October 18th 2021.
In this episode Saifedean talks to Nik Bhatia, author of Layered Money. They begin by discussing Nik’s first essays on bitcoin, The Time Value of Bitcoin and The Lightning Network Reference Rate, and why Nik thinks “Lightning banks” are on their way. They move on to talk about Nik’s book, starting with an overview of how “layered money” developed on top of gold through financial institutions, and how this eventually culminated in the emergence of a pure fiat financial system. Nik and Saifedean also discuss money as it exists today, including the role of central banks and the eurodollar system. They end with a discussion of what the financial system of the future will look like, including why Nik is confident that both bitcoin and the US dollar will continue to exist throughout his lifetime, and why we should be concerned about the rise of CBDCs.
- Nik’s 2018 essay The Time Value of Bitcoin.
- Nik’s 2019 essay The Lightning Network Reference Rate.
- Nik’s book Layered Money on Amazon.
- Explanation of the Bretton Woods System on Mises Wiki.
- Bank of International Settlements paper on the Triffin Dilemma, referenced in Layered Money.
- Bank of International Settlements paper on Central Bank Digital Currencies, referenced in Layered Money.
- 1971 paper by Federal Reserve Bank of St Louis, The Euro-dollar Market: Some First Principles, referenced in Layered Money.
Saifedean Ammous: [00:05:09] Hello, and welcome to another episode of The Bitcoin Standard Podcast. Our guest today is Nick Bhatia, a financial researcher and adjunct professor of finance and business economics at the University of Southern California Marshall School of Business. He teaches applied finance and fixed income securities, and he is also the author of the best-selling book, Layered Money.
He currently also writes a research publication on Substack called The Bitcoin Layer. I’m very happy to have Nick with us today to discuss his book which is quite substantiative and very educational, very enlightening book about Bitcoin and about the history of money and how money works and really gets into the details and the technical aspects of how monetary systems function and how Bitcoin fits in within those monetary arrangements.[00:06:00] Nick, thank you very much for joining us.
Nik Bhatia: Thank you so much for having me Saif!
Saifedean Ammous: So first of all, I wanted to begin a little bit by discussing your background, how you got into Bitcoin, how you found out about it. I know you used to work in bond trading before, so how did you go from bonds to Bitcoin?
Nik Bhatia: So I admit that for probably three years, I would see headlines about Bitcoin in my general newsfeed and ignored them. That was from 2013 to 2016, because 2013 was the first time it rose above a thousand dollars and people in my world started to, at least at the periphery pay attention to it and things were starting to be written about it.
And those that were curious at the time were able to fall down the rabbit hole. And I just didn’t do that. I was at an early stage in my bond trading career and just trying to [00:07:00] focus on that. Now in 2016 I started to see the word blockchain come across my desk in terms of research reports from investment banks.
And in particular, there was one Wells Fargo equity research report about all these blockchain and Bitcoin affiliated companies doing exciting things in emerging markets. And I read the whole report and my takeaway was I should learn what Bitcoin is.
Because I didn’t know what the word blockchain meant, I didn’t know what Bitcoin was. So 2016 is when I started that learning process. I was still fully in the middle of my bond trading career and trying to gain more responsibility, trade more volume, more instruments. But I fell down the Bitcoin rabbithole. I [00:08:00] think millions and millions of people, once it pulls you in you cannot unsee it.
And I had the Austrian background already. I had already learned about sound money, I was an advocate for gold. I was long gold at the time and so I really instantly understood what Bitcoin could be from that gold perspective. And I read Nathaniel Popper’s book, which, was a good history of the early days and made it exciting and interesting, and then started listening to Dr. Adam Back because I knew that if there was anybody to trust in this whole thing, Adam Back would be a good place to start.
He was one of the first people that I listened to every podcast appearance and I think just like the rest of us, it was a lot of [00:09:00] podcasts and Reddit and other things at the time, just trying to learn everything I could.
And eventually I wrote my first essay on Bitcoin in 2018, The Time Value of Bitcoin and the feedback was overwhelming. And I just knew that this is where I should be, I should be writing about Bitcoin and trying to advance Bitcoin because I believe in it. And I believe that it’s a force for good, and I wanted to be all in.
Saifedean Ammous: It just draws you in, you do the first thing about Bitcoin and then all the other stuff starts taking a back seat in your life. That’s why it’s called the rabbit hole so often for so many people, isn’t it?
Nik Bhatia: That’s right. And it just started to dominate my intellectual capacity and it never reversed course.[00:10:00]
Saifedean Ammous: Yeah. You can’t really see yourself going back to writing and working on just purely fiat matters anymore, can you?
Nik Bhatia: No, you have to include Bitcoin at the center of everything. It’s not even just something that you include. It has to be, for me at least, it’s the anchor of everything.
Saifedean Ammous: Yeah. So before we get to your book, tell us a little bit more about that fascinating article you wrote about the time value of Bitcoin.
Nik Bhatia: While I was falling down the Bitcoin rabbithole, there was the SegWit debate going on. Just learning about what SegWit was, why were people talking about it so much?
They were talking about it because of this thing called the Lightning Network. I was learning about that, and when I was learning about Lightning Network and how it would be constructed, I envisioned this scenario in which [00:11:00] people would be posting their Bitcoin to these channels as a collateral sort of agreement, from my lingo perspective, it’s posting Bitcoin as collateral for the facilitation of payments and you earn a yield off of that and nobody had really articulated this.
Nobody had written about it. It was talked about, I remember Andreas Antonopoulos had mentioned that this type of routing activity could earn you income. And that by itself just completely grabbed my attention. I introduced this concept of the Lightning Network reference rate, which would be a reference rate, somewhat of an average of the yield that big nodes in the network are earning through their routing activity.
It was completely [00:12:00] theoretical and speculative at the time, but people are doing the same thing that I wrote about three years ago. They’re earning Satoshis from their Bitcoin channels on the Lightning Network. Those channels are open to route economic activity, which is happening. I use the Lightning Network all the time for commerce and it works.
People that I know are doing their routing activity and earning small yield, but there’s yield there. And the paper was basically saying that the fact that there will be yield, we can reference it in a risk spectrum, and the Lightning Network rate can be somewhat of a baseline for the rest of the Bitcoin yield universe.
Saifedean Ammous: Yeah. Under the current stage of Bitcoin’s growth, there’s probably more yield to be made by lending [00:13:00] Bitcoin to exchanges, which is where a lot of people get their yield, and a lot of Bitcoin interest rate businesses get their yield from, which obviously involves a bit of risk, but as Bitcoin and the Lightning Network grows, you would expect that these kinds of use cases would disappear because there’s not going to be much exchange trading of Bitcoin against fiat if there is no more fiat left.
On the other hand, you’re going to have a lot of activity taking place on Lightning because I can’t really see Bitcoin taking over without a lot of activity on lightning. So if that were the case, then yeah, the activity on Lightning will become the reference rate.
It’ll become basically the risk-free rate. This is what you can do by putting your Bitcoin on the Lightning Network, it’s the baseline for earning Bitcoin. So every investment will have to beat [00:14:00] putting your money in Lightning in order to round payments.
For the listeners who are not very familiar with the way that lightening works is, it’s a way for processing transactions very quickly, but the way that works is that you have to put up some money in a channel and you open a channel between you and another party on the network, and then you put some coins in and they put some coins in that channel. And the more coins there are, the more payments you can process through this channel.
And the way that it works is individuals need to find the route between the sender and the receiver. And so if you find the route, you go through these people who have channels with one another, who all have their Bitcoin placed on the network. The bigger the network, the more nodes there are, the more interconnectedness, the more people can pay one another.
And the more coins you have, the more you’ll be able to earn. So it’s a fascinating concept that you presented there, which [00:15:00] is that that will become basically the risk-free rate. I’m wondering, do you really think that it’s apt to say that putting money on Lightning is risk free? Doesn’t it involve the risk of something bad happening to Lightning?
Nik Bhatia: Absolutely. And it is more of the reference rate, right? Treasury yields as you know are not explicitly risk-free either. There’s a risk to owning them, it’s just called risk-free because,
Saifedean Ammous: everything else is more risky.
Nik Bhatia: Right, exactly. Everything else is more risky. And it’s also the terminology that’s used to describe reference rates, like the reference rate is the risk-free rate. LIBOR is also considered a risk-free rate in interest rate calculations as well. And we know that LIBOR comes with full counterparty risk, it’s basically an average of lending to banks, it’s an interbank rate. Risk-free is also, it’s just another way of [00:16:00] saying reference.
And I do believe that there’s plenty of risk in running a Lightning node and doing routing activity because you can mismanage your node or your channels and potentially lose your Bitcoin if you’re doing any activity in Bitcoin. The most important nuance here is that you don’t have explicit counterparty risk.
You’re not sending your Bitcoin away to somebody like exchange lending is, you don’t have the Bitcoin, it’s not yours, it’s not even in your exchange wallet. And so with Lightning, all of your channels that are open, it’s a smart contract. So if you close the contract you get to, it’s basically a call on your own funds.
