Bitcoin – a specific cryptocurrency
Cryptocurrency – a digital currency based on a (decentralized) blockchain
Blockchain – a distributed system of record keeping

Let’s go in reverse order!

(Or keep it brief: A 10 Minute Video)

Blockchain:

The blockchain is an innovation in record keeping. It represents a substantial improvement on existing technologies for keeping records of any kind: transactions of money, keeping account of who owns what assets, or which tasks have been finished. For any record keeping technology to work it must answer two questions: Who gets to edit/add a new record? How to get everyone to agree on the ‘true’ record?

Historically, both of these decisions would be made by a trustworthy central authority: an admin or super-user. This remains true for centralized blockchains, also called private blockchains. Centralized blockchains are an improvement on earlier record keeping technologies in terms of authenticating transactions and allowing for the record to be stored in a decentralized manner, but hardly seem like a revolution. Like existing distributed record keeping technologies they fundamentally rely on being able to trust the central authority. Decentralized blockchains, where no one person makes the decisions, no longer require a trusted central authority. So how do decentralized blockchains allocate the right to edit and maintain agreement on the true record? The breakthrough of Bitcoin creator Satoshi Nakamura was to allocate the right to edit based on proof-of-work: those wishing to edit the blockchain use computers to solve unrelated numerical problems, and upon finding the solution —providing proof-of-work— they get the right to make an edit (to add a block to the chain) and receive a payment in the form of new coins. Users of the blockchain will have a stake in maintaining the true record because that record is precisely a record of the coins they have earnt in the past.

The use of proof-of-work as a way assign the right to edit remains at the core of decentralized, a.k.a. public, blockchains. That the existing users have a self-interest in sticking to the true record is also a key part. However neither of these is perfect, proof-of-work is inefficient as it involves using computer power to solve otherwise pointless numerical problems which is expensive in terms of electricity use and as a by-product is needlessly destructive for the environment. The self-interest of existing users in sticking to the true record, while it works almost all the time, does not perfectly guarantee that the one ‘true’ record will prevail; in the case of Bitcoin this has resulted in forks in the blockchain.

The other main strengths of the blockchain are that it is both untamperable and anonymous. Although it is not clear that they are genuinely anonymous, or that being untamperable is always desirable. See subpost on Untamperable? Anonymous? Crime? Price Manipulation?

Blockchain technology appears to be both innovative and also very useful in practice. Most commercial applications are based on centralized blockchains where the right to edit is allocated by some central authority who users simply have to trust, an improvement on previous database technologies they hardly look like a revolutionary new technology. The Ripple currency uses a private blockchain with the right to edit allocated by the Ripple Corporation, who also allow MIT and Microsoft to allocate edits. Various Banks are developing their own blockchain-related technologies to manage transactions. Maersk, a container shipping company, have joined with IBM to implement a blockchain for suppliers to keep track of shipping crates and customs permits. They hope to convince the whole shipping industry to use it for supply chain management. Sweden is looking to use blockchain to manage their land registry, the record of who owns what land. Blockchain also promises the possibility of new types of smart-contract and markets for data, such as Iota and Fetch.

For more on how blockchains operate, and why decentralized blockchains work, see subpost on The Theory of Blockchains. For some economic implications of centralized blockchains see subpost on Smart Contracts and Cartels.

Cryptocurrencies:

Cryptocurrencies, like Bitcoin, Etherium, and Ripple use blockchains as a way to record transactions in ‘coins’ (digital tokens) and keep track of everyones holdings of coin. A given cryptocurrency is associated with a single blockchain. These coins can be transferred from one account to another as payment for things. In this way they act like currencies. But are cryptocurrencies money? And are they better or worse than existing monies? To answer this I first look at a brief history of money, and come up with some defining characteristics of money. I then ask whether cryptocurrencies meet these definitions.

A Very Brief History of Money and Transactions: When two people want to trade how do they do so? If I have something you want, and you have something I want we can obviously just exchange these things. This is called Bartering, and we simply agree on exactly how many eggs I will give you in exchange for a loaf of bread. Economists call this situation a ‘double-coincidence of wants’, we both want something the other has. But what about if only one of us has something the other wants, I still want a loaf of bread but you don’t want any eggs? Money is a way to solve this problem, as everyone is always willing to exchange for money, knowing they can use it later to buy something they do want. In this sense money is like debt, you give me bread, and I give you an IOU in the form of money. Tally Sticks, one of the earliest forms of money, was literally debt. Money is also like trust, unless I trust that that debt will be repaid, I won’t accept it.

Early currencies were often coins made of Gold or Silver. But carrying around actual gold is inconvenient, and so commodity-backed money emerged; a note that a trusted party had promised they would exchange for a fixed amount of gold with anyone who wanted. Anything people agree to accept in trades can be money, so Cigarettes acted as money in Prisoner-of-War camps during World War II and even non-smokers accepted Cigarettes knowing they could always trade the Cigarette for something else later.

