Crypto 2.0 Musings - Bitcoin Supremacy

Back in January, I put forward an argument in my Distributed Ledgers and Disintermediation of Trust blog that aside from ideological and illegal reasons, Bitcoin could be adopted by the 2.5 billion un-banked people as the currency of choice due to lack of alternatives, and in doing so eventually replace national fiat currencies used by the banked - to reign supreme. In the later Seven Billion Currencies blog, I also mused if Bitcoin could serve as an international trade reserve currency, one that is not unilaterally influenced by issuing nation’s domestic policy to the possible detriment of foreign holders.

Recent public debates about how to technically scale Bitcoin beyond the current 7 transactions per second limit e.g. Bitcoin XT and BIP 100 versus 101 versus 102, prompted me to re-examine my arguments.

I looked through Bitcoin’s technical issues I have been capturing since January and came to the conclusion that all of them will be solved in due time based on the work being done by Bitcoin developers and the wider community e.g. transaction scaling, confirmation delays, no quality of service guarantees, transaction privacy, proof of work energy waste, right to be forgotten impossibility, etc.

So I turned my attention to Bitcoin’s ideological design implications. Bank of England’s Innovations in payment technologies and the emergence of digital currencies bulletin does a great job in explaining them:

‘The foundational motivations for Bitcoin appear to have been largely ideological. The digital currency was expressly designed to avoid any centralised control (of either the money supply or the payment system) and to minimise the degree of trust that participants need to place in any third party. The first block in Bitcoin’s block chain (the ‘genesis block’) includes the text: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” in reference to a newspaper article from that day (Duncan and Elliott (2009)), presumably in order both to demonstrate that it could not have been created before that date and to highlight the conceptual distinction between Bitcoin and the structure of modern monetary economies.’

Bitcoin avoids centralised control of payment system through pseudonymity, affording security and confidentiality in a consensus-based system without revealing legal identity, required for know your customer (KYC) and anti-money laundry (AML) controls. Governments managed to overcome such hurdles for cash, and they will again for Bitcoin.

Bitcoin avoids centralised control of money supply by gradually disbursing bitcoins as reward to miners until the 21 million limit is reached - an incentive for third parties to validate transactions.

Bitcoins are divisible down to 8 decimal points, so only 2.1 quadrillion satoshis, smallest Bitcoin transaction unit, can ever be mined, which will not cover the approximately 2.12 quadrillion cents in circulation today within combined Euro, US and UK economies alone. Adding extra decimal points should not be a complex fix to implement.

Fixed supply and use of terms like mining suggest that Bitcoin is modelling itself on the gold standard, abandoned by UK in 1931 due to inability of government to meet it’s obligation in the face of the great depression, and by US in 1971 for similar reasons, ending the Bretton Woods system of exchange rates tied to gold-backed US dollars.

UK’s rejection of gold standard lead to a sharp devaluation in sterling, which surprisingly helped UK to recover from the crisis. Perhaps then a fixed money supply is not always a great idea. Let’s explore how fiat money, today’s pounds and dollars, is actually created, in order to assess pros and cons versus the gold standard.

Centrally controlled money supply, contrary to popular belief, is not controlled by the central bank issuing base money (UK’s 3% of money supply that is notes and coins plus central bank reserves held by commercial banks that have to be used to achieve inter-bank settlement finality) and limiting it’s ability to multiply-up (fractional reserve banking) into broad money (remaining 97% of UK’s money supply - essentially IOUs from commercial banks to households and companies, created by commercial banks themselves though making loans) by setting reserve, liquidity and capital adequacy (Basel accords) ratios.

Bank of England does not impose any ratio limits, let’s commercial banks use deferred net settlement (helped by UK government’s Financial Services Compensation Scheme that guarantees first 75K of all bank deposits) to reduce need for base money and will happily issue new base money to commercial banks as additional reserve deposits matched typically to re-hypothecated (re-used) collateral loans wrapped in repurchase agreements. PositiveMoney.org does a good job explaining how money is really created:

‘So as long as all banks are increasing their lending at roughly the same rate, the money supply can keep increasing without the need for additional reserves. So banks don’t really depend on having reserves before they can create money. They can make the loan first and find the reserves to settle the payment by borrowing them from another bank. And collectively, banks can increase the money supply almost indefinitely without being restrained by the amount of central bank reserves. All this comes together to imply that the only thing that truly limits the creation of money is the willingness of banks to lend. And their willingness to lend depends on their confidence.’

Here is what Bank of England’s Money Creation in the Modern Economy bulletin has to say on this topic:

‘Money creation in practice differs from some popular misconceptions - banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.’

In a nutshell, it’s commercial bank’s lending that creates vast majority of money in circulation. This means that it is vital for bankers to lend responsibly since when they don’t, the rest of the society has to foot the bill. As the former chairman of the UK’s Financial Services Authority, Lord (Adair) Turner stated in February 2013:

'The financial crisis of 2007 to 2008 occurred because we failed to constrain the financial system’s creation of private credit and money.’

