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September
29
2017

Macquarie Lashes Out At Dimon:
"Modern Finance", Not Bitcoin, Is The Real Fraud
Tyler Durden

While the establishment including various central banks, China (which has a "modest" capital flight problem), commercial banks such as JPM and especially its CEO Jamie Dimon who called Bitcoin a 'fraud" similar to the tulip bubble of the 17th century, have come out as harsh opponents of cryptocurrencies, some notable "minority oppinions" have emerged in recent days, such as Morgan Stanley's CEO, James Gorman, who yesterday suggested that Dimon is wrong and that "Bitcoin is certainly more than a fad... the concept of an anonymous currency is an interesting concept."

However, the harshest criticism of Jamie Dimon's takedown of bitcoin came from Macquarie's head of AsiaPac equity strategy, Viktor Shvets who this morning said that it's not bitcoin that's the bubble- or fraud - but the entire modern financial system, which is 4x-5x bigger than the underlying economies, to wit:

When a number of financial executives recently described Bitcoin as a “fraud” akin to the tulip mania, it exhibited their apparent lack of appreciation of fundamental shifts that are altering global monetary and financial systems. If one describes Bitcoin as a fraud, how would one describe a ‘financial cloud’ that is at least 4x-5x larger than the underlying economies? It is unlikely that US$400 trillion+ of financial instruments circulating around the world would ever be repaid and most are now backed by assets that are already either worthless or are diminishing in value. How does one describe rates and  the yield curve that are either directly determined by CBs (BoJ or PBoC) or heavily influenced by them (Fed or ECB)? 

The following chart summarizes Shvets's concern: some $500 trillion in global financial assets including shadow banking, or roughly 500% global GDP.

As a result of this unprecedented financialization bubble, which is the true systemic fraud, "cryptocurrencies remain a tiny niche, but as in the case of tulips, they are a symptom of a deeply seated disease.  They represent a desperate search for alternatives to the above potential "train wreck." 

While we maintain that despite presence of US$7.5 trillion of excess reserves (amongst G4+Swiss central banks), global deflationary pressures are so strong that break-out of inflationary pressures is unlikely. However, if public sectors continue to insist on suppressing business/capital market cycles, then some form of full credit market nationalization and/or currency debasement becomes inevitable. 

Hence, cryptocurrencies.

Shvets' then gives some advice to the Dimons of the world: "people living in glass houses should not throw stones" and explains what is really happening: like gold, bitcoin has emerged as an insurance policy to the insanity unleashed by a reeling, establihsment political system and central bankers determined to preserve the status quo at all costs, who "instead of repudiation of debts, deleveraging and clearance of past excesses", have encouraged the opposite, namely "accelerated leveraging and avoidance of debt repudiation and clearance." As a result, setbacks have been relatively mild, and "we have not experienced a Kondratieff winter since 1930s"... so far. 

Shvets also warns that "there is always a price to pay for deliberate and long-term suppression of cycles, and that is subsequent recoveries (both real GDP and inflation) get progressively weaker" and adds that "eventually, gravity would take control, and it would be impossible to generate positive outcomes, as deflation takes control. However, it is not clear to us whether we are close to such a ‘black hole’. Our working assumption is that we would require a significant further jolt to the system to push us closer to the ‘black hole’ and force coalescence around far more robust policies, such as a merger of fiscal and monetary policies, minimum income guarantees, etc. This is where gold and cryptocurrencies come in. Both are outside the system, and offer an exposure to what can be effectively described as an insurance policy."

Shvets also admits that while cryptocurrencies are not yet money based on the conventional definition of being both "a store of value and a reliable and stable medium of exchange", he notes that "the big difference between today’s cryptocurrencies and (say tulips) is that even though Bitcoin price could be reflecting extreme speculation, it is built on a durable technology that is likely to continue to evolve and strengthen, and although governments might try to restrict and ban it, ultimately technology is going to win." 

Hence, the challenge facing central banks is that although cryptocurrencies are today a tiny portion of the overall money pool, the nature of monetary economy is rapidly changing and central banks would have no choice but to adjust. Consumers and businesses would ultimately carry wallets consisting of different types of sovereign and cryptocurrencies, while transactions would be increasingly conducted via new technology channels (such as block chain).

Summarizing his retort to Jamie Dimon, and echoing what Mike Novogratz said earlier this week, Shvets asks rhetorically "Is there a role for cryptocurrencies and gold in investment portfolios?" and answers "Absolutely" because as explained above, these are nothing more than insurance policies against degrading of fiat currencies. However, for now, he says that the "US$ remains the king and until changes to the monetary system become more pronounced (cryptocurrencies account for ~0.5% of cash in circulation), economies would continue to reside on a de-facto US$ standard."

