Programmatic Monetary Policy: Blockchain as Central Bank

The current and the new…

The rules of today’s money are set by relatively small groups of people behind closed doors. What happens if the rules of money were open, shared, and influenced by more participants?

The structure of our monetary system today rests on the decisions of a small number of political and economic figures. Most global currencies today are based on “fiat”, which means they are not backed by another commodity or valuable good. They derive value from the inherent utility of being accepted by the government for taxes and services, and from the trust we all put in them as mediums of exchange and value stores. Their supply is created and controlled by national central banks and a financial system comprised of a small set of government-regulated banks which borrow from those central banks. Those regulated banks then lend money out to individuals and businesses that power the economy. This is the environment we live in today, but blockchain technology poses a possible alternative future where monetary policy decisions and controls can be further separated from political ones and made by a much larger community of people.

Below I’ve compared the nation-state backed currency model (represented by the US dollar) to “crypto”-currencies such as bitcoin on several dimensions, attempting to answer the following questions.

Questions:

• Supply: How is the money supply determined?
• Placement: How is money injected into the system?
• Custodians: Who watches over the average joe’s in the system?
• Transactions: How is money transacted? Who bears the cost?
• Beneficiaries: Where are benefits accrued in the system?

Nation-State Backed Currencies

Nation-state backed currencies are what we use every day. The below discussion will center on the US dollar, but will occasionally delve into credit systems as they are sometimes inseparable from cold, hard cash in how the monetary system operates.

Supply: The supply of money is determined by the Federal Reserve. The Federal Reserve changes supply by buying and selling government bonds, which alters the interest rate at which banks get to borrow money from the Fed. Commercial banks then lend that money to businesses and individuals. The Federal Open Markets Committee, consisting of 12 economists, decides when and how to buy and sell securities and in effect change the “supply” of money via the interest rate. They target a constant rate of inflation, which devalues money over time and thus drives spending.

Placement: Money makes it into the system via loans from central banks to commercial banks and in turn, commercial banks to individuals and businesses. These loans each carry an interest rate that must be paid back by the borrower. This leads to a “debt-based” economy.

Custodians: While dollars can be stored in your mattress, most people with sizable amounts of money and regular incomes will opt to store it in a bank account. This provides extra benefits — banks are often connected to other financial products like stocks and bonds that provide returns to investors, and they allow us to transact with people over long distances electronically.

Transactions: For those who store their money in bank accounts, transactions between accounts at different banks can be done electronically through clearinghouses that hold accounts between banks. The credit card system also allows us to transact electronically and instantaneously over a distance, but comes with its own costs. The banks, clearinghouses, and credit card systems bear the cost of securing these transactions, which manifests in several ways:

• Time to settle the transaction: When sending money to another person at another bank, the transaction usually takes 2–3 days to complete. This is because clearinghouses only settle accounts between banks every 2–3 days - it would be prohibitively expensive for them to settle at a faster speed.
• Account minimums: Securing transactions for you is not worth the bank’s time if you do not put up a certain amount of money in your account that they can then lend out to others while you store it. As long as a large percentage of customers aren’t trying to withdraw at once, this system remains solvent.
• Actual per-transaction cost: Sometimes there’s an actual cost attached to the transaction itself, as with wire transfers or money orders.
• Credit card fees: Merchants pay for the speed and reliability of credit card transactions with a 3% fee on every purchase.

To send actual cash, the transaction costs are very high. You’ll need to use a money order, which can cost $5 and up depending on the amount sent. Or you could use the postal system, which takes days and incurs the risk of losing the cash to theft.

Beneficiaries: Any entity with money and the ability to lend it out benefits in this environment. Commercial banks are able to borrow money from the Fed, then turn around and lend that money out to businesses and individuals at a higher rate. They make money from the difference in rates.

Bitcoin

Bitcoin is the most well-known cryptocurrency globally and operates using a network of computers running the Bitcoin protocol which all share a database of addresses (akin to accounts) and the amount of bitcoin at each. The protocol specifies a “Proof-of-Work” algorithm that the computers use for achieving consensus on valid transactions.

Supply: Bitcoin’s supply is capped at 21M Bitcoin, with a predictable release schedule starting in 2009 and going until 2140. This is set by the bitcoin protocol’s algorithm and will not change unless a large number of the computers operating the network (over 50% of the computing power) decide to tamper with it and create a “fork” in the chain of blocks that record the holdings at each address (address is similar to an account at a bank).

