FINANCIAL ECONOMY DURING A REFORMATION
In the Reformation we saw the emergence of a new cultural and economic
class trying to defend itself in a dynamic, volatile and hostile environment.
It was a network of idiosyncratic economic actors, highly invested in their
cause, cut off from traditional ways of doing business, with highly potent
defenses at their disposal. Driven by a ferocious demand for increased
financial security, this resulted in a number of innovations and secular
trends. Below, we discuss several characteristics of the 16th century Dutch
financial economy, and extrapolate from them some likely parallel trends
that could sustainably emerge in the bitcoin space.
DEPOSIT BANKING: FULL RESERVE, STRICT PROTOCOLS
In 1609 in the Netherlands, merchants and city officials collaborated to
found the Amsterdam Wisselbank (AWB). It served two main purposes. First,
to guard the gold and silver wealth carried by the many hundreds of merchant refugees from the Southern Netherlands and other territories. Second,
it would issue internationally trusted, florin-denominated bank money and
bills of exchange.
The level of security of the AWB at the time was unparalleled in the world.
It was located in Amsterdam, a city protected by the Dutch Waterline, which
formed a moat over 50 miles long. The bank’s vault and operations were
located at the town’s most central and visible location: city hall. And the
bank’s organizational structure reflected a strong desire to be uncompromising in its fiduciary duties. The AWB counted four commissioners, and it was
prohibited for the physical office to ever be staffed alone. The commissioners supervised four bookkeepers, four counter-bookkeepers, three receivers
and a precious metal assayer. To prevent fraud, each of the bookkeepers was
only responsible for a designated task.21 The VOC trading company, arguably
the most powerful economic entity of its day, was an AWB account holder
and it only made payments through the Wisselbank.22
Despite a somewhat blemished track record as a full reserve bank, the reputation of the AWB was unparallelled in the 17th century, and its stability
and reliability played a key role in the prosperity of the Dutch Republic. As
late as 1820, Adam Smith in The Wealth of Nations praised the money of
the Wisselbank for “its intrinsic superiority to currency.” The AWB was not
cheap: it charged a 1% annual storage fee for gold coin, as well as opening
fees, transaction fees, and a 1.5% withdrawal fee. Overall, the advantages of
the AWB’s bank money were such that its banknotes carried an agio—they
traded at a premium versus the actual gold and physical coins they were backed by.
In the bitcoin community, in response to a cultural aversion of trusted third
parties, high risk of theft and loss, and long-term regulatory uncertainty, we
expect increased adoption of highly secure, trust-minimized bitcoin deposit
banking solutions.
The most trust-minimized solutions are those whereby theft or fraud is, by
design, rendered extremely difficult. With the use of delay mechanisms and
programmable nesting of signing authority, we’re seeing the beginning
of a compelling and robust custody suite for bitcoin, which can generate
a hitherto unparallelled level of security. We believe there is a lot of promise in the smart contract solutions recently explored by people such as Bob
McElrath23, Bryan Bishop,24 and Pieter Wuille.25 In that sense, the growing
adoption of multi-sig addresses for bitcoin storage is likely a promising start
of a much bigger trend. As of October 2019, 32% of all bitcoins in circulation are stored in the more privacy-friendly P2SH address format, and 12%
are visibly stored in multi-sig addresses (up from 0% in 2014).26
ENTERPRISE INSURANCE: CAUTIOUS WEB OF TRUST
With the 16th century seeing an explosion in maritime trade, it also meant
that financial technology was needed to deal with the accompanying risk.
The earliest forms of maritime insurance were in the form of “sea loans,”
which commanded a high interest rate as they were only repaid upon a
boat’s safe arrival at destination. This type of contract was especially useful if the investor did not have access to full information about the profitability of the sailor’s venture. An alternative was the “comenda” contract,
which gave the investor the right to share in the profits of a voyage in the
case of a successful completion. Both were imperfect substitutes of maritime insurance.27 Early insurance contracts have been found in Italy, where
merchants themselves acted as underwriters—which later gave rise to the
mutual form of insurance. By the sixteenth century, insurance had spread
to Britain, France, Holland, and Spain. One recurring challenge for the merchants was with claim collection; some financial centers proved less reliable
than others and a merchant went with the wrong underwriter he might never
see his money. Given how hard essential information was to come by in the
immature shipping market, the agency risk for underwriters was substantial.
