Part 2: David Andolfatto, An Overview of Bitcoin

March 31, 2014 | St. Louis Mo.

David Andolfatto, a vice president in the Research division at the Federal Reserve Bank of St. Louis, offers a brief overview of his presentation, which addresses these and other questions: What is bitcoin and what does it offer? How does it work? Who are its competitors? What's the impact on central banks?

First, Andolfatto takes a look at how things work currently—analyzing how transactions typically take place. He then discusses common complaints that the public has about the existing payment system. These complaints lead the public to looking for alternative options—such as bitcoins and other virtual currencies.

Presentation (pdf)


David Andolfatto: So good evening everyone. Ladies and gentlemen, it's a great pleasure for me to be here tonight to speak to you on the subject of bitcoin and on the nature of these virtual currencies, this virtual currency revolution that's upon us and what it portends in the way of the evolution of our money and payments system. I think that the spirit of the enterprise is aptly captured in these two quotes that I found on the Internet: one from a younger person and one from an older one. The younger person is this Tyler Winklevoss. You have probably heard of this name. He's one of the co-inventors of Facebook. If you saw that movie... what was it called, I didn't even see it. I've heard about it.

According to Tyler, we have elected to put our money and faith in a mathematical framework that is free of politics and human error. How noble. How naïve. But he's a youngster. I don't think he's even 30 years old.

Here's a bit older perspective, although it sounds a bit younger. It's from former vice president Al Gore. "I think the fact that within the bitcoin universe, an algorithm replaces the functions of the government is actually pretty cool." When I showed this to my colleagues, they go "Yeah, replacing Al Gore with a robot does sound pretty cool." But how would you tell?

Let me give you a little bit of an outline of how I intend to proceed through the talk this evening. First, I'll ask the question, "What is bitcoin? What does it offer? What does it do differently than the way things are done today?" And then I'll get a little bit into the nuts and bolts of how it works, and I'm certainly not an expert and I'm very happy to hear that there are people in the audience who have transacted in this currency. I really look forward to the Q&A.

Then, I'll proceed to ask questions that are on everybody's mind. We've all seen the price dynamics of late, I mean, the skyrocketing price. Is it a bubble? Is it a Ponzi scheme? What's going on here? Is bitcoin a good investment? Even apart from that, does bitcoin or any of these virtual currency protocols have the potential to be good monetary instruments?

When I'm done with that, I'm going to touch on a subject that not many people have spoken about, but I think is going to be something that people will be talking about in the future, in the future when, potentially, there will be multiple competing protocols out there, multiple competing virtual currencies. And then the question will come up, what would determine the exchange rate between these intrinsically useless digital currencies.

We have a lot of experience with this in economics and international finance with national fiat currencies. I think it's going to be an issue that's going to arise in the virtual currency revolution.

Once I do that, I'll touch on bitcoin and the underground economy. Can bitcoin be regulated? Can it be taxed? I'll talk a little bit about the evolution of money, where it's going, likely competing protocols — Ripple, Lightcoin — there's these competitors to bitcoin that you may or may not be aware of.

And then finally, I'll speculate a little bit on the future of central banks, including this one.

What Is Bitcoin?

First off, what is bitcoin? The way I think about bitcoin is that it's a set of rules written down as a computer program. And this computer program is designed to do two things. First, to create and manage a supply of digital currency units called bitcoins, and secondly to process payments between anonymous users by debiting and crediting digital accounts with these bitcoin units.

So the object here is to get ultimately, the cost of transacting money to any person around the world as low cost as it is to send an e-mail. Who invented it? Well, we don't really know, do we? Evidently, a programmer, or quite possibly a set of programmers more likely known only by the pseudonym Satoshi Nakamoto, which reveals only that he's probably not Japanese. Some people have a problem with this, that the inventor remains anonymous. It's no big deal, but the usual caveat applies: User beware.

I described bitcoin as a computer program, and that's what it is, but I don't want you to think about it as something that's written in stone. It's kind of like a living object. It evolves over time. Indeed, there's a dedicated group of volunteer programmers that work constantly to fix bugs in the program, kind of like what we do here at the Fed: fix bugs in our policy programs to improve it, to improve the code over time. It's very much how the Linux operating system has evolved over the last ten, 20 years.

