BitPay, Reaching a $2M Milestone in March, Cuts Fees

By Jon Matonis
PaymentsSource
Monday, March 25, 2013

http://www.paymentssource.com/news/bitpay-reaching-2m-milestone-in-march-cuts-fees-3013622-1.html

CEO Tony Gallippi

Bitcoin payment processor BitPay Inc. today announced its global processing volume for the month of March will exceed $2 million, a milestone for the company.

BitPay is also reducing its fees. The company will now process Bitcoin transactions and support settlement into 11 local currencies at a rate of 0.99% for all merchants. Previously, there were separate conversion fees on top of the 0.99% processing fee, so the company has essentially waived the currency conversion charges.

Bitcoin payments are designed to resemble cash transactions more than credit-card transactions. Bitcoin payments have no disallowed merchant category codes (MCCs), no selective payment embargoes, no chargebacks and near immediacy of final transaction confirmation.

Accepting the digital Bitcoin currency as a payment method allows merchants to reach customers in over 60 countries not supported by PayPal. It also allows merchants to reach various countries that are restricted by Visa and MasterCard for high fraud or lack of infrastructure. A consumer transacting in bitcoins needs only a mobile phone application or an Internet connection.

"We chose to celebrate this milestone by rewarding all merchants, large and small, with an across-the-board fee reduction, instead of offering tiered pricing which rewards only the largest merchants," says BitPay CEO Tony Gallippi, in a press release. "We want our merchants to use this fee reduction to offer discounts and incentives to their customers for paying with Bitcoin."

Settlements to local currencies are made with a guaranteed exchange rate locked in at the point of sale for no additional fee. This protects the merchant from potential volatility of the bitcoin exchange rate.

Supported currencies for settlement include the U.S. dollar, Canadian dollar, Australian dollar, New Zealand dollar, euro, Pound sterling, Danish krone, Mexican peso, Norwegian krone, Swedish krona and South African rand. Currently, BitPay provides one-day settlement for the U.S. and settlement in 2-3 days for other countries. Euro settlement is currently available in Belgium, Finland, France, Germany, Italy, Spain and the Netherlands.

BitPay has over 4,000 merchants on its payments platform and is acquiring new merchants at a rate of 1,000 per month, the company says. It also recently announced that it has integrated its payment platform with Amazon’s fulfillment services, enabling merchants to combine frictionless international payments with international shipping in a fully-automated system.

The Amazon deal alone is a massive win for BitPay as it fits perfectly with Amazon's expansion strategy and showcases the qualities of the bitcoin payment method. Gallippi said in an interview that "the Amazon partnership has the potential to catapult the company to an entirely new level."

Cyprus Goes Cashless The Hard Way

By Jon Matonis
Forbes
Sunday, March 24, 2013

http://www.forbes.com/sites/jonmatonis/2013/03/24/cyprus-goes-cashless-the-hard-way/

The rolling crisis in Cyprus should reach a crescendo this week. If the parliament votes yes on some type of deposit confiscation, it would mean the people of Cyprus have elected to go “all in” on the euro and link their fate with the fate of the single currency.

When given a clear opportunity to leave the eurozone, Cypriots will probably decide to stay rather than rebuild their banking infrastructure from scratch.

With the latest maneuverings and after going full-circle with a range of alternatives, it appears that European bailout terms could be met by a 20-25% levy on deposits only in excess of the guaranteed 100,000 euros. Cypriot Finance Minister Michael Sarris said yesterday that a deposit levy was back on the table as a way to come up with the 5.8 billion euros needed by the new March 25th deadline for the larger rescue amount to be approved.

Writing for SkyNews, Ed Conway described the raid on bank deposits as “a step across the financial Rubicon.” Indeed, it has ramped up expectations as to what is now within the range of options for other EMU member states. Politely calling it a levy or deposit tax doesn’t alter the fact that it still amounts to brazen theft. Others have called it legalized bank robbery.

The Statist quote of the day goes to Naomi Fowler, Taxcast producer for Tax Justice Network, who said, “I think Cyprus is a cautionary tale to citizens that their government’s adventures in tax havenry will cost them dearly.” She advocates for global penalties against the provision of financial privacy which to this observer warps the very meaning of the word justice.

“Only put money in the banking system that you can afford to lose,” advises financial commentator Max Keiser. This is no more true than last weekend in Cyprus when bank depositors had electronic transfers blocked and were initially told to prepare for a confiscatory levy of up to 9.9% of their deposit balances across the board. The government then ordered banks to keep ATMs stocked since cash and credit cards were the only remaining methods of transacting. However, it is not clear how much longer the credit cards will be functioning in the country.

With banks in Cyprus now scheduled to re-open on March 26th after eight days of consecutive closure, this would make the Cypriot banking-system shutdown tied with the U.S. (March 6-13th, 1933) for longest number of shutdown days, following only first place Argentina (April 20-29th, 2002) at 10 days. Should the crisis extend beyond eight days and the European Central Bank pulls the liquidity it has been pumping into Cypriot banks, the ATMs may become cashless.