Paraphrasing The Economist’s The origins of the financial crisis crash course article, financier’s folly saw a flood of irresponsible mortgage lending in America, doled out to ‘sub-prime’ borrowers in returned for over-priced property, being turned into supposedly low-risk securities through financial engineering that crumpled like a house of cards when the real estate market crashed and borrowers defaulted.

Bitcoin’s gold standard fixed supply approach appears to be the right one, as it removes banker’s risk from the economy, yet the world rejected it over 40 years ago, why? Here is Bank of England’s The Economics of Digital Currencies bulletin view:

‘Fixed money supply … would pose a number of problems for the macro-economy: for example, it could contribute to deflation in the prices of goods and services (and wages). Importantly, the inability of the money supply to vary in response to demand would likely cause welfare-destroying volatility in prices and real activity. 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 in order 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. A second problem derives from a pre-determined supply’s inability to respond to variation in demand. Aggregate demand for money is volatile, for reasons that may be seasonal (such as Christmas shopping), cyclical (such as recessions) or structural (such as from technology improvements). If the money supply cannot respond to these variations, volatility in prices will ensue, causing welfare-destroying volatility in economic activity. ‘

In other words, fixed supply cannot flex in sync with economy causing price volatility, forcing businesses to decrease investment (welfare-destroying) as they increase reserves to buffer against uncertainty. It also lacks flexibility to devalue against other currencies, making the economy uncompetitive as exports become more expensive, and imports cheaper.

This does not mean that Bitcoin cannot be a valuable asset; after all just because fiat money is no longer backed by gold, gold still holds considerable value. Gold is often used as a safe heaven, just life off-shore foreign reserve accounts, for wealth preservation in un-stable economies. Perhaps Bitcoin’s on-chain could become the new off-shore!

Crucially though, fixed money supply backed by proof of work in case of Bitcoin is by it’s very nature backward looking – prove that you did work to earn your reward that you can exchange for something of value in the future. Sounds very prudent and sensible. There is however no guarantee, nor indeed any promise of future redemption. Bitcoin’s FAQ argues that:

‘As with all currency, bitcoin's value comes only and directly from people willing to accept them as payment.’

The FAQ misses a crucial point about fiat currencies, unlike Bitcoin, they have a built in forward looking promise of work, rather than relying on a backward looking proof of work. It’s that promise of work that is in my opinion is the only true long-term value. I will attempt to prove this point to you through the use of a thought experiment.

What would happen if everyone stopped working today? In the short term, as long as you are not over reliant on skills (e.g. medical) you lack, you should fare adequately as you still have your house, fuel, water supply and store of food i.e. some goods have intrinsic value. Long term, as assets are exhausted or perish, yet required skills are un-available since no one is willing to work, society falls apart and money, even if it is in a form of yellow metal, looses all value.

How is it then that fiat currencies have a built in promise of work? Let’s see what happens when someone takes out a mortgage to buy a house. New money is created in form of bank deposit IOUs that are used to purchase the house, and a matching loan is created with an obligation on the borrower to pay interest on the loan or face repossession until the loan is repaid in full – typically 25 years. Most people need to work to earn money to pay off interest, which means in effect they promise to work for the next 25 years.

Promise’s value is very much based on the confidence that the individual will be able to sustain employment earnings for the duration of the loan, and that the house is worth the loaned amount, in case it has to be repossessed. Someone has to assess that confidence, collect and pay out interest and work with law enforcement agencies and the courts to repossess assets in case of default. That someone today is a bank charging a percentage spread (to reflect higher risk in case of default they take on higher loans) between bank deposit and loan interest rates, as an incentive to do business.

In other words, you need someone like a banker to assess confidence in a promise of work-based currency. You could consider a web of trust reputation system as an alternative to banker’s assessment of individual’s credit and employment history, however given how many LinkedIn endorsements I have from people who do not know me, I would suggest that unless you’ve got skin in the game, it’s not a good measure.

Bank of England’s The Economics of Digital Currencies bulletin also suggests alternative money creation methods, not reliant on bankers:

‘In order to address a need to respond to variation in demand, a more flexible rule would be required. For example, the growth rate of the currency supply could be adjusted to respond to transaction volumes in (close to) real time. Alternatively, a decentralised voting system could be developed. Finally, variant schemes could embrace existing monetary systems by seeking to match official broad money data or to target a fixed exchange rate, although this would require the abandonment of part of the schemes’ original ideology. ‘

Problem with all of the above suggestions, as well elsewhere mentioned mechanisms like formulaic currency growth, lies in the fact that no promise of work is made, regardless of people’s willingness to vote, or analytics ability to consistently forecast abnormal volatility stimulated by sudden geo-political events.

So, fiat currencies are not like bitcoin, they are actually bank deposit IOUs linked to fiat currencies and are banker’s confidence in state’s ability to entangle society into a promise of work and asset’s ability to hold value, in order to keep the economy ticking over – they encourage value creating behaviour.

