Bitcoin Series 14: Our robot overlords will use bitcoin

tl;dr:  Autonomous software and machines are coming soon.   They will transact with digital currencies.

Imagine the following, all of which is possible today:

1. Someone anonymously writes a software application that accepts payment in bitcoin.  Let’s say, trivially, a joke-of-the-day site that sells you a joke for $0.01 worth of bitcoin.
    
2. Imagine that this app is hosted at a webhost that accepts payment in bitcoin and it is programmed to pay its monthly hosting bill with the bitcoins it earns.   For the purposes of this exercise, let’s assume it is profitable.
    
3. Then, the software developer vanishes or dies.
    
4. At that point, for the first time in human history, a human invention will autonomously engage in economic activity without necessarily having, ultimately, a human owner.

Today no business operations can outlast your death without being transferred to another human owner because the financial system is ultimately tied to natural people.  Dave Winer talks about this all the time in a different context – how can you reliably maintain a memorial website and domain name that outlives you? – and correctly concludes that there are no satisfactory answers today.

If it is an operation held personally, your bank will eventually suspend your accounts once they realize that you are dead.    Even in the event of a corporation or a non-profit, there are still real-life breathing people who elect or appoint the Board of Directors or Board of Trustees that sign on the behalf of the corporation.    Ultimately, there is always a human in the mix to provide interaction with the existing financial system.

Bitcoin does not work this way.   You could embed a bitcoin wallet into an application and set it free into the world, either pre-loaded with bitcoins or with the ability to earn them.   And bitcoin wallet does not know and does not care who its ‘owner’ is.   It will work fine under all scenarios.

There will be an explosion of autonomous or semi-autonomous software and hardware that will come into being over the next twenty years, from smart appliances negotiating electricity rates with utility providers to self-driving taxis to software agents executing complex missions.    As they get more sophisticated, they will need to purchase items autonomously from computing services to, say, gas.   And they will do that with bitcoins or some future similar currency.

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Bitcoin Series 13: Only the Fed can make a DollarCoin

Over the last week, Balaji Srinivasan, Timothy Lee and Joe Weisenthal have mused publicly about a DollarCoin (DLC), aka a cryptocurrency pegged to the dollar that would eliminate the pesky BTC-USD volatility.

Summary:  I don't think it is possible to do in practice unless the Fed backs it.

Detail:

First I will state my bias upfront that the BTC-USD volatility is primarily a factor of market adoption (not something inherent to the currency) and will decrease over time.  But let's say we wanted to make a DLC and let's walk through the four proposals I have seen so far about how it could be done.

Let's assume away the problem of having a benchmark DLC-BTC exchange rate that applies across the world (even though that is a separate and large problem of its own).

Also, let's keep in mind that volatility in DLC  is much more problematic than in BTC.  In BTC, with its mostly fixed money supply, volatility has been generally on the way up.   With most versions of DLC, it is easy to keep it from rising, but harder to keep it from falling and that does not make for an appealing asset to hold -- no upside in any case, but some non-zero downside if the system fails.

Take 1: Adjust the mining difficulty based on supply and demand.  

In other words, when there is a lot of demand for DLC and price in USD goes up, allow bigger block rewards (increase the rate of money supply increase) to bring the price back down.  When there is less demand for DLC decrease the issuance of new DLC to reduce the new supply of DLC.

This will not work because it only affects the rate of increase of DLC.   So if you had a serious demand shock, the price would still fall below $1.

Take 2:  Issue or redeem DLC based on supply and demand

Have a mechanism to decrease money supply when needed by issuing or redeeming/destroying DLC based on market demand.

This would keep the exchange rate more or less stable, but would still destroy the wealth in your DLC wallet so has no real advantages.   In other words, instead of 10 DLCs worth $0.80, your wallet would drop to 8 DLCs worth $1.   Same outcome but more convoluted and introduces some other problems.

Take 3: A private company willing to redeem DLC for USD at a 1:1 rate.

Update:  This is Timothy Lee's idea.  Will add his clarification in italics.

Theoretically this would work, practically it won't.    

First of all, this would require a huge balance sheet to be tied up if all DLCs were backed up 1:1 with USD and I don't see what benefit the DLC-backer would receive in return that is large enough to compensate for that. 

Timothy Lee comment:   Would take deposits in USD, issue DLCs, invest the USD in safe assets and 'bank' could collect the interest as compensation.

