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Digital Currency:
The Transition to a Cashless Society
By
Kenneth Weiss
Faculty SIP Supervisor
Dr. Hannah Apps, Department of Economics and Business
A paper submitted in partial fulfillment of the requirements for the degree of Bachelor of Arts at Kalamazoo College
Fall 2015
i
Acknowledgements
First, I would like to take the time to acknowledge my family, friends, colleagues, and
various professors for contributing ideas and proofreading my research. Second, I would like to
thank Brett Scott, author of The Heretics Guide to Global Finance: Hacking the Future of
Money, for his outlook on the future of money in the world economy. Additionally, I would like
to thank him for aggregating and publishing various academic research pertaining to Bitcoin and
other digital currencies. Third, I would like to thank Val Srinivas, research leader at the Deloitte
Center for Financial Services, for his input on the Deloitte state-sponsored cryptocurrency paper.
Finally, I would like to give a special thanks to my SIP supervisor Dr. Hannah Apps for her
encouragement while I researched the new and exciting field of cryptocurrency. This study
would not have been possible without the knowledge and support from all of you.
ii
Abstract
During the 1800s, the United States banking system was undergoing a transition to
central banking. The history of the Second Bank of the United States shows that during this shift
there was a debate to determine who should control the money supply. Today, the world is
undergoing a transition to a cashless society through the use of digital currencies. On January 3,
2009, the release of Bitcoin (/BTC), the worlds first fully decentralized digital currency,
sparked a revolution. Unlike traditional currencies that are issued by central banks, Bitcoin has
no central monetary authority. Because of Bitcoins growing mainstream adoption, economists
have been exploring the viability of countries adopting centralized or decentralized digital
currencies. Based on this research, it is too early to speculate if the path toward a cashless
society will be centralized or decentralized. This is because there is no alternative digital
currency that has been implemented. As todays world is more globalized, any sort of digital
currency would have worldwide consequences. Therefore, future research regarding this
transition must be taken very seriously.
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Table of Contents
Acknowledgements ......................................................................................................................... i
Abstract .......................................................................................................................................... ii
Table of Contents .......................................................................................................................... iii
I. Introduction .................................................................................................................................1
II. Literature Review .......................................................................................................................3
2.1 Functions of Money ......................................................................................................3
2.2 Forms of Money ............................................................................................................5
2.3 Modern Central Banking System ..................................................................................8
2.4 Second Bank of the United States ...............................................................................11
III. Analysis ...................................................................................................................................13
3.1 Digital Currency vs. Cryptocurrency ..........................................................................13
3.2 Bitcoin: A Peer-to-Peer Electronic Cash System ........................................................14
3.3 Centralized Digital Currencies ....................................................................................21
3.4 Deloitte State-Sponsored Cryptocurrency Paper ........................................................21
3.5 Yanis Varoufakiss Future Tax Coin (FT Coin) Proposal ..........................................25
3.6 New Economics Foundation: ScotPound Proposal .....................................................27
IV. Conclusion ..............................................................................................................................31
Sources ..........................................................................................................................................34
Appendix .......................................................................................................................................37
1
I. Introduction
Technology has changed the way people live and communicate with each other.
More specifically, the rise of the internet changed the way people work, learn, build
relationships, and multi-task. For better or worse, the internet impacted many industries
in society. For instance, before the internet, established record companies controlled the
distribution of physical music product. Now, a majority of music is distributed directly to
consumers through online stores or streaming services (El Gamal, 2012). Despite the
many revolutionary changes that internet technology has brought the world, there are still
some parts of society whose structural functions have not progressed. The central
banking system is an evident example. Although consumer financial services evolved
through the internet, the core functions of how money works have remained largely
unchanged.
On January 3, 2009, the release of Bitcoin (/BTC), the first fully decentralized
digital currency, showed that it is a part of the worlds shift to a cashless society. Unlike
traditional currencies that are issued by central banks, Bitcoin has no central monetary
authority. It is maintained through a peer-to-peer computer network that operates on a
cryptographic protocol. New Bitcoins are created by miners who use special software to
solve complex mathematical problems. In exchange, they are rewarded with new units of
bitcoin. This provides an incentive for more people to mine bitcoin. Additionally, this
incentive helps maintain the integrity of this decentralized system. All transactions are
self-verified and posted to a secure public ledger known as the block chain. The invention
of a distributed ledger is revolutionary. Essentially, this technology allows value to be
exchanged safely without a middleman such as a government or a bank.
2
The development of this revolutionary technology accelerated the debate over
who should control the money supply. During the 1800s, a similar debate existed. The
United States banking system was undergoing a slow transition to central banking. The
history of the Second Bank of the United States shows there was a power struggle
between state banks and central banks over who should control the money supply. The
development of digital currencies shows that a similar debate exists between those
supporting centralized digital currencies and decentralized digital currencies.
This paper addresses whether or not any type of digital currency can fulfill the
three basic functions of money. Additionally, this paper considers the monetary policy
implications of these new currencies. Finally, this paper determines if the path toward a
cashless society will lead to a centralized or decentralized currency.
This library research paper is organized as follows. First, in the literature review,
this paper discusses the definition of money by using its main three functions. This
theoretical framework is central to determining what can be classified as money. Second,
different forms of money are explored to show how none of them is perfect. Third,
modern central banking is studied as it is an important aspect of modern monetary
systems. Fourth, the history of the Second Bank of the United States is discussed to show
the importance of who controls the money supply. Finally, analysis of Bitcoin and other
digital currencies are explored to see if they can be considered money.
