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Author Topic: Bubble and crashes  (Read 13619 times)
Gavin Andresen
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July 09, 2010, 11:59:35 AM
 #1

In a thread in the Bitcoin Discussion forum, dwdollar says:
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I think the bigger problem, as others mentioned, is shadow interests buying/selling to create speculative bubbles and subsequent crashes.  They could orchestrate these events at critical times (during a version release or media event) to discourage new users.
I think it will be impossible to tell if a bubble&crash is "natural" or "the men in black helicopters manipulating the system."

Bitcoin will get mentioned someplace with lots of readers, a bunch of those readers will like the idea and try to buy Bitcoins, their price will rise which will draw even more people to "invest", which will drive the price up even more... until people decide that the price isn't going to rise any more and everybody rushes to sell before the price drops.  I predict there will be between one and five Bitcoin bubbles (price will double or more and then crash back down below the starting price) in the next four years .

What do you all think-- are bubbles and crashes a natural emergent property of markets, or would Bitcoin be immune if nobody were trying to cause a bubble?

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NewLibertyStandard
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July 09, 2010, 01:51:05 PM
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I think bubbles and crashes will be less likely for the first years because as the price rises, people can generate new bitcoins and undercut other people's prices. But as the number of bitcoins per block decreases, it will be increasingly difficult to prevent bubbles and crashes unless a large investor tries to prevent them by limiting the amount of bitcoins he sells per day so that he always has enough bitcoins to undercut bitcoin speculators.

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July 09, 2010, 02:56:41 PM
 #3

Short selling is the traditional way bubbles are deflated. Unfortunately its overhead is quite large, involving contracts and lending. A small market can't support that. So might there be a gap in time when generating coins gets too costly and the market is still too small to support the necessary financial instruments?
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July 09, 2010, 03:14:06 PM
 #4

Humans are not oracle machines, therefore errors in judgment can be made. Bubbles can self-feed on themselves. However, these types of bubbles are not very harmful compared to the types of bubbles caused by fractional reserve banking.

Look at it this way: Bitcoin is like the digital equivalent of gold. You cannot create more Bitcoins than you can "mine" out of the digital ether. You also cannot lend more than you have.

To really mess things up, you'd have to create a Bitcoin substitute; a "paper" money for Bitcoin. For example, let's say a bank had 1 ton of gold, and lent out paper representing 10 tons of gold. This is what fractional reserve banking does. It works fine (aside from the massive price distortions in the economy) until everyone decides to redeem their paper for gold. Oops! People want to claim 10 tons, but only 1 ton exists! Looks like 90% of the people get screwed  and end up with no gold (or no Bitcoins).

So long as you are dealing with Bitcoin proper, and not a Bitcoin substitute, this kind of destructive credit bubble cannot occur. Whether the value goes up or down, you still have your Bitcoins. It would take a total loss of confidence in the entire Bitcoin system to wipe you out.

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July 09, 2010, 03:20:28 PM
 #5

Non-credit bubbles also provide excellent arbitrage opportunities. Let's say Bitcoin quintuples in price relative to Pecunix. If you believe that Bitcoin is overpriced relative to Pecunix, then you would sell Bitcoin to buy Pecunix. If you are right, you will profit.

The interest of everyone to make profit drives the price toward its "proper" value, and makes it difficult for a mass coordination of price action to occur. If there IS a massive coordination, unbacked credit is usually to blame.

What could even happen is that we could see wild swings in Bitcoin value relative to say, USD, but in reality it is the USD that's unstable, not Bitcoin.

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July 09, 2010, 03:24:11 PM
 #6

Short selling is the traditional way bubbles are deflated. Unfortunately its overhead is quite large, involving contracts and lending. A small market can't support that. So might there be a gap in time when generating coins gets too costly and the market is still too small to support the necessary financial instruments?


If you believe Bitcoin is overvalued compared to some other currency, there's no need to short sell, so long as you actually have Bitcoins. Just sell the Bitcoins you already have in return for that other currency. When Bitcoin comes back down, exchange back for Bitcoin. If you were right, then you profit!

If you don't have Bitcoins, then maybe by that time there will be a Bitcoin bank that will lend you some, in exchange for another asset Smiley

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July 09, 2010, 05:09:27 PM
 #7

So would there be any legal issues (int the US or elsewhere) with running a bitcoin lending service similar to a traditional bank?

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July 09, 2010, 05:22:28 PM
 #8

Even if there weren't, the law is so complex that any excuse could be concocted.

Your best bet here would be establishing a reputation and staying within the shadows of Tor or whatnot.

A reputation system for websites and nodes: The perfect complement to Bitcoin?

