Bitcoin: Why Should You Care?
January 27, 2015
When I first walked into my Capital Markets Initiative internship at Third Way (a centrist democrat think tank), I did not really know what to expect. On its website, the Initiative hosts guides on anything from Dark Pools (private trading exchanges) to the delisting of Dell from NASDAQ to bank liquidity. I became so anxious in the weekend leading up to my internship that I reread an entire semester’s worth of Monetary Economics notes.
By Matthew Caulfield, W’16
It turned out my first assignment wasn’t on Quantitative Easing or anything of that sort, but rather on Bitcoin, a “crypto-currency.” I hadn’t known anything about it apart from the time one of my (libertarian) friends told me it was the “future global currency.”
As I researched Bitcoin (while simultaneously attempting to overcome my skepticism), I learned that, if nothing else, Bitcoin is important. Here’s why.
What is Bitcoin?
A report explaining the basics of Bitcoin that I helped author will be published by Third Way in the coming months, so stay tuned. I’ll try to just get you acquainted with it so that you’ll understand some of its important implications.
A lot of people think the ‘new thing’ about Bitcoin is that it is a virtual currency. Truly, it is virtual, but virtual currencies have been in existence for some time: the airline miles you accrue, the credit card points you earn, even different currencies used in video games like World of Warcraft and Second Life all have tangible value. These are virtual mediums of exchange, and in some cases you can even convert these ‘virtual currencies’ to dollars or euros. Furthermore, somewhere around 90% of the US (M2) Money Supply is digital (i.e. not accounted for by currency in circulation). In short, we’re no strangers to transacting digitally.
What sets Bitcoin apart is that it is a special kind of virtual currency: a decentralized virtual currency. That means there are no official, central financial intermediaries (i.e. no banks or central bank) to facilitate transactions or control the currency’s value, use, or supply. There is no governmental influence. Rather than having banks facilitate transactions, “nodes” within the Bitcoin community (also known as “bitcoin miners”) process transactions, and update a universal ledger that contains the histories of every bitcoin transaction since Bitcoin’s inception. These miners are rewarded with new bitcoins that are created by the system.
Why is it important?
Bitcoin is an extremely interesting innovation, but there’s some confusion as to why the average person should pay any attention to it. Many see it as a tool for only two kinds of people: the wealthy who can afford to assume the risks associated with a volatile investment (bitcoin’s price is extremely volatile), and overzealous libertarians who have a beef with the central banking system and with government regulation altogether. It’s hard to see yourself fitting into the crowd to which Bitcoin seems to cater.
Bitcoin, however, has a wide range of policy implications, making it a meaningful concern for the general public. Last year, Senator Mark Warner (D-VA) admitted that he was “only just starting to wrap [his] head around the potential upside, downside, regulatory issues, monetary policy issues, taxation issues, and consumer protection issues that this innovation represents.”
The Financial Times has reason for dedicating an entire feed to Bitcoin news, and so do other news outlets for regularly publishing Bitcoin updates and developments; not only is it intriguing, but utterly relevant to the general readership. To illustrate Bitcoin’s general applicability to our lives, some trace similarities between the early histories of the Internet and Bitcoin. Marc Andreessen (a highly successful venture capitalist) in an NY Times op-ed on “Why Bitcoin Matters,” alludes to the fact that “critics of Bitcoin point to limited usage by ordinary consumers and merchants, but that same criticism was leveled against PCs and the Internet at the same stage,” and reminds us that, “it used to be technically challenging to even get on the Internet. Now it’s not.”
Sure, I agree it’s a hefty and bold statement to be comparing Bitcoin to the paradigm shift that was the World Wide Web, but such a comparison is not entirely unreasonable: for one, because Bitcoin is so innovative and now occupies a before nonexistent niche within financial markets, but, more importantly, because people won’t pay attention to anything to which they cannot relate.
I would be the first to admit that I will never buy or use Bitcoin, whether as a currency or an investment. And that may be true for you as well. But just as my hesitation to invest in credit default swaps does not have any bearing on their objective general relevance to you, me, or the US economy (read: the financial crisis), our lack of interest in Bitcoin does not make it unimportant to you, me, or the economy at large.
Most would agree that a decentralized currency gaining significant popularity or becoming a substantial store of wealth would undoubtedly bring up numerous policy concerns, at minimum within the areas that Senator Warner mentioned. The problem in the public consciousness, however, is the immediate (and almost natural) discounting of Bitcoin’s potential to reach such a tipping point. Too often is the concept of Bitcoin met with giggles and sarcasm in professional circles, with people too rarely regarding it with the sincerity and earnestness I believe it warrants.