Which then brings us to the real $500 trillion question: "whether in this new environment, would the US$ be dethroned as the key linchpin of the global trade and finance?"

And, as Shvets explains in his full note below, it is every investor's own answer to that question, that provides the justification whether to buy - or stay away from - cryptocurrencies. 

* * * 

From Macquarie Capital's Viktor Shvets

About cryptocurrencies and tulips

“Bitcoin is a sort of tulip… it is an instrument of speculation but certainly not a currency and we don’t see it as a threat to central bank policy.”

       - Vitor Constancio, ECB Vice President, September 2017

“You can’t have a business where people can invent a currency out of thin air… it is fraud and worse than tulips bulbs.”

       - Jamie Dimon, CEO JP Morgan, September 2017

Are cryptocurrencies new tulips?

The world today has more than one thousand cryptocurrencies and both their number and market capitalization has proliferated at an astounding speed. For example, in June 2016, the market capitalization of all cryptocurrencies was ~US$16bn (and over 80% was represented by Bitcoin). Today, market capitalization is in excess of US$160bn, and Bitcoin’s market share is only around 40%-45%. It was this rapid ascension that prompted the above-quoted references to tulip bubble in 17th century Holland. It is interesting that both Constancio of ECB and Dimon of JP Morgan referred to one of the  most famous bubbles, without explaining why tulip mania originated in the first place.

The same forces that created early 17th century asset inflation are powering…

Most scholars today agree that it was rapid expansion of flow of bullion into Amsterdam (which in the early part of 17th century was the key centre of European trade and finance) that created a feverish boom, ending with the collapse of the tulip mania in 1637. The large increase in silver flows from the New World between 1570 and 1630s (shipments more than doubled), currency debasements by various states across Europe to pay for the Thirty-Year War and many other wars that raged in the first half of the 17th century, when combined with Amsterdam’s standing as a safe and reliable depository of money, had significantly increased Dutch money supply. Although at the time there were no reliable monetary statistics, several indicators suggest a substantial rise in liquidity. For example, mint output rose from 9m guilders in 1630-32 to 17m guilders in 1633-35 and ballooned to 23m guilders at the peak of Tulip mania in 1636-38, falling back to 11m guilders in 1639-1641. Similarly, deposits at the Bank of Amsterdam rose from 3.6m guilders in 1632 to 5.7m guilders in 1637.

Indeed, it was a continent-wide phenomenon, with supply of the New World silver and demographic bulge, led to price rises for most commodities and not just tulips (from corn, wheat, meat to firewood). It had become known as the great inflationary pulse of late 16thearly 17th centuries. As today, it was a world of declining real wages and rapidly rising income and wealth inequalities. In Amsterdam, this inflationary pulse was aggravated by the new financial innovations, including establishment of the world’s first futures and options clubs in 1609. These clubs (mostly well-managed for professionals) encouraged reckless zero-margin financing for tulips and other commodities, which gradually sucked in an increasing number of participants, who were not professional tulip growers. The rest is history.

In some ways it is not dissimilar to the sub-prime crisis in 2008 or the dotcom bubble in 1999- 2001. Rising liquidity and loose standards always lead to bubbles. As Douglass North once remarked, “In a society that rewards pirate skills, such skills would proliferate.” Adapting that for today’s world, in a society that encourages financial speculation and financialization of underlying economies, rolling bubbles are the inevitable by-product, and as Gresham’s Law says, “Bad money drives out good.” In the case of 17th century Holland, any high-quality gold coins were immediately reminted into their poorer cousins. Today, systematic currency debasements drive wealth into alternative currencies and other means of safeguarding value, be they land holdings, fine wines or cryptocurrencies.

…alternative asset classes from Bitcoins to fine wines and gold

As the global economy embarked on a three-decade-long quest for stability at a time of stagnant productivity and declining returns on conventional labour, the stock of ‘money’ has expanded as dramatically as anything that had been experienced during late 16th-early 17th centuries. If we examine G4 economies (i.e. US, Eurozone, UK and Japan), the stock of narrow money expanded from 100 in 1996 to 380 as at June 2017, while nominal GDP has only expanded to 190. Today, the world’s narrow money supply (M1 – notes, coins and shortterm demand deposits) approximates US$33 trillion, while broader money supply (M2) is ~US$85 trillion and the value of all outstanding financial instruments (equities, sovereign and corporate bond markets, lending, shadow banking and repo markets) is around US$400 trillion or ~4x-5x global GDP. At the same time, G4 plus Switzerland CBs’ balance sheet exploded over the last decade from a run rate of US$2-3 trillion to almost US$16 trillion.

