Bitcoin and the money supply

Bitcoin’s future as an alternative currency is generating heated debate and in-depth analysis of its potential effect on the money supply. Just in the past week, the Bank for International Settlements (owned by the world’s central banks) and a senior official from the Central Bank of Canada have both issued public statements on the potential impact. Just over a month ago, the Bank of England did the same. The attention that this is getting is good for headlines, perhaps, and no doubt makes for interesting intellectual debate. The debate may be intellectual, but it is also hypothetical, beside the point, and not particularly helpful, for three main reasons.

by Levi Morsy for Unsplash
by Levi Morsy for Unsplash

First, we lost control of the money supply years ago, when we left the gold standard. Central banks can in theory expand and contract national money supply by printing money, buying securities, tweaking banking regulations, etc. More money means lower interest rates, less money means that interest rates go up, and that is how central banks hope to influence economic growth. Yet they have much less control over the result than we generally believe. The actual amount of money in circulation is actually up to the banks, individual users, foreign investors and a long list of players each of whom has a different agenda.

Since so much of the money that we spend and save doesn’t even have physical form any more, it’s even harder to count, let alone control. Even the Federal Reserve itself admits that “over recent decades… the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time.” And that’s just the US figures. Trying to get a feeling for the global money supply is a challenge, to say the least.

So, if we don’t know what the money supply is, how are earth are we going to know to what extent Bitcoin affects the final amount? And if the “official” money supply figures are not important anyway, as the Fed itself admits, what does it matter?

Second, a further layer to the irrelevance of this debate is that, while Bitcoin in many ways is a superior currency to the current fiat options, it won’t replace the dollar, the Euro, the Yuan or any other well-established local currency. Bitcoin is an ideal complement to local currencies, and is much better at trans-border payments and transfers. But the physical, practical, psychological and even emotional hurdles that need to be overcome before a culture relinquishes the comfort of the familiar and the convenience of the physical, outweigh the advantages of insisting on a blanket, society-wide adoption.

As Bitcoin takes over the international payments space, which is where its advantages really shine, it may end up surpassing major local currencies in terms of transaction volume, especially as trade becomes ever more international. But realistically, that won’t happen for many years yet. And even if (= when) it does, it won’t imply the elimination of other forms of payment. We will not end up with a bitcoin-dominated world.

Although it’s virtually impossible to have a reasonable idea of the global money supply, one figure that I saw earlier this year put the total at $43 trillion. The market capitalization of Bitcoin currently stands at under $5 billion. About 0.01%. Even when all the latent bitcoins have been mined and the supply stands at its potential maximum of 21 million, at current prices the Bitcoin market capitalization will only be $7.6 billion. Still not nearly enough to make a difference. Even if the price shot up (or gradually increased, if you prefer) to $1,000, and the world money supply stayed more or less the same, the total Bitcoin supply would still be less than 0.05% of the world money supply. In the year 2140. I don’t really see why central banks would tremble at that.

And third, this type of headline, while interesting, does little other than stoke the fear of this unknown financial concept that is going to bring about more change than we are comfortable with. I’m sure that if you asked a room full of anyone, even bankers who are supposed to understand the nuances, if they would like to see central banks lose control of the money supply, most would say no (even though, as I pointed out earlier, they don’t really have control of it anyway). No, we don’t want central banks to lose control of the economy. No, we don’t want Bitcoin to make our economy even more unstable.

And the headlines are actually misleading. In all three examples cited in the first paragraph (and there are many more), the word “unlikely” was prominently used. What the Senior Deputy Governor of the Central Bank of Canada actually said was: “In the unlikely situation in which cryptocurrencies were used broadly, a significant proportion of economic transactions would not be denominated in Canadian dollars.” We need to give more emphasis to the word unlikely. And we need to think about what level of “significant” is needed to wrest influence from the Central Bank. And with that we will realise that the Central Bank of Canada, the US, Europe and many other economic powers will most probably encounter greater dangers to their hegemony than Bitcoin. Which does not mean, of course, that Bitcoin won’t end up being powerful.

Bitcoin and terrorism

This is a risky thing to write about, as so many people tragically died in the Paris attacks, and no amount or sequence of words on the subject can hope to convey how so very sad and unfair that is.

But, while technology obviously facilitated the coordination of the atrocity, and electronic payment rails probably helped move the money that financed it, it is important to point out that technology is not the culprit. Yet that doesn’t stop the gleeful finger pointing and the vindicated headlines proclaiming that Bitcoin’s days are numbered because it obviously finances terrorists.

