Matt Levine entertains the possibility that all money is a ponzi:

"But of course crypto people will happily tell you that fiat currency is the biggest Ponzi scheme of all, and they are not really wrong are they?"

Here is my discussion with some crypto folks on Twitter making that claim.

I disagree. Here is a short (930 words, 3 minutes) blog post explaining why money is not a ponzi.

Aneroid is a small town in Saskatchewan. It has 100 inhabitants. Selma, one of the town's 100 inhabitants, starts a ponzi.

By ponzi, I am referring to a general class of economic phenomena that can only exist if additional people continue to join up. Under these schemes, old investors are paid with new investors' funds. Once the incoming flow of new entrants dries up, the ability to pay out funds to existing participants comes to an end. The scheme ends. This family of economic phenomena includes not only ponzi schemes but also pyramids, chain letters, MLMs, HYIPs, speculative bubbles, and Nakamoto schemes.

Out of the above options, Selma opts to go with a chain letter. She drafts one up on paper and sells a copy to her friends Tom, Sally, and Alice for $10. (I'm replicating the basic design of the notorious 1970s Circle of Gold chain letter). The letter requires the recipient to send $10 to the person at the top of the list, copy the letter (removing the name from the top of the list and writing one's own name at the bottom), and sell it on to three friends for $10.

Selma's chain letter proves to be popular. 99 inhabitants of Aneroid eventually buy a letter, send $10 to the person at the top of the list, and resell it.

But when Jack, the 100th inhabitant, buys a letter and sends $10 to the person at the top, he finds that he can't resell it. Everyone in Aneroid has grown tired of the game. The chain letter stops propagating, the flow of money ceases, and the whole enterprise dies. Jack $10 copy is worthless.

Does money have the same ending as Selma's chain letter?

Enter the Bank of Aneroid. 

The Bank of Aneroid is the town's sole issuer of banknotes. The Bank lends a $10 banknote to Selma secured by a $15 lien on her property. Selma spends the $10 note at Frank's hardware store who spends it at the grocery store etc etc, until it ends up in the hands of Jack. But to his dismay Jack finds that, for whatever reason, no one will accept the $10 note.

Alas, poor Jack. His $10 banknote now seems as worthless as his $10 chain letter.

Lucky for him, it isn't. Unlike a chain letter, Jack can return the $10 note to the original issuer, the Bank of Aneroid, for redemption.

Recall that the Bank of Aneroid owns Selma's $10 property-secured IOU. When Jack walks into the Bank and asks to have the note redeemed, the Bank of Aneroid makes good on its promise by selling Selma's debt in the debt market for $10 worth of gold or central bank money. It then pays this amount to Jack. The Bank of Aneroid then destroys its $10 note.

(Alternatively, the Bank of Aneroid can tell Selma to repay her $10 loan, the proceeds being used to pay Jack. Or the Bank can take the more extreme measure of seizing Selma's property and selling it in order to make good on its promise to redeem Jack's $10 banknote.)

As you can see, what I'm describing is not a ponzi scheme. That is, the Bank of Aneroid's $10 banknote isn't valuable because a new buyer keeps arriving to take it off of the previous owner's hands. It is valuable because the original issuer, the Bank of Aneroid, will always repurchase its note using its resources, i.e. its portfolio of loans.

Careful readers will protest at this point. "C'mon JP, you're talking about redeemable bank money. Of course that's not a ponzi. It's the non-redeemable stuff, fiat money, that's a ponzi!"

But I'd argue that the same principles apply to fiat money. I'm going to define fiat money as a banknote that can't be redeemed on demand by its holder into an underlying instrument, perhaps gold or government money. 

In our example, let's modify the Bank of Aneroid so that it issues fiat banknotes, not redeemable ones. Apart from that, everything remains the same. Now when Jack takes his unwanted $10 banknote back to the Bank of Aneroid for redemption, the bank refuses to convert it into an underlying medium.

Jack's $10 won't be worthless like the $10 chain letter, though.

"Sorry Jack, we can't redeem it," says the bank manager. "Our banknotes are non-convertible fiat notes. But Selma's $10 loan is due next week. To pay us back she's going to need your $10 note. Why don't you talk with her?"

And so Jack walks over to Selma's house and offers to sell her the $10 note. And Selma will buy it since she'll need it to repay her $10 debt to the Bank.

So in the end, Jack's $10 banknote is valuable—not because a ponzi process props it up—but because the bank that originally issued it reaccepts it. The support that a bank offers to its banknotes is more obvious when a banknote is immediately redeemable by its issuing bank at par. But even an non-redeemable fiat banknote has an underlying linkage back to the issuer that helps support its value.

By contrast, a chain letter (or any other ponzi-like instrument) lacks this connection and only has value as long as a new player emerges.  

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PS. This note is for Ethereum fans.

Another way to think about the question of fiat money is to bring in some stablecoin analogies. The Bank of Aneroid's non-redeemable fiat notes are equivalent to Rai or MakerDAO's Dai (before Maker introduced the PSM). 

Rai and pre-PSM Dai are fiat monies. Neither are directly redeemable into underlying USDC, Tether, or bank dollars. But this doesn't prevent Rai and Dai from staying close to their targets (in Rai's case $3-ish and in Dai's case $1.) In the absence of direct redeemability, the main force pushing these tokens towards target is the requirement that vault owners (i.e. debtors) repurchase Rai and Dai to repay their Rai- and Dai-denominated debts to the system. This is the same force that stabilized the Bank of Aneroid's $10 fiat note in my story. Recall that Frank's $10 note was valuable because Selma needed it to close her debt to the Bank of Aneroid.

Adding an on-demand redemption feature to the Bank of Aneroid's notes only makes this stabilization more direct and immediate, much like Maker's addition of a direct redemption mechanism, the PSM, resulted in a more direct fusion of Dai to its $1 target. (The PSM means that Dai has become non-fiat money.)

Another force keeping Rai and pre-PSM Dai anchored to their respective targets are the threat of Rai's "global settlement" or Maker's "emergency shutdown." Basically, in extreme scenarios both systems can be completely unwound. When this happens all the collateral held in the system gets distributed back to its respective stakeholders, including the owners of Rai and Dai. The knowledge that this could happen helps nudge the price of Rai and Dai closer to their targets.

The Bank of Aneroid's notes are also subject to their own version of emergency shutdown. At any point in time the owners of the Bank of Aneroid can wind up the bank. By collecting on all of their debts, selling those debts to others, or seizing collateral, the Bank can buy back all of the notes they have issued at par. The possibility that this could happen helps pull the Bank of Aneroid's fiat notes towards a stable terminal value.

Sure, there are stablecoins that depend on an underlying ponzi process to stay pegged to $1. But Rai and Dai do not fall into that category of stablecoins. Rai and Dai use non-ponzi mechanisms to create a stable version of the dollar. The Bank of Aneroid's fiat notes are not ponzi-ish for the same reasons that Rai and Dai are not ponzi-ish. And the same goes for Federal Reserve dollars, Bank of Canada dollars, and Bank of England pounds, which operate on the same principles as the Bank of Aneroid's fiat notes.

[[My first article with Breakermag was published in September 2018. Alas, Breakermag closed its doors in 2019. The website remained up for a while but it seems to have recently been decommissioned, so I'm salvaging this story from the abyss of disappearing internet content. I think it succinctly captures a point I make over and over. When we go to a casino, the verb we use to describe this activity is 'playing,' not 'investing.' Likewise, we should be using the word 'play' when we talk about what we do with crypto. Drill into what crypto is about and it's mostly (not always) gambling games—yes, novel games, but gambling nonetheless. Getting the semantics right is important. Owning crypto is fun and entertaining (and potentially problematic). So is going to the casino. But players shouldn't be fooled into thinking that they are engaging in a productive and socially beneficial enterprise.]]

No one invests in the lottery; they play it. Rather than investing in bitcoin, let’s play bitcoin.

On December 8, 2017, just a few days after bitcoin crossed the $10,000 mark for the first time, Coinbase CEO Brian Armstrong published a blog post asking customers to “invest responsibly.” A week after Armstrong’s appeal, the price of bitcoin hit $19,801, paused, and then proceeded on what has been nerve-wracking decline ever since.