“The future of the euro zone has been put on the line for a few billion euros. Yet, the assumption of Cyprus not being a systemic risk rests on a single expectation: that it stays in the euro zone,” according to Stephen Fidler at The Wall Street Journal. “Should it exit, all bets are off.” However, other countries should be sufficiently discouraged from taking that route if they see live television images of a full-blown banking panic and an economic collapse within an EU member nation.

For now, the general attitude among the troika appears to be let’s experiment with Cyprus and if things go badly, it’s not such a long-term big deal because Cyprus is too small to matter. That could prove to be an optimistic fantasy.

With capital controls to prevent a mass exodus from Cyprus banks now fait accompli regardless of the bailout decision, Jeremy Warner at the Telegraph says that it is the end of the single currency in all but name:

Yet the point is that if capital controls are introduced, it basically makes Cypriot euros into a national currency, rather than part of wider monetary union. The capital controls will severely limit your ability to get your euros out of Cyprus, rending them essentially worthless in the wider eurozone. It would be a bit like telling Scots they can’t spend their UK pounds in England. Monetary union is many things, but above all it is about free movement of money and a uniform value wherever it is spent. When these functions are disabled, then you cease to be part of a single currency.

The era of free capital movement is behind us. Capital controls are about government keeping your money within easy reach should they ever want it. A decentralized and nonpolitical currency like Bitcoin starts to look attractive by providing a safer destination for wary depositors, allowing them to store their money securely in a digital account on their own computers, away from the big governments and politicians’ reach. It is possible to purchase bitcoins in Cyprus at LocalBitcoins.com.

“Money flows to where confidence exists” says Alan Safahi, CEO of ZipZap, Inc., a global cash network with over 700,000 locations in the world. “As bitcoin gains more acceptance, consumer confidence increases and more money will flow to bitcoins, causing a continuous rise in price due to limited supply which then increases consumer confidence even more,” adds Safahi.

As this trend continues, ZipZap, which processes more purchases of bitcoin than any other cash network stands to benefit tremendously from this trend. “The growth opportunity is not limited to Europe. We are seeing a significant increase in volume in the past few days from consumers in the U.S.,” says Safahi.

The emerging trend towards bitcoin as a flight to safety seems to be accelerating despite the recent regulatory guidance from FinCEN (Financial Crimes Enforcement Network). As part of the Treasury Department, FinCEN’s guidance on enforcement would extend traditional money laundering rules to most types of virtual currencies, including bitcoin. Although bitcoin proponents emphasize that a test case has not emerged yet.

“It’s almost a badge of respect when the Treasury starts regulating you,” said James Rickards, author of Currency Wars. “You must be doing something right.”

“Gold is a great way to preserve wealth, but it is hard to move around,” added Rickards. “You do need some kind of alternative and Bitcoin fits the bill. I’m not surprised to see that happening.”

Bitcoin Foundation Reacts To FinCEN Guidance

By Patrick Murck
Bitcoin Foundation
Tuesday, March 19, 2013

https://bitcoinfoundation.org/today-we-are-all-money-transmitters-no-really/

FinCEN shook us all from our Monday afternoon stupor by dropping some provocative “guidance” for those involved in the business and use of digital currencies and, in particular those of us involved with the grand experiment that is Bitcoin.

You can and should read what FinCEN had to say for yourself here.

Upon an initial reading two things struck me:

1. FinCEN firmly believes that virtual currency in general, and bitcoin in particular, does not fall under the prepaid access rules.
2. FinCEN seems intent on recreating and expanding the prepaid access rules for virtual currency and bitcoin under the mantle of money transmission.

I was happy to see FinCEN issue some clarity around the overly-broad prepaid access rules and definitively state that they do not apply in the context of bitcoin. This is quite interesting because in my conversations with seasoned payments and digital currency lawyers, prepaid access seemed to be the most likely trigger for FinCEN regulation – closely followed, of course, by money transmission.

That’s about where my happiness ended as the clear guidance quickly devolved into something a little less comprehensible.

In particular, I’m a little disheartened that FinCEN appears to be creating an entirely new regulatory scheme under the guise of “guidance.” Of course, FinCEN cannot rely on this guidance in any enforcement action, as they must readily acknowledge. Simply put, under the Administrative Procedures Act (APA), FinCEN can’t promulgate new rules without going through a notice and comment proceeding whereby the public may have their voices heard. If FinCEN would like to expand its statutory authority over “money transmitters” to include brand new categories such as “administrators” and “exchangers” of digital currency it must do so through proper rule making proceedings and not by fiat. I welcome that conversation.

