Reflections on Bitcoin

Ever since I joined Citigroup as a strategic advisor in March of 2008, I’ve been spending a lot of time thinking about the ongoing transition toward a global digital money ecosystem.  For over 2,500 years, money has played a central role in the rise of civilizations and in human affairs of all kinds.  As a result, the historical transition to digital money is among the most exciting and important societal challenges in the coming decades.  Its impact might well be up there with that of other major technology-based societal transformations, including electricity, radio and TV, and the Internet and World Wide Web.

The evolution to a digital money ecosystem involves a lot more than the transformation of money - cash, checks, credit and debit cards, etc, - from physical to digital objects that we will carry in our smart mobile devices.  It encompasses the whole money ecosystem, including the global payment infrastructures, the management of personal identities and financial data, the global financial flows among institutions and between institutions and individuals, the government regulatory regimes, security and privacy issues, and so on.

Just about every aspect of the world’s economy is involved.  Over time, mobile devices will truly become our personal windows into an increasingly global, digital economy.  And, because continuing technology advances are now enabling us to bring the empowerment benefits of the digital revolution to just about everyone in the planet, digital money is a truly inclusive innovation with no apparent digital divide.  Mobile phones and Internet access have gone from a luxury to a necessity that most everyone in the planet will soon be able to afford. 

This evolution will take decades to fully play out, - historical transitions take their time.  But, it’s most definitely underway, with an increasing number of market pilots and research studies taking place around the world.

When discussing digital money, I often get asked my opinion of Bitcoin.  My answers have not been all that good because I honestly don’t know what to think of Bitcoin.  I usually tell people that the development of digital money ecosystems is such a complex undertaking that it’s best, at least for now, to stick to traditional currencies, e.g., $, £, €, ¥,₩, that all the parties involved understand.  Introducing new cryptocurrencies into the mix at this time adds all kinds of additional complications which we might be better able to deal with once the evolution is well underway. 

Bitcoin is both a digital currency and a peer-to-peer payment system.  Introduced in 2009, it uses cryptography to control the creation and transfer of money.  It’s not backed by central governments or banks.  Its standards, protection and promotion are governed by the Bitcoin Foundation.  Having been implemented in open source software, Bitcoin’s sophisticated protocols are widely available, which has helped bring it increasing usage and prominence.

The last few months in particular have seen a flurry of articles on Bitcoin by a number of highly respected technologists, economists and journalists.  Some, like my friend and former IBM colleague John Patrick, feel that “Bitcoin has all the trappings of the early days of the web.”  Others are pretty negative. 

So, I decided that it’s time for me to look deeper into Bitcoin, read a number of these recent articles, see if a consensus about its future is beginning to emerge, and try to form my own opinion.  Based on the articles I read, no consensus is at hand, their titles ranging from Why Bitcoin Matters to Why I Want Bitcoin to Die in a Fire.  I did find the articles quite instructive in helping to shape my own opinion, which I summarize at the end of this blog.  Let me explain how I got there. 

Why Bitcoin Matters is one of the most prominent recent articles, published in the NY times by technologist, entrepreneur and investor Marc Andreessen.  Andreessen compares Bitcoin in 2014 to personal computers in 1975 and the Internet in 1993.  His VC firm, Andreessen Horowitz has invested close to $50 million in Bitcoin-related start-ups, and continues to actively search for additional such investment opportunities.  In his column, Andreessen points out that there is an enormous gulf between what the press, economists and others believe Bitcoin is, and what a number of technologists and entrepreneurs like him are so excited about: 

“First, Bitcoin at its most fundamental level is a breakthrough in computer science - one that builds on 20 years of research into cryptographic currency, and 40 years of research in cryptography, by thousands of researchers around the world. . . Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property [e.g., money, signatures, contracts, stocks and bonds,] to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer.  The consequences of this breakthrough are hard to overstate.” 

He particularly values Bitcoin as a new kind of peer-to-peer payment system, “a way to exchange money or assets between parties with no pre-existing trust. . . the first Internet-wide payment system where transactions either happen with no fees or very low fees (down to fractions of pennies).  Existing payment systems charge fees of about 2 to 3 percent - and that’s in the developed world.  In lots of other places, there either are no modern payment systems or the rates are significantly higher.” 

As a digital currency, Bitcoin has been quite volatile, with large fluctuations in value over days, weeks and months.  Most recently, the exchange rate of a bitcoin has been fluctuating between $600 and $900.  Its volatility is largely due to speculation and relatively low payment volumes.  Despite its positive qualities as a highly secure digital payment system, many believe that the currency’s volatility will likely drive away the vast majority of individuals and merchants.  Andreessen disagrees:

“The criticism that merchants will not accept Bitcoin because of its volatility is also incorrect.  Bitcoin can be used entirely as a payment system; merchants do not need to hold any Bitcoin currency or be exposed to Bitcoin volatility at any time.  Any consumer or merchant can trade in and out of Bitcoin and other currencies any time they want.” 