In this context, cryptocurrencies remain a tiny niche, but as in the case of tulips, they are a symptom of a deeply seated disease. They represent a desperate search for alternatives to the above potential ‘train wreck’. While we maintain that despite presence of US$7.5 trillion of excess reserves (amongst G4+Swiss central banks), global deflationary pressures are so strong that break-out of inflationary pressures is unlikely. However, if public sectors continue to insist on suppressing business/capital market cycles, then some form of full credit market nationalization and/or currency debasement becomes inevitable. Hence, cryptocurrencies.

Unlike Holland of 1637, when the state was quite prepared to inflict pain by closing open futures and option contract positions, and thus quickly deflating the bubble, it is highly doubtful that today’s regulators would ever be prepared to embark on such a drastic action. As outlined in our recent review of the Kondratieff cycles (here), governments have been in the business of micro-managing economies and liquidity for at least three decades (certainly since Paul Volcker’s days). Instead of repudiation of debts, deleveraging and clearance of past excesses, central banks and politics encouraged accelerated leveraging and avoidance of debt repudiation and clearance. As a result, setbacks were relatively mild, and we have not experienced a Kondratieff winter since 1930s. However, as described in our note, there is always a price to pay for deliberate and long-term suppression of cycles, and that is subsequent recoveries (both real GDP and inflation) get progressively weaker. Eventually, gravity would take control, and it would be impossible to generate positive outcomes, as deflation takes control. However, it is not clear to us whether we are close to such a ‘black hole’. Our working assumption is that we would require a significant further jolt to the system to push us closer to the ‘black hole’ and force coalescence around far more robust policies, such as a merger of fiscal and monetary policies, minimum income guarantees, etc. 

This is where gold and cryptocurrencies come in. Both are outside the system, and offer an exposure to what can be effectively described as an insurance policy.

While cryptocurrencies are not yet stores of value or proper mediums of exchange, they…

While we do not pretend to be experts on Bitcoin or other multiple variations of cryptocurrencies (which use different software), the essential point about all of them is that they provide relatively secure and divisible means of transacting that is borderless, with predictable and decentralized supply. Although the above quotes indicate that senior financial executives believe that Bitcoin is a fraud, the reverse in many ways is true, as it is in fact a highly transparent system, with every transaction that has ever taken place recorded on the database (block chain), which is visible to all and every entry is permanent. The entire business case is built around mathematics rather than fraud. However, it is also true that it can be hacked (think of Mt Gox) and it has evolved into one of the key avenues that turbocharges potentially fraudulent and illegal transactions (think of Silk Road). But it is only natural, as criminals have a much higher than average tolerance to risk (an occupational hazard, so to speak), and hence they tend to be the first on the scene. Eventually, many of the custody and safety issues associated with cryptocurrencies would be resolved (or at least sufficiently blunted) to engender greater confidence.

…represent insurance policy against fiat currencies and proliferation of different transaction technologies

The essence of money is that it has to be accepted as a store of value and a reliable and stable medium of exchange. Cryptocurrencies at the current juncture do not satisfy either of these conditions. The massive booms and busts that Bit coin has experienced over the last three-to-four years is indicative of speculation rather than store of value. Similarly, there are few centres where cryptocurrencies can be today exchanged for actual services. In that respect, Vitor Constancio is correct that cryptocurrencies are not yet proper currencies. However, it is equally disingenuous to argue that US$ or Euro inherently have an underlying value. Being nothing more than fiat currencies, these are not backed by anything that is valuable, other than the prestige of and confidence in the state and the governments that issue that currency. As multiple examples from the past illustrate, the governments can and regularly do debase this privilege. It is during these times that alternatives—be they tulips, gold, antique cars, Bitcoin or seashells—spring up. If the governments ban Bitcoin from circulating within sovereign territory or attempt to over-regulate it, it is likely that money would simply shift to another assets (principally gold and precious metals) and if these are restricted (a la the US government ban on gold in 1930s-60s), then other assets would take its place. 

However, the big difference between today’s cryptocurrencies and (say tulips) is that even though Bitcoin price could be reflecting extreme speculation, it is built on a durable technology that is likely to continue to evolve and strengthen, and although governments might try to restrict and ban it, ultimately technology is going to win. Hence, the challenge facing central banks is that although  cryptocurrencies are today a tiny portion of the overall money pool, the nature of monetary economy is rapidly changing and central banks would have no choice but to adjust. Consumers and businesses would ultimately carry wallets consisting of different types of sovereign and cryptocurrencies, while transactions would be increasingly conducted via new technology channels (such as block chain). 

The key question is whether in this new environment, would the US$ be dethroned as the key linchpin of the global trade and finance?

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