And so in that way, because you have this call option on your funds at all times, [00:17:00] The Bitcoin is yours. The risk is unique because Bitcoin is unique and Lightning Network is unique, but it doesn’t have that explicit counterparty risk nature to it, and I think that’s very important. Now, I will also say that I use a custodial Lightning wallet for my transactions and I withdraw my Bitcoin, close my channels, whatnot, periodically when I feel like I need to use the blockchain and create my own final settlement.
But the act of running a lightning node and processing those payments and managing your collateral, managing your channels, it’s something that I would want to do really well. It’s not something that I would wanna half-ass or even just experiment with and not really pay too much attention to it.
I have to focus on writing as you know, so I’m writing, I’m not running a Lightning node and engaging in that type of [00:18:00] activity. But I do see this expanding, Lightning universe in which I will be able to post Bitcoin to a Lightning node operator that has disclosed their statistics, their routing statistics, and basically are offering me a counterparty situation where I sent them my Bitcoin, they use it to facilitate payments and I split the yield with them in some way, based on whatever the agreement is.
I’m excited to see that play out. It’s already starting to happen. Lightning Labs is doing terrific work with their allowing people to do all this type of channel management, in a more automated way.
So I looked for this kind of decentralized banking layer on top of Lightning to develop where everybody can be a Lightning Network node operator, route payments. [00:19:00] The people who do it best will attract the most capital, making a hobbyist maybe relegated to a very small yield.
And so this whole risk spectrum within Lightning network, something that I’m looking forward to seeing develop.
Saifedean Ammous: Yeah. In The Fiat Standard, I discuss the Lightning Network on the chapter on scaling Bitcoin, The Fiat Standard is going to be out next month. The way that I see it as not putting up money for Lightning is likely to develop into a professional activity more than a hobbyist activity over time, because I think there’s a very distinct difference between money that you hold as cash, because you want it to be available for you. People hold cash balances because of uncertainty about the future. You don’t want to have your money tied up in investments.
Ideally, you would [00:20:00] rather have your money earning a yield by being tied up in an investment, but then you choose to hold some cash because you you want to have some parts of your money not having investment risks, not having the risk of default because you don’t know what’s going to happen tomorrow. And because you want money that has a lot of liquidity and little uncertainty. Providing money for payment clearance is a distinct function from that.
Think about it this way, your checking account is money that’s the cash effectively, that you have, and it’s money that you’re using for your day-to-day expenses, it’s money that you don’t want to have to risk, it’s money that, in case of whatever happens in the world, you’ll still have that, or obviously not whatever, but it’s the money that has the least risk involved with it.
I can’t see that functioning also as that same sum working for clearing other [00:21:00] people’s payments. So my friend wants to buy a car, if they need to buy a car and they have to rely on my checking account being able to clear their payments so that I could, three hops away, get it to the guy who’s selling him the car, that’s a separate function.
That’s a function that’s going to require giving up on liquidity in order to facilitate payment processing. So that’s a little bit like investing in a bank in the analog world. And I think that’s just going to be an investment that’s going to have a a yield and that’s going to likely over time, the people that are going to do this best are going to be the people who do it most efficiently.
So it’s not going to be very efficient for you to put a lot of your money in a Lightning channel. Putting in the equivalent of, let’s say in today’s terms, something like $50,000. So that one day when one of your 20 friends wants to [00:22:00] buy a car, they can use your Lightning node in order to route the $50,000 for the car through that. I think is going to be more likely that financial institutions will develop that have large sums and are connected to many more people.
Then your friend will just go through that financial institution, which puts up a large sum of money because it is processing a lot of transactions. It’s not going to make sense for you because maybe one of your friends every year is going to need to use your balance in order to settle the price of a car. But for a financial institution, it makes sense when they’re using it regularly because they have a large number of clients connected to them.
So I would imagine it’s going to become more of a professional activity, liquidity provision on Lightning, distinct from the kind of image which many people seem to have about Lightning as it’s going to be peer to peer. And so when you buy the cars, just everybody’s going to be connected to everybody and everybody’s nose is going to be routing payments.
I don’t really see that being [00:23:00] the case. I think it’s going to be more of a professional thing, what do you think?
Nik Bhatia: I generally agree with that. I think we are progressing toward Lightning banks and bigger nodes and it’s already there. There is already some concentration on the Lightning Network in terms of those who route the most payments and are earning the most Satoshis in the network and that’s natural.
The most important thing is that it is open and so anybody can compete and it will become a professional activity, but it is completely open to competition. All you need is capital and routing expertise. You might even be able to use your own personal networking skills to your advantage in, meeting somebody and saying, Hey, let’s do some channel, balanced thing where I can help you route payments.
And you’re making that connection in real life and then you go and you open a channel with that person. So yeah, it’s definitely going to be professional activity, but any hobbyist, any person [00:24:00] that wants to participate in the network, wants to build a route around the central operators, even if it means paying a higher fee.
Because the routers that are professional will become big because they undercut everyone on fees and use their muscle in terms of capital. But if you want to pay a premium to avoid doing business with those people, you can make that happen in the lightning network. It’s all open and extremely cheap to do so anyway, we’re talking about Satoshis here and there. It’s not even in the realm of being expensive, like the Bitcoin blockchain sometimes gets expensive to use when it’s quite busy. The Lightning Network itself is a very empowering technology, but it definitely will follow that professional type of route.
Saifedean Ammous: Yeah, absolutely. I think this is the key distinction here, which is that in the fiat system, you can’t [00:25:00] compete because the market is closed and you need to be registered. You need to basically get a license from the oligopoly that is the existing banks. Whereas in Bitcoin Lightning, anybody can set up a node.
We’re going to get a degree of centralization, I think inevitably in Lightning, which can make a lot of Bitcoiners feel uncomfortable about it. But I think that it’s going to be incomparable, that level of centralization to what we have in fiat because in fiat it’s imposed by law and It’s difficult to break these monopolies and these monopolies are also protected through the government being able to print money and hand them out, which can’t happen in the case of Bitcoin.
So if a Lightning operator starts doing shady things, there’s nobody to bail them out, whereas in fiat there is. And if you don’t want to deal with them, you can always route around them. So I think what’s going to be driving the centralization of [00:26:00] Lightning is going to be the efficiency of it rather than political violence essentially.
And I think the possibility of exit is what’s going to ensure that members of that network will likely behave much better. Which I think brings us nicely to your book, Layered Money. First of all, tell us what inspired you to write this book and why Layered Money?
Nik Bhatia: So I wanted to write a book about Bitcoin for a long time. I read your book and I read Mastering Bitcoin by Andreas Antonopoulos. And I knew that there was an opportunity for me to write, because if I’m going to write a book, let’s be honest, it has to be different than The Bitcoin Standard, because your book is still you know, this whole time preference [00:27:00] illumination that you’ve given all of us is so fundamental in imagining why Bitcoin is powerful for the future.
So that’s that’s what your book did. I wanted to explain Bitcoin from a market’s guy perspective. I’m a trader and I’m a bond market person. And so I wanted to, in my mind when I had came up with the idea, the title was Bitcoin Through the Lens of a Bond Trader, that’s what I titled it in my mind, that’s how I would write this. I’m going to explain Bitcoin, but I trade treasuries so I want to explain treasuries why they’re so important, why Bitcoin is like treasuries of the future.
And that idea was there from the beginning. Then I read a paper called The Inherent Hierarchy of Money. I read that [00:28:00] paper in 2019, and I was preparing for my curriculum for my USC Marshall School of Business students. And I wanted to find papers that explained the monetary system and how it worked and just combing through papers, I found this hierarchy paper, and it articulated the difference between gold, currency and deposits in a three layer hierarchy where gold is the top and currency promises to pay gold and deposits promised to pay currency, in this three layered model.
And the light bulbs went off, I said this is just a theoretical model but it can be applied, and it was applied by the same professor and [00:29:00] other people that worked with him to the current financial system and the whole hierarchy concept is applied to the modern financial system. Very complex multi counterparty, multi-bank monetary system. I wanted to tell the whole story of money hierarchy from the origins of it, to the gold era, which you do.
You talk about the gold era in your book and then bring it to the modern era and then introduce Bitcoin within the hierarchy framework and explain why Bitcoin is a first layer money like gold was and resembles nothing else in the whole system. Including central bank liabilities, which are dollars other [00:30:00] currencies and then banking deposits, which is your checking account.
The most obscene one is that people compare Bitcoin to Venmo, which I tried to show that we’re talking about a fourth layer money, or a first layer money, and trying to compare them. It’s such an obscene comparison that I had to nip that in the bud.
That’s why I wrote Layered Money, the motivation was to explain why Bitcoin really stands on its own in monetary history, other than gold. Which you articulate very well in the book and it’s also one of the conclusions of my book as [00:31:00] well, because that’s what Bitcoin is.
That’s why it’s so powerful. Nothing else in history resembles Bitcoin other than gold, and look what gold has done. And Bitcoin is only 12 years old, so what can Bitcoin do for our society? It’s unimaginable. The Time Value of Bitcoin motivated me to write about Bitcoin.
