Monday, 25 March 2013

Is Bitcoin a money substitute?

Intro


This post is a third reaction to Patrik Korda's article about Bitcoin. There have been three main topics in our debate:
  • regression theorem
  • competition under network effect
  • money substitutes
With respect to the regression theorem, tomorrow, Korda is debating Konrad S. Graf at the weekly University of Texas Mises Circle. I assume as usually with the meetings, it will be done over Google+ Hangout and available on youtube after a couple of days. Graf's arguments are very similar to mine, so I don't think I have anything to add there. I'm just looking forwards to watching the debate.

The competition under the network effect I believe I addressed sufficiently. Korda does not see any mechanism for competition under the network effect (apart from barriers to entry), and appears to believe it's random, so the market shares of individual cryptocurrencies will randomly wildly fluctuate. I addressed the mechanics of competition under the network effect in previous two articles (firstsecond), and I think that Korda hasn't addressed my points sufficiently. So for the time being, I'll wait up his reaction on this topic.

The last discussed issue is whether Bitcoin is a money substitute (fiduciary medium, token money), or not. While I find it absurd, I decided to address the issue in yet another post. There are several reasons for it. First of all, I think that a proper scholar should address all arguments with a logically mounted defense, no matter how absurd they claim. So it's a matter of principle. The second issue is that I apparently have readers (how it happened is a mystery to me), and I have an obligation to explain the issue to them. So it's a social issue too. Last but not least, I tend to make very abstract arguments that expose implicit assumptions, and criticise my opponents for making these implicit assumptions and lacking imagination. But this problem is universal, I am not immune to making implicit assumptions either. In other words, it could be that I'm just arrogant and wrong, and miss a logical fallacy that I'm making myself. So it's a matter of pragmatism as well. I'm new to blogging so it's a learning process for me. I hadn't really put much thought about meta-blogging, I just thought that it's better to have a dedicated outlet for channeling my thoughts  rather than having them distributed across dozens of sites of other people. But I now made the conscious decision that I'll stick to proper scholarly work, and I'll treat apparent absurdities seriously. I think I tend to do that often anyway (treat absurdities seriously, that is), so it's not really much effort, I just need to remain conscious about it.

Definition of money substitutes


With respect to money substitutes, Korda made several interesting arguments that I hadn't considered before, and in fact shows that some of the points Mises makes are incomplete. Foremost, he is the only Austrian I know of, apart from me, that does not think that money substitutes need to be claims. While I still think his classification of Bitcoin is wrong (and I intend to prove it conclusively in this post), I sense that he, similarly as me, has the ability to expose implicit assumptions. I think if he thinks about the issue more deeply, he'll recognise the problems in his arguments. Austrian school and Bitcoin can benefit greatly from his skills. And even if we never end up agreeing, I think that defending from attacks is what makes assumptions stronger.

The issue with Korda's argument becomes most apparent if we try to understand the purpose of Part 1, Chapter 3 of Mises' Theory of Money and Credit (and the picture in Appendix B). I already touched upon that in my previous posts, where I argued that the reason for the classification is economic analysis, but I missed something even more fundamental (which Korda missed too). The purpose of the whole book is to analyse the exchange ratio between goods, with the particular emphasis on media of exchange (of which money is an example). In other words, Mises attempts to analyse prices. Why is it then necessary to divide money into different classes? Because the mechanisms of determining the price of individual classes of money are different. If the mechanism was the same, for the purpose of the whole book, a classification would be irrelevant. Mises realised that prices of different classes of monies are established differently, and that is why he invented those classes. In other words, he invented the class of money substitutes because the price of money in the narrower sense is determined by a different mechanism than that of money substitutes.

It is exposed a bit if we look at Part 3, Chapter 15:
The fact that is peculiar to money alone is not that mature and secure claims to money are as highly valued in commerce as the sums of money to which they refer, but rather that such claims are complete substitutes for money, and, as such, are able to fulfill all the functions of money in those markets in which their essential characteristics of maturity and security are recognized. It is this circumstance that makes it possible to issue more of this sort of substitute than the issuer is always in a position to convert. And so the fiduciary medium comes into being in addition to the money certificate.
Korda interprets this in such a way that Mises was trying to show that money substitutes compete with money in the narrower sense. But this is an incomplete interpretation. If we view it from the perspective of the pricing mechanism, we realise that Mises was also trying to explain that the price of money substitutes is not determined by the same mechanism than that of money in the narrower sense. The price of money substitutes is derived from the price of the price of money in the narrower sense. That is the essence of the quote.

