30 July 2014

Bitcoin - What Makes a Currency?

Today I'm diverging from the education theme to write about cryptocurrency. I am provoked, in part, by this quote from Alan Greenspan:

“It [Bitcoin] has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it. Maybe somebody else can.”

Now, Greenspan should know better than to say something like that. As a fiat currency, the dollar doesn't have any more intrinsic value than Bitcoin. And that's why I decided to write about this. Most of the supposed "Bitcoin Primers" out there are more confusing than helpful. They don't explain how money works or how cryptocurrencies like Bitcoin satisfy the requirements to become a currency.

What makes a Currency?

Currency is a form of money that accepted by a group of people to exchange value. A functional currency must have three important characteristics:
  • Scarcity - If you have too much of the currency, it's value will plummet toward zero. So, there must be a limited supply.
  • Verifiability - You must be able to verify that a unit or token of the currency is valid and not a forgery or imitation.
  • Availability - Despite scarcity, there still must be a stable supply of the currency to match growth in the corresponding economy.
Precious metals like gold and silver were the first common currencies. They meet all of the foregoing criteria. Gold is scarce; there's a limited amount of it available thereby endowing a small amount of gold with considerable value. It's verifiable; gold has certain characteristics, such as density, malleability and color, that make it easy to distinguish from other materials. And gold is available; while it is not common, gold mines still offer a consistent supply of the material.

One of the difficulties with early uses of gold currency was the complexity of exchange. Merchants had to use a balance or scale to determine how much gold was being offered. To facilitate easier exchange, governments, banks, and other trusted organizations would mint coins of consistent size and weight. This would allow someone to verify the value of a coin without resorting to a balance.

Fiat Currency

"Fiat" means, roughly, "because I said so." Fiat currency has value simply because some trusted entity says it does. It need not have any intrinsic value.

The first fiat money was the banknote. When making a large payment it could be inconvenient or dangerous to move large quantities of coins or bullion. Banks solved this problem for their customers by issuing banknotes. A banknote is a paper that a bank or other entity promises to exchange for a certain amount of coin, gold, or other currency. The bank could keep the corresponding gold locked away in a vault and people could carry more convenient paper certificates.

Beginning in 1863, the United States began issuing gold certificates as a form of paper money or banknote. Certificates like these were backed by stockpiles of gold held in places like Fort Knox. European countries did similar things. With the stresses of late 19th century wars and World War I that followed, countries discovered that they could issue more banknotes than their corresponding stockpiles. This led to a lot of instability until countries figured out how to regulate their currencies. But, by the end of the Great Depression, pretty much every economically developed country had fiat currencies controlled by a central bank. While backed by gold or other reserves, the value of these currencies is not directly tied to the value of gold.

Here's how the U.S Federal Reserve system works: The Federal Reserve Bank creates the money. Money is issued as currency (the familiar U.S. coins and bills) but also simply as bank balances. Indeed, far more money exists as bank records than in actual physical currency. Originally this was done through careful bookkeeping in bank ledgers. Now it's all done on computers. The money is issued in the form of low-interest loans, primarily to banks, which then lend the money to their customers and to other, smaller banks. Other central banking systems like the European Central Bank work in a similar way.

So, how does fiat money meet our requirements for currency?


Scarcity: Only one entity, the central bank, has the authority to create and issue the currency. The central bank limits the issue of money in order to preserve its value.

Verifiability: Coins and paper money are printed or minted using materials and techniques that are difficult for average people to reproduce but are fairly easy for to verify. Money in the form of bank balances is verifiable because each bank or credit union has accounts with higher-level banks ultimately reaching the Federal Reserve. So, when I write a check from my bank to yours, our two banks contact each other and transfer the value sending records up the banking chain until they reach a common parent bank which may be the Fed. Each bank in the chain verifies that the appropriate balances are in place before allowing the transaction to proceed.

Availability: Central banks can create as much money as they think the economy needs. The primary challenge for central banks is manage the money supply - ensuring both scarcity and availability.

Cryptocurrency

Bitcoin is the first, but by no means the only cryptocurrency. The challenge that the pseudonymous creators of Bitcoin tackled was to achieve the three features of currency - scarcity, verifiability, and availability - in the digital realm. They magnified the challenge by prohibiting a central authority like a government or a central bank. Trust, in the case of Bitcoin, is in the system, not in any particular institution.

Scarcity: The "coin" part of most cryptocurrency names is somewhat misleading. Bitcoin doesn't consist of a bunch of digital tokens that are exchanged. If that were the case it would be hard to prevent double-spending of the same token. Instead, cryptocurrencies work more like bank account balances. Bitcoin has is one, big, public ledger that is duplicated thousands of times. All transactions in the ledger must balance - for one account to receive value, another account must be reduced by the same amount. This ledger is called the block chain and it contains a record of every transaction since the creation of the currency.

Verifiability: Cryptocurrences rely on public-key cryptography to ensure that only the owner of a currency balance can initiate its transfer. The bitcoin owner uses their private key to sign the transfer record and then posts it to the network of block chain replicas. Any entity in the network can use that owner's public key to verify that the transaction is valid and that ownership has been transferred.

Availability: Those who host a copy of the block chain have to perform the cryptographic calculations necessary to verify transaction validity and prevent fraud. Those who do this fastest are periodically rewarded through the creation of new Bitcoin balances. Because of the reward, maintaining the block chain is known as "mining" and a small industry of Bitcoin mining software and devices has developed. All users of cryptocurrency benefit from this because the more miners exist, the more secure the currency becomes due to the duplication of records and validation.

This is a tremendously clever scheme because it simultaneously ensures a consistent supply of currency, decentralizes operation, and secures the network against manipulation by creating thousands of replicas of the block chain.

Potential Impact

The true value of any currency is the willingness of a community of people to use it for daily transactions. The three requirements, Scarcity, Verifiability, and Availability combine to cause people to trust a particular currency. When that trust is lost you can get bank runs, hyperinflation, or simple destruction of wealth. Meanwhile, the community rushes to find a new currency.

The advent of the internet with myriad handheld devices capable of initiating transactions makes it possible for multiple currencies to coexist. For the first time in history, people may have a choice among currencies to use in daily transactions. Central bankers, and the sovereign countries that endow them with their power, are appropriately worried. An industry that has historically been immune to competition no longer has that protection.

I think this is a good thing. Just like any other competitive market, competition should incentivize good behavior both from established central banks and from upstart cryptocurrencies.

1 comment :

Mark J. Guillen said...

This is all about digital money, the author has explained different kind of currencies very efficiently.
Bitcoin

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