Electronic currency can potentially take away the ability of central banks to control money

My column on Bitcoins that appeared in the "Poke me" section of economic times.

The unedited version (less dramatic) is below.

The future of money

Have you ever redeemed your credit card loyalty points to purchase a product of your choice? Or converted air-miles received as a frequent flyer to get some free tickets? If you have, you have already been exposed to virtual, electronic money. After all, a key purpose for money to exist is to function as a medium of exchange. These loyalty points serve the purpose of allowing you to exchange them for tangible goods and services.

When we carry out any of the above transactions, we do not see it as an alternative currency. The loyalty points can typically be exchanged for a limited set of goods, and are not universally acceptable. But what if they were? What if they worked as electronic money and were widely accepted?

Fiat money – a promise to pay backed by “confidence”

In a “Fiat Money” system – on which all contemporary economies are based, the notion of money - often represented by currency notes - is based on “confidence” that users have on the issuing authority. With no real assets backing the currency notes, issuers can issue as many notes as they want. However, economic growth cannot be assured by just printing money – it must come from higher production of goods and services. Consequently, if an issuer continues to “print” money, it will fall in value compared to other currencies or commodities.

One way to increase confidence is to back up fiat money by another commodity. Gold served as money for centuries, before it was replaced by “representative money” – where paper (representing the underlying commodity) could still be redeemed for gold. This changed in 1971 – when conversion was disallowed by the USA. Since then fiat money has been the basis of most transactions the world over.

Bitcoin – digital currency

All currency systems so far have required an issuing authority – with the ability to issue or destroy currency. In 2009, a yet unknown programmer using the pseudonym Satoshi Nakamoto published a proof of concept of a crypto-currency called “Bitcoin”. As the website (bitcoin.org) explains “building upon the notion that money is any object, or any sort of record, accepted as payment for goods and services and repayment of debts in a given country or socio-economic context, Bitcoin is designed around the idea of a new form of money that uses cryptography to control its creation and transactions, rather than relying on central authorities.”

Interested readers can study the specifics in detail at the website, but in summary, a user can create an online “wallet” and receive and pay bitcoins from it. All data (including transaction data) is stored in a distributed environment on the web. Since there is no issuing authority, the algorithm for generation of new bitcoins fixes the total number that will ever be in circulation.

Transaction ease is tremendous – there are no transaction charges (or very small ones), payments are easy to make and receive – like sending e-mails. In effect there are no political boundaries, no bank holidays and no one to censor who can receive or make payments and for what.

With reportedly only one breach which was sorted out, the system seems to offer sufficient security for people to have “confidence” in it. Bitcoins can be exchanged for regular currency at an automated price discovered basis transaction history. At present, the bitcoin website reports that daily transactions exceed $1mn per day distributed over 40,000 transactions. 

Why now?

So what makes bitcoins attractive in the current market context – and popular they clearly are (see graph of USD vs bitcoin over the past 1 year).

 

The key driver for popularity of bitcoins is risk that investors face in the current global economic environment, with central banks engaged in competitive devaluation of currency, and large financial institution risk remaining unmanageable.

Imagine if the depositors in Cyprus’ failed banks had, been holding their money in the form of bitcoins instead of holding their deposits in Euro. The Cyprus government, and European “troika” that forcibly took away almost 60% of the deposits would not have been able to get their hands on the money.

Investors have, over the past few years been using Gold and Silver as a portfolio insurance against currency devaluation and systemic risks of financial markets. However, like money, gold and other precious metals too are available to governments to usurp – and therefore, in a Cyprus like situation, are not adequate security. Bitcoins are however not accessible at a single location and, like the internet, cannot easily be controlled.

Bitcoins - the glitches

So long as bitcoins are used as a medium of transaction or as a store of value, it is highly likely that their popularity will grow. Questions arise on how governments would react – will bitcoin transactions be taxed for example?

Bitcoins offer total anonymity. One can have as many accounts as one wants. With smooth transition across borders without the use of banks, bitcoins have the ability to facilitate illegal transfer and transactions. The fact the governments’ are waking up to the emergence of online currencies is affirmed by a new law passed by the US government in mid March. It now requires that transactions more than $10,000 need to be reported.

Lastly, if its popularity rises, it will not take long for markets to start offering derivatives and structured products around it. With no regulatory framework, that would mean risk rise manifold. Despite these obvious road blocks, markets needs to look at this innovation carefully. The challenge that it throws to established order of central bank controlled currencies will, over time, lead to a re-examining of the very concept of money.