Cryptocurrency: Speculating on the future of money - 28th October 2017

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The rise of bitcoin and other blockchain-based digital ''currencies'' represents the biggest threat to the existing financial order in a very long time. Supplied

by James Eyers and Jessica Sier

It's lunchtime at The Ivy in Sydney on a late winter day. As office workers file into the busy Palings bar, Johnny Dilley and Joseph Weinberg are discussing the future of money over a couple of beers. The casually dressed pair, pioneers in the opaque world of bitcoin and cryptocurrencies, are fresh from a round of meetings with Australian regulators around the corner in Martin Place.

Almost 10 years after the first bitcoin was "mined" in January 2009, with a value a fraction of one cent, Dilley and Weinberg are not impressed.

"How high does it need to go before central banks take notice?" asks Dilley, referring to the changing way people are using money, and the way the price of bitcoin reflects that.

"Is it $5000? Is it $15,000? Is it $50,000? At some point they will realise that bitcoin is not going away."

As he evangelises about the opportunities of the digital money future, bitcoin is trading for $US4362. Dilley predicts it will hit $US50,000 in a decade.

Fast forward two months and, while $US50,000 still seems a long shot, the bitcoin price has continued to rise (it was hovering around $US6000 on Friday) and central banks and governments are sitting up, taking notice and, in several cases, starting to act.

The Reserve Bank of Australia's comments in Canberra on Friday that the technology behind bitcoin has "potential for widespread use in the financial sector and many other parts of the economy" is just the latest in a whirlwind series of moves indicating the governors of the global financial system are taking digital currencies more seriously.

There is a growing realisation that, taken to extremes, the rise of bitcoin and other blockchain-based digital "currencies" represents the biggest threat to the existing financial order in a very long time. If you can bypass the system, and the taxes and charges that come with it, why wouldn't you? It's a compelling argument, and one that a lot of people are betting will keep driving demand for, and the price of, bitcoin and its ilk.

It leaves the players in the established order a question that's simple enough, but for which the answer is anything but: can the incumbent, trusted parties – the central banks, commercial banks, regulators, tax collectors, national governments – take advantage of the efficiencies that come with direct, instantaneous transactions without handing control of the system that underpins the global economy to the barbarian at the gate?

The answer is the future of money itself.

Risks and rewards

Silicon Valley-based Dilley was an early bitcoin miner and tells us he's drinking beer with $US150,000 worth of the digital currency on a USB stick in his backpack. He is one of several computer scientists who spoke to AFR Weekend as went inside the murky crypto world to find what's driven values through the roof this year.

What we found was widespread optimism that prices in this new asset class are being fuelled not just by irrational speculators, though there are undoubtedly plenty of those, but also by a belief that demand for decentralised computer systems and peer-to-peer interactions, which cut out traditional banking channels, has nowhere to go but up.

Canadian Joseph Weinberg is the founder of a company called Paycase, which uses bitcoin to provide low-cost remittance services. He joined Dilley in Sydney on a visit arranged by Loretta Joseph, an adviser to the Australian Digital Commerce Association, who has been trying to bridge the gap between technologists, regulators and banks.

Weinberg says the growing popularity of bitcoin reflects a widespread frustration with both the fact that the government-backed or fiat currency of one country is not recognised in others, and the exorbitant costs of moving money through the banking system. It also reflects the desire of people to codify rules to make sure they can't subsequently be changed.

"The reason bitcoin works is it is acting like a government policy," he says. "That is, saying you can try however you want to game the system but it won't let you do it. And that's the insurance policy it holds. The bitcoin network works by saying the rules can't be broken, and that is our way of saying the system is continuing to work."

That bitcoin not only survived but surged after a recent major rift among its most influential technologists was seen as a significant hurdle cleared on the stability front. Weinberg reckons the history of money is replete with stumbling by central banks, including the excessive money printing that followed the financial crisis.

"Governments and central banks have never been good at managing money," he says. He expects that as more cryptocurrencies are created and start flowing over global blockchains, and as bitcoin continues to thrive, central banks "will have to start rethinking what their role is inside the actual economy itself".

It's not just bitcoin owners and backers making such claims.

In a recent article for the World Economic Forum, which hosts the annual Davos talkfest, Michael Bordo, professor of economics at Rutgers University, near New York, wrote: "It might not be prudent for central banks to be passive in their approach" to digital currencies, given the way in which trust is created is changing in the digital economy.