In hindsight, Armstrong’s “invest responsibly” post seems timely. Any novice would have saved themselves much money and stress if they’d taken his advice to be careful and had either reduced the amount they purchased or stayed entirely out of the market. These days, Reddit is littered with stories of disillusioned buyers who diverted large amounts of their savings into bitcoin or some other cryptocurrency near the December 2017 highs. One story, recounted in the New York Times, describes a 45-year-old Korean teacher who borrowed money to buy $90,000 worth of cryptocurrencies, only to lose most of it.

I have a problem with the words that Armstrong chose for his blog post. Most people do not invest in bitcoin. They play bitcoin. Using the correct word to describe the relationship that the great majority have with their bitcoins would be a powerful way to ensure that new buyers of bitcoin do not get the wrong expectations about what they are getting into.

Bitcoin lies in the same economic category as financial games like poker, roulette, and the lottery. These are all zero-sum games. The property binding 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. Because nothing additional is created in a zero-sum game, for every player who wins something from the pot, there must be a loser.

Compare this to win-win financial opportunities like stocks or bonds. In the case of a stock, each shareholder’s contribution is used to support the underlying firm’s deployment of capital. This cocktail of machinery, labor, and intellectual property is combined to create products, the sale of which generates a return. Put differently, as long as the firm’s managers deploy the money in the pot wisely, the firm can throw off more cash to shareholders than the sum originally put into the pot.

This generative capacity does not exist with zero-sum games. Take poker, for example. If five players have all bought into a poker game for $1,000, there is no way that the winner of the game can get more than $5,000. A zero-sum game cannot generate more than the sum of its parts. Likewise with bitcoin. The only way that a buyer at today’s price of $6,442 can avoid being a loser is if someone else is willing to buy that bitcoin at a higher price, say $6,995. Unlike a shareholder in a firm, bitcoin holders have not bought into a value-creating business. Their only escape is the next person in line.

What makes bitcoin different from other zero-sum games is the method for splitting the pot. Poker awards pots to whoever ends up with the best hand of cards. In the case of the lottery, the pot goes to the lucky number. Bitcoin divides pots on the basis of entrance order. Early birds are rewarded by late-comers.

This first-in-line redistribution mechanism is by no means bitcoin’s only unique feature. Rather than being hosted at a Las Vegas casino, bitcoin is a decentralized online game. This means that there is no way for the authorities to march into the casino and shut the game down. Nor can the system operator prevent people from participating. Whereas casino operators regularly bar people from entering, bitcoin is maintained by a network of independent validators that cannot easily censor users from making bitcoin wagers. Finally, bitcoin is automated by open source code, unlike say a human croupier who can make mistakes in redistributing a roulette pot. This code is fully auditable. Everyone can see what the rules are and check that they are being abided by. Contrast this with a lottery which reveals nothing of its inner workings.

In suggesting that bitcoin should be labelled a game rather than an investment, I don’t mean to belittle it. Financial games provide value. A casino employs not only croupiers but also managers, marketers, cooks, cleaning staff, programmers, security guards, and more. These jobs help the economy. People fly to Vegas for a reason. In moderation, financial games are fun, sort of like how going to a horror movie provides thrills.

Likewise, bitcoin’s price contortions can be entertaining. Combine this with the constant soap opera generated by the personalities involved in the space, and you’ve got a form of recreation that competes head on with Netflix, League of Legends, or the NFL. Bitcoin and its many ancillary services—exchanges, payments processors, and wallet providers—create jobs for programmers, marketers, lawyers, and economists.

If financial games were illegal, then the provision of lotteries, poker, and other forms of betting would shift to the underground economy. Not only would the quality of the product decline, but violence could rise as criminal organizations fight to control their gaming turf. Bringing these activities into the light—in bitcoin’s case by implementing an open and transparent online version—makes society safer.

And of course, there are times when bitcoin serves as more than just a financial game. In 2011, for instance, Wikileaks relied on bitcoin to maintain its connection to donors after being cut off from the banking system. This payments function was why bitcoin was originally created, but it has taken a distant back-seat to the technology’s dominant role as a decentralized financial game. Indeed, what makes bitcoin such a thrilling game—its rollercoaster peaks and troughs—is the very feature that militates against its usage as a medium of exchange. People don’t want volatile money, they want stable money.

This gets me back to Brian Armstrong’s admonition to Coinbase’s customers to invest responsibly. His warning label just doesn’t cut it. No one invests in a zero-sum game, they play it. A casino owner daring to suggest that playing roulette is akin to investing would be justifiably pilloried for engaging in purposeful deception or, at best, sloppy word usage. Same with a lottery operator who advertises Powerball tickets as an investment. Likewise, people buying bitcoins should not be encouraged to believe that they are engaging in the age-old art of investment appraisal. They are playing a zero-sum game. The word “investment” should be reserved for the act of allocating capital to win-win games like shares in private businesses, publicly traded stocks, and bonds.

I am not singling out Armstrong. The idea that bitcoin is an investment plagues the entire sector. Chris Burniske, a well-known bitcoin trader with more than 100,000 Twitter followers, has entitled his book (written with Jack Tatar) Cryptoassets — the innovative investor’s guide to bitcoin and beyond. Or take the recent CNBC interview of Meltem Demirors, CoinShares chief strategy officer, in which she made the curious analogy between bitcoin—a zero-sum game—to Amazon, a security that falls within the realm of investment analysis. I am also reminded of Litecoin creator Charlie Lee’s own “invest responsibly” moment on Twitter last December, even as he was dumping his holdings on novices at prices that would eventually prove to be near their peak.

The majority of newcomers are attracted to the crypto scene not for ideological reasons, but by the scent of big winnings. Many are betting a big part of their wealth on bitcoin or other cryptocurrencies. And no wonder. If a 20-year old with life savings of $1,000 can turn that amount into $10,000 in just a few weeks, they will have advanced their financial status far faster than by toiling away at a job, or putting it in a savings account. The dark side is that this $1,000 in savings can just as easily be destroyed by bitcoin’s inherent volatility. Dropping the word “investment” and replacing it with “game” would be a more accurate description of the activity in which bitcoin owners are participating. The flocks of new entrants might get a better inkling what kind of door they are entering. Maybe they will avoid doing serious damage to their futures.

With a game, nothing is assured. Games are something to dabble in, not vessels for one’s retirement savings. A problem gambler, someone who continuously bets their savings on zero-sum financial games despite the financial harm being inflicted on themselves and their family, doesn’t need the affirmation that the word “investing” brings to their activities. Instead of asking Coinbase users to “invest responsibly,” Armstrong should have used a version of the disclaimer that most American lotteries use, including Powerball: “Play Responsibly. Remember, it’s just a game.”

All Ethereum transactions can be tracked.

But there is a neat little tool that lets you remove this traceability: Tornado.cash. Alice submits her Ethereum tokens to a Tornado.cash smart contract where it gets commingled and mixed up with other people's tokens, then re-sent back to Alice at a separate address. (There are some extra things that happen, too. Read here.) Voila, the transaction trail has been obfuscated. All that an outside observer knows is that Alice's coins have been sourced from Tornado (for the rest of this post I'll use Tornado and Tornado.cash interchangeably). They know nothing about their history before then.  

Who uses Tornado? 

Some users are hobbyists and advocates of anonymity. They're not engaged in anything illegal. They want to consume privacy as a financial service. We'll call them legitimate users.

The other batch of users are criminals keen to hide the provenance of the Ethereum tokens that they've stolen by hacking or exploiting exchanges and other financial tools. When BitMart, an exchange, was hacked on December 4, $200 million was laundered through Tornado.cash. A few days later, $1.75 from an 8eight Finance exploit was processed by Tornado. (If you want more examples, ask me in the comments).

My question is this: given the presence of criminal funds on Tornado.cash, is it dangerous for legitimate users to connect to it? More specifically, does a legitimate user who submits their Ethereum tokens to a Tornado smart contract risk a money laundering conviction given that they may be interacting with criminally-derived money?

In the U.S., an individual can be convicted of money laundering if they knowingly conduct transactions in criminally-derived funds. For example, if Joe, a car dealer, sells a Lexus to a criminal for $75,000 in dirty cash, and knows that the transaction was made for the purposes of evading the authorities, then Joe can be found guilty of money laundering. It's a serious offence punishable with up to 20 years in jail.

Would the same principles apply to Tornado.cash users?

If a thief steals some Ethereum and deposits it into a Tornado smart contract where it is commingled with deposits made by a legitimate user, and this legitimate user withdraws their portion of that amount, then it seems to me that the legitimate user may have engaged in money laundering. That is, it's possible that they have conducted a financial transaction that involves the proceeds of an unlawful activity.