At some point paper money was invented, money that has no backing in commodities. Its value derives solely from trust in the issuer. When Marco Polo first came across paper money during his travels in China around the year 1300 he was so amazed by it he wrote “tell it how I might, you never would be satisfied that I was keeping within truth and reason”. Nowadays we are all used to paper money issued by Governments, called fiat-currencies as their value derives from Government fiat. Many other forms of money also exist: Cheques, Debit cards, Credit cards, M-Pesa, PayWave, Online Bank Transfers, and even three-meter wide stone discs weighing a few tonnes.

Private Money? In principle anyone can produce money, however it is only of any value if people trust it. Nowadays private banks regularly produce private money in the form of bank deposit accounts. Private in the sense of not being the public money issued by Governments. And at some times in history private money issued by private banks have been the only money, such as the US in the late 19th century. On a smaller scale many stores and airlines issue their own money (loyalty point programs, frequent flyer points), although most are not widely accepted. Many online games have their own in-game currencies, and for some major games like World of Warcraft people pay real-world money in exchange for in-game gold. Some people even make a living earning in-game gold and selling it for real-world money.

What is money? Some Definitions. Economists typically point to three main properties of any ‘good’ money. A store of value: it will be worth the same tomorrow as it is today. A medium of exchange: rather than having to physically carry eggs round to trade/barter for bread, I can sell my eggs at the market for money, then use that same money to buy bread from my local Baker. And a unit of account: how much do a half-dozen eggs cost? Answer is $4, not one loaf of bread. Other views on key properties exist. The ideas of money as debt, or trust have already been mentioned. Two other views are money as memory, a superledger of who owes what and similar to the idea of money as debt, and money as an information insensitive asset (when traded it is valued at par).

So how do Cryptocurrencies do on our main properties of what makes for good money. In particular, how is Bitcoin as a medium of exchange and as a store of value?

As a medium of exchange Bitcoin is rubbish. As of early 2018, the number of transactions that Bitcoin is able to process is limited to just 3-4 per second, compared to the 30,000 credit-card transactions per second by Visa. Since the demand for Bitcoin transactions is greater than this (self-imposed) limit transaction fees have emerged to determine which transactions get processed. In 2017 the average transaction cost of Bitcoin transactions was 0.89% of transaction value, and transactions took an average of 12.9 seconds to confirm. Most of these issues surrounding the number of transactions are purely technical, and some are solved by other cryptocurrencies. Becoming a medium of exchange was precisely the motivation for the Bitcoin Cash fork.

As a store of value Bitcoin is also rubbish. If it were a perfect store of value then its market capitalization which is a measure of its total value would be constant and appear on this graph as a horizontal line. It does not! Not even close. Obviously, perfect is extreme, the value of the US dollar change slightly over time due to inflation, and back when gold was used as money the discovery of the Americas and the large amounts of Gold there led to inflation. But Bitcoin is not even close to having a stable value.

So Bitcoin doesn’t make for good money. Other cryptocurrencies can mostly solve the medium of exchange problem, which is largely technical. Whether they can achieve a stable value remains to be seen. Which leaves the question, if Bitcoin is not money, then what is it? One answer is that Bitcoin is more like digital-gold: not very convenient for transactions, and with an unstable price, but might be used as a ‘safe-haven’ asset. Something to be purchased when everything else looks to be going bad.

This leaves the question of whether a future ‘good’ cryptocurrency that satifies the properties of medium of exchange and store of value might replace existing fiat-currencies? Monetary Theory suggests that cryptocurrencies won’t replace ‘good’ fiat-currencies, those that satisfy these same properties. Fiat-currencies have two added advantages, they are a monopoly (only the government can issue them), and they are needed to pay taxes. US dollars and Euros, with low and stable inflation, would be expected to fall into this category. But cryptocurrencies will replace ‘bad’ fiat-currencies, like the Venezuelan Bolivar where inflation in 2018 is tipped to exceed 1000%.

For more on whether cryptocurrencies might supplant Government-issued fiat-currency, like the US dollar, the Euro, and the New Zealand dollar, and for the implications for monetary policy and ideas like crypto-fiat, see subpost on Monetary Theory of Cryptocurrencies.

With all its limitations it is difficult to imagine that Bitcoin is the future. Nakamoto’s true legacy may be the advent of decentralized trust, and that legacy promises to be a valuable one.

Next post in this series on Crypocurrencies: The Theory of Blockchains

Footnote: To be precise, if Bitcoin were a perfect store of value its market capitalization, which is measured in US dollars, would not be constant (a horizontal line), instead it would have a very slight slope to account for the low average inflation of the US dollar over the years.