Bitcoin: Beyond the Basics

This 16-minute podcast was released Aug. 27, 2018.

Economist David Andolfatto in recording studio.

St. Louis Fed economist David Andolfatto takes a deep dive into cryptocurrency and the technology behind it. Learn about distributed ledgers, mining, hacking and regulation.

Transcript:

Laura Taylor: Welcome to Timely Topics. I am Laura Taylor, your host for this episode titled, “Bitcoin: Beyond the Basics.” With me today is David Andolfatto, a vice president and economist here at the Federal Reserve Bank of St. Louis, who’s here to demystify an increasingly popular topic – cryptocurrency. Now, the views in this podcast are our own and aren’t necessarily the views of the Federal Reserve Bank of St. Louis or the Federal Reserve Board of Governors. David, welcome to Timely Topics.

David Andolfatto: Thanks for having me, Laura.

Taylor: I think by now most of us know what bitcoin is. It’s a cryptocurrency. It’s unlike most common forms of currency like the dollar or the euro, yet it can be very valuable. It operates outside of a central bank, and it can be incredibly volatile. So, knowing those basics, let’s dig into some topics that most folks might not know about bitcoin. So, one question I get on occasion is, can you touch it? Is it an actual coin? And the answer is no. It’s not printed. So, David, where does bitcoin come from?

Andolfatto: Well, bitcoin comes from a decentralized computer algorithm. This program is just a set of rules that governs the issuance of these electronic digits. These credit entries that enter into what they call a blockchain, which is just a distributed ledger. In many ways it’s very similar to the way money is created in modern day economy. So, for example, chartered banks create digital entries into your bank account. And the only difference is that with bitcoin it’s done by a computer algorithm, whereas in the chartered banking system it’s actually done by humans.

Taylor: So, something else that we hear associated with bitcoin is mining. What does that mean? You know, I think when we think of the word mining we see, men going into a cave with axes and helmets. And that’s just not the case here. Tell us a little bit about what mining bitcoin is?

Andolfatto: Yeah. Mining is a bit of a misnomer. I guess I understand where it came from because literally it seems like what people are doing is discovering new deposits of electronic gold, if you like. But in fact, the miners are accountants. They’re charged with the responsibility of updating debit and credit operations to the ledger. And that’s just like what accountants do in regular banking systems.

So, the question is how do you pay these accountants for their service? The way we pay bankers is we pay them a salary. We don’t often describe going to work as mining for dollars. But, I mean, that’s basically what they’re doing. And so, in the bitcoin protocol, one way in which these accountants or miners are compensated is through the creation of new money. And so, this is really what a mining entails. It’s not the only way that the miners get compensated. They also get compensated for their services by charging a customer service fee as well. So, there’s really two sources of generating revenue. If you’re a miner you can be rewarded in a newly issued bitcoin, or some customer might pay you a service fee for facilitating the transaction.

Taylor: Let’s get a little more in depth here. Blockchain is a word that most people have heard about in connection to bitcoin. Maybe just in passing. So, what is blockchain and why is it important?

Andolfatto: I think it’s a very good question to ask yourself, what is blockchain, first of all? It’s a ledger containing information relating to the debiting and crediting of accounts over time. That’s, kind of, the same sort of information that banks have on their proprietary databases already that’s nothing new. It’s typically distributed, which is to say that it doesn’t exist in one central place. It’s visible to a large number of parties. It consists of timestamped blocks of information. You know, in one sense it’s really nothing new about blockchain. The way I understand the question is – how is this information going to be updated and maintained? In the modern world the answer has been we’re going to trust delegated third parties to this task. Okay? So, we trust our bankers, for example, to look after our books. In blockchain application, the answer is we’re going to rely on this more communal consensus mechanism where the community as a whole is going to have a role in agreeing on what goes into this ledger, this block of information.

Taylor: So, you recently wrote an article titled “Blockchain: What It Is, What It Does, and Why You Probably Don’t Need One.” So, in it you talk about trust and transparency. Can you tell us how these two attributes play a role in blockchain?

