Bitcoin
A Decentralized, Public Ledger
Digital Asset Transfer Mechanism
David Andolfatto
The views and opinions expressed here are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System.
Money and Payments System
1.
Monetary tokens: record-keeping devices.
2.
Ledgers: accounts containing monetary objects.
3.
Payment protocols: value transfer mechanisms.
4.
Monetary policy: protocol to manage money supply.
Money and Payments System
Money and Payments System
1. Monetary tokens.
Money and Payments System
2. Secure ledger.
Money and Payments System
3. Payment protocols.
Money and Payments System
4. Monetary policy: managing the supply of
marbles.
Early money and payment systems
Virtual data (memories) recorded on shared and distributed ledger
(communal brains) updated via consensus algorithm (gossip).
• Gift-giving economies, social credit systems.
Invention of coined tokens and precious metals (specie).
• Permits P2P exchange on invisible ledger (anonymous trade).
17th C. goldsmith banks issue paper money (receipts).
19th C. banknotes redeemable for specie, backed by assets.
How things work today
Monetary objects consist of liabilities issued by central and
chartered private banks: physical (cash) and digital objects.
• bank liabilities legally a digital version of 19th C. banknotes.
Cash payment: P2P debit/credit of personal wallets.
• permissionless accounts held in invisible ledger (personal wallets),
few KYC restrictions, anonymous (paper leaves no trail).
Digital payment: intermediated debit/credit of bank accounts.
• permissioned accounts, held in private bank ledgers, KYC
restrictions, identifiable payment history (digital trail).
Complaint 1: Inflation
Complaint 2: Payments System
Outdated payment systems (e.g., ACH).
Lack of direct communication between banks.
• Correspondent banking system for international payments.
Banks and MSBs charge too much.
Too much personal information presently at risk.
Bitcoin is a money & payments system
Digital money supply (bitcoin) managed by open-source computer
algorithm (Bitcoin). [ 21M unit cap ].
BTC exist on a publicly visible, distributed ledger: block chain.
• Block chain = history of all transactions.
BTC “account” = public + private key pairs (crypto. secure)
• Public-address transparent P.O. box + private key.
• Permissionless, pseudonymous.
Payment requests processed via consensus protocol called proof of
work (POW). No banks!
Bitcoin: deliverables
Capped money supply (hopefully) means long-run price-level
stability.
• Free ourselves of central banks (alas, not governments).
Ability to transfer value (bitcoin) between any two points in the
world (connected to the Internet) at trivial cost.
• Free ourselves of all banks (except from their lending arms).
What’s the innovation?
Virtual currency? Open-source algorithm? No.
Public/private key cryptography? Pseudonymous accounts? No.
Transparent online database? No.
Algorithmically determined money supply? Not really.
Innovation: block chain and POW consensus protocol.
• Packaged together with aforementioned innovations.
Bitcoin solved the double-spend problem of P2P digital asset
transfer (and mon. supp.) without use of “trusted” intermediaries.
• As close as one can get to unintermediated digital cash.
POW: Dynamic Membership Multisig
P2P payment requests broadcast to network are validated and
added to the block chain by pseudonymous “miner nodes.”
• Miners must collectively “sign off” on requests. How?
• Simple voting procedure will not work: Sybil attacks (spam).
POW makes it artificially expensive (hardware + electricity) to
validate payments—guards against Sybil attacks.
• Miners compete against each other to solve math problem, winner
gets to add validated requests to block chain.
(Winning) miners compensated in newly-issued bitcoin (and fees).
So, what’s the big deal?
A fixed supply of electronic digits that can be transferred over the
Internet without traditional middlemen.
• P2P transactions, no need to relinquish personal info to 3rd parties.
Can send $100M of BTC from here to Moscow in 10 min. almost
zero user cost (social cost higher).
• Bypass clunky ACH, correspondent banking system.
• Huge deal for international remittances market.
Block chain has proven to be highly secure (so far).
• Episodes of loss related to 3rd parties (Mt. Gox) not BTC.
Example: International Payments
Want to send $100 from my Chase NY to your account at Bank of
Cyprus, Nicosia ($50 fees at each end?).
