1. Bitcoin A Decentralized, Public Ledger Digital Asset Transfer Mechanism The views and opinions expressed here are not necessarily those of the Federal Reserve Bank of St. Louis or of the Federal Reserve System. David Andolfatto

2. Money and Payments System 1. Monetary tokens: record-keeping devices. 2. Ledgers: accounts containing monetary objects. 3. Payment protocols: value transfer mechanisms. 4. Monetary policy: protocol to manage money supply.

3. Money and Payments System

4. 1. Monetary tokens.

5. Money and Payments System 2. Secure ledger.

6. Money and Payments System 3. Payment protocols.

7. Money and Payments System 4. Monetary policy: managing the supply of marbles.

8. Three roles of money 1. Medium of exchange: record-keeping, info-value transfer. 2. Store of value (short-run vs long-run). Low/stable ROR preferred to high/volatile ROR. Money is used in high-velocity transactions, so stable short-run ROR more important than high long-run ROR. Note: base money is a small fraction of total wealth. 3. Unit of account. Determined by social convention, distinct from MOE. E.g., USD as vehicle currency, hyperinflations.

9. Early money and payment systems Virtual data (memories) recorded on shared and distributed ledger (communal brains) updated via consensus algorithm (gossip). Gift-giving economies, social credit systems. Invention of coined tokens and precious metals (specie). Permits P2P exchange on invisible ledger (anonymous trade). 17 th C. goldsmith banks issue paper money (receipts). 19 th C. banknotes redeemable for specie, backed by assets.

10. How things work today Monetary objects consist of liabilities issued by central and chartered private banks: physical (cash) and digital objects. bank liabilities legally a digital version of 19 th C. banknotes. Cash payment: P2P debit/credit of personal wallets. permissionless accounts held in invisible ledger (personal wallets), few KYC restrictions, anonymous (paper leaves no trail). Digital payment: intermediated debit/credit of bank accounts. permissioned accounts, held in private bank ledgers, KYC restrictions, identifiable payment history (digital trail).

11. Complaint 1: Inflation

12. Complaint 2: Payments System Outdated payment systems (e.g., ACH). Lack of direct communication between banks. Correspondent banking system for international payments. Banks and MSBs charge too much. Too much personal information presently at risk.

13. Bitcoin is a money & payments system Digital money supply (bitcoin) managed by open-source computer algorithm (Bitcoin). [ 21M unit cap ]. BTC exist on a publicly visible, distributed ledger: block chain. Block chain = history of all transactions. BTC “account” = public + private key pairs (crypto. secure) Public-address transparent P.O. box + private key. Permissionless, pseudonymous. Payment requests processed via consensus protocol called proof of work (POW). No banks!

14. Bitcoin: deliverables Capped money supply (hopefully) means long-run price-level stability. Free ourselves of central banks (alas, not governments). Ability to transfer value (bitcoin) between any two points in the world (connected to the Internet) at trivial cost. Free ourselves of all banks (except from their lending arms).

15. What’s the innovation? Virtual currency? Open-source algorithm? No. Public/private key cryptography? Pseudonymous accounts? No. Transparent online database? No. Algorithmically determined money supply? Not really. Innovation: block chain and POW consensus protocol. Packaged together with aforementioned innovations. Bitcoin solved the double-spend problem of P2P digital asset transfer (and mon. supp.) without use of “trusted” intermediaries. As close as one can get to unintermediated digital cash.

16. POW: Dynamic Membership Multisig P2P payment requests broadcast to network are validated and added to the block chain by pseudonymous “miner nodes.” Miners must collectively “sign off” on requests. How? Simple voting procedure will not work: Sybil attacks (spam). POW makes it artificially expensive (hardware + electricity) to validate payments—guards against Sybil attacks. Miners compete against each other to solve math problem, winner gets to add validated requests to block chain. (Winning) miners compensated in newly-issued bitcoin (and fees).

17. So, what’s the big deal? A fixed supply of electronic digits that can be transferred over the Internet without traditional middlemen. P2P transactions, no need to relinquish personal info to 3 rd parties. Can send $100M of BTC from here to Moscow in 10 min. almost zero user cost (social cost higher). Bypass clunky ACH, correspondent banking system. Huge deal for international remittances market. Block chain has proven to be highly secure (so far). Episodes of loss related to 3 rd parties (Mt. Gox) not BTC.