Now, Mises, and the Austrians that follow him, have a more precise definition of money substitutes, they argue that they are "mature and secure claims to money [in the narrower sense, ed]". In my thesis, I argued that this is imprecise from both sides: first, not all mature and secure claims to money are money substitutes (it's unlikely if the claim does not decrease transaction costs), and second, causal relationships other than claims also may result in money substitutes (so-called "complementary currencies" for example). But I didn't analyse the question of price in that depth. I assumed that the price is the same (now, other Austrians do that too, as I thoroughly quoted from in my previous article, so don't blame me, I didn't start it).

Korda argues that the price of money substitute doesn't have to be the same as the money in the narrower sense. I countered that the price of the money substitute can be (in the extreme) lower, but it can't be higher. Korda argued that Mises himself showed examples of money substitutes that trade at a premium. I was kind of rushing my argument, so I didn't really think it through and I must admit he has a point. I didn't find a Mises quote to the same, but I found mises.org wiki article on the Bank of Amsterdam which confirms it.

This caused me to think more deeply about the issue of price. Austrians in general assume that money substitutes have the same price as money in the narrower sense. There are few exceptions. Rothbard, I believe in America's Great Depression, argued that some claims must only be considered from the point of view of money supply only at a discounted rate. JP Koning, on the other hand, argues all the time that different forms of money have different liquidity levels and also different prices. So, the argument that the price needs to be exactly the same certainly is flaky. Heck, if Korda is right in attributing the report of premium on bank notes to Mises, Mises contradicted himself. That's a problem, and it needs to be fixed. I am pretty strict about having consistent definitions.

So how do we fix it? We define money substitutes from the same point of view that caused Mises to create the classification: the mechanism of establishing of price. But how to do that to allow for fluctuating prices? We borrow the concept of derivation from mathematics. In other words, if a price of money in the narrower sense changes, ceteris paribus, the price of the money substitute will change proportionately (i.e. there's a linear dependence). This allows for the possibility of a price change for another reason. If there is a perception of risk in the claim, the substitute will trade at a discount. If the money substitute is perfectly riskless, then it may appreciate to reflect the saving of transaction costs. It can't get out of these boundaries, because that would create an arbitrage opportunity. The funny thing is that the arbitrage opportunity also arises when complementary currencies (which I also count under money substitutes) attempt to trade at a fluctuating exchange rate, an argument which I made some time ago in another debate. Now, my point isn't that other factors can't influence the price, but that the price of the underlying money in the narrower sense must. I don't think that there are factors other than perception of risk and transaction costs, but I'm not building my argument to rely on that. For the purposes of this post, I will call this derivative relationship "coupling". The price of a money substitute is coupled to the price of the underlying money in the narrower sense.

In order for me to conclude my definition, it helps to investigate what happens when the price decouples, i.e. that changes in the price of the underlying money in the narrower sense won't have a proportionate effect on the money substitute anymore. Assuming that the former money substitute survives, it evolves into the new monetary base. One possibility that Mises himself mentioned was credit money, which happened when the country went off a metallic standard and people were expecting this to be temporary. Another possibility, one that many of us know from personal experience, is fiat money. In my thesis, I demonstrate this on the example of the Euro: at the end of 1998, the exchange ratios of 14 (if I calculate correctly) currencies were fixed with respect to Euro, and thus the Euro became a money substitute. After the old currencies were decommissioned, the Euro became fiat money (a separate money in the narrower sense). Yet another possibility, arguably, is commodity moneyLuther and Symes can be interpreted in a way that this is what happened with the old Somali Schilling: after the central bank and legal tender laws broke down, this increased the (now competitive) production of paper notes, until the production price of those notes was very close to the market price of these paper notes. Technically, the old Somali Schilling had been fiat money, not money substitute, but I argue in my thesis that all fiat money must begin as a money substitute, and according to Symes' historical analysis, originally, Somalia did have multiple competing commodity monies, and several monetary reforms after that, which introduced paper money substitutes.

