Federal Reserve: "In A Dystopian World, Bitcoin Would Dominate Payment Methods"

Amid a relentless barrage of doom and gloom - and then some more doom for good measure - establishment forecasts about the future of cryptocurrencies, including everyone from Goldman, to the BIS, to the World Bank, all of which have been some iteration on how cryptos have no future, this morning an unexpectedly objective and somber view on the future of bitcoin came from none other than the organization that prints (out of thin air) the nemesis to bitcoin: the Federal Reserve.

While the emphasis of the Q&A with New York Fed economists Michael Lee and Antoine Martin, which we have republished below, is the issue of "trust" and how it defines monetary exchange, there are several things that attracted our attention. 

The first is the Fed's take on what we have been saying since 2015, and the reason behind bitcoin's original surge in 2015/2016, namely its use for illicit purposes:

The Drug Enforcement Administration reports a sharp decline in bulk cash smuggling in 2016, which is the traditional payment method for drug shipments and suggests that payments may have shifted toward cryptocurrencies. Cryptocurrencies are more convenient than cash for many illegal activities that now take place online.

... cryptocurrencies are ideal for circumventing legal or regulatory authorities, because they aren’t governed by any. China, which actively controls capital flow, banned banks from dealing with bitcoin in 2013 (this was relaxed later), because it was thought to be used for money laundering. North Korea is reportedly responsible for state-sponsored hacks to steal cryptocurrencies, which help bypass economic sanctions that are enforced through the cooperation of financial institutions and countries.

This - the ability to hide and store dramatic amount of wealth in a tiny space - is also the reason why according to Goldman cryptocurrencies are really cryptocommodities, as they are not backed by a monetary authority like the Fed. This what Goldman said earlier this week: "Unlike other storage commodities like oil, gold, platinum, diamonds, and even cash, there is no need to hold much physical material to own bitcoin; even a technology as obsolete as the 3½ inch floppy disk can hold almost 30,000 private keys. There is no theoretical upper limit to the value of bitcoins in a wallet, but if we assume each wallet secured by this disk contains as much as the largest wallet today (180,000 BTC), this single disk could “hold” all bitcoins in existence and remain less than 0.5% full. Assuming a bitcoin market cap of roughly $190bn (as of late January), this disk would be the equivalent to either: 95% of the 4,583 tons of gold in Fort Knox, or 1,344 Very Large Crude Carrier supertankers of oil."

Next follows an exchange that many opponents of bitcoin have been leery to engage in, namely why does cryptos have value if they aren't backed by anything. The Fed's response - the admission that the dollar is in the same boat thanks to Nixon - is needless to say , surprising.

Q. If virtual currencies aren't backed by anything real, gold or some other physical commodity, does that mean they all eventually will be worthless?

A. You're right that they are not backed by a physical commodity, but then neither is the dollar and most other modern currencies. It’s long been known that currencies that are intrinsically worthless, mere pieces of paper, are recognized as valuable because payments with money are so much easier than the alternative, barter. The problem with barter, when everyone trades goods and services directly, is the dreaded “double coincidence of wants.” If I want to have dinner at my favorite restaurant but the cook is not interested in trading a meal for a bitcoin lecture, I have to keeping searching until I find a restaurant that I like where, coincidentally, the cook can’t hear enough about bitcoin.

Money, even intrinsically worthless paper money, cuts the “double coincidence” problem in half. I just need to find someone willing to pay me some of that paper for my lecture, then use that paper to pay for dinner. As long as I trust that someone will accept the paper, I’m willing to accept it in exchange for my lecture. It’s trust that the “worthless” piece of paper is actually worth something to other people that makes it an acceptable medium of exchange.

As a result, the price of bitcoin fluctuates with news that vendors or firms accept or decline bitcoin as a mode of payment. Late last year, bitcoin prices jumped after Square, a payments firm, was reported to be testing bitcoin. Wider adoption and acceptance of cryptocurrencies as a payment option naturally increases what they are worth.

All those points are rather spot on, and usually are remiss from the defense arsenal of some of the even staunchest bitcoin advocates.

What was most interesting, however, was the Fed's observation under what conditions cryptos could not only match, but supplant fiat as the dominant currency. The answer: bitcoin would dominate payment methods in a dystopian world, in other words a "decentralized" world, in which there is no more faith - or trust - in central banks.

Which, of course, is the whole point behind cryptocurrencies in the first place: to replace the dollar, and other fiat currencies, once the entire fractional-reserve lending platform, and last 100 years of monetary philosophy are exposed to be a fraud.