And then I just wanted to give my best essay that I could ever write on why Bitcoin matters for this planet. And I found at an angle through the hierarchy approach and my wife helped me name it Layered Money. And I’m very proud of the work and thank you for your inspiration and help along the way and congrats on your second book too. I can’t even imagine [00:32:00] going back into the trenches, so congrats to you!
Saifedean Ammous: Thank you, sir. I gotta say the point of your book, Layered Money is something that I tried to get to in The Bitcoin Standard. And it was perhaps one of the main, well the main motivation was the aspect of the hardness of the money and time preference and all of those things.
But another similar point was the idea that Bitcoin is a settlement network, it’s not a consumer payments network. And that’s something that I expressed in kind of intuitive, simple to understand terms, but I have nowhere near the kind of sophisticated understanding of financial markets to express it in the way that you do in Layered Money, which is why I think it’s such a great compliment.
The two books compliment each other very well because I intuitively try and explain the idea that look, there’s a limit on how many transactions take place, so Bitcoin will grow, but the [00:33:00] demand for holding Bitcoin is going to exceed the capacity of the chain to handle everybody’s coffee and lunch on chain.
And you know, I use the example of the gold standard as a way to illustrate this, but I think you do a terrific job of looking through the history of how money gold has evolved and how these layered systems have developed. I highly recommend people who have read The Bitcoin Standard to compliment it by reading this because I think they both arrive at similar conclusions, but through different analytical tools and yours is much more of, someone who’s in the trenches of how markets work.
So let’s dig into the substance of layered money. You begin first of all, by [00:34:00] discussing it in terms of the, you begin by talking about the history and you talk about the Bourse of Antwerp in 1531 and it birthed the money market and it gave us money market. So what is the relevance of that and for Bitcoin today?
Nik Bhatia: So in Antwerp, the thing that was most interesting was that you had all these bills of exchange, which were basically these debt instruments, and they were never traded, they only matured. They were a 90 day instrument and you give money on day one, and then on day 90 you get your money back.
There was no liquidity to these bills, they were just a promise to pay. In Antwerp for the first time, [00:35:00] these bills found a liquidity. So people would trade bills for notes and notes were invented during this time. And a note was just, I promise to pay you in what we think of cash today. Where a note is just the cash value that it says it is, it has no expiration.
And the counterparty that is written on it, is guaranteeing your money. So notes were invented during this time to provide liquidity for bills, other debt instruments. And this was really significant because what we think of as the money market today, which is you having checking account dollars or money market funds in a brokerage account, all these different types of cash, even treasury bills themselves people call cash, all these different types of [00:36:00] cash instruments, monetary instruments, really can trace their origin to the Antwerp Bourse.
Saifedean Ammous: Yeah. And you discuss how this evolved over time and then with the Dutch East India Company becoming the first average joint stock company, how did that add to the pyramid of layered money?
Nik Bhatia: So in Amsterdam, when the Dutch East India Company issued their first stock, because of their successes in Asia, the shares themselves started to appreciate in value.
And then of course, people that were early investors wanted to cash out. So when they cashed out, what were they cashing out into? The city of Amsterdam wanted to take advantage of this situation, and so they invented their own currency. The bank of [00:37:00] Amsterdam was created and they issued bank of Amsterdam deposits.
And the city of Amsterdam basically mandated everybody that was a cashier, basically people that dealt in paper promises and coins, had to surrender all their coins to the bank of Amsterdam. So it wasn’t a seizure, but it was a forfeit, a fiat mandate of paper. The idea of the central bank comes out of the Dutch East India shares appreciating and needing a market for liquidity.
The government swooped in and said, we will provide that cash instrument, and by the way, you have to use it and everything else is illegal. They funneled everybody [00:38:00] into the bank of Amsterdam deposit, which was a second layer money, right? Because the bank held the gold and silver coins physically in their vault. And that’s when really people just started accepting second layer money as the highest form of money that they were ever going to get.
And so this idea that you weren’t going to have gold and silver anymore, you were just going to have paper and deposits and you were going to be fine with it. It started then, in 1609, 1602 was when those shares started trading and 1609 was when the bank was created.
And The Bank of England, which followed, I know that it’s the next chapter there, the next part of the book, The Bank of England basically copied The Bank of Amsterdam, in terms of its motivation and how it [00:39:00] acted, how it was able to capitalize on the demand for money, right? Because if you boil it down to what The Bank of Amsterdam provided, they provided a tool that satisfied the demand for money, for cash at that time.
And so The Bank of England also said, we are going to satisfy that demand for money, and it’s our money that you’re going to use. Banks in England can operate via charter, but they have to use bank of England money in this layered system where gold is not really, it’s just starting to get tucked away, tucked away.
Saifedean Ammous: Yeah, and that basically took over the world. The entire planet copied The Bank of England’s model. Why do you think that is the case?
Nik Bhatia: Well, because gold is a powerful tool and if you own it, it gives you great power. And [00:40:00] so that’s basically what it is, governments wanted to replicate that power.
Saifedean Ammous: Yeah. The rest of the rest of the world was pretty much already on gold or at least silver, but The Bank of England provided basically the most efficient way of scaling gold, right?
Nik Bhatia: Yes they did. And yeah, United States copied that because the banks only make money when they create credit.
Gold is a restriction upon that. The way to make money as bankers is you lend and lend, and the more that you can leverage, the more profits you can gain. If you are restricted by gold and gold reserve ratios and all that, your profits aren’t going to be kept. It’s banks trying to find their way around that restriction and get off the gold standard, even [00:41:00] though they’re pretending to still be on it, for the last kind of 50 years of the gold standard. We were off of it by probably the 1930s, but it wasn’t until 71′ when everyone finally acknowledged that actually we don’t have one anymore.
Saifedean Ammous: Yeah. I’d say earlier, I think 1914, and I’ve discussed this in detail in The Fiat Standard. In 1914, in England, this isn’t talked about much, but The Bank of England effectively confiscated British people’s gold in 1914. It’s amazing, this is just something that is not really mentioned in history books, but recently there was a study that was released in 2019 and it was conducted by a guy called John Osborne, who was the secretary of Montagu Norman, who was the [00:42:00] chief of The Bank of England during World War I.
And it goes through all of the policies that The Bank of England carried out in World War I in order to finance the war. Two very interesting parts to this story. One was uncovered only in 2017 and one was uncovered in 2019, and I get into the details and the references in The Fiat Standard. The first thing was that the British government tried to finance the war effort by raising money by selling bonds.
And they only sold about a third of the bond. So they offered something, I think it was 400 million pounds at 4.1% 10 year maturity. And they thought, well is the British army and it’s the British people, they’re going to buy them, they’re going to lap them up. But the British people turned out to be smarter than their central bankers give them credit for.
And they realized investing in a war is not such a great [00:43:00] idea. Only a third of the bonds were sold. And then the bank of England, what they did in order to finance the war was, and this is astonishing, they got some high-ranking official in the bank of England and his assistant.
They got them to buy the two thirds of the bonds, which is an enormous amount. You’re talking about something like 216 million pounds back in 1914, which is an enormous amount of money. You maybe want to multiply by 300 in order to get to today’s quantities or maybe much more. But they got them to buy it under their own name, even though the money had come from The Bank of England.
And that’s how they financed the war effort. Of course, the implication of that was that the bank had a precarious liquidity position because it didn’t have enough gold to satisfy all of its demands. And so the next step, which was in [00:44:00] 1915, I call it in The Fiat Standard, I call this the fiat white paper. In Bitcoin, we had Satoshi send an email to the mailing list with the software and the specifications in the white paper.
In fiat, the way it worked is that The Bank of England told told all banks and all post offices, and post offices were a big deal back then, that they should take payment in gold and only make payment in notes. And over the next five years, The Bank of England collected hundreds of millions of pounds in gold coin and gave only paper and notes instead of it. It was effectively sovereign default, but it’s not discussed like that because it was the war and it was to support the war effort.
So nobody really likes to talk about it this way, but of course it did lead to inflation. By the end of World War I, there was enormous price inflation in England. [00:45:00] When you study the history of that, you see how, effectively they went off the gold standard, and then all of the problems of the 1920s and thirties, which later led to World War II came from the fact that Britain and many other governments also were in the same position, they could not go back to the gold standard at the old rate.
Because at the old rate, they’d already made so much more liabilities and so many more pound papers than they should have if they wanted to go back at the old rate.
And so they could have gone back to the gold standard by dropping the value of the pound, devaluing the pound effectively, but they did not want to do that. And so they tried to square the circle of continuing to print more money, maintaining the old gold exchange ratio and hoping that they could somehow restore [00:46:00] redemption.
And then they kept on kicking the can down the line throughout the 1920s with that, with a lot of inflation, which then led to the 1930s Great Depression. So this was really the root of the Great Depression all over the world, was the inflation that was used to pay for World War I, and I get into this in detail in The Fiat Standard.
But yeah, this system, the point I’m trying to make is that this system is great because it’s efficient and it allows for the scaling of gold, but it can also be abused, and allows banks some degree of freedom because yes they’re restricted by gold, but at the same time, they have a monopoly on the clearance of gold.
And they’re the only ones who can send your gold across borders, and so if you’re stuck with them, they can rug pull.
