Why you should be a Bitcoin Maximalist

I have been struggling for the last couple of months with trying to explain the phenomenon known as Bitcoin maximal-ism.  Essentially it is a movement that is focusing a lot of effort primarily into advocating the support of Bitcoin as the blockchain solution at the expense of all other crypto projects.  Being a pragmatist myself, I was at first very skeptical of the absolutist ideals that they seemed to advocate.  However, time has a way of cutting away the flash obscuring the truth behind wisdom, and I have come to appreciate the maximalist position more recently after much consideration.  This story starts and ends in exactly the same place, which is the theory and value of what we call money.

What is money?

Now, bear with me here, as I know I am bound to lose about half of you with boring economic terms reminiscent of the Econ 101 class that you took in university.  I promise that it is worth it.  One of the sources of confusion in crypto space which many people struggle with is that cryptocurrencies are a hybrid of the financial and economic discipline, with computer science and mathematics.  Surrounding this whole thing is the concept of money, and it doesn’t help that most economists can’t agree on the exact nature of money, specifically the objective exchange-value of money.  If you were to ask 10 people on the street the question “What is money?” you will inevitably get 10 different answers and 9 of them will be wrong.  The truth about money and why not many people understand what it is, is no accident.  Great lengths have been taken to ensure that this topic is never sufficiently taught in schools, and confusing or conflicting terminology is used in various different circles which compounds the problem.  So to begin to understand what money is we need to be very meticulous about the terminology that we employ so that we can begin to unravel the overlapping layers of meaning and obfuscation.  We shall start with the simple description of what money is; which is simply a medium of exchange, which can efficiently facilitate the indirect exchange of goods between parties.  If Bob is a Baker, and Will a wheat farmer, Bob can certainly exchange bread for wheat with Will.  But in the case where Will doesn’t want bread, and needs corn instead, and Charlie, the corn farmer doesn’t want wheat but wants bread, then Bob can exchange bread for corn with Charlie, which he can then exchange for wheat with Will.  In this simple example, the corn that Bob bought from Charlie was acting as the money, which is to say it had no value to Bob aside from its use as a facilitator of indirect exchange.  Indirect exchange in turn allows for efficient division of labour, so that people can specialize in baking, corn farming or shoe making, without having to learn all those skills for themselves in order to produce these products for their own consumption.  Money then, is simply a medium of exchange that facilitates the indirect exchange of goods.

Types of money

There are essentially 4 different types of money which have been used over the history of human civilization. Commodity money, credit money, fiat money, and money-substitutes.

Commodity money we are all familiar with.  It was the first money to be ‘invented’ by mankind.  It is simple a commodity that possessed certain qualities that made it amenable to be used as a medium for exchange, this involves properties like divisibility, immutability, easily verifiable, and impossible to forge.  Commodity money of antiquity, like gold and silver, were created spontaneously by the market.  It is in fact the only trust-free money that can be created by the market.  Nobody decreed that gold should be used.  It was used, and the task of governments in the past was to just verify and regulate its authenticity through the system of standardized minting and measurements.  Commodity money is created by expending work or labour in order to extract it from its natural state, and prepare it for use as a money.  This effort (and the entire industry that surrounds it) acts as a natural buffer to fluctuations in supply of the commodity, and thus a damper on the exchange-value of the commodity money.

Credit money is also created by the market, and it is essentially the use of an IOU as a money.  This money, however requires trust, in that every IOU comes with it a certain amount of counterparty risk.  In stable and strong markets, this risk is minimal, but in developing markets where corruption or insufficient legal systems exist to properly enforce contracts, this risk can be appreciable.  Credit money is characterized by the exchange of present goods for future money (or present money for future goods).  Credit money is used quite prolifically in American society in the last 50 years due to the success of credit networks such as VISA and Mastercard.  Credit money, being an IOU only has value so long as it is tethered to another type of money backing it.  In simple terms, IOUs are claims on an actual assets somewhere else, this can be future value in the case of interest bearing bonds, or simply warehouse warrants, or gold certificates.  It is important to note that before 1930s, the US dollar was a credit money, due to the nature of it being a claim to a certain amount of gold held by the national treasury, which was redeemable on demand.

Fiat money is the money that only has value because it has been decreed to have value by the governing state or body.  It has no intrinsic value, and in fact would in most cases be nothing but worthless paper if it were not for legal tender laws and the threat of imprisonment awaiting those who refuse it accept it as an instrument to extinguish any debts by other parties.

Money-substitutes are the last type of money.  Though it is probably more fair to call it a subclass.  It only exists when the conditions surround it such that they can be easily and readily redeemed for any of the other 3 types of money.  Bank deposits and token coinage is an example of a money-substitute.  Token coinage of course is used in most countries.  It is called ‘token’ and not the same as commodity money because it by itself is not intrinsically money.  For instance, if you were to take a quarter and melt it down to the elemental nickel/zinc, it would not have the value of 25 cents, nor would you be able to buy bubblegum with it. (the price of bubblegum being more than a quarter notwithstanding).  Another common money-substitute is poker chips at a casino, and food-stamps in the US.

