About this Issue

What if money were private?

One very correct answer is, simply: Money already is private. Sure, there’s the old familiar legal tender of the U.S. government, but the idea of money, and the practices that surround it, are not necessarily tied to the greenback. We all know how money works, and other things can certainly be used in the dollar’s place — if a buyer and seller agree. From there, if more buyers and sellers agree, the items they use may become a medium of exchange — a class of things held with the intention of passing them along in the market rather than using them directly.

Today, thanks to cryptography and computer networking, numbers can serve this purpose. That’s the promise of bitcoin, and, incredible as it sounds, it works. Shared verification across the network of users guarantees that no one spends a bitcoin twice. Cryptography means that users’ identities aren’t publicly tied to their purchases. Cryptography also guarantees that no one can generate fake bitcoins, either. Have any doubts? The code is open source. You can examine it for yourself.

But bitcoin isn’t foolproof. There are most certainly inefficiencies, pitfalls for the unwary, and opportunities for fraud, as there are in all known monetary systems. These challenges vary from one system to the next, and the question then becomes — which money is preferable, the public one, or this new private one, or perhaps some other? We would be remiss, as a libertarian publication, not to mention libertarians’ perennial favorite: the gold standard, combined with a regime of free banking. (It too has both advantages and disadvantages, of course!)

This month the Cato Institute’s own Jim Harper writes the lead essay, tackling the question of how private digital money works — and doesn’t. Here to discuss with him are computer security expert Dan Kaminsky, tech policy scholar Jerry Brito of the Mercatus Center, and economics graduate student Chuck Moulton, who is writing his dissertation on related matters.


Lead Essay

It’s Just Money

When cows were used as a medium of exchange, nobody called it “biocurrency.” In the cultures that traded seashells to escape the inefficiency of barter, they didn’t call it “calcicurrency.” It was just money.

New forms of money such as bitcoin are exciting for their technical underpinnings, but we might not want to make them more forbidding by calling them “cryptocurrency.” Cryptography is an important part of many digital currencies’ administration, and it is central to bitcoin, but at their core they are all just money.

Digital forms of money may have substantial effects on government’s relationship to money, on financial services providers, and on the public-private partnership between government and the financial services industry. “Too big to fail” and mass financial surveillance? Meet disintermediation.

Governments probably can’t stop digital currency. The “crypto wars” show that a community of determined information technology users cannot be beaten. And that’s good because, like cryptography generally, the societal benefits of “cryptocurrencies” will almost certainly exceed their costs. The open question is whether the government and financial services sector will try to hold digital currencies at bay, or whether they will willingly embrace all the benefits of a new era in money.


The concepts around money are forbidding for most people, which is surprising considering that we use currency every day. Economists and policymakers debate money’s origins and theory with fervor and devotion, but the simple story is that money arises to make trade more efficient. A dairy farmer who needs new boots doesn’t have to find a cobbler thirsty for milk. He can find anyone who wants milk, exchange his milk for money and then bring the money to the cobbler to pay for footwear. Money’s basic value is as a universal lubricant for trade. It’s an incredibly valuable social tool.

Anything can be money, including arrangements of bits. But to qualify as money in the eyes of traders, money has to have the mix of qualities that serves them best. These qualities include such things as:

  • wide or universal acceptance
  • resistance to replication/counterfeiting
  • divisibility into standardized units
  • transferability, such as on delivery
  • amenability to holding securely
  • high ratio of value to weight or volume
  • transportability
  • durability
  • high holdings relative to new creation; and
  • low storage costs.

The digital form taken by bitcoin and similar currencies make them excellent money along some dimensions, but quite poor along others. Digital currencies are unrivaled in their transportability, for example, as they can travel almost instantly to wherever someone has an Internet connection and a suitable digital device, regardless of borders. Their ratio of value to weight is close enough to infinite, their storage costs are close enough to zero, and they are perfectly standardized.

The math underlying bitcoin is brilliant. Assuming it continues to work as it has at higher scale, it controls the rate of new bitcoin creation and it immunizes bitcoins from counterfeiting. This makes it equal or superior to government currency by most people’s accounts. (A significant number see bitcoin’s fixed, unmanaged growth rate as a liability.)

But bitcoin is hard to secure. Its holders have suffered routine shocks when exchanges have been hacked, and the probability is high that Internet worms designed to steal this form of money will become widespread. Banking and payment systems denominated in dollars are also exposed to hacking, but these risks seem relatively well contained.

Digital currencies suffer from low acceptance compared to other, more popular forms of money, obviously. Criticisms of bitcoin based on its price volatility are really a proxy for its small, illiquid market. But because its digital protocols are available worldwide, its potential market is the entire world. If it became a worldwide currency, it would make dollars and Euros—to say nothing of guaranís—look volatile and unreliable by comparison.

Digital currencies’ qualities are contingent on unfolding developments in technology and society. The acceptance of bitcoin and similar currencies will change, as will people’s ability to hold them securely, the susceptibility of such currencies to inflation’s effects, their susceptibility to deflation, and other dimensions of quality in the eyes of traders.

Ideally, public policy would be indifferent to societies’ choices in money, letting the best form of money rise to the top. But public policy is in no sense indifferent to the money question. Rulers and governments have had their hands on the money for at least 4,000 years. And they will put their hands on digital money, too.

Governments and Money: Service Providers and Flim-Flam Artists

In his detailed and fascinating study, Fiat Paper Money: The History and Evolution of Our Currency, Ralph T. Foster documents much of the history of government money. Through the ages, governments have been at once helpful monetary service providers and shady flim-flam artists.

As rudimentary trade grew centuries ago, there was natural migration toward treating precious metals as money due to their high value-to-weight ratio, their transportability, acceptance, and durability. But lumps of gold and silver are not monetary perfection. In the absence of standards for purity and weight, metal money was less reliable and thus less efficient than it could be.

Governments filled this void by providing standardized coinage. Unique markings on coins could indicate provenance and thus purity and weight. Other minting techniques, such as ridged edges, were ingenious tools for assuring traders across vast expanses that they were accepting whole copies of these reliable stores of value.

But governments and rulers who issued coins were not doing so simply out of a charitable impulse or tender feelings toward the economies under their dominion. “Seigniorage” is profit going to producers of money for the service they provide. A government issuing coins that trade for greater value than the cost of their production could enjoy significant returns. The temptation to deviate from standards sometimes produced excess profits for governments that issued money with slightly less value in metal than their labeling indicated: the service provider as flim-flam artist.

Coins and other forms of physical money are difficult to transport and secure, so leaving the money in a bank and trading notes redeemable for money was a natural monetary innovation. The rise of paper money is the subject of long and detailed histories, but the short story, again, is that a written document could stand in for coin and other forms of money if it provided a reliable promise that it could be redeemed for the underlying money. As with metals, private paper money suffered from nonstandardization and susceptibility to counterfeiting that the relatively sophisticated administrative systems in governments were better positioned to control. They could also tax and outlaw competitive money. Prohibitive taxes and bond-collateral requirements dating to the Civil War have long prevented U.S. financial firms from challenging the Federal Reserve’s currency monopoly.

While some people talk about coinage and other forms of commodity money having “intrinsic” value, there is nothing intrinsic about it. The value of all things is contingent on perceptions of usefulness, and money of any kind has value based on the prospect that it can be traded for something. So it was an unsurprising step that paper money should break loose from having value in redeemability and take on freestanding value of its own.

Governments, having standardized redeemable paper money, eventually came to issue paper money not backed by gold, silver, or other valuable things. In the United States, President Richard Nixon “closed the gold window,” refusing to let foreign central banks redeem their dollars for gold, in August, 1971. Today, no major currency is backed by any commodity. This money is said to have value because of government fiat.