But that's not quite enough to establish money laundering. As I said earlier, to be convicted of money laundering a mental state of knowing has to be proven.

Many legitimate Tornado users interact with the tool without knowing much about it. They've never considered the possibility that by connecting to Tornado, they may be serving as a nexus for the laundering of criminally-derived property. Since knowing can't be established, then these users probably can't be judged guilty of money laundering.

But other legitimate users are not so unwitting. It's common knowledge that hacks and thefts are laundered on Tornado.cash. Some of the larger and more savvy Tornado users are no doubt aware that by commingling their funds in a Tornado smart contract they are providing criminals with a means of concealing the source of proceeds of unlawful activity. With knowing having been established, it's possible that their usage of Tornado.cash transcends into money laundering.

But even if the mental state of knowing can be established, one thing is still missing. There doesn't seem to be a clear and well-defined exchange of dirty crypto for clean. That is, when some stolen Ethereum gets deposited into a Tornado smart contract along with legitimate Ethereum, and then later withdrawn, there doesn't seem to be any way to explicitly link the withdrawal of that stolen Ethereum to a specific person. It's hidden by the software.

Put differently, there's no smoking gun.

I think it might be useful at this point to introduce an analogy using physical cash. It is clearly illegal for Joe, our auto-dealer, to knowingly take a criminal's $75,000 in cash. But let's imagine that Joe and the criminal decide to interpose a cash mixing box between themselves. Joe figures that this mixing box will allow him to receive payment without actually taking the criminal's banknotes. Does that make it legal?

It works like this. Two third-parties – Ted and Alice – put in $75,000 in "clean" cash into the mixing box. The criminal puts his dirty $75,000. Ted and Alice's $75,000 gets mixed with the criminal's $75,000. Ted and Alice each remove $75,000. Joe, the auto dealer, also removes $75,000. Joe then transfers the criminal the car.

There is no way for law enforcement to prove that the actual banknotes that Joe has received are the specific banknotes that were deposited by the criminal. Because they were commingled with legitimate money, Joe can deny having accepted criminally-derived funds. (As can Ted and Alice).

But does this set up absolve Joe of guilt? I doubt that the interposition of a cash mixing box would be perceived by a judge as altering the underlying relationship between Joe and the criminal. The mixing box would rightly be seen as a contrivance to throw the cops off. (See last footnote, below)

What about Ted and Alice? If Ted unwittingly contributes his $75,000 to the mixing box – i.e. he doesn't realize that he is helping to obfuscate the criminal's funds – then he probably wouldn't be found guilty of laundering money.

Alice, however, suspects that her contribution to the mixing box will be used to obfuscate the transaction trail between the criminal and Joe, but contributes anyways. The establishment of intention surely increases Alice's odds of a money laundering conviction. She might hope that she can get off because the commingling provided by the mixing box breaks the cash trail between her and the criminal. But again, there's a good chance the judge won't buy this argument.

It's important to keep in mind that Alice may have her own specific reasons for using the cash mixing box. Perhaps she values privacy and therefore periodically mix up all her notes. Maybe she likes to collect certain banknote serial numbers (i.e. ending in 2) and a cash mixing box is a convenient way for her to get exposure to a broad range of potentially collectible pieces.

A judge would somehow have to balance Alice's legitimate reasons for using the mixing box against the fact that she has knowingly conducted transactions in criminally-derived property. Is her right to pursue a peculiar hobby more important than protecting the public's welfare? I'm not sure how that balancing act would end up.
 
Bringing this back to Tornado.cash, I do wonder how safe it is to be a Alice. That is, I wonder how safe it is to be someone who knows that there are stolen Ethereum tokens inside Tornado smart contracts looking for an exit, yet despite the presence of this taint contributes Ethereum to that contract anyways. Even if Tornado obscures any explicit link between Alice and criminals, a judge could look past that.

Alice may say that "I used Tornado.cash because I value my financial privacy." This may be an adequate defence. Maybe not.

Clouding the story is the fact that Tornado.cash is currently paying a juicy financial reward to anyone who puts their cryptocurrency into its smart contracts. (See this video). The fact that Alice is earning 30-40% a year might make her claim to be a mere consumer of financial privacy less credible.

Perhaps one day we'll see a court case where this all gets thrashed out. A decent result would be if a judge ruled in favor of Alice, or at least partly so. The judge suggests that any incidental laundering of funds on Tornado.cash by licit consumers of privacy (like Alice) should be a non-criminal matter, subject to limit. Consider how several U.S. states have decriminalized the possession of small amounts of marijuana for personal use. In that same vein, a fixed amount of intentional commingling of funds on Tornado should be tolerated, the judge suggests, but only for the purposes of personal consumption. Anything above that would remain a felony.

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PS: Privacy advocates, please don't shout at me that money laundering laws are unethical. I am making a positive claim here, not a normative claim. That is, I'm not suggesting how things *should* be, but how they actually are. And my positive claim is that there is a risk, perhaps only a small one, that a legitimate user of Tornado.cash could be accused of money laundering. Yes or no?

PPS: Notice that I am no making the claim that Tornado.cash is itself engaged in money laundering, or that the people who have written the Tornado smart contracts are money launderers. I'm treating Tornado.cash as mere software, a digital hammer. A hammer doesn't break the law, people do. My assumption in this post is that society's rules against money laundering fall on the *users* of this software, not on the software itself or on the people who have developed the software.

PPPS: For software developers, if my positive claim is accurate (i.e. that it is risky to use Tornado.cash), is there a way to redesign the software that would solve the problem? More specifically, is there a way to limit the tool to licit users i.e. those who have a legitimate desire to consume anonymity, and keep out criminals? 

PPPPS: It's worth giving U.S. money laundering laws a read. Two of the big ones are located at 18 U.S.C. § 1956 and 18 U.S.C. § 1957. See here.

PPPPPS: On commingling... "Moreover, we cannot believe that Congress intended that participants in unlawful activities could prevent their own convictions under the money laundering statute simply by commingling funds derived from both 'specified unlawful activities' and other activities." U.S. v Jackson, 1991

David Andolfatto recently wrote a helpful article about whether Canada needs a central bank digital currency, or CBDC. I agree with David that a CBDC is "not an essential initiative at this point in time."

The way I see it, there are two big elephants in the room when it comes to introducing a central bank digital currency. Both of them suggest we should slow down any effort to issue CBDC.

But before I get to that, what is a CBDC? In brief, a CBDC is a new payments option that would allow regular Canadians to interact digitally with our nation's central bank, the Bank of Canada. For example, instead of having to use your Royal Bank account or Visa card to buy stuff at the supermarket or on Amazon, you could pay with a central bank digital tool, perhaps a Bank of Canada app or card. The Bank of Canada has been exploring whether the idea of issuing a CBDC for several years now, but so far hasn't pulled the trigger.

Here are what I believe to be the two big risks to rolling out a Canadian CBDC.

The most important one is white elephant risk.

In mature democracies like Canada, the provision of retail non-cash payments is a mostly-solved problem. Decent access to payments is already provided by a panoply of bank accounts, financial  apps, and cards. These existing options for connecting to the payments system are very safe. The $1,000 we hold in a checking accounts to make payments, for instance, is protected by government deposit insurance.

So if the Bank of Canada were to issue a CBDC, it's not obvious to me that many of us would bother using it. It would be just one more safe payments account among a sea of safe options.

That leaves the central bank in the position of having spent large amounts of money building and maintaining a payments network that none of us really needed or wanted in the first place.

Getting rid of an expensive and lacklustre CBDC could be difficult. Central bankers may feel like their reputations are tied to their CBDC projects. This, combined with the fact that central bankers don't feel the sting of a bottom line, may allow these white elephants to limp on for a very long time.

At the moment, most Canadians don't interact with Bank of Canada products (apart from holding cash, usage of which is falling). We mostly view the central bank as a competent technocratic body that does complicated stuff with interest rates. A CBDC project would suddenly put the Bank of Canada in direct digital contact with Canadians. But if the CBDC were to become a white elephant, this proximity could backfire on the central bank. It'll be know as the agency that runs a bloated payment system that the public dislikes. We don't want the Bank's brand to be hurt. We want the Bank of Canada to be trusted and deemed competent.

The second risk is black elephant risk. A black elephant is an obvious risk that people avoid discussing ahead of time.

Most discussions about CBDC centre on the technological hurdles involved in building one. But they often ignore the pesky sociological difficulties of running payments systems.