Nik Bhatia: Yeah, and they can leverage without anybody stopping them because you can’t call your gold from [00:47:00] them, and you can’t go up in layers in the gold system, they restrict you from doing it.
It’s closed doors, oligopoly, like you said. That was the huge problem. And in the end, they couldn’t end up getting away with it. They had to abandon the gold standard and admit that, yeah the first layer of our system is gone and there’s nothing you can do about it.
Saifedean Ammous: Yep. And so you think, in your book you say that it was the crash of 1929 that basically led to the abandonment of the gold standard, right?
Nik Bhatia: Yeah, it’s the actions by the federal government during the thirties, including the FDIC insurance I think doesn’t get as much play, but FDI insurance basically convinced everybody in America that they never would need gold again for their day to day transactions, because [00:48:00] their deposits were insured by the federal government. And the amount increased through time still to the point today where Americans think of their checking account as gold. It is as safe as gold when in reality, It’s a banking liability.
And yes, the banking liability is insured by the federal government, but it doesn’t change the fact that it is a lower layer instrument in the monetary hierarchy. You are far removed from the highest form of liquidity, which is like a treasury bill or a treasury note for example, or even a money market fund that owns treasuries.
In your checking account, you’re very far removed from that, but FDIC changed the psychology of Americans to convince them that banking deposits were absolutely fine and the highest form of [00:49:00] money that they would ever need. And really it made obsolete the idea that people would try to ascend the money hierarchy into higher forms of money, higher layer forms of money.
And then it disappeared from the consciousness of Americans, where they just think of the bank as the safest, keep it at the bank, that’s the safest place.
Saifedean Ammous: You can take it to the bank.
Nik Bhatia: Exactly, exactly.
Saifedean Ammous: Yeah. I guess now it would be a good time to just tell us what is it that in your mind constitutes the difference between those layers? What happens is you go up the hierarchy and down the hierarchy? The liquidity increases.
Nik Bhatia: Yeah, the liquidity definitely increases and the counterparty risk decreases.
Because if you have a checking account deposit [00:50:00] insured by the FDIC and the bank goes bankrupt, the bank has to appeal to the FDIC insurance fund to get the money back to the bank to get it to you. So you’re removed from the money itself, and the way to analyze these hierarchies is to really start at the top. What is the highest form of money in the system, and then see where the deposit or the fund that you might own falls into that multi-layered structure.
So the fact that the federal reserve owns U.S. treasuries as their asset means that U.S. treasuries are the first layer of money in the U. S. dollar system. Everything else that’s not a U.S. treasury security is a lower form of money. So your banking deposit or even your federal reserve note, because that’s issued by the FED, it’s on the FED’s liability side.
[00:51:00] And people don’t really have federal reserve money, right? Most people don’t have cash, they just have checking account deposits. Checking account deposits are backed by the assets at the bank, which to some small degree include reserve balances issued by the FED. And so that’s why checking account deposits are a third layer money in this framework because the bank only owns federal reserve liabilities, the FED owns the treasuries.
Banks might own treasuries, but they’re not really the backing of those deposits. And as we know, most bank deposits are only backed by loans marked on the balance sheet, which is another way of saying, we know we’ll get money back in the future and we’ll strike it as an asset today.
So this accounting system allows them to [00:52:00] create money out of thin air, issue deposits and then mark alone on their asset type.
Saifedean Ammous: Yeah, and as long as you’ve got some kind of mechanism of preventing people from cashing out their lower tiered money for higher money, then you can knock yourself out and other people will have to suffer from the consequences of your actions.
Nik Bhatia: That’s right. And you know if there’s a default because you’ve over leveraged, the losses get socialized. That’s been the case for quite some time now in the U. S. and it’s now the federal reserve’s official policy, is to socialize every banking loss that can be imaginable and not just in the United States, it’s worldwide.
The U. S. has prevented banking crises in Europe and elsewhere over the last 14 [00:53:00] years now. So all bank losses are now socialized at the federal reserve.
Saifedean Ammous: Yeah, absolutely. I guess we could summarize the business model as restrict the exchange between the top player money and lower layer monies, issue more lower layer monies, and then when the music stops, there’s not enough chairs, get the people who have the lower layer money to basically subsidize the people who made that money. So the victims end up paying for the perpetrators. It sounds like a scam, but it’s been quite sustainable unfortunately, for quite a while, hasn’t it?
Nik Bhatia: It has and I hope that layered money, apart from hopefully educating people about Bitcoin that have never heard of it, I hope it really gives people an idea of how the system currently works in the U. S. dollar spectrum and how these losses [00:54:00] are socialized in a very big way, and the FED just creates more lower layer forms of money and at their will.
Saifedean Ammous: Absolutely. All right, going back to the history lesson, so then we go off the gold standard and then we move on to the Bretton Woods system. And why do you think that was destined to fail from the beginning?
Nik Bhatia: Because if the world is going to use dollars for commerce, for economic activity, how is that related to a country’s currency that needs to be issued to make the country operate? Making the dollar an international standard for payments brought about an issue that there weren’t enough dollars to facilitate all that activity.
Because dollars were issued in the United [00:55:00] States, how are European countries supposed to use the dollar to trade with each other? And how were countries around the world supposed to engage in international commerce without dollars? And so banks outside of the United States started to fulfill that need completely outside of the U. S. financial system.
So you had this dual dollar system where you have onshore dollars, offshore dollars, and the meaning of a dollar really lost its place during that timeframe. That’s why Bretton Woods was destined to fail because it assumed the dollar would keep a fixed exchange rate with gold and convertability.
Half the dollars around the world weren’t even real onshore dollars that could be converted, so the meaning of a dollar disappeared completely. And that’s I think the most important [00:56:00] takeaway from Bretton Woods, it was destined to fail because you were trying to fix a problem abroad with a tool that was supposed to be a domestic tool.
It was the wrong solution from the beginning. Robert Triffin articulated that in the Triffin paradox and that’s exactly what happened.
Saifedean Ammous: Yeah, absolutely. It seems almost obvious in hindsight, but you can see why particularly in the U. S. people didn’t have much of an incentive to grasp the problem because ultimately it meant the U. S. had a lot of leeway in printing a lot of money, financing its own operations through the expansion of the money supply.
Cynics could argue [00:57:00] that has caused the United States economy to shift over the past 70 years into the current state where its main productive activity is the production of dollars, digital and physical dollars, which are sold off to the rest of the world because the rest of the world needs them.
So the whole world needs to use dollars and the U. S. can benefit enormously from the seniorage. It’s not like, as you explained in the book, it’s not like the money is just physical pieces of paper that they print out, it’s credit. And so more and more credit is generated in the U. S. and the U. S. just has an enormous amount of capability to generate more credit all the time because the world is always insatiably demanding more and more dollars.
Nik Bhatia: Absolutely, yeah. Credit is the instrument that brings the dollar and brings the power, keeps the power in the United States and in the [00:58:00] dollar system, because all the credit is issued in dollars. So it just perpetuates the dollar, and it’s also a big part of why the dollar itself will be the last currency standing.
It’s not going to be the first currency that Bitcoin knocks off per se. Bitcoin is going to take out all the little currencies first. The dollar is the most entrenched, has the deepest network effect, has this whole system of never ending credit rolling facilities that the FED is essentially backstopping because whenever they start to fall from par, the FED comes in and says, we have a facility that will buy these things at par, keep the whole system afloat.
You can’t expect that to go away, you can only expect it to continue. It’s the reason why people are in Bitcoin, [00:59:00] they understand this, that the fed will never be able to stop defending the dollar credit bubble. It’s going to last forever.
And so Bitcoin is the exit from that.
Saifedean Ammous: Yeah, absolutely. And I think another thing to add is that as other currencies fail, that strengthens the dollar because these people are right, some of them will move to Bitcoin, sure. But a lot of them still need to operate in the fiat system and knock off a fiat currency, and the people will dollarize.
We’ve seen it happen all over the world over the past 50, 60, 70 years. The fallback option for your local fiat is the dollar. It’s the global currency. In fact, the way that I like to say it, I [01:00:00] said this in The Fiat Standard, is that national currencies are effectively the U.S. dollar plus country risk.
The value of your currency, whatever country you are, we don’t see any national currency appreciate next to the dollar. We don’t see that happen over the longterm. It might happen for a year or two here and there, but you look over a 20 year timeframe and you don’t see a single fiat currency appreciating significantly over the dollar. So they’re all either pegged to the dollar or declining next to the dollar and the degree to which they decline is essentially country risk.
Nik Bhatia: Absolutely. And it’s not only country risk, but leveraging the banking system and how much the central bank is going to have to print, which is part of the country risk there, but leverage within the country can ruin the country’s currency because they’ll just have to print it.
And you’re right about people seeking the dollar as the exit, what do you think [01:01:00] people in Turkey are doing right now? They’re trying to get their hands on dollars, even though there will be people that end up in Bitcoin and it does increase Bitcoin adoption, and the people that choose Bitcoin over the dollar will be happier in the long term, the dollar will still win relative to the rest of the world in terms of the way that I think that the currency world will continue to play out.