Government Fiat and Monetary Management

In some respects, fiat currency is better money. Fiat currency can exist in quantities large enough to lubricate a large and growing economy. Physical commodity money may not be able to serve such a role because of small quantities, indivisibility, and other inherent restraints. But government’s provision of fiat currency also opens the door to some very serious flim-flam.

Because of the massive seigniorage available for those that do so, governments have routinely created fiat money in excess. Such action undercuts the value of currency in circulation, causing serious economic dislocation. More money chasing other valued goods and services causes prices to rise. This means that stored money—savings—loses its value, unjustly depriving savers and people on fixed incomes of wealth while unjustly enriching debtors (including governments). By one measure, the U.S. dollar has lost more than 95% of its value since 1913. Unsophisticated savers and investors who have held U.S. currency may retain the same number of dollars—even earning modest investment earnings that create the appearance of greater wealth—but the value of their money has been stolen fair and square by inflation.

Government management of money has significant costs because of its effect on investment and the economy as a whole. The possibility that monetary policy may change makes it harder to make long-term calculations about investment and debt. Accordingly, investments are more modest and debt obligations taken on more reluctantly. Uncertainty about government monetary policy confounds planning and causes prudent investors and business people to be more conservative, restraining economic growth. The fact of having government-managed fiat currency may produce huge opportunity costs to the economy and society.

Throughout history, governments have financed profligacy with fiat paper money, doing so until confidence in their currency wanes and the currency collapses. Steve Hanke counts 56 such episodes in the 20th and early 21st centuries in his paper with Nicholas Krus, World Hyperinflations. Ralph Foster counts many more.

On the other side of inflation is the possibility of deflation. “Good deflation” is the gradual fall of prices due to increased productivity. But deflation goes bad when people anticipating its rise in value hold money to the point where economic activity significantly slows. Held money, of course, is often put to productive use, re-circulated as loans, for example, thanks to fractional reserve banking. Money “on deposit” in one bank account is often also on loan and in the hands of a local business to finance an expansion, perhaps. It is hard to conceive of an economy being harmed over the long term by an excess of savings. But arriving at a new equilibrium value for a currency that could no longer be inflated—such as would happen if the dollar were to go back on an inappropriately pegged gold standard—could cause quite a hangover in an economy that has been running high on inflated sugar-money.

It was a historical accident that governments took over the provision of money. They were often the organizations with the wherewithal to produce money that was reliable and thus acceptable to traders—and they have had plenty of power to push aside competing money. The move from physical commodity money to paper money put governments in a position to manage money supplies, for good or bad.

Digital currencies undercut the contingencies that originally put the money in governments’ hands. They do not require governments to standardize them or ensure against counterfeiting—private administrative systems (including open source code) can handle these tasks. Digital currencies also threaten governments’ ability to collect seigniorage of all kinds, from the modest return on minting and printing to the exorbitant gains in inflating currency to monetize debt.

But this is not the only way that digital currencies threaten the status quo. Governments exercise close control over financial services providers for a variety of reasons. As they remake parts of the financial services industry, digital currencies will threaten interests that governments hold dear, including consumer protection and financial surveillance.

Government, Money, and Surveillance

Banking emerged to serve a market demand for storage of physical commodity money and later paper money, both of which are hard to store securely in large quantities. Fractional reserve banking made a profit-center of taking depositors’ money and loaning it out again, to the point where savers could be paid a share of the profits in the form of interest.

A related service, payments, emerged to meet the challenge of transporting coin and paper money as markets grew to span broad territories. The payments industry uses a variety of methods to transmit money, including checks, credit cards, debit cards, and wire transfers. There are many more, and more complex, financial services than only these, of course. Financial services generally have large economies of scale because of efficiencies that larger institutions can generate. As to payments, for example, moving rights to money within a single enterprise is far more efficient than securely transferring money among smaller ones.

Governments have become deeply involved in banking, payments, and other financial services, and not only because of their role in providing money. Consumer protection is an important justification for regulating financial services providers, for example, because they may literally affect individuals’ entire nest eggs. The effectiveness of government regulation is not a given, of course, and example after example in recent history illustrate failures of consumer protection regulation.

But governments’ tight attendance to money is not only explained by their consumer watchdog role. Money is a window onto people’s lives. Spending reveals the priorities and preferences of people and the choices they make across every domain of living. Subject to consumer protection regulations that determine whether they live or die, U.S. financial institutions are highly amenable to reporting movements of money—more amenable, it is almost certain, than telecommunications providers. Senators Ron Wyden (D-OR) and Mark Udall (D-CO) recently suggested that secret U.S. government surveillance could include “information on credit card purchases, medical records, library records, firearm sales records, financial information and a range of other sensitive subjects.” By following the money, governments can assure themselves with the least possible effort that people are meeting their tax obligations and obeying manifold legal restrictions.

Since at least the passage of the Bank Secrecy Act in 1970, banks have been required to keep records of cash purchases of negotiable instruments and file reports of cash purchases of these negotiable instruments of more than $10,000. Banks are obliged to report suspicious activity that might indicate money laundering, tax evasion, or other criminal activities. As an informal requirement before 9/11, and mandatory since passage of the USA-PATRIOT Act, financial services providers of all kinds must identify their customers so that all banking, payments, and other uses of financial services can be tracked. As a result, financial services providers are a conscript regiment in the U.S. government’s War on Drugs. Government surveillance through the medium of money is pervasive.

The natural scale of financial services providers and the keen interest of governments in money make for quite a public-private partnership. It was exactly the kind of partnership that guaranteed, for example, that Cypriot banks would turn over account holders’ funds on government demand during that country’s financial crisis. Large financial services providers reap super-normal profits while they nestle in government protection. In exchange, they serve governments’ need for financial surveillance and control.

The premises behind this symbiosis will not survive well in the era of digital money.

The Future of Digital Currencies: Bright but Uncertain

Government money arose historically because governments and rulers beat out private institutions at producing sufficiently reliable money. Digital currencies weaken that rationale because private institutions—in the case of bitcoin, code—can provide most qualities that traders look for in money. Government money enjoys universal acceptance, and would seem to have a permanent advantage, but what people think of as money can change.

The banking and payments industries likewise arose because physical money, whether coin or paper, was hard to store and transport securely in large quantities. Digital money is very lightweight. It is possible to secure, even in vast amounts, without a vault. And it is instantly transportable anywhere the Internet goes. Banking and payments won’t go away, but digital currencies undercut some of the rationale for these industries and should dramatically reshape them.

But don’t expect the alliance between government and today’s financial services industry to go gentle into that good night. A lot of money and power is at stake.

Early signs of rage against the dying of the status quo are all around. Witness the California Department of Financial Institutions’ wanton issuance of “cease and desist” letters in mid-June, including against the Bitcoin Foundation, which is not a financial services provider at all, but rather an advocacy group that encourages the use of bitcoin. In May, the U.S. Department of Homeland Security seized the Dwolla electronic payments account of leading bitcoin exchange MtGox because of paperwork violations related to the opening of a subsidiary’s U.S. bank account. The consumer protection rationale for government involvement in money is not well served by a regulator whose first response to financial services innovation is to yell “STOP!”

Earlier in June, the International Center for Missing and Exploited Children hosted a conference premised on the use of digital currencies for funding child pornography, human trafficking, and child exploitation (without evidence that bitcoin has ever been used for these purposes). And a federal money laundering enforcement against a Costa Rica–based virtual currency called Liberty Reserve was taken by some as a signal aimed at bitcoin—never mind that Liberty Reserve moved $6 billion in the last few years, more than twice the value of all bitcoin at its highest valuation in April, and six times the value of all bitcoin today. 

Digital currencies may be used, like cash, to fund illegal transactions, though early the rumors of bitcoin being fully anonymous are untrue. This is data to consider when balancing the benefits of digital currencies for societal welfare against their costs.