State Money Transmitter Issues

It should also be noted at the outset, in case there is any confusion, that FinCEN’s rule-making and interpretations have no practical effect on State money transmitter laws (although FinCEN or Congress may preempt such State laws in the future). State MTB laws and enforcement is something that should be discussed, and to some degree worried about, but it’s a separate issue.

FinCEN Overreaches

Read closely FinCEN’s guidance implies that every person who has ever had any virtual currency and has ever exchanged that virtual currency for real currency may now be considered a money transmitter under the Bank Secrecy Act. That is, of course, an untenable position.

FinCEN starts going off the tracks early on, as they carefully define a “User” (not subject to MSB registration) as “a person that obtains virtual currency to purchase goods or services” as opposed to an “Exchanger” who is “a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.” Left unsaid are any specifics around the facts and circumstances that would constitute “engaging as a business.”

What is crystal-clear is that once a person sells a single Satoshi for real currency that person is no longer a “User” and therefore not categorically exempted from MSB registration.

Later in the document as FinCEN turns its attention to discussing decentralized virtual currencies we get the money paragraph.

In a bizarre shot across the bow at miners, FinCEN states unequivocally that “a person that creates units of convertible virtual currency and sells those units to another person for real currency or its equivalent is engaged in transmission to another location and is a money transmitter.”

And then, for good measure, FinCEN completely muddies the waters by stating: “In addition, a person is an exchanger and a money transmitter if the person accepts such decentralized convertible virtual currency from one person and transmits it to another person as part of the acceptance and transfer of currency, funds, or other value that substitutes for currency.”

FinCEN’s position as it relates to bitcoin can be summed up as follows:

1. A person may spend money to purchase bitcoin or mine bitcoin and then exchange the currency for goods and/or services without having to register with FinCEN as an MSB.
2. If a person receives real money in exchange for their bitcoin they MAY have to register with FinCEN.
3. If a miner exchanges their mined bitcoin for real money they MUST register with FinCEN.
4. Anyone transacting bitcoin on someone else’s behalf MUST register with FinCEN.

This framework would wildly expand the reach of FinCEN and the BSA, and would be infeasible for many, if not most, members of the bitcoin community to comply with. An individual or micro-business cannot be expected to create a robust AML/KYC program anytime they sell 1 or 100 bitcoin on an exchange or in-person. The BSA was never intended to apply this broadly and reach this far into people’s everyday lives. Perhaps a little more guidance is needed.

Patrick Murck is general counsel at the Bitcoin Foundation. Reprinted with permission.

For further reading:
"The War On Bitcoin—and Anonymity", Eli Dourado, March 20, 2013
"FinCEN sounds death knell for US based Bitcoin businesses", Irdial, March 19, 2013

Is Institutional Money Coming Into Bitcoin?

By Jon Matonis
Bitcoin Foundation
Tuesday, March 26, 2013

http://www.financialsense.com/contributors/jon-matonis/is-institutional-money-coming-into-bitcoin

This month saw two important developments on the road to a mature and robust bitcoin economy.

First, there was the joint CoinLab and Mt. Gox announcement involving Silicon Valley Bank that I wrote about here. While the North American accounts represent a huge amount of trading volume and a large percentage of Mt. Gox’s book, the more interesting aspect was CoinLab’s intention to provide investment channels for long-term bitcoin investors similar to the various gold and silver investment vehicles. Bitcoin is increasingly becoming a favorable asset class and structuring vehicles for institutional participation is a good thing, because it broadens bitcoin’s base and expands the network effect.

Also, on March 8th, the first bitcoin hedge fund formally launched, administered by Exante, Ltd. headquartered in Malta. With 80,000 BTC currently under management, their fund holds control to approximately .73% of all bitcoin in existence today. The fund has a sophisticated security strategy and the threat model addresses most of an institution’s concerns including data loss risk, hardware failure risk, jurisdictional risk, external hacker risk, dishonest employee risk, and employee death or disability risk. Using Shamir’s Secret Sharing algorithm, the container password is then split into three parts utilizing a 2-of-3 secret sharing model spread across multiple jurisdictions.

Individuals may ask why they need a professional fund with fees to manage what they can do on their own for free. And while this may be correct for knowledgeable and careful individuals, it is negligent for a company or an institution. Any institution investing on behalf of its customers has a fiduciary duty to protect those assets from theft, data loss, and jurisdictional risk. Additionally, a succession plan must be in place that anticipates reliance on multiple parties and the distribution of that reliance.

I would even say that it is negligent also for individuals not to have a shared secret and backup plan, because being a single-owner BTC holder is akin to burying gold bullion in the wilderness and not telling anyone. It may even be worse than that because someone from the future would at least have the random hope of finding the gold.

Professional funds for bitcoin investment can also provide an element of active management which would include the responsible use of leverage and risk control strategies that lock in gains through the use of proprietary derivatives and market timing. Also, the launch of a registered bitcoin ETF (Exchange-Traded Fund) in the United States is not that unrealistic.

