Is Bitcoin Money? Does It Matter?

• Executive Summary

According to the US Federal Reserve Board, “in extreme but unlikely scenarios, the use of banks to conduct payments could become obsolete.”[i] This post describes Bitcoin protocols, bitcoin, users, and intermediaries. As to whether bitcoin is money, I conclude that it is not. It is likely neither a “medium of account” nor a “store of value.” However, this conclusion may be less important if bitcoin (or other digital currency) attains systemic status as a payment system. Then, there may be an impact on the US Federal Reserve’s monetary policy. Alternatively, the Fed may issue so-called Fedcoin.

Further posts will be forthcoming on compliance and regulatory issues related to bitcoin and the impact on financial institutions if the Fed issues digital currency.

• What is Bitcoin?

As set forth by Satoshi Nakamoto, Bitcoin is a “purely peer-to-peer version of electronic cash [that allows] online payments to be sent directly from one party to another without going through a financial institution.”[ii] According to its advocates, the goal of Bitcoin is to serve as an alternative existing payment system and to enable transactions across national borders and currency denominations without central banks and financial intermediaries.[iii]

“Bitcoin is merely a protocol. A set of rules. The protocols that assign the ownership of bits of information without duplication are called bitcoins … the protocol is referred to as Bitcoin and the units of currency as bitcoins." [iv] Although bitcoin is the largest regarding market capitalization, there are many other units of virtual currency (“VC”) For the purpose of this post, VC includes “cryptocurrency” and “digital currency.”

VCs may operate in a centralized, decentralized, or hybrid model. Bitcoin uses a decentralized model which includes: (1) the use of cryptography with “miners”; (2) no central bank; (3) the fact that bitcoins do not represent a liability; and (4) the currency units are ultimately limited (21 million the case of bitcoin).[v]

There are users and intermediaries in the Bitcoin protocol. The intermediaries include: (1) Exchanges where buyers and sellers trade bitcoin – these tend to combine the function of an ECN[vi] with a broker-dealer; (2) Miners or Mining Pools that verify the validity of transactions - the first miner to solve a computationally intensive problem is awarded a block reward of new bitcoin (thus increasing money supply) and, increasingly, a transaction fee; and (3) Connectors – those that connect the final users – primarily a platform for users to exchange regular currencies, manage balances, and transact with others.[vii]

•   Is Bitcoin Money?

In determining if bitcoin is money, the following economic definition of money is utilized. Is the asset: (a) a medium of exchange; (b) a medium of account, and (c) used as a store of value? [viii]  

a.      Is it a “Medium of Exchange”? 

Bitcoin is accepted as payment from a growing number of online entities, including Expedia, PayPal, and Virgin America. However, the willingness of business counterparts to accept a VC does not by itself imply that it is widely used.

Unlike fiat currency, which is backed by a sovereign entity, bitcoin relies solely on the self-fulfilling expectation of private agents that it will be accepted.

b.      Is it a “Medium of Account”?

A “medium of account” is the unit in which all prices in the economy are quoted. Bitcoin instead is a “medium of transaction” (i.e., it facilitates the exchange). There is little evidence of any digital currency being used as a unit of account. Payment facilities typically offer retailers the opportunity to price entirely in fiat currencies, using the digital currency only temporarily as a payment system. Prices denoted in the medium of account tend to be “sticky” while prices denoted in other units tend to fluctuate. The entities which accept bitcoin compare the bitcoin quote with the US dollar price and immediately convert to fiat currency upon the purchase of the good/service because of the price volatility. “Some economists consider the operation as a unit of account to be the most important characteristic of money. Indeed, it is commonly argued that a defining feature of monetary policy lies in central banks’ control of the unit of account.”[ix]

c.      Is it “Used as a Store of Value?”

This is debatable because of: (1) high price volatility unrelated to economic or financial factors; (2) bitcoins are neither liabilities of the state nor private entities.[x] Digital currencies lack any intrinsic demand for use in production or for consumption. Their worth as a store of value rests on people’s beliefs regarding its future supply and demand. The belief that they will continue to remain in demand depends on the users’ evolving beliefs about the ultimate success of the VC.