If M-PESA is any sign, there are tremendous benefits available from the use of digital currencies. “Pesa” is Swahili for money, and in Kenya, mobile-pesa, a phone-based payments system, has arisen from the relatively extensive mobile phone infrastructure. And it has given Kenyans access to financial services that they otherwise lacked. In some places, mobile phone users began to transfer value using pre-paid mobile phone credits sent via Short Message Service (SMS). Kenya’s leading mobile service provider, Safaricom, sought to formalize this process with M-PESA, its SMS-based money transfer system that allows individuals to deposit, send, and withdraw funds.

By the end of 2009, M-PESA had reached 65 percent of Kenyan households, and the Economist reported that Kenyan households using M-PESA saw their incomes increase from 5 percent to as much as 30 percent after beginning to use mobile banking. Worldwide, only about one billion have bank accounts, but three billion—nearly half—have mobile phones. Just think of the reductions in crime, human trafficking, and child exploitation that might occur as societies grew wealthy enough to empower both parents and local law enforcement with tools to protect the innocent. Interfering with financial innovation to stanch criminal payments is penny-wise and pound-foolish.

If digital currencies are suppressed in western markets because powerful government and business interests ally against them, their adoption path will travel through the global south. While they uplift societies badly in need by giving people access to wealth accumulation tools, digital currencies like bitcoin will be impossible to exclude from the rest of the world because they literally can travel unseen wherever the Internet goes. Encryption and a variety of techniques make it impossible to prevent otherwise free people from storing, transmitting, and trading bitcoin if they want to.

The “crypto wars” in the United States began in the 1970s, when publicly available encryption technology began to rival the government’s ability to break cryptographic codes. The U.S. government treated cryptographic algorithms and software as munitions, going so far as to investigate cryptographer Phil Zimmermann for violating the Arms Export Control Act when he released a free version of software he wrote called PGP (Pretty Good Privacy). In the early 1990s, as the Internet rose to prominence, the Clinton administration tried to get industry to adopt the Clipper chip, an encryption chip to which the government would have back-door access. When this failed, they tried to introduce key escrow, the policy of requiring all encryption systems to leave a spare key with a “trusted third party” who could make it available to the government.

The government rightly lost the crypto wars because the benefits of having strong encryption in the hands of good actors—for privacy, commerce, free speech, and so on—exceeded the costs of trying and failing to keep strong encryption out of the hands of bad actors. This history illustrates the choice before policymakers and financial business strategists with regard to digital currencies. Like cryptography, digital currency cannot be bottled up if a community truly wants to use it.

The choice is not whether to have digital currencies. The choice is between adopting digital currencies the hard way or the easy way. The hard way is trying to outlaw banking, payments, and other financial services denominated in new currencies. The easy way is embracing them, making them part of mainstream financial systems, and accepting the greater liberty, power, and privacy they accord to individuals.

Response Essays

Plain Old Money Has Gotten Buggy

“Bitcoin:  It turns nerd forums into libertarian forums.”  Funny, and mostly true.  Nerds sometimes avoid political issues, except to the degree that they break the Internet (thus my involvement in the long and ultimately successful fight against the anti-piracy bills SOPA and PIPA, whose security impacts upon the Internet were simply not considered).  And yet bitcoin, more than perhaps any technology of the last decade, has fired up the imaginations of countless engineers, by simply asking the following question:

What if we really could apply the Internet to money?

To understand this question, and how it’s caused something of a political awakening, one must consider two things.  First, the Internet represents the intersection of a near-complete lack of regulation and astonishing success.  The Internet was by no means the first attempt at creating a global electronic network – old-timers remember well Minitel and Delphi and CompuServe and Prodigy and America Online (with its billion dollar buy of telephone lines).  But this was the one that worked – it was cheap to connect to (no hourly rates), and you didn’t have to ask anyone permission or pay anyone rents to bring services online.

The second thing to realize is that plain old money’s gotten buggy, particularly for those who don’t have much of it.  Just today I passed a sign at a local check cashing shop, proudly proclaiming “Send up to $50 for only $5!”  Only a 10% minimum fee for transmitting funds?  What a bargain.  Not to mention the scams being pulled on workers receiving their payment via debit cards – withdrawal limits, fees for withdrawal, fees for lack of withdrawal, fees for balance inquiry…

Credit cards don’t work person to person, checks don’t work at pretty much any retail establishment, cash doesn’t work if the bill’s too big, PayPal shuts down if you look at it funny, and you can just lie about how much gold you have (a thing you pointedly cannot do with cryptographic currencies).

Bitcoin isn’t perfect.  But it’s certainly not competing with perfection.  What if money worked as reliably as the Internet?

There is, of course, a fundamental aspect of the Net that deserves recognition:  It’s actually not a “guaranteed reliable” system.  Previous forms of networked communication – telephone networks – were “circuit switched”:  A reliable path, with predictable properties, was negotiated for a given communication.  This was difficult to implement and ultimately rather expensive.  The Internet, by contrast, is “packet switched”:  Little chunks are sent out, and hopefully arrive by one of many paths.  There’s no guarantee, but through that fuzziness, remarkable reliability is nonetheless achieved, at ever lowering costs.

Bitcoin leverages this unreliability in two different ways.  First, it actually uses the most unreliable – but redundant – transport of information on the Internet to distribute news of proposed transactions:  A Peer-to-Peer network, just like Napster and its ilk.  Secondly, and perhaps more importantly, bitcoin doesn’t support remediating bad transactions.  The vast majority of regulation is really focused on managing, and reversing if necessary, disputed transfers.  Bitcoin goes so far as to call your store of money your “wallet.”

The U.S. government does not make you whole if you drop a wad of $100s on the street – and if they did, the cost of administering cash would be substantially higher.  Interestingly, while $100s have serial numbers, there’s no realistic way for an individual to track their stolen cash.  Bitcoins by contrast publicly announce their location each time they’re spent, meaning the moment they show up at a non-anonymous location – like a major currency exchange – that party can immediately be sued for possession of stolen property.  In a very real way, stolen bitcoin is like stolen art – tainted, trackable, and honestly, probably too dangerous to steal in the first place.

In a fundamental way, it’s just less expensive to operate bitcoin.  Cost of operation does not define price, of course, as any observer of Coca-Cola or movie theater popcorn can attest.  Other forms of value storage and transfer (two different things) are expensive because they must deal with fraud.  But let’s be honest, they’re also expensive because they can be.  There’s a small enough population of parties to allow for fairly bald-faced rent-seeking behavior.

Is bitcoin immune to small-population rent-seeking behavior?  That is, in fact, a very good question.  Yes, bitcoin is based on math.  The question is, who does the math?

Satoshi Nakamoto, bitcoin’s pseudonymous author and – should bitcoin hit $1,000 – the world’s first cryptographic billionaire, originally designed bitcoin to leverage the hundreds of millions of CPUs deployed all over the globe.  This meant that anyone could go ahead and “join in,” creating far too many participants for any regulatory regime to quell (and indeed, efforts to suppress the population would just end up growing it).

This design could not last.  Once it became apparent that there was, in fact, money to be made “mining” bitcoin, many users switched from using the central processor in their computers to using the graphical processor.  This change dramatically reduced the number of computers able to significantly participate in maintaining the network – if you didn’t have the latest GPU, you were effectively irrelevant.

Still, though, there are a lot of people with fast GPUs.  The “regulatory set” shrank, but not enough.  What’s caused issues is the fact that, no matter how many people are mining bitcoin, there can only be 144 winners a day.  If nothing was done about this, this could mean miners might go months or even years without any revenue.  And so something was done:  Outside of Satoshi’s design, “Mining Pools” formed, aggregating the efforts of many bitcoin participants and “smoothing out” the flow of mined bitcoin.

A system designed to have hundreds of thousands of participants that could never realistically be forced to (or choose to) all abuse their position suddenly found itself limited to a small handful of parties, only two (or even one!) of which held “the keys to the kingdom.”