18. Example: International Payments Want to send $100 from my Chase NY to your account at Bank of Cyprus, Nicosia ($50 fees at each end?). Align Commerce claims to “use the blockchain” to effect same transfer at much lower cost (price). How? 1.AC ACH debits my USD Chase account (slowest part). 2.AC buys BTC (sells USD) on domestic BTC exchange. 3.AC sells BTC (buys EUR) on foreign BTC exchange. 4.AC SEPA credits your Bank of Cyprus account.

19. Example: International Payments Want to send $100 from my Chase NY to your account at Bank of Cyprus, Nicosia ($50 fees at each end?). Align Commerce claims to “use the blockchain” to effect same transfer at much lower cost. 1.AC ACH debits my Chase account (slowest part). 2.AC buys BTC (sells USD) on domestic BTC exchange. 3.AC sells BTC (buys EUR) on foreign BTC exchange. 4.AC SEPA credits your Bank of Cyprus account. “Using the blockchain” = using BTC as a “vehicle currency.” “free”

20. Bitcoin as digital gold Like gold, supply of bitcoin not subject to government manipulation. Though government can still tax and legislate. Compliance is an issue (it always is). W/o hassle of storing, assaying, transporting physical gold. Highly volatile, but may nevertheless be preferable to mismanaged monetary systems?

21. Inflation rates, selected countries

22. Downsides Highly volatile exchange rate (e.g., against unit of account). Though, not such a big deal if BTC became the unit of account. But inelastic money supply makes it a lousy money. While users costs are (presently) low, total costs (miner compensation) range between 2-4% of transaction volume. Most of this cost is financed through seigniorage revenue. Since BTC supply will cease to grow, user fees will have to replace seigniorage. Not entirely clear where this cost will settle.

23. Bitcoin market price

24. Bitcoin miner

25. Statistics BTC in circulation 14M = $3B (compare USD, $1.3T).

26. Statistics BTC in circulation 14M = $3B (compare USD, $1.3T). 75 transactions/min (compare Visa, 200,000/min).

27. Statistics BTC in circulation 14M = $3B (compare USD, $1.3T). 75 transactions/min (compare Visa, 200,000/min).

28. Statistics BTC in circulation 14M = $3B (compare USD, $1.3T). 75 transactions/min (compare Visa, 200,000/min). (Ironically) Most are intermediated via Coinbase, Bitpay, etc.

29. Bitcoin and banking Bitcoin solves a payment problem, not a credit problem. Credit supported by reputation, collateral. Banks turn illiquid assets (reputation, collateral) into money. Demandable liabilities, redeemable for base money @ par. Base money = historically specie, today fiat currency. Fractional reserve banking (liquidity transformation). What prevents banks from issuing demandable liabilities redeemable in BTC (or any other object)?

30. Bitcoin and banking U.S. “free” banking era 1836-63. Thousands of private state-chartered banks issuing their own banknotes redeemable on demand for specie. Private clearinghouses (e.g., Suffolk Bank 1818-58). National banking era 1863-1913. National banknotes redeemable for specie on demand. State banknotes replaced by checking accounts. No central bank, no lender-of-last resort.

31. Bitcoin vs. Fedcoin Existing banking system largely based on pre-Internet tech. Why not permit online utility accounts with Fed? U.S. Treasury: http://www.treasurydirect.gov/http://www.treasurydirect.gov/ Or full-service narrow banks (100% reserves). Dispense with FDIC. Dirt cheap payment processing costs (vs. POW). No exchange rate volatility relative to USD. New monetary policy instrument: interest-bearing money? But subject to U.S. monetary policy, not permissionless, etc.

32. Future of Money and Payments Fiat systems with politically insulated protocols have little to fear. USD already faces fierce competition. POW is costly relative to trusted central ledger—mining is a waste of resources (that may be worth paying). Fedcoin? Primary consequence of BTC will be to drive rents lower. Consumers will benefit, but can MSBs using block chain compete? Where is comparative advantage? Technology? Compliance? Credit side of banking (liquidity transformation) in regulated and shadow banking sectors not immediately affected (Bitcoin 2.0?)

33. Beyond Bitcoin Key innovation is the block chain—a distributed public ledger maintained by communal consensus mechanism. Think of any activity that currently makes use of intermediaries—these are all under threat. Banking and money services businesses. Brokerage, title transfer, escrow services. Dispute resolution mechanisms, voting, etc. “This is 1995 for the Internet.” Who knows what lies ahead...

34. Thank you David Andolfatto VP Research, FRB St. Louis May 01, 2015