It's open source. It's an open source code, so what does that mean? It means that anyone is free to go and read it. You just go to the Internet and go and read it. It's fantastic and sounds great, doesn't it? There's a bit of a downside, though. It's kind of big, like really big. Secondly, it's written in a language that you probably don't understand, or almost nobody understands.

I asked my co-author, Ian Preston, to give me an estimate of how big it is, and he reported that it's something like 17 megabytes of source code out there, which I had no idea how big that was. So I said "Put it to me in language that I can understand." He said it's about the size of 500 large telephone books. I still didn't quite understand how big that was, so he said "Well, it's the size of a typical bill coming out of Washington, D.C. lately." I went "Holy cow!" And it's kind of written in the same obtuse language, right?

Before I go on to describe how bitcoin works, how do things work right now generally? I mean, we're all kind of familiar with how things work. Let me just review it briefly, bring everybody up to speed. We have a money supply in the United States, the U.S. dollar, and this money supply consists of two objects. First, it's the Federal Reserve paper, the Federal Reserve notes that we use every day to transact in. And the second important part of this money is in the form of digital units that are basically created and managed by a set of chartered banks.

So this money supply is managed by the banking system: the Fed and together with the chartered banks in the country. The Federal Reserve paper, of course, has legal tender status. Bank accounts are insured by some government agency in the United States, the Federal Deposit Insurance Corp.

So that's the money supply. How are payments processed. Well, payments are processed in one of two ways typically, and we're familiar with both ways, right? First of all, payments can be cleared bilaterally, just by cash, hand to hand. I debit my pocket of cash. I credit your pocket with cash. It's done. Now, one property of this transaction is that a lot of the information of the transaction remains private between, say, you and me. The identity of who's done the transacting, the nature of the goods transacted, that's not really part of the public database, if you'd like, it would be difficult for some agency to discover it, unless we just voluntarily revealed it, of course.

The second main way to process payments is through the use of an intermediary. So, the Bank of America, if you have an account there, or you might use Western Union or PayPal, for example. And the way this works, of course, is by instruction. We send our instruction to an intermediary, historically by way of check, but these days typically, by way of debit card, and we instruct the intermediary to debit our account and to credit the account of the merchant.

One property of these types of transactions is that there's a lot more information that's recorded and stored: the identity of the parties who have been transacted typically, the name of the merchant, the goods that are purchased, and this type of information is potentially in case, for example, some government agency wants to audit you for example.

What are some common complaints about this system? I mean, we live and we work in this system, and of course, everybody complains. We hate banks. We hate banks. Everybody hates banks. Even I hate banks. (laughter) Hate is a little strong. Even though there's been a lot of progress in the last 20 or 30 years or last 10 or 20 years whatever in connecting us together, what's still true is that these digital networks still remain highly disconnected. This is especially a problem in the developing world or the underdeveloped world. There's still lots of people who are unbanked. They'd like to have ways to process the payments, but they find it very difficult, although that's changing now very quickly. Even domestically and in well-developed economies, sometimes it seems like financial institutions don't really speak to each other as well as they might.

What's another common complaint? Well, they charge too much for processing payments. I went to the Internet to check how much it would cost me to send $100 from St. Louis to Vancouver, and it was like, Western Union would charge $10 for that transaction. 10 percent, that's a big fee. I mean, it costs me nothing to send an e-mail, but they charge me $10 to send electronic digits in currency form? How do they get away with that?

For some people, a lack of privacy is a problem. Not for all people, some people like the fact that these intermediaries keep records. We're in America, some people like to keep things private.

We hate banks, but we especially hate central banks, right? There's a lot of things to complain about (with) central banks. Not the Fed, of course, but in general. One of the main complaints is that banks diminish the purchasing power of money by printing too much of it. Around the world and throughout history, they tend to create inflation.

So those are common complaints, and these types of complaints that motivate these responses from the community. What can we do with these technological advances to kind of circumvent these kind of problems?