Which subtype of money in the narrower sense will be the result of a decoupling depends on the circumstances. But the point is that the coupling is a necessary feature of the money substitute. Without it, it either collapses or changes its nature, i.e. its price will be determined by a different mechanism.


What determines the price of Bitcoin?


Now, let's look back at Bitcoin. Korda argues that Bitcoin is a money substitute of all of the fiat currencies it trades against. Let's take then the dollar for example. What happens to the price of Bitcoin if the price of dollar decreases by 1%? We don't know. It may change or it may not. We certainly can't be sure that it will decrease by 1%. We can't even be sure it will change in the same direction, it could perfectly well cause people to prefer Bitcoin to USD and increase its price. The issue becomes even more apparent if we investigate what happens if the USD decreases by 1%, and the EUR increases by 1%. The price of Bitcoin is not coupled to any other money, or any other good for that matter. So it's not a money substitute.

What's even more, it never was coupled to anything else in the first place. As I argue in my thesis, the first available records of market price of Bitcoin show that at the beginning, the market price was derived from the variable production costs of Bitcoin. It wasn't coupled to any other good, i.e. it wasn't only not a substitute of money, but not a substitute of anything. Once again, the term "substitute" in this context does not refer to the similarity, rather to the causal relationship, the "coupling".


Conclusion


I believe that, motivated by Korda's resolute defense, I managed to both explain and fix the gaps in Mises' arguments. I exposed the essence of Mises' arguments, and the essence of a money substitute. I also showed that Bitcoin does not have this essence, and never had.

If Korda (or anyone else for that matter) would like to counter my argument, I'll make it very easy to respond. The only thing he needs to do is to answer the question "How is the price of money substitutes determined?"

11 comments:

  1. Considering I was unable to participate in the debate last night, I will write up a response. Please delete this comment once I post the response. However, going forward I would greatly appreciate if we move the discussion into my article. For one, a lot of points were already asked by others, and I have answered them. Second, it helps me keep a track of everything.

    I certainly did not expect my article to gain such attention, but I suppose that's what happens at all-time highs. On the contrary, my ACI article has gotten zero attention, but I suppose that's what happens at all-time lows.

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    Replies
    1. Patrik,

      I myself would at this point prefer a moderated oral debate. I hope I didn't misrepresent your arguments yesterday, I tried to stay very generic and possibly uncontroversial, to avoid ripping into you too harshly since you couldn't defend yourself. I was also expecting that it would be Graf debating you, not me, so I didn't prepare as thoroughly as I would have liked.

      Bitcoin has a kind of fanclub. It's similar with other online movements, e.g. I remember in the late 90s/early 00s with Linux and Open Source. If you mention it in a way that people disagree with, you're going to get flak. Don't take that personally. That per se does not invalidate your arguments. ACI on the other hand doesn't have a fanclub.

      I am a stubborn guy that will keep complaining until I believe that all the disagreements have been addressed, or until I come to the conclusion that an impasse has been reached. I have been like this as long as I remember. I appear to have, unintentionally, assembled a sort of fanclub too, so wherever I debate, others follow.

      I believe you haven't addressed my points to the extent I would have liked, and I think in an oral debate I can push you harder to address them. I really get annoyed when others ignore my arguments and I can't do anything about it (e.g. when they write on websites). I think an oral debate can resolve the issues more quickly, even though from experience I'm not as eloquent when improvising rather than when preparing the text in advance. I myself did attempt to take your arguments seriously and analyse them thoroughly, and adjusted my arguments to cater for the points you made. I don't think you did the same with respect to my arguments.

      Delete
  2. First off, I should mention that I am not an Austrian nor a libertarian per se. For example, I strongly believe in peak oil, which is commonly looked upon as a lefty belief. Moreover, I think of austerity, which the right typically considers the correct course of action, as a counter-productive measure that shrinks GDP faster than the deficit, thus exacerbating it. The reason why I wrote the bitcoin article from an Austrian perspective is because towards the end of last year, I have seen a lot quasi-Austrians starting to rush into bitcoins. This was very much the same thing I have witnessed from late 2010 until the pop in May of 2011 in the silver market. I fear that a lot of naïve players are swallowing the false dialogue and are being led into the slaughterhouse by the likes of Max Keiser, who incidentally pumped and dumped silver in 2011 as well.