Less than 50% of all bitcoins in circulation are used in transactions – about half for small value (less than $100 per transaction).[xi] This implies that bitcoins are being hoarded for investment and not as a store of value.

For these reasons, bitcoin is not money. But, with somewhat circular logic, it could be considered money, if the government states that it is. This is truly ironic, as Bitcoin was developed in response to the Western Financial crisis.

•   Could Bitcoin Impact Federal Monetary Policy?

Decisions concerning the money supply are called monetary policy. The importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time.

Classically, the change in the supply/demand of money: (1) contributes to inflation/deflation; (2) impacts interest rates; and (3) impacts business cycles.

The historical track record of containing inflation is mixed across both private and public systems. However, when there are systemic liquidity shortages at times of financial crisis, and there is a need for a lender of last resort (“LOLR”), public systems are better. History also suggests that central banks in the main economies emerged in response to the need for LOLR and to manage bank runs.[xii]

The role of US Fed is to: (1) conduct monetary policy by influencing monetary and credit conditions in the economy; (2) supervise and regulate banking institutions to ensure safety and soundness of the nation’s banking system and protect credit rights of consumers; (3) maintain the stability of the financial system and contain systemic risk; and (4) provide financial services to depository institutions, including payments systems. The Fed performs this role by fractional reserve banking using: (1) open market operations; (2) the reserve rate; and (3) its discount policy.

Bitcoin is a self-regulating peer to peer system that is neither backed by the central bank nor the government. Bitcoin cannot be inflated, stimulated, or depressed by the central bank or government.[xiii]

Because of limited current supply, VCs in principle have limited inflationary risk, unlike privately provided monies of the past. However, if the supply of VCs significantly increases, this may lead to inflation.[xiv] There are parallels with historical episodes of unregulated banks that issued their own banknotes as a form of private money (the pictures above are examples of such a banknotes). There is a risk of uncontrolled inflation (that is, a fall in the purchasing power) if private issuers overuse their ability to create currency at a very low marginal cost.[xv]

There are three possible monetary policy risks related to bitcoin:

a.      The Potential for Structural Deflation

With bitcoin and most VC, monetary supply is pre-determined and governed by a protocol that ensures that the eventual total supply is fixed. This effectively removes any discretion from the determination of the money supply. This may contribute to deflation in the prices of goods, services, and wages. Importantly, the inability of the money supply to vary in response to demand may cause volatility in prices and real activity.[xvi] “When the prices of goods and services are falling, households have an incentive to postpone or even abandon spending plans. Expected price deflation also raises the minimum return an entrepreneur must offer to raise funding for investment in physical capital. Economic theory, therefore, predicts both aggregate demand and potential output to fall and, if the deflation is indefinite, the unemployment rate to be permanently higher.”[xvii]

b.      In an Economy with a High Share of VCs

The central bank’s ability through monetary policy to manage the business cycle may be limited. VC protocols typically don’t allow for the expansion of the money supply in response to a negative demand shock. As set forth by Keynes, this could exacerbate recessions and lead to a deflationary spiral as during the Great Depression.

c.      VCs are Not Able to Replace the LOLR Function of Central Banks

The ability of institutions to provide emergency liquidity does not exist with VCs.[xviii]

• What is Next for the Fed and Financial Institutions?

Essentially, people believe that VCs are convertible to fiat currency. Exchanges facilitate this belief. However, if enough people have a reason to believe otherwise, and if there is a “bank run” on one VC, it could cause bank runs on other VCs. In other words, privately issued VCs are susceptible to the same problems as privately issued bank notes. 

For reasons of brevity, this post has not explored open vs closed blockchains. Suffice to say, the Fed would want a closed Bitcoin. One way for it to create its own cryptocurrency would be to "fork"[xix] the Bitcoin protocol. The Fed could then alter monetary policy (by money altering money supply) through changing the miner's block rewards.[xx] However, many questions remain including the future role of financial institutions with a central bank crypto-currency such as their role in taking deposits and fractional reserves.

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Note: this post is based on my submission in the Harvard class about the Federal Reserve’s “Monetary Policy After the Financial Crisis” that I completed in the Spring. Thanks also to a former executive at the Federal Reserve Bank of New York for a critique of the content, although the analysis and conclusions are solely my own.