Placement: Money is injected in to the system via a process called “mining”. Mining is done by computers on the bitcoin network which are responsible for verifying transactions and ensuring no amounts at any addresses are tampered with. When a single computer successfully verifies a set of transactions and proves that verification to the network, it receives a reward of Bitcoins to an indicated address, thus increasing the supply of bitcoin. This reward shrinks over time until it stops in 2140, when there will be 21 million bitcoin in circulation.

Custodians: Individual owners of addresses are responsible for safely storing the private keys to those addresses, which allow them to spend the bitcoin associated with those addresses. Those owners can hold their private keys on paper, in their heads, or on a hardware device. This is similar to storing US dollars under your mattress, but a lot more convenient since the money is effectively reduced to the size of a string of characters and it can be accessed anywhere that individual can get internet access. Individuals can also elect to move their bitcoin to an exchange or third party custodian who then holds the private keys for them.

Transactions: Transactions are fully settled in 1–2 hours, depending on the number of transactions being broadcast at a given time. Bitcoin and other cryptocurrency protocols are working on making this even faster via new and faster consensus mechanisms. The mining computers bear the cost of securing these transactions via power they use to perform computational “work”, but are compensated by programmatic rewards and transaction fees paid by the addresses sending transactions.

Beneficiaries: The owners of the mining computers doing the verification of the transactions are the beneficiaries of this system, receiving bitcoin in exchange for the cost of power to run their computers. These miners are similar to banks and clearinghouses in that they verify transactions between two parties, except for two key differences: 1) mining computers are all competing against each other to verify transactions, forcing every computer to work faster and for lower fees, 2) mining computers only verify transactions, they do not take out loans or grant loans like commercial banks.

Ethereum

Ethereum is a protocol which arrived several years after Bitcoin and brought new innovations to the idea of a public blockchain. One of these improvements which is still upcoming for Ethereum is called the “Proof-of-Stake” consensus algorithm. This algorithm replaces the need for mining computers to spend electricity to verify transactions. Instead of using computing power, “stakeholders” would risk stakes of Ether (the “currency” of Ethereum) in order to verify transactions. In theory, this will make transactions much faster and reduce the high power requirements of protocols like Bitcoin, which utilize “Proof-of-Work” consensus algorithms. The below will consider a future where Proof-of-Stake is implemented in Ethereum, in order to provide a contrasting view to Bitcoin’s monetary system.

While Ethereum has utility benefits beyond being a currency, the below will only speak to the protocol’s characteristics as a monetary system.

Supply: Ethereum’s supply, unlike Bitcoin’s, is uncapped. Every year will see 2% inflation in the supply of Ether. In theory, this ensures Ether keeps flowing in the system as an individual unit’s value is slowly eroded over time.

Placement: Money is injected into the system via “stakers”. These are holders of Ether who act like miners but instead of doing complex mathematics using computer power to verify transactions, these holders “stake” an amount of coins that are forfeited if they are caught verifying fraudulent transactions. If they are honest, one of these stakers is paid transaction fees and a small reward of Ether that drives 2% inflation, just like Bitcoin miners who successfully verify a block of transactions. Money thus enters the system via individuals with large amounts of Ether who are staking some part of their fortune on blocks of transactions.

Custodians: Just like Bitcoin, individual owners are responsible for keeping their private keys safe, or storing them with a third party they trust. They still have all the ease and accessibility of the internet, and their Ether is technically with them everywhere they go — no need to come home to pull it out of their mattress.

Transactions: Transactions are verified by “stakers” who bear a cost only in the risk that they might lose their stake if they perform a fraudulent act. Transactions in this system could be near-instantaneous.

Beneficiaries: The beneficiaries of this monetary system are those with large holdings of Ether. These players will be able to put down large stakes to verify blocks of transactions, and as long as they are honest will make continuous revenues by doing so, just as miners do with Bitcoin. In this system, the rich get richer via verifying transactions.

New Paradigms for Money

Today’s monetary systems are run by a selective few economists and politicians, some elected and many appointed. These policies are made and changed behind closed doors without community input, and the benefits of the system created accrue to those governments and banks that lend and secure the overall system.

However, monetary systems are a technology, and they need not be built this way.

Monetary systems of the future could be separate from any nation state existing today and ruled directly by the participants in the system. The rules can be transparent and predictable; the transactions secured by a commoditized market of competing computers or verifiers instead of an oligopoly of banks; the value of the currency determined by every user with less influence from the fiat control of governments. There are many questions of governance, technology, and political change that are being worked on today to further the adoption of this system, but the technologies we have today in cryptocurrencies like Bitcoin are laying the foundation for a more equal, just, and fascinating tomorrow.

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Images credited to:

• How the Economic Machine Works
• Minerjet.com