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llama
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July 09, 2010, 09:10:24 PM
 #9

Even with real bitcoins, there can still be fractional reserve banking.  Banks could be a spectrum, like this:

On the far left side of the spectrum, you would have pure depositories.  "Jack's BC Protection Co." would simply accept your BC for safekeeping (Jack backs up his wallet file Wink ). Jack won't touch your BC while he holds them, so you definitely won't earn interest.  In fact, you might even have to pay Jack a small fee just for securely holding your BC.

Slightly to the right of the depositories is "Bob's Low-Risk BC Bank".  But this time, after you deposit some BC with Bob, Bob loans out 25% of your BC into reliable investments, and tells you he's doing this.  Now, you earn a little bit of interest just for having your money "sit there".  99% of the time, you can cash all your money out on a moment's notice, and this time you'll have that interest too!  1% of the time, there can be problems.  This risk comes from two places: First, the risk inherent in the investments themselves (it's possible Bob was unlucky with his investment choices).  Second, the risk that everyone will try to cash out all at once. 

On the far right of the spectrum is "Bernie's Daredevil Bank".  This time, after you make a deposit, Bernie invests 95% of it in risky projects.  You'll earn an impressive interest rate, but it comes at great risk.

Note that every one of the banks or funds I described is it's uses.  As long as you are optimistic about our economy growing as a whole, then each of the investing banks offers a positive expected value.  The higher the risk, the higher the expected value.  The risk you will choose to take on depends on your individual needs and timeline (think of how people decrease their stocks to bonds ratio as they near retirement).  If you're curious about how to choose the ideal level of risk, look into the Kelly Criterion and Kelly methods.   

There is also value inherent in the services that banks provide.  You could try to seek investment projects on your own and earn interest without a bank, but it would be very costly in and of itself to do so.  Also, the aggregation provided by banks helps lower risk and provides flexibility.

It will be important that the banks are really trustworthy so that people can accurately compute risk and reward.  This may require the use of private, trusted auditing companies.  The great thing about BC banks though is that with less government regulation and fewer barriers to entry, there will be more competition among banks, which will improve the industry as a whole.



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July 09, 2010, 11:13:42 PM
 #10

Hi llama,

Agreed, though what you describe isn't fractional reserve banking. If you invest in stocks and bonds, those investments are not money proper. It's regular investment risk, which carries with it its own chance of getting wiped out, but you never get the kind of distortions that you do with fractional reserve banking, because you never have "phantom" bitcoins entering the economy and distorting prices.

Here is an example with gold:

Situation 1: You go to a full reserve bank and deposit a one ounce gold coin. The bank gives you a deposit slip, showing that you have one ounce on deposit. The bank then puts this ounce of gold into its reserves. It prints a bank note, worth one ounce, and lends this to somebody. Note that with full reserve banking, it doesn't even have to print a bank note. It could also just lend out the gold coin directly.

So far, the money supply stays the same and there are no price distortions. You gave up one gold, the bank lent out a bank note redeemable for an ounce of gold. No problem.

If one of the loans goes bad, then the bank does not lose all of its reserves. If 50% of the loans go bad, then everyone might have to take a 50% haircut. It would require every single loan made by the bank to go bad in order for you to lose your entire deposit.

The bank can only safely let you withdraw your deposit once a loan has been called back in. For a large bank with thousands of loans, this sort of maturity matching shouldn't be too difficult.

Situation 2: You go to a fractional reserve bank and deposit a one ounce gold coin. The bank gives you a deposit slip, showing that you have one ounce on deposit. The bank then puts this ounce of gold into its reserves. It prints ten bank notes, worth ten ounces, and lends these to somebody.

So far, the money supply has been increased by 9 ounces. You gave up one gold, the bank lent out bank notes redeemable for ten ounces of gold. This is a problem, because ten ounces of gold don't actually exist. The money supply was increased by 9 ounces net, which ends up robbing ALL gold holders of the value of their gold. This is therefore a form of fraud and theft.

If one of the loans goes bad, then the bank loses the same amount of reserve as it does in the full reserve bank. The problem is that there are 10 times as many loans outstanding. Out of these total amount of loans outstanding, if only 5% of the loans go bad, then everyone might have to take a 50% haircut. It only requires 10% of the loans made by the bank to go bad in order for you to lose your entire deposit.

The bank can never safely let you withdraw your deposit since it has 10 times the amount of IOUs outstanding, but it does so anyway. This is fraud against the other depositors, since there is not enough capital outstanding to cover all of the loans.