Quartz last Thursday brandished the provocative headline, “The Paris attacks look to be altering the EU’s stance on bitcoin”:

quartz bitcoin

The Telegraph newspaper declared that “Europe plans crackdown on Bitcoin after Paris attacks”, Business Insider claimed that “Europe is going to clamp down on Bitcoin to try to stop terrorism funding”, and the International Business Times UK ran with a SEO-friendly “Paris attacks: EU to crack down on bitcoin transfers in attempt to strangle Isis funding”. The Washington Times seems to have had the most fun with “EU look [sic] to ban Bitcoin after Paris attacks”. Apparently Reuters had reported that EU Interior and Justice ministers were going to propose a crackdown on cryptocurrencies and the anonymous use of pre-paid cards, to prevent those channels from being used for terrorist funding. Now, I confess that I haven’t seen the draft document, but surely it’s a leap to go from “propose a crackdown” (whatever that means) to “banned”?

The sparse excerpt given of the memo in the Reuters report recommends that the European Commission “strengthen controls of non-banking payment methods such as electronic/anonymous payments and virtual currencies and transfers of gold, precious metals, by pre-paid cards.” Again, I’m not sure why “strengthen controls” is interpreted to mean “clamp down”, other than to produce a catchier headline. A strengthening of controls would, in my opinion, have happened anyway, as virtual currencies become an increasing part of the financial fabric. A better anti-money laundering policy is, I think we can all agree, a good idea, unless the regulation stifles the application of innovation for social good.

Extreme reactions from politicians and the media are totally understandable in extreme circumstances. But realistically, even if a Bitcoin “clamp down” is recommended, is this really going to stop terrorist funding? No, probably not, and the setback to economic progress is likely to be material. Another victory for the terrorists?

And for the record, just last month the UK government published a national risk assessment, which concluded that the most likely vulnerability when it comes to money laundering and terrorist financing is… traditional banks. The least likely? Digital currencies.

UK govt national risk assessment

As an aside (although it’s not really an aside), I get thoroughly annoyed when the press touts Bitcoin’s anonymity as a threat. First of all, Bitcoin is not anonymous. It is pseudonymous, and it is usually possible, with careful forensics, to detect where a payment originated. After all, the history of every single bitcoin in existence is on the public ledger for all to see. It is possible to enhance Bitcoin’s anonymity, but it requires some manipulation, and even then, is not totally undetectable.

And if you want to claim that anonymity is bad, we should look at doing away with cash, don’t you think? Of course I’m not being serious (although maybe not totally, we can debate this another time), my point is that anonymity in finance is something that we have dealt with ever since money was invented. A dollar, or a piece of gold, or a shell, does not care who holds it. The current backlash over the power of encryption falls on the same weak argument – that terrorists and criminals use encrypted communications to plan and plot, so obviously it should be banned – without taking into account the good that encryption can do. Governments and dissidents can communicate securely. State and business secrets can be preserved. Privacy can be respected.

Suppose that we squash implicated technological innovations because of the potential for abuse. I’ll wager that more criminal or even terrorist activity has been plotted via email, web bulletin boards, even blog posts or web pages. So, should we ban the Internet? The UK government’s risk assessment puts banks as the top potential terrorist finance funnel – should we ban banks? The French police found an unlocked phone with an un-encrypted message that triggered the attacks. Should we ban mobile phones? Messaging services?

Would it even make any difference?

It’s worth bearing in mind that the same technologies that facilitated the criminal communication also helped to identify the mastermind and catch the accomplices. The same technologies that offered logistical and economic help for the terrorists, also delivered copious amounts of connection and support for the families and friends of the victims, and for a society in shock. I believe that regulation is good. Over-regulation is not. And in something as decentralized as Bitcoin, regulation is difficult to enforce. It needs to be regulation that the community as a whole recognizes as being beneficial for widespread acceptance. Bitcoin is a self-regulating concept. What we need is regulation that we believe is fair and appropriate. Regulation that encourages and protects.

“Strengthening controls” of Bitcoin and other cryptocurrencies, if it goes beyond enhancing anti-money laundering barriers, is no more than unproductive finger pointing which could set back the development and acceptance of a financial innovation which can help people around the world transfer assets securely and inexpensively, enjoy greater financial independence, and even emerge from poverty. And the media should be careful about playing a pivotal role in the barriers to innovation, just to grab attention.

 

What are smart contracts?

