In honour of St. Patrick’s Day, I want to look at crypto-currencies through the eyes of a Leprechaun. While crypto-currencies have been described as ‘digital gold,’ would a Leprechaun be likely to put them in his pot at the end of the rainbow? What are crypto-currencies, what gives them value, and what does the current fascination with them suggest about the state of our existing financial system?
Crypto-currencies such as Bitcoin were developed to combine the advantages of cash transactions and the advantages of electronic payments. What is so great about cash? Well, when I purchase something with cash, the transaction is immediate. I get the item I want, and the vendor gets my money right then and there. Also, unlike with a cheque or an electronic payment which needs to be cleared by my bank, I don’t need to identify myself in any way so the transaction is entirely anonymous.
However, cash has limitations as well. Most crucially, it can’t be used if you are unable to physically hand it over. Every online sale and travel booking and the great majority of purchase orders therefore rely upon cheque or credit payments cleared by banks. Even on a daily basis, the greater convenience of using debit or credit cards means that most of us only use cash on a limited basis for small transactions.
The financial crisis of 2008, though, was a wake-up call for some computer programmers who observed and became alarmed by two related facts. First, they were alarmed that the electronic payments system we depend upon is operated and controlled by insolvent banks. Second, they were alarmed that central banks responded to the problem of insolvent commercial banks by giving them additional money created out of thin air, despite the fact that such money printing reduces the purchasing power of currency already in existence.
And so was born Bitcoin, a digital currency that uses the internet and cryptography to perform the payments and clearing functions currently carried out by bank-operated systems such as Interac.
While our current bank-based system processes and clears electronic transactions using a centralized payments system, Bitcoin uses a decentralized system that depends upon what is called a distributed ledger. Every time a Bitcoin is spent, a secure message is sent to a number of ledgers (really just databases) which record that the ownership of the Bitcoin has changed. These ledgers store the transaction information for each and every Bitcoin in existence on what is called the blockchain, where each transaction (or block) for a unit of Bitcoin is added to the records of its previous transactions (the chain). The databases/distributed ledgers (which can be viewed by anyone using the system) continually check with one another to ensure that they are correct and up-to-date.
People willing to do the work of hosting and updating the ledgers on their computers (called Bitcoin ‘miners’) are rewarded with Bitcoin currency units. As a final feature designed to distinguish Bitcoin from existing central bank-issued currencies, the creators of Bitcoin capped the possible number of Bitcoin in circulation at 21 million to support the currency’s value.
Having made transactions immediate (like current cash transactions) and convenient (like current electronic transactions), the final challenge was to make them as anonymous as cash. To this end, Bitcoin users employ encrypted alternative identities (or ‘keys’) which make it impossible for others to determine their true identity.
As a proof-of-concept, Bitcoin has succeeded. However, as it has grown, some important limitations have become apparent. First, recording every transaction for every currency unit is a lot of work and requires enormous computing power, electricity, and time. At best, Bitcoin can process 7 transactions per second. This past December, it took almost 80 minutes for a Bitcoin transaction to be confirmed.
By contrast, the Visa payments system can process somewhere around 50 000 transactions per second, and confirm each one in seconds. Clearly, a centralized payments system is much more efficient than a decentralized one.
This being the case, what explains the continuing interest in crypto-currencies? Discounting those late speculators who were only interested in chasing seemingly easy gains (and who are now nursing serious losses), the majority of early crypto-currency adopters were motivated by a profound mistrust of the current banking and financial system to create an alternative system which depended neither on banks to clear transactions nor central banks to issue currency.
Looked at this way, crypto-currencies may be best understood as an attempt at a technical solution to a very profound economic problem, a lack of trust in our existing financial institutions and the fiat currency created from computer keystrokes and backed by nothing that is their lifeblood.
Alternatively, they may also be looked at as an opportunistic attempt to emulate the global fiat currency-based banking system. If central banks have been able to create money from nothing but ledger entries for almost 50 years and use it to enrich their well-connected friends and allies, why shouldn’t computer programmers be able to do likewise? Why should anyone toil to produce useful goods and services if they can instead simply create money?
The unsettling fact is that, for all their innovation, crypto-currencies like Bitcoin are nothing but ledger entries. They may be distributed ledger entries and they may be private ledger entries, but they are still just ledger entries. Even more unsettling, though, is that fact that the currencies currently in our bank accounts are also just ledger entries without even the privacy and inflation protection of crypto-currencies like Bitcoin!
At the end of the day, I don’t think a Leprechaun would want to fill his pot at the end of the rainbow with crypto-currency or fiat currency. No, the Leprechaun would no doubt want to continue filling his pot with gold. As trust and confidence in our current financial system continues to ebb, we would be well-advised to follow the Leprechaun’s example.