Bitcoin, Cybercurrencies and Blockchain

What would we do without money/currency? Money is the unit in which we express prices (making it easer to compare the relative cost of things) and the asset with which we pay for our purchases and debts. A good currency has a stable value relative to goods and services (low or zero inflation) and is universally (or very widely) accepted in payment. The U.S. dollar receives high marks by these criteria. Bitcoin, however, fails miserably in all of these respects.

Why would anyone want to hold a highly volatile “currency” whose value one year ago was $1,230, then rose to $19,343 on December 16, 2017, dropped to $6,915 February 5 of this year and is now $9,364 (March 10, 2018). In addition, bitcoin is not accepted in payment almost anywhere? See my earlier explanation of bitcoin: “Cryptocurrencies-the bitcoin phenomena”

Bitcoin is better characterized as a security – an investment asset. It’s sort of like an option on a lottery, except that a lottery promises to pay something to the lucky person(s) holding the ticket. Bitcoin doesn’t promise to pay out anything to anyone. Its value is simply what you can get someone else to pay you for a bitcoin you want to sell. Buying bitcoin is a bet that its value will rise for some reason while you own it. Its ideological appeal for some is that it exists and functions totally independent of government; and its economic appeal is that it allows the transfer of funds (illegally gained or not) without much chance of being detected. For an excellent review of these points see Peter Morici’s: “Bitcoin-investors-have-reason-to-worry”.

Even if bitcoin had a well-behaved value and was widely accepted, the engine for maintaining and delivering it, a permissionless distributed public ledger of all bitcoin transactions linked together in blocks attached to an ever growing chain (blockchain), is deeply flawed. Records of who owns bitcoins and all transactions involving them are maintained in a database (ledger) copied to everyone with a bitcoin address (account). The system is open to everyone (permissionless) and not dependent on trusting any participants. Each bitcoin transaction is directly between the seller (or payer) and the buyer (payee) peer-to-peer without passing through a central registry such as would be maintained by a bank. Given the ease with which electronic data can be copied, preventing the spending of the same money multiple times when it openly exists in thousands of copies one as official as the other (the so-called double spending problem) in an environment where no one is trusted by design is the main challenge that blockchain ledgers need to overcome.

The majority of payments today are made by digitally transferring the ownership of digital records of money, i.e. electronic transfers of bank deposits. Our deposits of money with banks, which are a bit over half of so-called narrow money in the U.S. (M1= Currency outside of banks + demand deposits in banks), exist as digital records in each bank’s central deposit registry. Banks are so called trusted third parties responsible for insuring that our deposits are not touched and moved without our permission and are responsible for resolving any disputes or problems with regard to our deposits.

If we are paying money to someone who has their account in the same bank, we can go on line and transfer the money from our account to theirs in a millisecond without a service charge. These central registries are fortified with very robust protocols that insure their safety. The process is a bit more complicated if we are making a payment to someone whose account is in a different bank and there is scope for the speed, efficiency and cost of such interbank payments to be improved.

Blockchain’s claim to eliminate the need for trusted third parties by transferring ownership (e.g. of bank balances) directly peer to peer and publishing copies of the ledger containing the record of our transactions and resulting ownership in hundreds of nodes (our computers) around the world. The objective of a system that eliminates the need to trust anyone to safeguard your money from double spending necessitates some very complex and costly operations to substitute for a trusted third party.

For bitcoin, so called, miners are given increasingly difficult mathematical problems to solve to establish that the latest blockchain transaction is unique rather than a copy. The first miner to solve the problem cryptographically stamps the digital transaction record as genuine (in effect notarizes it) adding a new block of transactions to the chain and distributes it publically to all nodes. The winning miner is rewarded with new bitcoin (for as long as they continue to be created). Not only is the manpower and computer capacity required for this competition enormous, but the electricity consumed in bitcoin mining is now greater than is consumed in all of Ireland. https://powercompare.co.uk/bitcoin/

It takes around ten minutes to confirm the authenticity of a bitcoin transaction on average. Ten minutes standing at the check out counter waiting for your payment to be confirmed is an unacceptable eternity. “A familiar critique of Bitcoin is that “it does not scale” in the sense that, as it is currently implemented, the network is not capable of supporting a global payments system that requires many thousands of transactions per second. At the moment, this is true; Bitcoin can support up to 7 transactions per second as compared to the 2,000 transactions per second typically processed by Visa (with the potential to scale to an estimated 56,000 per second).” “The-bitcoin-scaling-debate”

Moreover, most bitcoin users don’t have the IT sophistication to operate and manage their own copy of the blockchain and thus deposit their bitcoins (or other cyptocurrencies) with exchanges that manage transactions for them. These trusted third parties in all but name are in effect banks (though they do not lend your bitcoins to others while waiting for you to use them). “Every-disadvantage-has-its-advantage-reviewing-blockchain”

To participate in the bitcoin system (to buy, use or sell bitcoin, to take the example of the best known cybercurrency) you must register to obtain an address (account). It is a closed system in that you can only deal in bitcoin with other registrants (account holders). If a central bank, for example, issued a digital version of its currency, it would also be a closed system in the same way. Participants would need to be registered with it (i.e. open accounts with it) in order to participate and could only use this Central Bank Digital Currency (CBDC) with other account holders.

When problems arise or views differ on whether and what changes might be desirable in the permissionless blockchain world, there is no one responsible to address it. There is no trusted third party to take responsibility. The bitter disputes among bitcoin “leaders” and its several hard forks (breaking off different versions of bitcoins) illustrate the seriousness of this problem.

The claim is often made that even if blockchain-DLT systems are fatally flawed as the vehicle for making payments, the blockchain technology may have revolutionizing uses for other public records such as property ownership and its transfers. However, the blockchain has so many serious disadvantages that even this more limited claim is very doubtful. “Blockchain Demystified”

To address or minimize these serious drawbacks of Distributed Ledger Technology, cryptocurrencies (there haven’t been any other applications of blockchain after ten years talking about it) have been rapidly moving away from the purer, permissionless, Proof of Work version used by bitcoin to more restricted and limited permissioned, Proof of Stake approaches. None of these to date are as efficient and secure as centralized ledges of the sort used by our banks. “What-if-blockchain-is-useless?”  “Ten-years-in-nobody-has-come-up-with-a-use-case-for-blockchain”

This is not to say that exciting things aren’t happening in the ownership registry area. Digitizing ownership records introduces dramatic economies in tracking ownership and transfers of ownership. Automating many or all of the steps involved in real estate sales with the use of digitized smart contracts can significantly shorten the time and cost of the many steps (mortgage loan agreement and disbursement, collateral confirmation, settlement, title transfer, etc.). “A-pioneer-in-real-estate-blockchain-emerges-in-Europe.” In addition, a number of central banks are considering issuing digital versions of their currencies. These will probably use central registries rather than blockchains. “Central Bank Digital Currency: Bordo-Levin.” But does blockchain technology have any advantages to outweigh the many disadvantages that can’t be achieved quicker, cheaper and more securely with central registries operated by trusted third parties. Probably not. Project Jasper of the Bank of Canada concluded that: “the versions of distributed ledger currently available may not provide an overall net benefit when compared with existing centralized systems for interbank payments.  Core wholesale payment systems function quite efficiently.”  https://www.bankofcanada.ca/wp-content/uploads/2017/05/fsr-june-2017-chapman.pdf    “SWIFT says blockchain not ready”

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
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One Response to Bitcoin, Cybercurrencies and Blockchain

  1. Michael Connolly says:

    Very interesting blog. Thanks, Mike Connolly

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