Saifedean Ammous: Absolutely. I think that’s the case. The dollar is the final boss that Bitcoin needs to take out. And the more small bosses Bitcoin takes out, the bigger the final boss gets. But it’s okay because Bitcoin is ready for it.
Nik Bhatia: Absolutely. And I just think it’s going to last for my lifetime or for the foreseeable future, this coexistence of the Bitcoin system and the dollar system, the dollar system is deeply entrenched. But I [01:02:00] think that Bitcoin is rising up to that challenge and is a worthy competitor and we’ll continue to just grow and grow in relation to the dollar.
Saifedean Ammous: Yeah. Bitcoin needs to grow a lot and I guess that’s the kind of, in a sense people might interpret this as being bearish Bitcoin, that you’re saying that the dollar is going to be around for a long time, but in a sense, it’s also quite bullish Bitcoin because it’s saying that Bitcoin still has an enormously long race to run.
And the only way that it runs that race is Bitcoin’s number go up. The price keeps going up, then the size of the Bitcoin market the size of the Bitcoin network increases.
So what is the eurodollar system, exactly? Could you explain that?
Nik Bhatia: Yeah, so the eurodollar system is that system of offshore dollars that banks abroad used to [01:03:00] finance the economic activity of countries and companies outside of the United States.
The word eurodollar basically comes from dollars that are issued in Europe, not within the federal reserves hierarchy. These are dollars that are only backed by the loans that are marked on the asset side of those European banks. They’re just time deposits that are issued, at the beginning, in Europe.
And eurodollars are not real dollars, if a European bank fails and you have dollars with them on deposit, those are not FDIC insured dollars. So in that way, they are a different type of dollar, but the character on your screen says USD no matter where you are.
And so the eurodollar system itself is still alive and well [01:04:00] today. I think the last reading was 12 or $13 trillion of USD issued by banks outside of the United States. And by definition, banks outside of the United States are not regulated by the federal reserve system. And so they are not officially onshore U.S. dollars. They are simply liabilities of banks that promised to pay dollars in the future.
And so the eurodollar system itself kept building up from essentially the minute World War II was over, 44′,45′ Bretton woods was 44′ until 2007. During that period, it got so big that it was about to fail entirely December 2007. The warning signs were in August, 2007, when [01:05:00] LIBOR, which is an interest rate to value risk in the eurodollar market, when LIBOR started to widen in relation to onshore dollars in August 2007, ended up in what would have been a collapse of a European banking system starting in December, 2007. As the subprime mortgage crisis made certain banks over there have to strike losses on their balance sheet and send worry into those banks.
The whole system would have collapsed if the FED had not opened a foreign exchange swap line with the ECB and the Swiss National Bank as well, December 2007. It’s a moment that’s not talked about enough in history, but basically this implicit bailout of eurodollars around the world started in [01:06:00] December, 2007 and has never been lifted.
The mistake, call it what you will, but the events from 1944 to 2007 in the eurodollar system, which could have easily blown up every bank that exists because of over leverage, is more or less disappeared from history because of the FED swift action in December of 2007.
The eurodollar system is now backed implicitly by the FED because European banks can go to the ECB, the ECB can go to the FED, they can print euros, post them as collateral to the FED, borrow dollars, and then lend real dollars mind you, FED dollars and lend those dollars to European banks to paper over their [01:07:00] losses, and extend and pretend, kick the can down the road, yada yada. That system is still in full effect and it’s a story that’s not told.
And it’s why the FED will always keep having to print, print, print, create, create, create second layer money. And, foreign exchange swap lines are another form of second layer of money because they’re basically using euros as collateral to create that money, euros that were printed also out of thin air.
So it’s like this hocus pocus game, and Bitcoiners understand this. They know that the bailout is never ending. So the only way to avoid the depreciation in the dollar long-term is to own something else. And that’s honestly is why a lot of people are long stocks, because they know they have to own something.
They can’t just have dollars. The dollar doesn’t mean anything anymore.
If they [01:08:00] own a part of a company that can earn in dollars or any other currency, they’ll protect the depreciation. And to an extent, that is absolutely correct. People that have been long stocks since 2007, 2008 have done very well for themselves relative to a cash position or a government bond position.
So those people that are in stocks for that reason are correct. It’s just that they’re underperforming Bitcoin overall time horizons because Bitcoin is a new phenomenon. And so people are late into it. I feel like I was late in 2016, people in 2021 might feel that they’re late, but they’re not. They’re still early because the story has a long time to play out.
Saifedean Ammous: Yeah. So I guess what happened in 2007, 2008, 2009? A lot of people think of it as essentially the U. S. nationalizing the banking [01:09:00] system in the U. S. but I think perhaps the less known part of the story is that it was also nationalizing the banking system pretty much all over the world, because everywhere had to rely on the U. S. dollars federal reserve swap lines in order to survive.
And so this continues today. It’s just been going on, and as we said, they just need to keep the money printer running, because there’s an enormous amount of dollar destruction taking place because of all the malinvestments that are encouraged by the inflation in the first place.
And so then you need to create more and more inflation to counteract that. And how do you see this playing out with Bitcoin? First of all, before we get to Bitcoin, why wouldn’t gold be a good solution to this? 2007, 2008, 2009, when I was first getting to start to understand [01:10:00] what was going on back then, in my mind it seemed like a no brainer.
They’re just going to keep printing more and more money. And the only thing that was going to hold onto this value is gold. And so stocks, bonds, everything else is going to be, everything that is denominated in fiat is going to go down in value, whereas gold because nobody can print it, will go up. Why was this wrong?
Nik Bhatia: Because I think stocks were the correct answer. We live in a corporate dominated world where gold sitting in a vault isn’t going to perform in the same way as productive companies with cutting edge technology, psychological expertise on the consumer and all these things, our attention being attacked nonstop, by advertisements in every corner of the globe.
That type of environment is conducive to stocks outperforming gold in this scenario. And [01:11:00] empirically it’s easy to say that’s the reason cause we’re in a corporate dominated world. So stocks outperformed gold because gold just sits in a vault somewhere.
Looking back on it in hindsight, that is how I would characterize it. It’s not that gold is bad. Gold has still appreciated in terms of the dollar since this crisis began in 07′ to 09′. But it’s performance versus stocks is poor, even versus bonds as interest rates decline because the FED is printing more money and buying the bonds and removing them from supply.
They’re lowering volatility by doing that, and that increases bond prices. I just think that gold is done as a monetary tool, Bitcoin confirms that. But stocks we’re also telling [01:12:00] somewhat of that story early in the years post financial crisis. That stocks were the correct thing to own to hedge against the unlimited bailouts from the FED, the nationalizing of the international banking system, that equity in productive companies was the way to go. That’s my theory.
Saifedean Ammous: Yeah. I think writing The Fiat Standard gave me a similar kind of answer, perhaps slightly different, I think on a first pass, you’d say yeah hold gold, but I think the fact that gold is just immobile and there’s no gold banking system means that you’re effectively, to some extent buying an industrial metal and not an alternative financial asset because there are no gold banks.
If there was a free market in which you could set up a gold bank, I think 2007, 2008, you would have had a [01:13:00] resurrection of a gold standard. But of course, there are laws that stopped that. In fact, 2010, 11′ and 12′ and 13′, instead of getting into Bitcoin, I wasted a big chunk of my life on some enormously expensive mistake of trying to build something similar to Bitcoin, but based on gold.
This was before I had heard about Bitcoin. I had this idea that what the world needed was essentially, online banking. An app on your phone where you could send money, something similar to PayPal or Venmo, but instead of it being linked to dollars, which are linked to the federal reserve and the banking system, the dollar based backing system, you want to do it with gold.
It was an expensive lesson in trying to figure out why that won’t be built and a very powerful lesson on understanding Bitcoin’s value [01:14:00] proposition. You can’t build a financial system around gold just simply because governments won’t let you, there are a million ways to do that.
And I came to know them quite intimately over time. And in the U. S. and Canada, there was a company that tried to do something like this, it was called BitGold at some point, and then they switched to Goldmoney and effectively it didn’t work out for them because every transaction has to have capital gains. It was not easy for them to get all the banking clearances that would allow merchants to accept and receive gold. So that gave me an understanding of why gold won’t work and why we need Bitcoin.
Now, I think the better way of hedging yourself against this kind of monetary system is not to hold gold, but to be short fiat. The reason that [01:15:00] stocks outperformed, the reason the stocks turned out to be the winning bet and not gold is that stocks are a great way of shorting fiat because companies issue a lot of debt. Companies have bonds and they take on debt and the bigger the company, the more debt it can take on.
So buying stocks is effectively a way for you to take ownership of an entity that shorts fiat. And this really only became clear to me after Michael Saylor came into the scene and after writing The Fiat Standard, and thinking very hard about how this thing works. Yeah, the system is closed and there’s no way out of it, but there is one, and goldbugs understand this, this is the frustrating part which is that gold bugs understand that there is inflation, and yet most of them have the mental hangup that the world is going to have to fall apart, that all of this stuff is going to have to collapse. And that’s [01:16:00] what stops them from thinking, not all of them, but stops many of them from realizing that, stop trying to fight this and get on the winning side.