In a blockchain "whitepaper" published in June, the World Economic Forum said: "We've never had this capability before – trusted transactions directly between two or more total strangers, authenticated by mass collaboration, and powered by collective self-interests, rather than by corporations motivated by profit or governments motivated by power."

Bitcoin ATM with Metropolitan Hotel licensee Peter Phillips and Jason Williams from BitPOS.
Christopher Pearce

Marc-David L. Seidel, professor of entrepreneurship at the University of Vancouver and author of the paper, Questioning Centralised Organisations in a Time of Distributed Trust, also penned a recent piece for the WEF.

"We used to assume that large, centralised organisations had legitimacy and power. But that's starting to change. As distributed trust technologies develop, we will continue to see this power shift," he wrote earlier this month.

"If the central bank does not produce any form of digital currency, there is a risk that it loses monetary control, with greater potential for severe economic downturns.

"It's a world where the role of powerful central institutions will be greatly diminished."

But governments don't like giving up control at the best of times, let alone over something as fundamental as the monetary system.

Now we're starting to see a reaction.

China and Russia strike back

The response was sudden and overwhelming. Having watched on passively as its citizens became the world's biggest bitcoin traders to evade a strict $US50,000-a-year limit on transfers out of the country, in September China decided it had seen enough.

With little warning, the People's Bank of China decreed that all bitcoin exchanges would close, affecting almost 54 per cent of the world's crypto currency trade. The market shuddered and within three days from the announcement on September 11, the value of bitcoin plunged almost 40 per cent to $US3226.

But just as some were predicting the end was nigh, the trade simply moved on. Given bitcoin's decentralised nature, the transactions were smoothly picked up by other exchanges, particularly in Japan and South Korea. Australian exchanges even picked up some of the slack.

A month later, China also banned Initial Coin Offering (ICO) speculation, a form of fundraising where projects issue a cryptocurrency to early supports of a project. The surge in ICOs this year helped drive the bitcoin price higher as buyers of new coins trade through buying bitcoin first.

Last week Russia tried something different. Russians have been using bitcoin to transfer wealth across borders and evade tax since the digital currency's inception. After first banning Russian exchanges, President Vladimir Putin decided the Russian central bank should become the first country on earth to issue its own crypto currency, the CryptoRuble, digital money designed to interact with bitcoin and other cryptocurrencies, with a 13 per cent tax on each transaction. Exact details remain sketchy.

Central banks moving behind the scenes

Other global central banks are moving, too, typically with few public announcements. The Bank of England is working on a multi-year research project, as is the Riksbank in Sweden, where cash use is slumping. Meanwhile, both the Bank of Canada and Monetary Authority of Singapore have been conducting experiments with the R3 consortium on using digital versions of their dollars for interbank payments. The Bank of Canada said earlier this year that the technology was not yet mature enough to run that system, but it is continuing to monitor developments.

While their approaches differ, all are motivated by the same desire to retain control and tap into the efficiencies the blockchain can deliver.

So what are those efficiencies? The disruptive force of bitcoin to banking comes from its technological breakthrough that allows payments to travel from person to person, without the need for a central party like a bank to validate the transaction.

One of the key innovations of blockchain, the technology platform that records and validates bitcoin payments, is its digital time-stamping system, which stops digital money being spent twice. Each transaction is recorded in a "block" that is then locked up so it can never be changed. The public nature of the system allows anyone to see and therefore validate the full history of the movement of a particular bitcoin (although the identity of the seller and buyer of the coin is kept private via encryption).

Central banks are studying whether aspects of the system can assist with transparency, speed and more flexible monetary policy. One benefit being debated by economists is the potential for a digital currency to remove the "zero lower bound" constraint, which makes monetary policy less effective when official rates are set near zero. That's because if central banks tried to push their official rates below zero, people would simply hold (central-bank issued) cash. But because a digital currency can be programmed to not only pay an interest rate but receive one, central banks could use them to run policies of negative rates to further stimulate sluggish economies.

But whether these advantages are actually necessary has kept the likes of the RBA on the sidelines – until now.

The RBA's head of payments policy, Tony Richards, told a House of Representatives committee hearing on Friday that the demand for central bank-issued digital currencies would be limited because "right now it seems Australian households and businesses are very happy to transact in Australian dollars and use their transaction accounts in Australian financial institutions protected by the Financial Claims Scheme".

However, Dr Richards indicated the RBA is taking an open-minded approach to the issue and the RBA realises the technology behind bitcoin has the "potential for widespread use in the financial sector and many other parts of the economy".