Sometimes merchants would deliberately over-insure and sink their ship,
or they would buy insurance on a ship they knew was already lost. Because
of the high risks involved, merchants paid a premium for quality underwriters, and underwriters would often confine themselves to working with merchants they could trust. Other factors that determined insurance rates were
the financial stability of the underwriters and the city’s rule-of-law culture.
Insurance broker licensing and guilding was repeatedly tried by authorities
in Amsterdam and Venice, but remained largely unpopular.
Insurance in the bitcoin industry is still in a very early stage. Since the
advent of the bitcoin mining industry in 2013 we have seen many examples
of proto insurance contracts: investors will pre-order mining rigs from mining startups, who use the proceeds to produce the chips and manufacture
the machines, and, similar to 16th century maritime trade, upon successful
completion of the mission, are then able to share in the venture’s profits.
Also several bitcoin custodians have some form of insurance, but the fine
print often shows that it’s only the hot wallets that are insured—which usually represents less than 10% of the bitcoin under management. Similar to
16th century commerce, there are a plethora of unknowns when it comes
to underwriting risk in the space: price volatility risk, regulatory risk, infosec
risk, service provider risk, and so on. Given how globally saleable bitcoin is,
even nation state level attacks cannot be ruled out. Insurance providers that
are successful in this space will have to be extremely knowledgeable about
both operations and technology, and will need to work within a framework
that guarantees accountability and long-term relationships. It is no coincidence that self-insurance in the form of a reserve fund has become a staple
of the bitcoin custody industry.
LIQUID COLLATERAL AS BASIS FOR LENDING %story% DERIVATIVES
In 1602 merchants from the Netherlands merged together six small companies and pooled 64 tonnes of gold to form the Dutch East India Company
(VOC). The VOC’s mission was to own and operate a fleet of merchant ships
to trade with Asia, for which it received monopoly privileges by the Dutch
government.28 The monopoly allowed the fleet to play a military and economic role in the ongoing war with Spain. In 1604 the company did a public offering—the first modern IPO—allowing any buyer to own its shares. It
was a success: in Amsterdam, over 2% of the population subscribed.29 The
deliberate absence of bearer shares and the clear ownership and transfer
rules fulfilled key requirements for a transparent market.30 In 1610 the first
dividends were paid to investors.
The VOC shares proved highly liquid and desirable as collateral: within
months after the company’s foundation, shares valued at 27,600 guilders
were used as surety in a prisoner exchange deal. And in 1607 a nobleman
borrowed 2,000 guilders at 8% against 3,000 guilders worth of VOC shares
as collateral (LTV ratio of 66%). The collateral market for VOC shares was
very active, but because it was a private market not many records survived.
By 1623 the government specifically regulated the procedure for VOC share
liquidations in the case of loan defaults by their owner, and by the 1640s
the Amsterdam stock exchange had a regular repo trade operation for VOC
shares. Interest rates on the Amsterdam market for (secured) loans dropped
from 8% in 1596 to under 6% in 1620. The deep liquidity of the VOC market also made them the perfect underlying asset for a flourishing derivatives market in 17th century Amsterdam, with forwards (including shorting),
options, and repo contracts. In his VOC focused dissertation, historian L.O.
Petram concludes that “after the period 1630-50, investors were primarily
interested in the financial services the secondary market provided, rather
than in the East India trade itself.”31
Shifting over to today, we see similarities between bitcoin savers and the
historical VOC shareholders: they are often long-term committed, they have
a relatively high concentration of their wealth tied up in the asset, they don’t
like to sell it as that triggers capital gains taxes, and as millennials they have
ambitions to make further investments. Going forward, we expect the use
of bitcoin as collateral for borrowing to become increasingly widespread.32
We are also bullish on bitcoin derivatives markets, as it allows businesses
to precisely tailor their risk management strategy as they pursue sustainable growth in the bitcoin industry. Our hypothesis is that the sectors in
which price volatility impacts an economy the most will grow the largest
derivatives markets: VOC shares in 16th century Amsterdam, agriculture and
precious metals in 1980, interest rates today, and tomorrow perhaps bitcoin.