So what is Bitcoin?

So where does Bitcoin sit in these definitions of money?  Well I know I would be in disagreement with many gold bugs and hard money advocates like Peter Schiff when I say this, but I believe Bitcoin is clearly a commodity money.  Sure, it is virtual.  It is by no sense ‘hard’ in the visceral or tangible sense, but it is clearly a commodity money in so far as the characteristics that economists such as Ludwig von Mises had set out to so meticulously define 80 years ago.  It requires work to produce, it costs money to produce, and the mining or production industry is not directly influenced by the politics and monetary policy of the day.  In fact, the only thing that should incentivize the producers is good old fashioned capitalist greed.  Greed is in fact one of the most pure and predictable of incentives.  It was very likely that in past centuries many environmentalists lamented at the fact that so many gold mining companies were wasting vast resources and energy in digging this yellow metal out of the ground.  They may have even lobbied their governments to put restrictions on the gold mining industry “for the collective good of mankind”.  “Look at all the wasted effort and energy that they expend just to ingratiate themselves”, they would have said.  I tell you definitively that these people did not understand the market and the mechanisms that work within it nor the forces that naturally control the flow of supply to meet demand. (The demand for money).   I digress, however, as I think you will agree that the point of Bitcoin having all the characteristics of a commodity money have been shown, and thus should therefore act exactly as one in the economy.

Altcoins

So why all the altcoins?  To date I believe the number is in the thousands if one were to count every type of digital currency created since the advent of Bitcoin.  But why do they exist?  Why do perfectly logical smart people devote so much time to creating them and promoting them?

Simply put:

1) People are greedy

2) People do not understand money

3) People do not grasp that blockchain and Bitcoin is an experiment in money, as much as, or perhaps more than it is an innovation in technology

People are greedy

The first requires little explanation.  People are motivated by greed.  Ponzi schemes are great for “redistributing wealth” from people who do not possess the same information or reasoning capabilities as you may have.  It is easy to mask a new altcoin in a thick blanket of rhetoric singing praises of “equality of opportunity”, “common good” or “freeing the people from oppression”; you know, socialistic sounding marketing phrases that any reasonable, even-tempered bipedal on the planet would agree to.  Start a coin, premine it, or create a fixed supply of money which only you control, and enjoy all the benefits of the central bank, which is to say you use the same mechanism of wealth distribution used for centuries, except with you at the top of the pyramid instead of the government.

People do not understand money

The second point deals with the fact that most people don’t understand what money is, and there for do not really understand what it takes to create a money.  I have previously explained what money is and the types of money that exist.  In order for a thing to be a money, it must clearly fit into one of these categories.  Anything less would be equivalent to Monopoly(TM) money.  It may be money-like, but it is not a money.  This point is where we lose a lot of smart minds wasting their time working on POS (Proof of Stake) systems which aims to either “solve” the distribution issue of Bitcoin or the mining energy expenditure issue.  The fact that I use the word “solve” in quotes belies my opinion on the matter.  They are not problems.  As I have explained in the previous example of gold, complaining that Bitcoin mining firms will ‘go berserk’ if left to its own devices and spend half the world’s energy supply in mining is ludicrous and only serves to illustrate to the astute reader that the speaker does not understand economics.  For even the most devote Keynesian would admit that the free market will find the correct price such that a given activity is profitable.  Miners who expend capital to increase the supply of Bitcoin when the demand for it stays the same or does not increase the same amount will soon find themselves losing money, and at some point they will stop their mining activity.  There is no need for a “government” to step in to regulate the market**.  Ever.  The market is self-regulating by the forces of greed vs fear alone.  As for the question of fair distribution, I ask what is “fair”?  Is a old panhandler who found gold in the rivers of California and subsequently made a fortune by fishing the nuggets out of a river doing anything unfair or unconstitutional?  Would we rather see a law passed that forced all gold miners who profited from the gold rush to relinquish a portion of their gains to the public? (Yes!, I suppose, if you are a communist)  The problem with trying to hand tailor a distribution of money is that you need to control a fixed supply.  A fixed supply virtual asset which is created from nothing and distributed to people, has no value, no more than monopoly money has value.  Sure there may be some token value created by a few people buying it on the promise of future gains, but in truth it is no more valuable than money printed by Parker Bros.  This is because any POS coin is in fact, a fiat money.  Or rather, a bad attempt at creating a fiat money.  Fiat money only works when you can force people to attribute value to it, and use it.  If you hold no such power, you may as well be handing out orange $200 bills as people pass “GO”.