"The greatest potential is likely to be in sectors where work flows involve lots of different parties with no trusted central entity, and where current practices are quite inefficient," he said. "Some frequently suggested financial sector use cases include correspondent banking and remittances, as well as trade financing."

The RBA recently received a proposal from a group of local start-ups including AgriDigital, which says the creation of a "Digital Australian Dollar" would allow it to incorporate payments into its blockchain to manage an agricultural supply chain. The RBA has responded that while it does not want to endorse any project, it would like to be kept abreast of progress and outcomes as an observer.

The downsides of fiat-style digital currencies

Some of the world's most prominent economists are backing central banks to keep their trusty fiat currencies.

"It is folly to think that bitcoin will ever be allowed to supplant central-bank-issued money," Kenneth Rogoff, the Harvard University professor, wrote this month.

"It is one thing for governments to allow small anonymous transactions with virtual currencies; indeed, this would be desirable. But it is an entirely different matter for governments to allow large-scale anonymous payments, which would make it extremely difficult to collect taxes or counter criminal activity."

Indeed, Rogoff sees a future where the value of bitcoin "will collapse", replaced by digital fiat currencies that offer all the good stuff of bitcoin without the loss of control.

"It is hard to see what would stop central banks from creating their own digital currencies and using regulation to tilt the playing field until they win. The long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates."

Westpac's corporate venture capital fund Reinventure Group invested in Coinbase, one of the dominant global bitcoin players, in June 2015. This has provided Reinventure co-founder Simon Cant with a box seat as the technology develops.

He predicts there will be a proliferation of cryptocurrencies, although it is unlikely all these digital tokens will completely displace national currencies. But he believes "national currencies will almost inevitably become digitised".

Not everyone is as bullish.

That central banks as far afield as Canada, India and Sweden are examining ways of taking their fiat currencies digital has some bitcoin purists ringing alarm bells.

Their arguments centre around two main themes: that the real strength of bitcoin is in its libertarian, distributed construct that is controlled by no one, and that digital fiat currencies will have unintended consequences.

Among these, the World Economic Forum says digital currencies would disintermediate commercial banks, pushing up the cost of bank funding and making it more volatile.

If central banks were to issue digital currencies through accounts at the central bank, one model for implementing them, this could also make commercial bank runs occur more rapidly in a crisis, as people flocked to the central bank-backed version, because it would be considered safer than the digital deposit which remain a liability of the commercial bank.

In considering bitcoin, central banks are adapting and morphing the underlying technology into order to allow them to maintain control of the system. Some think this is dangerous.

"Central banks issuing their own cryptocurrencies is fraught with problems because they are not exactly using the same tech but a modified version of the tech to suit their own purposes," says Jon Matonis, who was the head forex trader at Visa before heading up nChain, a blockchain research hub.

"They are not decentralised so are not resilient to DDoS attacks or abuse. They don't have a cap on issuance, so they are still inflationary. They are not permissionless, so a central bank is still the gatekeeper, and they are not resistant to censorship because acceptance can be defined or restricted by a central bank."

Whether it is bitcoin or digital fiat currencies we are using in 15 years ultimately might come down to which one we trust to be the safest store of value.

The Venezuela situation

Trust is hard won and easily lost in all walks of life, but there are few areas where a loss of trust has such a rapid and dramatic effect as a national currency. Venezuela is facing one of the most severe periods of hyperinflation since the Weimar Republic, with the annual inflation rate nudging 1600 per cent.

As much of the rest of the world remains cautious of bitcoin, which is still to fully shake its reputation as the currency of choice for money launderers and drug traffickers, Venezuelans have started mining and transacting in bitcoin en masse.

A heavily subsidised electricity sector has allowed people to set up mining operations that are slowly churning out the cryptocurrency and, thanks to the proliferation of smartphones, people are able to buy and sell with ease (one bitcoin can be divided into 100 million satoshis).

"My paper money is not worth anything and, yes, I do not know whether my bitcoin will be worth 1000 or 100 tomorrow," a Venezuelan woman told Reuters. "But at least I am sure my bitcoin will be worth something."

In this case, trust in the decentralised network has surpassed that of the central bank, says Professor Seidel.

"You'll see genuine adoption first in countries where people have issues with their currencies and central banks already.

"A good marker is to look at countries that tend to use harder currencies, like those that have a local currency but also accept US dollars in most forms of commerce. As long as they have the internet, things like cryptocurrency will serve them well."

