Chapter 6 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.
The Invention Of Bitcoin
On 31st October 2008, in the middle of the most intense period of the financial implosion of the 2008 global financial crisis, a whitepaper was published by a pseudonymous individual called Satoshi Nakamoto. The groundbreaking paper described a new transformational type of money, Bitcoin. Bitcoin was the world’s first decentralized electronic money. Bitcoin required no banks and no central banks, instead users could run the core financial infrastructure themselves, on their home computers and engage in peer-to-peer electronic unblockable bearer like transactions, without trusting financial intermediaries. The timing of the launch was absolutely perfect, right when trust in banks was at a historic low.
In the eyes of Bitcoin supporters, Bitcoin was a revolutionary new technology, set to free the world from the ills of the banking and economic system and provide much needed financial freedom to the masses. Bitcoin was an unstoppable positive force, which would act as a tool to resist authoritarian governments, disrupt the inefficient and corrupt financial architecture and provide services to the world’s poor and unbanked. At the same time, Bitcoin supporters and investors would benefit financially, as others began to realize Bitcoin’s incredible transformational potential.
On the other hand, skeptics view Bitcoin as a joke, another tulip mania. Paying money for a token that was totally virtual made no sense and it would surely collapse in price. At the same time, they viewed the typical Bitcoiner diagnosis of society’s economic problems as flawed and naive.
As Bitcoin continued to grow and appreciate in price, the view of Bitcoin skeptics pivoted. It was no longer seen as a useless scam, guaranteed to end in catastrophic failure. Opponents of Bitcoin changed their minds, they started to see it also as a revolutionary new and transformational technology. Not as a way to solve problems with the financial plumbing in the economy, but instead as a new, fascinating and perfect object of speculation and price bubbles. Bubbles which persisted far longer than they expected. Through this lens, the timing of Bitcoin’s launch was also perfect. Bitcoin launched at the same time as central banks engaged on a path of unprecedented easing and record low interest rates, fueling financial speculative bubbles. This greatly benefited Bitcoin, causing it to appreciate in value at an incredible pace.
However, Bitcoin is not the perfect object of speculation. One can do better. Bitcoin has no inherent interest rate or yield. Bitcoin’s critics often compare it to a ponzi scheme, however ponzi schemes typically have a yield or promised rate of return. For example, Charles Ponzi, after whom this type of scheme is named, famously promised his clients a 50% profit in 45 days. That is not to say there were no ponzi schemes and other scams inside the Bitcoin space. These scams and promises of extraordinary returns have indeed attracted large amounts of capital into the cryptocurrency ecosystem. However, the Bitcoin protocol itself promises no yield. If one merely buys Bitcoin, one either wants to use Bitcoin or one is hoping to benefit from price appreciation. Had Bitcoin been designed purely as an object of perfect speculation, it could have attempted to include a yield in the core protocol. Some alternative coins have adopted schemes like this. In September 2022, Ethereum switched to Proof of Stake and under this system, the phrase “perfect object of speculation” to describe Ethereum, may be even more appropriate.
Bitcoin does of course have Proof of Work mining, where newly issued coins are allocated to miners who extend the Bitcoin blockchain. This business activity does have potential returns and therefore a yield. However, Bitcoin mining is very much an industrial process, one needs to purchase and operate expensive unstable equipment and use large amounts of energy. Much of the value here leaks out of Bitcoin to equipment manufacturers and energy producers. Bitcoin mining is a risky industrial process, not a way to generate passive income. Proudhon’s 1849 critique, that interest is a “reward for idleness” is not applicable here. While for Proof of Stake systems, the criticism may be more valid.
The Bitcoin Interest Rate
With no yield or interest rate built into the Bitcoin protocol, a Bitcoin interest rate will only emerge if people start to borrow and lend Bitcoin. Given the complexity and uncertainty of how to determine the interest rate, it is quite challenging to evaluate interest rates in the context of Bitcoin. What if people start making loans in Bitcoin? What rates will they charge and how could we interpret these interest rates?
Bitcoin has a fixed and known issuance rate. There will only ever be 21 million coins and new coins are only issued on a fixed schedule known in advance. Therefore, Bitcoin interest rates cannot be a monetary phenomenon. At least the interest rate should not change due to monetary policy changes. However, the Bitcoin protocol only replaces central banks in this context. Commercial Bitcoin lenders could still lend out Bitcoin they do not have, expanding credit just like they do with fiat money. However, the level of credit expansion under a Bitcoin system is probably not likely to reach the scale it does with fiat money. The lending institution may feel it is always under a certain type of pressure, that depositors could always ask for their Bitcoin back and demand it on-chain. This kind of pressure does not exist in the fiat system, as funds are locked into the banking system unless they are redeemed in the form of physical cash. This form of redemption is not likely to happen at scale, as holding physical cash has various logistical problems. There is a risk for Bitcoin though, if the Bitcoin deposit taking institutions are vertically integrated with the providers of custody technology and the end clients don’t have the capability to custody the funds themselves. If this happens Bitcoin will look more and more like a fiat money system. At least for now, this has not happened to the extent required to materially undermine Bitcoin’s supply properties. For now, the Bitcoin interest rate will not be driven by monetary considerations. And therefore other factors will determine Bitcoin interest rates.
