Bitcoin's Big Problems

I'm Scott Lanman, an economics editor with Bloomberg News in Washington. On this episode, we head across the Atlantic to talk with our guests, who's based in Switzerland at the Bank for International Settlements, which is essentially a cential bank for central banks. Jon Song Shin is the head of Research at the BIS. Previously, he was a professor Sir at Princeton University and the London School of Economics. Dr Shinn,

thank you for joining us on Benchmark. Thank you, Scot, it's good to be on the on the show now, Jean, it was actually your boss, Augustine Carston's the head of the b i S who made that comment about bitcoin being a bubble, a Ponzi scheme, and an environmental disaster. You recently had a chapter in the bi S Economic Report and made a speech on the topic that we're a bit less sensational, though still critical of the limits

with bitcoin and cryptocurrencies. Before we get into those issues, let me ask you why do you think bitcoin and cryptocurrencies have gotten so much hype and attention and hit a nerve with some people as the next big thing. I think it's the promise of technology solving one of the basic problems and economics, which is to generate trust in a very decentralized way. And to re address that question,

it's worth thinking about what money is. And money is a social institution where I accept money as payment in the expectation that others will accept money. And in that sense, money itself is a worthless token, and that's true whether it's a piece of paper with a face on it or whether it's the digital token. But the fact that

others accept the money gives it value. And in that sense, although the tokens are intrinsically worthless, it becomes something of value because of the social conventions that back up the use of money. And I think what's really captured the imagination is that bitcoin and other cryptocurrencies have come along which promise money like acceptability, but without the backing of

a central authority like a central bank. That's right, and I found that history of money in your chapter very fascinating, and I agree that it is kind of avoiding the use of authority, this anti authority streak that runs through some veins of our world, that's probably driving that. Let's just talk about the use of bitcoin for a moment. How does buying something with bitcoin compare or contrast with a regular online transaction that I might do with a

credit card. Yes, so I think it's worth looking at some of the some of the basic concepts here when anthropologists have looked back and looked at early human society is without money, with the conjecture that you know, goods were provided for the promise of someone to return their

favor in the future. And in that sense, money can be seen as a kind of record keeping device where we keep tabs on who's paid whom and who I was what to whom, and rather than having a tangle of io us, money is a kind of summary of the services that you've provide others in the past and gives you an entitlement to goods and services with respect

to others in the future. Now, the way that cryptocurrencies work, in particular a blockchain based cryptocurrencies work, is that it's an ecosystem which has the users who make and receive payments. But then you need others to maintain the system. So there are the bookkeepers who record the transactions. And what's very distinctive about bitcoin and other similar cryptocurrencies is that the register is maintained by broadcasting the transactions to every

node in the system. That's to say, every there is a network of bookkeepers and the ledger is updated simultaneously so that every ledger is identical, and in that sense,

there is no need for a central authority. So if I were to make a transaction, what would happen is I will record the transaction, make a payment to let's say a vendor, and then the the bookkeeper who who will update the leisure, will then broadcast that transaction to every other bookkeeper and all the books, all the ledgers are updated simultaneously, and so when everyone accepts that transaction,

that would be a value transaction within the system. And that's different from a traditional system, the current system where it's really a central authority like the central bank, that would validate the transaction. Correct, that's right. So under the conventional system, what would happen is that I have a deposit in the bank and then I make a payment by instructing the bank to make the payment to a vendor.

What the bank would do is then to debit my account and credit the account of the vendor and in the payment system as a whole all. Ultimately, what would back up the system is that these transactions are then settled on the central banks balance sheet. Now, when you talk about how everybody has to keep this ledger, this gets to the issue of why bitcoin or why cryptocurrencies can only get so big. You really get to this

issue of what you call scalability. What would happen if if bitcoin or cryptocurrency were to become so widely used that it were kind of like a global currency and it would require tons and tons of computing power just to process each individual transaction. Is that where we get into the environmental disaster part of what Mr Carson said, Yes, I think this goes to the ecosystem that I discussed earlier.

So there are the users who make and receive payments, but then there are the bookkeepers, and the way that the system works is to use the individual incentives of the bookkeepers so that they have an incentive to maintain the system, and they have an incentive to maintain the system that keeps the records faithful to the intentions of

the users. And the way that it works in the case of bitcoin is that the miners compete to scoop up the transactions that are waiting to be processed, and they compete by solving mathematical puzzles using computing power at their disposal, and the solution of the puzzles do not serve any particular purpose in itself other than to select a minor to update the payment and um. The natural question then is what is in it for the miners?

