Monday, June 27, 2011

Bitcoin, Banking, and the New Gold Standard

Our future, totally hyperinflation-proof milli-bitcoin note.
Many Bitcoin enthusiasts and opponents alike seem to think that, since it permits secure electronic transfers to take place over the Internet with no middleman, Bitcoin somehow will make traditional banking obsolete.  This is a misapprehension.

Banks will still have a significant role to play in the future Bitcoin-based economy.  Sure, perhaps they will have greatly reduced revenue in one particular area:  Namely, fees from long-distance monetary transactions (wire transfers, etc.), but to some degree they have lost their dominance of that market already, due to Internet-based services such as Paypal and Liberty Reserve.  But, banks should still be able to make enough profit in other areas to run a healthy business.

Here are some important value-added services that banks, in a Bitcoin-based economy, can still provide.  These are services that they already provide closely analogous forms of today:


  1. Secure storage of Bitcoin reserves in a "vault" of heavily-encrypted wallets protected by multiple layers of physical and electronic security.

  2. Interest-earning demand deposit accounts.  (Where the interest paid out is earned by the bank's making loans based on those deposits.)

  3. Loans may by made crediting the debtor with a Bitcoin-denominated loan account, from which physical bank notes denominated in Bitcoins may be withdrawn, and transferred to other parties to make payments (just like with paper money today).  In a system free of central banks, each bank could set their own reserve requirement, and the market could decide which banks offer the best combination of interest rate (on deposit accounts), reserve requirements, and trustability.  Alternatively, nations that choose to maintain a central banking system could have a uniform system of paper money (like Federal Reserve Notes), except denominated in Bitcoins and backed by Bitcoins, so that the base money supply can never be inflated.

  4. Bitcoin-denominated checking accounts, with attached ATM/debit cards - these could work just like today's cards, except with transactions denominated in Bitcoins instead of dollars, and could be used to pay merchants who already have the infrastructure needed to accept such forms of payment (printed checks and plastic swipes).  The only difference is that the unit of denomination would be Bitcoins instead of dollars/euros.  Or, even better:  The dollar itself could be redefined to just be a synonym for, say, 0.00001 BTC - this would mean the total base supply of these "new dollars" would then be 2.1 trillion, about the right amount for a major base physical currency, and almost the same as the supply of physical US dollars today.
Thus, there is no reason that the mainstream banking system has to consider Bitcoin to be an enemy.  The only thing that is really fundamentally broken about the present banking system (and that Bitcoin fixes) is that the supply of base currency in dollars is not fixed, making the monetary system vulnerable to hyperinflation in times of crisis.  This cannot happen with Bitcoin, since their base supply is limited to never be more than 21 million.  The total money supply can still be inflated by a limited amount by fractional-reserve banking practices (by creating more nominal value in accounts than exists in base currency), but never by more than a factor of (say) 100x, if the reserve requirement is limited to no less than (say) 1%.

So, if everyone who holds physical dollars now (coins and bills) simply exchanges those base dollars for Bitcoins (at the fair equilibrium exchange rate, which will be somewhere in the neighborhood of $100,000 per Bitcoin), then everyone will end up with a proportional number of Bitcoins to the number of physical dollars they are holding now, and if the dollar is then just redefined to be 0.00001 BTC, then the entire existing banking system can continue to exist and operate pretty much unmodified, except that the dollar henceforth becomes forever immune to hyperinflation of its base supply, since the base supply of Bitcoins is fixed by the very nature of its peer-to-peer protocol.

In other words, the US government should simply declare that US dollar-valued bills (Federal Reserve Notes) are henceforth an inviolable promise, by the Fed, to pay the bearer 0.00001 BTC for each dollar's worth of nominal value.  This puts a "floor" under the value of the dollar, and prevents it from ever falling below that level (i.e., prevents the base supply of dollar-denominated bills from rising above $2.1 trillion).

Of course, choosing the US government and dollar for this example was merely arbitrary; any other country could do the same with its own sovereign currency, perhaps even enshrining the Bitcoin-backing of their currency in their constitution, and thereby forever stabilize their currency against any possible threat of hyperinflation.  Think about what this would do for confidence in that country's money!

