Is my money safe: There’s a FDIC for that.

One of the interesting discussions I’ve had regarding one of my early blog posts has been around bitcoin lending.

The invention of credit has had great implications for economic prosperity and progress. Arguably, the discovery of gold and similar minerals can be credited to have unleashed significant economic progress. It isn’t the intrinsic value of gold that created this value, but rather gold allowed a mechanism to measure credit.

The benefits of credit are widely apparent. A trader on the Silk Road could take a loan from a wealthy individual and use that to buy goods that he would later sell at a profit in a different country, paying back the creditor on his return.

Bitcoin, by design, is a deflationary currency i.e. it’s value increases by time since the amount of Bitcoin released into the network decreases by time and only 21 million bitcoins will be released.

This is in stark contrast to the money supplies issued by governments. There is no upper limit to the amount of dollars the US Fed can print. There used to be a time when all currency issued had to be backed by a certain amount of gold which did impose an upper limit. The gold system was discontinued to allow for expansion of credit to finance World War 2.

So the key question remains: Does Bitcoin lending occur, and if it does, what is the incentive to lend Bitcoin?

The main argument against the extension of credit via Bitcoin is that, by definition, the motive to lend money is to make a return (through interest). However, in the case of Bitcoin, you make a return by simply holding on to it (value increases steadily due to a deflationary network).

The counter argument becomes pretty simple. At the end of the day, if the return you realize through lending is greater than the return you realize through saving, as a rational investor, you would be inclined to lend Bitcoins. However, the ability to gauge the return you would get simply by holding the asset is wherein lies Bitcoin’s weakness.

The high volatility of Bitcoin makes it especially difficult for an investor to reliably “predict” the return they could expect by holding on to the asset.

Additionally, if you were to setup a Bitcoin lending network like a traditional bank, at any point in time you would have lent more Bitcoin then you have collected from depositors. This is the basic economics of how banks work. For each dollar that some one deposits at the bank, you lend out a multiple of that.

The reason that works is at any point in time, only a small percentage of depositors will ask to withdraw their money.

However, there is risk to that. If the amount of depositors looking to liquidate their assets does exceed the current assets the bank does own, the bank will be unable to fulfill its obligations and will “go under”. A typical “run on the bank”, and the reason why most banks fail.

This is a very important to issue to consider, and brings me to the original title of the post. The US Government ensures every bank deposit in the United States up to $250,000. That is to say, if you had deposits in a bank that went under, the US Government will reimburse you up to $250,000.

The US Dollar, backed by the full faith and credit of the United States Government has a clear advantage when it comes to extending credit.

So does Bitcoin lending occur? Yes – a lot of Bitcoin lending appears to be emanating from peer to peer lending networks where an investor could lend Bitcoin to individuals in economies where interest rates are exorbitantly high due to certain economic and political factors, but it remains to be seen whether it turns out to be a significant source of credit.

Below is an assurance from the US Government at my local Wells Fargo, assuring me my money is safe :).

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Byzantine Generals’ Problem: So what’s bitcoin?

I’ve had a great response to my first few posts and one of the questions/feedback I received most has been “Can you talk about what exactly bitcoin is?” So let’s take a step back and explore some of the philosophical and mathematical under pinnings that led to the bitcoin network.

The bitcoin network is widely credited to have solved the Byzantine Generals’ Problem, at least in practice, with certain assumptions.

That was a loaded phrase, so let’ explore in detail.

The Byzantine General’s Problem was first defined in 1982 by a group researchers out of SRI International. The research was in part funded by NASA and is a reflection of the impact the government has had in starting the internet revolution.

The scenario is defined as a group of Byzantine Generals with their troops camped around an enemy city. Communicating only by messenger, they must agree upon a battle plan. However, one or more of them might be traitors and might try to confuse others.

The Byzantine Generals’ Problem succinctly summarizes the issue with decentralized networks and why a centralized body (commercial banks/central banks/governments) has played a critical guarantor role in facilitating electronic transactions.

In our Byzantine Generals’ problem, the only way to ensure the messages are relayed accurately is for a centralized messenger dispatch system that ensures accurate messages are dispatched to all the generals.

To analogize this to an electronic financial system – the generals are merchants and individuals looking to make transactions, relaying messages is the finite money supply and the amount of money people possess (and thus can use for transactions) and the traitors are fraudsters that would take advantage by disseminating incorrect information. The incorrect information would be a fraudster looking to spend the same amount of money in multiple places (double spending).

Let’s say we develop an electronic financial system where a certain set of characters is generated for each unit of currency. Without a centralized authority certifying whether the unit of currency has been spent or not, a fraudster could send the same unit of currency to multiple individuals and hence spending the same “unit currency” in multiple places.

This is an important issue to consider since the existence of a centralized authority (banks) is what ultimately causes transaction costs to balloon (middle man taking cuts) and is why (to this day) international money transfers can take up to 5 days.

The bitcoin network solves this problem by storing each transaction on a public ledger known as the “block chain”. Every transaction that is made on the bitcoin network is recorded on to the block chain. If all the transactions are recorded on a block chain, what prevents somebody from tampering with it or spending the same bitcoin multiple times? The answer is in the decentralized manner in which bitcoin authenticates transactions.

Each time a block chain is created, a distributed network of nodes goes through a mathematical process to verify each of the transactions on the block chain. Each transaction on the block chain is related to the previous transaction. Whenever a node solves the mathematical problem to verify the transactions, it is rewarded with a certain amount of bitcoins. This reward is issued to encourage individuals to solve the mathematical problems to verify the transactions.

The nodes are setup by individuals looking to “mine” bitcoins by solving the mathematical problems. As long as the number of honest nodes is greater than fraudelent nodes, the authenticity of the system is maintained.

In essence, Bitcoin is an electronic currency that allows it to be used as a store of value without need of a centralized authority. The implications of this are significant especially as it relates to transaction costs and speed of transaction. It’s these technological properties that give it fascinating implications for use as a money supply and many other applications outside of currency yet to be explored.

For the more technically minded, here’s a link to the original research paper on the Byzantine Generals’ Problem. And here’s a White Paper from the founder of Bitcoin, Satoshi Nakamoto, whose identity is still unknown.

P.S.  I didn’t have any charts for this blog post but I thought it was interesting to find out I live 13 minutes from SRI International, where the research paper for the Byzantines Generals’ Problem was written.

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