Andolfatto: Well, the whole issue about information is that, you know, people have to trust that it’s accurate, that it’s secure. Otherwise it hardly has any use. You know, you have to trust that the bank’s going to keep your records square, otherwise, you know, it’s meaningless. Now, transparency, you know, this is, this is something that is kind of a funny thing. What’s true, and blockchain is that the algorithm is absolutely transparent in the sense that it just exists out there as open source code. It’s very much like the Constitution of the United States. You can just go and take a look. And it’s written. You can see it. And you can kind of see that the rules are being followed according to the way they’re written. So, this is an added degree of transparency that this endeavor permits.

Taylor: So, because of this transparency does that in some way mean that blockchain technology is unhackable? You know, is bitcoin a completely safe asset?

Andolfatto: That’s a good question, too. There’s a sense in which that’s true, I think. Because bitcoin is open source. It’s a code that evolves over time because sometimes, you know, people find bugs in the code and you have to patch it. The fact is that if, somebody tried to go in and hack this code for their own personal benefit, everybody can see the hack going on and kind of see the obvious motive behind the hack, that what happens is that the entire community just refuses to follow that version of the software with that particular hack. And so, the hack actually becomes worthless because the community wholesale rejects it. And so, that’s the great strength and resiliency of, kind of, an open distributed ledger. It’s very, very…I’m not going to say immune. But it’s kind of highly resistant to kind of hacks.

Taylor: Interesting. Okay. So, now we know about bitcoin and blockchain. And we’ve probably all heard of other cryptocurrencies, too. Litecoin, there’s many more. So, with so many competitors, what does that mean for the future of cryptocurrency?

Andolfatto: Well, I mean, we’re really in the infancy here of this endeavor. Bitcoin came out in 2009. That’s not even 10 years ago. So, we really don’t know where this is going. A lot of these coins, they differ from bitcoin only, you know, to the extent that they might offer faster payment processing, or some of them might offer greater degrees of anonymity. They’re kind of filling in where people in the world view as kind of what their niche needs or wants. There’s already a precedent for this; there are many, many, many examples of local currencies coexisting with the U.S. dollar within the United States already. And so, one could well imagine a variety of different cryptocurrencies arising that service the particular niche needs of certain communities. I mean, who knows? It’s really hard to say what’s going to happen. But, you know, that would be something that could happen and wouldn’t be inconsistent with what we’ve seen happen in the past with paper monies.

Taylor: Right. Interesting. Somewhat adjacent to this, government sponsored cryptocurrency, something you’ve studied is the idea of Fedcoin. And so, walk us through that idea a little bit.

Andolfatto: The idea of Fedcoin you can divide into two parts. One, why not permit individuals and firms, businesses, or whoever to open up accounts with the Fed directly? This would be, kind of, a good idea, I think, because among other things it would eliminate the need for deposit insurance because accounts with the Fed are perfectly safe already. You don’t have to worry about counterparty risk, first of all. And, you know, if you’re a cash manager at a large firm, for example, and you need to park, I don’t know, 50 million or 500 million dollars in a safe vehicle for seven days because you have a payroll to meet. I mean, what these people do now is they go to the shadow banking sector. And they deposit their money there. They’re not going to deposit the money in a bank because the bank only insures these deposits up to 250,000 dollars. But imagine if they had access to an account at the Fed, they could just deposit the money in the Fed. It’ll be extremely safe and they don’t have to worry about the so-called shadow banking sector to facilitate their cash management needs. So, there’s that aspect to it, right? And there’s a big discussion and debate one could have about what sort of effect this sort of system might have on the incumbent banks, et cetera.

The second notion of Fedcoin is more dramatic and more controversial: the possibility of issuing a digital barrier instrument. Something that would not require somebody to relinquish personal information in order to open up a digital account. This is exactly what bitcoin permits. I can go to bitcoin, download a digital wallet. I don’t have to reveal any personal information. The Fed could potentially do the same thing if it wanted. There’s nothing that prevents the Fed from letting people open up anonymous digital bank accounts, so that’s the second notion of a Fedcoin. And so, I argue that that system could potentially give all the benefits of bitcoin but with a much more stable exchange rate, for example. One of the costs would be that you would have to subject yourself to the monetary policy of the Fed. And for people who aren’t very trusting of the Fed that might be something that would discourage them. But in principle it’s possible.