Fickle customers want to be able to reverse payments when they aren't happy with the products they buy. Users are frequently swindled out of their money by fraudsters and will expect restitution. If Jack accidentally send $500 to Alice instead of the $50 that he intended to send, he will want $450 back. What if Alice disagrees?

This requires that central bank constantly arbitrate disputes.

That's not all. Criminals will try to use a CBDC to sell illegal products. The central bank will have to start policing what is illegal and what isn't. Controversial businesses, say white nationalist publishing houses or kinky porn sites, will line up to use it. That means getting embroiled in politics.  

These are the not the sorts of issues I want my central bankers to get bogged down in. The risk is that demanding CBDC users distract the Bank of Canada from the vital task of conducting monetary policy.

The Bank of Canada might try to outsource the governance of a CBDC to the private sector. But that begs the question: if the central bank doesn't want the burden of running a payments system, why is it trying to get in the game at all? Why not just stick with the status quo, which seems to be working?

In sum, if I had any suggestions for Canadian citizens on how they should appraise a Canadian CBDC, it would be this. Given the above white & black elephant risks, the Bank of Canada shouldn't lead, it should follow. Watch the first few trail-blazing central banks to see how their CBDC projects pan out. (The Swedes, who are aggressively purchasing a CBDC, are a good candidate). If the Swedish CBDC succeeds, copy it. If the Swedes fail, continue on as before. There's no advantage to being the first to market.

[This is an adaptation of an article I wrote last year for CoinDesk]

Satoshi Nakamoto's electronic cash system – Bitcoin – was originally intended for people to make online payments. But it never caught on as a mainstream payments option. Bitcoin's wild, and potentially lucrative, price changes have prevented it from developing into a popular substitute for Zelle, Visa, ACH, or PayPal. On top of that, the process used to run the bitcoin network, proof-of-work, is incredibly costly (by design).

What would cause bitcoin payments to go mainstream in America? That is, if ten years from now everyone was using volatile bitcoin tokens as their main medium of exchange, what major events would have gotten us to that point?

Unfortunately, the path to mainstream bitcoin payments is not an uplifting one. It requires that the U.S.'s reliable payments pipelines, the ones that have knitted Americans together for decades, stop doing their job. This unraveling of the payments system would be just one part of a broader decaying of American society. Only when these core payments systems are inoperational, and American society is on its knees, will a third-best payments rails like bitcoin be called into play.  

Here's a short story about how America's payments infrastructure slowly implodes and bitcoin payments go mainstream.

We all know that America is ideologically divided. This political storm has been spreading into commercial affairs with companies being required to take a stand on many polarizing issues. The payments industry in particular has become a major venue for conflict. (Think controversies over fundraising for Kyle Rittenhouse and card network censorship of sex workers.)

Imagine a world in which these divisions were to deepen.

In 2023, activists successfully pressure payment processors to make broad-based purges of businesses that are deemed too Republican. One casualty, the Wall Street Journal, is de-platformed by its acquiring bank. (An acquiring bank is the financial institution that hooks businesses into the Visa and Mastercard networks.) The Journal quickly gets a new Republican-friendly acquirer. Companies with Trump-supporting executives like Home Depot and Goya Foods are cut off by their acquiring banks, too.

Republican activists react by pressuring financial institutions to unplug Democrat-aligned businesses. In 2024, several large banks stop connecting abortion clinics to the Visa and MasterCard networks.

By the late 2020s a divided ecosystem of payments processors and acquirers has emerged. One half specializes in connecting businesses and nonprofits deemed Republican to the card networks. The other half specializes in connecting Democrat ones. Any bank or processor that tries to stay neutral is shunned – she who connects my enemy to Visa is my enemy.

Even at this level of divisiveness, Republicans and Democrats can still make payments with each other. That's because MasterCard and Visa remain neutral. The two networks allow both Republican- and Democrat-aligned acquiring banks, and the businesses that these banks serve, to connect to their networks. And thus dollars can flow across the ideological chasm.

But in 2029, Democrat activists succeed in pressuring Visa to end their neutrality and disconnect all Republican acquiring banks and processors. Suddenly, businesses that are deemed Republican can no longer accept Visa cards. The next year MasterCard is pressured to go Republican. All Democrat-leaning businesses are exiled from the MasterCard network.

America is now divided into two card fiefdoms. Apple (D) is Visa, Walmart (R) is MasterCard. Amazon (D) is Visa, Home Depot (R) is MasterCard.

But commerce can still occur across the divide. Any consumer who wants to shop at both Republican and Democrat stores need only make sure they have both a Visa and a MasterCard.

Getting both brands might not always be possible, however. Republican individuals may find it difficult to pass the increasingly politicized application process for a Visa card. Likewise, Democrat consumers find it challenging to make it through the application process for a MasterCard. 

That's when bitcoin might become a more useful payments mechanism. Since the Bitcoin network is censorship resistant –  anyone who want to use it can easily get access – it provides a means for Republicans to shop at Democrat stores and vice versa.

And so bitcoin finally becomes more popular for payments, but only because American society has moved backwards to a less civilized state. The easiest and most efficient option, cards, have degraded to the point that a back-up technology, Bitcoin, must be relied on. You can see that bitcoin isn't a progressive technology, it is a retrogressive one.

Up till this point in my story, the broad ideological upheaval between left and right has been reflected in a splitting-up of the card networks. Notice that the underlying payments plumbing on which America's entire private payments system runs, the Federal Reserve, has remained neutral throughout.

In 2031, that changes. The neutrality of the Federal Reserve, made up of 12 district Reserve banks, comes to an end. The CEO and directors of the Federal Reserve Bank of Kansas City, all staunch Republicans, decide to stop providing Democrat-leaning banks in their district with access to Fedwire. (The Kansas City district includes the states of Kansas, Wyoming, Nebraska, Colorado and Oklahoma.)

Fedwire, the Federal Reserve's real-time settlement system, is America's core payments utility. When anyone makes a payment from his or her bank to another bank, it'll eventually be settled by a movement of funds along Fedwire. By cutting off Democrat-leaning banks and their customers from this key utility, the Kansas City Fed effectively severs them from the U.S. payments system.

In retaliation, the Federal Reserve Banks of San Francisco and Boston disconnect Republican banks from Fedwire, in one swoop unbanking all Republican-leaning businesses located in their districts. The remaining ten district Reserve banks all pick sides, too.

If they haven't already done so, Republican leaning businesses rush to relocate to Republican districts. Otherwise they will not get banking services. Democrat businesses migrate to Democrat districts.

Those businesses brave enough to stick it out in a hostile district will need an alternative payments mechanism for connecting with their suppliers and customers. Cash will be one option. For non-face-to-face payments, however, bitcoin may be their only option. And so as America descends into partisanship and the Federal Reserve crumbles, an awkward bitcoin "cash system" becomes a way around an increasingly balkanized payments system.

Even in this hyper-factionalized America, inter-district trade between Democrat and Republican zones can still occur. A car mechanic in a Democrat district can buy tires from a part dealer in a Republican state. That's because Democrat-leaning Federal Reserve banks (such as the San Francisco Fed) remain connected to Republican-leaning Federal Reserve banks (such as the Kansas City Fed) through Fedwire. Fedwire continues to unite disparate parts of the country.

That stops in 2033. The San Francisco Fed halts all incoming payments from Republican Reserve banks including the Kansas City Fed, Atlanta Fed, and Dallas Fed. In reaction, Reserve banks in Republican enclaves such as Kansas City cut off Democrat districts. At that point there ceases to be a universal U.S. dollar. Money held in accounts in Georgia and Florida and Oklahoma can't move into accounts in California or Washington, and vice versa. The payment tissue that once connected all Americans has torn.

With the collapse of Fedwire, cross-border trade and remittances between hostile Democrat and Republican enclaves get very tricky to carry out. Society may have regressed far enough back that silver and gold once again become an international settlement medium, just like in the 1600s and 1700s. Or perhaps bitcoin would become America's preferred medium for making payments across enclaves. Unlike gold, bitcoin can be transferred remotely.

The collapse of America's payment infrastructure would be just one theatre in a much larger cleaving of American society along ideological lines. Other key bits of American infrastructure would also begin to fall apart: the courts, law enforcement, the education system. There would be large physical dislocations as Republican families flee Republican enclaves and Democrats to Democrat enclaves.