These early stages of bitcoin in the ‘store of value’ role are precursors to a more advanced futures and options market. As more and more merchants decide to maintain and spend bitcoin balances rather than instantaneously converting out into national currencies, the derivatives and risk management tools will play a vital role. Just as commercial gold mining companies hedge their future production to protect against volatile price declines, bitcoin operators will be able to hedge bitcoins on their balance sheet without liquidating the underlying asset.

If bitcoin is digital gold, then gold is analog bitcoin. This is not just Wall Street titans getting involved and ruining Bitcoin as some have claimed. It is a necessary prerequisite for Bitcoin’s evolving role in global trade.

FinCEN Spying Plan Invites Privacy Workarounds

By Jon Matonis
American Banker
Thursday, March 21, 2013

http://www.americanbanker.com/bankthink/fincen-spying-plan-invites-privacy-workarounds-1057728-1.html

The dangers to financial privacy are monumental. Consider an Obama administration plan to give spy agencies unfettered access to data on American citizens and others who bank in the U.S.

Suspicious Activity Reports, filed by financial institutions that operate in the U.S., are the primary documents that the Financial Crimes Enforcement Network intends to share. The reports cover all personal cash transactions exceeding $10,000, suspected incidents of money laundering, loan fraud, computer hacking and counterfeiting.

The Treasury Department proposal, revealed by Reuters last week, aims to consolidate financial data banks, criminal records and military intelligence. This initiative will put intelligence agencies, such as the Central Intelligence Agency and the National Security Agency, on the same footing as the Federal Bureau of Investigation, which currently does not have to make case-by-case informational requests to Fincen.

Also under the new proposal, Fincen's database would be linked to the Joint Worldwide Intelligence Communications System, which U.S. defense and law enforcement agencies use to share classified information.

Money was never meant to be a method of supranational identity tracking. Its use in that way could signal some level of law enforcement desperation. When all other enforcement tactics fail, surveil the finances.

More than 25,000 financial firms, including banks, securities dealers, casinos, and money transfer agencies, routinely file "suspicious activity reports" to Fincen, according to the Reuters article. Banks and other firms tend to over-report some financial details of ordinary citizens since the requirements for filing are so strict they don't want to be accused of failing to disclose activity that later proves questionable.

Increasing encroachment against financial privacy like this Fincen move "raises concerns as to whether people could find their information in a file as a potential terrorist suspect without having the appropriate predicate for that and find themselves potentially falsely accused," Sharon Bradford Franklin, senior counsel for the Rule of Law Program at the Constitution Project, told Reuters.

One protection from becoming scooped up in a fishing expedition and being falsely accused is the use of virtual or alternative currencies. But this week, Fincen issued guidance on virtual currencies and regulatory responsibilities.

Clarifying circumstances where the "money transmitter" definition applies under the law, Fincen classified de-centralized virtual currency as a convertible virtual currency that has no central repository and no single administrator, and that persons may obtain by their own computing or manufacturing effort. Although bitcoin was not singled out by name, the guidance appears directed at cryptocurrencies that operate in a peer-to-peer, distributed fashion such as Bitcoin.

The primary impact of the likely tighter compliance will be felt by the bitcoin-to-fiat exchanges operating in the U.S. and this will lead to jurisdictional competition, as seen in online casino gambling where the more entrepreneurial jurisdictions rose to dominance by embracing the technology early and not overregulating.

Almost serendipitously, discussions about adding privacy extensions to the Bitcoin cryptographic money protocol have been increasing lately.

Bitcoin is nonpolitical money and it falls outside the scope of reporting financial institutions. Since bitcoin does not provide user and transactional privacy by default, multiple bitcoin wallets and Tor, a client software and volunteer server network that enables online anonymity, can enhance privacy without modification to the core Bitcoin code. Nonetheless, code-modifying proposals for augmenting Bitcoin privacy have been introduced. One idea calls for automatic mixing techniques, which would periodically give all users the opportunity to shuffle coins among one another, making the money harder to trace without implicating individuals. Another concept is "coin control," a method for users to select which of their wallet’s multiple addresses to use as the "from address" (currently picked somewhat randomly by the client software).

Various proposals for improving bitcoin privacy include "Patching The Bitcoin Client" (2011), "Automatic Coin Mixing" (2012), "Coin Control" (2012), and "Yet Another Coin Control Release" (2013).

Also, a recent cryptographic bitcoin privacy extension submitted by researchers from The Johns Hopkins University was accepted for presentation to the IEEE Symposium on Security & Privacy in Oakland, Calif. The paper Zerocoin: Anonymous Distributed E-Cash from Bitcoin will be introduced on day two of the May conference.

Having received a preliminary copy of the academic paper, I interviewed Hopkins research professor Matthew Green about some of the details of Zerocoin.

