Cryptocurrency and the problem of intermediation.

• Author: Harwick, Cameron
• Position: Essay

The rise of cryptocurrency in the past decade is more than simply a technological feat; it is a real-world incarnation of a monetary system with numerous features that have existed to date only as thought experiments. As with any unprecedented innovation, bold claims are made for it. The boldest, perhaps, is the claim that cryptocurrency in general or Bitcoin in particular can or will supplant the current international regime of central-bank-issued monies.

The claim has some plausibility. Distributed technologies such as Uber and Airbnb are already rendering obsolete many established regulatory regimes, much to consumers' benefit. Because cryptocurrencies lack a central issuer, the hope is that they, too, will be able to grow outside of established regulatory structures until they become too big to ignore. Of course, the challenger faces a number of daunting hurdles before this goal becomes feasible. Existing regulatory structures are not totally avoidable. Bitcoin, in addition to the opposition it faces and will continue to face from established interests, also must overcome a number of technical and economic hurdles.

Bitcoin's purchasing-power volatility, on the order of history's most severe episodes of hyperinflation, is emblematic of these latter hurdles. In contrast to the narrow focus on stabilization that has characterized much of the literature thus far, this paper considers the institutional prerequisites of purchasing-power stability, economic efficiency, and sustained economic growth-namely, a market for financial intermediation. It is such a market that cryptocurrency entrepreneurs will find most difficult to operate outside existing regulatory regimes.

After a brief introduction to the mechanism of cryptocurrency, this paper compares its development over the past several years to the development of fractional-reserve banking under a regime of gold redeemability. From there, drawing on the historical experience of gold, it explores the technical, legal, and economic hurdles that cryptocurrencies face in the future, focusing on the unique problems of financial intermediation in these currencies. Although cryptocurrencies have already established a niche for themselves as media of exchange, these hurdles will need to be overcome before cryptocurrencies can be competitive with-much less supplant-central-bank issues.

Finally, the paper evaluates some schemes to stabilize purchasing power by automatically adjusting the quantity of coins and concludes that the future progress of Bitcoin-and of cryptocurrency more generally-depends not only on the achievement of a more or less stable purchasing power, but also on the establishment of financial intermediaries whose cryptocurrency-denominated liabilities circulate as media of exchange. Although stability is certainly necessary to support a modern industrial economy, it is hardly sufficient: to achieve demand elasticity for a currency outside of a market of financial intermediaries is no foundation for economic growth and efficiency. Without such a market, Bitcoin remains in a sense "dependent" on other currencies such as the dollar.

What Is Cryptocurrency?

A cryptocurrency is a method of constituting virtual "coins" and providing for their secure ownership and transaction using a cryptographic problem. This problem is designed to be easy to verify but computationally difficult to arrive at a solution. Various cryptocurrencies use different functions for this purpose, the most common being a hash target, by which hashes are calculated so as to come in lower than a certain value. (1) The hash target (i.e., the difficulty of the problem) is adjusted every so often based on the total computing power on the network, which has the advantage of keeping the time between solutions more or less constant. Other protocols, such as Primecoin, provide for the problem by the calculation of large prime numbers. In theory, any hard-to-calculate but easy-to-verify function with easily adjustable difficulty would do.

This computationally intensive "proof of work" is the method by which transactions are verified as unique and trustworthy. To incentivize participation, transactors can include a transaction fee that goes to the first user to successfully verify it. This fee is optional in Bitcoin but mandatory in some others.

In addition, the network rewards verifiers with a certain number of coins after they have successfully verified a block of transactions. This process, called "mining," is the means by which the supply of coins on a network is expanded, and the adjustable difficulty ensures that computing advances will not affect the rate of expansion. As might be expected, the marginal cost of mining (mainly electricity) tends to equilibrate to the marginal benefit. (2) In Bitcoin's case, the reward for mining halves every 210,000 blocks verified, leading to a supply path over time with a positive first derivative that diminishes discontinuously to zero. ' A great variety of supply schemes have been implemented by alternative cryptocurrencies, some of which are discussed in subsequent sections.