“Smart” is a very loaded word. According to my Google dictionary, it means “having or showing a quick-witted intelligence”. Quick-witted is not usually a word that you associate with contracts. Most of them are barely intelligible.

Unless we start to look at what we mean by “contract”. We are all familiar with pages of legalese when we want to take out a bank loan or buy a car or, god forbid, a house. Employment contract, sales contract, rent contract… Even a will or final testament is a type of contract.

by Mari Helin-Tuominen for Unsplash
by Mari Helin-Tuominen for Unsplash

We are so used to the concept of a contract being a whole lot of words, some of which we don’t understand, that we forget what it’s really for. To reduce risk. In a contract, we want to establish the conditions for a transaction, while protecting ourselves from the possibility of the other party not fulfilling their part of the bargain. Contracts not only set up the conditions for the transaction, but also what will happen if various conditions are not met, or if either side is not satisfied. Contracts are long because of the lack of trust.

Wouldn’t it be great if we could come up with a way to simplify contracts? To make the trust implicit? And while we’re at it, to remove the control of the contract from one party, and make it tamper-proof, time-stamped, and verifiable by the public? And to make it indestructible, stored on decentralized servers, away from fire/flood/failure risk?

Enter Bitcoin.

Based on a decentralized network, Bitcoin’s very philosophy solves the problem of how to transact with people or institutions that you don’t trust. And it does so with a few simple lines of code. Your Bitcoin commitments are validated by the network, then published on the blockchain for everyone to see*. They are almost impossible to tamper with, so you can’t retroactively “change your mind”.

How can this be adapted to the concept of contracts? Each Bitcoin transaction is already a very simple type of contract, in which someone promises to pay someone else in bitcoin. The only condition attached is that the transaction be valid, in that the payer actually owns the bitcoins that he or she wishes to send, and that he or she hasn’t already sent them somewhere else. If that condition is met, the “contract” is fulfilled and the bitcoins change hands.

For more complicated scenarios, the Bitcoin code does allow the insertion of if-then clauses. If this happens, then this.

“If the box arrives at its destination before Tuesday, pay me $249.49.“

“When the document has been uploaded and has 2000 words, send the images.”

“If Real Madrid wins the championship, pay me €1000.”

These are contracts. And if the condition is something that can be verified without a person or centralized authority getting involved, then the “then” part of the clause can be activated automatically. Instead of highly-paid professionals and reams of paper, you have a few lines of code that enact the same conditions in a much simpler, cheaper and faster process.

What kinds of conditions can be met without human intervention? Prices, for instance. In fact, financial contracts are one of the more interesting and practical applications of this technology. If this (a published price reaches a certain level, or a valuation is announced) happens, then pay a certain amount to someone, or transfer certain information.

Deliveries can also be verified online. Once a receipt is electronically acknowledged, pay the supplier.

Transfers of funds: once this amount enters this account, release this document.

Wills or last testaments: once the death certificate is filed online, funds can be released.

Even marketing: once this ranking in Google is reached, pay this amount.

Smart contracts are effectively self-executing agreements. This function can be used to create new financial instruments, new types of deals, even new business sectors.

They can be used on the Bitcoin protocol, or on separate platforms like Ethereum, which use blockchain technology, but don’t run on the blockchain. Ethereum doesn’t even use bitcoins, preferring their very own digital currency called ether. Ethereum is notably different from the Bitcoin protocol in that it can be fully programmed. Bitcoin’s flexibility in programming is very limited. It can include if-then functions, but that’s about it. Ethereum can include if-then, loops and a whole lot more. On Ethereum, smart contracts can get sophisticated.

Many other platforms are also working on empowering smart contracts: SmartContract, Symbiont, Ripple, Hedgy, Counterparty and Mirror are just some of the teams proposing innovative blockchain-based solutions. Several other platforms are in development, to enhance smart contract capability. This is going to get very interesting.

*There are ways to keep the information in Bitcoin- or blockchain-based contracts private. We’ll talk more about this later.

(For more on how Bitcoin works, see Bitcoin Basics.)

How do coloured coins (or colored coins) work?

