What problem does Bitcoin solve?

In our previous post we analyzed Bitcoin as a whole and the characteristics of Bitcoin’s blockchain consensus system. In this post we are going to focus on the problem that Bitcoin solves as a monetary unit.

Picture by Miguel Á. Padriñán

The same way than in plain language we ask “How much do you weight?” and we answer in kilograms, despite we know that mass (fundamental magnitude in physics) and weight (derived magnitude) are not the same, also in plain language we call money to any medium of exchange, but it is not the same a medium of exchange for which its producer does not oblige himself to anything such as gold, silver or salt, than a medium of exchange that represents the obligation from a third party such as convertible notes for gold or silver, or today’s Dollars or Euros. The former is Money and the latter is Credit as Carlos Bondone demonstrates in his book Currency Theory.

Currencies backed by gold, silver, bonds or mortgages represent an obligation from a third party, no matter if they are convertible or not. Because even for inconvertible currencies to have some value it is essential that the issuer obliges itself to accept it. Could the reader imagine that when we request a mortgage to the bank we receive Euros but when we have to pay it back the bank rejects our Euros and requests us gold coins instead? Or that the Federal Reserve buys bonds with its issued dollars but when the Bond matures then requests gold instead of Dollars to the treasury?, How much would such a currency last?

The new thing about Bitcoin is not having a digital currency, we alredy had digital currencies. Digital currencies based on credit. The new thing about Bitcoin is that for the first time in history we have digital Money. Money as of our definition above, that is, a currency that does not represent the obligation of a third party and which its utility, and therefore value, is rendered exclusively by its properties as a medium of exchange (portable, divisible, difficult to fake, easy to identify, etc).

Hereinafter I will write Money in bold and caps to make very clear that I am referering explicitly to a medium of exchange that does not represent any obligation from anyone.

Digital Money versus digital credit currency. Is it really that important the difference? Maybe the reader is thinking that we are just turning around about a simple label or a semantic question. Not at all. The irruption of digital Money has, amongst others, the three following major basic implications:

  1. A currency based on credit needs to rely on a very complex and sound legal infrastructure in order to have value. Legislators, laws, regulations, lawyers, registrars, notaries, solicitors, arbitrers, prosecutors, judges, courts, police, prison system, etc. Without relying in this infrastructure banks could not enforce their assets, that are mostly debts from governments, corporations and retail. If they can’t enforce their assets, the value of their liabilities, which the currency we all use, would be endangered. On the opposite, the value of Money such as Gold or Bitcoin can be smaller or greater, more volatile or more stable, but in any case its value absolutely does not depend on anyone enforcing debt assets.
  2. With digital Money, the need of the State participating in the currency business is greatly reduced. By that parciticipation I am not referring to legal tender laws, nor that the State could dictate the value of its currency. The market does not care at all about those two things in respect of the value of credit-currency. Indisputable proofs of what I am claiming are hyperinflation episodes and also the reaction of the market bidding up monetary prices as soon as it detects the slightest currency inflation reek. However, the market does realize the effectiveness of the State to support a legal infrastructure, and very specially the market is very aware of the effectiveness of the State on using its inherent monopoly of violence in order to enforce and underpin such a legal infrastructure. Therefore, a very important cost of the current credit based monetary system is hidden and subsidized by the State. It is irrelevant that we might not be aware of that cost and its amount, or if that cost comes packed within a “social contract” that we all have allegedly agreed upon. It is a fact that this cost exists, and it is a fact that physical or digital Money does not need from that cost in order to have value.
  3. The irruption of digital Money makes unnecesary the linkage between the business of intermediation of savings and credit from the business of payments. Banks offer us payment services at lower costs because in exchange we allow them to profit by loaning out our deposits, apart from benefiting from a subsidized legal infrastructure as described above. It is not the purpose of this post to judge this loaning activity, I merely describe what we have been doing during many decades and that if banks would just safeguard our deposits in order to offer us payment services, they would have to charge much higher fees than they currently do.

Some readers might be thinking that sometimes transactions fees in Bitcoin are quite high (over $20 for a few days at the end of 2017). This fact has to be correctly analyzed. This is because Bitcoin network receives more transactions than it can process, in that case miners choose to process those transactions that are willing to pay higher fees. This is a sympton that demand is greater than supply, a basic free market mechanism which incentivizes to look for a solution on the supply side (such as Lightning Network) or other solutions that other cryptocurrencies are trying to provide, in some cases trying to substitute the energy cost (proof of work) by a financial cost (proof of stake).

In my view, Bitcoin transaction fees represent a much lower cost than the cost of making use of the legal infrastructure that a fiat currency needs in order to have value, and it is reasonable to expect that those Bitcoin fees are going to significantly decrease in the future. But much more importantly, the transaction fees of Bitcoin are transparent, specific and determinable and subject to free market rules, so therefore fully open to competition and improvement. It is not a hidden and subsidized cost as it is the case for fiat currencies.

Finally, we have the costs and risks of custody / theft. Bitcoin is bearer Money, and as such it involves a cost/risk of custody that we must not ignore. It still remains to be seen what solutions the free market is able to find to minimize this risk.

Other alternatives proposed to the current monetary system such as Free Banking or the Gold Standard would suffer to some extent from the same problem in relation to the costs of making use of the legal system, or for the cases of pure custody of Money we would have to face much higher fees for payments due to custody costs, and also some legal cost in relation to discourage custodians to break their obligations.

The main problem that Bitcoin solves is the impossibility that we had until very recently to digitalize Money, so we are possibly in the verge of a significant disruption on payments systems because until very recently credit had been extremely superior to Money in respect of portability.

With the advent of Bitcoin, for the first time we have a Money that can compete in portability with credit, leaving behind the huge legal costs that credit currencies necessarily imply.

Originally published in spanish at www.juandemariana.org on May 18, 2018.