The digital currency ecosystem and the blockchain

Here is an intuitive way to think about how cryptocurrencies such as Bitcoin work:

For cryptocurrencies, this database is called the blockchain. We can loosely think of the blockchain as a ledger of monetary accounts, in which each account is associated with a unique address. These money accounts are like post office boxes with windows that allow anyone visiting the post office to to see the monetary balances contained in each account. These windows are perfectly secure. While anyone can watch, no one can access the money without the correct password. This password is created automatically when the account is opened and known only to the person who created the account (unless it is deliberately or accidentally disclosed to others). The person’s account name is pseudonymous (unless disclosed voluntarily). These last two properties imply that cryptocurrencies (and crypto-assets more generally) are digital bearer instruments. That is, ownership control is defined by possession (in this case, of the private password). …

As with physical money, no permission is required to acquire and spend crypto-assets. There is also no need to disclose any personal information when opening an account. Anyone with internet access can download a cryptocurrency wallet, software used to communicate with the system’s miners (the aforementioned volunteer accountants). The wallet software simultaneously generates a public address (the “location” of an account) and a private key (password). Once done, the consumer front-end experience for initiating payment requests and managing money balances is very similar to online banking as it exists today. Of course, if a private key is lost or stolen, there’s no customer service to call and no way to get your money back.

David Andolfatto and Fernando M. Martin offer this description in “The Blockchain Revolution: Decoding Digital Currencies,” which appears in the St. Louis Federal Reserve’s 2021 Annual Report.

The terminology of a “bearer” instrument may not be familiar to some readers, but it is simple. Money is a “bearer” instrument: the person who holds the money can spend it. In the late 19th and early 20th century, there were financial instruments called “bearer bonds”, immortalized in many detective/adventure novels, where anyone walked into a bank holding the physical piece of paper that represented the bond could deposit it without any other proof of ownership. Similarly, if an outside actor can access the digital record of a cryptocurrency, they can simply take the assets.

The concern is more than hypothetical. the the wall street journal published a story late last week titled “Crypto Thieves Get Bolder by the Heist, Stealing Record Amounts.” They point out that in the last 38 weeks there have been 37 major hacks in cryptocurrency/blockchain organizations. Last year, losses were about $3.2 billion; this year it may be bigger. The most recent big hack involved a “stablecoin” currency called Beanstalk, essentially draining it of digital assets valued at $182 million.

In the St. Louis Fed report, Andolfatto and Martin provide a readable overview of blockchain-related ecosystems: cryptocurrency, stablecoins, central bank digital currency, decentralized finance, and more. Their tone is resolutely balanced, neither advocating nor attacking these developments, but simply pointing out how they work and the trade-offs they entail. They write:

[P]Perhaps Bitcoin’s most attractive feature is that it operates independently of any government or concentration of power. Bitcoin is a Decentralized Autonomous Organization (DAO). Its laws and regulations exist as open source computer code living on potentially millions of computers. Blockchain is beyond the (direct) reach of government interference or regulation. There is no physical location for Bitcoin. It is not a registered business. There is no CEO. Bitcoin has no (conventional) employees. The protocol produces a digital asset whose supply is, by design, capped at 21 million BTC. Participation is voluntary and without permission. Large-value payments can be made to multiple accounts quickly and affordably. It’s not too hard to imagine how many people these properties can attract.

There are obvious practical applications of such a currency. If you want to make an international payment, for example, creating a cryptocurrency account and sharing the passwords with someone on the other end may incur lower fees than conventional ways of transferring money. money or transfer between international banks. The most prominent example is El Salvador, which uses the US dollar as its official currency, but recently announced that it will also use Bitcoin as its official currency. This political experiment – ​​two official currencies whose values ​​can fluctuate against each other – has obvious inherent tensions.

But while blockchain-related transactions can certainly serve useful purposes in some cases, I feel like most of the energy around cryptocurrency is driven by factors: the lure of the anonymity and therefore the ability to circumvent existing regulations, and the allure of making money if the value of cryptocurrencies rises against the US dollar. They write:

Much of the excitement associated with cryptocurrencies seems to stem from the prospect of making money through capital gains via currency appreciation against the US dollar (USD). … Of course, the price of a financial security can be linked to its underlying fundamentals. However, it is not entirely clear what these fundamentals are for cryptocurrency or how they could generate continued capital gains for investors beyond the initial phase of rapid adoption. Additionally, while the supply of a given cryptocurrency such as Bitcoin may be capped, the supply of close substitutes (from the perspective of investors, not users) is potentially endless. So, while the total market capitalization of cryptocurrencies may continue to grow, that growth may come more from newly created cryptocurrencies and not from growth in the unit price of a given cryptocurrency, such as Bitcoin.

Sylvia B. Polson