Operating as a decentralized layer of anonymous cash on top of the existing Bitcoin network, "Zerocoin creates an 'escrow pool' of bitcoins, which users can contribute to and then later redeem from," Green explained. Users receive different coins than they put in (though the same amount) and there is no entity that can trace your transactions or steal your money. "Unlike previous e-cash schemes, this whole process requires no trusted party. As long as all the nodes in the network support the Zerocoin protocol, the system works in a fully distributed fashion," added Green.

Zerocoin developers are working on improved efficiency because implementation is impractical today given the space constraints of the “blocks” that make up the Bitcoin public ledger. "For one thing, the transactions are very large (40kb to spend a coin)," Green said. "While this isn't the end of the world – and bandwidth is always increasing – supporting these would put quite a strain on the block chain."

When I asked Green about the possibility of a "back door" for law enforcement that had been floated recently, he clarified, "The back door isn't part of Zerocoin. There's absolutely no need for it, and building one in would take significant additional effort. In fact, we only mentioned it as a brief note in the conclusion of our paper, mostly to motivate future research work."

If someone did try to build a back door for any reason, the open source Zerocoin would quickly become Zero-adoption.

A Critique of Patrik Korda's 'Bitcoin Bubble 2.0'

By Peter Šurda
Economics of Bitcoin
Wednesday, March 6, 2013

http://www.economicsofbitcoin.com/2013/03/re-bitcoin-bubble-20-by-patrik-korda.html

Patrik Korda recently published a critique of Bitcoin: http://seekingalpha.com/instablog/7761841-patrik-korda/1616371-bitcoin-bubble-2-0. I get agitated when I disagree with others, so I wrote a rebuttal.

Competition under the network effect

Korda's first argument is that because it is easy to create a new cryptocurency, they will compete each other out of the market, kinda "race to the bottom", ending up with a hyperinflation and a collapse. However, he does not seem to understand the network effect, one of the most important aspects of money. The network effect both allows that money actually exists in the first place, as well as creates switching costs. As JP Koning said, "liquidity is sticky".

The problem with Korda's argument becomes more apparent because he himself shows a counterexample. He quotes Mises in explaining that silver has been replaced by gold and this demonetised silver. This explains how competition works under the presence of a strong network effect: the expected long term state is where a small number (maybe even one) media of exchange are the dominant ones, and other market players are far less liquid. For the same reason, a situation where there is a large number of competing cryptocurrencies without clear dominant players is not a stable state, rather a small number of dominant players will emerge.

The network effect is recognisable in particular with immaterial goods: there are a small dominant number of general purpose operating systems (Windows, iOS, Linux), a small dominant number of languages (Mandarin and English dominate, then Spanish and Hindi follow after a gap, and those four account for about half of the world population (I'm approximating, as people can speak more than one language)), there is only one dominant general purpose communication protocol (what we commonly call "the internet"), and so on. Surely, the composition of the dominant players can change, but it is a relatively slow process that does not magically happen overnight. Surely, there are a myriad of minor players, but there always tend to be a low number of dominant players.

If I said that everyone can create their own language, therefore without barriers to entry, everyone would end up with their own language and the ability to communicate would collapse, you'd surely think that I'm a moron.

Another important factor related to the network effect is path dependence. This means that the order in which choices are made influences the end result. This can mean, for example, the first mover advantage. Bitcoin is the first practically usable cryptocurrency, so it has a head start against others. And surely, JP Koning has a useful infographic showing that the market capitalisation of Bitcoin, the first mover, far outstrips the market capitalisation of others (by a factor of 100, at the time of making the graphic). This is also consistent with my claim from above that there typically is a small number of dominant players. Even though there is government interference in the choice of media of exchange (what we call fiat monies), international trade is affected significantly less than national, and we still have a small amount of major players (the USD and Euro).

I'm not arguing here that Bitcoin can't be replaced by something else, but that the scenario described by Korda makes no sense.

Usability

Korda makes the argument that Bitcoin is only usable with electricity and smart phone, but this is incorrect. Bitcoin is the first form-invariant medium of exchange, and can be used in almost any imaginable form, without having to rely on a middleman. Something like this never existed before in the history. People that criticise Bitcoin from this point of view tend to confuse implementation with the fundamentals.

Mises' Regression theorem

Korda, unfortunately, missed the core point of Graf's article. Even if there appears to be a wide disagreement on what the regression theorem actually says, we can be pretty sure about what it doesn't say. It doesn't say what happens to a medium of exchange after it becomes medium of exchange (and Robert Murphy concurs). It only talks about what happens before it becomes a medium of exchange. It does not say what happens between a medium of exchange becoming a medium of exchange and it becoming money, and it does not say what happens after it becomes money. It also does not talk about the scope of usage as a medium of exchange, how many people use it for something else than a medium of exchange, which media of exchange are sustainable, or any such invention that is frequently ascribed to it in particular by critics of Bitcoin. So unless Korda decides to mimick Smiling Dave and claim that Bitcoin is not a medium of exchange (and neither are gold, blue chip stocks or US bonds), the objection with respect to regression theorem is methodologically flawed.