Notably, the most obvious abuses of bitcoin remain impossible. Nobody can elect themself the bank and declare themselves trillionaires.  But they can revert transactions, block arbitrary parties from using the network, and of course establish high fees.

For a time, one could argue that, should a pool abuse its power, the miners supporting it would rescind their participation.  But dedicated hardware – ASICs, for Application Specific Integrated Circuits – has been built for bitcoin.  The pools simply do not need their armies of miners anymore.  Those who acquire these chips and bring them online essentially have the capacity to immediately dominate all the math done to support bitcoin.

It does not actually need to be this way.  Satoshi’s original design could be restored – there does exist math for which Intel/AMD CPUs are in fact the most efficient chips possible.  (To put it another way, if you could execute this math problem significantly faster, you should not mine bitcoin, you should compete with Intel.)

I’ve publicly predicted – with arguably excessive certainty – that such a change in the “Proof of Work” math of bitcoin will occur.  This prediction is unpopular; the counterargument is that to return the maintenance of the bitcoin network to large numbers of desktop machines is to hand control of bitcoin over to operators of botnets – massive networks of compromised machines, each forced to do the bidding of a criminal taskmaster with neither interest nor investment in the health of the bitcoin network.

I’d like to believe that botnet operators can only maintain their grip on large networks by being non-disruptive.  Forcing millions of machines to spend all available CPU and memory resources maintaining the bitcoin network should be a thing that would attract notice.  But thirteen years working in computer security compels me to admit there’s little to support that assertion.  Bitcoin botnets are already popping up, making the technology something of an “attractive nuisance” (albeit at a limited scale, maybe thanks to these pesky ASICs). 

And so we end up at a rather curious argument by bitcoin’s supporters:  The masses cannot be trusted to maintain the system, as they are easily swayed by a demagogue; instead, only a small group of elites, invested in the continuing and proper functioning of the network, can be trusted.  And it is ultimately these elites who set the fees for transactions in the long run.

Of course, it’s always possible that huge numbers of people will buy bitcoin-specific ASICs, blunting the effectiveness of the big miners.  It’s also possible that the nation-states – who have been making silicon that does cryptographic math for quite some time and actually created the raw math of bitcoin – might themselves just throw their rather large hat in.

On the one hand, bitcoin is in fact a revolution, a dollar bill with a teleporter.  On the other, what if nothing changes?  Say hello to the new boss, same as the old boss.

It’s More Than Just Money

Bitcoin is certainly money, but it is not just money. And that’s what’s so exciting about it.

In his lead essay, Jim Harper masterfully explains why bitcoin is money and why it is in many ways superior to government fiat currencies. As Jim says, bitcoin is immune to the kind of hyperinflation that has plagued countries from Argentina to Zimbabwe. But what is more revolutionary is the greater bitcoin system itself, which not only allows there to be no central banker, but also makes many other innovations possible.

Bitcoin is essentially a decentralized ledger system. Until its invention, online digital payments had to rely on trusted third parties, like PayPal or Bank of America, to keep a ledger of accountholder balances. These are necessary to keep track of who owns what. If I send you $100 via PayPal, PayPal deducts the amount from my account and adds it to your account. Without such an intermediary, digital money could be spent twice. It’s not difficult to see how: Imagine that there are no intermediaries with ledgers and that digital cash is simply a computer file, just as digital documents are computer files. I could send you $100 by attaching a money file to a message. But just as with e-mail, sending you an attachment does not remove that file from my computer. I would retain a copy of the money file after I had sent it. I could then easily send the same $100 file to a second person. In computer science, this is known as the “double spending” problem, and until bitcoin it could only be solved by employing a ledger-keeping trusted third party.

Bitcoin’s invention is revolutionary because for the first time the double-spending problem can be solved without the need for a third party. Bitcoin does this by distributing the necessary ledger among all of the users of the system via a peer-to-peer network. Every transaction that occurs in the bitcoin economy is registered in a publicly distributed ledger, which is called the blockchain. New transactions are checked against the blockchain to ensure that the same bitcoins haven’t been previously spent, thus eliminating the double-spending problem. The global peer-to-peer network, composed of thousands of users, takes the place of an intermediary; you and I can transact without PayPal or any other central authority.

The fact that bitcoin is a distributed ledger makes it much more than just money. As Jim Harper hinted, it is also a payments system, which is something separate and apart from money. Seashells and cows can be money, but they can’t be payment systems on their own. And because it is a distributed and decentralized payments system, bitcoin is censorship-resistant.

In late 2010, after WikiLeaks began releasing its trove of State Department cables, many individuals sought to show solidarity with the group by making a donation to it. They found, however, that many payment processors, including Visa, MasterCard, and PayPal, would not remit money to WikiLeaks as a result of U.S. government pressure. PayPal even froze the group’s account so that it could not access funds it had already collected.

“Hey, Visa, Mastercard, Paypal: It’s MY money,” media critic Jeff Jarvis tweeted at the time. “How DARE you tell me where I can and can’t spend it?”

Yet as long as you rely on an intermediary to transact, it can indeed tell you how you can and can’t spend your money. This is why governments seeking to control online activity tend to regulate not end users, but intermediaries. For example, online gambling and sports betting is perfectly legal in countries like the UK, Ireland, and Australia, and residents of the U.S. will have no problem reaching the websites of gaming sites from those countries. Placing a bet is another matter, however, because the Unlawful Internet Gambling Enforcement Act of 2006 requires payments systems to block transactions to online gambling sites. And the rightfully defeated Stop Online Piracy Act would have worked in much the same way by requiring payment processors to block transactions to persons merely suspected of piracy.

By decentralizing the ledger, the bitcoin protocol leaves governments with no intermediary to regulate. Even if bitcoin fails as money, perhaps because it proves not to be a good store of value, it can still be a censorship-resistant payments system

And it doesn’t end there. The fact that bitcoin is a distributed ledger means it is a protocol that allows for a vast number of other decentralized applications beyond payments. Bitcoin is not just one thing—not just money or a payments system—but a platform on top of which other layers of functionality can run, much like the Web or e-mail are applications that run on top of the Internet’s foundational TCP/IP protocol. It therefore has the potential to spawn any number of other services that are decentralized, and thus difficult to regulate or control.

For example, bitcoins are ultimately tokens (like cows or seashells) that are imbued with whatever value we agree they represent. To date, bitcoins have mostly tended to represent national currency values at a market rate, but there is no reason why particular bitcoins (or infinitesimal fractions thereof) could not represent a share of stock, a bond, an IOU, or a piece of real property. In this way, the bitcoin protocol, as a distributed ledger, could facilitate decentralized stock and bond exchanges, credit markets, or property registries.

As Robert Graham has pointed out, essentially anything that can be done with a ledger can be done on top of bitcoin, except without having to rely on intermediaries. He gives the example of bitcoin as a decentralized notary service that allows anyone to verify that a document existed at a certain point in time. Let’s say you have written a movie screenplay and before you shop it around in Hollywood you want to record that you had it first. To accomplish this, you can add the document’s cryptographic signature to the blockchain, bitcoin’s public ledger. If someone ever claims the screenplay as their own, you can point to the blockchain to prove you had it first.

Perhaps most interestingly, bitcoin could facilitate decentralized futures markets, whether for betting on stock or commodity prices, sports, elections, or anything else. One could publish to the decentralized ledger a prediction about the future and the amount one is willing to bet, and someone else could publish a message accepting the bet. At that point, both parties would be committed to the transaction, and when the event came to pass, the network would confirm who owns the wagered bitcoins, just as it confirms any other transaction. This could all be accomplished without relying on a betting site or any other easy-to-regulate intermediary.