Bitcoin is an innovation in money, more so than technology

This is the crux of it.  The issue is that most computer geeks think that Bitcoin is an innovation in technology.  Accordingly, they see iterative improvements on it as a positive thing, like how cell phone technology improved over time with different companies contributing innovations to the craft over the years.  I cannot remember how many times I have heard developers defend the idea that innovating with different blockchain implementations can only be a net good thing.  “Look at how Apple improved upon Microsoft” they would say, or “look how TCP/IP improved upon frame relay networks!” they would shout.  I say this: these people are categorically misunderstanding what the essence of Bitcoin is.  It is not so much a technology innovation as it is an innovation in money.  Let that fact brew in your mind for a couple of seconds. Bitcoin is an innovation in money.  Money has not seen any real innovation since that fateful day almost 100 years ago at Jekyll Island when the industrialists and bankers got together and designed the Federal Reserve system in order to “solve” what they saw as a problem with the elasticity of money.  Bitcoin created a new sub-category of commodity money: /money/commodity money/digital. Due to the nature of Bitcoin being a money innovation, and the fact that commodity money has a very particular way in which it can come to be accepted as a money (the mining or work process in extracting and preparing the commodity for use) this essentially means that a lot of technologists are wasting their efforts in trying to build better versions of it because they only see it for its technological implementation.  If they only realized what many of us with financial backgrounds have realized, which is that Bitcoin is a new money, then they would be more likely to better spend their efforts building technology on top of this new money network, instead of trying to build their own version of it.

The Cultural Divide

What the crypto space now is suffering from is a divide; a divide in mindset, background and thinking.  It is into this gulf that all altcoins find their existence.  On one side you will find the computer scientists, the mathematicians, the nerds.  On the other you will find the economists and the financiers.  Neither side respects the other enough to actually consider listening to what the other side is saying.  You have folks like Peter Schiff saying that Bitcoin is geek money and isn’t real money. You have Bitcoiners saying that economists and bankers are dinosaurs and this new digital technology will disrupt and break all the rules of the old regime. Both are wrong. Both are right. Both are too blinded by their own arrogance to realize this.

So geeks, computer scientists, developers everywhere. Please stop wasting your time on self-gratifying Ponzi schemes, POS currency systems and other lessor coins and help contribute to making Bitcoin better. It’s an open source code base. Use your brain power for good. Support the only internet money.  Trust me, I’ve sat on both sides of the fence being an engineer working at big bank trading floors for over 14 years, the race is over and Bitcoin has won.  Time to fight the real war, which is the separation of money from the state. Let’s all help make this experiment in new money work.

Next time, I will explore the reasons why there can only be one digital commodity money in world, and why that money is Bitcoin.
** The only time a market should/may be restricted is when it is a question of morality or human decency, and even then, some atheist, anarchists would disagree on that point.  The debate of which is beyond the scope of this topic.
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Legal hurdles facing crypto currencies

As Bitcoin becomes more and more popular as a form of payment, there are still governments that would rather people stayed away from it altogether. Left wing activists would have us believe that this is due to governments scheming with their totalitarian doctrines, but I believe mostly this is just due to the less sinister reason that the government must maintain some regulation over its own economy.

I remember when I was about 6 years old my mother introduced me to the banking system. She helped me gather all the coins and new bills I had saved up from Chinese New Year red packets, rolled them up and took me to the bank to open a bank account. I remember not really grasping what was going on, but I do recall the strange notion that I had just “lost something” when all I got back for my troubles was a little book that had a number printed on it. That feeling, that the banking system was essentially taking something of value from me and I had to trust it to keep it safe was something that took a while to get accustomed to. Indeed, owning that trust, or credit is something that the banking system has been very protective of as it is the bases of their business model. The government on the other hand, not being a for-profit entity, has a more high level goal of maintaining economic growth and stability. Part of doing that successfully means controlling the flow of wealth into and out of the country. As banks being linked to a national central bank system have a record of all deposits, withdrawals and transfers within the system, you can see why the banking business and government have both a natural proclivity to work together to achieve their individual ends.

So what does Bitcoin represent that is such a threat? Well with any large scale connected money system, the danger is that funds obtained by illicit means have a large ecosystem in which to resurface as clean money. Which of course allows for criminal elements to become organized and grow as quickly as legal businesses. This is the basis of Anti-Money Laundering (AML) and money transmission regulations. The idea of course is to identify and prevent the movement of money which come from the proceeds of crime. This creates a deterrent to the business of crime and presumably makes the society a safer place for law abiding citizens.

I digress; back to why Governments are apprehensive about Bitcoin –because Bitcoin is the first successful implementation of electronic cash, and governments have been trying to get rid of cash since the advent of the central banking system. This is because cash is difficult to track and therefore essentially “invisible” to the government. The only saving grace is that moving around a lot of cash is difficult (1million USD weighs 20 pounds). Bitcoin allows the equivalent amount of wealth to be brought across borders as simply as one can bring a smartphone or even a piece of paper, so on the surface, governments have a reason to be apprehensive.