Replace gold with Bitcoin. With Bitcoin, it's harder for situation 2 to happen, because I don't see why anyone would accept a substitute for Bitcoin (the substitute being the bank's paper) as money in the first place when you could use Bitcoin directly. Unlike gold, it's easy to transport and transfer large sums of Bitcoins.

Some banks might try it, but any bank paper would rightly be viewed with suspicion, since they might be engaging in fractional reserve banking. People would be much more willing to accept Bitcoins directly, and if a bank is loaning out Bitcoins directly, then they cannot engage in fractional reserve banking.

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July 10, 2010, 01:09:54 AM
 #11

Bitcoiner,

I think we have a fundamental disagreement here.  I admit that my own understanding here is limited, but this is my conception of fractional reserve:

A fractional reserve bank never lends out more "gold" than it has in its "vaults".  Fractional reserve banking means just that: the bank is required to keep a fraction of it's callable deposits in its reserves.  So, if the reserve requirement is 10%, and a bank has $100,000 in callable deposits, then it must keep $10,000 in reserves but can lend out $90,000.  Note that $90,000 is less than it's total callable deposits.  If they did what you were saying, then it would have to be called negative reserve banking.

I'm almost certain I know the source of your confusion.  I'm sure you're used to hearing that fractional reserve banking "creates" money.  So, you are led to the belief that they issue notes for more money than they actually ever have available at any given time.  This is not so. In truth, this kind of banking does not increase the actual number of dollar bills in circulation.  I believe this is called the M0 money supply (someone correct that term if I'm off).  Applied to Bitcoin, there would never be more than 21 million BC's in circulation, even with fractional reserve banking.

What fractional reserve banking does do is increase the M1 money supply, which includes all callable deposits (I like to call this "checkbook money").  The logic goes like this:

In an economy with a 10% reserve requirement, somebody makes a $100 deposit.  The bank holds $10, and loans $90 out as, say, a home loan.  That money goes to the construction company, and ultimately ends up back in a bank as a deposit.  Now the second bank keeps a 0.1*90= $9 reserve on that money, and again loans the $81 remainder out.  That $81 eventually winds up in (you guessed it!) another bank!  The process repeats.  So now, even though there is still only $100 in gold/currency actually existing in all these different banks as reserves, there are all of these callable deposits: $100 + $90 + $81 + $72.90 ... = $1,000! (Deposit/RR) So, from that single $100 deposit of currency, there is now $1,000 worth of callable deposits!  So, money has been "created" in the M1 money supply, even though there is still only $100 of currency.

Please continue the discussion.  I have a hard time seeing the perspective of the anti-fractional reserve clan myself.

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July 10, 2010, 05:22:06 AM
 #12

llama,

Thanks for clearing that up, I had my understanding of the money creation process confused. It is however, still the same result in the end. $100 of deposits becomes $1000 of money, with a 10% reserve requirement.

For example, I deposit 100 ounces of gold into the bank, it lends out 90 ounces of gold, and gives me a deposit slip for 100 ounces of gold. It appears that so long as my 100 ounces are locked away as savings, then no fraud or price distortions have been committed on fractional reserve banking's part.

The issue here is that under fractional reserve banking, the original deposits are all withdrawable and spendable. If I then go and withdraw that 100 ounces of gold, and the bank allows me to, then the bank has committed fraud against every other depositor of the bank! How? Well, it is impossible for ALL of us to withdraw our deposits, since the bank has loaned most of them out! Let's say the bank knows this and gives me paper money, redeemable for gold, and hoping that I'm not prescient enough to demand real gold instead of paper. If I now spend these ounces, I distort prices by causing inflation. Why? There were only 100 ounces before, but now there are 90 additional "phantom" ounces (and up to 900 additional phantom ounces should the process continue). The bank has stolen value from everyone by increasing the supply of money, all other things being equal.

Let's look at the same scenario with Bitcoins:

I deposit 100 Bitcoins with bank XYZ, and it lends out 90 Bitcoins, and gives me a deposit slip for 100 Bitcoins. I withdraw my 100 Bitcoins the next day. Again, it is impossible for the bank to meet my demand without giving me someone else's Bitcoins; again, fraud. Either the bank has to give me a Bitcoin-substitute (like paper money for gold) and hope that we're stupid enough to accept it or the bank has to go bust. That is why I believe that it will be hard to commit this type of fraud with Bitcoins because, unlike gold-backed paper, there is little reason to accept a Bitcoin substitute over the real thing.

This is where the problem in fractional reserve banking lies; though now that I better understand the money creation process I must be specific and state that it's not the fact that a fraction of the reserves are lent out; it's the fact that more promises are issued than there are reserves to support those promises.

