While it appears that Bitcoin currently stands a chance at avoiding the sort of arbitrage detailed herein — due to the fact that fees are mingled with coinbase reward, meaning fresh UTXOs can still be tainted — who is to suggest that a new digital currency with a less decentralized and privacy-centric architecture would not be subjected to this sort of arbitrage?
And who is to suggest that privacy will ever be fully realized on Bitcoin? It is currently very difficult to maintain full privacy throughout a full transaction life cycle, and the powers that be are not exactly pro-privacy. To automatically assume that Bitcoin will offer any individual the ability to privately transact moving forward does not factor in the nuance of the situation.
In fact, a small premium to spot price for newly mined BTC currently exists (albeit being for unique reasons and, perhaps, only a temporary phenomena) so this article merely extrapolates where this premium can go from here when applied to a currency that does not employ some of the creation, distribution, and tracking mechanisms that Bitcoin does.
Privacy versus regulatory and technical issues aside, let's just say that a "yet-to-be-developed" digital currency with minimal privacy features is going to be released tomorrow. In reference to the IMF's Special Drawing Right (SDR) basket of currencies framework, let's call this currency "SDR", and assume it follows a similar path as that being taken by Facebook's Libra project. And I will assume that the hypothetical digital SDR is identical to Bitcoin in many ways, less its privacy enhancements in CoinJoin, lightning network, Schnorr signatures, and others.
h/t to both Nic Carter and Dan Held for providing the resources to learn about Bitcoin's privacy-centric features and busting many of the industry myths with respect to virgin coin premiums.
I expect that large players coming into the digital currency marketplace will pay a healthy premium for freshly mined SDR.
Freshly mined SDR have something of immense value from a regulatory compliance and risk management perspective: a clean transaction history.
Considering the number of government agencies, companies, products, and services arising out of the want and need to track transactions, attribute wallet addresses to specific user types, and classify where transactions have taken place in the past makes one thing very clear:
In addition to digital currencies creating digital scarcity, they are also the most readily-auditable asset class.
That is another key component of its value proposition. SDR is auditable by anyone. It is a public ledger database with any and all information with regards to when a transaction occurred, who the interacting parties are, the amount of the transfer, and the confirmation of the value transfer via a Proof of Work consensus model that rewards the miners.
The thing about being auditable is that it provides transparency. With transparency comes trust and system integrity. This integrity can facilitate two strangers confidently interacting without having to trust one another.
More importantly, from a security perspective, an auditable transaction ledger provides immense value because with so many eyes on the ledger searching for discrepancies, any faulty transactions will be amended in rapid fashion. The same cannot be said of private databases, who notably suffer from having limited eyes on hand and eyes that shift with the ever changing wind of incentive.
With SDR being completely and fully auditable (in other words, not private at all) an entire secondary arbitrage market where people will pay for “clean” SDR in regulated environments and move “blood diamond” SDR to less regulated locales will emerge.
Focusing on the regulated environments, the reason why clean SDR will have a premium is because investors will not want the headache of interacting with governmental bodies and exchanges holding up transactions involving "dirty" SDR.
For example, should you have SDR that at any point interacted with a wallet address associated with terrorism, drugs, sex trafficking, or anything illegal, when you send this SDR to Coinbase to sell, Coinbase will flag this transaction and halt its execution in order to protect itself and its business from legal scrutiny.
Of course, during this transaction review process, as a trader/investor/fund manager you will have lost time in what could have been a profitable move.
What if the price decreases in this time? What if it increases? What if you missed out on an arb move because your fund transfer was caught up in the regulatory and compliance machinery?
Exactly how this process shakes out remains unclear. Yet, with increasing attention from both the public and the government bodies it will undoubtedly become a reality soon. With the number of companies working towards understanding each wallet address, tracking UTXOs, monitoring users, and the like, it is inevitable that shady transactions will come to be eradicated from highly regulated economies.
Just as in any other market, the shadiness will be exported to less regulated environments or environments that appear to be regulated but have extensive loopholes built into them.
So what will this premium be? 10%, 20%, 500%, more?
Considering the amount of time and resources that existing organizations spend on legalese, risk management, and compliance staff in order to avoid having any run-ins with the governmental agencies, I would posit that a 20-30% premium can be expected.
“We currently employ nearly 200 people (more than 25% of the company) in compliance-related functions. As of Q1 2018, we are processing more than 1 law enforcement request per day, seven days a week." — Kraken
“Bain & Co estimates that Governance Risk and Compliance (GRC) spend accounts for 15-20% of “run the bank cost”, and 40% of “change the bank costs”.
This range simply being derived from the amount of capex most organizations have with respect to staffing and operating the aforementioned legal, risk management, regulatory and compliance teams.
Implications
Accepting this concept that clean SDR will have a price premium relative to others with less desirable transaction histories creates interesting effects.
For one, it makes miners more valuable moving forward as they are the ones with first contact to SDR with clean transaction histories.
As we stand now, most miners take the SDR they’ve mined and stake it as collateral with one of many financial tech companies offering fiat loans. The miners partner with these companies, stake their SDR collateral on-chain with multi-sig wallets, and then take out fiat loans to keep the lights on, pay their staff, and pay general capex expenses.
In many ways, it is no different than how most commodity mining production companies operate. However, unlike commodity producers who have no transaction history concerns because commodities are not very auditable, SDR miners will have clean SDR supplies and investors will come knocking at their doors offering a premium to spot price for these clean coins.
This will create even further incentive for people to mine SDR moving forward, which in turn, accelerates adoption, competition, and the narrative even further.
Secondly, it will create and consolidate an entire industry for data analytics providers and brokers who deal entirely in identifying, sourcing, and executing the transfer of clean and/or dirty SDR.
Ecosystem intelligence providers will need to map out and attribute all of the wallet address clusters to specific user types and transaction types. They will do this using various methods, but in essence, they will be able to understand what kind of entity lies behind each transaction that ever took place within the SDR ecosystem.
What if I hold an entirely clean wallet address full of clean SDR and I transfer in 1 dirty SDR, or 0.0001 dirty SDR? Is the entire wallet address now considered dirty? Can you separate out different SDR? How about separating out different increments of SDRs (think Satoshis)?
I have no doubt in my mind that provided with the proper incentive (which is implied by being bullish on digital currencies), the various data analytics companies will find methods to make these kinds of determinations, most likely by analyzing UTXOs and applying advancements in machine learning techniques.
At the same time, market makers and brokers will need to provide the marketplace and the pricing inputs for the various SDR transaction history classifications. These marketplaces will span borders, time zones, and languages and will only drive more liquidity to the asset class.
Conclusion
As I have said time and time again, it does not truly matter what pushes people into digital assets, so long as they come. Considering the financial incentives provided, it seems a very reasonable assumption to make that this network effect theory has many more chapters to fully play out.
As these chapters play out we can inevitably expect ups-and-downs, however when zooming out to a longer term time frame, the trend appears to have legs underneath it.
"People think about Bitcoin incorrectly. They think about it as currency or about gold or hoarding, speculation, about how much money do you make. When really, what it is is an API for programmable cash transactions."
— Naval Ravikant
DISCLAIMER : This content is for informational, educational and research purposes only. This post is not to be taken as personalized investment advice.