The relevance of complementary currencies is acutely
underlined by the emergence of a global economy dominated by the rules
of finance where state sponsored currencies are competing for growth and
trade surplus. Until 2009, ideas for a monetary reform could revolve
only around money supply mechanisms orchestrated by governments and the
banking system. With the inception of a universal currency harnessing
the transforming power of the web, new avenues may be explored for
economic and social changes: here is why a universal currency like
Bitcoin can help redefine money.
The Bitcoin Database of Transactions
The bitcoin protocol specifies how to build and maintain a distributed
database of transactions on the internet. Transactions are published and
signed electronically (using asymmetric cryptography and key pairs).
The protocol enforces confirmation of every transaction by the network
nodes.
Because all transactions in the database are linked together
cryptographically, a property that explains why the bitcoin database is
usually referred to as the bitcoin “chain”, any change in a past
transaction would require computing an entirely new database from that
point on.
Signatures by private keys ensure the title of property to any given
amount of bitcoins: knowledge of the private key associated to the
receiving address is required to send a part or the whole of any
transaction output. The bitcoin transaction database holds all the
necessary information for an address owner to receive and spend any
amount of bitcoin: the database and the communication protocol together
bring to life a new electronic currency.
Bitcoin Money Supply
Moreover, the bitcoin protocol specifies a money supply mechanism.
Bitcoins are generated gradually by the network until a maximum quantity
of 21 million bitcoins is reached. Bitcoins are created
ex nihilo,
pretty much in the same way as dollars are created when a commercial
bank lends money to someone who is buying a house. The house existed
before the loan. In fact, the seller is walking away with the dollars,
de facto
transferring the ownership of the house to the bank. The bank
essentially created the money in its ledger out of thin air: it recorded
the amount of the loan as a bank’s liability upon crediting with it the
account of the borrower and that same amount was recorded as a bank’s
asset, i.e. as a loan that must be paid back to the bank. Even top
bankers and economists, including Nobel Prize winner Maurice Allais,
call it magic.
Bitcoin builds on the recognition of the fact that the monopolistic
aspect of the money supply mechanism in today’s banking system deserves
at least to be revisited, if only because it has lasted for several
hundred years. If only because of the continued effects of the financial
crises, Bitcoin allows us to experiment with a new concept for money.
Bitcoin, as a new universal currency, is a true innovation, building
on numerous prior attempts to create a sustainable currency and doing so
independently of any state or centralized organization.
Towards the growth of a Bitcoin Economy?
Some bankers I spoke with shrug off Bitcoin on the somewhat circular
logic that it cannot be backed by any assets in the real world. Well,
thanks to merchants accepting bitcoins and to online exchanges trading
bitcoins just like any other currency, a Bitcoin economy is emerging. If
the economy of the euro or the dollar collapses, the expectation of a
backing by the central banks is based on the assumption that a
government has unlimited taxation power over said economy. The current
financial crisis in Greece or, to a lesser extend in the US,
demonstrates that actual use of this theoretical power is a stretch of
economic reality. The truth of the matter is that 90% of the money today
is created in the books of the banks and that price stability is the
determining factor towards continuing public support of the central
banks view.
There are over 140 state sponsored currencies in use across the world
today. It is hard to prove that a new complementary currency will
jeopardize the world’s economic outlook only because this new currency,
unlike all the others, stems from a distributed monetary system without a
central authority. The innovative feature of bitcoin that truly sets it
apart from anything that existed before is simple: it is cash online
without the necessity for a central organization or third party. As
such, it is making other forms of cash transaction comparatively less
convenient. Removing the necessity does not affect the usefulness of a
third party in some cases. Transaction processing between merchants and
their customers will always entail some kind of dispute resolution
system, regardless of the currency that is being used for payments.
E-gold, as a tentatively universal currency backed by gold, was
created in 1996 and failed mainly because it relied on a central
organization to manage an inventory of gold. The quantity of gold needed
was supposed to grow with the e-gold economy, which was impractical,
dangerous and fundamentally useless in a digital age. (Another
shortcoming of e-gold was the lack of a specific protocol: relying
solely on a web browser to conduct irreversible transactions makes it
difficult to secure them.)
Bitcoin money supply mechanism simulates the extraction of a rare
metal with a mathematical model, using a clever recipe proven in
electronic signature schemes and hashing algorithms that can be found
today as ingredients in most banking systems.
One can think of bitcoin as a currency backed not by gold but by a
metaphoric substitute of gold, since the quantity of bitcoins is limited
by design: 21 million bitcoins.
Like gold, bitcoins can be seen as bonds that never mature but unlike
gold, bitcoins bear virtually infinite divisibility and liquidity with
no vaulting costs. According to 2010 year-end estimates by
GMFS,
total above ground stocks of gold are 166,600 tons worth US$6,500
Billion by 2010 average gold price, of which around US$2,400 Billion are
held privately or by official reserves, in the form of coins and bars.
