Bitcoin is still here: attractive for retail transactions and money transfers

Rand Paul likes to be seen as a political pioneer. But recently the Kentucky senator and Tea Party star has begun to break new ground in the financial field. When he announced his 2016 US presidential campaign, he said he would accept donations in Bitcoin. This makes him the first US politician to raise funds using cryptocurrency. Given the Republican Party's deep distrust of fiat currency and the Federal Reserve, the move is likely to be welcomed by its liberal supporters.

But there’s another big Bitcoin drama that investors should be watching. Behind the scenes, Wall Street financiers are launching market experiments — experiments that have nothing to do with the retail payments or donations usually associated with Bitcoin, but with wholesale finance. In particular, a number of projects are in the works that will use Bitcoin for back-office settlements in financial markets. And, while these projects are still in their early stages, they could become significant; not least because they attract the backing of wealthy investors.

To understand what's going on, we should take a moment to think about the six-year-old technology behind Bitcoin. Cryptocurrencies are often described in popular culture and among Paul's Tea Party followers as "electronic money." But it's more accurate to think of them as financial ledgers -- a public record of how many bitcoins each user has in their bitcoin "wallet."

The ledger is mathematically signed to prevent unauthorized tampering. Owning a Bitcoin is like owning a password - it identifies you as the owner of a specific wallet, and the public ledger (or "blockchain") proves who owns the contents of the wallet. Trust in the system is established not by a third party (trust in official monetary systems is established by central banks as third parties, for example) but by a cryptographic system. This can make Bitcoin a store of value (although it has become a poor store of value recently; the price of Bitcoin has fallen by nearly half in the past 12 months.)

But this encrypted ledger can also be used to conduct financial transactions through blockchain technology, which has three significant features. First, blockchain can theoretically execute transactions instantly. Second, blockchain can also complete transactions anonymously. Third, transactions can be conducted without using third parties or paying fees to banks (or clearing houses). This is because the operating costs of expanding the Bitcoin system are borne by the anonymous owners of servers that connect computer code to obtain new bitcoins (a process known as "mining").

These features make Bitcoin attractive for retail transactions and money transfers, both legal and illegal. But in theory, they could be useful in financial markets. Bankers always say they are at the forefront of innovation, but many of the systems they use are extremely old. It often takes days and costs a lot of money to settle a loan or a derivatives trade. This makes the financial system in urgent need of disruption.

Some well-known people and institutions have already joined in. Last month, former JPMorgan banker Blythe Masters brought a company called Digital Asset Holdings into the public eye, which is developing a Bitcoin settlement system. Don Wilson, a well-known figure in the Chicago financial market, and Sunil Hirani, a derivatives and foreign exchange expert, also work for the company. In addition, JPMorgan has also applied for a patent for a technology that sounds similar to Bitcoin; other banks and financial companies are also applying for patents.

Whether these plans will succeed remains to be seen. One obstacle is the lack of clarity from regulators. Another is the stigma that Bitcoin has for sometimes being used by criminals. And then there’s the issue of anonymity. Digital Asset Holdings says it wants to give Bitcoin much-needed transparency. But that’s hard to do in a system run by anonymous computer experts unless the company itself becomes a third-party intermediary and charges fees, which would take away some of Bitcoin’s charm.

None of these issues deter Bitcoin enthusiasts; after all, they point out, most financial innovations seem unlikely to succeed at first. Credit derivatives, for example, seemed strange when Masters and others invented them 30 years ago.

So perhaps the real lesson for investors is that the focus of “innovation” is changing: In an environment of ultra-low interest rates, the idea of ​​creating financial products looks less exciting. Stuffy back-office technology is the new innovation frontier. Just think of it as another consequence of the weird post-crisis financial system, one in which money has become so warped that conventional assumptions are turned upside down, Paul’s supporters might say.