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July 10, 2010, 05:32:13 AM
 #13

Let me add that I do not propose any outlawing of fractional reserve banking, as that would be completely against the spirit of voluntarism and of the open-source nature of Bitcoin. Smiley

So long as they fully disclose that the entire deposit is at risk and therefore subject to complete loss if only % of depositors ask for their funds back, or deposits are maturity matched and locked in for a specific amount of time, then it is not fraudulent. I believe that the first scenario is inherently unstable, like a marble on a pinpoint.

As Bitcoin is entirely voluntary, the wost offenders would see their note value drop to 0, if indeed people do accept promises for Bitcoins rather than the Bitcoins themselves, which is necessary for the money multiplier aspect of fractional reserve banking to work.

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July 10, 2010, 06:49:17 AM
 #14

My bitcoin investment tip:Instead of buying bitcoins in a lump sum,  slowly buy smaller amounts of bitcoins over a longer period of time. This spreads the cost basis out , providing insulation against changes in market price.Also called dollar cost averaging.It is almost impossible to time your entrance into the market so dont.By regularly buying each week it also underpins the confidence in bitcoins.

Remember - Time in the market is better than timing the market.
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July 10, 2010, 07:26:19 AM
 #15

Bitcoiner, I think we're getting to some common ground here.  Let me clarify a few points:

First of all, let's get off of the idea of gold being deposited for a minute and switch to cash.  So, when I say cash, I'm talking about physical dollar bills.  This is the way it works in the modern world (ppl deposit cash, not gold)  And, to apply it to bitcoin, simply switch cash with bitcoins, same thing.

When people call their deposits back from the bank, the bank gives them cash back.  The never print their own notes or anything like that.  The closest thing that a bank would have to their own notes would be a certificate of deposit itself, and even a dull customer would not accept a certificate of deposit when, well, cashing out their old deposit.  If a bank cannot furnish the cash, then it is a very very rare condition called insolvency, and it's dealt with by shutting down the bank, not issuing some kind of new currency.

Now, if the reserve requirement (RR) is 10%, then in actuality banks will keep slightly more than 10% of their deposits in cash, say 12%.  When anybody wants to withdraw all of their money, they can do so instantly, drawing from the bank's cash pool.  In our example, this may cause the bank to now have, say only 11% of their deposits in cash, but that's okay because they're still over the RR.  They haven't deceived any other depositors, because they still hold over 10% of those deposits in cash.  If the person who withdrew his money is not replaced by a new depositor, then the bank will not renew some of their non-liquid investments when they mature, so they will be back at 12% cash.  

It is true that if every customer demanded their cash back at the same time, the bank would not be able to provide all of that money.  The bank uses very intricate formulas to ensure that in any reasonable scenario they will be able to provide instant cash to any demanding customer.  These formulas are based on the fact that it's very probably that some fraction of depositors will require cash on any given day, but very improbable that everyone would, say, happen to be making a very large purchase on the same day and all require cash at the same time.  Analogy: our banks our somewhat like our hospitals; if everyone got sick on the same day, we would not have enough hospitals to deal with them.  But, this is simply so unlikely, that it's certainly not worth building hospitals enough to hold every human alive.  In fact, the only conceivable time when people do all demand money at the same time is this funny little catch-22 called the Bank Run, where people demand all their money simply because they're scared everyone else is doing the same thing (it's a self-fulfilling prophecy)!  The FDIC was setup to prevent exactly this behavior--by the very nature of insuring people's deposits, the FDIC stopped people from ever worrying about not having access to their money, preventing bank runs.  In this way, the FDIC provides great value, even when it doesn't pay have to pay out a dime!  And don't worry, the FDIC can effectively be replicated even without the government by having banks insure each other.  

I agree with you that fractional reserve banking should not be outlawed Wink.  If it were, then it would be impossible to earn interest on money held in the bank.

I agree with you that banks should disclose that money invested in them is at risk, and subject to loss.  Even now, they do have to do this by law (and even if not by law, I would hope by customer demand).  When you sign up for a bank account, there's a summary of the risk that is involved.

I do think that  Bitcoin will by its nature solve many of the problems that are attributed to FR banking, even though bitcoins will be FR banked themselves.  For example, I think that having a government mandated RR right now creates an environment where banks feel pressured to use the bare minimum RR to be competitive.  Without a mandated RR, banks can operate at a variety of RR, creating different risk-reward packages for customers (like the banks I described in my earlier post).  Also, since bitcoins are so easy to spend, there will not longer be a need for checks.  This means that BC will effectively be cashed out much more often, preventing latent solvency problems from building up in the system like they currently can.

Personally, I cannot wait to invest my money in a BC bank.