A few weeks ago, technology journalist Glenn Fleishman wrote an article refuting a number of Andreessen’s arguments.  The article starts out by agreeing that Bitcoin represents a major innovation in payment systems:  

“I agree with Andreessen that Bitcoin is the first practical, large-scale mechanism to deal with the problem of decentralizing trust - no parties need know each other nor trust each other for transactions to complete successfully, verifiably, and irrevocably. . . I also agree completely with Andreessen that Bitcoin can be used for an enormous number of non-currency related purposes in which permanent, irreversible proofs of transactions are required.” 

But he then goes on to argue with many of the points made by Andreessen, including Bitcoin’s liquidity and low fees, and its advantages related to fraud, theft and other illegal activities.  This past November, Fleishman published an article in The Economist, Bitcoin under Pressure, where he notes in the tag line: “It is mathematically elegant, increasingly popular and highly controversial.  Bitcoin’s success is putting it under growing strain.”  He goes on to explain his concerns:  

“Bitcoin’s success has revealed three weaknesses in particular.  It is not as secure and anonymous as it seems; the mining system that both increases the Bitcoin supply and ensures the integrity of the currency has led to an unsustainable computational arms-race; and the distributed-ledger system is becoming unwieldy.  Will Bitcoin’s self-correcting mechanisms, and the enlightened self-interest of its users, be able to address these weaknesses and keep Bitcoin on the rails? . . . Perhaps Bitcoin, like the internet, will smoothly evolve from a quirky experiment to a trusted utility.  But it could also go the way of Napster, the trailblazing music-sharing system that pioneered a new category, but was superseded by superior implementations that overcame its technical and commercial flaws.”

Fleishman believes that Bitcoin offers an opportunity to reimagine how the financial system can and should work in the Internet era.  But he makes a distinction between its future as a technology and its future as a currency.   “Bitcoin shows a path for massively more secure, reliable, and sensible ways to store value and move it around.  As a currency, I have little faith that it will become a replacement for dollars, euros, or renminbi.  As a model for a future payment and transaction system, I believe it’s already shown its value.” 

Fleishman’s conclusion, which I agree with, is similar to Karen Webster’s, a top payments expert, who wrote in Looking Ahead at the Close of 2013: “Our prediction is that those who are in the best position to exploit bitcoin’s success will be those who recognize that there’s a difference between the technology that enables bitcoin and bitcoin the currency and will invest in perfecting the former and not the latter.” 

A number of the articles were quite negative.  At a panel in the 2014 World Economic Forum in Davos, Yale economist and Nobel Laureate  Robert Schiller said that Bitcoin “is just an amazing example of a bubble.”  As reported in Business Insider, Schiller said that while he finds Bitcoin to be an inspiration because of the computer science, he does not think of it as an economic advance and views it as a return to the dark ages.  Schiller, an expert on economic bubbles, believes that much of its fascination is due to its extreme volatility. 

Another Nobel Prize winning economist, Paul Krugman chose the title Bitcoin is Evil for one of his recent NY Times columns.  Krugman’s main reason for his negative views is similar to that of author Charlie Stross, who wrote a strong critique of Bitcoin in Why I want Bitcoin to die in a fire:

“Like all currency systems, Bitcoin comes with an implicit political agenda attached.  Decisions we take about how to manage money, taxation, and the economy have consequences: by its consequences you may judge a finance system. . . Bitcoin looks like it was designed as a weapon intended to damage central banking and money issuing banks, with a Libertarian political agenda in mind - to damage states ability to collect tax and monitor their citizens financial transactions.”

Finally, there is the question whether Bitcoin and other virtual currencies should be subject to financial regulations, similar to those currently in place for existing currencies.  Anti-money laundering is one such regulations enforced by governments around the world to curtail illicit activities like the flow of money from the drug trade and the financing of terrorist activities.  Bitcoin has been linked to such illicit activities, which has led to a few recent arrests.  Governments have started looking at how to regulate Bitcoin and similar digital currencies. 

“The days of anonymous transactions in Bitcoin and operating an exchange with no outside interference are over,” was the concluding paragraph in this article on the subject.  “As virtual currencies develop, firms devoted to aiding trading, and perhaps even their users, will encounter greater government regulation, along with the costs that come with compliance.” 

So, after reading and reflecting on these various articles, here is how I would now summarize my views on Bitcoin: 

• The cryptographic advances and technologies underlying Bitcoin will likely play a major role in the development of the Internet of Money, that is, an Internet era, digital money ecosystem.  But, as is the case with all complex platforms, its architecture, protocols and governance will have to evolve.  It remains to be seen whether the resulting platform will still be called Bitcoin or something else will have taken its place.
• For the foreseeable future, the bulk of the money flowing through such a digital money ecosystem will continue to be based on existing currencies.  Digital currencies may play important niche roles.  It’s not clear at this point whether Bitcoin itself will be one of the surviving digital currencies.
• Given the central role played by money in all aspects of the economy, society and our personal lives,  governments will continue to regulate its use, whether based on existing or new digital currencies.