"Lunacy" you say? Well, it's a conversation worth having after the next market crash, one which most likely will wipe out what little faith remains in central banks, in fractional reserve lending, in conventional economics and in fiat.

Incidentally, this is precisely what Deutsche Bank's chief credit strategist, Jim Reid, predicted would be the ultimate endgame: the extinction of fiat, and the return to hard, or alternative, currency.

Here is the Fed:

Q: So are cryptocurrencies the future of money?

Martin: It will ultimately depend on how well they compete with other, already established payment methods—cash, checks, debit and credit cards, PayPal, and others. Cryptocurrencies arguably solve the problem of making payments in a trustless environment, but it is not obvious that this is a problem that needs solving, at least in the United States and other advanced economies. And solving that problem creates others. One is scalability; the process of picking random validators takes time, is expensive, and consumes tremendous amounts of energy.

Another issue lately is extreme volatility in the value of cryptocurrencies which makes them less useful as currencies. This volatility is an inherent feature by design. Since there is no central bank that adjusts the supply of bitcoin to accommodate changes in demand, bitcoin's value can swing sharply with demand. In a world where all things were priced in bitcoin, this would likely translate into massive swings in inflation and economic activity. In contrast, providing an “elastic” currency to promote financial and price stability is a goal shared by the Federal Reserve System, the European Central Bank, the Bank of Japan, and many other central banks.

The trust-proofing provided by cryptocurrencies also comes at the expense of another key feature of a payment method: convenience. If we lived in a dystopian world without trust, bitcoin might dominate existing payment methods. But in this world, where people do tend to trust financial institutions to handle payments and central banks to maintain the value of money it seems unlikely that bitcoin could ever be as convenient as existing payment means.

That said, bitcoin and other cryptocurrencies are trying to improve scalability and convenience so perhaps in the future one of these cryptocurrencies could realistically compete with current payment methods. But, fundamentally, we wonder whether a payment method designed to function where trust in institutions is completely absent can ever be as convenient as one where trust is required, but also already exists.

The punchline, again:

If we lived in a dystopian world without trust, bitcoin might dominate existing payment methods. But in this world, where people do tend to trust financial institutions to handle payments and central banks to maintain the value of money it seems unlikely that bitcoin could ever be as convenient as existing payment means.

Which begs the question: what happens when the "trust" dies? The answer, of course, is the very existence of cryptos: to create a world in which not one network is reliant on "trust" and the presence of a master node.

Here the Fed truly hits it on the head: in an environment of "trust" fiat is perfectly viable. It is what happens after, when the trust ends - in financial institutions, in central and commercial banks, in contract relationships - whether the result of a global monetary collapse, a systemic market crash, or something else, that will see the replacement of fiat with cryptocurrencies.

Full note below (link)

Bitcoin and other “cryptocurrencies” have been much in the news lately, in part because of their wild gyrations in value. Michael Lee and Antoine Martin, economists in the New York Fed’s Money and Payment Studies function, have been following cryptocurrencies and agreed to answer some questions about digital money.

Q: Let’s start simply. What even is cryptocurrency?

Martin: Cryptocurrencies are digital, or virtual, money. Bitcoin, which was created in 2009, is the first and probably the best known cryptocurrency, but many others have followed, such as Ethereum, Ripple, Bitcoin Cash, Litecoin, etc.

Q: Do they have utility that other forms of money lack?

Lee: Like any functioning form of currency, cryptocurrencies facilitate payments between parties and provide a store of value. What’s special about them is that they can serve those roles even in environments where trust—or lack of trust—is a problem.

Trust is implicit for practically any means of payment. Say I need to buy groceries. If I pay with a personal check, the grocer has to trust that the check isn’t “hot” (that I own the account and it has sufficient funds). Common payment methods, like debit or credit cards, also entail a surprising degree of trust. The grocer and I have to trust the banks that connect us when I swipe, trust the payment system or “plumbing,” whereby funds flow from my account to the grocers.

Some of these problems go away with cash because when I hand cash to the grocer, there is no need for trusted intermediaries. But if you think about it, even cash requires some trust. The grocer has to believe that the cash I pay with will retain its value and not be eroded by inflation or confiscatory monetary reforms. So she needs to trust the central bank.

Q: Have cryptocurrencies made progress toward solving the problem of mistrust?

Martin: One important element in any payment system is “validation,” determining which transactions can proceed through the system and which should be refused as invalid. For example, a validator could check if there are sufficient funds in the account of the person who wants to make a payment. If there is, the payment will go through. But if there isn’t, the payment will be refused. If you recall the last time you swiped your credit or debit card, the few seconds you had to wait was that validation. But if the merchant doesn’t trust the validator, and doubts she will ultimately be paid, she’s unlikely to accept your card.