What are the incentives for the miners to engage in this kind of activity, And the answer is, of course, that they receive a reward for engaging in mining and engaging in updating the ledger, and the reward comes in two forms. One is a reward in terms of the of the bitcoin itself, so there's a block rewards are called, but that part is due to be phased out over time. But the other part, which is A crucial part is that the users pay a voluntary user fee, So they

pay a fee so that the transactions are processed. And because it's voluntary, it really depends on how much the system is being used at that time. So if there is a lot of congestion in the system where many users are trying to have their transaction process, then you're you're competing with other users who are also paying their fees. So um, when you have a lot of congestion, you can have episodes when the users have to pay quite a high fee in order for their transaction to be processed.

At some point last year in December, you had to pay in excess of fifty dollars per transaction in order to have your for a two dollar coffee, as you as you men in that paper right exactly. So if you bought a two dollar coffee and insisted on paying for it using bitcoin, you would have had to pay in excess of fifty dollars to have that transaction processed. Now, the natural question there is why don't you just increase

the capacity, because that is simply a technical issue. But I think this is where the question becomes very interesting, because we need to think about not only the technology, but also the economics, because the question down is what's in it for the minor when you increase the capacity, Well, there,

because the user fee is voluntary. If you increase the capacity to such an extent that there is no congestion, then the users really have no incentive to pay a volunteer user fee, and then there are no rewards there to be collected by the miners, and the bookkeepers themselves will have no reward worts to sustain, you know, their activity. So I think this is a case where the economics really bump into the the technology. How do you get from here to where you say that it could break

the Internet if it's too big. I think that's really about the specific workings of of a particular type of cryptogramesy, which is which is bitcoin, and the the idea is that once the transactions accumulate over time, and the and the value of a system like this is that the whole history of transactions are recorded, and everyone is carrying around the ledger of all the past transactions, and the

size of the transactions become larger and larger. And if you imagine lugging around a very large ledger of the history of all transactions and that ever occurred, then these files can become larger and larger, and it could become a very big burton on on the capacity of the system to actually maintain. But of course this is particular to a specific cryptocurrency, which is bitcoin. It's not a general point about cryptoccorencies that may rely on alternative ways

of keeping records. So let's talk about the other issue, another major issue that you discussed, and that's the finality of transactions. Can you talk a little bit about about this hurdle that someone might be able to actually go back and maybe erase the transaction you made to to falsify the ledger. Isn't that a major weakness of cryptocurrencies? Yes, And I think this, uh, the issue of finality goes

back to what a payment system is. So finality is the idea that once you've made a payment, it's final, so that no one can go back and alter the facts to to you know, distort history as it were. And so the technicalist you're here is that because what is a valid payment depends on what the bookkeepers agree is a valid payment. It is the result of the collective decision of the bookkeepers themselves, and just as there is a an interaction between the users, there is also

an interaction between the miners. And the way that a block chain based cryptocurrency works is that what is the truth depends on what is the current valid chain of the blocks of transactions, and theoretically it is possible for a group of the bookkeepers to clude and hitch the latest transaction to a block that is further up the chain, rather than follow the rules and hitch the block to

the longest chain. And if that happens, the branch that consists of the transactions recorded in the block that comes to a dead end become all void. So you may have thought that you have brought something and paid for it, but then if it is part of a branch that dies off, it no longer becomes valid. And so um, if your transaction ends up in one of these dead end chains, your payment, which you thought you had made,

turns out not to have been made after all. And so although it's very likely that when your transaction is accepted and hitched to the latest chain that your payment is valid, it's not valid. It's valid with a very high percentage, but not exactly. And once UM you allow the possibility that a payment may not be final with certainty. What you might come across is a case where you would like to make a payment which which is conditional

on another payment. So if it's a very large payment, I don't have money in my account at the moment, I am relying on receiving a payment in order to make my own payment. Well, imagine that we have an economy where there is a large network of these very complex payments. If it turns out that some of the payments in the past are declared null and void, then there will be a cascade of payments which were relying

on that payment which become undermined as well. So you could have another twist to what is a fairly familiar problem in systemic risk, where could have a cascade of defaults where one payment being declared void will mean that other payments are declared void as well. Now it doesn't sound like a very stable system, or or at least

something with a lot of holes that you're describing. Probably why central banks have been fairly downbeat on on cryptocurrencies as as something that you know could actually be used in the world, and the Bank for International Settlements view is uh you know, it's partly because as a bank that kind of gathers central bankers together, institution that gathers them together. You often talk about these kinds of regulatory issues.

