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By JP Koning
Posted September 2, 2020
Not all bitcoins are the same. If someone steals 100 bitcoins from a cryptocurrency exchange and tries to sell them, they’ll have to price them at a discount to the market price in order to compensate the buyer for the risk of laundering them. Different bitcoins different prices.
This isn’t just a bitcoin phenomenon. There are two wholesale markets for banknotes, too. The legitimate one is comprised of banks, retailers, and cash-in-transit companies like Brinks that exchange notes at par. And the illegitimate one is made up of mob lawyers, drug dealers, and note brokers exchanging dirty notes at 20 or 30 cents on the dollar. Different dollars different prices.
You can find this same fractionalization everywhere: in electronics or prescription medicine or used cars. There is a licit and illicit price in each market.
But the difference between dirty and clean prices isn’t the dichotomy that interests me in this post. Could we see a two-tiered market develop for clean bitcoins? In other words, could a situation arise in which Jerry’s 100% legitimate bitcoin’s are worth more than Elaine’s 100% legitimate bitcoins?
I’d argue that the precedent already exists in the gold market.
Last month I wrote a quick explainer on the London Bullion Market Association, or LBMA, for CoinDesk. The LBMA is a standards-setting body for the gold market. It defines what constitutes a London “good delivery” gold bar and what doesn’t. These standards include physical details like purity, weight, height, and appearance. Increasingly, the LBMA’s standards are being stretched to include details about sourcing. Has the miner extracted the metal in an environmentally friendly and ethical way? Are they laundering money for Mexican drug lords?
Good delivery bars can only be stored in a handful of London-based vaults. A strict paper trail is maintained to ensure that nothing gets in (or out) of this walled-garden. The moment a bar is withdrawn from a London vault, it loses it’s good delivery status.
This has the effect of creating a two-tiered licit gold market, one in which London gold is worth more than non-London gold.
Consider that the world’s largest buyers congregate in London to trade gold. A 400-ounce gold bar fabricated by a refiner that doesn’t have the LBMA’s stamp of approval can’t access the incredibly liquid London market. And so it won’t be worth as much as an LBMA-approved 400-ounce bar. (No one wants to buy your metal if it can’t be immediately on-sold in London.)
To be granted London “good delivery” status, an unapproved bar must go through a process of being anointed. That means bringing the bar to a refiner on the LBMA’s approved refiner list. The refiner vets the bar owner to check for money laundering, much like a banker would. Only then can the bar be melted down and reformed into an entirely new and approved bar. But all of these steps are costly.
As my CoinDesk article suggests, we might one day see the same sort of fractionalization emerge in the bitcoin market. A core group of exchanges and custodians would begin to define what qualifies as a “good delivery” bitcoin. Standards would mostly apply to the provenance of bitcoins. Since the history of bitcoin transactions can be easily monitored, it is relatively easy to cast aspersions on certain flows of bitcoins, perhaps because they happen to pass through suspicious addresses or are mixed by coin tumblers. (As Izabella Kaminska suggested a while back, bitcoin has a lien problem. Tim Swanson has been writing about this for a while, for instance in A Kimberly Process for Cryptocurrency.)
Should a bitcoin be withdrawn from this “walled garden” of approved exchanges and custodians it would fall out of the Bitcoin Marketing Association’s “chain of custody” and, as such, would no longer have access to core liquid markets. And so unapproved bitcoins would be forced to trade in lower quality venues with lax vetting standards, and less liquidity.
An online retailer might not want to take the risk of selling their products for unapproved bitcoins (i.e. ones that come from non-vetted personal wallets). Sure, it might be possible for the retailer to accept non-approved flows with the intention of re-depositing them into the Bitcoin Marketing Association’s system in order to get the Bitcoin Marketing Association price. But there would always be the risk of an unexpected blockade or freeze of a customer’s unapproved bitcoins. And so retailers would ask their customers to only spend approved bitcoins straight from their Coinbase wallets.
By the way, the sort of LBMA-driven dichotomy that exists in gold (and could one day exist in bitcoin) does not exist in banknote markets. There is no such thing as a good & expensive $20 bill and a good but cheap $20 bill. Cash, as we say in the monetary biz, is pretty much fungible.
Why do we see a two-tiered gold market but just a single-tiered banknote market?
There are probably many reasons for this, but a big difference is the sorts of people that occupy each market. The gold market is populated by investors, the most dominant of which are large institutional investors and central banks. These big players do not want the risk of having their gold being tarnished in any way. They don’t want their $50 million in gold bars to end up being fake, or subject to a court dispute, or frozen by law enforcement due to money laundering concerns. That’s why the LBMA standards exist; to make gold safe for big institutional buyers.
But cash is different. Warren Buffett and Ray Dalio don’t occupy this particular market. The market for coins and notes is dominated by regular people. Furthermore, banknotes are primarily used in small day-to-day retail purchases, not financial speculation. This sort of activity is not conducive to the emergence of a centralized marketing association. Cash transfers are done too quickly, and in small amounts, and by folks who don’t have deep enough pockets to pay for verification.
The market for banknotes is literally everywhere (each corner store in town will accept them), whereas the market for gold tends to clump up in a certain specific physical locations. This centralization makes standardization easier.
Bitcoins are more like a gold bars than a banknotes. Let’s face it, it’s been ten years since bitcoin appeared on the scene and no one really use bitcoin it as money (just like they don’t use gold as money). The majority of bitcoin demand is a demand to hoard the stuff for price exposure, much like the yellow metal. And like gold, the market for bitcoins has coagulated around exchanges. It’s not an everywhere market, not like the market for banknotes.
So to sum up, the market for bitcoins is very much like that for gold. Given that a standardized gold market has evolved, I wouldn’t be surprised to see the same happen to the bitcoin market, especially if big financial institutions start arriving.