    I believe that bitcoins are a lose-lose proposition for libertarian minded people going forward. In the interview that I posted in my article, bitcoin developer Jeff Garzik stated that (1) bitcoins were either a bubble that will collapse or (2) bitcoins were coming up to the level at which they would trade as a worldwide digital currency, this was his response to the dramatic price increase at the time. In retrospect, bitcoin did in fact turn out to be a bubble. Obviously, my position is that bitcoins are once again taking the shape of a bubble. What does this mean for the quasi-Austrians rushing in at or near all-time highs? Well, it means that potentially they will lose a lot of their money in a short period of time. I would rather they take profits off the table and wait things out. I know a lot of early money has already taken chips off the table. This guy, who was and still is very much a bitcoin proponent, was mining and buying the stuff for pennies just a few years ago.

    http://www.youtube.com/watch?v=xGjOkkxrxT0

    For the sake of argument, let us suppose that this time around bitcoins are not a bubble and are instead coming up to the level at which they will start to trade as a worldwide digital currency. How could this be bad for libertarians? The answer to this question was also addressed by Jeff Garzik in the interview I posted in my article. Most consumers are not libertarians. With mainstream acceptance comes mainstream policy, which includes registration of the exchanges as money service businesses, regulation, fraud insurance, and higher fees to pay for all of this. In other words: the works. I do not think Jeff Garzik was being cynical when he said that the long arm of the government will in fact reach bitcoin, I think he was being realistic.

    Now that these points are out of the way, let’s get to your article.

    ‘The competition under the network effect I believe I addressed sufficiently. Korda does not see any mechanism for competition under the network effect (apart from barriers to entry), and appears to believe it's random, so the market shares of individual cryptocurrencies will randomly wildly fluctuate. I addressed the mechanics of competition under the network effect in previous two articles (first, second), and I think that Korda hasn't addressed my points sufficiently. So for the time being, I'll wait up his reaction on this topic’

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    Replies
    1. This isn’t a fair description of my position. I simply do not attribute as much weight to the network effect nor as much rationality to the market process as you do. It doesn’t always follow that being first is a guarantee for success. Nor does it always follow that a product which overtakes another has to be superior in some fashion or another. Standard economic theory would lead one to believe a competitor can win out by either offering a superior product or a lower price. However, there are times when offering what is virtually the same product but at a higher price is the right strategy, as Charlie Munger would point out. Moreover, sometimes offering less is the better course of action. The classic example of this is red bull, which used to come in large cans and sell for the same price it does today. Another example would be facebook, which is generally more clean-cut and does not allow as much personalization as does myspace.

      Preferences change and various products have certain predictable lifespans.
      This is xanga:
      http://www.google.com/trends/explore#q=xanga
      This is myspace:
      http://www.google.com/trends/explore#q=myspace
      This is facebook:
      http://www.google.com/trends/explore#q=facebook

      I believe we will get a batman formation in bitcoin:
      http://www.google.com/trends/explore#q=bitcoin
      Moreover, I believe the subsequent knockoffs will look similar to litecoin:
      http://www.google.com/trends/explore#q=litecoin

      You seem to think of bitcoin as a language, whereas I think of it as more of a good. People typically do not have an incentive to make up their own language out of nowhere. On the other hand, there has since time immemorial been a great incentive for alchemy. This is particularly relevant to bitcoin because it has a built-in goldrush mechanism. Grown men did not turn their basements into graphic card warehouses so that they may bring down the Federal Reserve and bring about some sort of utopia, they did it because they saw that eventually they could sell something that cost only a few pennies (at the time) to produce for a much greater sum later on. This is the primary reason why people, such as myself, have piled into litecoins earlier this month. I banked on my parable.

      Moreover there are always, and I mean always, unforeseen complications. The most recent one as far as bitcoin is concerned are the so-called forks. One example that I love to use, but that is unfortunately often neglected, is prosper.com. Lots of people lost lots of money in that investment primarily due to unforeseen complications. I believe that digital token money may very well have a big future, but that doesn’t mean bitcoins cannot go the way of xanga. Contrary to the network effect, the fact that bitcoins were first may very well be a detriment. If something major goes wrong, rationally or irrationally, people will switch over to a competitor, even if that competitor may be inferior or nearly identical with little to no improvements.