Second, it has all the problems of centralization that have destroyed most previous private currencies, including counterparty risk and regulatory risk.  

So, best case scenario your DLCs are worth $1.   Worst case scenario something goes wrong (regulation, fraud, incompetence) and they are not.

Take 4: A network of (banks) using colored coins to represent USD

I think this is what Balaji was hinting at today.   It is the closest idea to being viable, but I think it just obfuscates the counterparty risk.  

Even if a network of banks agreed that they would use colored coins to represent USD for transactions between them, there would still need to be transaction confirmation in their systems (that they actually have the USD available to back up their commitments).    So the costs would be higher, it would have to be centralized and there would be counterparty risk.   In other words, what happens if Citi was on the hook for $1B of colored coins, redeemable in USD, and failed overnight?   

And it remains vulnerable to regulatory pressure in a way the BTC itself is not.    Would a US sanctions regime not be enforced in this DLC network?  It would have to be.   And the same for any other country, which means that fungibility would go out the window too.

Take 5:  FedCoin

Let's say the Federal Reserve set up a DLC and said it would always redeem DLC 1:1 with USD.   It is the most credible party in the world to make the redemption promise as it can always 'print' more USD.    

It would also make a public commitment that if the DLC:USD exchange rate started rising that it would issue more DLCs until the benchmark rate was down to 1:1.     Because their redemption guarantee is credible, the floor would be stable so they could over-issue at first and keep the price from rising as well.

I don't see any technical reason why this couldn't work.  It won't happen any time soon, but if cryptocurrencies become everything people hope they will be, it will happen someday.   The USD won't be the first go to for it, but would it shock me if in 5 years, say, the Swiss do it?  Not at all.

This is approximately my default 'optimistic case' outcome for the cryptocurrency landscape in 10-15 years: Several national cryptocurrencies that have the full backing of their respective central banks and all the transaction benefits of native digital currencies plus 1 or 2 serious transnational currencies 'winners' (aka BTC) that have predictable money supply/issuance. 

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Bitcoin Series 12: Krugman and bitcoin

I think it will be helpful to clarify where Krugman is right about bitcoin and one subtle but very important point he and his uber-nerd friend might be missing.

(1) First, let's accept that Krugman forgets more about economics while having his morning coffee than most of the rest of us will ever know in our whole lives.   He fully deserves to be taken seriously on economic issues.

(2) I think most of his reaction to bitcoin is based on the fact that there is a vocal subset of the bitcoin community that says things like:  (a) bitcoin will replace fiat currency or (b) bitcoin is better than the dollar because there is no 'money printing' or (c) bitcoin will replace the dollar some day.

This is all patently nonsense.   Krugman is right to slap it down and he will be particularly sensitive to it because he has spent his whole life fighting austerians/gold standardians and so on.

So far, so good.   

(3) In the last 24 hours however, Krugman has:

(a) Accepted that bitcoin is a technological breakthrough but also made a price / valuation call (aka it is a 'bubble' aka it is overvalued).   My guess is that he would have made the same valuation call if / when bitcoin was valued at $10 (aka, it has no intrinsic value, it can't be a store of value and the price will fall) so it is not like he is saying it should be $100/coin vs $700/coin.   He is effectively saying that it is intrinsically worth very little.

(b) He then got a lot of flack for his 1998 prediction that the internet would have no more impact than the fax machine, something that he is downplaying today with the fair justification that he is not a technologist, he is an economist. 

So, in aggregate, he is saying:   

(c) Bitcoin is, in fact, a nifty technology

(d) But it is overvalued (in a bubble)

Unfortunately, there is no way you can make the case that it is overvalued or undervalued or correctly valued without having an opinion about what its ultimate adoption rate would be.  

This is the part he is missing: Since there is no way to use bitcoin-the-technology without buying bitcoins-the-coins, so long as there is demand for bitcoin-the-technology, people who want to use it will need to buy bitcoins from people who already have bitcoins and those people will demand some non-zero price for them.  

This is a bit counter-intuitive, but it is counter-intuitive in more or less the exact same way that it was counter-intuitive that the internet network would have a lot of value in 1998, which is why it keeps getting brought up as a possible 'blind spot' in his thinking. Even hyper-smart, Nobel prize winners can't be expected to keep the whole set of human knowledge in their brains at once!