But if America's electrical and telecommunications infrastructure has crumbled, too, would it even be possible for people to use bitcoin, which is reliant on the internet?

It’s a stretch, but we can imagine distributed solar power solving the electricity problem. As for accessing the bitcoin network, tinkerers could try to connect old-fashioned ham radios to Blockstream's bitcoin satellite. If the remnants of AT&T and Verizon can only provide patchy internet service, so-called decentralized mesh networks might offer an alternative way to access the web.

This dystopian future probably isn’t going to happen. It's just a story. For now, bitcoin remains an unpopular payments system. Let’s all hope that it stays unpopular. No one wants to live in a country that has declined so far that bitcoin has become a vital way to make payments.

 

These days I see many do-it-yourself investors comparing the huge yields they can earn on stablecoin lending to the tiny yields on bank accounts. Cryptocurrency influencers like to draw attention to this big gap, portraying crypto as the heroic replacement to stodgy regular finance, or "TradFi". The Celsius Network, one of the leading providers of high-yield stablecoin products, uses the slogan "Unbank yourself." The implication is that anyone who holds their money in a bank account is a chump.

Beware, DIY investors. These marketing pitches are wrong, indeed dangerous. 

In finance, a juicy yield is almost always associated with big risk. Shifting finance to blockchains doesn't change this truth. High-yielding stablecoin strategies are not a better sort of bank account. Rather, they're a potentially hazardous investment more akin with penny stocks and CCC-rated junk bonds.

Let me explain with a recent example:

Stablecoin lending yields more than twice as much as US junk bonds and almost 150 times as much as the average US savings account.

No wonder why the cryptocurrency lending industry is growing at such a staggering rate.

From our weekly market report: https://t.co/tj905wIDuo pic.twitter.com/ScDzIAFdVj

— Arcane Research (@ArcaneResearch) November 13, 2021

The premise of this tweet and the attached chart is that you can make far more on your stable crypto dollars than on old fashioned dollars stuck in a bank account.

The problem with this comparison is that it's not contrasting equal things. It's comparing apples to oranges.

The true counterpart to a 0.06% yield on a bank account isn't the interest rate one can earn by on-lending stablecoins via protocols like Celsius or Compound. No, the proper analog is the interest rate one earns by simply holding a stablecoin such as Tether or USDC. And because stablecoin issuers don't pay interest to people who own stablecons, this rate is effectively 0%. Which is *ahem* below the 0.06% rate on a U.S. savings account.

Hardly a selling point. Unfortunately, the above chart forgets to mention the 0% rate on stablecoins.

Let me flesh this out further. When you own a stablecoin or keep money in a saving account, you are basically lending to the issuer of those dollars. If you hold 1,000 USDt (Tether stablecoins), for instance, you're a creditor to Tether Inc. That is, Tether Inc owes you $1,000. Likewise, if you keep $1,000 in a Bank of America savings account, you're lending $1,000 to Bank of America.

Think about this or a moment.

Lending involves risk. The borrowing party may not be able to keep its promise to you. Bank of America is a pretty safe entity to lend to. It'll probably keep its promise to you. But the firms that issue Tether and USDC are not safe borrowers. They are small. Not much is known about them. In Tether's case, it is entirely unregulated. And Circle, the issuer of USDC, is only lightly regulated. If you are acting as a lender to Tether or Circle, you should be getting *much* more than the 0% rate that they're offering you.

On top of that, your loan to Bank of America is protected by government insurance. Nothing protects your loan to Tether or Circle. Even worse, as a creditor to Tether and Circle, it's not apparent where you rank in terms of seniority. This ranking is important because in the case of a failure, senior creditors get paid first, junior creditors last. At least with a Bank of America account you're at the front of the line.

Far more prudent to lend to a government-insured bank and collect 0.06% than lend to a black box stablecoin and get 0%.

Of course, stablecoins aren't just held. It's what you can do with stablecoins that excites people. Which gets us to the massive crypto lending rates that are illustrated in the chart. Aave and Compound are decentralized lending protocols. If you on-lend your stablecoins via these two protocols, you can earn 2.69% to 3.14%.

Celsius, Nexo, and Blockfi are centralized marketplaces where rates for onlending stablecoins reach as high as 8.88%.

The thing is, you *should* be getting a high rate for onlending your stablecoins on these venues. You're taking a big risk by using them. These platforms could go broke, get hacked, or break. In the case of centralized platforms, there is very little information about how they are using your funds. Furthermore, you don't know where you stand in seniority among other Celsius, Nexo, or BlockFi creditors. These are black boxes, folks.

And remember, even though you've lent away your Tether or USDC on Celsius or Aave, you're still fully exposed to all the original credit risk of Tether or Circle. 

For instance, say you lend 1,000 USDt on Celsius's platform and Tether, the issuer of USDt, collapses. The price of USDt stablecoins falls from its $1 peg to $0.10. Celsius comes through, though. It keeps its promise to you and repays the 1000 USDt it owe you. Alas, now that amount is only worth $100.

So for DIY investors considering stablecoin lending strategies, any loan to Celsius or Aave involves a combination of two risks: the possibility that Tether or Circle (the issuer of USDC) go under and the chance that Celsius or Aave break. Add the two together and you're getting involved in a pretty dangerous strategy, one for which you should be well-compensated.

Rather than clapping your self on the back for getting 8% from stablecoins instead of 0.06% in a savings account, you should be asking yourself whether 8% is enough.

I recently tweeted something about the world's largest stablecoin, Tether. It gives me an opportunity to ask a broader question about money in general:

Tether's terms of service explicitly prevents it from creating new USDT stablecoin units for bitcoin: "only money will be accepted upon issuance." So why is Tether lending USDT to Celsius in return for bitcoin/ethereum collateral?https://t.co/tka3LxMVxc via @kadhim pic.twitter.com/CwIVAbXwhS

— John Paul Koning (@jp_koning) October 19, 2021

Tether issues USDt, which are U.S. dollar-denominated IOUs redeemable for actual dollars at $1. Unlike a PayPal IOU, a Tether IOU exists on a blockchain.

What the tweet (and linked-to article) is saying, in short, is that Tether has misadvertised itself. Tether says in its terms of service that it only creates new stablecoin tokens, USDt, in acceptance for money. That is, to get $1 worth of USDt from Tether, you need to send it $1 in actual U.S. dollars. But in reality, Tether does not seem to be waiting for deposits to roll in before issuing new USDt. As the FT's Kadhim Shubber reports, it is directly lending new USDt out, much like how a bank puts new dollar IOUs into circulation by lending them out.

I want to use Tether to ask a more general question about the economics of money creation. Granted, Tether is not issuing stablecoins according to its terms of service. But does it really make an economic difference whether Tether lends out new USDt stablecoins or if it only creates them when someone deposits U.S. dollars?

We could also ask the same about PayPal. PayPal only creates new PayPal dollars when someone transfers U.S. dollars to PayPal. But what if PayPal were to start creating new PayPal dollars by lending them into existence? Would the monetary economics of the PayPal change?

I'd argue that it doesn't. But I'd be interested in hearing the other side of the debate. I'll show why the method of issuing Tethers or PayPals doesn't really matter using two quick examples.

Let me quickly outline one assumption I'll be using. The market has a certain demand to hold USDt, and if that demand is exceeded by new issuance of USDt, the excess USDt will be quickly sent back to Tether for redemption at $1. That is, given the existence of a $1 peg, a stablecoin issuer can never exceed the market's demand for a stablecoin.

Say that Tether has $100 in USDt outstanding and also has $100 sitting in a bank account as backing. 

Under the first scenario, one that is consistent with Tether's terms of service, John arrives and deposits $10 with Tether and gets $10 USDt. Now there is $110 USDt outstanding. There is also $110 sitting in Tether's bank account. Next, Tether lends $10 of the $110 in its bank account to Sally at 6% per year. It asks for collateral to protect itself. That is, Tether requires Sally to pledge $15 worth of bitcoin as security.

Now for the second scenario, the one described in Kadhim Shubber's FT article. Tether prints $10 worth of new USDt out of nothing and lends it directly to Sally at 6%. Tether asks Sally to pledge $15 worth of bitcoin as collateral. There are now $110 USDt in circulation. If Tether were to overissue by lending more USDt than the market wants to hold, that amount would quickly reflux back to Tether for redemption at $1. (So if Tether lends Sally $15 USDt but the market only wants $10 USDt, then $5 USDt would quickly be brought back to Tether for redemption. Tether adjusts by reducing its exposure to Sally by $5.)

