Economics beyond financial intermediation: digital currencies' possibilities for growth, poverty alleviation, and international development.

Author:Ammous, Saifedean
Position::Report
 
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  1. Introduction

    At the beginning of the twenty-first century, the telecommunication revolution has improved virtually all aspects of modern economic life. Email has vastly increased the ability to communicate information across the world, compared with paper mail and the telegram. Websites like Amazon and eBay have given consumers an infinitely wider array of products and producers while allowing producers to extend their reach to large numbers of consumers. Global Positioning Satellite systems have made driving and navigation safer and easier. Various fields of industry and agriculture have benefited from the innovations that better communication and efficient production-chain management have produced. Search engines have made information accessible worldwide in a manner heretofore unimaginable. Many more global transformative innovations exist, yet there remains one field where business continues as it has for decades: finance and banking.

    As former chairman of the US Federal Reserve System Paul Volcker famously put it, the "single most important" innovation the financial industry has witnessed in the past twenty-five years is the automated teller machine (ATM), (1) adding: "I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth" (Hosking and Jagger 2009). While banks have produced various new financial instruments and methods of hedging risk and maximizing their profitability, the banking experience for the consumer has not changed much since the ATM allowed withdrawals outside of bank branch locations and bank operating hours. Transferring money continues to cost significant amounts of money and time for the majority of people. The most common method for nonpersonal payment today is still the credit card, which was invented in 1950, back when the vinyl record was the most prevalent method of listening to music recordings. (2) Since 1950, vinyl records have evolved to tape cartridges, four-tracks, compact cassettes, compact discs, and finally mass storage digital music players, while credit cards are still in use today, featuring glaring problems. Most notably, credit card payment is still initiated by the recipient, meaning the payer must disclose their sensitive information to the recipient and risk compromising it every time they want to make a payment.

    High payment transaction costs constitute a small problem for the populations of rich industrial nations, but they are an insurmountable obstacle for much of the world's poor, who do not present an attractive market for financial institutions and thus remain largely unbanked and unable to access financial services altogether. When they must use financial services for remittances, the fees they pay are exorbitantly high compared to the small amounts transferred.

    Banking has not improved the speed and cost of transactions because of a dual logistical-political problem. Any transaction not carried out with cash in person has to rely on third-party intermediation to prevent double spending--that is, to ensure that the payer has the funds and is not making other payments that exceed these funds. Two parties cannot perform a financial transaction between their accounts without the custodian of the payer's account verifying that the sender has sufficient funds to perform the transaction. With the political and economic importance of financial intermediation, this role has been regulated by governments, limiting entry and exit, and isolating intermediaries from true free-market competition that would weed out the inefficient and only allow the productive to survive. Capture of the regulatory agencies by the regulated parties has protected their rents by preventing market competition from more rapidly advancing the interests of the transacting parties. The result is that even as telecommunication technology has advanced, transaction costs have remained high, and modern financial innovation has not overcome this logistical and political obstacle.

    But this changed in 2008, when a pseudonymously published nine-page paper laid out the first workable design of a payment system technology that eliminates the need for trusted third-party intermediation: Bitcoin.

    This paper discusses Bitcoin and the impact it can have on economic development. Section 2 explains Bitcoin functionally, in terms of the technologies that constitute it, outlining four main functions: transfer of digital goods, the blockchain, the currency, and smart contracts. Section 3 outlines the main strengths and advantages of Bitcoin, while section 4 discusses other digital currencies and their importance and chances of success. This paper discusses bitcoin in particular, since bitcoin is by far the largest and most important digital currency, but the paper's main thrust concerns the actual technology of digital currencies. Section 5 provides a preliminary brainstorming of the impact that digital currencies can have on developing countries and on the world's poorest people, illustrating ways in which it can help the impoverished overcome the institutional drawbacks of their countries and participate in a growing global economy. II.

  2. What Is Bitcoin?

    Bitcoin is a network that allows for digital payment between its members without third-party intermediation. Payment is irreversible, initiated by the payer, and extremely fast and cheap. Transactions appear for the recipient immediately and can be sent for free; the average transaction confirmation time for the period from January 2012 through June 2015 was 8.32 minutes, while the average transaction fee was 0.000412 bitcoin, or $0.0753. (3) This paper takes a functional approach to the understanding of Bitcoin. Its features and constituent parts can be expressed in terms of four distinct technologies: a technology for the transfer of digital goods, a common asset ledger (the blockchain), a limited-supply currency, and a technology for implementing "smart contracts." This section explains the basics of all four technologies.

    1. Transfer of Digital "Goods"

      The groundbreaking innovation of Bitcoin is that it is the first technology for transferring digital "goods" from one network location to another. Since the inception of computer networks, it has been possible to send digital data and objects between computers, but such a "transfer" actually only sends a copy of the data to the recipient, maintaining another copy with the sender. In other words, it is a method of copying, not sending. By using public-key cryptography on a decentralized asset ledger, Bitcoin allows for goods to be stored on the public asset ledger and for their ownership to be restricted to the person who has the requisite public key.

      Before Bitcoin, all digital goods were nonrival and not scarce--they could be reproduced endlessly at virtually zero marginal cost and consumed simultaneously. For example, when an individual buys a song from a music website and stores it on her PC, she can then send it to other people while keeping a copy of it, and they could all listen to it at the same time. But the Bitcoin network allows the song's seller to ensure that it can be accessed by only one PC. Should the owner of that PC choose to transfer the song's key to someone else, she would immediately lose access to the song.

      Through the use of cryptography, Bitcoin brings the scarcity, rivalry, finality, and irreversibility of physical transactions to the digital realm. A digital song can now be treated just like a physical cassette or CD, a rival good that cannot be played on two machines at the same time. This is not just true for music files, but for all kinds of digital data, goods, programs, and, most significantly, currency. Before Bitcoin, any form of direct payment between two parties was unworkable, because there was no way to guarantee that the payer would reduce the currency balance in his account, or not use his balance for more than one payment. Any form of payment had to rely on a trusted third party that maintained a balance for the payer and payee and that checked the transaction against the payer's balance to ensure the balance was sufficient. The third party then debited the payer's account while crediting the payee's account. By offering the possibility of reliable irreversible transfers of digital goods that leave no trace with the sender, Bitcoin solves the double-spending problem and makes payment without trusted third-party intermediation possible.

      As such, Bitcoin is the world's first instance of digital cash, transferring the useful properties of paper cash to the digital realm. (4) Just like personal cash transactions, Bitcoin payments are irreversible and need no trusted third party intermediary. Unlike personal cash transactions, Bitcoin transactions are not restricted by space limitations; the transacting parties need not meet in the same place at the same time for the transaction to happen, since payment can be made instantaneously across the world to any device with an Internet connection. Instead of utilizing a trusted third-party intermediary, Bitcoin is based on cryptographic proof verified by the central processing unit (CPU) power of the total network. As such, Bitcoin can be understood as being to currency what email is to paper mail: an infinitely faster and cheaper digital shortcut for a physical-world activity that has been carried out for millennia.

      Bitcoin allows for the transfer of digital goods without intermediation by maintaining the full record of ownership and transactions in a transparent distributed asset ledger shared by all computers on the decentralized peer-to-peer network. This record is named the blockchain. The blockchain is not just a record of transactions; it can also be inscribed with text, data, and programming code, which can be made publically available or encrypted to restrict access.

    2. The Blockchain

      Technically, Bitcoin is an algorithm that records an ongoing chain of transactions between members...

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