Keep in mind that, as of now, Bitcoin’s use as a store of wealth is, in the least, non-negligible by any definition. Currently, Bitcoin’s market capitalization is around 7.6 billion dollars, and at its peak has climbed to around 13.9 billion (that’s right, billion with a b). Additionally, it has a daily transaction volume that hovers around 44 million USD. Reaching a popularity or wealth threshold that not only warrants (as it does now), but perhaps necessitates attention and/or legislation doesn’t seem all that remote a possibility. Already, the Senate has held hearings on Bitcoin (late last year), and a number of politicians have made comments on the crypto-currency. It has even garnered attention from the Department of Treasury and multiple state regulators.
Very intelligent people in the media, policy, and academic realms have made predictions that it will fizzle out, with Jim Angel (a former Visiting Associate Professor at Wharton) calling it an “online game” more than anything else. But a lot of Bitcoin’s dismissal is misguided and, in some sense, irresponsible.
To be fair, Jim Angel doubts its viability as a currency, as do I, comparing it to the USD’s failed brittle gold-standard of yesteryear. But Bitcoin has some very real and useful applications on the horizon, looking beyond the short-sighted pessimism that fixates on its applications as a currency or investment vehicle and beyond the libertarian that’s shouting in the corner. Immediate rejection of something that has yet to be thoroughly explored and evaluated for use (whether in the context of its intended use or in the context of incidental uses or benefits) is simply unproductive. Surely, everything merits criticism, but the sometimes outright dismissal that is pervasive in recent debate around Bitcoin is unreasonable for two reasons: one, there are some useful applications that we are still exploring, and, two, and most importantly, we don’t know what others there could be.
One possible application is a payment system involving fewer fees for merchants. Currently, a domestic check card transaction involves around 1.5-3% in fees between interchange fees (the fees a customer’s bank charges the merchant for sending the money to the merchant’s bank) and acquiring fees (the fees the merchant’s bank charges for receiving the money from the customer’s bank). These charges are driven by check card networks (e.g. Visa, MasterCard) who charge these banks fees for the privilege of its customers using the network.
In fact, “[these fees] are one of the biggest costs of running a retail business.” And a lot of these costs can be passed on to customers in pricing, so these fees are a problem for both parties of the transaction. If payment systems can be implemented (as they are being developed, now) to take advantage of the effectively fee-free structure of bitcoin’s payment system, and tailored so that a merchant does not even have to have heard of bitcoin to use it (think a third-party payment company that handles all the bitcoin mechanics in the background), merchants could see a huge reduction in fees and, in particular for small margin businesses, significant increases in net profit. Perhaps the most widely felt effect this would have, though, is the competition it would create for already existing check card networks, putting downward pressure on their fee levels.
Additionally, new pricing strategies can arise, like the one Marc Andreessen suggests called “micro-payments.” Here’s an excerpt from his article of just one application:
Bitcoins have the nifty property of infinite divisibility: currently down to eight decimal places after the dot, but more in the future. So you can specify an arbitrarily small amount of money, like a thousandth of a penny, and send it to anyone in the world for free or near-free. One reason media businesses such as newspapers struggle to charge for content is because they need to charge either all (pay the entire subscription fee for all the content) or nothing (which then results in all those terrible banner ads everywhere on the web). All of a sudden, with Bitcoin, there is an economically viable way to charge arbitrarily small amounts of money per article, or per section, or per hour, or per video play, or per archive access, or per news alert.
New pricing strategies often benefit both consumers and producers, maximizing the consumer and producer surpluses within the simplified Supply-Demand graphs we all labored over in our Intro to Economics classes. With more perfect pricing, we get ever closer to equilibrium price—everyone wins.
The third, and final, attribute I want to mention is the exceedingly exotic idea of the “colored coin.” Colored coins, “is a concept designed to be layered on top of Bitcoin, creating a new set of information about coins being exchanged. Using colored coins, bitcoins could be ‘colored’ with specific attributes.” These new coins become more like a chip or token that could represent anything.
Admittedly, this is the most esoteric application I have come across and, at this point of development, is relatively difficult to understand. But basically, imagine bitcoins whose possession meant something more. That something was tied to a bitcoin, like a house or a boat. Really, the ownership of any asset, physical or digital, could be transferred over the internet with no third party, and probably even without a contract or notary, for that matter. You could safely and securely give someone a right to ownership for an asset with the ease with which you would hand them a dollar. This would create waves in every sector of the economy, and I’m not being hyperbolic.
There are many more applications that we’ve already figured out, but what is most exciting about Bitcoin is its enabling of future innovation. It solves a lot of problems that developers, computer scientists, and monetary theorists have experienced in the past in trying to develop decentralized currencies as well as novel payment systems. It is a step towards a new future, with, at the risk of sounding corny, currently unimaginable prospects for new applications and future financial innovations.
When the Internet was created, no one ever really saw what was coming. With Bitcoin, maybe we can squint and just make out the light at the end of the tunnel.
 All of the views expressed herein are my own and not necessarily that of Third Way or its staff.
 Marc Andreessen makes a much better case for Bitcoin in his NY Times article, with several more applications. http://dealbook.nytimes.com/2014/01/21/why-bitcoin-matters/
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