With bitcoin there isn’t one designated validator. Instead, everybody in the bitcoin network could be picked, essentially at random, to validate recent transactions. The details are a bit technical and more details can be found in a recent St. Louis Fed paper on cryptocurrencies.

Q: Aren’t cryptocurrencies sometimes associated with illicit activities?

Lee: Definitely, and this is likely related to trust also. Criminals, who typically use cash for the anonymity and security it provides, may be moving to cryptocurrencies. The Drug Enforcement Administration reports a sharp decline in bulk cash smuggling in 2016, which is the traditional payment method for drug shipments and suggests that payments may have shifted toward cryptocurrencies. Cryptocurrencies are more convenient than cash for many illegal activities that now take place online. In 2013, following a government crackdown on Silk Road—an online marketplace that was used to trade illegal goods—bitcoin prices plunged. And for good reason too.

More broadly, cryptocurrencies are ideal for circumventing legal or regulatory authorities, because they aren’t governed by any. China, which actively controls capital flow, banned banks from dealing with bitcoin in 2013 (this was relaxed later), because it was thought to be used for money laundering. North Korea is reportedly responsible for state-sponsored hacks to steal cryptocurrencies, which help bypass economic sanctions that are enforced through the cooperation of financial institutions and countries.

Earlier, we talked about how a currency requires people to trust in its value. When Greece fell deeper into financial distress in 2015, Greek interests and trading in bitcoin rose quickly amidst fears of capital controls and the possibility of exiting the eurozone. Bitcoin became attractive as trust eroded.

Q: If virtual currencies aren't backed by anything real, gold or some other physical commodity, does that mean they all eventually will be worthless?

Lee: You're right that they are not backed by a physical commodity, but then neither is the dollar and most other modern currencies. It’s long been known that currencies that are intrinsically worthless, mere pieces of paper, are recognized as valuable because payments with money are so much easier than the alternative, barter. The problem with barter, when everyone trades goods and services directly, is the dreaded “double coincidence of wants.” If I want to have dinner at my favorite restaurant but the cook is not interested in trading a meal for a bitcoin lecture, I have to keeping searching until I find a restaurant that I like where, coincidentally, the cook can’t hear enough about bitcoin.

Money, even intrinsically worthless paper money, cuts the “double coincidence” problem in half. I just need to find someone willing to pay me some of that paper for my lecture, then use that paper to pay for dinner. As long as I trust that someone will accept the paper, I’m willing to accept it in exchange for my lecture. It’s trust that the “worthless” piece of paper is actually worth something to other people that makes it an acceptable medium of exchange.

As a result, the price of bitcoin fluctuates with news that vendors or firms accept or decline bitcoin as a mode of payment. Late last year, bitcoin prices jumped after Square, a payments firm, was reported to be testing bitcoin. Wider adoption and acceptance of cryptocurrencies as a payment option naturally increases what they are worth.

Q: So are cryptocurrencies the future of money?

Martin: It will ultimately depend on how well they compete with other, already established payment methods—cash, checks, debit and credit cards, PayPal, and others. Cryptocurrencies arguably solve the problem of making payments in a trustless environment, but it is not obvious that this is a problem that needs solving, at least in the United States and other advanced economies. And solving that problem creates others. One is scalability; the process of picking random validators takes time, is expensive, and consumes tremendous amounts of energy.

Another issue lately is extreme volatility in the value of cryptocurrencies which makes them less useful as currencies. This volatility is an inherent feature by design. Since there is no central bank that adjusts the supply of bitcoin to accommodate changes in demand, bitcoin's value can swing sharply with demand. In a world where all things were priced in bitcoin, this would likely translate into massive swings in inflation and economic activity. In contrast, providing an “elastic” currency to promote financial and price stability is a goal shared by the Federal Reserve System, the European Central Bank, the Bank of Japan, and many other central banks.

The trust-proofing provided by cryptocurrencies also comes at the expense of another key feature of a payment method: convenience. If we lived in a dystopian world without trust, bitcoin might dominate existing payment methods. But in this world, where people do tend to trust financial institutions to handle payments and central banks to maintain the value of money it seems unlikely that bitcoin could ever be as convenient as existing payment means.

That said, bitcoin and other cryptocurrencies are trying to improve scalability and convenience so perhaps in the future one of these cryptocurrencies could realistically compete with current payment methods. But, fundamentally, we wonder whether a payment method designed to function where trust in institutions is completely absent can ever be as convenient as one where trust is required, but also already exists.