It's always been a matter of trust

Back in Sydney, publican Peter Phillips has been observing a growing level of trust in digital currency since he installed a new bitcoin ATM in his Metropolitan Hotel in the Sydney CBD three weeks ago.

A growing number of customers have been stuffing it with Australian dollars, then holding their mobile phone up to a camera to transfer the bitcoins to the phone via a QR code. Phillips accepts the cryptocurrency as a method of payment via an app on his smartphone but few are buying their schooners with bitcoins.

"With the price going up and up, not so many customers are interested in paying with bitcoin, they want to hold onto them," says Phillips, whose pub on the corner of George and Bridge streets hosts a regular meet-up of bitcoin enthusiasts. The number of attendees has spiked this year, from a dozen or two to more than a hundred.

Jason Williams, the founder of BitPOS, which installed the ATM, says more than $10,000 has been fed into the machine in its first 2½ weeks in the Metropolitan. He considers the ATM a research experiment that will help consumers build trust and understand that "sending money is just as easy as sending an email".

"The ability for people to move money with this technology needs to be understood, the potential and also the ramifications," says Williams, a former Westpac banker.

"Cryptocurrencies will change the game, because you don't need to trust institutions; it's all maths-based now. Regulators will need to come on board sooner rather than later. Because if they don't, the world will change underneath them and they might no longer be relevant."

Trust is central to all transactions and, in the case of our existing financial system, trust rests most assuredly in the central banks. Their legitimacy gives them the power to increase and curb money supply and their role, as a central arbiter, is to record and track who is lending money to who and at what price.

Historically, most central banks provided some kind of gold or metals standard to underpin the value of the currency they issued. The trust that paper money had value initially lay in gold, now that trust lies in the institution and the legitimacy of government.

"It's true that trust structures are moving around a bit now," says Asher Tan, chief executive of CoinJar, one of the larger bitcoin exchanges in Australia.

"The whole idea that people inherently trust central banks, as much as they did 10 or 20 years ago, is changing. Quantitative easing introduced a challenge to the traditional trust in central institutions. But bitcoin has the same challenges, it's just people have to trust in the algorithms or the network rather than banks."

Professor Seidel says: "Central banks no longer underpin their currency with anything other than a reassurance that the paper in circulation does actually have value, or that digits in an account have value."

This reassurance was sorely tested during the GFC when the value of stocks, bonds and currency plummeted as confidence in major, Western centralised institutions fell. The extraordinary monetary policy enacted by the US Federal Reserve eventually stabilised the global economy and has even pushed it back towards a growth path, but, to some, the cat was out of the bag.

Where else could people put their wealth, their hard-earned cash, when one spark could destabilise the banks?

"Nothing can stop me from sending bitcoin to anyone I please," says Adam Ludwin, chief executive officer of Chain. "Nothing can stop me from executing code on Ethereum. Nothing can stop me from storing files on Filecoin. As long as I have an internet connection and pay the network's transaction fee, denominated in its crypto asset, I am free to do what I want."

Evolution

Emboldening the individual to control and transact their own asset, wherever they please, is at the heart of bitcoin philosophy, but the technology is evolving beyond its libertarian roots.

There are now hundreds of crypto-assets, more evolved than bitcoin can ever hope to be. Bitcoin itself is a simple method of transacting financial value across a network: it can really be nothing more. But the applications stemming from these decentralised networks point to a future where trusted third parties are unnecessary. Instead, the trust is placed in the incentivised network.

"In just the last few years the world has invented a way to create software services that have no central operator," Ludwin says.

"With just the internet, an open protocol, and a new kind of asset, we can represent networks that dynamically assemble the resources to provide many kinds of services."

For Dilley, who has already made about 25 per cent on his bitcoin stash since that late winter beer, the future of money is bitcoin. No question.

"I fundamentally believe there will be a point in the human future when owning a single bitcoin makes you very, very wealthy," he says.

Demand will be driven by a realisation that "institutions represent risk in society because they have a centre point of control and failure".

"Society has made trade-offs for things these institutions provide, like stable money, which is healthy for commerce, and having banks take on risk to facilitate loans and business. These are good things. But smart people, with capital not traditionally tied to those institutions, are increasingly looking for ways to cut them out of the centre of their personal equations, to minimise risk."

"There is a difference between the institutions waking up and thinking they can adopt pieces of the technology piecemeal, and realising they need to have a strategy about bitcoin itself, because it's not going away."

Whether bitcoin can actually reach the $US50,000 price Dilley forecasts ultimately will be a question of control, and trust.

(The Australian Financial Review)