Regulation therefore should be at the points where fiat currencies are exchanged for Bitcoin, as exchanges are well equipped to keep a watchful eye for suspicious transactions the same way they have been doing all along. At the end of the day, everyone has to pay their taxes so there will always be an intrinsic demand for fiat. For Bitcoin to Bitcoin transactions industry watchdogs or government funded agencies can keep watch on the movement of illicit wealth through the system. Merchants can register their addresses or use BIP32 wallets in order to report their transactions to authorities when demanded of them. There is no legitimate reason behind the “criminal element” argument, and yet governments keep on harping on this. Why? Opinions vary, but my money is on the fact that it sounds sufficiently scary enough to ward away people from using Bitcoin. One saying that has become very near to my heart having worked with traders on Wall Street for over 14 years; “When in doubt, follow the money”. In this case the money happens to be RMB and it’s leading us right to the largest bitcoin trading volumes in the world, China.

China has been openly negative towards Bitcoin, and one doesn’t have to dig too far to find out why. China’s currency is being artificially suppressed in order to keep the competitive advantage of Chinese labour. This point has been a contentious issue with US lawmakers for the better half of the last decade. As the currency is being artificially kept weak that implies that the black market rate for RMB is much higher than the official rate, giving a strong incentive for the wealthy and well-to-do in China to try to move their wealth overseas. Bitcoin’s strong suit, is in its electronic cash like qualities which helps facilitate this movement of capital. At it’s base, Bitcoin is the freedom of money and in countries where the freedoms of the people are tightly controlled, Bitcoin is a clear and present threat to that control.

So if governments who control their citizen’s freedoms stand to lose the most from Bitcoin usage, one must take a long hard look at US lawmakers stance on Bitcoin, and decide whether it is really being driven by a desire to protect the greater stability and good of the economy or is it more to protect the existing or potential government controls and agendas?

As President and founder of Bittoku, one of the reasons why I founded the company in Japan is because I firmly believe that being placed in between the political influences of China and US, lawmakers in countries like Japan and Korea will be able to find the pragmatic happy middle ground for Bitcoin, and make the choices that benefits the greater economy and freedoms of people. Having lived in Japan for over 10 years and having family in Korea, I can say that Japanese and Koreans tend to favour efficiency and practicality over political rhetoric.

I hope that taking a strong political lead on Bitcoin is something that Japanese lawmakers can do, which will set an example for other countries which may not have the best interests or 和 of the community that they serve in mind.

Bitcoin and banking business

I often hear from the libertarian leaning friends of mine when they talk about bitcoin they often herald it as signalling the end of banks. Bitcoin allows for peer-to-peer transactions, without a central clearing authority, so it is often thought that the mass adoption of Bitcoin will mean the end of the need for the banking industry. This is one of the biggest misconceptions about Bitcoin and by extension alternative digital currencies today. To say that the digitization and the liberation of money means the end of banks is akin to saying that the digitization and liberation of information means the end of universities and schools; it just doesn’t add up. But why? To explore this question, one first has to quantify exactly what the institution of a bank is and what are the functions that it performs. After which it should become obvious why the removal of an intermediary for cash transactions does not mean the end of the banking business.

Savings and loans

This is the bread and butter of a commercial bank. Commercial banking is simply the banking business that caters to persons and for-profit, non-financial corporations (company’s that make things or do things, and charge you money for it). This business is simply the collecting of excess funds from individuals, providing them safe keeping of the money and in turn loaning a portion of the money out to businesses in need of funds. In return for loaning out individuals money, the bank pays interest. On the other side, the bank needs only to charge a higher rate of interest on the loans, and the bank turns a profit (assuming they also properly manage the default risk of borrowers).  This model relies on the fact that the money in deposit accounts not all be withdrawn at the same time, as the bank has already lent it out.  In order to create a dis-incentive for people against withdrawing their funds, the bank charges usage fees, which it usually waives if you keep your balance over some requisite amount on a monthly basis.

In a hypothetical world which is completely converted over to a digital currency, the need for the pooling and lending of excess capital from people who have it to people who need it is a fundamental requirement in a capitalist system. Without it, the economy would sputter to a standstill as businesses in need to raise funds will find it extremely hard to do so if the funds are all distributed. Additionally, loaning out funds isn’t something that can be simply ‘open sourced’. Running a profitable S&L business requires a certain level of expertise in evaluating the credit worthiness of the borrowers. Something that takes experience and significant accounting rigor to do correctly. The instant somebody or a group of people start doing this, they essentially are doing banking.

Investment Banking

This is the business of creating and dealing with financial instruments which allow for businesses to manage their business risks. They range from Kellog’s buying commodity futures contracts to hedge against drought which may affect corn prices, to businesses looking to restructure their debt. Although investment banks are not normally the ‘banks’ that people mean when they talk about the end of banking due to digital currencies, they have been loosely associated with a negative image of banks due to the financial crisis’ that occurred in the last decade due to over-leveraging and lack of proper fiscal controls. This business is largely unaffected by the advent of digital currencies. If anything Bitcoin and blockchain currencies promise to drive this business to become more transparent, as contracts which contain settlement risk can be better managed using a system that does not require 3rd parties to ensure trust. Imagine swap contracts where the notional is lockup up in a multi-signature wallet. No hiding these off balance sheet if everything is open for all to see.