In summary, you can't figure out what a bitcoin is worth without knowing (a) the future adoption rate and demand for bitcoins, (b) discounted to the present.   Given this is an almost impossible thing to predict, this is not much different than Krugman calling Instagram overvalued at a $1B valuation.   And if he is making those types of calls, I am not sure how much value his macro expertise adds - he is just another technology prognosticator at that point.

(4) So, to conclude:

(a) Bitcoin would be a terrible national currency.  Krugman is correct.

(b) Bitcoin has not invented anything new in monetary economics. Krugman is correct.

(c) Bitcoin is a significant technical innovation.  Krugman is correct.

(d) Bitcoin will have a non-zero value because of the value of its network and Krugman seems to be missing this part altogether.    If he does accept this and is simply making a valuation call on bitcoin, well, he is a better man than me because I don't know how one could do that at this stage.

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Bitcoin Series 11: Digital currency will be a winner-take-all game

Digital currency is a 'network effects' business and, more specifically, it is a two-sided market.

In other words, it means that it is a type of market that requires two distinct types of participants to be useful (most often merchants and consumers).   A classified ads market is a two sided market - you need sellers providing listings and buyers who want to purchase from the sellers.   A social network, on the other hand, is not a two-sided market as users are all of the same type.  Social networks have great network effects but they are still not as strong as those of 2-sided markets.

Two sided markets are notoriously difficult to kick-start and then notoriously difficult to displace once they become established.   What we have seen in the last fifteen years with the internet confirms this.    The first 2-sided internet marketplaces to achieve scale (eBay, Craigslist) have proved remarkably resilient to new competitors even when, in the case of Craigslist, their feature set seems mired in 1999.    Whereas 1-sided markets (like social networks), while having serious network effect stickiness, are displaceable (MySpace, Friendster, etc).

Digital currency is a classic 2-sided market.    If no merchants accept, say, bitcoins, it is not particularly useful for consumers to have a bitcoin wallet.   If no consumers have bitcoin wallets, then it is not particularly enticing for merchants to accept bitcoins.   So something has to happen to get the first group on board in order to get the second group on board.

Given this, what are the conclusions that one could draw about bitcoin and digital currencies in general:

(1) Bitcoin has probably achieved escape velocity relative to its clones, in terms of usage, money supply and public awareness of its brand.   It has a good chance of becoming the generic word for digital currency.

By the end of 2014, there will be millions, if not tens of millions, of consumer wallets and hundreds of thousands of merchants who directly or indirectly accept bitcoin.

That is probably enough to end the 'competition' for which cryptocurrency will be broadly adopted.

(2) Given this, it is going to be extraordinarily difficult for any 'alt-coin' (alternative digital currency) to displace bitcoin.   Even if a certain alt-coin has certain feature X that is superior to bitcoin (and I am not convinced that any alt-coins do have any meaningful advantages at this point), that will not be sufficient to dislodge bitcoin.   Getting consumers and merchants to use/accept bitcoins is already a huge adoption/branding challenge that requires a few hundred million dollars, if not a few billion dollars, of free / editorial publicity to solve.   Minor technical improvements (if they are not co-opted by bitcoin itself) are not going to cause a rush of users to a second, third or fourth digital currency.

(3) With this lens in place, the speculative excitement around the 'asset value' of bitcoin isn't a bad thing.   It is probably in fact a necessary condition to generate interest, generate publicity and induce the first million consumers to open a bitcoin wallet.   Bitcoin is truly in the stage where all publicity is good publicity.  The fact that some people now hold bitcoins, for speculation or just curiosity, is what is now drawing in the merchants.   

The biggest risk to a new digital currency is not that it is volatile in the beginning (something that will calm down over time), but that nobody knows or cares that it exists. By accident or by extremely savvy design, bitcoin has solved the awareness problem in spades.

Caveats:

(1) By 'winner-take-all', I mean 80%+ market share.

(2) What could keep bitcoin from achieving that level of market share in digital currencies?  Only two things I can imagine

(a) Regulatory decrees in specific countries:  E.g. if Brazil banned bitcoin exchanges but allowed "brazilcoin" exchanges, that would probably move the market share needle in Brazil (though that would inevitably create a brazilcoin-bitcoin black market).

(b) Government-backed coins:  An officially backed digital currency would take market share.   Though hardly imminent, this is something we will discuss in a later post.

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