Monday, July 4, 2011

Shorting the Dollar

The situation in Washington continues to fascinate one with its utter insanity.  Republicans walked out on talks to raise the debt ceiling after refusing the Democrats' generous deal to end the deficit which only closed 20% of the budget gap through increased revenue (ending tax loopholes) and accepted 80% in spending cuts.  And the Senate has refused to even debate the debt ceiling openly on the floor.

Both sides are stalling and stonewalling, and it is looking more and more like the August 2nd deadline may arrive with no deal being reached, and so the U.S. may go into at least a technical default, failing to meet some financial obligations, or (I half expect) paying some bills by just printing new currency (resurrecting the old United States Notes, for example - which are still legal tender, but are no longer backed by gold).  Of course, international investors would react to any kind of default with complete horror and shock.  Standard & Poors has said that if this happened, they would immediately lower the U.S. credit rating to "D" - their lowest score.  And certainly, investors would shed U.S. Treasuries like the plague, knowing that they were no longer a safe investment.  Yields on T-bills would skyrocket so high that we would be forced to keep printing more and more money just to keep the interest payments manageable.  The value of the dollar would plunge on the Forex, and in general across world markets.  And back in the U.S., price inflation would skyrocket, as critical imported commodities - most notably oil - suddenly became much more expensive.

One wonders, in the current environment, whether it might not be prudent to hedge against the possible loss in value of one's dollar-denominated investments (including stocks in companies that hold a lot of cash) by short-selling the dollar - which just means, taking a short (leveraged) position in dollars against some other, more inelastic commodity.  Many suggest gold, but the gold supply could always increase unexpectedly - for example, a lost cache of gold and other treasures valued at $22 billion was just discovered in India.  Further, if global investors collectively lose faith in the dollar as a reserve currency, large institutional holders of gold may be forced to open their long-sealed vaults, as they start using bullion again as their preferred medium for conducting regular international settlements.  As the "velocity" of exchange of non-dollar-denominated transactions increases, the effective supply of gold that is actively in circulation may actually increase (rather than decrease), so the price of gold may not fare as well in that environment as one might otherwise expect.

As a result, my best suggestion for hedging against a fall in the U.S. dollar is to short-sell the dollar against not gold, but the Bitcoin.  The base supply of Bitcoins is guaranteed, by the nature of its peer-to-peer protocol, to increase only at a slow and decelerating rate, until the limiting supply of 21 million is reached asymptotically over coming decades.  Bitcoins are mathematically impossible to counterfeit, and they can only be obtained by exchange or by "mining" them - which is the slang term for helping to secure the authenticity of transactions within Bitcoin's peer-to-peer network.  The important point is that the supply of Bitcoins cannot be hyperinflated by any government, or other central authority.  And unlike gold, they can be transmitted between parties very easily and at negligible cost directly over the Internet.

How does short-selling work?  It is actually very simple.  All you need is a way to borrow a substantial amount of the asset you are shorting.  For U.S. dollars, a simple cash loan (from any source) would suffice.  Depending on how confident you are that the dollar will fall, you might even be willing to take a cash advance on your credit card.  (Personally, I would, if I still had any credit cards.)  Then, you exchange the asset you're shorting for something else whose (medium- to long-term) stability you are more confident in - which (in my case) is Bitcoins.  (Why not Euros?  In part because the Euro, too, is in danger, because of the Greek debt crisis, which is not over yet, not by a long shot.)

U.S. dollars can be traded for Bitcoins on any of several exchanges, the most popular of which is Mt. Gox, which recently suffered a setback (it was taken down by hackers for a week), but no permanent harm was done in the attack, and it has come back more secure than ever.  It is still by far the most popular exchange.  The price of Bitcoins in U.S. dollars is fairly cheap right now (down about 55% from its high in early June), but it can be expected to rebound significantly if the U.S. goes into default.  Anyway, its longer-term trend has been an increase in price by more than 100x over the last 9 months.  (See logarithmic chart below - the price increased from below US$0.10/BTC to more than $10.00/BTC from Oct. 2010 to July 2011.)

Bitcoin price in US dollars over the past 10 months. (Click to enlarge.)

Let us now examine a hypothetical scenario for a short-sell play.  Suppose one borrows US$10,000 for a 1-year period at 10% interest, and immediately exchanges it for Bitcoins (BTC) - at the current price of about US$13.50/BTC, this would buy the short-seller about 741 BTC.  Now, suppose that the U.S. goes into at least a technical default, and international investors start dumping the dollar, and its value (measured in terms of a basket of currencies and/or international commodities) goes down 50% over the next year.  Then, even if the overall popularity of Bitcoins did not grow at all over that period, their value in US dollars would go up by a factor of 2x (+100%) because of the fall of the dollar.  So the 741 BTC would become worth $20,000, and you could pay off the original loan ($10K) plus the interest ($1K) and have $9K to spare.  This, then, effectively hedges the short-seller against the possibility that $9K worth of his personal savings might decline in real value by 50% over this period.

Alternatively, if the U.S. doesn't default, and the value of the dollar stays about the same, and Bitcoins retain the same popularity that they have currently, then their price in dollars stays about the same, and so at worst you can just sell the Bitcoins at the end of the year and pay off the debt, and you are just out the $1,000 in interest - which is worth it, perhaps, for the added peace of mind that you gained with the hedge.

Of course, the picture looks far better if we build into the model that the Bitcoin may continue to gain in popularity as more people learn about its benefits, as it has done in the past.  Suppose conservatively that the popularity of the Bitcoin increases just 10x over the next year (compared to its 100x increase over the past year) - this could happen either because of the widespread debt crisis in the world's leading sovereign currencies, or just because of increasing public knowledge and education about Bitcoin's security advantages.  If this happened, then the initial $10,000 investment in Bitcoins would turn into as much as $200,000 (if the value of the dollar falls by half), or at least $100,000 (if the value of the dollar stays the same).  In either case, the $1,000 interest payment on the loan becomes completely negligible, and the short-seller has gained enormously (since effectively, the value of the dollar in Bitcoins has indeed fallen greatly, by a factor of 10-20x).

As a result of the above considerations, and because of my own uncertainty about the near-term prospects for the U.S. dollar, I am hereby publicly announcing that I am willing to take a personal loan from anyone, at 10% interest (or less of course), and of any size from $1,000 up to at least $10,000, which I will personally use to short the dollar against the Bitcoin in coming months.  (I would offer to take even more, but I want to be responsible, and make sure that the loan is for an amount that I could surely afford to cover the interest payments on even in the worst case.)  

So, dear readers, put your money where your mouth is.  If you, unlike me, believe that the value of the dollar will almost certainly remain fairly steady over the next year, then you should view 10% as a pretty decent return on investment, and offer me a loan contract.  

But if, like me, you have some serious doubts about the prospects for the U.S. dollar (along with other national currencies) looking forward, then, like me, you should similarly be willing to borrow as many of those dollars as you can responsibly afford to pay back, and then use that leverage to buy up all the Bitcoins that you can.  Or, you could reasonably stock up on petroleum ETFs or something like that instead, although if the global economy tanks, demand for oil might not do so well either.  And, unless you're already a sophisticated investor, buying Bitcoins is a heck of a lot easier.

In other words, bottom line is, if you want to protect your personal savings right now, you should short-sell the dollar, one way or another.  I know that I am.  If you disagree, then please send me your loan offer at michael.patrick.frank@gmail.com. :)

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