The predictions market Intrade, a darling of academic economists and political scientists, recently ceased operations after it was sued by the Commodities Futures Trading Commission. And futures in motion picture box office receipts were prohibited by the Dodd-Frank financial reform legislation, shortly before Senator Chris Dodd decamped to become head of the Motion Picture Association of America. A predictions market built as a peer-to-peer network on top of bitcoin, however, could not be easily shut down or regulated, nor would there be an operator that could run away with user’s funds, as is also alleged of Intrade.

One could go on citing examples of imaginative potential uses of a decentralized ledger like bitcoin, including censorship-proof messaging and broadcasting, a decentralized domain name system, and much more. The bottom line, however, is that bitcoin has the potential to be much more than just digital money. It is a platform for financial and informational innovation that is open to anyone and everyone without needing to get permission to experiment.

The potential benefits to the economy and for liberty are profound, but such as system also threatens the authority of states. The few examples I’ve related touch on the regulatory jurisdictions of the Treasury Department, the Securities and Exchange Commission, the Commodities Futures Trading Commission, the Consumer Financial Protection Bureau, various state regulators, and probably also the Internal Revenue Service. These entities are beginning to assert their authority in the face of the challenge posed by decentralized currencies. 

While it is true that bitcoin’s decentralized nature make it virtually impossible to shut down or regulate, it would be naive to think that governments could not substantially raise the costs of using it and slow down its development. As Jim Harper says, the choice is not whether to have digital currencies, it is whether we will have them the hard way or the easy way. The same goes for all of the decentralized applications a system like bitcoin enables. This is why it behooves us to begin to educate policymakers about what is coming so that we can avoid the hard way as much as we can, and begin to enjoy the benefits as soon as possible.

It’s a Sound-Money Alternative to the Dollar

Governments have historically done a terrible job administering monetary systems.  Through a gradual inflation, the U.S. dollar has lost 96% of its purchasing power in the last 100 years.  Even worse, the dollar’s inflation has been anything but stable, with booms and busts including episodes of deflation and double digit inflation.  Yet compared with most other government monies the dollar is a paragon of stability.  Currency crises around the world are frequent in the financial news – including the occasional hyperinflation.

It should be no surprise to any student of economics that when government has a monopoly on money, it will be mismanaged.  A better approach would be a free market in money: currency competition among entrepreneurs.  Bitcoin is one of the opening salvos in this battle.  In some respects it is very promising as an alternative currency and as a possible wholesale replacement for a national currency. In other respects it falls short.

Bitcoin is a fiat currency that has achieved popularity and value without the mandate of a government legal tender law.  On the contrary, the government strongly discourages bitcoin use and has used regulations to frustrate its adoption.  I’m unaware of any previous widespread adoption of a fiat currency through voluntary spontaneous order; they invariably have been imposed by coercive central planning.

Many cultures adopted gold as their commodity money due its high degree of marketability, which can be traced back to the following important characteristics: gold is uniform, durable, divisible, portable, and stable in value.  Bitcoins compare with gold quite favorably by those metrics.  Bitcoins are durable as just bytes on a hard drive; divisible and fusible because they are divisible to 8 decimal places; portable in that you can hold all bitcoins ever issued on a thumb drive; stable value is a bit questionable, but their growth rate is fixed by a technology rule, so seasons play no part in the supply side of their value; and uniform due to the block chain verification of bitcoin ownership.

The bitcoin protocol distributes seigniorage income among users who run decentralized mining software with spare processor cycles.  A new block is created every 10 minutes that solves a cryptographic puzzle to verify the most recent transactions.  Each block contains new bitcoins plus transaction fees in the form of tips.  Specialized mining machines running arrays of graphics cards (GPU) now collect much of the seigniorage; some bitcoin clones such as litecoin seek to reverse that trend, making the computation more memory intensive to favor CPUs over GPUs.  Bitcoin’s Cantillon effect – the redistribution of wealth to those who receive new money earlier when the money supply expands – benefits hordes of miners rather than a select group of primary dealers.

The price level of bitcoins is determined by the intersection of money supply and money demand.

Money supply of bitcoins is predictable due to a monetary rule: it will increase at a decelerating rate with some bitcoins created with each new block roughly every 10 minutes – that number halving every four years.  This is a geometric series that converges over time to 21 million bitcoins.  Because the rule is embedded in the program code, it is harder to modify than a rule imposed by central bankers, by statute, or even by the Constitution.

Money demand of bitcoins is more chaotic.  Over time bitcoin has become more attractive due to money’s network effect: its value for any individual increases as more people use it.  Positive shocks to money demand include prominent positive media mentions of bitcoin and popular websites beginning to accept bitcoin.  Negative shocks to money demand include exchange shutdowns due to security vulnerabilities and government action.

Because the money supply is so stable, bitcoin’s price level variability is almost entirely attributable to money demand fluctuations.  Normally currencies dampen or eliminate the effect of seasonal or event driven money demand shocks on the price level with an elastic money supply.

Commodity money has long-term money supply elasticity due to mining.  If the price level of gold rises due to a rightward shift in money demand, this incentivizes more intensive mining of gold, which will push the gold supply curve right and thus return the price level to its previous long term equilibrium.  Even though bitcoin analogizes its money creation to mining, it lacks this negative feedback mechanism.  If the price level of bitcoin rises due to a rightward shift in money demand, this incentivizes more people to mine for bitcoins.  But here the analogy falls apart.  When more people mine bitcoin they will be able to solve the cryptographic puzzle quicker.  The network automatically adjusts the difficulty of the puzzle to make it again solve in an average time of 10 minutes, taking into account the additional miners / CPU cycles doing work.  So instead of adjusting the money supply curve, positive shocks to money demand just make the cryptography stronger.

Several economists have suggested changing the bitcoin protocol or creating a new cryptographic currency with a money supply that is elastic to money demand.  A better and simpler policy would be to freeze the monetary base and let the money multiplier handle money supply elasticity.  Fractional reserve banking introduces elasticity into the money supply through a money multiplier on the monetary base as deposits are lent out.  Unfortunately there are not yet any real bitcoin banks that loan out deposits (Flexcoin is a money warehouse with 100% reserves).  The money multiplier can either be controlled by a central bank manipulating interest rates or allowed to develop organically with free banking, which entails free-market interest rates and competitive bank-issued notes redeemable on demand for base money.  Free banking does a much better job than central banks smoothing out seasonal variations in the price level due to Christmas shopping, farm harvests, etc.

George Selgin’s productivity norm research into deflation distinguishes between velocity and real output driven changes.  In his model under a free banking system changes in money demand due to velocity fluctuations are matched by corresponding changes in the money supply to hold the price level fixed, but changes in money demand due to rises or drops in real output are allowed to fully affect the price level.  Even if bitcoins were paired with free banking to stabilize velocity effects, we would still expect the price level to fall as real output rises.

One common problem with deflationary economies is making small change.  Bitcoins anticipate this problem, as they are divisible down to 8 decimal places: buyers and sellers can trade 0.00000001 bitcoins.  This also leaves open the possibility of micropayments for goods and services like viewing a webpage.

It would be entirely reasonable for a developing country to dollarize to bitcoins, embracing sound money as a replacement for a faltering, untrusted national currency.  Coupling bitcoins with free banking both introduces elasticity into the money supply to smooth out the price level and also creates a physical manifestation of bitcoins that people can trade for goods and services without needing Internet connectivity.  As a second best alternative to dollarization, a country could implement a currency board fixed 1:1 to bitcoins.

The biggest challenge to bitcoin and other alternative currencies is government intervention in the form of legal tender, counterfeiting, and anti–money laundering laws.

Legal tender laws encourage the use of a particular currency through three main mechanisms: public receivability for taxes, court enforcement for repayment of debt, and laws requiring use for spot transactions.  So far they have not been an impediment to bitcoin’s gradual adoption as an alternative currency in parallel with the dollar, though no doubt that would change if domestic businesses began refusing dollar transactions en masse.

