Wednesday, December 24, 2014

Franco, Understanding Bitcoin

Although it seems that everybody and his brother have weighed in on the merits of Bitcoin, I suspect that few have more than a superficial knowledge of how it actually works. Pedro Franco aims to change that state of affairs with his in-depth study, Understanding Bitcoin: Cryptography, Engineering, and Economics (Wiley, 2015). Most of the book is easily accessible to anyone with a rudimentary grasp of financial transactions. It doesn’t even require a lot of mental effort to follow the general thrust of the author’s lengthy account of Bitcoin cryptography.

I have no doubt that money will increasingly be digitized and that paper bills and coins will be a thing of the past. The main question is whether decentralized cryptocurrencies can ever replace, in whole or in part, fiat currencies or whether fiat currencies will morph into some form of cryptocurrencies themselves.

As it stands now, critics argue that Bitcoin is not a currency because it does not serve the three functions of money—medium of exchange, store of value, and unit of account. But does it have to fulfill all three functions or can the three functions of money be unbundled? “A consensus seems to be emerging among economists that Bitcoin is a good medium of exchange, a risky store of value and a poor unit of account.” (p. 22)

We know that the price of bitcoins is extraordinarily volatile, making them a poor store of value. Bitcoin is also wanting as a unit of account: merchants don’t quote prices in bitcoins because the Bitcoin economy is tiny and, again, the price of bitcoins isn’t stable. Even as a medium of exchange, which is touted as its strength, Bitcoin is not without its problems. For instance, it is illiquid compared to fiat currencies, transactions take several minutes on average to be confirmed, and it could face scalability pressures.

But even if Bitcoin or one of its competitors/successors never becomes a generally accepted currency, the technology that underlies it could have other applications. For instance, the blockchain at the heart of Bitcoin could be used to register the ownership and transfer of any digital asset, such as digital bonds or shares, or even physical assets such as cars. And off-chain transactions could be used for frequent micropayments—such as paying for online newspaper articles read or for data consumption at WiFi hotspots.

Franco offers a balanced account of the pros and cons of Bitcoin as well as a clear description of how it works. All in all, the book was an enlightening read.

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