Under both methods of issuance, we end up at the exact same spot. There are $110 USDt in circulation. Backing that amount, Tether has $100 in cash in a bank account and $10 worth of a 6% loan secured by bitcoin.

So economically speaking, it doesn't matter whether Tether lends out new USDt or if it creates new USDt upon reception of actual dollars. Either way, $10 worth of new USDt will go into circulation. And either way, that issuance will be backed by a 6% loan to Sally collateralized by $15 worth of bitcoin.

The interesting thing is that even though there is no difference between the two scenarios, our language and law distinguishes between Tether 1 and Tether 2. In the first scenario, Tether is considered a fintech, a money services business, or a payments company, and thus subject to a certain set of laws. In the second scenario it is a bank, or a depository, and thus subject to an entirely different set of laws.

But if the two Tethers have the same economic function, why don't we the use the same language and set of laws & regulations for each?

I spend a fair amount of time tracking real-world use cases for cryptocurrencies. I'm not talking about silly speculation, or millionaire crypto hobbyists using their bitcoins to buy Teslas, or illegal dark web markets that use Monero for payments. I'm talking about actual licit businesses that have turned to cryptocurrency payments -- not because they particularly care about crypto -- but because they need to.

To date, the retail kratom industry is one of the best examples I've been able to find of broad non-speculative licit cryptocurrency adoption. Kratom is a plant that grows in southeast Asia. The kratom leaf can be ground into a green powder that, when ingested, acts as a stimulant. In the U.S., online kratom stores are ubiquitous.

I'm not going to get into whether kratom is dangerous or has medicinal value, or whether it should be legal or not. (For that sort of discussion, I'd suggest visiting the FDA, WebMD, or the Mayo Clinic.) The main point I want to make in this post is that kratom is legal in the US (although several states have banned it).

Although kratom is legal, MasterCard and Visa have decided to prohibit kratom sales from their networks. This poses big problems for online kratom shops. Because the card networks dominate online payments, exile by these oligopolies causes serious financial damage to the unfortunate targets. To survive, the kratom industry has been forced to turn to backup payments systems.

MasterCard's Business Risk Assessment and Monitoring (BRAM) policy, for instance, lists a number of impermissible activities:

Source: Netpay

Most of the prohibited transactions listed by MasterCard are illegal, such as the sale of child pornography. But some are legal, including the sale of "certain types of drugs or chemicals." MasterCard specifically mentions salvia divinorum, a legal drug that has hallucinogenic properties. Although it isn't listed as an example, kratom is usually considered to fall into the same category as salvia.

Acquirers, the financial institutions that connect businesses to the card networks, face large penalties if Visa or MasterCard catch them facilitating prohibited card transactions. To reduce this risk, acquirers will often hire what are called Merchant Monitoring Service Providers, or MMSPs, to scan through retailer data and spot anything that looks dangerous. MMSPs such as LegitScripts are very aggressive about rooting out kratom sales.

Despite the card networks disallowing kratom sales, many of the 20 or so sites that I scanned through still offer card payments. According to my research, kratom sites have a number of ways of securing card availability, one of which is called transactions laundering. That is, a kratom site camouflages its prohibited product sales by routing them through a front store that sells legitimate goods. Eventually these prohibited transactions get caught by the card network or the acquirer, and the site's card network access is revoked. It then has to scramble to build another front.

One commenter on Reddit describes kratom transaction laundering thusly:

"...we can do manual credit cards (as I can) over the phone because we use standard processors that don’t know it’s kratom. We do this by creating Dba’s that have fake web presences selling other products and they don’t find out it’s kratom for a while. Usually we can get a processor to work for 3-12 months before it gets shut down."

(Note: Dba refers to "Doing Business As". A DBA is a business pseudonym or a “fictitious name filing.”)

Another route that kratom sites take to get access to the card networks is to use an overseas aggregator. Kratom Crazy, a website that has since closed for business, describes how and why:

"International is the only way to go because card schemes are less aggressive on banks in international communities. This doesn’t mean they can’t be fined or shut down – oh because they can and still do. No aggregate account we have ever seen has lasted over 6 months before being shut down. The major downside is these accounts are usually 9% fees and up plus 10% rolling reserve over 6 months. So the merchant takes 19%+ off the top immediately plus they have to wait for 2-3 weeks before seeing the first days processing payout. Its a bad deal all around and a massive risk for losing money. In addition, when these accounts get shut down, there is usually no payout to the merchants."

So the upshot is that the sort of card network access that many kratom sites have managed to secure is unreliable and spotty. Indeed, many sites don't accept cards at all, including (at the time of writing) OG Botanicals, Canada Kratom Express, Krypto Kratum, and Rhizohm. Rhizohm's payments page goes to some pains to explain how it would rather be honest than lie to get card access:

Source: rhizOhm

Which gets us to cryptocurrency. Almost all of the kratom sites, including those that haven't been able to sneak themselves into the card networks, accept cryptocurrencies including Bitcoin, Ethereum, Litecoin, XRP, Stellar Lumens, or some other one. Third-party crypto processors like CoinPayments or Coinbase Commerce are typically used for payments processing.

When they accept cards, kratom sites often offer discounts for cryptocurrency payments. For instance, Happy Hippo's checkout page offers a 20% discount:

It's easy to understand why kratom sites would offer such discounts. It's expensive to use overseas aggregators for card payments. By steering a customer to Bitcoin or Ethereum, a kratom vendor saves itself the pain of a 10-15% card processing fee.

But cryptocurrency isn't the only payments option that kratom sites fall back on. Even more popular than crypto is eChecks, a traditional "fiat" form of payment that gets processed via an automated clearing house, or ACH. A kratom buyer inputs their bank routing and account numbers into the payments page, the payment then gets routed to the ACH network and, once cleared & settled, the funds arrive in the kratom merchant's bank account.

In the same way that a business must work with a card acquirer to get access to Visa or MasterCard payments, they must work with an eCheck acquirer in order to accept eCheck payments. But onboarding standards seems to be much looser with eCheck acquirers than card acquirers. For instance, in the screen shot below an eCheck acquirer is actively soliciting all sorts of high-risk industries, including not only kratom but also CBD oil and MLM-based businesses.  

If there's an online retail payments option that's as badass as bitcoin, it's got to be eChecks.https://t.co/HJfEIeQER3 pic.twitter.com/sb4DnHW2X1

— John Paul Koning (@jp_koning) October 7, 2021

Many kratom sites also accept a bespoke payments method called GreenBean Pay. Users open an account with GreanBean Pay and submit their banking account information. The service then uses Plaid -- a piece of financial plumbing that allows apps to hook into banks -- to link to the buyer's bank account and process the kratom payment.

Lastly, a bunch of kratom sites accept person-to-person payments options such as Cash App, Venmo, Zelle, and Interac eTransfer. (This probably goes against these services' terms of service, which generally limit usage to person-to-person payments).

While these backup options have become vital for connecting kratom retailers to the public, they are not really a great substitute for a card network connection. Cryptocurrency is clunky, awkward, and risky. eCheck is slow. By not offering the convenience of card payments, kratom sites lose out on a steady stream of would-be buyers. And this is evident by how desperate they are to find hacks that get them back into the Visa and MasterCard walled gardens.

In closing, I want to touch on something I mentioned in my previous post on MasterCard and porn. A big reason that card networks refuse to process legal transactions for things like kratom (or, similarly, for salvia divinorum, which I wrote about here) is they don't want to damage their brand. These substances may be permitted by law but they are controversial, and so the networks refuse to touch them.

All businesses have the right to protect their brands. But the card networks are oligopolies, and thus necessary for online survival. And so in my view the card networks should be required to forfeit their right to protect their brands. That is, Visa and MasterCard (insofar as they retain their oligopolistic powers) should not be be allowed to police vendors for what they deem to be controversial but legal products.

Which is not to say that I'm a champion of kratom. I'm only suggesting that the appropriate way to control such a product is not by card network bans, but by the Drug Enforcement Agency declaring it to be a scheduled drug.

The good news is that these sorts of situations are very rare. The card companies allow almost every legal transaction under the sun on to their networks, save a few outliers like kratum. This means that the population of licit businesses that need to use a back-up system like cryptocurrency payments (or echecks) is not very big. But examples like this still warrant our attention. Even if we don't particularly care about kratom, one day a product that we regularly consume could get censored by Visa or MasterCard.

