Recent headlines like: “Bitcoin Mania: Even Grandma Wants In on the Action” and “When Grandma and Grandpa Join the Frenzy, You Know Bitcoin Is Turning into a Bubble,” suggest that bitcoin has become part of the common man’s conversation. Recently, the value of bitcoin eclipsed $19,000 after starting the year just a tad below $1000. While the price appreciation of bitcoin has garnered the lion’s share of the public’s attention, the more important question is: how bitcoin and other cryptocurrencies along with the underlying technology are going to impact the way we pay, save and invest locally and globally?
What Problem Is Being Solved?
In the white paper, Satoshi Nakamoto, the creator of bitcoin, describes the need for an online currency or medium of exchange that does not require intermediation by a financial institution, network, or other third-party, i.e. no centralized authority overseeing each transaction. Furthermore, today, online transactions can be expensive and take days, especially for cross border transactions. Bitcoin and other cryptocurrencies are generally able to provide a faster, less costly alternative.
A key contribution of bitcoin is the underlying technology that eliminates third-party intermediation. In order to achieve unintermediated transactions, cryptocurrencies have to solve the double-spend problem. Because bitcoin and other cryptocurrencies are unintermediated, creators of cryptocurrencies must prevent users of their currency to spend the same value for more than one transaction. Bitcoin solves this problem by using cryptography and a community of miners that verifies each transaction and links it to all previous transactions through a blockchain and records it on a distributed ledger. These miners are rewarded for their efforts in bitcoin. Unlike fiat currency, bitcoins are only produced for this purpose.
Another advantage argued by the proponents of bitcoin is the cap of 21 million units unless there is a change to the protocol. Proponents of bitcoin argue that limiting the supply of bitcoin eliminates the inflationary tendencies of central banks. Other means to prevent inflationary tendencies include using another country’s currency, Pegging a country’s currency to another country’s, or joining a currency union such as the Eurozone. However, the inability to increase or decrease the money supply may result in large positive or negative changes to the price level as witnessed during the gold standard in the United States (see Paul Krugman and the FRED blog).
What Is Money?
Money has evolved over centuries. In the distant past, money took the form of commodities such as gold, silver, other precious metals, or even cattle. Money slowly evolved from the exchange of commodities to privately or publicly-issued currency generally backed by precious metals. Eventually, governments abandoned the backing of their currencies with commodities and created fiat currencies. Fiat currencies have no intrinsic value.
In addition to being a medium of exchange, money has two other key functions: store of value and unit of account. Money is used as a store of value for liquidity needs, i.e. to make future purchases, and for savings more broadly. Money’s unit of account role allows for comparison among different goods and services in the economy and often referred to as a numeraire. Today, bitcoin does not serve as a store of value or unit of account.
Can Cryptocurrencies Replace Fiat Currency?
Cryptocurrencies share certain key aspects of fiat currency: decentralized and anonymous payments. Physical currency transactions are decentralized because the underlying currency can be used without a centralized intermediary such as a financial institution or payment network. They are anonymous because the transactors and the nature of the transactions are not recorded.
Although the best known and largest by market cap, bitcoin is only one type of over 1300 different cryptocurrencies that exist. Today, bitcoin’s total market cap is $316 billion (at the time of publishing). For comparison, the total US currency outstanding is $1.59 trillion. In addition, bank liabilities that are used as money (as measured in M1 excluding currency) account for another $2 trillion. While the total bitcoin value in circulation may be small in comparison to the U.S. dollar, the reason why bitcoin continues to receive attention from policymakers, financial institutions, and businesses lies in its immense potential to dramatically change our financial system.
What lies at the heart of the disruptive nature of cryptocurrencies, is a new technology to make secure and anonymous payments with features of fiat currency in an online environment. However, there remain major challenges that need to be addressed before grandmas and grandpas would feel comfortable using bitcoin in their daily lives. Wilko Bolt and Maarten R.C. van Oordt develop an economic framework that attempts to disentangle a cryptocurrency’s payment function from its current speculative nature.
For any cryptocurrency to successfully compete with fiat currencies, it must achieve trust among transactors. More specifically, buyers must know that sellers will accept it for payment and sellers must know that they can use the cryptocurrency that they accepted for other types of transactions. Today, we are starting to see some acceptance of cryptocurrencies in different contexts such as cab fares in Rome, real estate transactions in Dubai, store purchases in Tokyo, purchases on Overstock.com, and charitable donations to universities.
However, in these cases, the cryptocurrency is often used as a vehicle for transactions where both the buyer and the seller quickly convert from the cryptocurrency to a fiat currency or a bank deposit to avoid fluctuations in the value of the cryptocurrency. To become a true substitute for fiat currency, users would hold the value in the cryptocurrency to make subsequent purchases. In other words, the cryptocurrency must become a store of value.
How Are the Incumbents Responding?
If cryptocurrencies are providing an online currency with similar characteristics to physical fiat currency, it is not surprising that some central banks are exploring digital currency issuance. Philip Lowe, Governor of the Reserve Bank of Australia, said: “It is possible that the RBA might, in time, issue a new form of digital money … perhaps using distributed ledger technology.” However, Lowe also brought up the caveat alluded to earlier that current excitement with cryptocurrencies “feels more like a speculative mania than it has to do with their use as an efficient and convenient form of electronic payment. For a broader discussion of central-bank issued cryptocurrencies, see Morten Bech and Rodney Garratt.
While we are at the beginning of the adoption and usage of cryptocurrencies, the incumbents are reacting to the fast-growing cryptocurrency market. First, governments and central banks are considering issuing their own cryptocurrencies suggesting that digital currency may be necessary for online and global commerce. Second, payment networks are offering bitcoin debit cards suggesting that existing payment providers recognize the benefits of cryptocurrencies. Third, the underlying technology that records bitcoin transactions, i.e. a blockchain recorded on a distributed ledger using cryptography, is being considered and used by financial intermediaries in other contexts. Whether bitcoin exists or not 20 years from now, its disruption will have benefits for decades to come.