And the winning side is not to hold the dollars, it’s to short dollars. The people running the dollars, instead of the people benefiting from dollars, the investors are able to win in this game are the people who are able to short dollars the most. As Saylor said, that you want to have your assets be in Bitcoin and you want to have your liabilities in dollars.
Shorting dollars is the way to win this game.
Nik Bhatia: Yeah. You articulated that perfectly about companies using their ability to issue bonds, to short the dollar essentially, being in a short position. If you own stocks, you are synthetically issuing credit [01:17:00] and leveraging your position and empowering yourself through that.
So that’s absolutely right. That is a big part of why stocks have won, is because they just issue debt and buy back their shares, make the earnings look better in addition to growing their profits naturally as well. They are financial engineering machines.
And the correct position is to be short dollars from that engineering standpoint. So if you’re in stocks, you’re able to capitalize on this trend.
Saifedean Ammous: Absolutely, yeah. I think that’s the kind of expensive lesson that a lot of goldbugs should learn quickly. So now we get to Bitcoin.
So why is Bitcoin different from gold? And in my mind as I would say, is because Bitcoin’s clearance is [01:18:00] unstoppable. And so you can actually build an alternative financial system on Bitcoin. It’s not just a shiny rock that you keep in your basement to look at. It can actually be sent halfway around the world.
And if you need to leave because there is a problem, if you want to trade with somebody else when your local banking system is messed up, your gold is useless, but your Bitcoin is not.
Nik Bhatia: Yeah. Bitcoin being digital in it’s nature, it’s numerical nature, you just go back to Satoshi’s original writings and we knew exactly what he was doing. He was trying to replicate this idea that gold is the correct way to build a monetary system, cause it’s sound money and it’s scarce. But we have to make it digital and we have to make the settlement [01:19:00] decentralized and instantly verifiable that Bitcoin is real.
It’s so powerful. In this internet era, Jack Dorsey says it’s the native currency of the internet, we need that. Gold can’t even come close to doing that, and e-gold doesn’t fix the problem because it’s just a second layer of money. We can move this first layer of money around the planet really quickly, that’s never been possible.
Saifedean Ammous: Yeah. I guess the kind of punchline to all of this is how is Bitcoin going to be layered?
Nik Bhatia: And it already is Saif. You know, people listening to this have exchange deposits. Those are second layer Bitcoin, because you just have a balance, it’s issued by the counterparty.
You have the ability to withdraw your Bitcoin, go from the second to the first layer in 10 [01:20:00] minutes, 30 minutes. And that’s very empowering, but it doesn’t change the fact that what you have is a deposit. What you have is a second layer. What you have is counterparty risk. And so that’s the case for every single person that owns Bitcoin through an investment vehicle, they own second layer Bitcoin.
Using, let’s say an exchange deposit. Let’s say I have a company, the idea is to do a Bitcoin bank, and I use a qualified custodian for the Bitcoin that I hold or that I claim to hold, and I issue liabilities based off of that, that’s going to now be a three layered system through counterparty risks where the bank has Bitcoin, but it’s just deposits, and the custodian has the Bitcoin itself.
So the custodian is the one with the first layer money. And the person who [01:21:00] owns, or has a deposit with the bank and stuff, third layer of Bitcoin, that’s the counterparty relationship that is already unfolding today, and already exists today. Then you have the Lightning Network, which is a unique second layer in that you don’t have counterparty risks, but you have this channel. The Bitcoin is suspended in these channels.
You have 10 minutes or so until you can get final settlement of that, but it is some sort of layered situation. And do I see leverage bitcoin banking with leverage and all that kind of stuff happening? Sure. That’s why we use Bitcoin and the blockchain and our nodes to verify that the Bitcoin is ours.
But if you’re not doing that and you have some sort of counterparty risk, you’re always going to have that risk that the money isn’t yours. And so that I expect to more or less follow history [01:22:00] in that you will have banks, you will have defaults, you will have bank runs, you will have people ascend the hierarchy of money and try to get their hands on real Bitcoin in a crisis by withdrawing, just like a bank run.
And that triggers exchanges going out in Bitcoins, knock on wood, we haven’t had a big exchange hack in a while, but I’m sure there’s going to be another one. There’s going to be a default, that default might trigger something in another exchange. It’s going to happen.
There are bad actors that will always try to over leverage. There are good actors that will also try to over leverage, but just get caught. And so it would be naive to think that these problems are not going to come to Bitcoin. But [01:23:00] the behavior that it triggers is that people should own their own Bitcoin so they don’t have any of these problems.
And that is something that is widely understood. People that own Bitcoin widely understand the risk in even keeping their Bitcoin on an exchange. Let alone at some bank offering some yield that is separated by layers of counterparties and things like that. Hold your own keys so that you don’t have these issues.
That’s the only takeaway here, and learn from history that banks and exchanges and counterparties will default. So do your due diligence when you’re choosing your Bitcoin investment vehicles or counterparties or custodians.
Saifedean Ammous: Yeah. What do you think of the idea, and I tend to lean toward this, which is that in fiat because of the [01:24:00] presence of a lender of last resort, then your layers can grow in a pyramid shape.
Say you have a certain amount of gold, but then the gold backed money is going to be larger than the quantity of gold, and then the deposits and the banking layers and the second and third and fourth layers, with each level, because there’s a lender of last resort out there to bail out the bank, they can create more and more liabilities.
So as the layers grow in the fiat system, it takes the shape of the pyramid because each new layer adds more to the supply. In Bitcoin, because of the absence of a lender of last resort, you would expect that the layers would go in more of a rectangular shape in that yes, there will be these bank runs that you talk about.
There will be shenanigans, there will be people doing all of those [01:25:00] things, but that’s self-correcting. You try and do something like this, you lose your Bitcoin and problem solved, and then there’s nobody to bail you out by devaluing everybody else’s Bitcoins. The shape of the pyramid is going to look much more like a rectangle in that there’s limited capacity for bankers and financial institutions to effectively make more Bitcoin, increase the supply of Bitcoin.
Because a) there’s nobody to bail anybody out, and b), and I think this is perhaps the most important fact is that Bitcoin still offers, say half a million transaction capacity for payment clearance every day, and so half a million people everyday can take part in a bank run. It’s expensive to go on-chain, transactions off-chain and second and third layer transactions are going to be cheaper, but if you are worried, if you think that your bank is being dishonest about [01:26:00] the amount of Bitcoin that they keep, then it’s easy for you to take out your money and withdraw it, much easier than it is with fiat.
Still, I think Bitcoin on-chain transaction fees are going to rise enormously with time, but still it’s going to be a price well worth paying if you suspect your bank is engaged in fractioning off your Bitcoins, and therefore inflating the Bitcoin supply and putting you at risk. So then we’d expect that the layers of the banking system would look a little bit more like a rectangle in that it’s more about just simply scaling through allowing a larger number of transactions than it is about making more Bitcoin, which is what the fiat financial system does.
Nik Bhatia: Yeah, I would strongly agree with that. Because we have the power to do the bank run, essentially instantly, it will keep people in check. It will reduce leverage in the system [01:27:00] and price always sniffs out problems. And so if some bank is issuing a Bitcoin deposit with leverage, obviously that’s not going to be something that you can hold in your Bitcoin wallet because it’s not real Bitcoin.
And if that deposit has any price discovery on any exchange and it slips from it’s one-to-one Bitcoin ratio, a bank run could happen very quickly. And I think the threat of that is part of the game theory that banks that are even attempting to leverage Bitcoin, it’ll cause them to stay away from that type of activity.
Your rectangular description of the layered system is something that I would agree with.
Saifedean Ammous: Fantastic. Sadly we agree so much. [01:28:00] There’s not much room for a more vigorous discussion, but then the final point is the central bank digital currencies.
What do you think of that?
Nik Bhatia: Yeah, it’s an inevitability for sure. I think it’s going to be extremely utilized as a political tool. I think that the U.S. government will use the CBDC FED coin to issue welfare payments, UBI, universal basic income to citizens of the United States and take some monetary policy power away from the FED in that regard. Where Congress is issuing stimulus through the FED’s instrument.[01:29:00]
That’s a scenario I see playing out over the next five plus years in the U. S. A highly political tool for governments and central banks to team up to continue keeping their system going. The U.S. has already engaged in forms of UBI since the pandemic and that’s something that is starting to stick as just accepted policy, that people just get money in their checking accounts every month from the government.
So I’m definitely watching CBDCs from the UBI perspective from that side. I do think that CBDCs will be used to try to make [01:30:00] cash obsolete, paper money, that privacy tool that people still use, I think they’ll try to get rid of that. This will drive more people into Bitcoin for sure. But I think that also CBDCs will be used to modernize the financial system.
The traditional financial system that still uses these ancient wire systems and messaging systems and fax machines. CBDCs will be used to modernize all of that archaic technology that are still used by banks today and central banks. So CBDCs, in my opinion are guaranteed to happen. They will come with a lot of political baggage.
They’ll come with modernized technology, and they’ll [01:31:00] come with violations of privacy, financial surveillance, tax, implications just in terms of tax privacy implications, things of that nature. So there’s so much that’s coming with CBDCs and they’re definitely happening. It’s just a matter of time.