Counterfeiting laws have been used against other alternative currencies such as the Liberty Dollar, which was shut down on the grounds that its notes and coins resembled the dollar.  Bitcoin is unlikely to suffer from this line of attack because it uses a completely different unit of account and has a unique sign (฿).

Anti–money laundering laws have been bitcoin’s albatross since its inception.  The relevant provisions (codified in the Bank Secrecy Act, the Money Laundering Control Act, and title III of the USA PATRIOT Act) boil down to registering, recordkeeping, and reporting requirements.  By criminalizing innocuous behavior, these laws have made it easier to identify and prosecute drug traffickers and terrorists at the expense of a huge regulatory burden on financial institutions.  Bitcoin is anonymous by design.  There is a record of every bitcoin transaction; however, addresses are not easily tied to individuals, and people can create as many addresses as they want.  On the Tor network, coin mixing services like Bitcoin Fog further obfuscate the source of funds and online black markets like Silk Road facilitate the anonymous sale of drugs.  FinCEN wants to regulate bitcoin not because it’s an alternative currency, but rather because it’s a payment processor (anonymous transactions frustrate the goals of anti–money laundering laws); therefore, bitcoin exchanges have been targeted as unlicensed money transmitting businesses.  It’s lose/lose: either the exchanges shut down, or they cripple one of the best bitcoin features (anonymity) by spying on their customers for the government.  In this era of government monitoring of phone calls, email, instant messages, Facebook, Skype chats, postal mail, and income, we all should be very skeptical of anti–money laundering laws, which let the surveillance state monitor financial transactions.

The uncertain legal landscape and cost of complying with regulations discourage bitcoin adoption by risk averse companies.  Also hurt are the unbanked poor, who can’t afford transaction fees charged by conventional banks, and immigrants, who want to cheaply send remittances to their families abroad; bitcoin could address both issues if regulation didn’t price solutions out of the market.

Bitcoin has great promise as an alternative currency or a replacement national currency; however, it has several technological issues that suggest a second or third generation cryptocurrency may be the one to finally take hold.  The block chain size has been growing exponentially because it records all transactions ever, which means within a few years it won’t be storable on most hard drives.  BitTorrent could store parts of the block chain in a distributed decentralized fashion though.  Transactions are only processed every 10 minutes, requiring the customer to wait until the payment can be verified.  This makes bitcoin a bit unworkable as payment for a book or a coffee at a normal store.  In theory an intermediary such as a bitcoin bank debit card or redeemable paper bitcoin bank notes could process transactions faster internally and clear to bitcoins later.  Or an alternative implementation could process transactions faster – for example, litecoin creates a new block every 2.5 minutes.  The wildly variable bitcoin price level inhibits its adoption; however, this can be mitigated with fractional reserve bitcoin banks and free banking, using the money multiplier to make bitcoin elastic to demand.  These issues are worrisome, yet surmountable.

Money is one half of practically all transactions.  It’s too important to leave to government, which mismanages everything.   Economists ought to look closely at bitcoin as a sound-money alternative to the dollar.

The True Value of Bitcoin

I’m often asked what a bitcoin is worth right now, referring to the price in fiat currency a unit is valued at, and I usually respond that I don’t know and I don’t care. The true value of bitcoin as a system, and therefore of a single bitcoin or fraction thereof, is currently immeasurable. This is generally met with skepticism, as if I’m playing a semantic game. And perhaps I am to some degree. But it’s really not quite so simple as saying “$91.92 USD.” The true value of bitcoin is not what a single bitcoin can be purchased for today but the combined future value of two intangibles: the composition of the bitcoin community and bitcoin’s useful purpose.

The first part is easy to understand. Bitcoin is the accumulation of the talent, hard work and dedication of the people who develop and maintain the protocol, build industries around the protocol, the merchants and consumers who use the bitcoin protocol in their daily lives, and those who promote and protect the protocol. As more people become a part of the bitcoin community, the value of the system increases.

The second part requires a deeper dive into what bitcoin actually is (hint: it’s not virtual currency).

Bitcoin is Distributed Finance

Bitcoin is not just money. Bitcoin is a protocol for fixing, storing, and transferring value. This includes the recursive use of Bitcoin to fix, store, and transfer bitcoin itself as a thing of value. Money presupposes such an underlying transparent and accountable system for fixing and transferring property. While some may treat bitcoin like money, in reality it is a new class of digital asset. As a digital asset, the first widely adopted use of bitcoin was as a safe and secure store and transfer mechanism for fiat currency value. This is how most people think of and use Bitcoin today, as a substitute for money, but it is an inadequate classification. Perhaps the best way to think of bitcoin is as a method for Value over IP (sadly, VoIP is taken as an acronym).

When I first encountered bitcoin, the first thing that struck me was the way in which bitcoin replaces the traditional chain of title in property law. The bitcoin protocol secures a party’s interest in an asset in an identifiable and secure manner, and provides a transparent set of rules and enforcement mechanisms so that all parties are held equally accountable. It does all this without any reliance on financial, regulatory, or judicial authorities. Truly, bitcoin is code as law.

Perhaps bitcoin can best be understood as a response to failing institutions. Private financial institutions have failed to address a systemic inequity with regard to who has access to the global financial system. Public institutions spend more resources keeping people out of the global financial system than in building infrastructure to allow the world’s disenfranchised to access global finance.

Indeed, while some have wrung their hands and complained about the challenges traditional financial institutions have in serving disenfranchised populations, others have stepped up and created consumer-friendly solutions. As it happens, Kenyans using the Kipochi wallet have access to a global financial system using bitcoin and, as they want, can convert bitcoin into m-pesa for local transactions and purchases.

Where the government and private sector have failed, open-source development may have found the answer in bitcoin.

The Value of Bitcoin as A Distributed Financial System

The way to assess bitcoin’s true value is by quality of the community and how that community utilizes the bitcoin protocol to address market needs. If bitcoin becomes the digital asset ledger for System D assets and transactions it would address a $10 trillion market that is completely unaddressed by either public or private financial institutions. This is why most investors in the industry feel that the current $1 billion market cap is low given bitcoin’s potential to reconceive how society’s value and property are conceptualized, stored and managed in an Internet-enabled world.

This is all very exciting, but bitcoin only has value as a system to the extent individual participation and inclusion are respected. In order for any system to be useful to System D and disenfranchised populations it must be private, decentralized (and thus extra-governmental) and transactions within the system must be irreversible (and thus secure and respected). It is the combination of these three elements that makes bitcoin anti-fragile. And it is this combination of elements that allows for securitization of digital assets, perfect fungibility of those assets and thereby the unearthing of new and previously inaccessible sources of capital.

A compromise on any of these core principles devalues bitcoin as a whole. That is why the community will aggressively challenge any threats to these principles.

Privacy Is Intrinsic to the Value of Bitcoin

Unlike chain of title in property law, the bitcoin protocol does not rely on proof of identity for an individual to assert proof of ownership to a digital asset stored within the blockchain (the distributed public ledger that records assets in the bitcoin protocol). All that is required to assert ownership is possession or knowledge of a bitcoin private key (sort of like a password for your bitcoin address).

Privacy is an essential component of bitcoin because the protocol authenticates ownership and transactions via a distributed ledger system. Without privacy Bitcoin becomes far more nefarious than anything the NSA could dream up. It would be a full, public transaction log detailing, in an identifiable way, every value transfer you and every other bitcoin user has ever made.

In many instances, bitcoin’s private method of recording property rights is far superior to identity-based systems. For dissidents, journalists, political activists and other stigmatized classes of people privacy is essential to their livelihood and, in some parts of the world, even their survival. This method is also superior to legacy systems where uncertainty over ownership  has stifled innovation. Gone would be the days of trying to decode the identity of an owner of a copyright because of poor identifying information relating to the artist, uncertain contractual rights, or simple failure to assert a claim of ownership in a timely manner. The blockchain would make ownership of copyrighted material transparent, secure, and simple to assert and prove. Contractual rights, royalties, and even droit moral could be incorporated into the blockchain. Royalty and license payments could be automated and fully auditable in real-time.

