A proposed inefficiency in the Bitcoin markets

The book Fortune's Formula describes a simple investing scheme invented by Claude Shannon, referred to as "Shannon's Demon", that's specifically designed to make money in markets described by log random walks. I found a blog post describing the scheme here. (Some previous discussion.) I'd expect this kind of volatility harvesting scheme to work better for Bitcoins than for other assets because Bitcoins are more volatile.

However, I'm not convinced that the market for Bitcoins is efficient... for example, there are going to be 84 million Litecoins to Bitcoins' 21 million, but typical investors don't know that, so 4 Litecoins for $100 feels like more of a steal than 1 Bitcoin for $100 (even Silicon Valley software engineers commonly forget to account for this basic division operation). There was talk on /r/bitcoin about how once the price got to the $1000 range, people seemed reluctant to invest since it seemed so expensive and how things should be reframed as "mBTC". And I'd expect that quant firms are reluctant to trade bitcoins due to factors like institutional regulation and it not being serious-seeming enough for themselves or their investors.

If you were a quant, you would know that random walks on a log scale (geometric Brownian motion) are what people normally use for asset prices. It's what's beneath Black-Scholes, for example.

Ok, I admit I was ignorant of this. I just observed that the graph in the Wikipedia article for "Random Walk Hypothesis" was linear-scale. Thanks.

The point can be formulated even stronger: An additive random walk will go negative.

My main issue with Bitcoin is a consequence of point 2: How can Bitcoin, in the long term, possibly avoid a deflationary spiral? At a certain point, it can't inflate any more.

My other issue is that the maximum number of tradable units of Bitcoin is 21 million BTC / 10^-8 (smallest fraction trade-able), and 10^15 is not enough currency to run a serious global-scale economy on. But that can be fixed with additional cryptocurrencies more easily than the first problem.

Is there a way to outguess real estate markets that doesn't involve buying relatively illiquid properties for thousands of dollars?

BTW, I would be interested in seeing a list of exotic markets if you've got one handy.

There are also fun and shiny exotic alternatives.

Salviati: I am proposing a way to outguess any markets that look like random walks on a log scale with a big step size.

I'd take bets against Bitcoin resulting in any significant restructuring of government. Remember, Warren Buffett pays lower tax rates than his secretary. Criminals around the world are already quite successful at money laundering. And yet society has not collapsed. This won't collapse it either.

It could be that I'm wrong in my reasoning, but it appears to me that bitcoin allows tax evasion and black markets to function on such a breathtaking scale.

Bitcoin has less anonymity than cash. Every movement of coins is recorded in a publicly verified ledger. You can use some trickery like CoinJoins to try to regain some privacy, but even these can be mitigated by state-level actors, and don't solve the problem that actually spending coins typically revels your real-world identity to the merchant you are interacting with (who must comply with local KYC laws).

You know what allows tax evasion and black markets on a breathtaking scale? Greenbacks. Do you think a criminal - even a technically competent one - would prefer a suitcase of cash or bitcoin transaction? One of these is, outside of extenuous circumstances, truly anonymous and untraceable.

it appears to me that bitcoin allows tax evasion and black markets to function on such a breathtaking scale that if bitcoin persists and expands into common use then I anticipate, like tomatoes in winter, the withering of formal governmental power in its current form

I don't think this is true.

Let me list some points in random order.

• Cash allows tax evasion and black markets to function. In the years BET (Before Electronic Transactions) cash and similar pieces of paper were very very popular and they did not destroy governments.

• Bitcoin is not anonymous. It's pseudonymous with transactions being always public. An actor with state-level resources (e.g. the NSA) would likely be able to track sufficiently large amounts of BTC.

• Governments have official currencies. There are enough coercive pieces in there so that you can't just run a whole economy on bitcoins and simply ignore the official currency. This means there must be exchanges and they will be very very important. These exchanges are / will be under full effect of government regulations.

• Non-virtual businesses cannot and will not just pretend not to exist and so not owe any taxes (e.g. payroll taxes). Tiny businesses can try to stay under the radar, medium and large businesses can not.