Align Commerce claims to “use the blockchain” to effect same
transfer at much lower cost (price). How?
1. AC ACH debits my USD Chase account (slowest part).
2. AC buys BTC (sells USD) on domestic BTC exchange.
3. AC sells BTC (buys EUR) on foreign BTC exchange.
4. AC SEPA credits your Bank of Cyprus account.
Example: International Payments
Want to send $100 from my Chase NY to your account at Bank of
Cyprus, Nicosia ($50 fees at each end?).
Align Commerce claims to “use the blockchain” to effect same
transfer at much lower cost.
1. AC ACH debits my Chase account (slowest part).
2. AC buys BTC (sells USD) on domestic BTC exchange.
3. AC sells BTC (buys EUR) on foreign BTC exchange.
4. AC SEPA credits your Bank of Cyprus account.
“free”
“Using the blockchain” = using BTC as a “vehicle currency.”
Bitcoin as digital gold
Like gold, supply of bitcoin not subject to government
manipulation.
• Though government can still tax and legislate.
• Compliance is an issue (it always is).
W/o hassle of storing, assaying, transporting physical gold.
Highly volatile, but may nevertheless be preferable to
mismanaged monetary systems?
Inflation rates, selected countries
Downsides
Highly volatile exchange rate (e.g., against unit of account).
• Though, not such a big deal if BTC became the unit of account.
• But inelastic money supply makes it a lousy money.
While users costs are (presently) low, total costs (miner
compensation) range between 2-4% of transaction volume.
• Most of this cost is financed through seigniorage revenue.
• Since BTC supply will cease to grow, user fees will have to
replace seigniorage.
• Not entirely clear where this cost will settle.
Bitcoin market price
Bitcoin miner
Statistics
BTC in circulation 14M = $3B (compare USD, $1.3T).
Statistics
BTC in circulation 14M = $3B (compare USD, $1.3T).
75 transactions/min (compare Visa, 200,000/min).
Statistics
BTC in circulation 14M = $3B (compare USD, $1.3T).
75 transactions/min (compare Visa, 200,000/min).
Statistics
BTC in circulation 14M = $3B (compare USD, $1.3T).
75 transactions/min (compare Visa, 200,000/min).
(Ironically) Most are intermediated via Coinbase, Bitpay, etc.
Bitcoin and banking
Bitcoin solves a payment problem, not a credit problem.
• Credit supported by reputation, collateral.
Banks turn illiquid assets (reputation, collateral) into money.
• Demandable liabilities, redeemable for base money @ par.
• Base money = historically specie, today fiat currency.
• Fractional reserve banking (liquidity transformation).
What prevents banks from issuing demandable liabilities
redeemable in BTC (or any other object)?
Bitcoin and banking
U.S. “free” banking era 1836-63.
• Thousands of private state-chartered banks issuing their own
banknotes redeemable on demand for specie.
• Private clearinghouses (e.g., Suffolk Bank 1818-58).
National banking era 1863-1913.
• National banknotes redeemable for specie on demand.
• State banknotes replaced by checking accounts.
No central bank, no lender-of-last resort.
Bitcoin vs. Fedcoin
Existing banking system largely based on pre-Internet tech.
Why not permit online utility accounts with Fed?
• U.S. Treasury: http://www.treasurydirect.gov/
• Or full-service narrow banks (100% reserves).
• Dispense with FDIC.
Dirt cheap payment processing costs (vs. POW).
No exchange rate volatility relative to USD.
New monetary policy instrument: interest-bearing money?
But subject to U.S. monetary policy, not permissionless, etc.
Future of Money and Payments
Fiat systems with politically insulated protocols have little to fear.
• USD already faces fierce competition.
POW is costly relative to trusted central ledger—mining is a waste
of resources (that may be worth paying). Fedcoin?
• Primary consequence of BTC will be to drive rents lower.
• Consumers will benefit, but can MSBs using block chain compete?
• Where is comparative advantage? Technology? Compliance?
Credit side of banking (liquidity transformation) in regulated and
shadow banking sectors not immediately affected (Bitcoin 2.0?)
Thank you
David Andolfatto
VP Research, FRB St. Louis
May 01, 2015