Bitcoin and the future of digital payments.

Author:Luther, William J.

Following the publication of a white paper by Satoshi Nakamoto in 2008, bitcoin was quietly introduced to the world in 2009 as not much more than an obscure piece of code. For more than a year after its introduction, each bitcoin in circulation traded for pennies as a community of coders made minor modifications and refinements to the open-source client at the system's core. Its value climbed to roughly $1.00 by February 2011 and then to nearly $30 four months later before settling down to an average of just $8.16 from July 2011 to February 2012. After that, demand began to increase. First gradually. Then suddenly.

In mid-2015, one bitcoin exchanged for roughly $290. It is accepted by a wide variety of businesses around the world, from major online retailers to food trucks. An entire cottage industry has emerged to help individuals buy, sell, store, transfer, and track the price of bitcoin. It is routinely the subject of major media coverage. And everyone with even a passing interest in bitcoin seems to have one question in mind: Will it survive?

Opinions regarding the future of bitcoin are mixed. Jennifer Shasky Calvery, the director of the Financial Crimes Enforcement Network, suggests bitcoin could become "a significant player in the financial system" (2013). Others express optimism regarding the underlying blockchain technology but reserve judgment on bitcoin in particular. Nassim Taleb, for example, believes "[b]itcoin is the beginning of something great: a currency without a government, something necessary and imperative." However, he remains unsure "whether [bitcoin] is the best potential setup" and recognizes that it takes "a long time to establish confidence" in a new payment system (2013). Still others see little hope for bitcoin. Although Paul Krugman acknowledges that bitcoin solves "an interesting information problem," he doubts "whether solving that problem has any economic value" (2014).

In this essay, I consider the factors affecting the likelihood that bitcoin will continue to facilitate exchange in the future. First, I discuss the obstacles to bitcoin from incumbent monies and alt-coins. Then I offer my view on the future of bitcoin and digital payments.

Bitcoin and the Incumbent-Monies Problem

The biggest obstacle to the widespread adoption of bitcoin is the incumbent-monies problem. Virtually everyone in the world is already using money. Therefore, the decision to use bitcoin is, at least on the margin, the decision to stop using an incumbent money. The problem: switching costs and network effects favor the status quo (Luther forthcoming).

Switching costs refer to any cost required to transition from the incumbent money to bitcoin. They include the need to retool vending and automatic teller machines; to update menus and transaction records; and even to learn to think and calculate in terms of a new unit of account. If bitcoin is to have any hope of replacing an incumbent money, it must be sufficiently better to warrant the cost of switching. (1)

Network effects result when the value of a good or service depends on the total number of those using it. Monies are characterized by network effects because a medium of exchange is useful only to the extent that one's trading partners are willing to accept it. Moreover, when one is choosing between multiple monies (or would-be monies), historical acceptance might act as a particularly salient focal point for coordinating on the incumbent money (Luther and White 2011; Luther forthcoming). Hence, even if bitcoin warrants the costs of switching, it must also be sufficiently better than an incumbent money (net of switching costs) to warrant the costs of coordination. (2)

The incumbent-monies problem is exacerbated by the fact that virtually all incumbent monies employed at present are government sponsored. These monies typically benefit from some form of legal-tender status and public receivability (i.e., the government accepts taxes in and makes payments with the incumbent money). By providing a lower bound on the network size of the incumbent money, legal-tender status and public receivability make it more difficult to overcome the network-effects problem. (3)

Government-sponsored incumbent monies also permit the issuer to conduct monetary policy, generate seigniorage revenue...

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