• Consider a typical contemporary office worker. He gets a salary, say, in USD. His employer reports that salary to the government so that the government withholds a variety of taxes. Let's say that worker now gets his salary in bitcoins -- how does it improve his capability to evade taxes? His salary is still reported to the government.

I think the potential society-level impact of Bitcoin has been seriously overestimated.

There are plenty of revenue sources available even to a government that can't effectively track financial transactions. To name one, you can't hide real estate, or other physical commodities, behind crypto.

Maybe they're not cracking down on Bitcoin for the same reason China isn't cracking down on free online proxies. (Read the whole post.)

That could be a top-level Discussion post.

You are underestimating... Very badly.. Both the coercive power of a modern government and the sheer bloody-mindedness of a modern government in the face of overt threats.

If what it takes to stop that senario from happening is a zero'th level block in every motherboard, tablet and smartphone sold then you will not be able to buy hardware without that lockout. Chipfabs and assembly plants cant hide from the nice people with the automatic weapons, after all.

Current tax havens exist - at all - because politicians are not really very interested in shutting them down. It would be trivial to destroy them, and wouldn't take a single bullet. All it would take would be to stop recognizing money transfers to and from those jurisdictions, and the caymans would be nothing but a serverfarm with a bunch of pointless ones and zeroes on it. Escalating to the point where tax evasion become an actual threat, rather than a reason for more donations to politicians would be darwin award level of stupid. Bitcoin is that stupid, by design. Thus it is going to get stomped on.

Which means "the smart money" are likely viewing the bitcoin market as a classic case of tulip mania. This does not mean they are not investing - it is really easy to make money in an inflating bubble if you know you are going to get early warning before it collapses. Hedgefunds have congress critters on payroll, and can therefore be confident that they are going to know that the hammer is about to drop in advance of every other player in the market, and unwind their position onto suitable patsies. Such as tech-libertarians who are buying into the narrative. In the final reckoning, bitcoin might as well have been deliberately designed to separate you. Yes, you. The person reading this. From your money.

It could be that I'm wrong in my reasoning, but it appears to me that bitcoin allows tax evasion and black markets to function on such a breathtaking scale that if bitcoin persists and expands into common use then I anticipate, like tomatoes in winter, the withering of formal governmental power in its current form (based as it is on tax collection

Do you know how they catch tax evaders in Italy? They go to the harbour and look at the yachts. edit: and pretending to be poor to cheat taxes completely defeats the point of being rich. Granted, some people will do that, but they effectively eliminate themselves from the economy, as if those coins disappeared, raising the value of all other coins. They pay nearly 100% tax rate. It would be worthwhile to encourage that kind of behaviour, it's good for the environment, and it taxes more than any government taxes.

This is a long and well presented comment: I will chime in with army1987 that you could certainly write this up as a top level discussion post.

My response to it is that I think you are overestimating the value of our current form of government. This could be taken the wrong way, so let me be clear: It is a very good thing that w have a government. Without it, our lives would be nasty, brutish and short. Despite this, government-as-we-know-it (nationalism) is a very recent invention, and while it does some great things (and some not-so-great things), it (in its current form) is far from essential for society.

Democracy is better than monarchy, yes, but that does not mean it is the ideal government. (Recall that famous Churchill quote.) Trying to preserve it when future technology renders it obsolete is a bad idea, in my opinion.

So what should replace it? That is a deep and important issue, and one I can philosophise in depth over. This comment is already long, so I will spare a lengthy discussion here, but it suffices to say that while I am not sure, and this is a topic that needs much deep research and serious thought, I do see several possible directions and solutions that could bare fruit. If you are interested in continuing this conversation I would be happy to expound upon them.

In short, my two related arguments are that: 1) While Bitcoin may or may not bring down nationalism, that in itself does not mean anarchy and and a Hobbesian state of nature; and 2) Democracy is nice, in that it's better than most other forms of government, but it's by no means essential.