Can Bitcoin become money?

Similarly as in the section about the regression theorem, Korda conflates medium of exchange (whatever is used in indirect exchange) and money (the most liquid good, and thus by implication, the most liquid medium of exchange). I consider the question of Bitcoin becoming money irrelevant for the near future. I have the same opinion as Vijay Boyapati, I think that if Bitcoin becomes money, that would be an unprecedented success. It would be the end of fiat money, and possibly also the state. But the implied criticism of Korda is a false dichotomy: either Bitcoin is money, or it's useless. I dub this fallacy money or nothing (and chicks for free). Contrary to this dichotomy, there is a wide range on the liquidity scale which is called "secondary media of exchange" (Mises) or "quasi monies" (Rothbard), that do provide, through liquidity, useful services. Bitcoin's further advantage is the decrease of transaction costs, which can be practically utilised as long as some level of liquidity persists. It already can be utilised now. There already are plenty of situations where the switch to Bitcoin improves utility. The criticism is like saying that unless everyone learns English, it makes no sense to learn it. Or even better, that it makes no sense to get an email address unless everyone uses email already.

Classification according to ToMC

As I wrote in my thesis, as Bitcoin is not money (yet), merely a medium of exchange, it is impossible to use the classification system of Mises to classify Bitcoin. If it becomes money, then we would have a classification problem. How to solve it I leave open in this post, as I consider it merely a theoretical question with no practical relevance. In my thesis I present options for solving it.

Now, Korda claims that Bitcoin is token money. However, going upwards from the bottom of the graphic in Mises' ToMC Appendix B, Bitcoins are not token money, because they are not fiduciary media, because they are not money substitutes. The Austrians use two definitions of money substitutes (I explain the difference between the two in my thesis):

• absolutely secure and immediately payable claims to money (in the narrower sense)
• things that act as full substitutes to money (in the narrower sense) from economic point of view

Irrespective of which of these definitions is correct, Bitcoins, clearly, are neither, as there is no underlying "money in the narrower sense". So the attempt of Korda to provide a classification of Bitcoin failed.

Anonymity

This is a complicated question, I just want to dissolve some unclarities. While some information about Bitcoin transactions is recorded in the blockchain, and publicly available, this information does not include any references to the identity of the parties involved in the transaction. While a vector analysis can reveal some relationships hidden upon first look, there are on the other hand many other things that can be done to obfuscate this. Examples are mixers (either explicit ones or ones that can do that function indirectly, e.g. Satoshi Dice), and some features that have not been fully implemented yet, e.g. transaction rewriting, or proposals for new opcodes.

From economic point of view, the "perfectness" of Bitcoin's anonymity is not the relevant question. The relevant question is whether this is significantly (from the point of view of users) better than the alternatives, and if it presents a significant cost increase for the attacker (e.g. the state). I'll leave this one open too, I'll just add that for transactions that do not involve a physical meeting of the trading parties, anything else than cryptocurrencies is highly unlikely to provide a comparative advantage over Bitcoin from the perspective of anonymity.

Bubble

Korda seems to think that the question of the Bitcoin price being a bubble is important. I on the other hand consider it completely irrelevant. The relevant question is if Bitcoin decreases transaction costs, and the answer is that it does. Whether the price changes are a bubble or not does not change the answer to the question whether it has a comparative advantage against other media of exchange. The price is irrelevant (thanks for the slogan, Tony). Emphasising the bubble is kind of like saying that when the dot com bubble burst, this must mean that the internet is unsustainable and must collapse.

Almost all critiques of Bitcoin entirely ignore transaction costs. It's like arguing that there's no point in internet if we already have the library, the post office and the TV. According to the logic of these critiques, the businesses will decide to forego a highly profitable opportunity of providing services that increase the efficiency of social interaction and their potential customers are going to forego a reduction of costs of these interactions. Instead, the arbitrary judgement of these critics concludes that the target market is somewhere entirely elsewhere (in barter in a village, for example), and at the same time that arbitrary target market is not a good match for Bitcoin. It baffles me all the time. But I hear it all the time too. People have fixed ideas about what they think money should do, and when Bitcoin doesn't fit into that scope, they don't understand it. It is difficult to recognise a paradigm shift while it's happening, but it is always obvious after it already has taken place. I guess some people just have to endure having their brains in an ignorant state while the market structure changes around them and those with more foresight are able to increase the efficiency of their business operations (and increase their profit).

My recommendation for serious economic analysis of Bitcoin is to ignore the price as much as possible, as long as there is one (i.e. the price is higher than zero). It's simply not relevant.