A coin itself is constituted by its transaction history on the network, going back to the block from which it was mined. Each input into a transaction points to the output of a previous transaction. This history is kept track of by every computer on the network in a continuously updating record called the "blockchain"--literally a chain of transaction blocks to which newly verified blocks are added. Because transaction records are public, anonymity is maintained only by keeping the account owners private. If titere are competing blockchains among different users-for example, if two transactions are received in a different order by different users or if someone attempts to forge a transaction-the protocol defines rules by which only one is accepted. This method is quite secure, the more so as the protocol gains wider currency. Bitcoin and its close relatives will prefer the longest blockchain--that is, the one with the most computing power behind it. Thus, to forge a transaction, an attacker would have to make sure that his own blockchain was longer than the legitimate one, requiring him to have at his disposal more computing power than the total of the honest nodes. (4)

Here we may briefly put to rest several recurring fears surrounding cryptocurrencies. First, the proliferation of copycat currencies (altcoins) cannot be inflationary unless any protocol is a perfect substitute for any other. (5) Whether they are substitutable in some technical sense or not, entrenched network benefits mean that copycat protocols will not displace or rival existing protocols without clear feature advantages. Where physical notes from one bank or another may fit equally well in a wallet (and both of which might even be dollars), holding multiple cryptocurrencies involves the technical inconvenience of operating on multiple disjunct protocols, plus the additional calculational inconvenience that the currencies float against one another in value. (6)

Second, though the protocol is indeed defined arbitrarily in software, it cannot be changed arbitrarily once created. Once a protocol comes into use, the control of its constitution depends entirely on continued trust in the developers. Each user must be persuaded to upgrade. Thus, contra Reuben Grinberg, the fact that "most users would use [a] new version of the software because of their trust in the development team" does not make the development team "the de facto central bank of Bitcoin" (2012, 175-76 n. 71). "Bank of issue," in fact, would be a broader category (private, noncentral banks have also issued currency throughout history), a safer claim, and still wrong. The power of a bank of issue consists in its ability to issue new currency indistinguishable from (or in the case of a central bank with the same legal-tender status as) the old and hence to gather seigniorage. The Bitcoin development team has no such power. (7) Given the precedent of open-source cryptocurrency protocols, trust in the developers is reasonably attributed to their continuing trust worthiness: a malicious update will be easily spotted and ignored.

The Moneyness of Cryptocurrency

What makes cryptocurrency money? Ludwig von Mises's regression theorem (1996, 408-10) explaining the emergence of money, by which a particular commodity gradually overcomes network hurdles and becomes accepted as money by virtue of its increasing liquidity, has lately been taken by some armchair Austrians to imply that cryptocurrency cannot be money because it has never been accepted as something useful of its own account. This is a curious argument, considering that Mises saw money as a category of human action. In other words, something is money when people use it as money-that is, as a medium of indirect exchange. In this sense, cryptocurrency clearly qualifies as money. The regression theorem begins with the fact of a money and reconstructs the history by which it became such. It cannot be used in the other direction, starting with the observed history of a commodity and passing judgment on its moneyness.

If the theorem is interpreted strictly so as to demand some nonmonetary starting point to give it its original positive value, we could say that Bitcoin's innovativeness or antiauthoritarian ethos was a consumption good for its initial adopters (Lawrence White [2014] calls this "affinity demand"). It would be less of a stretch, however, to say that nonmonetary (industrial) use is a possible (and so far the most historically significant) starting point, but not the only conceivable one. It would be foolish to try to enumerate an exhaustive list of the ways a commodity, even an inconvertible one, might initially gain wide enough acceptance to function as money. History, in this case, rules out an interpretation that denies to cryptocurrencies the possibility of being money.

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