Banking Payments

Bitcoin and banks

Bitcoin, banks and cryptocurrency. Photo by ivosar,
Written by Dave Birch

Does the future of cryptocurrency involve an inter-bank “high powered” digital fiat, and will it be bitcoin? Dave Birch is not so sure.

My old friend Alistair Milne has just published a very interesting paper on ‘Cryptocurrencies from an Austrian Perspective‘ (SSRN, 12 April 2017) in which he explores the use of new technology to reimplement money by taking away money creation from commercial banks. He proposes …

… using [cryptocurrency] to move both bank money and money-financed bank loans off balance sheet onto a single shared cryptocurrency ledger, together with government issued fiat money. This stops bank failures disrupting money and payments and hence helps achieve monetary outcomes desired by the Austrian school of economics: reducing excessive state interference in the market for credit (through bank regulation, lender of last resort and bail-out) and discouraging unsustainable money and credit expansions (leading to financial crisis and depression).

As part of this interesting proposal, he talks about the “Austrian cryptocurrency myth” that tokens created in the operation of a double permission-less shared ledger could compete with fiat currencies in everyday use, and concludes that for reasons relating to technology and governance, they could not. Other people disagree. Bitcoin pioneer Hal Finney (who sadly passed away in 2014) wrote this about bitcoin in 2010. (It’s a long quote, but I need to include it in full to give context to some later comments.)

“Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the blockchain. There needs to be a secondary level of payment systems which is lighter weight and more efficient. Likewise, the time needed for Bitcoin transactions to finalize will be impractical for medium to large value purchases.

“Bitcoin backed banks will solve these problems. They can work like banks did before nationalization of currency. Different banks can have different policies, some more aggressive, some more conservative. Some would be fractional reserve while others may be 100% Bitcoin backed. Interest rates may vary. Cash from some banks may trade at a discount to that from others.

“George Selgin has worked out the theory of competitive free banking in detail, and he argues that such a system would be stable, inflation resistant and self-regulating.”

The ultimate fate of bitcoin

In my new book ‘Before Babylon, Beyond Bitcoin’, I explore the “5Cs” who might create digital money in the future: central banks, commercial banks, companies, cryptography and communities. Hal is here talking about the second case, that of what’s called “free banking”, and is right to point to George Selgin as a leading scholar in this field (here’s a podcast I recorded with George a few years ago), and his books are a must-read if you’re serious about money. (You should probably also read Lawrence White’s Free banking in Scotland before 1844 to understand the relationship between competition and innovation under such circumstances.) Hal went on to talk further about this Hayekian scenario, with cryptocurrency replacing gold or central bank balances for settlement:

“I believe this will be the ultimate fate of Bitcoin, to be the ‘high-powered money’ that serves as a reserve currency for banks that issue their own digital cash. Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.”

Hal Finney was a much smarter guy than I am, so I feel rather sheepish about disagreeing with him on this point. It is entirely possible that cryptocurrency will come to exist as a settlement money that connects other different monies (although my suspicion is that these will be community-based more than simply bank-based). But is this a role for bitcoin? This kind of settlement role for blockchain technology is mentioned in BBVA Research’s recent paper on central bank digital currencies (Central Bank Digital Currencies, Gouveia et al, March 2017) which concludes that the most likely near-term use of “digital fiat” is precisely for such inter-bank payments, saying that:

“The most likely option in the short-term is the use of blockchain technology only for wholesale payment systems. Under this scheme the CBDC would be held by banks and other participants in wholesale payment systems (but not by the general public), identified (as opposed to anonymous) and non-interest bearing. This scenario would increase the efficiency of wholesale payment systems, and has few drawbacks for the public at large or for policy makers, although banks could be hit due to higher competition with non-bank payment institutions.”

Bogus transactions

While the BBVA report talks in general about central bank digital currency, it refers repeatedly to distributed ledger technology as the mechanism for managing this currency. Note that in the summary above, however, it refers specifically to “blockchain technology”. I would have thought this the least likely form of distributed ledger to implement such a system. The main reason for using a blockchain is that it’s resistant to attacks from untrusted actors who are part of the consensus-forming network. But if the central bank is going to, for example, use commercial banks as the nodes in the consensus-forming network, then surely these must be trusted actors? If a rogue bank starts introducing bogus transactions, the central bank has a lot more to worry about than maintaining retail balances. But that’s by the by.

If BBVA is correct, and the future involves an inter-bank “high powered” digital fiat, then was Hal right to think that this would be bitcoin? Here, I agree with Alistair. It’s not clear to me at all, even if we do get past the issues with mining centralisation, segregated witness, lightning networks and hard forks, that bitcoin (or bitcoin-like) blockchain-based cryptocurrencies are the way to do it, but I’m open to informed debate on this point. And I imagine I’ll get it at the 20th annual Consult Hyperion ‘Tomorrow’s Transactions’ Forum in London on 26-27 April.

READ NEXT: Bitcoin or ether – which currency will win?

– This article is reproduced with kind permission. Some minor changes have been made to reflect BankNXT style considerations. Read more here. Photo by ivosar,

About the author

Dave Birch

David GW Birch is an author, adviser and commentator on digital financial services. He is Global Ambassador for Consult Hyperion (the secure electronic transactions consultancy that he helped to found), Technology Fellow at the Centre for the Study of Financial Innovation (the London-based think tank) and a Visiting Professor at the University of Surrey Business School. He is an internationally recognised thought leader in digital identity and digital money, and was named one of the global top 15 favourite sources of business information by Wired magazine.

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