My former colleague Howard Wall asked me to join Lawrence White yesterday evening to discuss the role and future of cryptocurrencies at an event hosted by the Hammond Institute for Free Enterprise. It was a great honor to share the stage with Larry.
I've been thinking about cryptocurrencies for a long time; many of my writings and talks on the subject can be found here. My thoughts on the subject are evolving as I learn more about the phenomenon. For what it's worth, I thought I'd share my opening remarks with interested readers below. As usual, any feedback is welcome.
The Role and Future of Cryptocurrencies
A money and
payments system is about managing databases containing the money accounts of
individuals and organizations. Any database management system must necessarily
define read and write protocols. Read privileges specify who can view what on
the database. Write privileges specify who gets to write what to the database.
example, we can read what’s in our bank account. So can the bank and its
regulators. But other people cannot see how much money is held in any account
apart from their own. While we cannot write directly to our account, we can
send our bank instructions to so on our behalf. The bank can also write directly
to our account. It may, for example, credit our account with interest, or debit
it for service fees.
Note that bank
accounts are digital. Moreover, the messages we send to our bank over the
Internet are secured with the aid of cryptography. In this sense, one could say
that bank deposits are a form of cryptocurrency.
deposits, however, are not typically viewed as cryptocurrencies. Well then, what
are the distinguishing characteristics of a cryptocurrency? It’s not so
clear-cut, but two things come to my mind. First, the database for a
cryptocurrency is typically associated with an open-read privilege. This
implies that the database can, in principle, at least, be subject to audits
from any person, or any agency, at any time, all the time. This property offers a degree of financial
transparency that is unheard of in conventional money services businesses. Second,
the task of managing the database is typically decentralized in some manner to
“validator nodes;” or, what one might label more mundanely as “accountants” in
the non-crypto world. What is interesting here is how these validators are
potentially recruited and compensated. For Bitcoin, anyone can potentially
become a validator and compensation arrives in the form of a stochastic reward.
comes to keeping track of money balances, an open-write privilege is problematic.
This is known as the double-spend problem. In conventional payment systems, the
double-spend problem is solved by delegating database management to a trusted
third party. A cryptocurrency like Bitcoin or Ethereum must instead rely on a
consensus mechanism that somehow ensures that a dispersed write-privilege does
not result in garbage being written to the database. To date, the most popular
mechanisms are based on PoW (Proof of Work) and PoS (Proof of Stake). But there
are others as well, and one should expect innovation along this dimension
since, as far as I know, no existing consensus mechanism has yet proven to be entirely
the same can be said of conventional database management systems. To young
eyes, the current system seems a hopelessly tangled mess of databases that have
trouble communicating with each other. Moreover, they appear not to be very
secure at times. But despite the problems we all encounter with the modern
banking system, one should, in fairness, acknowledge the tremendous
achievements that have taken place over the last fifty years. For example, we
are now able to travel to foreign countries with just a credit card. This is
not the way things worked until relatively recently. Anyone who has had the
experience of needing traveler’s checks can fill you in on what it was like to
travel in the old days.
there’s been so much progress in money and payments, what accounts for the emergence
and proliferation of cryptocurrencies?
As is so
often the case, I think the fundamental cause of this development is rapid
technological change moving against a relatively slow-moving incumbency that
includes banks, money services businesses, and especially their regulators. In
saying this, I do not mean to assign blame; the inertial properties of existing
institutional arrangements likely has some merit. Institutional inertia can stabilizing,
for example. But to benefit the communities they serve, institutions also have to evolve to meet the
challenges of new technologies. And I think this is happening today in the
sphere of money and payments.