And you know, it’s something that people should watch out for. They should own Bitcoin because it’s outside of that system. If they start to see things that they don’t like about that system it should motivate you to keep your money in Bitcoin or outside of that system. It’s also my goal to opine on what some of the things the CBDC should be, because I know that it’s coming.
You know, advocating for the [01:32:00] exchangeability factor of it. Making it freely tradeable I think is the most important thing that we can ask for as people. Let me send it to and from anybody, including Bitcoin exchanges for example. If I want to send it to a Bitcoin exchange, I should be able to do that, because it’s my money. So I don’t know if that’s just me doing wishful thinking, but I have a voice and I’m going to be trying to write about this type of stuff going forward.
Saifedean Ammous: What do you think of the idea that a central bank digital currencies are going to essentially flatten the layers of money in that it’s going to be similar to what the Soviet Union’s monetary system had in which there are no financial, maybe not entirely, but when everybody’s money is an app that is run by the central bank, you’ve disintermediated banks out of [01:33:00] the business.
And then everybody has an app that is linked to the central bank and the central bank decides how much money you get every month. They give you your UBI, they decide what you can spend your money on.
They decide to take away your money when you say mean things on Twitter and they stop you from buying meat and fossil fuel because those things cause boiling oceans or whatever is the latest science. But of course, realistically this is this is the way that they’ve been fighting inflation for 50 years, which is to try and get people to stay away from the things that are rising in price and substitute them away and use cheaper substitutes that are not price sensitive.
So if this were to be the case, and this is kind of the discussion that I have in the final chapter of The Fiat Standard, I [01:34:00] tend to agree with you, I think there is likely to be a long period of time in which Bitcoin and the dollar co-exist. And I explained this in The Fiat Standard as a result of the fact that the fiat system is not as inflationary as the money printers might suggest.
You see the headlines and they’ve printed a trillion here and a trillion there, but there is the credit system where money is constantly being destroyed because people are defaulting and businesses are going out of business, and so credit is being destroyed and that leads to the money supply declining.
It’s not exactly easy to get to the stage of being a Venezuela in a modern economy, because you have a banking system on the higher layers where the more you print, the more you create a business cycle, the more you create the booms and then the more you have busts. So it’s self-correcting in a sense, [01:35:00] the recessions are what protects the dollar from hyperinflation, what protects fiat currencies from hyperinflation.
When you look at examples of hyperinflations, you see that there’s always a point where the central bank just goes batshit crazy and starts printing like crazy. So Lebanon, this started happening in July 2019, the physical notes, the supply of the physical notes just shot through the roof. And so far it’s gone up something like eight fold in just two years, two years and a few months, the total supply of physical bills has gone up enormously.
So before that the banking Ponzi scheme had been running for almost 30 years, and it was self-correcting because when you issue too much credit, businesses go out and then the credit collapses. But once you start printing a lot of money directly and handing it out to people, that’s when you get the Venezuelas and Lebanons and the hyperinflationary systems.[01:36:00]
Do you think central bank digital currencies take us closer to that world? And then what does that mean for banks? Are we just gonna get rid of banks and replace them all with one big central bank?
Nik Bhatia: I have a bias here as an American, but I really see Europe going more of the way of China. Highly restrictive on the way that you use the currency, displacing commercial banking to some degree. Advocating that a lot of people basically don’t fire their bank, but still protecting banks and saying that we’ll start, the ECB has said this already, that’s on their website, that they’re going to charge negative interest rates on digital Euro balances above X amount, so as to not [01:37:00] make people just flee their bank in entirety.
So banks will offer a more attractive interest rate relative to central bank digital currencies. And that’ll keep the banking system alive where people will be attracted by that higher yield and choose one currency over the other.
But I think that in the U.S. you’re not going to see that type of attack on the banks. First of all, banks have a huge power position in the United States. The American banks, JP Morgan, Citi, bank of America, Wells Fargo, and then the investment banks themselves, huge influencers on the United States government.
So when a central bank digital currency is being designed, it’s going to be done with the idea that the layered money system will be kept in tact. [01:38:00] Banks will be able to use the FED coin to leverage and issue their own deposits and create credit. The credit culture in the United States is still very strong.
The federal reserve can not be the source of credit for the country, nor do they want to in my opinion. They don’t want to be looking at your credit score and determining whether you get a mortgage or not. All that activity I think will still be done at the banking level. So in the United States, no, I don’t think banks are going by the wayside.
In China, I think commercial banking might be officially on watch, it might be destroyed by the central bank digital currency. I think Europe will be somewhere in the middle, especially on that fossil fuels comment that you said where they won’t let you buy this or that in digital Euro, because it didn’t pass some ESG score.
I think that’s very possible [01:39:00] in countries from banks like the ECB. I’m not making that express prediction, but that type of activity, restrictive activity is definitely possible and likely from some central banks. And others I think will just have more of a free market approach to them.
And again, that might be me being optimistic as an American and with my bias, but that’s what I’ll be watching for.
Saifedean Ammous: Okay. Well we have Stefano, he has a question for you. Stefano, do you want, go ahead?
Stefano: Yes, of course. Hello, Nick! So my question is about your teaching. You are a university professor of traditional finance, right?
So I’m curious to hear if your interest in Bitcoin has changed how you teach traditional finance, if at all. And then secondly, how do your colleagues in traditional finance view your [01:40:00] positions in Bitcoin and your positive views of that?
Nik Bhatia: I’ll speak quickly about my colleagues. There are a few professors at USC that are very supportive of what I’m doing and love reading my material and that kind of thing.
I haven’t made a ton of inroads at the department level. I am a fixed income professor. So to answer the other part of your question, my course does cover now central bank digital currencies at the end of the course because CBDCs are a fixed income instrument, they will be. So they do fall within my domain. And because of that, I do introduce the idea that Bitcoin triggered this response that central banks tend to respond with their own digital currencies.
And my students also know that I am a Bitcoin professional in that I write for a living about Bitcoin and all that kind of stuff. So I do though take my role as a [01:41:00] fixed income professor very seriously. They did not ask me to teach Bitcoin in that role. They hired me to teach fixed income, to be a bond market guy, to give my experience as a bond market professional.
And I do take that seriously. So that is the experience that I deliver to my students. In the Q&A before and after class, and people want to ask me about Bitcoin, of course I’m there for the students and there to educate them, but I try to say it early and often that this is not a Bitcoin course.
We’re here to learn about rates and the market, and I’m here to entertain all geopolitical conversations, which now more and more do involve Bitcoin, as part of that market’s discussion. But we’re here to focus on rates. So I haven’t pushed let’s just say, the Bitcoin agenda at USC because it’s not [01:42:00] why they brought me in.
I do try to bring my hierarchy of money expertise to the department and be that resource and propagate these papers in financial academia that I strongly agree with and set up people’s understanding for Bitcoin in the future. You know, just in terms of understanding how the monetary system works and its hierarchy.
But I hope that I answered your questions Stefano.
Stefano: Yes, your perspective is very balanced.
Nik Bhatia: Thank you so much!
Saifedean Ammous: All right, Theo you have a question?
Theo: Yeah, thank you Nick for coming! A very interesting discussion. At the beginning, you spoke about how we can earn a passive income by collateralizing Bitcoin in Lightning channels, and now you can also earn passive income by [01:43:00] basically opening covershot position on the real market with Bitcoin.
And we have seen in the past months that the interest rates you can generate by doing that. Basically range between 10 and 40%, depending on the market sentiment and stuff like that. And the ways those contracts are built, basically you have to borrow one currency and then another.
So these rates basically represent an interest rate differential between fiats and Bitcoin. And do you think we are witnessing the emergence of a kind of yield curve that is less distorted, that more faithfully represents the real cost of [01:44:00] opportunity of immobilizing capital because it can not be printed on paper, you have to collateralize the Bitcoin for a certain duration.
So if you look at the different rates for the different duration, you can see some kind of a curve, but what micro significance would you give to that?
Nik Bhatia: The yield curve on Bitcoin is something that is alive and well, let’s just say. The rates that you’re describing are capturable by people that have the market sophistication in the derivatives markets. Yields are being captured in Lightning network, albeit they might be a lot lower, by people that have that sort of expertise. Yields are being captured with exchange lending. Yields are being [01:45:00] captured in the cash and carry trade between CME futures and spot Bitcoin.
There are so many ways to make yield with your Bitcoin today, most of them requiring counterparty risk and exchange risk and all these different individual risks. And the macro significance of this is enormous because it continues to shift, and it’s part of what I wrote about in 2018, we have to propagate this idea of Bitcoin is not just gold that sits in a vault.
It is actually digital collateral that you can move around to capitalize on your ability to move it from point A to point B at the right time or at the right interest rates or the right borrowing rates. And so it [01:46:00] modernizes Bitcoin. The yield curve modernizes Bitcoin, takes it away from a commodity, makes it into an asset class.
The Bitcoin ETF just got approved. People are going to start getting Bitcoin exposure for the first time. They’re going to have a negative performance versus Bitcoin, they’re going to realize that somebody is capturing the difference between Bitcoin’s return and the ETF return, and that somebody is hedge funds engaging in a cash and carry trade where they sell futures and buy spot capture the difference.