This is definitely a good word of warning, and I think it's 60% likely that when the first serious Bitcoin-shorting vehicle is introduced, there will be at least a 30% price drop in the first week (if 60% seems high, remember Bitcoin drops 30% lots of weeks).

I think Dogecoin is an even starker example of what's possible when you don't have a derivatives market.

Tangent: Wtf is up with the various types of derivatives markets? Why can't we just have asset markets and prediction markets?

Hm, pretty sure your logic doesn't make sense here.

By your logic, Euros/Dollar, Yen/Dollar, and other currency prices would also be random walks on a log scale. But I don't believe they are.

I think the reason Bitcoin is a log-scale random walk is that people's beliefs about BTC's Expected Value is Fermi-estimate-like.

And I think the only reason stocks and other standard exponentially-increasing investment vehicles are exponentially increasing, is because they entitle you to a constant fraction of the exponentially-increasingly-valuable economy.

can't dispute the conclusion but I object to the argument.

Because, the argument doesn't apply to this model: "Probabilities are calculated from a random walk, except for large unlikely changes, or changes when the price is near zero."

Approximate models always have a range of applicability. Showing that the model gives absurd results outside the range of applicability for which it's intended doesn't mean much.

Then if it goes to 900$, it has an equal chance of going up or down 90$ the next day

No, it would have an equal chance of going up $100 or down $90.

O hai.

Imagine if everyone agreed that the best way to calculate Bitcoin's expected future value was to look at a single source of news: the Bitcoin guru. Every day, if the Bitcoin guru goes on TV with his thumbs up, then everyone agrees that that is worth a Bayesian update of 1.25x to the expected future price, while thumbs down is worth a Bayesian update of 0.8x. And no one has a better model of how the Bitcoin guru's thumb works than the fair-coin-flip model.

In other words, pretend you know that everyone's expected future value of Bitcoin follows a log random walk. Now you can use inductive reasoning to conclude: If the expected future value of BTC is $1000/coin today, then it will be either $1250 or $800 tomorrow.

I used to think an "efficient market" was necessarily a market which current price captures people's consensus expectation of future prices. But in my example, it seems possible to have a guaranteed-positive-return trading strategy: investing say 10% of your portfolio in BTC, and constantly trading as required to rebalance your 10% asset allocation.

There are a few names you can use for that...

"Drag Trading": trading that causes market prices to be dragged toward their past value and away from their current expected future value.

"Shannon's Demon": a kind of Drag Trading - trading to maintain a constant % of BTC in your portfolio, i.e. near-continuous portfolio rebalancing.

"Kelly Criterion Trading": An instance of the Shannon's Demon strategy, where you choose your asset percentages in proportion to their long-term future relative value, which you derive by asking yourself what relative percentages of the world's wealth are stored in your different asset classes.

My big point has two parts:

1. I think I've shown that an "efficient market" might not have prices that directly reflect a consensus of future prices, but instead might show some "price drag".

2. Bitcoin's wildly swinging prices is evidence that it is lacking this "price drag", unless the model of expected future price drag is even more volatile than the exponentially-volatile one in my thought experiment.

Therefore drag-trading Bitcoin seems promising.

I don't know what gave you the idea that I'm talking about Bitcoin prices rising.

I'm suggesting there's a systematic inefficiency, that the price changes with a predictably large magnitude but an unpredictable direction.

Hey, that wasn't nice. I assume Liron was partially trying to find advise and/or co-investors for making money off this himself.

Which thread in /r/Bitcoin?

An improvised model for explaining the seemingly exponential growth is the belief that there is inherent risk of being forgotten as a currency but that this risk falls exponentially with time or price itself.

There no reason why that risk should fall.

Bitcoins has such risks as a mathematician inventing a way to break public key crypto that would completely destroy it. Again if people build useable quantum computers, bitcoin is gone.

For being an digital currency bitcoin has massive amounts of transfer costs. It's possible that someone creates a better online currency.

How does this "negative drift term" work? What variables are in it?

Alright, done.