Governments have incredible powers to dictate what people buy online.

By virtue of being oligopolies, the two payments networks -- MasterCard and Visa -- exercise the same powers as governments do. If MasterCard bars your business from its network, you effectively don't exist.  

We may not agree with how governments set rules about what things we can buy, but at least there is a somewhat transparent and democratic process -- however flawed -- behind the government's decisions. Visa and MasterCard's rulings, on the other hand, are opaque and driven by card executives, not voters. It is important to monitor these networks to see how they are exercising their powers of online censorship.

In this spirit, here are some thoughts on MasterCard's new rule change, AN 5196, which governs websites that provide adult content. Now, it could be that you don't particularly care about porn. But even then, it's worthwhile to pick through the rule change to see how the scope of online commerce is about to be narrowed. As I wrote in my recent article for the Sound Money Project, the sex industry exists at the edge of the payments universe and thus serves as a useful barometer for the general state of payments inclusion.

AN 5196: A short description

Issued earlier this year, AN 5196, or Revised Standards for New Specialty Merchant Registration Requirements for Adult Content Merchants, requires adult sites to obtain consent from all models who are depicted in a video or image. Sites must also verify the identity and age of all models. These systems must be in place by October 15, 2021. It is the job of acquirers, those companies that connect adult sites to the MasterCard network, to ensure that rules are being followed. Sites that don't comply will be disciplined or banned.

Here is how one site, JustForFans, is implementing the changes:

"We understand how scary this transition can be for our models..." JustForFans, a porn site, explains how MasterCard's new rules for adult content are being implemented: https://t.co/WV6QHoEmlx pic.twitter.com/gGxuJVroFJ

— John Paul Koning (@jp_koning) September 24, 2021

In addition to collecting information, MasterCard will now require that content be reviewed by sites prior to publication to ensure that it is not illegal and that it does not "otherwise violate the Standards." If the content is a real-time stream, the site must be able monitor it and take it down immediately.

AN 5196 will also require porn sites to provide their acquirer with monthly reports including a list of all content flagged as "potentially illegal or otherwise in violation of the Standards," as well as the actions taken to address these violations.

Although MasterCard's actions are designed to reduce the amount of illegal adult content, it will also result in less legal adult content being available online. I'll get into that later.

For now, let's start by going through the justification for MasterCard's censoring of illegal content. This decision isn't entirely up to MasterCard, as I'm going to show.

The fight against illegal online content

Many nations have laws that prohibit various types of adult content. Child pornography is universally illegal. Revenge porn, or the posting of pornographic images of a partner without permission, is also prohibited in many jurisdictions, either explicitly via anti-revenge porn laws or through anti-privacy and/or anti-cyberharassment laws. Sex trafficking, which includes cases such as Girls Do Porn, (a company that used fraud and intimidation to recruit non-professionals to pose in porn videos) is also illegal. Obscenity is prohibited in many jurisdictions, too.

Society has generally gone one step further than punishing the people who are responsible for committing crime. To help further reduce crime, we also punish the financial institutions that facilitate these illegal transactions. If a bank knowingly provides services to a child pornography site, for instance, that bank may be held criminally liable for laundering money.

To avoid being punished for accepting the proceeds of crime, financial institutions make an effort to filter out illegal payments, say by implementing customer due diligence, or know-your-customer (KYC), requirements. By demonstrating to law enforcement that they have filters in place, bankers can avoid prosecution for money laundering.

It is courtesy of this filters that financial institutions like MasterCard help project society's laws about content, however imperfect, onto online commerce. MasterCard performs this role of censor because we (i.e. voters and politicians) have delegated it that role.

Which gets us back to AN 5196.

A 2020 exposé by the New York Times revealed that one of the world' biggest porn sites, PornHub, had allowed child sexual abuse material and other non-consensual videos to appear on its site. (I wrote about this event here.) Because card acquirers must ensure that the businesses they connect to the MasterCard network are not selling illegal content, Pornhub should never have been allowed to host this content in the first place.

MasterCard's response was AN 5196. Prior to the Pornhub incident, acquirers were obligated to stop illegal porn from being transacted on the MasterCard network, but they were allowed to devise their own methods for doing so. The new rules impose explicit and uniform procedures across all acquirers. (I've already described what they are in the first section, including collecting identification.)

Legal content caught in the blast radius

AN 5196 will almost certainly reduce the amount of illegal content being transacted along the MasterCard network, and thus the amount of illegal content available on the internet. And that's a good thing. Some illegal content will inevitably flow to alternative adult sites that use cryptocurrencies or eChecks for payments. But without the ease of card transactions, this content won't attract the same number of eyeballs as before.  

Unfortunately, AN 5196 has a blast radius. It will also reduce the amount of legal adult content available on the internet. Because adult sites will now have to collect the personal data of all people appearing in videos and other images, content makers who worry about being doxxed by insiders at porn site, or who fear losing their data to hackers who compromise sites, will stop providing content. (To be fair, some adult sites were already requiring identification prior to MasterCard's rule change.)

It might be possible to design systems to reduce the amount of law-abiding models who self-censor themselves out of fear of losing personal data. But this would require a different, more privacy friendly, approach to managing identity. That's a whole other conversation.

MasterCard's ban will also reduce the amount of legal but risqué/controversial material that is available online. 

You'll notice that AN 5196 requires adult sites to preview all content not only for potentially illegality but also for violations of "the Standards." 

What are MasterCard's standards?

In addition to prohibiting illegal material, MasterCard has long prohibited any transactions that may hurt its brand or "damage the goodwill of the Corporation." It provides a bit more clarity on this in 5.12.7 (2) of its rule book, where it declares the following activities to be in violation of its rules:

"The sale of a product or service, including an image, which is patently offensive and lacks serious artistic value (such as, by way of example and not limitation, images of nonconsensual sexual behavior, sexual exploitation of a minor, nonconsensual mutilation of a person or body part, and bestiality), or any other material that the Corporation deems unacceptable to sell in connection with a Mark."

I'm not entirely sure how MasterCard or its acquirers determine what is "unacceptable" or lacking "serious artistic value." Whatever the case, AN 5196 is likely to lead to an increase in brand-related censorship. The new set of rules requires that adult sites peruse each individual bit of content prior to publication. With sites applying more attention to content than ever before, this increases the likelihood of legal material being removed out of concern over MasterCard's reputation.

In addition, sites must now file monthly reports with their acquirers in which they list all content flagged as illegal or in violation of the Standards. The pressure to demonstrate that they are protecting MasterCard's brand will probably lead adult sites to apply harsher censoring standards than before.

Should monopolies be allowed to censor legal material?

If I may editorialize a bit, all businesses have the right to protect their brands. But MasterCard is an oligopoly, and thus necessary for online survival. And so it should be required to forfeit that right. That is, MasterCard shouldn't be allowed to police content for what it deems to be controversial material that could hurt its reputation. Governments have to provide services to every citizen, even ones who look funny or do strange things. The same should apply to MasterCard. 

So to sum up, the scope of online commerce is about to be narrowed. AN 5196 will reduce the amount of content available online by: 1) reducing illegal adult content; 2) reducing legal adult content being produced by those preferring anonymity, and; 3) reducing legal content that is deemed to be brand-damaging.

As far as I know, this is the first time that a card network has forced a set of content providers to adopt a know-your-customer requirement. For now, MasterCard has limited this requirement to adult sites. But who knows, one day it may require other types of content providers (i.e. social media?) to adopt the same standards as porn. While there may be benefits to this sort of policy, let's not forget the costs.

Last week I wrote about Balaji Srinivasan's idea of creating a decentralized version of the Billion Prices Project. The post got me thinking again about the topic of alternative inflation indexes.

One of the most well-known of the alt-inflation indexes is John Williams' ShadowStats, often cited by gold bugs and bitcoin maximalists. As of August 2011, ShadowStats puts U.S. inflation at 13% versus official inflation of 5%, as illustrated in the chart below.

Source: ShadowStats

That's a huge gap. One of the two data series has to be wrong.

I've always dreamt about writing a blog post on ShadowStats, but never had the gumption or statistical chops for it. So I was happy to see that economist Ed Dolan announced on Twitter that he was  republishing a 2015 blog post in which he carefully critiqued ShadowStats. It's such a good article that I'm not going to bother writing my own ShadowStats post anymore.