The total stocks minus approximately 30,000 tons held in official
reserves worldwide as of august 2011, gives us an estimated “market”
size of US$1,230 Billion for gold as a private store of value. If we
were to compute a fictitious exchange rate with the dollar based on
these numbers, we would project an exchange rate of around US$600 for
one BTC, if bitcoins were to capture only a 1% fraction of the private
market for gold as a hedging instrument.
By the same token, if the bitcoin economy were to grow up to 5% of
the US GDP, i.e. approximately US$750 Billion USD, and assuming the
velocity of bitcoins to be the same as that of the dollars (around 50),
then one bitcoin would represent the equivalent of US$700.
The numbers translate to a $15 Billion future valuation estimate for
the bitcoin network. They are consistent with the market capitalization
of Visa, Inc. ($55 Billion as of august 2011) or MasterCard ($39
Billion). Buying bitcoins today is like buying stocks of a new global
electronic transaction network. At $10 as of august 2011, Bitcoins can
be considered undervalued even if it is likely that other universal
currencies might try to step in at some stage.
One would think at first that such a valuation would provide an
investor with the rationale for purchasing the most powerful computer on
earth (“K” in Japan as of June 2011) to take over the bitcoin network.
However, doing so would drive away today’s “mining” participants and, at
least temporarily would reduce the value of the bitcoins to zero. The
supercomputer would stay idle, acting as a deterrent to any seller of
bitcoin, waiting for the intruder to back away. In other words, to
mitigate this risk, the new operator himself or herself would have had
to acquire a large amount of bitcoins beforehand to keep the bitcoin
economy running after the takeover, in the hope that more sellers would
return after the more or less chaotic transition.
Additionally, by the time the attack is ready, it is unclear whether
said supercomputer would be able to match the majority of the hashing
power of the current nodes while this cumulative power is going up day
after day. The uncertainty surrounding the outcome of this kind of
hostile takeover makes it more likely that a rational investor would
simply buy bitcoins much in the same way he or she would buy stocks in a
start-up venture.
Another, more naïve attack would consist in buying “pools” of miners
that are thriving these days on the bitcoin network. By joining a mining
pool, a miner aims at gaining a share of the steady flow of bitcoin
expected with a large amount of aggregate hashing power. The share is
prorated according to the hashing power contributed by the miner.
Conversely a solo miner can go for a long period before he/she earns the
50-bitcoin reward associated with the computation of a new block of
transactions. Statistically, the expected rewards are the same though,
only the income flow is steadier in a pool. Hence a miner would have no
incentive to stay with a pool under the control of a hostile investor.
He or she would simply switch to another pool or start mining solo.
This analysis remains true even after all the bitcoins have been
minted. In fact, the incentive to “mine” transaction blocks will sustain
the decline in the rewards by virtue of the increasing transaction fees
combined with the increase in value of the bitcoins.
Electronic Money and Trust Management
Bitcoin is backed not only by this kind of projection but also by the
trust of the “network nodes” that is materialized in the aggregate
computing power of this group of people. Anyone with a personal computer
and a graphic card (GPU) can join in and start participating in this
giant transaction processing pool that defines the bitcoin network. It
requires only downloading a piece of free software known as “mining”
software in reference to the bitcoin money supply rules. Today, there
are several tens of thousands of such “miners” around the world.
In contrast, Ripple, launched in 2004, attempted to create a
universal currency by knitting together a web of Local Exchange
Transaction Systems (LETS): IOUs issued in any LETS could be forwarded
to any participant in the network, across a Web of Trust mechanism.
However, a Web of Trust requires a central authority to manage trust
certificates and to prevent fraud, raising lots of practical issues: the
thorny problem of registering people to link them to a secure digital
identity can lead a technological innovation to its demise even before
it reaches any sizable roll out stage.
Bitcoin proof of work protocol avoids the need for a secure web of
trust, relying instead on the assumption that a majority of the
computing power is in the hands of honest participants: “honest” here
simply means that they will cooperate to make the network confirm
legitimate transactions. Legitimate transactions on the bitcoin network
are those that can be linked cryptographically to the “genesis”
transaction via the “longest” chain: the chain “length” refers to the
depth of its proof-of-work, not to the number of transaction blocks. The
“genesis” transaction is one that took place in January 2009 and got
things started. This concept of cloud computing applied to the
confirmation of transactions is very consequential: only two years after
the launch of bitcoin, it takes already as much computing power as the
“K” computer to take over the network. Taking over the network today
with such a powerful machine would not prevent the network from
operating but would disturb transaction confirmations until participants
find a way to overcome the attack and regain control of the operations.
Recovery strategies could be applied to resume operations normally
thereafter. In other words, even assuming that a government or a large
organization would be able to harness so much computing power to engage
in such heavy-weight counter measure against the bitcoin network, its
expected outcome is uncertain at best. This property makes bitcoin as
resilient as a transaction network can be.