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July 10, 2010, 03:55:45 PM
 #16

Hi llama,

I read your post and I don't disagree with what you've said. I am not that concerned about bank runs to be honest, so long as the banks don't blatantly lie and say that they always have funds available; in order to be non-fraudulent, deposits must be either locked in and maturity matched against any expiring loan, or they must be backed by assets at the bank which remain at the bank. In fact, with Bitcoins this will be naturally enforced because the banks cannot naturally create more Bitcoins than they have.

My real issue with fractional reserve banking, in combination with legal tender and central banking, is the way that it multiplies the supply of money and steals wealth via inflation.

I agree with you that fractional reserve banking should not be outlawed Wink.  If it were, then it would be impossible to earn interest on money held in the bank.

I submit that interest on money creation is illegitimate. If the banks are the creators of money, the only legalized money creators (others are called counterfeiters), and they collect interest on this created money, then what is the natural flow of wealth in a society that legitimizes such inflation?

Under a "hard" money like gold or Bitcoins, you already receive natural interest just by holding the currency, via the natural expansion of production and productivity covered under the currency. Interest would still exist, of course, but it would be relegated to its proper role of dealing with risk and time preference, rather than of keeping up with inflation and spiraling debt payments!

Besides, banks pay YOU peanuts, barely enough to keep up with inflation Wink

I agree with you that banks should disclose that money invested in them is at risk, and subject to loss.  Even now, they do have to do this by law (and even if not by law, I would hope by customer demand).  When you sign up for a bank account, there's a summary of the risk that is involved.

I do think that  Bitcoin will by its nature solve many of the problems that are attributed to FR banking, even though bitcoins will be FR banked themselves.  For example, I think that having a government mandated RR right now creates an environment where banks feel pressured to use the bare minimum RR to be competitive.  Without a mandated RR, banks can operate at a variety of RR, creating different risk-reward packages for customers (like the banks I described in my earlier post).  Also, since bitcoins are so easy to spend, there will not longer be a need for checks.  This means that BC will effectively be cashed out much more often, preventing latent solvency problems from building up in the system like they currently can.

Personally, I cannot wait to invest my money in a BC bank.

Since it is impossible for the bank to create BRs out of thin air, the way that it's done now in fiat currency, then the money expansion aspect of FR is prevented from taking place. Wink

I would love to see an explosion of Bitcoins on the web; I think slowly, more and more people are becoming aware of it. It is already far more successful than alternatives such as Ripplepay (at least the last time I checked).

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July 10, 2010, 05:34:22 PM
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Quote
I think that having a government mandated RR right now creates an environment where banks feel pressured to use the bare minimum RR to be competitive.

The problem is the deposit insurance and too-big-to-fail. Banks have too little incentive to lower their risks if they are insured anyway. Without them the need for government-mandated reserve requirements would go away.

What does Bitcoin have to do with reserve requirements, though? From a banking perspective, isn't Bitcoin just another currency among others? (Although a currency with lower need for banking services.)
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July 12, 2010, 01:30:28 AM
 #18

Bitcoiner,

It still seems like you're a bit hung up on the fact that banks create cash.  This is not true.  If the government minted only $1 trillion, even after all the banks do their FR thing there will still only be $1 trillion.

Any "money creation" that the banks currently do (increasing the M1 money supply) will be equally present even if they used BC instead of USD.

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July 12, 2010, 03:23:36 AM
 #19

Bitcoiner,

It still seems like you're a bit hung up on the fact that banks create cash.  This is not true.  If the government minted only $1 trillion, even after all the banks do their FR thing there will still only be $1 trillion.

Any "money creation" that the banks currently do (increasing the M1 money supply) will be equally present even if they used BC instead of USD.
If someone deposits 100 at a bank, the bank loans out 90, and the original person can still spend his 100 or withdraw them, then money has most certainly been created. I am not seeing how this cannot be the case. I also don't see how this is possible with BCs, so not sure how the two situations are the same.

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July 12, 2010, 06:01:23 AM
 #20

If someone deposits 100 at a bank, the bank loans out 90, and the original person can still spend his 100 or withdraw them...
[/quote]

In reality, he would not be able to if that was the only deposit in the bank.  The bank *creates the illusion* of there being more money because most people will not attempt to withdraw at the same time.  It operates on the expectation that most investments will not be withdrawn, at least not all at once, and that most loans will be repaid.

When people do all withdraw at the same time, such that the amount of withdrawals is larger than the actual cash on hand at the bank, it's called a bank run, and the bank defaults and some people don't get their money back (though in Western countries today, the government generally lends the bank the money necessary to complete the client withdrawals as bank collapses tend to have nasty economic consequences).
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