      Delete
    2. ‘With respect to money substitutes, Korda made several interesting arguments that I hadn't considered before, and in fact shows that some of the points Mises makes are incomplete. Foremost, he is the only Austrian I know of, apart from me, that does not think that money substitutes need to be claims’

      Initially, you challenged my position of bitcoins being token money because they were not claims for a fixed amount of fiat. I found this rather strange because not all tokens represent a fixed quantity, let alone token money. I think you were correct in your thesis in having written:

      “In the extreme case since my definition allows for a money substitute that does not represent a claim at all, the reserve can be entirely absent”

      That being said, I found your reformation of the regression theorem a bit odd and more akin to the labor theory of value, which I will get to a bit later.

      ‘But I didn't analyse the question of price in that depth. I assumed that the price is the same (now, other Austrians do that too, as I thoroughly quoted from in my previous article, so don't blame me, I didn't start it)’

      I purposefully didn’t want to bring other Austrians into the mix because there are various views on this sort of thing. I figured all that needs to be said about these matters could be gotten from the founder, Menger, and the Austrian who spent most time actually thinking about money, Mises. In many cases, subsequent Austrians have not necessarily added and built upon the TMC, they have perverted it instead. One only has to read a little bit of Hayek or Selgin to realize this. Joseph Schumpeter, whom I consider one of the best economists of all time, was particularly weak on the topic on money. In fact, part of the reason why Mises wrote the TMC was to twist his nose a bit.

      ‘Korda argues that the price of money substitute doesn't have to be the same as the money in the narrower sense. I countered that the price of the money substitute can be (in the extreme) lower, but it can't be higher’

      Actually, initially you argued that it must be fixed. It was only subsequently that you budged and stated that it can in fact fluctuate, but only downwards according to you.

      Delete
    3. ‘Korda argued that Mises himself showed examples of money substitutes that trade at a premium. I was kind of rushing my argument, so I didn't really think it through and I must admit he has a point’

      I didn’t have a particular quote in mind, but I do remember Mises writing at several times and in several works of the premium at which money-substitutes have traded. It would have been a glaring error had Mises missed this, for it is a clear matter of history, the most obvious one being the British pound in the 19th century. Here is a quote I found doing ctrl + f in TMC:

      “Thus in Japan as early as the middle of the fourteenth century, certain notes issued by rich merchants were in great demand because they offered a means of avoiding the costs and inconveniences involved in the transport of the heavy copper coinage.The premium at which bank-notes sometimes stood as against metallic currency before the development of the interlocal cheque-and-clearing business and the post-office-order service can most easily be explained along these lines.”

      ‘Heck, if Korda is right in attributing the report of premium on bank notes to Mises, Mises contradicted himself’

      I don’t see how this is the case. Mises wrote all sorts of scenarios. There were times when there was a great influx of specie and in which it made great sense for substitutes to trade at a premium due to convenience. On the other hand, there have been times of what Mises called ‘gold-premium’, which were typically associated with fiduciary inflation. I think people often misread Mises, who was more of a value-free descriptive economist as opposed to an ideologist. Moreover, when Mises did occasionally step out of his value-free economist role and turned ideological, it was always with a logical tone, pointing the various means necessary in order to produce the desired ends. As Schumpeter would put it,
      “History is a record of “effects” the vast majority of which nobody intended to produce”

      Delete
    4. ‘One possibility that Mises himself mentioned was credit money, which happened when the country went off a metallic standard and people were expecting this to be temporary’

      I don’t think this is correct. You can have credit money on a metallic standard. But as regards my article and our exchange, this point is irrelevant. All that needs to be said is that bitcoins are not a credit money.

      ‘The price of Bitcoin is not coupled to any other money, or any other good for that matter. So it's not a money substitute’

      Per your thesis, once again:
      “In the extreme case since my definition allows for a money substitute that does not represent a claim at all, the reserve can be entirely absent”

      To use an analogy, I did not stress the point that substitutes can trade at a premium because Mises said so. Rather, it is a matter of empirical record. Likewise, we know that various currencies and various types of currencies may and in fact do fluctuate relative to each other.

