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Author Topic: Proposal for ETFs as a stabilizing institution  (Read 516 times)
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June 29, 2011, 06:13:13 PM

Hi, all.  Newly-signed up on the forum (hence the Newbie status), but I've been following Bitcoins with great interest since they first popped up on my radar screen a couple of months ago.  And recently I've been kicking around (mostly in my own head) the following idea (a bit long, but bear with me if you're interested):

First, in the Caymans (or Bermuda, or the BVI, or any similar well-established and legally-sophisticated jurisdiction*), establish two completely separate and legally-independent companies which will operate as "exchange-traded funds."  Then create (and hold via a third legal entity, completely separate from the 2 funds) an online exchange, on which those with registered accounts can buy and sell equity claims (i.e., shares) in the two funds.

<* You could also use a Delaware LLC or similar U.S. entity, as this structure is not about avoiding or evading U.S. law, but it's simply the case that (sad but true) I have a little more faith in the likelihood of the Rule of Law being respected and upheld by British-trained judges in the Caymans or Bermuda or the BVI than I do by U.S. judges and legislators...>

The two separate funds would be:

(1) A BTC-denominated USD-backed-ETF -- which holds only U.S. currency (and short-term Treasuries) -- and the shares of which are denominated in and trade (to regular investors) only in BTCs, and

(2) A USD-denominated BTC-backed-ETF -- which holds only BTCs (or perhaps, say, holds only 2 categories of physical assets, specifically (i) one or more encrypted thumb drives which themselves contain the only copies of wallets holding such BTCs, and (ii) a safe (or safe-deposit box in the Caymans) in which those thumb drives (and the password to unencrypt, if necessary) are securely kept -- and the shares of which are denominated in and trade (to regular investors) only in USD.

These companies would be audited and subject to Caymans law, so that investors could be confident (to the extent you trust the auditor, i.e., as confident as you can be when you invest in stock of any publicly-traded company) that the entities really are 100%-fully-backed by the paired currency.

The exchange would thus provide a liquid market where merchants and speculators could quickly and easily hedge their exposure to (or bet on movements in) USD/BTC fluctuations.

On this latter point, in some sense I suppose that's just another way of saying they would be providing a similar function to MTGox, Tradehill, or any other operating exchange -- and it would not be my intention to displace or replace any other exchange (competition is a good thing!!) -- but with a couple of key differences/advantages:

  • first, investors have certainty (from the audit and attestation) that shares they are trading truly represent an ownership interest in a pool of USD or BTC, as the case may be; I mean, trust is great when it's well-earned and well-deserved, and having suffered through the MTGox hack/crash along with many of you and having recovered my account with no loss of my BTCs or USD on deposit there, I trust MTGox and Magical Tux and think they've done a terrific job under difficult circumstances in recovering, BUT  to go to the next level of acceptance and adoption we need legal certainty of the sort this proposed structure would provide; and
  • second, the structure provides (hopefully) some degree of insulation from attacks/seizures/freezings by governments on "anti-money-laundering" or "know-your-customer" grounds, because (and I think this may be important) ordinary investors would not be actually changing USD-to-BTC or BTC-to-USD on the exchange, but instead merely (a) trading, solely with BTCs, in-and-out of a derivative instrument (which happens to derive its value from the value of a fixed amount of US currency), if they are trading in the USD-backed-ETF, or (b) trading, solely with USD, in-and-out of a derivative instrument (which happens to derive its value from the value of a fixed amount of BTCs), if they are trading in the BTC-backed-ETF.

Unlike existing exchanges, this online stock-exchange would not be operating as a currency exchanger or currency transmitter.  But it does provide a liquid means of immediately and fully hedging (or loading up on, if I'm a risk-loving speculator) risk of future moves in the USD/BTC exchange rate.


So, for example, suppose I'm an online merchant, and I've just heard a little bit about these weird "Bitcoin" things and I don't really understand them all that well and really don't want to spend the time to understand them as I'm too busy running my business.  And I still operate that business pretty much fully on a USD-basis: I pay for my ISP service in USD, I pay my suppliers in USD, I have a couple of assistants whom I pay USD wages, and I take my profits in USD which I turn around and use to pay my monthly rent and buy food.  But over the past few weeks an increasing number of customers have asked about the ability to buy my merchandise in Bitcoins, and because I don't want to needlessly lose any sales, I decide I'll give it a shot, and I ask my much-more-tech-savvy assistant to make the necessary changes so that I can accept payment in BTCs (and set up an "online wallet," whatever the heck *that* means...) as long as I can lock in the US Dollar value right away (as I'm still a little suspicious that this whole thing sounds a little too good to be true, so I say "I don't want to sell my *real* merchandise, which I had to pay *real* greenback backed-by-the-full-faith-and-credit-of-the-United-States dollar bills to procure, and end up with nothing to show for it but a bunch of worthless digital magic beans."