Is there any way that this world can potentially be regulated by any institution which you basically have to create a new global regulator out of whole cloth if this were to become something that was that was more widely used. I think to some extent, the whole nature of cryptocorencies is that they were designed to lie outside any particular jurisdiction. But I think the issue of regulation, you know, need not become a big issue unless it affects, you know,

other aspects of economic activity. I think what what has generated some disquiet is the fact that cryptocurrencies piggyback on the conventional monetary system. I mean, it's it's really the price in conventional money of cryptocurrencies which has grabbed all the headlines, and it's the way in which it has taken on some of the appearance of financial assets that

has I think also generated some some concerns. So it's the fact that they are intertwined with the conventional monatory system and they have a price in terms of conventional money, which you know, gives it another dimension, and um, I think there is a larger debate about whether cryptocurrencies have taken on more of a character of an asset where people pay to hold them rather than to use them

as money. And I think it's the second aspect of you know, this attribute of cryptocurrencies as financial assets, which has I think generated a debate about whether about whether they should be regulated, whether consumers should be protected from fraud and market manipulation. And I think this is where the um the debates on regulation have become much more acute. And certainly the price of bitcoin has been a regular

headline on Bloomberg for some years now. Now aside from how big bitcoin or cryptocurrencies would get, you know, we hear a lot about blockchain technology that you were discussing, and you know, how it could potentially be used in ways maybe outside of the cryptocurrency world. Is their promise for blockchain technology by itself, and in addition, are their potential uses for cryptocurrencies on a small scale that might be vow that might actually help some corners of the

financial system. I think it's a definitely the case that the technology itself has many useful applications. The the general version of blockchain is what's called distributed ledger technology, and the idea there is that among many dispersed individuals, they can keep a record of the current state of a complex system by updating in um in real time the ledger of all the transactions, so that everyone can have

the same view of where things stand. So this is an idea with with many applications, for example, within a single firm, where you have many decision makers within the firm, but you know they may be separated by distance, and they may be separated by different time zones, but you can always keep track of where things stand, where you

stand with respect to the system. And this is just like any other database where you know you can update, you know who's paid whom, where the goods are, where the next input needs to be made, and so on, and the technology itself can be maintained without any particular use as as currency. It's just like it's just like updating an Excel spreadsheet, but making sure that everyone has

exactly the same copy of that spreadsheet. I think where it becomes much more difficult is when the technology takes on this attribute of a financial asset which then masquerades as a currency. Uh, and then you know, gives rise to promises that may not be full of fulfilled, you know, given the some of the underlying flaws of the economics. Now, to wrap up in your speech, you conclude that cryptocurrencies quote fall a long way short of being able to

sustain a monetary system. After all we've discussed here, is there any chance that we're all wrong and will wake up one day and it will be central banks who are the relics and bitcoin that's replaced the dollar as the world's leading currency. I think the bar for that is quite high. If we think about the way that

the monitor system works. It's underpinned by trust, and the promise of cryptocurrencies is that you can deliver that trust in a decentralized way while at the same time having the scale to accommodate you know, very large transactions by very many people in a flexible way, and something which gives certainty. And it's certainly possible that the technology will

advance that will iron out some of the wrinkles. But one of the things that we tried very hard to do um in the special Chapter of the Annual Economic Report is to point out that the underlying economics are really quite challenging, and no matter how advanced the technology becomes, the underlying problems innate in the economics look like you know, quite insurmountable problems. Okay, John song Shin, head of Research at the Bank for International Settlements in Basel, Switzerland, Thank

you very much for being with us on Benchmark. Thank you, scot Benchmark will be back next week. Until then, you can find us on the Bloomberg terminal, Bloomberg dot com or Bloomberg app as well as podcast destinations such as Apple Podcasts, Spotify or wherever you listen. We love it if you took the time to rate and review the show. Some more listeners can find us and you can find us on Twitter follow me at Scott Landman, and our guest is at h y U N S O n G s A h I M. Benchmark is produced by

tofor Foreheads. The head of Bloomberg Podcasts is Francesca Levie. Thanks for listening. See you next time.