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.
So, for 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.
Bank 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.
When it 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 satisfactory.
Of course, 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.
Well, if 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.
What new 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 scale.
The 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 societies.
What do cryptocurrencies offer individuals and society? What are the concerns of regulators and policymakers?
To answer 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.
In one 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 banking sector.
Viewed in 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.
The question 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.
Regulators 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 place?
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.
The future 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.