty fulfilling is obligations, whether these are the payment of interest, delivery of a commodity, or redemption at a given date. If the counterparty goes down, as did Lehman Brothers, that creates a black hole of unquantifiable proportions on the balance sheet of other institutions in the system. As each institution has these dependency relationships with other institutions, the effect of one bank collapsing reverberates throughout the entire system. As Steve Eisman, one of the few that saw the 2008 Financial Crisis coming put it:
“’There’s no limit to the risk in the market,’ he said. ‘A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!’ The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup’s shareholders, bondholders, and employees — but the sums involved were known to all. Citigroup’s failure, however, would also trigger the payoff of a massive bet of unknown dimensions from people who had sold credit default swaps on Citigroup to those who had bought them.’”
So the reason why the Bitcoin Enhanced approach can appear so radical is because the financial system itself has changed so fundamentally. And the problem that Bitcoin Enhanced seeks to solve for investors is exactly how to avoid the risk of this fragile system of dependencies collapsing.
Its solution is not some new untested, complex, technological fix. Its solution is to return to the time-tested mechanisms that have given stability to the financial system the world over for centuries.
An Internet of Finance
Interestingly, if the return of Bitcoin Enhanced to the price mechanisms of the past spawns imitators we may start to see the financial system evolving into something that looks quite modern — the Internet. Because the Bitcoin Enhanced tokens do not depend on anything outside themselves for their value (no underlying assets) they are in effect silos of value, self-contained systems where value is self-generated by users trading on the exchange. Without dependencies, if, say, Bitcoin Enhanced goes down because the Target Price keeps falling, this failure is a loss for token holders but it does not jeopardise the entire system.
Discreet components like this are exactly what make the Internet so robust. If a router or server goes down then the data is simply re-routed.
In the long run a robust financial system is in everyone’s interest. Discreet silos of value are the only way that true diversification of an investment portfolio can take place. In the current system of dependencies there cannot be any diversification away from the risks of the system itself because everything is connected to everything else.
What makes this whole process so interesting is that building such robustness into the system looks like returning to the enduring way value has been created for centuries — through the expectation of people themselves.
 Michael Lewis The Big Short, page 263.