When a friend of mine first enthused to me about bitcoins in 2010, my response was muted. “Great idea,” I said, “for keeping track of who owns a particular copy of an item of digital content, but forget about it for currency.” He either didn’t understand or didn’t want to understand why I said that. Now, it seems I wasn’t far wrong.
I’ve been consulting to central banks and working in IT security for payments systems for over a decade. Bitcoins first came on to the scene about eight years ago, and were predicted to have put dinosaurs like me out of jobs by, er, seven and a half years ago. That hasn’t happened yet – though maybe it will. But I think there are good reasons why it won’t, and here they are.
Before I get started, two things. First, Satoshi’s paper which launched cryptocurrencies wasn’t ambitious – he wanted to disintermediate financial transactions, not turn the world on its head. However, the stampede of venture capitalists and the like are ambitious – otherwise, they wouldn’t be in the game – and this post is directed at them. Second, “cryptocurrency” is difficult to type and hard to read, so I’ve used “bitcoin” as a placeholder to mean cryptocurrencies in general.
That said, to business. The reasons I think bitcoins are doomed are to do with the nature of currency, which to me comes in two parts.
1. Repository of Future Value
The idea that money is a repository of future value may seem unconventional. After all, no less an authority than wikipedia says that money is a medium of exchange, a measure of value, a standard of deferred payment and a store of value, not a repository of future value. However, I defend my definition at a trivial level by observing that I’ve done no more than combine the latter two of wiki’s definitions, and at a deeper level thus:
The banknote in my wallet is worth nothing until I spend it: a future event. In quotidian transactions, I give you that banknote and you give me a good or service. So I realise the value of the note by transferring the promise from me to you – and on it goes. However, some future owner of the banknote may go to the entity that issued the banknote and demand payment. At that point, the issuer has to make good on the promise by giving the bearer goods or services.
The common understanding is that, at that time, a banknote will derive its value from the assets by which it was backed – until a few decades ago, gold. So a citizen could stroll into a government office and redeem her banknote for an appropriate share of the government’s assets.
As early as the late nineteenth century, it had become obvious that no government could or would liquidate its assets and carve them up amongst the citizenry. The dissolution of the Gold Standard in the Bretton Woods conference and later legislative moves (I’m told it took the US until 1976 to get around to de-legislating gold) were nothing more than bowing to the inevitable. And this is because modern governments don’t run on assets, but debt. And a modern currency’s value is determined by the ability of a government to raise taxes to service that debt. That ability is contingent to some extent on the government’s assets. But it is far more contingent on the government and its citizens honouring the social contract which binds them: people paying their taxes, and the government spending them in broad accordance with its citizens’ wishes. This is of course imperfect at the best of times, but that’s why America and Europe, with strong institutions and firm social contracts, have currencies that are valued, and why Zimbabwe didn’t.
The problem that bitcoin faces is that it’s not a government. It has no ability to compel people to pay taxes. It therefore has no ability to deliver on the value when the day comes. The sole and only way of realising the value of a bitcoin is to find someone who is willing to exchange the bitcoin for goods or services. It that person can’t be found, the bearer is stuck. She has no means to compel, no rights as a citizen.
Now, I’m not saying that governments don’t fail; that citizens don’t get screwed – look at the aftermath of the Global Financial Crisis of 2008, or anywhere that’s gone through hyperinflation. But these are exceptions. Nearly all of the time, bearers of conventional currency have recourse: they have rights and the means to enforce them. Bearers of bitcoins are in a legal vacuum.
2. Transfer of Future Value
Or, to put it simply, payments.
People expect – with good reason – that payments are fast, cheap and reliable.
A typical payment in a modern payments system, using the SWIFT / ISO20022 messages or using ATMs with ISO 8583, is in the order of 600 bytes of data – about as long as this paragraph – and follows this sequence: make sure I have the funds available, remove (or block) them from my account, credit them to your account. This can be done in microseconds. The slow part is the communications, which can take a few seconds for credit cards, and a few milliseconds for touch-and-go (NFC) payments.
Cryptocurrency payments are neither fast nor cheap. This is because the underlying technology, the blockchain, is neither fast nor cheap by deisgn. A typical blockchain is about 130 Gb. The processing of a blockchain transaction is inordinately complicated, requiring the generation of very big prime numbers, which are to be vetted for coincidental adherence to a given set of criteria. Most numbers don’t comply, and are discarded. One of those which does comply will replace that already in the blockchain. This uses vast amounts of computer power: if all the world’s trillions of transactions were processed by blockchains, there wouldn’t be enough power left over to switch on a light bulb.
There are ways of pruning the blockchain, and there are cryptocurrencies out there which are moving away from generating huge prime numbers for each and every transaction. But they’re all based on public/private key encryption, and this is computationally far more demanding than conventional payments. (For the record, credit cards and ATM payments typically use symmetrical keys, which require a couple of orders of magnitude less of computer power. The symmetric keys are periodically updated using public/private key encryption.)
Yes, there are special purpose chips and whatnot. But it all comes to the same thing: more computing power means a higher cost per transaction, and whatever advances are made that reduce the cost of processing cryptocurrency transactions will carry over to conventional payments: the latter will always be cheaper.
To put it another way: the gold standard of a modern payment is that you can swipe your card or phone while passing through a turnstile without breaking stride. To do this, the transaction must be cheap, simple and very fast. No cryptocurrency comes close.
However, even if there’s a sudden change in the laws of physics, there’s another major hurdle. Regulators.
3. Protecting the Public
As soon as cryptocurrencies become mainstream, regulators will leap into the fray. Cryptocurrencies are very useful tool for money-laundering sleuths as they contain a complete transaction history. However, there is no way of associating a particular wallet with an actual human being or organization – hence the current popularity of cryptocurrencies amongst crooks. But as soon as the problem becomes big enough – and I’m told it already has – regulators will mandate that cryptocurrency providers perform the same checks on their customers as banks as are required to on theirs. Setting aside that anonymity was a stated aim of cryptocurrencies, so Know-Your-Customer rather defeats that point, the cost structure in this respect is going to be the same as for conventional payments.
In summary: the same regulatory overhead, a much higher per transaction cost due to increased computation, and no recourse. So bitcoin bearers pay more and get less. Not an attractive proposition.
I said all this eight years ago, and here we are, eight years on. Cryptocurrencies have faded from view. Yes, they’re still there, yes, there’s still some action, and yes, bitcoins are trading at about USD4,000 per coin. But there’s little sign that they’ve revolutionized the world’s financial markets.
What has happened is a sudden rush of interest in the underlying technology for what I though eight years ago was the problem this particular solution seeks. Blockchains are decentralized, secure ledgers that contain entries detailing who owns what. In the case of the original bitcoin, the “what” was money. For the reasons above, I never thought this had much promise. But for movies, books, music and the like – now known by the ghastly term ”intellectual property” or IP - there is a rapid trend that the primary delivery mode is digital. And that creates the problem of validating that the person who views / listens to the work, owns it.
The solution being touted is that each person has a wallet full of tokens, and each token gives her certain rights over a certain digital copy of a given work. That has some mileage. The problem is that the value of digital content is converging on zero. That means there’s precious little money in tracking who owns a particular copy of a work. Which means that we have a problem, a solution, an no way of making it pay. Back to square one.
* Thanks to Gavin Costin for his comments on the original post.