A Counterintuitive Fiat Money Arbitrage

I maintain a notebook on financial arbitrage strategies. If this sounds like a weird hobby, it probably is. But I cannot help it. From my observation and experience, anyone who has ever consistently made money in the markets does this.

It is one of those “we all do it, but don’t talk about it” things. The reason for this lies in the definition of the word “arbitrage”. Investopedia describes the word as follows:

“Arbitrage takes advantage of the inevitable inefficiencies in markets.”

— Investopedia

In the context of markets, an “inefficiency” means that the arbitrageur (the person or entity that is engaging in the act of arbitrage) knows something that the majority of the market does not. In other words, an arbitrage is possible only if the arbitrageur has an unfair informational advantage.

Note that this is pretty much the opposite of the “I will teach you how to make money in the markets” snake-oil sales pitch that is omnipresent on the web these days. From my experience, if someone is consistently making money in the markets, they never say a word about it (myself included).

So, if all this is true, why am I writing an essay about an arbitrage strategy? Well, I have held on to this “idea” for years now, and have not acted on it. This is because this strategy is more on the theoretical side and largely impractical. But it serves well for educational purposes.

Furthermore, I am not the first person to come across this arbitrage; I have read accounts of this in several unrelated literature sources as well. It is like an open secret that is readily available for people who are observant enough to see.

Having said this, a word of warning: I am not responsible for any legal outcomes that arise from any poor decisions on the part of the reader. So, please do not do anything illegal or ill-conceived based on what I share in this essay.

Before we start discussing the strategy, though, we need to cover a fundamental property of fiat money in the financial markets.

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A Brief History of Fiat Money and Inflation

If you have not read my essay on a story-based beginner’s introduction to fiat money, then I highly recommend doing so, as I will be referencing those concepts in this essay. In that essay, I narrated a fictitious historical account that served to cover the basics.

But this time around, let us touch upon real history. The earliest application of fiat money dates back to 7th Century AD/CE China. Fast forward to the 10th Century, the Song Dynasty issued the first paper money known as jiaozi.

This paper money was technically not fiat money, since the dynasty valued the notes at a certain exchange rate for gold, silver, or silk. But in practice, they did not allow any conversion, making it effectively fiat money.

The original plan was to retire these notes every three years and replace them with new notes at a 3% service charge. But again, in reality, more and more notes were printed and no retirement took place. This meant that inflation was unavoidable.

Does that sound familiar to you? It sounds an awful lot like the world we live in today. On the one hand, it is interesting to note how the combination of old notes not being replaced and new notes being printed leads to inflation (I am oversimplfying the dynamic here, but bear with me). On the other hand, there is at least one arbitrage opportunity hidden in this dynamic.

The Value of Fiat Money

Inmy original essay on how fiat money works, I mentioned that fiat money theoretically does not have any value by itself. Its value arises only in the context of financial transactions that are agreed upon by buyers and sellers in the markets.

However, that is only true theoretically. In practicality, paper is not free and printing presses are not free. Even in the context of the new digital economy, all those 1s and 0s are definitely cheaper than paper, but certainly not free. For instance, running computers, hard disks, solid state drives, etc., costs money.

This is the second crucial factor that I will be considering for my little arbitrage strategy.

The Counterintuitive Fiat Money Arbitrage — Revealed

The strategy I am about to reveal is centered not around digital money or even notes. It is specifically centered around coins. I am looking for specific coins that are old enough to contain considerable metal content, but do not have much monetary value in today’s inflated markets.

The authorities responsible for printing coins typically calculate the cost of each printing each coin such that it is negligible in comparison to the value of its denomination. However, there is one factor that works against this calculation: inflation.

If I look hard enough, I might find coins that are worth more than their denomination. In other words, the value of the metal(s) that comprise each such coin would be more than the monetary value of the coin.

This creates an arbitrage opportunity, especially in today’s economy. People dislike carrying spare change in their wallets so much, that I know of several services exchange coins for a cost. You read that right; there already exist services that take in all sorts of coins and credit you with digital money or notes for, say, a 10% service charge.

This in itself is an arbitrage strategy. However, the strategy that I am focusing on goes several steps further.

The Risk in Executing the Fiat Money Arbitrage

Remember: I am interested in the metal value of each coin, not the monetary value. So, what I do is simply exchange large quantities of these coins and store them in secure containment facilities. These containment facilities will cost me money. I mentioned that arbitrageurs make money; I never said that it will be completely free or easy, for that matter.

In an ideal world, I could just melt these coins and sell the raw stock in a preferred exchange. But the real world does not work like that. In most countries, there exist laws against this. In other words, destroying currency is considered a punishable crime in many countries. How can I proceed?

Now comes the risk involved in this arbitrage. I need to wait for the coins to officially go defunct. In other words, the coins slowly go out of circulation to the point that the regulatory authority announces that these coins are officially not transactable anymore.

From this point onward, the coins are not official currency, but just standard objects. I may choose to do what I please with them. But how can I be sure that these coins will go defunct? Well, that is the risk I take with this strategy.

The coin that I chose may or may not go defunct in my lifespan. I have to price these factors into my strategy and initial research as well. What are the coins that have been announced defunct in the past 10 years? Which coins are (probably) next? Do these coins fit the other criteria to pull this strategy off? You get the picture.

Final Comments

In essence, this is a simple arbitrage strategy that takes advantage of the fact that fiat money is theoretically value-less, but practically has inherent value and the fact that inflation might push the inherent material value past the denomination value.

Having said this, let me come back to why I am sharing this strategy. My intention is for this information to be educational, and not be suggestive of anything illegal. This is in fact another big risk with arbitrage. Often, operating on the edge of information puts arbitrageurs on the edge of legal regulations as well.

It is indeed risky. As they say, “there is no free lunch” in the markets. So, let me repeat it one more time. Please do not do anything illegal or ill-conceived based on the information I have shared in this essay. I am sharing this information purely for educational purposes.

With that out of the way, I hope this essay provided you with interesting insights. Thank you for reading!

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Further reading that might interest you:

• I Accidentally Almost Started A Business. Here Is What Happened.
• Startup Ideas: Is There Value In Ranking Creators?
• Ergodicity: The Hidden Reason For Society’s Growth And Your Misfortune.

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