A universal currency like Bitcoin, which is using digital signatures
and asymmetric cryptography, has the interesting additional property
that it can go back and forth from digital to fiduciary status. The old
boundaries between electronic transactions and cash transactions are
blurred: the file containing the key pairs (public receiving address and
secret key to sign the outgoing transfer of the amount received) can be
printed. Let us say the public key is left apparent and the secret key
is hidden underneath a cover: the cover can only be removed in a
non-reversible manner. In doing so we have created a new e-note
containing the bitcoins received on the public address that cannot be
spent until the secret key is revealed. The e-note can be traded as long
as it is not tampered with. The amount received on the public address
can be printed also in a tamper-proof process: the amount received on
the public address becomes the denomination of the e-note (7). When the
cover of the secret key is removed, the e-note amount in bitcoins can be
redeemed electronically for any payment using bitcoins. In further
contrast with old notions of fiat money, e-notes without denomination
are also possible: the amount received on any address can be checked by
the recipient in the public bitcoin transaction database.
Decentralization and Deflation
By definition, a truly decentralized universal currency must start
without a central authority regulating its money supply mechanism: this
precludes establishing any form of correlation between the money supply
and any set of economic parameters or measurements. Such systemic
correlation would yield endless discussions between the users, hence
requiring a governing body capable of moderating the discussion and
enforcing the rules by some yet unknown universal democratic standards.
For the same reason, the new transaction software must be free
software to escape the limitations and opacity of proprietary software.
As Richard Stallman summed it up in his now famous statement: “The point
of free software is either the users control the software or the
software controls the users”.
To a large extend, state sponsored currencies like the euro or the
dollar are created in a black box, with a lot of media attention focused
on interest rates rather than money supply. A central organization
promoting a currency system based on proprietary software would not be a
game changer.
Therefore the money supply mechanism must be hard coded and published
in the specifications from the outset, with little or no room for the
currency to wiggle out of it to its possible demise. In the same logic,
it is neither possible nor necessary to predict the rate of adoption and
growth of the user base for the new currency: these numbers cannot be
factored in with precision. The money supply model is therefore
deflationary, defining a maximum quantity, unless the rules of
generation are bound to the number of users by a user authentication
protocol. This requirement is not compatible with an objective to design
a decentralized currency since user authentication requires issuing
identity certificates either in a web of trust or with a certification
authority.
The Bitcoin specifications not only fulfill the requirement for a
limited money supply but also make provisions for transaction fees to
provide a sustainable incentive for miners to keep mining even after the
rewards for the generation of new bitcoins have dwindled to zero.
Because Bitcoins are traded electronically, unlike gold, they are
infinitely divisible and enjoy a high velocity, so a deflationary spiral
can only reduce the scope of bitcoin to the function of a store of
value, a more practical process than is used for gold. In fact, the
deflationary spiral would have adverse economic consequences only if
bitcoins were the exclusive currency in a given territory. That’s not
the case: as a complementary currency, bitcoins are supposed to coexist
with the local state sponsored currency not to replace it. Prices will
most likely be expressed in local currencies. In an electronic online
transaction, the price expressed in a universal currency can be easily
adjusted in real time for exchange rate variations. Only for off line
transactions, price stability is a strong requirement for a new
universal currency.
In short, deflation will augment the attractiveness of bitcoins as a
store of value and will only marginally affect its application as a
trade currency.
Conclusions
Where do we go from here? In a global economy, the inception of one or
more universal currencies is bound to happen as soon as technology
permits it.
Bitcoin, as the first, is paving the way for new applications. In
particular, bitcoin can greatly enhance the efficiency of money transfer
where it is lacking, specifically development aid that was once
famously characterized (by economist Peter Bauer) as
“an excellent method for transferring money from poor people in rich countries to rich people in poor countries”.
Bitcoin can leverage the generalization of mobile phones in developing
countries to enable a money transfer directly to the recipient,
bypassing all state bureaucracies and banking intermediaries. The
institution or non-governmental organization responsible for the
transfer could simply assign bitcoin addresses to recipients and their
local merchants then fulfill the money transfers and payments in
bitcoins.
The technology is enabling both a new kind of transaction network and a new universal currency.
By analogy, it is worth noticing that the World Wide Web does have a
governing body, namely W3C, a non-profit organization made of more than
300 members among the largest companies in the high tech sector.
Clearly, any leverage applied by a government to one of its constituents
in W3C can be balanced out by the others if it does not fit the bill of
the general interest. Because this principle holds successfully for the
technology enabling new ways of producing and sharing as valuable an
asset as knowledge, one is permitted to hope that a similar organization
can also deal one day with the Bitcoin protocol specifications at a
technical level to maintain its immunity from the hazards of
macro-economic measurements.
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