“Coloured”* does not refer to the aesthetics of Bitcoin (although it sounds pretty), but to the information that colours* transmit. We colour-code labels: a yellow sticker means file right away, a green sticker means read as soon as possible. We underline in red phrases that need correcting, in blue phrases that generate a comment. Colour can itself be an efficient code for more information, easy to learn and to understand.

colored stickers

The same principle applies to coloured coins. By “coloured”, we mean “labelled with additional code”. And this humble piece of additional code can extend the use of Bitcoin beyond what we can imagine today, and change the way we transact and do business. Before we go into the how, a brief look at some technical stuff:

The structure of the Bitcoin program allows each transaction to insert some “metadata**”. So if we want to add some “colour”, all we need to do is to spend a fraction of a bitcoin and add some metadata to that transaction. That converts it into a “coloured coin”, which still functions as Bitcoin, in that it is validated by the nodes, incorporated into a block and added to the blockchain. Like normal bitcoins, coloured coins are verifiable, non-changeable and transparent. But they can do so much more than just pay for something.

Some examples of coloured coins are:

  • Shares in a company
  • Tickets to gain admission to an event
  • Car ownership
  • Deeds to real estate
  • Ownership of domain names

Coloured coins add a huge amount of flexibility and versatility to Bitcoin, enabling it to act as a transmitter of non-monetary value, as a verifier of fact, as a time-stamper, as many other things, some of which we haven’t even thought of yet. Each coloured coin transaction, though, does require a small amount of bitcoin to be processed, which is never spent. So if this use for Bitcoin takes off, and it’s likely that it will, the amount of unspent bitcoins will grow, and we’re not yet sure what the effect of that will be.

Also, coloured coins can’t function with all wallets. You wallet needs to be “coloured coin aware” to avoid losing or corrupting the attached information. Some of the main desktop wallets that can handle coloured coins are Coinprism and Copay, with ChromaWallet still in development. Each can also issue coloured coins, but those coins will not be compatible with the other coloured coin wallet. That’s a bit messy, and could be a barrier to extensive coloured coin adoption.

And just in case you weren’t confused yet, coins can have more than one colour.

The concept is actually not as confusing as it sounds. It’s simply an instruction as to how to treat that transaction. With no colour/instruction, it’s a simple transfer of bitcoins. With a colour/instruction, it’s a transfer of bitcoins (usually the minimum amount) plus some other type of transaction.

* Big-time spelling confusion: I’m English, so coloured for me has a “u” in it. But across the ocean they’re called “colored coins”. This should be fun.

** If you’re curious about the difference between “metadata” and “data”, metadata is data about data. So why are we not just inserting “data” into the transaction? Because what you’re really inserting is a link to that data, or a hash (condensed encryption) of that data, not the data itself. There is a low cap (40 Bytes, or approximately 40 characters) on the size of the information that can be inserted, so a hash is more efficient and gives much more flexibility. Technically, it is data about data. And, metadata sounds cooler.

(For more on how Bitcoin works, see Bitcoin Basics.)

Are bitcoins fungible?

Two things are fungible if they are indistinguishable in terms of value from each other. They are completely interchangeable, and mutually replaceable. Fungibility is a basic requirement for any currency. One dollar has the same value as another dollar, one euro can be substituted for another euro. While it’s possible that you could get attached to a certain dollar because it has a special scribble on it, that attachment technically makes the dollar worthless. Or it could be worth even more, depending on who did the scribbling. What monetary value does a dollar have if you’re not willing to part with it? Even if the monetary value is higher than the face value, it technically is no longer a dollar, but a collectors’ item. So, for a currency to have monetary value, it needs to be fungible.

Are bitcoins fungible?

No, not really. Each bitcoin has a history associated with it, a log of all previous transactions, that anyone can see on the public ledger (it’s not easy to understand, lots of hashes and codes, but it’s there if you want to take a look).

bitcoin transaction

Since it’s very unlikely that any two histories are the same, this makes each bitcoin unique. And it’s possible that I really like the history behind my bitcoin, so I’m not willing to trade it for the less interesting history of your bitcoin. This means that the two bitcoins are technically not fungible.

Yet Bitcoin works as a currency, even though each bitcoin is different from the others. This is a very unusual property for a currency to have. And it can be used to make Bitcoin even more powerful.

When you scribble on a dollar bill, you are effectively adding additional information to that item. It is no longer just a dollar bill, it is a dollar bill with an additional message. We can do the same thing to bitcoins.

We can add to any bitcoin some additional information, or “metadata”, that helps it to function as something other than currency, such as a smart contract, or a time validation. This vastly increases Bitcoin’s value and broadens the technology into other fields. One of the most common ways of doing this is through coloured coins (more on these later), which add functionality while retaining all of Bitcoin’s advantages. The potential is colourful. (Sorry.)

(For more on how Bitcoin works, see Bitcoin Basics.)