Capital Markets

This is the business of issuing and disseminating debt. Debt is what drives the current economy, as businesses often spend what they do not have, in a calculated bet that they can become profitable and pay off the debt before the interest burden drives them to bankruptcy. The analogy I often use is that a debt driven society is like a Formula One race, everyone is driving a very fragile, specialized car, which is optimized for speed and running on paved tracks. A debt-free society is more like a rally car, a much more durable car, which can operate on different road conditions, and can take a lot of damage before becoming inoperable. Problem is, if you bring a rally car to a Formula One race, you are going to lose. However, when an external, unforeseen event happens, (a black swan waddles across the race track) most of all the F1 cars will end up in a smoldering multi-car pile-up.

Though economists may argue the merits of an economy based on debt, the fact is that Bitcoin won’t really affect this market at all. In fact, having debt in a Bitcoin world may even be safer, as collateral can be put onto the blockchain and debt failure events would automatically release collateral as needed without third party trustees or escrow companies to facilitate the transfer. What this means is less fees, more efficiency.

Security and Availability of your Funds

Banks allow for you to deposit your money in one branch, and for you to withdraw it from another branch somewhere else geographically. This was actually the very first service that banks offered, dating back to the Knights Templar holding the gold of crusaders who deposited in Europe and issued them notes with which they could use to redeem for gold in the Holy Land. This is arguably the ONLY service which will completely disappear with Bitcoin. With the exception of some cases where security on a large scale may be required, the function of being able to move your money around freely does come essentially free with bitcoin and does not require a centralized authority to ensure its operation. Additionally Bitcoin allows for one to arguably make your savings as secure as Fort Knox, by way using paper or brain wallets.

So what does the future of banking look like?

Whether we know it or not, we still need the economic functions that a bank provides, though one can argue that there may be less of a compelling reason for these functions to be concentrated in a single social institution like a bank. That said, the only thing that I am convinced about regarding Bitcoin’s effect on the existing banking system is that it will force banking functions to dis-aggregate from the banks that fail to respond to this evolution, to one’s that decide to change their business model and adopt a more distributed view on banking services. If one were to use the example of the internet, one only needs to point to the fact that we still have information clusters, like YouTube, Wikipedia, Google, to see that even in a fully free and distributed environment, people tend to gravitate towards certain aggregated clusters of information, perhaps driven by the same forces that drive humans to live in cities instead of in rural communes.

So does this mean that like the Masons of the Middle Ages, people with banking skill will naturally form closed societies that protect and progress the art of banking? Or will it be more like the art of computer science, which has become the model of a free academic movement where participants are more than willing to assist new learners in the art, for nothing more than progressing the art itself and peer recognition?

Only time will tell, but if I had to put my bitcoin on it, I would put it on the Masons.

51% attacks, should we be worried?

There has been many accounts in recent weeks of the dangers of a 51% attack on the bitcoin network and what that would mean.  Indeed the mining pool Ghash.io did manage to grapple the majority from the network which sparked doomsday folks to start calling for the end of days for bitcoin.  Fear not, for there are several reasons why this would not happen, and there are many reasons why a majority in the bitcoin processing network doesn’t mean the end of the world.

Double spending attacks.

As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they’ll generate the longest chain and outpace attackers.

-Satoshi Nakamoto

The first thing that people are quick to point out is that if a group of people owned more than half the network hashing power, then they would be able to double spend coins.  While this is technically true, it is realistically impossible.  The reason boils down to human nature.  A mining pool is a organization that distributes the hashing load over many participants. Each one of these individuals is contributing to the team effort to solve a block and in return is being paid by pool for their services.  They have no incentive to contribute their hashing power if it became known that the pool that they were contributing to was in reality using their majority to cause double spends, which would erode trust in bitcoin, and thus erode the value of their payouts.  Satoshi developed the mining system with careful attention to the balance of incentive and rewards for all bitcoin network participants.  This system does not change just because the role of one of these participants has became distributed.  The dis-incentives for a single entity to launch a 51% attack on the network remain the same if the entity was pool of individuals controlled by a single entity.  Once the network were to notice a large number of orphaned blocks coming from a certain majority pool rejecting other transactions, then I believe a large number of the offending pools participants will leave the pool to join another.  Assisting in a double spending attack as a member in the pool has no benefit to any given individual.  The double spent coins would belong to a small few individuals given the number of transactions per block, and the vast majority of the pool members will only see the value of their bitcoin eroded by the loss of confidence in the network once the attack was noticed.

