Tuesday, November 25, 2014

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.

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    1. CommentedChristopher Meyer

      Will it be the Napster of money – an approach that perishes in the process of destabilizing the status quo, but leads to massive changes over time?

    2. CommentedWalt French

      Actual extension of credit requires trust, so Bitcoin doesn't actually touch it… only transactions that can be definitively identified. The real function of banks, savings & loans, are not touched by Bitcoin. Nor can I see how they would be.

      I'll have to research why Paul is opposed to 'em, but I take it that Krugman's objection is to taking away the role of the central banks, that of availability of money. I'd sure love a proponent of new money to tell us why it wouldn't be like the 19th century panics and runs, or, for that matter, like the huge bubble of money created by the shadow banks in the last decade, a bubble that the world is still trying to recover from.

    3. CommentedFabio Souza

      Bitcoin may show some good qualities to financial industry, but it's value is anly virtually. Well, it exchanges are real, but its creation is especulative.

    4. CommentedMK Anon

      "o, to ask whether bankers’ massive paychecks are fair is really to ask how much value is created by financial matchmaking"
      ... and risk taking.
      I won't lent anonymously my bitcoins to anyone anywhere. Banks cannot be replaced like that..

      A currency is a policy tool. in times of depression, quantitative easing by central bank help the recovery. In the long run, quantity of money should more or less grow with economic growth rate (otherwise, you are in a endless deflation, i.e. what everyone wants to avoid..)

    5. CommentedKir Komrik

      Thank you for this very appropriate and timely article,

      The so-called bitcoin is, imo, a dangerous construct because it fails exactly where most people fail in their understanding of the most basic fundamentals of economics. Currency is not wealth. Yes, bitcoin will tend to create bubbles because it does not adequately associate new currency production with new wealth production. This is key to a solid currency.

      And, of course, the Rule of Law is required to back the currency so that all who use the currency know that this currency to wealth association was done without fraud. This is why the best we can do so far is the Federal Reserve. To replace it, we need a way to associate new currency and wealth in a way that is verifiable and for which the public is confident is not fraudulent.

      - kk