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Buying into Bitcoin

LONDON – The Internet currency Bitcoin is surrounded by uncertainty. Is it a speculative bubble? Is it really as anonymous as its proponents claim? Can one actually use it to purchase the legendary White Widow strain of marijuana, or to hire a hit man?

These are certainly interesting questions, but they are diverting attention from far more important discussions about Bitcoin’s potential to drive financial-sector innovation.

Bitcoin is so innovative, in fact, that beyond breaking the conventions of currency, it has even transcended partisan ideologies. Indeed, the Nobel laureate economist Paul Krugman and US Tea Party icon Ron Paul are diametrically opposed on virtually every issue but Bitcoin (both deeply dislike it).

And yet Bitcoin’s opponents should be asking how the groundbreaking ideas that underlie it could be applied to reforming the global financial system. Although the 2008 financial crisis exposed profound institutional shortcomings, the response – including heightened regulatory safeguards like the 2010 Dodd-Frank Act in the United States and the Basel III banking standards – has failed to bring about the needed transformation. Likewise, protest movements like Occupy Wall Street, aimed at raising awareness of – and ultimately reforming – the culture of finance, have delivered mixed results.

But the fact is that no one – except perhaps the small coterie of financial insiders who have benefited enormously from taxpayer-financed bailouts – should be satisfied with the current system, not least because another crisis, most likely accompanied by more bank bailouts, can reasonably be expected in the not-so-distant future.

While the exact timing of the next meltdown cannot be known, one thing is certain: consideration of what kind of financial system would best serve the world in the twenty-first century would be incomplete without Bitcoin. After all, the technology behind it could not only help to reduce systemic risk by creating safeguards shielding the payments system from useful but unpredictable financial activities; it could also play an important role in bolstering much-needed economic growth.

Financial institutions essentially act as matchmakers, linking investors, borrowers, and savers, and recording what people own and owe. In exchange for these services, financial professionals are compensated very generously. So, to ask whether bankers’ massive paychecks are fair is really to ask how much value is created by financial matchmaking – a question to which there is no simple answer. What is clear is that, by allowing a greater proportion of an economy’s wealth to be channeled toward investment and other productive economic activities, a more efficient financial-services industry boosts economic growth.

In other words, the financial-services industry can be viewed as a kind of tax on the rest of the economy. And, given the high costs of financial systems that are antiquated, costly, and inefficient – in London, for example, paper checks must physically be sent from one bank to another, meaning that it takes 5-6 days for the funds to be transferred – the smaller the financial system, the better off everyone else will be.

The inefficiency of the world’s financial system is not simply a result of obsolete rules and structures; profit-seeking is also a major factor. While British authorities recently announced that the transfer of physical checks would be abolished, a two-day check-clearing delay will remain. Given that scanned images of checks could easily be processed electronically almost instantaneously, the enduring delay can be explained only by “float” – that is, the interest earned by holding onto money for as long as possible.

Float is just one of the many ways the financial-services industry extracts resources from the economy. The 3-5% charge levied by credit-card companies works out to several hundred billion dollars in annual profits for companies like Visa and MasterCard. Fees for wire transfers and for exchanging currency can quickly climb to 10% or more per transaction, with interruptions and complex procedures making such services even more costly.

But there is reason for hope. With the innovations pioneered by Bitcoin, the fees, delays, and other inefficiencies that serve to line the pockets of those in the financial-services industry can largely be eliminated.

Ahead of US Senate hearings last November, former Federal Reserve Chairman Ben Bernanke wrote a letter to senators saying that Bitcoin may “hold long-term promise, particularly if the innovations promote a faster, more secure, and more efficient payment system.” As if on cue, the US retail giant Target was hacked – another episode in a long string of major financial-data heists.

Bitcoin, with its capacity for anonymity, could certainly help to make the global financial system more secure, saving consumers and businesses significant inconvenience and expense. At the same time, it offers an alternative store of value, and its use as a medium of exchange is steadily growing.

But perhaps the most exciting innovation offered by Bitcoin is the “blockchain” – peer-to-peer software that keeps a record of all transactions and a tally of who owns what. The blockchain essentially serves the “ledger” function that banks do today, but at a fraction of the cost to consumers and businesses.

Powered by an open-source algorithm and maintained by anyone who chooses to download the free software, Bitcoin marks a return to a community-based approach to money and banking, with financial services more closely connected to the people who use them. Large, monolithic third-party managers like today’s “too big to fail” banks would be cut out. Indeed, with software like the blockchain powering a new financial architecture, “the people” would effectively become the bank.

Bitcoin and its ecosystem are still maturing, and only time will tell if current price levels reflect a speculative bubble. But the innovations pioneered by Bitcoin can – and therefore should – play a transformative role in building a safer, less expensive, and more effective financial system.