 

Comments

[Bill Tetzlaff]

Irving, Thanks for the thoughtful summary. I have been reading the popular press articles, but not attempting the cryptography underpinnings, and come to similar conclusions. I do suspect that the anonymity of transactions involving illegal activity is the main attraction, and that the mining aspect is a bit of a Ponzi scheme, ant it may collapse, like the Madoff accounts.

[Christopher Carfi]

Irving, thank you for the thoughtful and nuanced look at the space. It certainly does feel like early days. Many of your points and counterpoints are aligned with the things I am seeing as well. It is likely that the most interesting aspects are the protocol possibilities, perhaps even more so than the currency aspects themselves.

[Mark Montgomery]

Greetings Irving. Bitcoin is dangerous from a security perspective - has gone further faster than I thought it would, but obviously any global currency will be subject to security and regulation. However, I think your comments on taking decades and seeking consensus on disruptive technology is dangerous. In fact I know it is. AT&T said almost the precise thing to Vint Cerf about the Internet, MS with Google - the list is long just in my own circles and history. Disruptive technology doesn't wait for consensus or ask permission of incumbents. While it's true that it may take a decade or two to become dominant, by that time it's too late for others to catch up, and the velocity in which big bang disruptions are occurring is increasing--roughly half the time it took a decade ago in digital environment from initial investment to become market leaders. They are rare. No denying they exist, or that a strong global demand exists for alts to banking. That said, I don't personally see future innovation in currency rising in Bitcoin fashion at all. Rather I agree with you that a conversion will take place. But that shouldn't necessarily rest easy with banks. .02- mm

[andy]

Very thoughtful, educated, and objective analysis. Well done.

[Aditya Menon]

Irving - we discussed yesterday how Bitcoin provides real-time value transfer from one individual to another using a publically verifiable distributed ledger, however that existing payment systems required elaborate governance and trust relationships in order to deliver a similar service. For example the CLS system was created to solve a particular problem of risk management for global FX trading to avoid settlement risk. The result was the creation of a global real-time payment and settlement network, however that relied on local RTGS systems for it’s implementation, creating the tiered trust model that I alluded to earlier. Real time payment systems exist within the boundaries of countries, But CLS provided continuously linked settlement across geographies in real time. What this tells us is that financial institutions are quite capable of creating efficient mechanisms for payment and settlement even across borders, albeit for larger value transactions, therefore they may be a way for financial institutions to use the “Concept” of bitcoins to create a more efficient global value exchange that works just as well for small value as it does for large value transactions. If it were built on the same model as CLS, then it would need a low-value real time clearing and settlement system in each country, which exists in some countries – notably – Faster Payments UK, South Africa’s BankServ and India’s IMPS, but not in others. The obvious pitfall of this line of thinking is why would banks shoot themselves in the foot by creating a free or extremely low cost value transfer mechanism ? What's your view ?

[Jim]

If Bitcoin looks like a libertarian attack on the current banking system, that is because the current banking system IS an fascistic attack on Libertarians, As well, Napster has pretty much become YouTube, a huge success!

Further more if you are this so called 'expert on digital money' why not try to some how justify that to readers instead of glossing right over that and going straight into a wild attack bitcoin?

[Todd Fletcher]

"Perhaps Bitcoin, like the internet, will smoothly evolve from a quirky experiment to a trusted utility. But it could also go the way of Napster"

I think the former, open source projects often overcome the limitations of vision that limit private enterprises. In fact, that has already been the case. Bitcoin has shown this by continuing to evolve and become more robust.

[reuven Brenner]

Irving, I would say the Bitcoin stuff is pretty simple. Following a roundtable, here is a brief excerpt, published 2 days ago:

http://www.atimes.com/atimes/Global_Economy/GECON-01-140214.html
best, Reuven Brenner

[David Rangel]

Irving,

I very much respect your opinion and think this is a very reasoned and measured post, but I find your conclusions a bit too non-committal. Also, quoting Webster and Fleishman's view (separating the Bitcoin protocol from the currency) leads to an important misunderstanding. This is why:

1) Bitcoin (the cryptocurrency protocol/system) has proven that it can serve as an efficient way to execute transactions globally with minimal friction. That is clear and few dispute it.
2) If you believe that this function (enabling transactions) is valuable (and few would say it is not), then because of how Bitcoin works, the Bitcoin currency MUST have associated value. That is because you cannot separate the currency from the protocol (this is the common misunderstanding).
3) Once you see that the currency is an inseparable part of the system, it is also inevitable that the currency will have some value and role in transferring value in different industries.

Now, I acknowledge that the ultimate winner may not be Bitcoin itself. If something unforeseen happens (e.g., an unexpected bug), it could be another cryptocurrency that emerges as an ultimate winner. But cryptocurrencies are a real technical breakthrough that is here to stay, and because of how they work, their role as an actual currency (store of value, medium of exchange) is inevitable.

I have a longer form explanation in the URL I submitted with this comment.

Thanks,

David