Going a step further, the blockchain could also prove an elegant solution to applying copyright law’s first sale doctrine to digital goods. A content producer could create a unique digital asset in the blockchain for each instance of a digital good. This asset would embody a unique and transferable ownership right to a consumer, and the consumer could freely transfer this right via the blockchain. Because a unique instance on the blockchain is required to unlock the content, the seller would lose access and the buyer would gain access in a manner not unlike how a physical book or cd is transacted. Of course, these transactions would be fully transparent and auditable.

Privacy on the network begets transparency. You can’t expect participants to allow full financial transparency at the institutional level if the participants can’t choose to guarantee the privacy of their individual transactions. The trade-off here is clear, privacy for individuals leads to transparency in formerly opaque business. This is why we saw the first provably fair gaming service developed on the bitcoin protocol and now sold for close to $12 million.

But it’s easy to see how things could quickly go awry if privacy, and indeed anonymity, isn’t respected on the network. A single data breach at a bitcoin exchange service maintaining all or part of an identifying database could lead to the exposure of a user’s entire online financial life (I imagine the Federal Trade Commission would have something to say about that). While some types of exchanges will have to verify and record customer identities in relation to fiat currency to bitcoin exchanges, this is ultimately a consumer choice issue. It is the consumer’s choice to use an exchange that requires identity verification or to find another means of obtaining bitcoin.

As a result, bitcoin firmly puts financial privacy back in the hands of consumers for the first time in at least a generation.

A Sane Regulatory Environment

The most immediate threat to bitcoin quickly fulfilling its highest purpose as a useful system is overbroad and defensive reactions from the regulatory and law enforcement community. Over time, it’s possible and maybe even likely that any overbroad or defensive regulatory response may be rendered moot by the technology. But in the short term it would dramatically impact the speed with which bitcoin can be deployed to solve pressing market needs and global inequity—and thus suppress the value of bitcoin itself.

It is the modern way that arguing to restrict or condition access to any system is to argue on the wrong side of history. Technology and networked society has driven a wave of openness, collaboration, participation, and individual responsibility. Those institutions willing to go with the tide and ride the wave will be carried along, while those who resist too strenuously will be swamped.

One notable way forward is for the industry to show a willingness to regulate itself, in particular when it comes to interactions with traditional financial institutions and regulatory authorities. But such organizations have to know their limits and keep in mind what is feasible and value accretive for the community as a whole. As Jon Matonis, the Bitcoin Foundation’s Executive Director, has said: “As self-regulatory organizations are excellent non-governmental solutions for industry best practices, they need to be vigilant about maintaining the integrity of the original mission. In the case of bitcoin as a negotiable digital asset class, the protection of core fundamental attributes includes perfect fungibility, payment irreversibility, and user-defined privacy.”

Resisting inclusion and openness by creating lists of “tainted” bitcoins or restricting transactions to bitcoin addresses that attain a sufficient identity score (for knowing your counterparty) may seem to be a clear and certain path to easing the regulatory concerns, but such systems would dramatically impact the fungibility and participatory nature of the overall system and thereby devalue the entire bitcoin project. Any customer identification that goes beyond the transition from traditional finance to bitcoin is a line in the sand that cannot be crossed no matter how expediently it eases the regulatory burden for some businesses in the space.

Thinking that the most regulated businesses in the most regulated jurisdictions will dictate the core values of the bitcoin community is folly. Entrepreneurs may choose to create highly regulated businesses that utilize the bitcoin protocol, but those regulations must be their burden to bear.

Before we start discussing what concessions the bitcoin community should make, we should first decide which stakeholders should be appeased and why. Why, for example is law enforcement driving this conversation instead of consumer or merchant advocates? Is it in anyone’s best interest to have law enforcement making policy decisions that directly affect consumer choice, financial privacy, and market dynamics?

Indeed, we need to have a frank discussion not only about law enforcement’s “seat at the table” but of the broader tradeoffs implicit in the aggressive enforcement of financial crime, preferably before we criminalize entire nascent industries.

Some clear and notable effects of increased enforcement efforts are:

  • A chilling effect on banking for innovative non-financial institutions like virtual currency and distributed financial firms. Some national banks have instituted blanket policies that they will not take on the regulatory risk of banking any business associated with bitcoin without regard to a particular company’s compliance measures or risk profile.
  • Growth in the number of underbanked and unbanked people as fewer people are able or willing to clear the compliance hurdles necessary to effectively “know your customer” or “know your counterparty.”
  • Exclusion of “high-risk” groups of people (often poor, marginalized, and ethnic minorities) from the global financial system, often with grave humanitarian consequences. Global remittance is the lifeblood for many communities. Companies facilitating these transfers are routinely shut down by banks unwilling to take the risk of banking “high-risk” populations.
  • For the few companies that can still operate in the global remittance space, compliance costs and uncertainty have resulted in less competition and astronomical fees on populations that are least able to bear the burden of these costs: a pure tax on the poor and disenfranchised for being poor and disenfranchised.

This leads one to seriously question whether law enforcement concerns, which are at times unproven and theoretical, should be dictating these public policy outcomes. Or, if perhaps we should be discussing whether law enforcement efforts are costing us, as a society, more than we benefit from them.

Here are a couple of modest proposals to bring some sanity back to the US regulatory environment for the emerging payments industry broadly and as stop-gap measures for bitcoin as it evolves beyond traditional finance:

  • Create uniformity and clarity out of kafkaesque state-by-state money transmitter regulations either through preemption and integration into a federal agency or through home-rule and reciprocity agreements.

U.S. rules and procedures related to money transmission are arguably the most opaque, anti-competitive, and parochial regulations that companies in the United States have to face, and they are offensive to an open and participatory system.

Perhaps the root cause for the failing multi-state regulation of money transmission is that each individual state is not required to respect the judgment of another state. Instead, each state wants to assert jurisdiction over any business that touches one of their consumers, leading to a regulatory patchwork that is unworkable in an Internet-enabled world where customers could be anywhere at any given time. The Internet doesn’t respect borders and jurisdiction.

And so now we have arrived at a point of sheer absurdity, where state regulators don’t understand the applicability of their own rules to a particular industry, but at the same time the industry will still be held to account for failing to abide by the incomprehensible rules—that is, once the regulators get around to figuring them out at some point in the future. To be clear, the industry (which at times could be a two-person technology startup) should in principle be able to understand the rules regarding money transmission and how they apply to their business. This violates our most basic sense of fairness. No one should have their lives ruined and face jail time for violating rules that no one can understand.

In fact, it is the duty of law enforcement and regulators to explain the rules in a clear and comprehensible fashion before applying them to and enforcing them within a new industry. It is also the duty of regulators in a free society to make these decisions in the open, transparently, and with participation from the public.

  • Safe harbor protection under the BSA for banks and financial institutions exercising reasonable diligence and good-faith efforts to mitigate financial crime.

Bank Secrecy Act compliance is rooted in a results-based methodology. Firms that fall under FinCEN’s administration of the BSA are required to put in place policies and procedures to ensure proper and accurate reporting of customer transactions and to proactively prevent financial crime from occurring within their systems, even from one bad actor. The outcome of this results-based approach is that firms suffer from great uncertainty as to where that elusive “one bad actor” could be in their system and how they will be treated by regulators if, despite best efforts, some financial crime is detected. In practice this leads to a culture of risk-aversion and an ever shrinking circle of “safe bet” firms that are allowed to participate in the global financial system and reap the benefits therefrom.