Conclusion

Regrettably, Korda's criticism contains many flaws. Hopefully I manged to address them. My most important argument is that one should be careful to avoid mixing theoretical and empirical issues. To summarise my counterarguments:

• Due to network effect, the market structure will move towards a small number of dominant cryptocurrencies, so there's no hyperinflation
• Whether Bitcoin can become money is not important, as using it is already advantageous now, as a medium of exchange. If it ever becomes money, that would really rock though.
• Non-economists do not understand the regression theorem and invent their own versions of it which are nonsensical
• Bitcoin is not token money as it never was a money substitute
• Bitcoin is pseudonymous, and has a comparative advantage against competitors from this point of view
• The price of Bitcoin is irrelevant

Reprinted with permission.

Read part 2 of the critique: "The classification and the future of Bitcoin"
Read part 3 of the critique: "Is Bitcoin a money substitute?"
Read part 4 of the critique: "Response to Korda's Mises.org article"

How Cryptocurrencies Could Upend Banks' Monetary Role

By Jon Matonis
American Banker
Friday, March 15, 2013

http://www.americanbanker.com/bankthink/how-cryptocurrencies-could-upend-banks-monetary-role-1057597-1.html

Peter Šurda

I recently had a fascinating chat with the economist Peter Šurda to discuss how nonpolitical cryptocurrencies like bitcoin could alter the future of fractional reserve banking.

Peter is also a software developer experienced in the online payments industry and will present at the Bitcoin 2013: The Future of Payments conference in San Jose in May. His 2012 master's thesis at Vienna University of Economics and Business was entitled Economics of Bitcoin: Is Bitcoin an Alternative to Fiat Currencies and Gold? He's an abstract thinker, but the implications of his work are tantalizing: that digital money like Bitcoin opens up possibilities for banking without central planners or a lender of last resort, where interest rates and reserve requirements are driven purely by the market.

The debate between the full reserve bankers and the fractional reserve bankers is an old one and it has been explored in depth by the Austrian school of economics. More recently, the debate has been broadened to include the dynamics of introducing the bitcoin cryptocurrency, which is the functional equivalent of digital gold, since its supply is predictable and fixed. (There are currently 10.9 million bitcoins in circulation with a total fixed supply of 21 million expected to be mined before 2140, 99% of them by the year 2032.) The Austrian school economist Michael Suede and the technologist Eli Gothill have speculated that fractional reserve banking can indeed appear within a bitcoin monetary environment. This is where we join up with Peter.

JON MATONIS: I enjoyed your blog post, "Market Forces and Fractional Reserve Banking." Do you consider fractional reserve banking to be compatible with Austrian economics?

PETER ŠURDA: First of all, I would like to separate fractional reserve banking and credit expansion. On one hand, there are ways of increasing the money supply, in the broader sense, which do not require fractional reserve banking or changes in the monetary base such as a system based on the principle of mutual credit like LETS [local exchange trading systems], or a fiat currency that uses bitcoin as reserves (i.e. they are not claims in the sense that Ludwig von Mises uses them, but they act as full substitutes). From the opposite direction, fractional reserve banking does not necessarily lead to credit expansion.

I agree with the full reservists that credit expansion has the effects described by the Austrian Business Cycle Theory. However, I agree with the free bankers that fractional reserve banking is not necessarily a violation of property rights and other ways of increasing the money supply also are not necessarily a violation of property rights.

So I think that the economic and legal analysis are two separate issues and need to be addressed separately. I avoided the legal analysis in my thesis and concentrated on Austrian Business Cycle Theory and policy issues, but in an earlier draft I have several pages about legal aspects too, and I discussed the topic with [the legal theorist] Stephan Kinsella.

JON MATONIS: How does a nonpolitical cryptocurrency like bitcoin alter the landscape in the "full reserve" versus "fractional reserve" banking debate?

PETER ŠURDA: Austrians have made arguments in the past that lead to the conclusion that fractional reserve banking does not necessarily lead to credit expansion, even though they never explicitly formulated it this way and might not have realized the connection. The reason is that if credit instruments do not decrease transaction costs over the monetary base, they are unlikely to act as a part of the money supply. Bitcoin shows that this is not only a hypothetical but empirically possible to implement. With Bitcoin, it is much less likely that credit expansion will occur.

In other words, we need to separate two things. Why do people want to hold fractional reserve banking instruments, which may include the interest payments as one of the reasons, and why do people want to use fractional reserve banking instruments as a medium of exchange which, I argue, requires that the fractional reserve banking instruments decrease transaction costs. That they historically manifested themselves through a common instrument is an empirical quirk and not an economic rule. The ability to loan money is beneficial. Contrary to many Austrians, I agree that maturity transformation can be beneficial, and if the loan ends up being a liquid instrument, it also can be beneficial. But if it is so liquid that it becomes a part of the money supply, that's when it has a detrimental effect on the economy.

For full reservists, Bitcoin shows that the question of fractional reserve banking is less important than they thought. Fractional reservists, on the other hand, need to think about the nature of the mechanisms equilibrating the money supply. I tried to explain the issue to [the economists] George Selgin and David Glasner in comments on their websites, but I wasn't successful in getting my point through.

