Monday, 26 September 2011

Bitcoin Bonds and "Too Big To Fail"

One aspect of the financial system crucial to the capitalist system is borrowing. Companies borrow money so they can invest. This might be for example to build a new factory or develop new technology. Ignoring equities for now, money borrowed is usually in the form of bonds or loans; Alice gives $1000 to Bob on the condition that Bob pays her back the $1000 at a specified later date as well as $20 each year as an incentive for Alice to put up the cash.

Bonds are big. According to wikipedia the net value of outstanding bonds is $82 trillion. In 2010, $3 trillion worth of corporate bonds were issued. Bloomberg reported in Dec 2010 that GE Capital alone planned on issuing $25 billion through 2011. AT&T will be required to pay back (or rollover) $10 billion worth of bonds as they come due in 2011.

The question is, could bonds denominated in bitcoin be issued? Technologically, there's good reason to believe that the Open Transactions project will enable the issuing of bonds and other contracts that can be subsequently traded in a cryptographically secure manner. Since OT allows anyone to be the issuer of their own contracts, bonds could in principle be issued in bitcoins.

However, there a problems of large bitcoins debts. Since the cost of trashing the blockchain is both finite and easily calculable from the current difficulty level and market price of electricity, this places an upper bound on the size of a bond that can be safely issued. If BadCorp were to find themselves in a situation where their total bond issuance is substantially higher than the 'attack price', it would make economic sense for them to do the following:

  1. Buy access to (possibly by buying the hardware) a mining pool with 50% of the global hashrate.
  2. Continually harass the blockchain by reverting blocks, enabling double-spend attacks and so on so that
  3. Everyone else loses trust in the blockchain leading to
  4. Market crash in the value of bitcoins.
  5. Now bitcoins are worth a small fraction of what they were, buy them up and pay back your debt.
Now one criticism of this fraud would seem to be that since it's highly illegal and pretty obvious, the bitcoin economy could rely on meatspace police to stop this market manipulation / fraud. But when you think about it, it's not that easy since there's nothing to link BadCorp to the blockchain destruction that happened. They would outsource 1 and 2 above to some criminal gang, and probably no one would even suspect, far less be able to prove, that BadCorp had anything to do with it. BadCorp would be indistinguishable from any other company that happened to denominate their bonds in bitcoin who also benefited from being able to pay back their debts cheaply. This kind of situation happens in the real world whenever a currency experiences hyper-inflation - debtors prosper.

The key problem here is not that the bondholder doesn't get paid; corporate defaults happen all the time. The problem is that the bond issuer has a financial incentive to trash the entire system. So one bond issuance from the wrong company could end in disaster for everyone. The same potential problem exists in the real world to the extent that a bondholder can manipulate the real currency. The reason this doesn't happen is that it's far, far harder to attack a real currency.

One implication of the above is that no potential bond buyers can trust a bond issued in excess of the bitcoin attack price. At today's levels, multimillion dollar-equivalent bitcoin bond issues will not happen, since investors would be sowing the seeds of their own destruction.

Are there more subtle problems? Probably, yes. For example what if a group of highly indebted entities conspire to bring down bitcoin? You could argue that bank bailouts during the credit crunch were a real-world form of this attack. "Too big to fail" was the attack vector used to devalue the currency and hence the debts. But while in the real world the attack price is measured in trillions of dollars, in bitcoin it is measured in millions of dollars.

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