Most people do not have the time and expertise to make that confidence assessment, as demonstrated by relatively low uptake of crowd lending by retail customers as compared to hedge funds, so yes, this does create a massive over-reliance on bankers to get it right, and yes existing controls (central bank only grants banking licences to vetted organisation) failed in 2007 – but so far no one has come up with a better model – and that in my opinion includes Bitcoin.

Bitcoin is a brilliant new technology that unfortunately encourages value-destroying behaviour.

If Bitcoin’s ideology prevents it’s ascent to supremacy, then why all the hype about blockchains? To understand that, you need to understand what the regulators are thinking.

On one hand regulators expressed a desire to address one of the root causes of irresponsible lending - and that's the compensation practices, here is what the Financial Stability Board has to say: 

'Compensation practices at large financial institutions were a key contributing factor to the global financial crisis. High short-term profits led to generous bonus payments to employees without adequate regard to the longer-term risks they imposed on their firms. These perverse incentives amplified the excessive risk-taking that severely threatened the global financial system and left firms with fewer resources to absorb losses as risks materialised. The FSB work on compensation practices are intended to reduce incentives towards excessive risk taking that may arise from the structure of compensation schemes. Any compensation system must work in concert with other management tools in pursuit of prudent risk taking.'

On the other they also want to have better ways of detecting irresponsible lending before it gets out of hand i.e. much greater transparency. Some extracts from Financial Stability Board on the subject: 

'Strengthened core market infrastructures to reduce the potential for contagion arising from the interconnectedness of significant market participants and the limited transparency of counterparty relationships.'

and

'Large volumes of outstanding bilateral transactions had created a complex and deeply interdependent network of exposures that ultimately contributed to a build-up of systemic risk. The stresses of the crisis exposed these risks: insufficient transparency regarding counterparty exposures; inadequate collateralisation practices; cumbersome operational processes; uncoordinated default management arrangements; and market misconduct concerns.

In response, the G20 Leaders agreed in 2009 to a comprehensive reform agenda for these markets, with the objectives of improving transparency, mitigating systemic risk, and protecting against market abuse.

To achieve these objectives, the G20 has agreed that:

• all OTC derivatives contracts should be reported to trade repositories (TRs);
• all standardised contracts should be cleared through central counterparties (CCPs);
• all standardised contracts should be traded on exchanges or electronic trading platforms, where appropriate;
• non-centrally cleared (bilateral) contracts should be subject to higher capital requirements and minimum margining requirements.'

and

'FSB has coordinated the develop of policies in five areas where oversight and regulation needs to be strengthened to mitigate the potential systemic risks associated with shadow banking:

• mitigating the spill-over effect between the regular banking system and the shadow banking system;
• reducing the susceptibility of money market funds (MMFs) to “runs”;
• improving transparency and aligning incentives associated with securitisation;
• dampening pro-cyclicality and other financial stability risks associated with securities financing transactions; and
• assessing and mitigating systemic risks posed by other shadow entities and activities.'

The idea is that if asset-trading transactions are done in public marketplaces or at least stored in public trade repositories (to accurately value assets), and asset provenance is well understood (to detect if same asset is over-leveraged), then analytics can be applied almost in real time to assess if loans are increasingly over-confident, and central bank rates adjusted before point of no return is reached and normal monetary policy levers fail i.e. lowering the risk of banking. To that end, they are encouraging or in some circumstances mandating the use of centralised clearance and trade reporting, best-known means today to improve transparency.

In my The Great Un-bundle blog, I put forward an argument that smart contract enabled blockchain (see Smartchain), a platform for trusted platforms, supports execution (by a Peer-to-Peer Autonomous Legal Entity) of complex processes like Delivery Versus Payment for many different types of asset classes (see Multi Asset Chains), which are often really just legal agreements of promises, which in turn lowers barrier to entry for new marketplaces and enables asset provenance tracking, nicely aligning to regulator’s agenda – check out Bank of England’s published research agenda. In addition, if asset life cycle is automated and collateral is held under escrow by the loan smart contract, then servicing and seizure under default becomes automated and does not require as many intermediaries, lowering the cost of banking.

All of this can be done using a central utility, however no single country has so far moved to a fully centralised single utility banking model, so blockchain actually plays nicely with the way people operate today – trusting mostly just themselves to keep a ledger of assets and perform the transaction validation checks, but solves today’s complexity of ledger reconciliation and linking transactions to universally agreed upon verification business logic.

Since blockchain needs to support promise of work’s required multiple asset classes and complex autonomous escrow conditions, Bitcoin is not a natural choice due to it’s limited support of complex logic and models – something core Bitcoin was never designed to support.

Coloured coins and other Bitcoin meta-protocols like Open Assets, OmniLayer and Counterparty.io have been developed to compensate; but all of them rely on Bitcoin economics. Newer protocols like Ethereum, not tied to Bitcoin, are in my opinion better indicators of what the future could look like – essentially evolving blockchain into crowd cloud data trusts.