Transactions would be small

The transactions that would possible to be double spent would be of small amount of coin.  This is because in order to execute a double spend attack, one has to pay for a good with some coin, have the goods delivered, and then have the transaction backed out.  Most retailers selling goods of significant value will usually wait for several confirmations before confirming the sale and delivering the goods.  The only merchants that may not would be ones selling items about the value of a coffee.  Not much of a benefit considering the value loss in bitcoin due to a theoretical double spend attack.

Blacklisting

Any double spend attack, once discovered and publicized, would immediately get the mining pool put onto a blacklist, and thus others on the network would ignore blocks being published by that pool.  This feature is not currently built into the protocol, but it may be in the future.  Bitcoin, being a distributed network, like the internet, is very resilient to damage, and can re-route around damaged sections.

Summary, 51% majority attacks:

Not as bad as people are lead to believe.

Does bitcoin mean the end to Fractional Reserve Banking?

Though bitcoin and the blockchain technology that it bestowed unto the world have many practical uses, many of which we have only begun to scratch the surface of, there remains lot of confusion about its effect on the existing fractional reserve banking system (FRB).  Having worked in the banking industry for over 12 years, I can say that it remains one of the few topics that most people do not have a good understanding of, and continues to be misunderstood even among many who work in finance.   Indeed, there seems to be an air of ‘masonic knowledge’ that surrounds the details of how money is created, moves around and destroyed in our current monetary system, which is possibly due to historical reasons, and perpetuated by those who wish to keep the well guarded ‘secrets’ of the art to the selected few who are deemed high enough rank to be stewards of the information.

FRB is generally the act of a bank or institution creating money by lending out its deposits, without actually debiting the deposit account when it does so.  There are no laws forbidding the activity*, nor are there any laws that enforce it’s use either.  It is purely a voluntary act made by a bank, motivated by it’s desire for profit.  This is an important point: there is nothing that forces a bank or a depository institution to engage in FRB.  This is contrary to what most people believe, as many confuse the practice of FRB with the central bank’s practice of printing money, when in fact the two are completely different things.  For example, FRB can occur in systems outside of the fiat money system, for instance, in gold.  Most believe the US stores of physical gold held in custody for other countries are running an FRB system, as in recent years when Venezuela and Germany asked for their physical gold held in the US to be repatriated, the Fed hemmed and hawed and a multi-year repayment plan was drawn up.  In the case of Germany, they reportedly will be able to have 50% of their gold delivered by 2020.  I don’t know about you, but if I asked my bank if I could access the contents of my safety deposit box, and they told me to come back in 7 years, I would be a tad suspicious that they were running an FRB and had actually lent out or rehypothecated my deposits.

With bitcoin, FRB is still possible, as the act of creating an FRB only requires that a party lend out their deposits, without reducing the original deposit account when it is done.  This is entirely possible with bitcoin, if the banking company keeps the addresses that they use to pool their depository assets private from the depositors who have banked with them.  For example, if Adam banks 100 BTC with a coinbank, he sends 100 BTC to an address controlled by the coinbank.  At this point, Adam’s money ceases to be his, and it is transformed to a number on a private ledger, essentially off the blockchain**.  The coinbank could then decide to loan out 80 BTC to Eve, who runs a small bitcoin software development company.  The bank sends 80 BTC to Eve’s address from its pool of assets.  As Eve’s company pays its employees in bitcoin, she does not want to change the BTC to fiat, and instead wants to put it into safe storage and easy access for paying her employees.  She happens to use the same coinbank as her bank, so she redeposits the 80 BTC into her account at coinbank.  In this way, with an initial actual 100 BTC that was deposited with coinbank, there is now a total of 180 BTC on coinbanks accounts split between Adam (100) and Eve (80).  The bank has just ‘created’ bitcoin on accounts, even though there is nothing that can actually back 180 BTC if both Adam and Eve decide to withdrawal all their accounts at the same time.

What would stop a bitcoin bank from doing this?  Presumably, nothing.  In fact, it is only the relative lack of cheap lenders of last resort in the bitcoin ecosystem that makes engaging in this activity a bit too risky for the current bitcoin banks.   In the existing fiat system, banks can always borrow money from the Federal Reserve through the FedFunds window, if they fall short in their current accounts. (i.e. they lent out more than the sum of what they took in and what they actually have on account. )  If bitcoin became a mainstream currency, then it stands to reason that the large holders of bitcoin may start to lend out their bitcoin on an overnight basis, at interest, to bitcoin banks in need to fulfill their daily withdrawal requirements.

In conclusion, FRB is an artifact of humans lending to each other, and it is a result of our collective proclivity to extend credit to each other.

Bitcoin and the blockchain, while allowing us the ability to demand and ensure that banks maintain a 100% reserve requirement, does not enforce it.  Therefore, it is up to each and everyone of us to evaluate the credit worthiness of the companies that we choose to act as custodians of our money, and to demand to know who they in turn extend credit to and by how much.  Perhaps, if we find none worthy, we should be prepared to be our very own bankers.  Indeed FRB is not only a future possibility for digital currencies, once bitcoin companies start to pay interest on deposits, it will be an inevitability.
Next article, I’ll talk a bit about banking and bitcoin, and how they can coexist.