The supply cap, Bitcoin’s economic critics proclaim, is a major weakness. As a result of this, in a Bitcoin based economy, there will be deflation and slow growth. This will reduce consumption, as people hoard money. The interest rate could also be too high, which would cause underinvestment, due to a lack of demand to borrow at high rates and therefore the economy would not grow at a decent rate. This could result in widespread poverty. Even if there are Bitcoin denominated investment and loans, in the event of an economic slowdown there is nothing the authorities could do to stimulate the economy by lowering rates. Debt Deflation would persist and be a major problem and the economy could stagnate for long periods of time. Companies and people could be stuck with large growing debt burdens and interest payments they could not afford. Of course, it’s ironic that Bitcoin’s economic critics make these points. Bitcoin is extremely unlikely to become a major investment currency and from the perspective of Bitcoin’s critics, the chances of this should be laughably tiny. Therefore, from their point of view it is unclear why these critics spend so much time articulating a potential problem; that will never actually materialize.
Part of the dream of Bitcoin, to many of its supporters, is a form of money free from manipulation. This means both that the authorities cannot censor transactions and also that the authorities cannot alter the supply or engage in manipulative monetary policies, which many Bitcoiners consider to have been destructive to the economy. In particular, the allegation is that interest rates have been kept too low for too long. Under a Bitcoin system, interest rates could be determined more freely, by the market. People can freely engage in lending arrangements without regulation and the invisible hand of the market will ensure that the return on assets, time preferences and supply and demand for credit of all market participants, consumers and investors, are all factored in. Since the Bitcoin supply is known, we no longer have the problem of a large gold discovery causing unexpected inflation. We also no longer have the problem of trying to calculate the natural rate of interest, whatever rate the market decides is the most appropriate rate. The prices of other goods and services in the economy are not set by the authorities, so why should the price of money be any different?
Throughout Bitcoin’s history, borrowing Bitcoin has been considered inappropriate for various reasons. Firstly, the price has appreciated considerably. This raises the question as to why a borrower would even want a liability in Bitcoin, a liability that could keep increasing in value. There is no real significant circular Bitcoin economy emerging and no businesses have Bitcoin denominated revenues (perhaps with the exception of Bitcoin miners and Bitcoin financial services firms). Therefore, why would any business want a loan in an appreciating currency that doesn’t match up with its revenue? Instead, most businesses would much prefer a fiat loan than a Bitcoin one. Only a small number of entities have borrowed in Bitcoin, normally for highly specialized purposes.
Whether an economic system with a free-floating Bitcoin interest rate will work is an open question. Even if the completely free market approach is adopted for Bitcoin rates, it might not even be the case that the Bitcoin interest rate would be significantly higher than the interest rates for fiat money. It could, for example, be cheaper to borrow in Bitcoin. While demand to borrow Bitcoin is low, demand to lend Bitcoin is often quite high. Because Bitcoin has a supply cap and it tends to appreciate, demand to invest and save in Bitcoin is high. Investors do not need to be encouraged by high interest rates to invest in Bitcoin, as they want exposure to an appreciating asset anyway. Therefore, perhaps Bitcoin interest rates should be very low. In Bitcoin’s short history, most Bitcoin interest rates have indeed been reasonably low. However, due to a lack of sustainable demand for Bitcoin loans, it is difficult to see how this debt market will mature and what kind of interest rates we could experience in the long term.
The desired endgame for most Bitcoiners is clear, they want the free markets approach to interest rates. Many Bitcoin supporters believe in a hyperbitcoinisation type scenario, where rampant inflation causes a loss of confidence in fiat money. Bitcoin then becomes a significant store of value in the economy and some merchants begin demanding payments in Bitcoin. Bitcoin could then become a major unit of account. If this happens, some businesses may slowly start to want to take out loans in Bitcoin. Interest rates may then finally be free to some extent, perhaps for the first time in history.
In this scenario it is difficult to reason much about what kind of interest rates we would have. What levels would interest rates be? How volatile would interest rates be over time? What would the interest rate duration curve look like? What would the dispersion of rates be across different lenders and borrowers in the economy? It is unlikely we will obtain the answers to these questions by analysis or logical reasoning. We would just have to wait and see. What we can do, however, is look at the story of interest rates in Bitcoin and cryptocurrency so far.