Naturally, the first time some country (or set of countries) does this, the value of the Bitcoin will quickly rise to the equilibrium level determined by the target base money supply of the given currenc(y/ies), since whenever note-bearers demand an exchange for their central bank notes in base Bitcoins, the bank in question will have to buy enough Bitcoins to actually cover the note.

It will thus be a situation very similar to the old international gold standard; however, since Bitcoins can be much more easily transferred between parties, using them will make the execution of international settlements much more fluid than it was in the old gold-standard days.  Also, a country can easily prove how many Bitcoins it controls by making a transfer (since the Bitcoin transaction ledger is public).  In contrast, letting everyone weigh all the gold in Fort Knox would be far more problematic.

In other words, what I'm proposing here is nothing less than a new international standard as to how all of the world's liquid currencies should be fundamentally backed:  Not by gold, but by Bitcoins.  One could back Bitcoins in turn by gold, buy why would you?  Really, they are even safer than gold.  Unlimited amounts of new gold might someday be synthesized in advanced nuclear reactors, or produced by mining it from asteroids, but unlimited numbers of Bitcoins never can be produced - this is guaranteed by the system's design.  And, if and when any nation becomes nervous about the value of another nation's currency, they can settle this by demanding payment of the other nation's notes, in the form of the equivalent amount of Bitcoins, which can be easily transmitted over the network, no muss, no fuss.

In conclusion, rather than fighting Bitcoins, the world's banks and governments should come together and embrace them fully, as the proper universal new basis of all money, and thereby place the entire world economy on a much more secure, stable, and streamlined foundation than it has ever had before.

7 comments:

  1. I like bitcoin, I have bitcoins, and I appreciate your "embrace bitcoin" message.

    But there's a few things that make no sense in your article:

    You say:
    "if everyone who holds physical dollars now simply exchanges those base dollars for Bitcoins [...], then everyone will end up with a proportional number of Bitcoins to the number of physical dollars they are holding now"

    It is not clear what you mean by "exchange". If someone "exchanges" their USD for BTC, then they get bitcoins, but SOMEONE ELSE gets USD. Hence, not "everyone" will end up with bitcoins.

    The US government cannot simply declare that USD bill can be tied to a specific value of bitcoins, unless they are holding that amount of bitcoins (the BTC/USD rate multiplied by the number of USD in circulation). Just as when the dollar was backed by gold. There was a reserve of gold backing it up.

    Also, you can't tie the entire amount of USD to the entire amount of USD.
    I mean, are you aware that there are OTHER countries in the world? These countries don't use USD, and they can still exchange bitcoins for their local currency.

    You can't back bitcoins with gold. There's a known number of bitcoins and there will be a maximum number of them. Gold can still be found, and we're not sure how much of we have.

    Something (your article?) tells me you don't really understand how bitcoin works.

    ReplyDelete
  2. What about mining? If USD is tied to a specific value of BTC, they'll also have to ensure, that nobody takes over the network (>50%)....

    ReplyDelete
  3. >> "The US government cannot simply declare that USD bill can be tied to a specific value of bitcoins, unless they are holding that amount of bitcoins (the BTC/USD rate multiplied by the number of USD in circulation). Just as when the dollar was backed by gold. There was a reserve of gold backing it up."

    Well, then the US government had better get busy mining Bitcoins... :D

    Other countries could do the same. Their currencies would end up being worth different amounts depending on how many Bitcoins they had in reserve backing them up.

    ReplyDelete
  4. >> "What about mining? If USD is tied to a specific value of BTC, they'll also have to ensure, that nobody takes over the network (>50%)...."

    It would be a very good thing if governments had an incentive to help make sure that doesn't happen. They could use existing anti-trust statutes to forcibly break up any mining pools that grow too large, for example.

    ReplyDelete
  5. JulianG says:
    >> It is not clear what you mean by "exchange". If someone "exchanges" their USD for BTC, then they get bitcoins, but SOMEONE ELSE gets USD. Hence, not "everyone" will end up with bitcoins.

    True, but as more and more people exchange USD for BTC, the value of the USD will fall while the value of BTC rises. The end result is that all the nominal value that was formerly conferred upon USD will end up in BTCs instead.

    ReplyDelete
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