JON MATONIS: If bitcoin is digital gold, does that portend a future where a bitcoin standard (akin to the gold standard) can emerge or partial bitcoin backing for other currencies?

PETER ŠURDA: They probably can emerge, but the more important question is whether they would be preferred to bitcoin. Only something that provides a significant improvement would be preferred. I only know two potential candidates for that: Ripple and OpenTransactions.

JON MATONIS: In a bitcoin world, is fractional reserve banking only possible with offline substitutes (such as physical coins or cards, which can be traded hand-to-hand, containing the private key to a bitcoin address) or an intentional "fork" in the block chain ledger?

PETER ŠURDA: Hypothetically, the reserves can be offline and the substitute can be a clearing system like Ripple, so there are other possibilities too. But if I understand your point correctly, offline "substitutes" might have a higher chance of actually becoming full substitutes because they might have more obvious advantages.

JON MATONIS: As the recent block chain fork episode demonstrates, there is a need for offline bitcoin transactions to continue. Is this demand sufficient for a money substitute to evolve, such as offline substitutes with full or partial bitcoin backing?

PETER ŠURDA: This is primarily an empirical question, so we can't be completely sure about that. I think the probability for this is significantly lower than with the currencies that we've known historically. The end result is also path-dependent; for instance, it depends on how quickly bitcoin matures and/or adapts to changes compared to the potential substitute.

Fractional reserve banking does not come into existence magically. It must follow economic rules. With gold and similar commodities, fractional reserve banking comes into existence for these reasons: On the demand side, there is a demand for money substitutes, because they provide something that money proper does not; and on the supply side, money substitutes carry maintenance costs for the issuer (e.g. storage of gold) and these need to be offset somehow. The issuer can charge on holding (e.g. demurrage of bank notes), transacting (e.g. check clearing), or, obviously, externalize the costs through fractional reserves. From the point of view of an individual user, fractional reserve banking appears to be the least costly alternative. So obviously fractional reserve banking wins.

Putting it together: If there is a general demand for money substitutes, this leads to fractional reserve banking. Unless it's illegal. Then it might not. Solution: Have money which does not lead to the creation of money substitutes. Bitcoin shows that at least hypothetically, this is possible. I might even go a bit further and make this statement: If on a free market money substitutes do not develop even though there is no legal or technical obstacle for them, it means that the choice of money is Pareto-optimal since no change in the monetary system leads to an increase in utility.

JON MATONIS: Does a demand for positive return on bitcoin balances lead to an environment of competitive bank lending with risk-adjusted interest rates? And will this lead to an environment of fractional reserve banking with depositors offered higher interest rates in exchange for the additional risk premium of running a fractional portfolio?

PETER ŠURDA: Yes, I would say it does, but until there are industry niches that primarily use bitcoin, it is probably not much different from gambling.

This might lead to negotiable credit instruments with maturity-mismatching or maturity transformation, depending on which economic school you use for terminology. However, I don't think this feature alone is sufficient for these instruments to be accepted as full substitutes whereas George Selgin appears to think it is. Now, whether to call such a situation "fractional reserve banking" even though no credit expansion occurs is unclear. I lean towards yes, but there could be other interpretations.

JON MATONIS: How do you see bitcoin changing interest rate structures and lending practices?

PETER ŠURDA: Using Bitcoin for loans only makes sense for those businesses that use bitcoin as a unit of account, unless, of course, you're just speculating on the market but don't actually sell any goods or services. I think this will only occur at much higher levels of liquidity or until we can be quite sure that it deserves the label "money." Until these higher levels of liquidity are reached, the price of bitcoin will probably be quite volatile, which reduces the likelihood that people use it as a unit of account.

However, there could be niche market segments that use bitcoin as a primary medium of exchange and [bitcoin] mining is the most obvious candidate. For these, the unit of account function would make sense even if the global market penetration is lower.

Assuming one of these thresholds is crossed and the money supply remains inelastic (i.e. no significant credit expansion), the interest rate of bitcoin should be a good reflection of the time preference of those market participants that use it as a unit of account. Bitcoin also makes it much easier for lending to occur in a decentralized manner, I think. Rather than a small number of "too big to fail" institutions, we should see smaller specialized teams that act as facilitators without owning the liabilities or being liable themselves.

JON MATONIS: Can a free market fractional reserve system (as opposed to a central banking fractional reserve system) coexist with full reserve banking? Or will one drive out the other?

PETER ŠURDA: I think that if money substitutes emerge, fractional reserve banking will out-compete 100% reserve banking in the market. I deal with this a bit in an earlier draft of the thesis. If they don't emerge, on the other hand, we'll have a money supply equivalent to the monetary base and debt will not cause changes in the money supply. It would be viewed as merely highly liquid credit. I don't think they can coexist for a long time assuming the same underlying money in the narrower sense, of course.