* The Federal Reserve does require that member banks keep a minimum of 10% of their deposits on reserve. (as of writing)

** Some notable exceptions being bitcoin ‘banks’ that remain completely ‘on-chain’ which means that they never use their own bitcoin addresses to pool their deposits, and instead, they just manage a list of addresses which their clients have entrusted to them. The block chain does allow for the public audit-ability of banks who wish to maintain a 100% reserve.

Should Bitcoin follow the Skype model?

regulationRecently circulating on the internet is a wonderfully thought provoking article by Micheal Jackson, former COO of Skype, regarding Bitcoin which advocates that bitcoin should learn from skype in how to approach the issue of regulation.  It is a well reasoned argument and a convincing call for disruptive technologies like Bitcoin to stop wasting time trying to fit into some pre-defined status quo, and instead to just barrel straight ahead, keep on doing what you are doing, and let the bureaucrats who care about laws worry about determining how Bitcoin fits into the context of them.  While this approach has it’s merits, I disagree that this would be the best approach for Bitcoin to take, and here are my reasons why:

1) It’s reckless.

This “shoot them all, and let god sort them out” mentality to the issue of regulation is irresponsible. It may work in the technology sector, where brazen silicon valley startup hot shots are continuously redefining what we the masses ‘absolutely need’, but this attitude is not appropriate for something as ‘hard’ and traditional as cash.  Sure, internet redefined information exchange and killed the library, google redefined search and killed the brick and mortar marketplace, and social media killed hanging out with the gang in the school parking lot.  But this doesn’t mean the contender for the successor of paper money should play by the same rebellious, ‘punk-rock’ rules.  The article even went as far as advising NOT to consult lawyers about their interpretation of the rules in your jurisdiction regarding the use of Bitcoin, instead suggesting that you, the visionary entrepreneur, read the laws and figure out which loopholes you can exploit.  I don’t know about you, but I don’t think any advice that advocates not seeking legal professionals and trying and figure things out yourself is ever a good idea.

2) Bitcoin is ‘off the charts’ disruptive

Unlike other disruptive technologies that come from the industry, Bitcoin is disruptive at a level which actually could threaten social institutions which have taken the last 100 years to develop.  Said in another way, if a technologies disruptive effect was measured like earthquakes, then Bitcoin would be a 8.6, being beat only by the internet, the splitting of the atom, and the discovery of fire.  The notable difference when compared with it’s other siblings of the information age, is that while you could always opt not to use the internet, or Skype, or your smartphone, you cannot easily ‘opt out’ of using money.   Bitcoin, as a disruptive technology, needs to cater to the entire demographic of humans.  (That means ol’ Granny and Grampy Smith as well).   Due to this potential to effect everyone on the planet (except Buddhist monks living atop a mountain), governments will be forced eventually to regulate players in the industry who wish to act as stewards  of citizens’ wealth.   Granny’s everywhere would demand it, and granny isn’t savvy enough with the technical intricacies of multi-signature wallets and Shamir’s Shared Secrets to be able to trust a business based on its number of Facebook ‘likes’.  People like granny will want governments to ensure that her money is safe.  This means regulation is an eventuality, and putting it off now is just putting off work that is going to have to be done anyway.

Let me be clear, I’m not arguing for voluntarily and proactively asking for governments legal opinion on your business’ legality.  I’m arguing that you should prepare your business plans expecting that regulation will come, lest you be disrupted when it eventually does.

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Bitcoin and its potential role in the global economy

As it may be expected, as both a technologist, and somebody who works in the financial industry, Bitcoin and other digital currencies have caught the interest of myself and many other people, for many different reasons.  But perhaps unlike others, my interest is purely from an economic standpoint.  Most specifically, the idea that an economy can exist in a zero-inflation environment.

Gold standard

Many of these discussions inevitably stems from the fact that as no central authority like the Fed can control the creation of the currency, this would lend itself to a deflationary economy. It made me really think about what that really meant, and whether or not something like a currency that could not be directly controlled could ever be used successfully as a store of value. History, of course was full of such cases, the most notable and the most recent, of course was the gold standard. Make no mistake though, there is nothing special about gold, before that there was silver, electrum, gems and beads. In fact, there are even cases in some pacific islands where large stone wheels were used as legal tender, in fact, history is replete with cases where the currency was in a form which did not lend itself to be easily manipulated by central authorities. So taken in this light, fiat currencies is only a recent invention, and only has been in effect for just over 40 years, and in the eyes of history, that is nothing more than a blink of the eye. In this short period of time, there is not enough time to show evidence for nor against the success of this system. In fact, the system came about due to the problems that came from attempting the keep the fiat currency redeemable for gold. This restricted the amount of credit that could be issued to the amount of gold the banks had in the reserves. Defenders of fiat currencies will be quick to say that such restrictions to the creation of money, and its ability to quickly increase the money supply, was one of the causes of the Great Depression.