About me: Currently, I am a Managing Director at a seed funding firm and a consultant, presenter, and expert witness serving the financial services industry with a passion for FinTech. Previously I worked as a Senior Attorney and Chief Compliance & Risk Officer with experience at the SEC, Pacific Exchange, Royal Bank of Canada, Prudential, and Marsh & McLennan. I can be reached at [email protected] and (646) 319-7845.

ENDNOTES

[i]   D. Mills, et. al, “Distributed Ledger Technology in Payments, Clearing, and Settlement.” Finance and Economics Discussion Series, Federal Reserve Board, Washington DC (No. 2016-95). https://www.federalreserve.gov/econresdata/feds/2016/files/2016095pap.pdf

[ii]   S. Nakamoto, “Bitcoin: A Peer-to-Peer Electronic Cash System,” https://bitcoin.org/bitcoin.pdf (retrieved on Oct. 18, 2017).

[iii]   S. Lo & J.C. Wang, “Bitcoin as Money?”, Current Policy Perspectives, Federal Reserve Branch of Boston (No. 14-4). https://www.bostonfed.org/publications/current-policy-perspectives/2014/bitcoin-as-money.aspx

[iv]   S. Molamedi, “A Friendly Introduction for Economists to the Bitcoin Protocol,” Tannu Tuva Initiative (Feb. 28, 2014). https://tannutuva.org/blog/2014/2/28/a-friendly-introduction-for-economists-to-the-bitcoin-protocol

[v]   Dong He, et al., “Virtual Currencies and Beyond: Initial Conclusions,” IMF Staff Discussion Note (Jan. 2016). https://www.imf.org/external/pubs/ft/sdn/2016/sdn1603.pdf

[vi]   An Electronic Communications Network (“ECN”) is an electronic system that widely disseminates orders and permits the execution of orders in whole or in part. The primary products that are traded on ECNs are stocks and currencies.

[vii]   Supra, note 3.

[viii]   The Bank of England notes that “It is not always the case that a given asset serves, or categorically does not serve, these functions. Different assets may, at various times, play some or all of these roles. And they may offer them for some people, but not for others. For example, Radford (1945) documents that cigarettes served all three of these roles within prisoner of war camps during the Second World War. Furthermore, meeting these economic definitions does not necessarily imply that an asset will be regarded as money for legal or regulatory purposes.” R. Ali, et. al. “The Economics of Digital Currencies,” Bank of England Quarterly Bulletin, (Q3 2014). https://www.bankofengland.co.uk/publications/Pages/quarterlybulletin/2014/qb14q3prereleasedigitalcurrenciesbitcoin.aspx

[ix]   Id., at p. 8.

[x]   Supra, note 5.

[xi]   A. Badev & M. Chen, “Bitcoin: Technical Background and Data Analysis,” Staff Paper Federal Reserve Board (Oct. 7, 2014). https://www.federalreserve.gov/econresdata/feds/2014/files/2014104pap.pdf

[xii]   Supra, note 5.

[xiii]   G, LeBlanc, “The Effects of Cryptocurrencies on the Banking Industry and Monetary Policy,” East. Mich. Univ. (2016). https://commons.emich.edu/cgi/viewcontent.cgi?article=1498&context=honors

[xiv]   Supra, note 5.

[xv]  Supra, note 8, at p. 10.

[xvi]   Id., at p. 6.

[xvii]   Id., at p. 7.

[xviii]  Supra, note 5.

[xix] At its most basic, a fork is what happens when a blockchain diverges into two potential paths forward — either regarding a network’s transaction history or a new rule in deciding what makes a transaction valid. A. Castor, “A Short Guide to Bitcoin Forks,” www.CoinDesk.com (Mar. 27, 2017).

[xx] S. Molamedi, “Will Bitcoin Ever Become Money? A Path to Decentralized Central Banking,” Tannu Tuva Initiative (July 21, 2014). https://tannutuva.org/blog/2014/7/21/will-bitcoins-ever-become-money-a-path-to-decentralized-central-banking

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