technologies are we talking about? Innovations in communications, like the
Internet, have been transformational. As well, there have been advances in data
storage and cryptography that have played a critical role. All these
innovations are, however, within the grasp of incumbent banks and money service
businesses. And indeed, incumbents have made use of these technologies. Internet
banking and PayPal are real things, after all. I think the important innovation as
far as cryptocurrencies are concerned isthe development of database
management protocols that permits a degree of decentralization for managing large
databases. I say “large” databases because we already have decentralized
database management systems for small communities, like gift exchange or the
exchange of favors among friends (see: Why the Blockchain Should be Familiar to You). Advances in data storage and communications
have, in effect, permitted this ancient form of communal record-keeping to
decentralized or communal aspect of managing a database is, of course, very
much at odds with the notion of delegating the responsibility to a privileged
set of institutions. Some people believe that these developments will lead to a
revolution—an overthrow of existing institutions—a triumph in democracy over a
privileged class. What is much more likely is an evolution of existing
institutions to accommodate the threat posed by the potential usurpers in a
manner that serves the broader community. In short, what we are likely to
witness is the usual pattern of economic development in relatively well-functioning
cryptocurrencies offer individuals and society? What are the concerns of
regulators and policymakers?
these questions, we need to recognize that there are different classes of
cryptocurrencies, each of which cater to a specific constituency. Broadly, they
can be categorized as belonging to one of two groups distinguished by their
respective exchange rate regimes and governance structures.
group, we have the decentralized autonomous organizations, like Bitcoin. From
the perspective of domestic policymakers, Bitcoin can be viewed as foreign
currency operating under a floating exchange rate regime. Except that there’s
no negotiating with Bitcoin (there's no negotiating with some countries either). The intermediaries that deal or broker BTC
transactions can, however, be regulated.
In the other
group, we have the so-called stablecoins, like USD Coin (sponsored by Circle
and Coinbase) and Diem (sponsored by Facebook). To domestic policymakers,
stablecoins can be viewed as checkable mutual funds operating under a unilateral
fixed exchange rate regime utilizing various forms of collateral. The major
innovation here has less to do with technological innovation and more to do
with the willingness and ability to process USD payments outside the commercial
this light, cryptocurrencies do not look so unfamiliar. As a foreign
currency operating under a floating exchange rate, they’ll likely never displace the domestic unit of account. They may,
however, serve as store-of-value or portfolio hedge. And they may facilitate
certain kinds of payments, typically on-chain and large-value. As a stablecoin
offering a par exchange rate, they suffer from all the usual problems of
uninsured fractional reserve banking—unless they promise to back their
currencies fully with USD cash.
here is whether these products are offering something fundamentally more
cost-effective when it comes to making payments, or whether they owe their
existence primarily to regulatory arbitrage. I do not know the answer to this
question, but I suspect that much of what they have to offer comes from the
latter. Diem, for example, can bypass banking regulations by not becoming a
bank. It can leverage Facebook’s huge social network as a payment system
connecting 2B+ users around the world. It can potentially offer
money-transmitting services for “free” or, rather, in exchange for personal
data. My guess is that banks (or even PayPal) are not permitted operate in this manner. Regulatory advantage: Diem.
need to keep a close eye on these structures since it is politically impossible
to commit to the doctrine of caveat emptor when it comes to money and banking.
The temptation, as always, will be to replace “cash” for higher-yielding “cash
equivalents” on the balance sheet. The structure slowly evolves into an
uninsured fractional reserve bank, but in the shadow bank sector. If something
goes wrong, depositors will seek compensation, first from the firm and then from the government. After all, how could a
government knowingly permit such an unstable structure to exist in the first
To sum up, I
think the future of cryptocurrencies like Bitcoin is to serve as an alternative
asset class for investors. I doubt that it will ever become a dominant medium
of exchange in any large economy. Fractional reserve banks using BTC as
reserves are not likely to be tolerated.
of stablecoins seems more interesting to me. In the first instance, they seem
capable of filling the gaps that remain apparent in modern day payment systems
(think correspondent banking here). But the main effect here is likely to spur
conventional banks and their regulators to fill these gaps at a faster pace. There
is a possibility that a project like Diem might one day abandon its peg to the
USD and offer itself as a stand-alone currency. Policymakers would in that case
be concerned about a country maintaining monetary policy sovereignty. One manifestation
of this concern could be a pre-emptive action on the part of the government,
for example, by offering its own universally-accessible CBDC.