ACCESS TO CAPITAL IN A DEFLATIONARY WORLD
Life annuities are contracts that are sold for a fixed price, giving the issuer
the right to receiving regular payments for as long as he lives. They were
frequently used from the 14th century onwards as loan substitutes, because
they didn’t violate the Catholic Church’s ban on usury.33 (From the 16th century, the law usually guaranteed that perpetual annuities could be cancelled
by paying back the capital sum.) Life annuity contracts were often used to
fund capital-intensive enterprises that had a relatively low risk profile: businesses, farms, and local governments. In the 14th century Lowlands, two economic profiles emerged. In the coastal area, with sandy soils and regularly
pestered by floods, many landowners borrowed themselves into eventual
expropriation. In the more stable interior of Flanders, annuity-based credit
was used for accelerating business development (most often to unlock a
real estate investment), while older inhabitants would buy the contracts as
a form of retirement income. Annuities could be transferred to third parties
and thus became a popular financial instrument among the urban population. As the Dutch Revolt came into swing, and as income from maritime
trade increased, the protection of cities and their citizens became more
important, and cities would raise capital by means of issuing annuities.
An important reason why annuities were popular so much earlier than
mutual life insurance (which only emerged in 18th century England), was
that it requires a lot more trust in the entity providing the policy—the insured
needs to literally trust them from beyond the grave, and there is no collateral
that can be clawed back. There was potentially a cultural component as well, where customers felt more comfortable betting on a long life (annuity) than
betting on a shorter one (life insurance).
Having only recently passed its 10th anniversary, bitcoin denominated
lending is alive and well. Genesis Capital reportedly generated over $2
billion worth of bitcoin-denominated loans and borrows since launching in
March 2018.34 We’re seeing demand coming from hedge funds, businesses
with bitcoin inventory, and individual traders. We see a parallel between historical annuities issued by Dutch cities and today’s IEO tokens, which stands
for “Intial Exchange Offering.”35 For example Bitfinex created an IEO token
(called LEO) in order to tap the market for liquidity during a legally challenging time, as well as to de-risk its Tether related liquidity problem.36 By
making an open-ended offer to repurchase LEO tokens at market value, this
token has annuity-like characteristics. Other offshore exchanges have done
the same: Binance created an offering with Binance Coin, Huobi launched
Huobi Token, and FTX has FTX Token.37 Bitcoin exchanges often have loyal
customer bases which depend on their services to some extent, and these
tokens allow them to tap into that trust by in effect borrowing from the
public. In analogy with the embattled Dutch towns and the income hungry
merchants, we expect a continued popularity of these annuity-like offerings
among offshore bitcoin exchanges and crypto trading millennials. In fact,
they are the first examples of proto life insurance products in the bitcoin
marketplace. Over time we expect the emergence of life insurance mutual
companies, which might very well breathe new life into the severely weakened traditional life insurance industry. Studies have repeatedly shown that
inflation dampens demand for life insurance over time, and so conversely if
bitcoin-as-hard-money sees widespread adoption, it is logical for life insurance products to become highly popular once more.
CONCLUSION
Venture Capitalist Eric Weinstein recently opined that the adage “good ideas
beat bad ideas” is false, and that the correct formulation is rather “fit ideas
beat unfit ideas.”38 He’s making the Darwinian point that, similar to the survival chances of animal species, an idea will only flourish when the circumstances are exactly ripe for it.
And indeed, history shows the quality of an idea in itself is not enough
for it to blossom socially. A working steam engine was described by Hero
of Alexandria in the 1st century BC, and yet it was only commercialized
1,600 years later. The movable type printing press already existed before
Gutenberg’s machine, in 14th century Korea - yet didn’t lead to a revolution
there. And centuries before Columbus and Hudson, the vikings had already
landed in America. In other words, often circumstances are such that a highly
potent idea just doesn’t make into popular adoption.
But once in a while, the puzzle of circumstance fits together in a peculiar
way, creating fertile ground for many ideas to be adopted at once, and allowing for a spectacle of chain reactions that profoundly reshapes society. The
Protestant Reformation was such a time: ideas germinated, rebellion erupted,
wounds healed, and a generation of radical entrepreneurs produced an
unprecedented series of foundational economic and financial innovations.
This happened 500 years ago, and it may be happening once more.
Today we see broad parts of society, millennials especially, acting increasingly critical of central bank interventionism. At the same time technologists, at an accellerating pace, are developing an array of tools that allow
for disruption of the economic status quo. In a decade the millennial generation is projected to have the highest earning power of all generations,
and this tech-savvy post 9/11 generation has encryption to its disposal as
a defensive technology. Meanwhile the bitcoin ecosystem is maturing in all
aspects of its economy, in particular in deposit banking, insurance, lending
and derivatives, and early forms of life insurance. If this process persists, bitcoin’s layered protocol suite could become a global powerhouse and potential alternative to the IMFS.
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