On Friday, I did a Third Way panel on bitcoins with Jerry Brito of Coin Center, a think tank dedicated to all things bitcoin. I was the appointed skeptic, thanks to my earlier writings on digital currency.
It was a productive event, and I thought it would be worth writing about my skepticism and the hurdles I see for the bitcoins’ development. To explain that, though, I need to talk about what bitcoins are. The fact is there is no singular “what” — and therein lies both their strength and their weakness, and also much of the confusion about the digital currency’s future.
Here’s one way to think about bitcoins: Imagine that Western Union ran the money supply — and no one ran Western Union. Bitcoin is trying to be both a form of money and a system of accounting for payments made in that currency. Its major innovation is doing this in a distributed, peer-to-peer fashion, rather than relying on a central authority to create the money or maintain the transaction ledger.
Sophisticated bitcoin analysts and investors seem interested mostly in Bitcoin as a payment system, which they hope will lower transaction costs significantly. They are less interested in it as a form of money.
On the other hand, much of the enthusiasm about bitcoins seems to come from people who want them as a way to get rich or pay for things — in other words, people who think of bitcoins primarily in terms of money.
That matters, because the things we look for in a payment system and the things we look for in money are pretty different.
We want a payment system to be reliable — if I use it to pay you $400, it should cost me only $400, and you should be sure of getting the money. We’d like it to be fast, and we’d like it to be ubiquitous.
We want money to be a store of value and a medium of exchange. We want to give it to people and get something of value back, and we want to be able to save it.
These things are not absolute qualities that are either on or off like a light switch; they are a spectrum, and they are not necessarily tied to each other. For example, the great money stones of the Yap Islanders are an excellent store of value — a giant stone is hard to steal or destroy. But you’d get awfully tired trying to drag one of these things around the mall.
Or consider prison currencies, such as cans of mackerel, preferred because, ironically, no one wants to eat the mackerel, which makes it a good store of value. And within the prison, it is also a decent medium of exchange — it is possible to price other goods in terms of mackerel. On the other hand, as soon as you leave prison, your can is worth a buck fifty, and you’ll have a hard time finding someone who will trade you cigarettes and magazines for your fish.
In other words, payment networks and money have at least one thing in common: the bigger the network, the more valuable they are.
That ought to be a good starting point for growth in the bitcoin ecosystem. But I think there is a danger here: If most of the network growth is driven by people who think of bitcoins as money, then a change in that sentiment could cause the network to shrink — at which point it undermines the strength of the payment system.
If bitcoins are ubiquitous, it’s easy to piggyback a payment system on it. If people lose interest in bitcoins, however, all sorts of problems crop up. The currency will become illiquid.
Liquidity is just a way of saying “how easy is it for me to trade this for something else?” A dollar is super-liquid; you can use it here or abroad. But a multimillion-dollar Manhattan apartment, while a good store of value, will take some time to unload — and is less liquid.
Like “store of value” or “medium of exchange,” “liquidity” is not a fixed quantity. Some markets are very liquid, and then stop being so, as we all found out during the financial crisis.
This matters with bitcoins because someone has to hold that liquidity risk.
Imagine a system in which we’re mostly using bitcoins to do lightning-fast currency transactions: I go to Mexico and use an ATM service that buys bitcoins with the dollars in my U.S.-based bank account, then immediately turns the dollars into pesos and gives me the cash. Who is buying those bitcoins from me? Someone needs to be making a market in all these other currencies so the system has enough liquidity for me to use it seamlessly wherever I go.
One way that could happen is if many people are using bitcoins, so lots of them want to buy bitcoins with pesos and sell them for dollars at any given time. Another way to accomplish the same thing is to have an intermediary who holds all those bitcoins and sells them for dollars while buying them for pesos. Someone always has to be at the other end of every transaction.
This is what financial institutions do with lots of asset classes, including currencies, so you can buy or sell even if there doesn’t happen to be anyone on the other side who wants to do that trade at the moment. We could have institutions do that for bitcoins.
But a few points are worth pointing out. First, most currencies are pretty liquid, so they’re not permanently holding onto that cash — they’re just making sure you can buy what you need at 10:47 this morning, even if no one comes along who wants to sell that much cash until 3:17 this afternoon. Making a market in an illiquid market is a very different, and considerably more expensive, business. Which is the second thing we should point out: The folks who make the markets generally want to get paid for their trouble.
We can imagine a situation in which institutions basically just held all the bitcoins and used them to make transactions. But they’d first have to get the cash to buy the bitcoins – – and then they would charge you a nice fee for making them hold a big, illiquid asset. Illiquid assets are hard to not only sell but to price. Those sorts of markets are vulnerable to big price swings, not because anything has changed about the underlying asset but because people get forced to sell, or buy, at a moment when no one on the other side is interested in trading at the “fair” price. That means they have to offer a big discount to sell or pay a big premium to buy. And since any such institutions would also effectively be in the currency-trading business, they’d also be assuming the risks of holding all the other currencies that people want to change their bitcoins into.
If my perception is correct that most people now holding bitcoins are doing so because they view them as a speculative financial asset — or a substitute for a credit card, or a way to evade government surveillance of their transactions — rather than a way to make payment accounting cheaper, then liquidity will dry up when they figure out the drawbacks of those uses. Absent liquidity, transaction fees will rise to compensate the market makers and the people who maintain the block chain (the public ledger of all transactions). Then it might not be cheaper or more convenient than existing payment systems.
In at least one scenario, a collapse in bitcoins’ monetary value could actually help: Institutions could buy them up, then use them as a sort of low- cost back-end system. But for this to happen, everyone now holding bitcoins must lose a lot of money as the value of their holdings plunges close to zero. This creates problems on the ledger side of the transaction, because maintaining the ledger requires considerable computer resources. Currently, people are paid for that computer processing in two ways: First, “miners,” whose efforts maintain the block chain, are periodically rewarded with new bitcoins; second, very small transaction fees are offered to process transfers. If the value of bitcoins falls, however, these rewards may prove inadequate, meaning that some new way will have to be found to finance this activity.
There are other risks too: that bitcoins will become more embedded in criminal networks and governments will shut the system down; that theft will become too widespread as ordinary, less security-savvy users adopt it; that governments will regulate bitcoin transactions, adding costs until they’re not much cheaper than what we already have.
The primary risk is simply that bitcoins’ allure will wear off. When it does, bitcoin will stop working very well.
Probably at least some enduring uses will be found for its rather neat technology. But I’m skeptical of the idea of bitcoins as a ubiquitous substitute for credit cards or dollars. It’s far more likely that in the future, however many people are using bitcoin-derived technologies, no one outside of a few technologists, and some disappointed investors will even know their name.