Since the general ‘freeing’ of money from a physical basis and allowing it to be created whenever the Central bank deemed it necessary, the Feds have consistently used this tactic in times of crisis, or even in times when the economy would just dip below the level of expectation that they had forcast. It is akin to a person who is addicted to pain killers, who takes them at the first hint of problems. Soon they begin to take them just to feel normal, as the brain, like the economy, gets accustomed to the drug, and the effect lessons.

Perhaps then, indefinitely inflatable currencies have outlived their usefulness, and it is time that we all took a long hard look at whether it would be sensible to go back to the days of a currency which is grounded? Could Bitcoin fill that need? What issues would that present? Before we can consider this, we have to make very clear that Bitcoin is not the same as gold. Although the two have similar properties, they also differ in some very important ways. Firstly, the intrinsic value of gold is apparent to everyone who has held it in their hands. It’s value is somehow innately obvious to humans since time immemorial. Bitcoin, on the other hand, while having intrinsic value as a payment network, is not something that people can innately understand, and even when explained, people still have a hard time grasping. This is due to the fact that Bitcoin, like the internet, has ‘distributed’ intrinsic value. Namely, it has value only because other people use it, and it’s value stems from it’s utility alone. Imagine an internet comprised only of individuals who could not connect to each other; it wouldn’t be of much value to have an internet web page which nobody could reach. The other marked difference between gold and Bitcoin is that gold, while its reserves on the earth are indeed limited and static, tend not to be lost very easily. (Spanish galleons in the carribean not withstanding) Bitcoin on the other hand, due to its digital nature, make it much easier to store a very large amount of value in a very easy to lose medium. The classic example being of the fellow who threw away over 8 million dollars worth of Bitcoin when he binned his old computer. So Bitcoin, unlike gold, has some interesting digital aspects which make it more difficult for people to accept as a store of value but these I believe can be remedied with time and better education.

International reserve currency

So if Bitcoin can match gold on all its merits, and time and familiarly can lesson its shortcomings, could it be used as a reserve currency? Keynes argued for the adoption of a shared reserve currency called the bancor which would be used to regulate foreign trade by way of being a medium of exchange for a countries foreign reserves. In this way, any country could exchange bancor for another country’s reserves, which it could then use to pay for imports. This proposal, which echoes the current IMF’s SDR system, used as a means of regulating foreign trade deficit accounts between countries, has some merit to it. Though the current system is flawed as it uses the US dollar as reserve currency, which means the dollar is serving a dual purpose of facilitating foreign trade deficits, and also being used to fulfill the requirements of the internal economy of the US. This overloading of the currency is what makes monetary and fiscal policy of the US excessively complicated. Like servants of two masters, policians in America find it difficult to serve both the international community and their own citizens.

Despite the temptation to think of Bitcoin as a reserve currency, the issue with this is that as a facilitator of international trade, it is necessary for governments to restrict the use of it to central banks alone as without this restriction it would erode the governments ability to control it’s own economy.

Replacement for fiat

So what about Bitcoin as a the primary currency of a country’s economy? This too has some problems. Foremost, being unable to print it to stimulate the economy means that the government has it’s hands tied in times of economic crisis. Faced with a real drop in employment and investment and deflation the government would be forced to source more Bitcoin from foreign entities, perhaps paying for them through SDRs like bancors. This may well work but the speed of which this can be effected is relatively slow in a situation where the speed of response is a critical factor on the success of the fiscal stimulus. Additionally this opens up the possibility of other countries unwillingness to lend for political reasons which would limit the governments ability to protect its economy from external forces.

Secondly, and most importantly as an obstacle to Bitcoins adoption as a national currency is one of the fundamental facts of society today: taxes. As long as people have to pay their taxes in the local currency, then there will always be a need for fiat currencies issued by governments.

Thus any natural evolution of Bitcoin will inevitably see it evolve into a third currency or medium of exchange. A sort of neutral currency which is used as a conversion medium between the fiat currencies of the world, a currency which truly reflects the demand of each individual countries fiat and by extension, it’s economic output vs another’s. A sort of USD, but not subject to the policies of any one country. Essentially what this means is that as more and more people use Bitcoin as an inter-fiat currency, it’s value becomes more and more reflective of the true value of a countries balance of trade vis-a-vis it’s international neighbors. Perhaps when this happens then the exchange rate from fiat currencies to Bitcoin instead of USD should replace the current valuation method of the bancor. If you follow this to it’s natural conclusion, then it means Bitcoin will become the defacto reserve currency of the world. One thing that would have to happen first, the regulatory position of governments on Bitcoin will first have to be clarified to the point where speculation on the currency will stabilize.