So, we have kind of these two visions of Fedcoin. One is, I think, more traditional, more standard. Something that might happen one day. The second one, I don’t see happening. You know, people are going to be worried about money laundering and, many people are suggesting we eliminate cash specifically for these reasons. And indeed, I believe that historically bearer instruments are more or less outlawed in the United States in many jurisdictions. I don’t see any major economy adopting it anytime soon.

Taylor: So, we touched lightly on the idea of moving toward a cashless society. Do you see cryptocurrencies becoming the new normal?

Andolfatto: That is really hard to say for sure. But, you know, on the foreseeable future I would say no. It’s amazing that cash, physical cash still dominates anything digital in at least one regard. And that is that these digital cryptocurrencies, they all have to rely on a database that’s openly visible in some way. Cash doesn’t have that. I mean, nobody knows where the cash is. Cash is way more anonymous than any digital object could ever be. And so, to the extent that people value anonymity, there is some reason to believe that cash will never disappear for that reason. Although, again, it’s not entirely clear what is going to be technologically feasible in the future in terms of generating these anonymous objects. But this is what I see at least in the foreseeable future. I just don’t see cash going away.

Taylor: So, I’d like to end on a topic that’s been in the news a lot. And that’s regulation. Some argue that cryptocurrencies should be regulated much like stocks or commodities are. What are your thoughts on that?

Andolfatto: Well, this is an interesting statement because it really depends on what we’re talking about here. So, something like bitcoin, for example, it’s just not possible to regulate the bitcoin protocol directly. Because it doesn’t exist. There’s no central place that it exists. It’s a communally shared database. And so, it’s literally impossible to regulate, for authorities to regulate bitcoin directly. It is possible for authorities to regulate the intermediaries that are using bitcoin. So, there’s a number of money service businesses that are exchanges, for example, that are and can be regulated. So, any sort of business that uses bitcoin could be regulated in the usual way. But in terms of regulating the actual currencies, I mean, this is like, saying that the United States is going to regulate the supply of pesos. I mean, we have no jurisdiction over the supply of pesos. And it’s even worse than that because at least in the case of pesos you could put pressure on the Mexican government. But bitcoin is not a government. Bitcoin is a computer program. And you can berate and threaten a computer program all you want. It’s not going to bow to your demand. So, to some extent, they’re really beyond the reach of any regulatory authority. And this can both be promising along some dimensions but it can also be very scary, I think, as well.

Taylor: So, David, is there anything you’d like to leave us with today?

Andolfatto: I think the main thing I’d leave you with is, look, don’t get bamboozled by all the terminology that’s out there. When people say blockchain, in particular, or cryptocurrency and stuff like that, I mean, try not to be overly, kind of, wowed. A lot of the people working this space seem to be rediscovering old ideas that have emerged and have been learned in monetary theory for like, hundreds of years now. I think it’s great that they’re seeing that. But it’s not like everything is new here. So, I think I’d suggest to people to kind of keep things in perspective along that dimension. Look the terms up or challenge people to define them.

And the final thing I’d say is, you know it’s very tempting for people to view the existing payment infrastructure or the database management system as a snapshot in time. But, in fact, there’s been a lot of technological evolution that’s been going on in this space for a very long time. So, in that sense these disruptions are not new, as well. They’ve been happening all the time. And so, in this sense I would recommend that people try to develop a historical perspective. Go and read a bit of history and kind of understand where we are in the context of the evolution of all these technologies. This looks to me like just more of the same old thing. Innovation, innovation, innovation.

Taylor: Well, thanks for bringing that perspective and helping to demystify some of those words we do hear like bitcoin and blockchain. To learn more about the St. Louis Fed’s research or David’s research on bitcoin and blockchain, visit us online at stlouisfed.org.