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Federal Bank VP: Bitcoin Threat Means Banks Must ‘Adapt or Die’

(@danielcawrey) | Published on April 1, 2014 at 13:18 BST

On 31st March, the Federal Reserve Bank of St. Louis – one of the 12 Federal Reserve banks – held a talk on bitcoin from a banking and economic viewpoint.

The session, entitled ‘Bitcoin and Beyond: The Possibilities and the Pitfalls of Virtual Currencies’, was presented by economist David Andolfatto, who is Vice President at the bank and a professor at Simon Fraser University.

Andolfatto offered some interesting insight into bitcoin from his perspective. Many aspects of the talk were positive about the digital currency, some were more negative, and overall the session was quite balanced.

At points, Andolfatto even seemed fascinated with the concept of bitcoin:

“What do we have here? A stroke of genius, I think.”

Bitcoin through a banker’s eyes

The central bank's auditorium for the bitcoin session. Source: Federal Reserve of St. Louis
The bank’s auditorium for the bitcoin presentation. Source: Federal Reserve Bank of St. Louis

To begin with, the ‘Bitcoin and Beyond’ session took newcomers to the concept of digital currencies through some of the basics. Explained Andolfatto:

“Bitcoin is a set of rules written down as a computer program. The object here ultimately is to get the costs of transactions as low as sending an email.”

The economist talked about bitcoin’s open source nature, saying that, “it’s not something set in stone, it is a living object, that evolves over time”. Furthermore, as bitcoin can be improved over time, so can the dollar.

Said Andolfatto: “That’s what we do at the Fed, we fix bugs, in a way.”

The dismal state of banking

In the sometimes candid talk, Andolfatto said it was no surprise that decentralized systems of money came along, because “everybody hates banks, even I hate banks.”

The problem with banking is that it lacks innovation and many people don’t have access to financial institutions, he said.

As an example of a common criticism of the banking system, the economist mentioned the costs of sending $100 from St. Louis to Vancouver, Canada. A bank charges $10, or 10% for that transaction. Said Andolfatto:

“Even in well-developed economies, banks don’t always work as well together as we’d like.”

Email, on the other hand, is simple and costs very little, if anything at all. Andolfatto believes that money transmission over the Internet should be the same way.

Is bitcoin money?

Bitcoin is a technology that competes with money. It has two central goals, according to Andolfatto:

“The hope is to basically slay the inflation dragon. And to drive transactions costs down to zero. That’s the vision.”

However, he argued that bitcoin isn’t stable enough to be money.

“Is bitcoin a good money?” he asked. “Good money should maintain a stable purchasing power over a short period of time.”

At this point, Andolfatto presented a series of graphs: one showing the stability of the USD, which the Fed targets an annual 2% inflation rate, compared to other currencies:

Source: Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis

Another graph illustrated the volatility of bitcoin in relation to the US dollar:

Source: Federal Reserve Bank of St. Louis
Source: Federal Reserve Bank of St. Louis

Over the short term, Andolfatto argued, bitcoin is too volatile to be considered money. The value tomorrow could be much different than today, which creates uncertainty in bitcoin as a purchasing tool.

Payments innovation

Andolfatto believes that while bitcoin is not stable enough as a form of money, it has other properties that will spark innovation in banking.

Reducing friction in payments is where cryptocurrencies will force banks to evolve, he said:

“I think that the Federal Reserve can compete with bitcoin as a currency. But not the payments portion.”

The Federal Reserve has been in existence for 100 years, and Andolfatto said that banks should not fear competition from bitcoin. However, they should see it as a sign that the times have changed:

“Well-run central banks should welcome the emerging competition.”

Regulating the ‘Hydra’

Not all central banks are well run, of course. Bitcoin regulations that will eventually be introduced in different countries all over the world will force many central bankers to reveal how confident they are in their money systems.

That’s because trying to control distributed systems like bitcoin will prove to be a very difficult task. The lack of a central bitcoin authority was likened by Andolfatto to the many-headed Lernaean Hydra in Greek mythology.

Source: Federal Reserve of St. Louis
Source: Federal Reserve of St. Louis

The legend told that, for each head of the Hydra that a warrior cut off, two more would grow back in its place. Said Andolfatto:

“How do you regulate something that has no central head? It’s like trying to slay the Hydra.”

Outlook

“What’s striking is the rapid price growth and the volatility” in bitcoin, said Andolfatto. From an economic perspective, he said it’s hard to determine whether bitcoin is really a good investment or not.

“We have very good economic theory that asset prices are hard to forecast. How do you forecast these things?”

Belief in bitcoin, according to Andolfatto, will come down to trust in the system and whether or not investors are confident they will be able to exchange bitcoin for other stores of value.

He said:

“Most assets are valued by how easily they can be liquidated. [Bitcoin investors] view it as a liquid instrument, that someone will accept it in exchange down the road.”

IRS Ruling

David Andolfatto during his presentation. Source: Federal Reserve of St. Louis
David Andolfatto during the presentation. Source: Federal Reserve of St. Louis

A recent IRS ruling indicated that bitcoin should be treated as property, and capital gains from buying and selling it must be accounted for in terms of tax reporting.

This regulatory guidance from the IRS is a way to make virtual currency adoption too expensive to use as real money. Said Andolfatto:

“Compliance means added record-keeping costs.”

Protocols that zip money digitally around the globe derived from bitcoin, such as Ripple Labs, may be one benefactor in terms of the IRS’s regulatory guidance:

“Ripple is a currency-agnostic protocol. Ripple is the winner. It processes anything. It’s quite possible this ruling benefits payment processors, rather than virtual currencies.”

‘Adapt or die’

Andolfatto is sure that, ultimately, new systems will upend the monetary hierarchy of today – eventually forcing substantial changes within the banking and payments industry.

The future may be unclear for virtual currencies, but they should, in the long run, bring change:

“The threat of entry into the money and payments system [...] forces traditional institutions to adapt or die.”

Federal Reserve of St. Louis image via Shutterstock

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