Friday, November 9, 2012
Bitcoin (for monetary economists) - why bitcoin is great and why it's doomed
Bitcoin is a pretty complex institution. If you're a cryptoanalyst you'll have one explanation for bitcoin, if you're developer you'll have another. What follows is a useful way for monetary economists to think about bitcoin.
What I do in this post is explain how bitcoin compares to a central bank note and a bank deposit. The conclusion is that bitcoin does something truly revolutionary. It also has a lethal problem at its core.
There's two characteristics of a bank deposit. The first is the deposit's intrinsic nature. A deposit is a claim on the credit of the issuing bank. Secondly, these deposits can be traded. The issuing bank keeps a ledger detailing who holds every deposit. When people wish to exchange with each other the prospective trade is announced to the bank. The bank then checks the identities of transactors and verifies that the deposits are there. Then it simply rearranges the pattern of deposits on its ledger.
To abstract from this story, there's the actual "thing" issued, and the record-keeping of that thing.
Central bank-issued notes also have an intrinsic nature. They are claims on the credit of the issuing central bank. As for record-keeping, the central bank doesn't keep a ledger of noteholders. Rather, people spend cash anonymously without announcing trades to the central bank for verification. The only bit of record-keeping the central bank does is record the serial numbers of outstanding notes. The central bank protects its issue from counterfeit paper by strict anti-counterfeiting laws and complex patterns to dissuade copying.
One might say that record-keeping of deposits is finely detailed. Both the quantity and the distribution of deposits are recorded. Record-keeping of central bank notes is coarse and granular. Only quantity, not distribution, is tracked.
Bitcoin also has a record-keeping feature. This mechanism is a fine one, not a granular one. It has to be fine because digital tokens like bitcoin can be easily copied and spent multiple times. This is called the double-spending problem. The bitcoin mechanism gets around the double-spending problem by doing what deposit banks do -- track both the quantity and distribution of bitcoin. When a bitcoin transaction is announced, the bitcoin mechanism checks that the person selling bitcoin has real bitcoin in their possession. Once verified, the mechanism updates its records to indicate that the given quantity of bitcoin has changed ownership.
What makes Bitcoin different from deposit banks is that the process of announcing, verifying, and recording trades is distributed, not centralized. In effect, the ledger has been made public, not private.
The bitcoin ledger, which is made up of a history of every trade of bitcoin in history, is downloaded and stored onto the computers of bitcoin users all over the world. This history is called the Blockchain. When a prospective bitcoin trade is announced, thousands of different computers all over the world hear this announcement. They all independently work to verify that the seller's bitcoin already appear in the Blockchain and are indeed the seller's. The transaction is verified, usually after ten minutes of work, the Blockchain updated, and the new owner of bitcoin can now spend it.
Bitcoin is a revolutionary record-keeping system. It is incredibly fast, efficient, cheap, and safe. I can send my Bitcoin from Canada to someone in Africa, have the transaction verified and cleared in 10 minutes, and only pay a fee of a few cents. Doing the same through the SWIFT system would take days and require a $35 fee. If I were a banker, I'd be afraid.
The lethal problem at the core of the bitcoin mechanism is that a bitcoin has no intrinsic value. Notes and deposits are claims on the credit of the issuing bank, but bitcoin is a claim on no one. Bitcoin are no more than bits, indications that someone has received something. But that "something" is worthless. It's like having a library with the best archival system in the world, yet the only books in the library are filled with empty pages.
For some odd reason Bitcoin have a positive value right now (about $11/BTC). But without an intrinsic tether, I think that bitcoin's price is doomed to hit zero. It will be incredibly sad if the failure of bitcoin's price means that the good aspects of bitcoin - specifically bitcoin-as-record-keeping mechanism - is thrown out with the bath water.
What the bitcoin record-keeping mechanism needs is an already-valuable underlying asset to which it can be tethered. Rather than tracking, verifying, and recording the movement of intrinsically worthless 1s and 0s, it will track the movement of something valuable.
In the future, perhaps someone will create a distributed credit system. Rather than banks lending to people by creating deposits, people will lend to each other by creating deposits. P2P lending. Say these P2P deposits are to be made tradeable, or negotiable. Then you'll need some sort of record-keeping mechanism like bitcoin to track where deposits have gone. Why not tether bitcoin to a P2P credit system? That way you have a P2P credit system and a P2P payments record-keeping mechansim all rolled into one.
It'll be just like the old system of bills of exchange, for anyone who needs evidence.