Then that idea will popularize, people will be like how can I make Bitcoin yield for me? And it really grows into an asset class. So I hope Theo that answers your question. I think it’s a big deal.
Theo: Yeah, perfectly. And just a quick follow-up, do you think for example in some years we would go to hedge fund and use those kinds of rates as a benchmark?[01:47:00]
Nik Bhatia: It’s yet to be seen what benchmark people will use. But I’m looking forward to, and if someone doesn’t do it soon enough, I’m going to have to launch this yield curve monitor of all these products in Bitcoin, differentiate between the types of risks.
Here’s a lending risk, here’s a derivatives risk, here’s a lightening risk, here are the yields, here are the timeframes, the maturities, the bullet structures, all these types of things. I’m looking forward to that type of thing being out there for people to see sooner than later, hopefully.
Theo: Please do, seems fascinating! Thanks for your answer!
Saifedean Ammous: Yeah, I think it’s necessary and consequently it’s also I think a great business idea. I think building a product that standardizes measurements of risk and [01:48:00] yield across the Bitcoin space is likely going to be extremely valuable over time. All right, we have another question from Flavio.
Flavio, you want to ask you a question?
Flavio: Hey there, hey Nick. Thanks Saif for the interview and the discussion, very interesting! I wanted to ask, what are your thoughts on the ETF that’s coming up launching tomorrow? I’m hearing a lot of comments that it’s just a play for the establishment to try to stabilize through market manipulation, but we know Bitcoin’s anti-fragile so they’re not going to succeed at it, but what are your thoughts?
Nik Bhatia: Yeah, I would agree with you. It’s naive to think that one vehicle is going to affect the price. Bitcoin has so many different prices that are arbitraged all over the world. There are studies that say that the CME futures price itself is the leading price. So this vehicle will be one of the participants in that market.
One day it might turn out that one ETF is the dominant [01:49:00] influence on prices around the world, but the way that Bitcoin settles, I think arbitrage and arbitragers around the world are always acting on differences in Bitcoin price, and people physically wanting to withdraw Bitcoin to their own wallets is still gonna be the most powerful force over any medium term time horizon.
You might be able to manipulate, any whale might be able to manipulate the price for a little while in any vehicle, but over the medium term and by medium term I mean like after a few days or even a few weeks, when certain contracts expire and all that, in the end the market will win.
Bitcoin is the purest market we’ve ever had because there is no one Bitcoin price. There will never be one Bitcoin price. That is something very beautiful and [01:50:00] rare. And so the fact that there’s never, ever going to be one Bitcoin price, how can you think that one entity is going to be able to manipulate it?
There’s just too much decentralized settlement of it. So again, I’m an optimist, but it’s something I’ll definitely be watching for, especially this lead lag analysis between Bitcoin futures and other spot prices. It’s I just wrote about it for my publication, The Bitcoin Layer sent it out to subscribers yesterday, talked a little bit about this dynamic.
Flavio: Thank you.
Saifedean Ammous: Alright, William?
William: Yes, I got a question about potential damage caused by exponential printing of the U. S. dollar and the impact on emerging economies since they have no ability to print. If you look at the case of El Salvador, which has now taken up the [01:51:00] position of legal tender as a potential solution, but El Salvador has no ability to clear dollars or print dollars, and therefore the exponential growth of U.S. dollars is fine for the U. S. because they get the benefit of the stimulus, and also the majority of global commodities are priced in dollars. So for emerging economies, it is a huge headwind which could cause major destabilization and clearly the Bitcoin potential standard could be a refuge for a lot of these economies.
So, do you think that the glue could be coming unstuck in the global financial system as a result of huge creation of U.S. dollars?
Nik Bhatia: Yes. What you’re describing is part of the currency war that we’ve been experiencing for over a decade now and in this [01:52:00] currency war, when the FED prints dollars, that money, which is called hot money, finds its way into emerging markets.
It ends up strengthening the currency locally, and a stronger local currency is a net negative on financial conditions for these countries. So then they end up struggling, they have to deal with all their domestic issues, they end up printing money as a result, to try to weaken their currency back and get it more into an equilibrium.
That type of dynamic is something that we’ve seen frequently, and I think we’ll continue to see going forward. It’s this musical chairs of who’s going to do the next round of printing, and usually it’s the ECB, and the FED, and The Bank of Japan [01:53:00] taking turns. All these other emerging market economies have to also stimulate by printing money and doing bond purchases or doing bank programs.
It does destabilize these emerging markets and then they have to themselves weaken their own currencies by printing money to respond. And it just drives an overall inflation level around the planet and just an increase of the money supply that ends up in asset prices.
Saifedean Ammous: Yeah, Nathan has a question.
Nathan: Nick, you referenced the central bank currencies, kind of a two-part question. First of all, when you say central bank digital currency, are you suggesting a total wipe out of cash? In other words, is a hundred dollar bill gone? And then following up on that, does that create some kind of [01:54:00] a black market role for gold, silver?
Nik Bhatia: Okay, so the first question, does it replace cash. Potentially yes, and potentially not. The ECB and the FED have both said that while this will be on par with cash, we might not be eliminating cash right away. But I do think cash paper cash will go away in the longer term.
But let’s just say I don’t think when the FED introduces their CBDC over the next few years, that dollar bills will go away right away. Maybe over a longer term. And then does it increase the black market usage of gold and silver? Unlikely honestly, in the age of Bitcoin and all this other digital currencies that are floating around the world. Like people that want to use shitcoins are using them here and there [01:55:00] for their own purpose, but young people are not carrying around gold and silver coins and using that as their exit from the fiat system.
I really just see the next generation just going into digital money of any sort, they should be doing their own education and learning about Bitcoin. But I can see that a lot of young people are not, they’re getting into shitcoins because they’re scared of you know, Bitcoin being at $60,000.
They think they’ve missed it, and there’s a lot of misinformation out there, but people are just going into digital currencies.
Nathan: That speaks to buying digital products and stuff that may be someone considers illegal. And I see that, I see the crapcoins working in that environment for various reasons, but I’m looking more at buying an unregistered gun.
The hundred dollar bill is the king [01:56:00] of the world. If you try tearing into that, you’re tearing into a fabric that really runs pretty deep, and that market isn’t going to just go away, it’s going to react somehow. I’m just kinda trying to think through what might that be.
Nik Bhatia: Yeah. And that’s exactly the reason I don’t think they can just eliminate the paper dollar anytime soon. There’s a huge use for the paper dollars outside of the United States. Most of the hundred dollars bills in existence are outside of the United States. They’re outside of the U. S. banking system, the FED has published research on this.
So if you eliminate paper cash at the U. S. level, you can cause a lot of problems. It’s a big part of the reason I don’t think that’s something they’ll do right away, but again, [01:57:00] more likely to happen in Europe where they eliminate cash. I do think that is possible in the next five years let’s say.
Nathan: Thanks Nick!
Student: Hi nick! What do you see as risks or attack vectors for the bitcoin network? What would keep you up at night?
Nik Bhatia: Over the medium to longterm, I don’t see a lot of risks to Bitcoin, I think it will grow as a network.
And I think it’ll grow to be used by over a billion people over the next few years. We’re at somewhere between one and 200 million today, so a 5 to 10 X increase in the adoption rate of Bitcoin, I think is absolutely inevitable. And in that way, I don’t see any longer-term risks for Bitcoin.
In the short-term, there’s so many, if you’re talking about price for example, the number of things that could take Bitcoin from [01:58:00] $61,000 today down to $30,000, there’s so many things, exchanges going down, things like that. But the protocol is sound, it has a hundred percent uptime and it’s just, it’s very boring, right?
People just describe Bitcoin is very boring. It’s this time chain, it’s just a clock and it’s ticking. Bitcoin itself I think is doing great and has established itself as this impervious technology. Of course headlines regulation risk, there are all these things that can drive Bitcoin down in the short term if you’re talking about price there.
Student: I was talking more about the adoption of Bitcoin itself. Any sort of falsifiable statement that if it comes through, then you’re concerned about Bitcoin’s future.
Nik Bhatia: Yeah, look at the American [01:59:00] regulatory landscape, that’s one of people’s, they were worried about it as one of the biggest risks.
We have legalized ETFs now, Coinbase IPO in this country. It’s just a regulatory green light from the United States, and I think the rest of the world will see that and follow suit. Politicians that try to go against Bitcoin, I do not think they’re going to do very well. And so there’s this incentive, there’s this game theory involved. From the Bitcoin protocol’s perspective, and the risks to Bitcoin as a network I just, I just don’t see them.
Student: Thank you.
Saifedean Ammous: All right. We’ve been going for about two hours now which is what we try to keep as the longer limit. Thank you so much Nick for joining us. This was absolutely fascinating, and I hope that people will enjoy [02:00:00] listening to it. It’s it’s a fascinating book and I highly recommend people read it, and thanks again!
Nik Bhatia: Thank you Saif for having me so much. Congrats on your second book and hope to see you soon in person!
Saifedean Ammous: Cheers, likewise! Take care.
Nik Bhatia: Take care.