ShadowStats attracts a lot of sneers from the econ commentariat. What makes Dolan's post so effective is that he gracefully takes Williams' arguments on their merits and then proceeds to analyze them. Put differently, he doesn't try to damn ShadowStats with straw man arguments. He steel-mans it (or steelwomens it).   

Anyways, do read the post. 

Dolan saves his best criticism for the end. When Dolan was writing his post in 2015, the gap between official inflation and ShadowStats inflation was a whopping 7% (see chart above). What Dolan finds is that the majority of this 7% gap can be attributed to a simple double-counting error committed by Williams. By correcting this double-counting error, the ShadowStats inflation number shrinks. And so the gap between it and the official CPI is actually far less menacing than Williams' anti-government fans like to make out.

Dolan challenges Williams to correct his double-counting mistake. But you can see why Williams might find this difficult to do. He has been selling his data for many years on a subscription basis. Admitting that his product contains errors could anger his customer base.

The other part of Dolan's blog post that I want to draw attention to is a set of simple cross-checks he performs to see whether official inflation or ShadowStats is more accurate. For instance, taking grocery prices from a 1982 advertisement and projecting them forward with both inflation indexes, Dolan finds that the official CPI does a better job of predicting where modern grocery prices actually ended up.

It would be unfair to do just one set of crosschecks. Which is why Dolan does a bunch of them. It's worth reading through each one. ShadowStats does not make out well. (For instance, in order for ShadowStats to be right, you've got to believe that the U.S. economy has been in a recession for the last two decades.)

To finish my blog post off, I'm going to add to Dolan's list of cross-checks by adding one of my own. This cross-check is meant specifically for one of the main consumers of ShadowStats data: gold bugs.

If gold investors think ShadowStats data is right, and many of them do, then they also have to accept that gold has lost 91% of its value since January 1980 (see chart below of the gold price adjusted for ShadowStats inflation). Which means that the yellow metal is an awful hedge against inflation, and anyone who buys it for that reason is making a big mistake.

Source: Bullionstar

The far more reasonable position to take is that the ShadowStats data is wrong, and that gold has actually been a decent hedge against inflation since 1980. Using official inflation numbers rather than ShadowStats, the price of gold today is almost even with its 1980 level.

So gold bugs, you can relax. You haven't lost your sanity -- gold is not an awful inflation hedge. Rather, ShadowStats is an awful measure of inflation.

Balaji Srinivasan, an angel investor, wants to kick start an updated version of MIT's Billion Prices Project. He will invest $100,000 in the project that best envisions how to create a publicly-available decentralized inflation dashboard, one that relies on scraped data from retailer websites.

A truly global inflation dashboard would be the next coinmarketcap. It'd be bigger than that, in fact.

So we're offering a little prize to build one. https://t.co/OtZJS8FRWA

— Balaji Srinivasan (@balajis) August 5, 2021

Many years ago I was a big fan of the MIT's Billion Prices Project, so I perked up when I read about Srinivasan's contest. Created by economists Roberto Rigobon & Alberto Cavallo, the Billion Prices Project collected, or scraped, data from retailers' websites and used it to generate an alternative version of various government-tabled consumer price indexes. (I wrote about the Project here.) Members of the public could get access to Billion Prices U.S. data, albeit with a small delay.

This was incredibly useful! Because government consumer price indexes are published monthly, but websites can be scraped 24/7, the Billion Prices Project was far more responsive to price changes than government consumer price indexes are. It gave you insights into tomorrow's CPI announcement, today.

The Billion Prices Project also garnered attention because it revealed how Argentinean authorities had distorted official statistics to make inflation appear more muted than it really was. Conversely, the Billion Prices Project regularly confirmed the accuracy of U.S. Bureau of Labor Statistics' consumer price indexes, making it a useful tool for whacking gold bugs and inflation truthers over the head.  

While I like Srinivasan's general idea of bringing real-time scraped inflation data to the masses, I see three big problems.

The first problem is over-reliance on scraped data. Scraping is fast and cheap, but only a portion of the global economy's prices are scrape-able. Amazon and Walmart may sell almost every type of physical good under the sun here in Canada and the U.S., but they don't sell services. So while it's easy to find scraped prices of laptop computers, forget about prices for haircuts, rent, or healthcare.

That leaves a pretty big hole. Government statistical agencies such as the Bureau of Labor Statistics (BLS) or Statistics Canada are able to capture services prices because they send out human inspectors to check the prices of things like haircuts and back-rubs. Lacking price data on these items, Srinivasan's inflation dashboard will never be as accurate as the dashboards published by Statistics Canada or the BLS.

Consider too that goods in many developing and undeveloped countries are not available online. Amazon, for instance, isn't going to provide any clues into what is going on with vegetable prices in Afghanistan, or shoe prices in Yemen. Srinivasan says that he wants an "internationally useful" dashboard, but he's certainly not going to get one by relying on scraping alone. He's going to get a rich folks' dashboard.

Which leads into the second problem: the business model won't work. Compiling inflation indexes is costly, but Srinivasan wants his decentralized inflation dashboard to be made public, and presumably free. That's just not possible.

Rigobon & Cavallo's own Billion Prices Project is a good example of this dilemma.

Mere grants weren't enough to fund the Billion Prices Project. Yes, scraping may be cheaper than using physical data collectors, but it's still expensive to compile price indexes. Bills had to be paid. And so the whole Billion Price Project sold out. It was folded into a company called PriceStats and sold as a proprietary product to rich investors and central banks.

At first PriceStats continued to offer some free public dashboards. But this was never going to last. Rigobon & Cavallo's data had commercial value because it was quicker than government data, and could be used by traders to beat the market. Making even a portion of that data available to the public destroyed its commercial value. And so over time the public-facing parts were all discontinued. The Billion Prices Project, at least the public service side of it, is effectively dead. 

How data from PriceStats/The Billion Prices Project overlapped with US consumer price indexes [source]

Srinivasan's proposal faces the same tradeoffs as the Billion Prices Project. Price data is expensive to collect, compile, store, and process. Government agencies like the BLS are funded by taxes, not profits, and so they can give it away for free. We all benefit from this public service. But the calculus is different for private companies. To fund data collection, they must implement some sort of pay-wall. Srinivasan wants to make a public inflation dashboard, much like the BLS does. But he can't. He's not a government. 

(And no, an inflation dashboard won't be able to rely on advertising revenues, say like how Coinmarketcap does. Frenetic gamblers are addicted to checking coin prices. Inflation data doesn't attract eyeballs).

The last problem with Srinivasan's project is the basket problem. The introductory page that describes the project focuses on how to scrape for data. But this omits one of the biggest challenges to compiling any consumer price index: determining what the consumer price basket actually is. That is, what exactly is the "basket" of goods and services that the average consumer consumes each month?  

Government statistics agencies such as the Bureau of Labor Statistics solve this problem by conducting national surveys. For instance, the BLS's baskets are based on interviews with 24,000 Americans each quarter about their spending habits. The BLS gets even more precise data by having 12,000 of those participants keep a detailed diary that lists all expenses for a week.

But that's an incredibly resource-intensive process.

To avoid having to run costly surveys in order to build a representative consumption basket, the Billion Prices Project had a simple solution: it borrowed the BLS's baskets. But Srinivasan's project has declared this solution to be out of bounds. The project's website describes inflation as a "government-caused problem," and so the project can't rely on "government statistics."

Which means that Srinivasan's project will have to build its own representative price basket using its own surveys. Unless it can bring the same amount of financial resources to bear as the BLS, I don't see how it can pull this off.

Alternatively, the project will have to use the BLS's "untrustworthy" data. But that means contradicting its stated philosophy.

To sum up, Srinivasan envisions his decentralized inflation dashboard as being a superior alternative to untrustworthy government dashboards. But government consumer price indexes are far better than he is making them out to be, given the huge amount of money, time, and expertise committed to statistics agencies. (Yes, there are exceptions like Argentina). If any inflation dashboard is likely to be untrustworthy, I fear it will be Srinivasan's built-on-the-cheap dashboard.

(By the way, you'll notice I didn't discuss the decentralized aspect of the inflation dashboard. The project has enough challenges already, before even getting to the decentralized bit.)

All that being said, I'm in the same camp as Srinivasan. Scraped inflation data is neat and useful, and I think the public should be getting access to it. But my preferred solution is different than the one put forth by Srinivasan. Hey, BLS and Statistics Canada! When are you ever going to unveil some sort of free real-time consumer price index that relies on scraped data?

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Srinivasan responds. Joe Weisenthal blogs.