      ‘As I argue in my thesis, the first available records of market price of Bitcoin show that at the beginning, the market price was derived from the variable production costs of Bitcoin’

      This is more akin to the labor theory of value in my opinion. It takes time, energy, and in essence money to produce a desired outcome in a videogame. However, it does not follow that therefore the various gamers out there should be getting paid for accomplishing those objectives. The essence of the regression theorem is that the object at hand has use-value prior to attaining exchange-value.

      Per Ludwig von Mises:

      ‘‘If in this way we continually go farther and farther back we must eventually arrive at a point where we no longer find any component in the objective exchange-value of money that arises from valuations based on the function of money as a common medium of exchange; where the value of money is nothing other than the value of an object that is useful in some other way than as money. But this point is not merely an instrumental concept of theory; it is an actual phenomenon of economic history, making its appearance at the moment when indirect exchange begins”

      Morever, Ludwig von Mises stated that:

      “Menger has pointed out that the special suitability of goods for hoarding, and their consequent widespread employment for this purpose, has been one of the most important causes of their increased marketability and therefore of their qualification as media of exchange”

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    5. I have known of families and individuals who hoard things which are extremely durable, such as gold. However, I have not heard of anyone hoarding binary digits.

      The primary reason that I classified bitcoins as token money was that there was no other place to put them. I could have taken the easy route and merely stated that they were not money or that they were something which deserves a whole new category, but I am far too humble for that approach.
      In fact, I think you tried to take this approach by claiming that bitcoins were a medium of exchange, but not yet money (commonly used medium of exchange). However, this merely postpones the issue at hand. If we presume that bitcoins will eventually become money, which is presumably what most bitcoiners would like, then we are back to square one in having to classify them. In your thesis, you seem to claim that bitcoins are a commodity money, which is presumably why you have reformulated the regression theorem. I am not sure if you still hold this view. However, it doesn’t hold much water in my personal opinion.

      I think the present monetary system has many deficiencies, and bitcoin is one outcome of that. Per Ludwig von Mises,
      “Nevertheless, one thing can safely be asserted: that token coinage is always the result of attempts to remedy deficiencies in the existing monetary system”

      ‘How is the price of money substitutes [bitcoins] determined?’

      In your thesis, you claim that “the price of bitcoin correlates with the public interest in bitcoin”

      Although this is true, a more precise way of putting it would be that interest in bitcoin follows the price of bitcoin. This is exactly why I think the price of bitcoin is relevant towards its potential success and that a bubble will be very detrimental. As for what determines the price of bitcoin: various people buying and selling bitcoins. The average bitcoin transaction is over $1,000 per a trusted source of mine. The implication here is that unless people are shopping at Bergdorf Goodman or Barney’s with bitcoins, people are buying them as a speculative vehicle. There already exists a bitcoin hedge fund, a subsidiary of the Exante, that takes subscriptions of $110,000 from accredited investors and buys bitcoins with them. I’ve been in the markets long enough to see how this story ends.

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    6. ‘I myself did attempt to take your arguments seriously and analyse them thoroughly, and adjusted my arguments to cater for the points you made. I don't think you did the same with respect to my arguments’

      I will have to disagree on this point. Your first article practically claims that all of my points are irrelevant. You went on to say that the primary advantage of bitcoins were the lower transaction costs. While it is certainly true that exchanging binary digits is much cheaper than having to move fiat, or worse yet, specie around the globe, there is another edge to this sword. Let us not forget that the most common arguments for fractional-reserve banking or fiat money are in fact lower transaction costs. I think transaction costs can be greatly eliminated via companies such as BullionVault or GoldMoney. However, I do admit that token digital money does have the advantage in this field. As for bitcoin, I think they are at present a lose-lose proposition. To reiterate, if it pops this is not good news for the holders of bitcoins. If it does not pop and is instead reasserting itself as a worldwide currency, then it is bound to lose its libertarianism as Garzik pointed out.

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  3. For the record, there is another example of a money substitute that trades at a premium - and it comes directly from Austria:

    http://wiki.mises.org/wiki/Inflations_during_Napoleonic_Wars#Austria_1792-1815

    $0.02

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  4. Truly the main dread if for the individuals who have the view that Bitcoin could wind up plainly useless, which is a hard exchange by which to recuperate; unless the broker were to be shorting. new ico

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