Fed official Andolfatto: Bitcoin payment network and central bank business

The original author, David Andolfatto, is the vice president of the Federal Reserve Bank of St. Louis. In Andolfatto's view, Bitcoin has many advantages, but it also has big problems. Central banks such as the Federal Reserve can learn from this technology and issue a cryptocurrency with a stable exchange rate through an anonymous consensus algorithm. The article only represents the author's own views and does not represent any position of the Federal Reserve Bank of St. Louis or the Federal Reserve System.

Economic exchange depends critically on secure and reliable payment systems. Since payment systems are fundamentally about recording and transmitting information, it is no surprise that the development of payment systems is linked to the development of electronic data storage and communication. One of the most exciting new things is the Bitcoin payment network, an algorithm-based, community-driven currency and payment system. I thought I needed some time to gather my thoughts on this payment network and think about how central banks might respond to this innovation.

Bitcoin is an open source software designed to manage a currency and payment system without the help of traditional intermediaries such as chartered banks and central banks. Its role as a chartered bank processing payments is replaced by a consensus protocol (mining), where the transaction history is recorded on an open ledger (the Bitcoin blockchain). The role of the central bank is replaced by "fixed" money supply rules (Note: the Bitcoin network is not really fixed, because in principle, the community can change the parameters of the program through "voting").

Bitcoin is the closest thing to digital cash that humanity has seen so far. Due to its relatively fixed supply (we can think of it that way), people sometimes compare the Bitcoin network to a digital gold system.

Let's talk about cash for a minute. Cash is a bearer instrument (ownership is equivalent to possession). Cash payments are made in a peer-to-peer manner, without the help of an intermediary. When I buy my morning coffee, I pay and the merchant receives the same amount of cash. To some extent, cash solves the double-spending problem. It is difficult to counterfeit, and the use of a cash-based payment system is permissionless (there is no application process for opening a cash wallet, and no personal information is required to close an account). Therefore, cash is "censorship-resistant", which means that you can use cash however you want. Finally, the distribution of cash is carried out on an invisible general ledger, which provides a certain degree of anonymity. Cash transactions do not leave a written record.

Digital money issued by banks, on the other hand, is different from cash in several ways. One major difference is that any transaction between two traders must be mediated by a bank. Traders need to trust the bank that the bank will do the correct accounting, and it is this trust that "solves" the double-spending problem of digital bank money. In other words, bank money requires permission. In this process, people must apply for a bank account and give up a lot of personal information to trust the bank to help them solve this accounting process safely. Those who cannot correctly identify themselves are deprived of the right to enjoy traditional banking services (it is estimated that one-quarter of households in the United States do not have a bank account). Bank money is not censorship-resistant, and banks may not process certain types of payment requests. Of course, transactions in bank money will also leave a digital footprint with your identity (even though the system ledger is closed), which will be connected to a specific transaction history.

So what are the benefits of the Bitcoin transaction network? This may vary from person to person, but in summary, I have listed the following points:

First, it has the potential to be a long-term store of value.

Second, anyone with access to the internet can set up their own Bitcoin account (public/private key pair) for free, just like cash, no permission is required. The public key is like an account number, and the private key is like a password. As long as the private key is safe, the account balance will remain safe.

Third, like cash, you don’t need to provide any personal information when opening a Bitcoin account, so there is no need to worry about the security of your private information.

Fourth, like cash, Bitcoin is censorship-resistant, and no one can stop you from transacting with anyone.

Fifth, Bitcoin can provide a higher degree of anonymity than bank money, but not as much as cash (unlike cash, the blockchain ledger is visible and public).

Sixth, the entire money supply (the blockchain) relies on a distributed ledger that can be replicated everywhere, so "sending money somewhere" means updating the ledger run by all computers. There are no banks and no borders.

Seventh, the user's value transfer cost is relatively low.

As I said, how consumers perceive these advantages may depend on a lot of factors. In my opinion, it has great benefits for people who don't have access to traditional banking services. For those who live in areas with high inflation, its benefits may be greater.

So what are the costs of the Bitcoin payment network? First, it is not a unit of account because its monetary policy and demand are unstable and its value is highly volatile, which makes it inconvenient as a payment instrument (even if it is a good long-term store of value).

Second, it has the same level of security as cash (losing your private key is equivalent to losing your wallet). Of course, people can also use third-party services, but if that is the case, why not just use the bank?

Third, although the user cost of the Bitcoin network is currently low, its social cost (primarily electricity) is high relative to the operating cost of a trusted ledger.

Fourth, due to its cash-like properties, Bitcoin can also facilitate illegal transactions. (Of course, cash has the same problems.)

Could the emergence of Bitcoin affect the central bank’s thinking?

First, the threat of Bitcoin (and other currency alternatives) has a restraining effect on central banks’ monetary policies.

Second, to the extent that Bitcoin becomes a significant payment instrument (or unit of account), it could open the door to financial instability. In principle, demand liabilities should be traded at risk differentials. But in practice, they may not do so. Especially in times of economic complacency, they may be seen as close to a perfect substitute for bank money and cash. The question is, what if there is a "run" crisis in such a system? The question of whether Bitcoin can serve as a unit of account is exacerbated (see dollar-denominated loans issued by European banks). A classic bank panic is possible when the FDIC may not be able to provide services, when there is no lender of last resort to issue BTC. In this case, central banks and fiscal authorities will have to think about something.

My personal suggestion is that central banks should consider offering digital money services (perhaps even cryptocurrencies) to the retail and wholesale sectors. These accounts would obviously not need to be insured. They would provide companies with a safe place to manage their cash without having to report to banks or the shadow banking sector. They would give monetary policy an additional tool to pay low interest (possibly negative) on payments. To the extent that paper money would be replaced, this would also save a lot of costs.

It’s hard for me to argue that a digital currency provided by a central bank would be a downside. Critics might say that it exposes people to potentially inferior monetary policy. This may be true, and for these people, money alternatives should be possible (including Bitcoin). On the payment side, critics might argue that central bank accounts would be permissioned, that personal information would be required, that KYC restrictions would apply (so no censorship resistance), etc. To address these issues, the central bank could go a step further and issue a fixed-rate cryptocurrency (Fedcoin) where clearing is done via an anonymous community consensus algorithm inspired by Bitcoin. I don’t think we’ll be able to implement something like this any time soon, but it’s technically feasible. Of course, people will complain that Fedcoin will incentivize illegal transactions, etc., but it’s worth reminding everyone that legal cash issued by central banks has the same problems.

There is also the question of how such innovations might affect the traditional banking model, which I will discuss in another article.

Original article: http://andolfatto.blogspot.fr/2015/11/bitcoin-and-central-banking.html
By David Andolfatto
Compiled by: Satuoxi
Editor: Satuoxi
Source (translation): Babbitt Information