Firms should be rewarded for their good faith efforts to root out financial crime, for adopting industry best practices, and for taking seriously their responsibility as upstanding members of the global financial system. Allowing for statutory, and thereby certain, safe harbor protection for those firms, if it so happens that a bad actor slips through their net, would allow firms to take more risk onboarding customers and increase participation in the global financial system.

As it is, the regulatory process is much like a sausage factory: every animal looks different going in, and they all look like sausage coming out. It seems that to satisfy some of the voices in the regulatory and law enforcement community, bitcoin must grow to resemble a low-cost version of PayPal or Western Union. It must be less disruptive to traditional finance, not more disruptive, and it must put less power in the hands of consumers and merchants and more power in the hands of the state and intermediary institutions. It may be that for bitcoin to be palatable to some stakeholders it will have to look like the sausage Washington, DC is used to eating. But it just so happens that sausage is less valuable than steak.

The Future of Distributed Finance

The point of the bitcoin project isn’t to reform the traditional financial system. It isn’t to integrate into the traditional financial system. The point is to obviate the traditional financial system.

Unlike traditional public and private institutions, the bitcoin community is open, transparent, and participatory. Anyone, from a law enforcement official in Washington, DC to a Haitian street merchant, can have a say in how bitcoin develops and participate in the project. It is the responsibility of existing stakeholders in the global financial system to find common ground and participate on equal footing.

The right of an individual to make sovereign financial decisions and participate freely and without undue burden in the global economy is a cornerstone of human dignity and empowerment. Since the end of the colonial era, traditional financial institutions have failed to develop systems to include disenfranchised and developing world populations. Unsurprisingly, the result of this failure is that others have taken the matter out of their hands. For better or worse, distributed and participatory finance is here, it’s valuable, and it’s worth fighting for.

Satoshi lit the fuse. We are the dynamite.

The Conversation

Waiting for the Shoes to Drop

The phrase “waiting for the other shoe to drop” comes from a story about an old apartment house. One of the dwellers on an upper floor comes home late and, in preparing for bed, drops his shoe. Realizing this would wake his downstairs neighbors, he carefully and quietly places his other shoe on the floor. After a long interval, a neighbor who has been lying awake yells up, “For God’s sake, drop the other shoe!”

Widespread agreement about the merits of bitcoin among our panel inclines me to lay awake wondering which of two shoes will drop. Will it be a flaw in the technical structure that results in calamitously skewed incentives? Or will it be the opposition of governments, who see the threats in unfettered value transfer and seek to censor it?

The bitcoin protocol anticipates much in the world of money and payments, but it doesn’t appear to anticipate a quirk of its own creation, the possibility that one miner will do more than 51% of the “mining.” As Dan Kaminsky points out, if one person or entity is positioned to do most of the processing that maintains the public ledger that Jerry Brito extols so well, he, she, or it can affect what makes it into the ledger. That power is subject to exploitation.

Likewise, as Chuck Moulton points out, the bitcoin protocol may not be well tuned to the monetary needs that actually result from the use of digital currency. The amount of bitcoin is not responsive to the demand for money — it even insulates against attempts to create bitcoin ahead of schedule — so it could serve less well than a currency whose supply is responsive.

I believe problems like these and others are headed off in the near term by the prospect that bitcoin will increase in value. Given potentially huge growth in value, anyone with the ability to undermine the bitcoin ecosystem should realize that doing so will make him- or herself worse off. Witness the reticence of the BTC Guild to mine more than 50%. The bitcoin protocol can probably be amended to fix problems, even dealing some parties short-term losses, because all stand to see longer-term gains.

There’s some hand-waving in that, and there may be dynamics that are not susceptible to these self-correcting incentives. Perhaps when bitcoin nears an equilbrium price based on perceptions that it has reached its largest scale, exploiters of technically based incentive errors will emerge. But that will be a while.

The other shoe — the first most likely to drop — is government interference with bitcoin adoption and use. The governments who now supply money, enjoying the benefits of seigniorage and surveillance for doing so, have the opposite incentives. The greater the value of bitcoin (especially as driven by common use), the greater the incentive of governments to take steps against it.

In my main essay, I noted the ham-handed issuance of “cease and desist” letters by the California Department of Financial Institutions. Since then, the Bitcoin Foundation has gently chided the U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) for insinuating that anonymous transactions and irreversible transactions are inherently questionable. If they are, then cash money is inherently questionable.

These are bellwethers of future antagonism to bitcoin from the actors who stand to lose the most, governments and traditional financial services providers. And you shouldn’t need to be told that they’re a team.

Simplifying quite dramatically, the outcome for bitcoin is dictated by a sort of perceptual-political-economic calculus: Are the apparent benefits of bitcoin (B) available to enough people (P) who are capable of defending (D) it? Or are the apparent costs (C) of bitcoin to governments (G) and financial services providers (F) greater?

Is (B)(P)(D) greater than (C)(G+F)?

Over the long-term, the benefits of bitcoin to people who can defend it in the public square will win out, but between now and then, the combined efforts of politically adept government regulators and the financial services industry will be significant.

The Challenges Ahead for Bitcoin

Dan Kaminsky points out one of Bitcoin’s greatest weaknesses: the potential for a bad actor to gain control of more than 50 percent of the network’s computing power. If that happened, the bad actor could engage in all kinds of mischief, including reversing his transactions and preventing others’ transactions from being confirmed.

As Bitcoin’s computing power moves to specialized computers known as ASICs, the universe of persons who control the network shrinks—thus making it easier that a pool of just a few miners (or potentially just one), could take control of the network. Kaminsky suggests changing Bitcoin’s proof of work math to be more amenable to solution by general purpose PCs, thus ensuring the expansion of the the number of persons who control the network’s computing power—even if that means that criminal botnets will get in on the action.

Jim Harper argues that Kaminsky’s doomsday scenario is not likely to transpire because anyone who abuses control of the network will only be making themselves worse off. After all, what’s the use of controlling a network that no one trusts? Harper points to the fact that the largest Bitcoin mining pool voluntarily restricts itself to less than 50 percent. But this serves to make Kaminsky’s point. The fact is that what began as a decentralized system now relies on the voluntary action of a few individuals to avoid a crisis of confidence.

While I acknowledge Kaminsky’s critique, I tend to agree with Harper that, in the near-term at least, the individual self-interests of those in a position to overtake the network keep them in check. And in the long term, this episode of centralization may prove to be but a blip in Bitcoin’s evolution. As Jeff Garzik, one of Bitcoin’s lead developers, has pointed out, the market is responding to the growing demand for ASICs, with new entrants producing more and cheaper machines. This will have the effect of swinging the pendulum in the other direction, back toward greater democratization of computing power.

Why not just switch to math problems better suited to general purpose CPUs, the most democratized kind of processing power there is? Because specialized ASICs provide greater hashing power, and as Garzik says, “More mining power makes it more difficult to reverse bitcoin transactions. The more widely spread that is, the more difficult it is to shut down bitcoin itself.” In the end the network may come to enjoy greater computational power and greater decentralization.

Jim wonders what will be the next shoe to drop. “Will it be a flaw in the technical structure that results in calamitously skewed incentives? Or will it be the opposition of governments, who see the threats in unfettered value transfer and seek to censor it?”

My fear is that it could be both. In a time of $2 billion NSA data centers, and billions more in secret cybersecurity budgets, it would be trivial for certain governments to engage in a 51 percent attack with the intent of disrupting the Bitcoin network. I don’t mean to be conspiratorial. Such an attack by the U.S. government, for example, would be unprecedented, and at $1 billion the Bitcoin economy hardly threatens the dollar. So it’s more than unlikely that the U.S. government would resort to such a drastic measure anytime in the foreseeable future. That said, the greater total hashing power of the Bitcoin network, the more costly it is for such an attack to succeed, which further argues for a large market in ASICs.