So, I'm now up-and-running with a "pay with Bitcoins" option, which is proving to be popular, and over the past hour I've sold 353 BTC worth of merchandise, which I'm now preparing to ship out the door.  I know BTCs are trading right now at about $17/BTC, so my 353 BTC equates to just about $6000 (in fact, I quite deliberately set the BTC price of my goods so that it moves up and down in conjunction with the exchange rate, so that I'm always selling my t-shirts (say) at about $30 or the BTC equivalent of $30, my sweatshirts at $45 or the BTC equivalent, etc.).  So far, so good, but I want to lock in that $6000 of value regardless of where the USD/BTC exchange rate goes tomorrow or next week (or even an hour from now).  So I (or my tech-savvy assistant) go online, log into my ETF-exchange account, and with my 353 BTC I acquire at market (i.e., simply by lifting the outstanding offers in the offer book) 60 shares of the USD-ETF, with each share representing an undivided legal interest in $100 of the U.S. currency that the fund holds in its own USD-denominated bank account.

I am now fully hedged against future fluctuations in the BTC/USD exchange ratio.  With regard to my sales revenues from today's BTC sales, that's worth $6000 today and (while those shares, which I paid 353 BTC for today, will likely trade at some completely different amount in Bitcoins tomorrow and the day after that), those 600 shares will be worth USD$6000 tomorrow and the next day regardless of whether BTCs shoot up in value to $50/BTC, or collapse completely to $0.03/BTC -- because I'm legally entitled to 60 claims on $100 of the cash that the fund has (and which we know it has -- it's fully-reserved!) in its USD-denominated bank accounts.

But, (you may protest), I still don't really have $6000 cold, hard, USD cash, though, right? And this "undivided right" I have to cash in the Fund's account is all well-and-good, but if I and other regular investors like me can't actually force the Fund to cough up the $6000, then why would I think that the price  of the shares in BTC will bear any correlation to the "real" BTC/USD exchange rate.

Here's where -- just as with ETFs in the "real world" today -- we would have a number of special accredited investors (who have been cleared through a detailed identity/background check -- again, to ensure compliance with the anti-money-laundering and "know your customer" rules, as these are the only people who are actually converting USD into BTC and vice-versa), who would have the right to either redeem or create new blocks of Fund shares in exchange for blocks of USD cash either deposited or withdrawn.  So, such an investor could, at periodic intervals, contribute/deposit USD$10,000 (or multiples thereof) into the Fund and take back a newly-minted block of 100 shares (or multiple thereof, again -- each share represents a claim on $100 of the Fund's assets, remember) which s/he could then immediately sell on the exchange for BTCs.  Conversely, any such investor would have the right at periodic intervals to take a block of 100 shares and "turn it in" to the Fund to be cancelled and redeemed out for USD$10,000 cash to such investor.

In this way, in a sufficiently liquid market (and assuming sufficiently rational and self-motivated special accredited investors), the self-interested elimination of arbitrage opportunities would ensure that the share price of a single share of the USD-ETF will always accurately reflect the "real" exchange rate of USD$100 in Bitcoins (because if it gets out-of-line at all, the special investors will swoop in and make free money by arbitraging the difference -- either creating new blocks of Fund shares if they are overvalued in BTC relative to USD, or redeeming out blocks of Fund shares if they are undervalued in BTC relative to USD).

The whole process would really function exactly the same way (but in mirror image, if you will) for the USD-denominated BTC-ETF.  (And note that the latter can operate in a hedging function just as easily as in the original example -- if I'm precommitted to pay you 150BTC in a week, but (for whatever reason) I don't want to actually buy 150BTC today I could nonetheless buy, say, 15 shares of the BTC-ETF for $2550 today, and I'm fully hedged on my 150BTC exposure to exchange-rate risk for the next week.  Does it also possibly open up an avenue for a big flood of dumb-speculative-money into BTCs as people who have heard just vague things about how BTCs are a great speculative investment, but can't be bothered with actually figuring out how to set up and protect a wallet and figure out all this complicated techno-speak, and just want to make a pure speculative bet on the rise in the value of BTCs vs. the USD? Sure, but that's not the point, and inevitably that will happen regardless if and as Bitcoins continue to demonstrate continued success and staying power. So we might as well get any future speculative bubbles out of the way sooner rather than later to reach a point of long-term stability that much quicker, right?).

If you've stayed with me all the way to the end, thanks -- and I welcome your thoughts/comments/suggestions.
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