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II. Literature Review
2.1 Functions of Money
What is Money?
It is important to comprehend the basic principles of money to determine if the
path toward a cashless society will lead to a centralized or decentralized currency. These
functions are essential to concluding if digital currencies can be considered money in
their current state.
What is money? On the surface, this should be a very simple question to answer.
Everyone uses money, works for it, and thinks about it. However, unless you are an
economist, defining what money is and where it comes from can be very difficult. The
following will demystify this question by exploring the three basic functions of money.
Medium of Exchange
First, a digital currency must be a sufficient medium of exchange to be considered
money. Since ancient times, money has played an important function as a medium of
exchange in society. A medium of exchange is an intermediary instrument used to
facilitate the sale, purchase or trade of goods between parties (Nikolakopulos, 2015). For
example, producers sell their goods to vendors in exchange for money. In turn, vendors
sell these goods to consumers in exchange for money. Similarly, everyone in society sells
their services in exchange for money. With this money, people in society buy the goods
and services that they need or want.
4
Money can only operate as a medium of exchange when the general population
accepts it in that role. For example, Amy is willing to accept money for marketing
consulting if she is confident others will accept this money from her in the future.
Unit of Account
Second, a digital currency must be a sufficient unit of account to be considered
money. A unit of account is a standard monetary unit of measurement of the cost of
goods, services, or assets. Simply, prices for goods or services are quoted in terms of
money rather than in terms of other goods or services (Nikolakopulos, 2015).
For example, if Menelik walks into an Italian restaurant, he may see a menu that
shows that a large pizza costs $15 and a lasagna dinner costs $10. Because money is a
unit of account, he is able to compare these prices. However, if Twinkies and Ding Dongs
were used as units of account, comparing prices would be problematic. Menelik would
have a difficult time determining what costs more, a large pizza costing 10 Twinkies or a
lasagna dinner costing 15 Ding Dongs.
Store of Value
Finally, a digital currency must be a sufficient store of value to be considered
money. A store of value is any form of commodity, asset, or money that people use to
transfer purchasing power from the present to the future (Nikolakopulos, 2015).
For example, Ahmed teaches as a college professor in exchange for a salary.
Assume that he is saving five percent of his salary to go toward replacing his hat in the
coming year. In this scenario, his savings acts as a store of value. Assuming normal
5
economic conditions such as low inflation, Ahmed can choose at any time to purchase a
new hat. Conversely, Ahmed would refuse to teach if he were only paid in food. This is
because he would have to consume it before the food expires and loses its value.
Consequently, he would need to find someone willing to trade a new hat for some of his
food in the short-term.
2.2 Forms of Money
Why it matters?
It is important to understand the different forms of money that have evolved
throughout history to gain perspective on the current transition of the world toward a
cashless society. The financial system of todays world is the product of centuries of
evolution. The limitations of each incarnation of money led to new innovations. Similar
to the past, changes to money will continue to occur in response to social and
technological progress (Kolar, 1993). The following section looks at different forms of
money to demonstrate that none of them are perfect. Therefore, it is unreasonable to
believe that digital currencies can be a perfect form of money. As the history of money is
complex, this paper does not discuss a complete historical narrative of the evolution of
money.
Barter System
In prehistoric times, people lived much simpler lives by only relying on their
basic needs. Because of this, they were self-sufficient due to hunting and fishing. During
6
this time period, people had very few wants. As time progressed, these wants grew.
Naturally, human beings became incapable of satisfying all of their wants.
The barter system grew out of this reality. Scottish economist Adam Smith
explains the origin and use of money in The Wealth of Nations. Before money existed in
its current form, the world used a barter system to exchange goods or services. Bartering
is when an economic actor, such as a person, exchanges goods or services without the use
of a monetary medium (Smith, 1776). Suppose we have Tim and Hannah. Tim, a chicken
farmer, has five chickens but wants to get some pears. Hannah, a farmer, has ten pears
but wants some chickens. In the unlikely scenario that Tim and Hannah meet, Hannah
may trade some of her pears for one of Tims chickens. Although bartering is slow, it was
sufficient to satisfy some of the peoples basic wants during that time period.
Naturally, as trade became more complex, the economic problem of double
coincidence of wants became more prevalent. William Stanley Jevons explains that
double coincidence of wants is the difficulty of finding two people whose disposable
possessions mutually suit each other's wants. Although there may be many people
wanting and many possessing those things wanted, these transactions are rare because
there must be a double coincidence of wants (Jevons, 1875).
Metallic Commodity Money & Commodity-Exchange Money
As civilization progressed, metallic commodity money became widespread. Coins
made of metals like gold, silver, and copper were used in exchange for goods or services.
Coins were ideal because they can be easily handled. Smriti Chand rationalizes the
benefits of metallism being officially adopted by governments. If a government minted
7
coins, it standardized the weight and content of these metals. Because of this, they were
more easily exchanged (Chand, n.d.). For example, a $100 gold coin would have $100
worth of gold in it. Metallic money was the main form of money throughout the major
portion of recorded history.
Although metallic commodity money was more convenient than bartering, there
were still some practical issues. For example, it was dangerous to carry gold or silver
coins around. This is one of many problems that led to the creation of commodity-
exchange money. Andrew Beattie explains that as metallic commodity money became
more impractical, people started storing their gold at goldsmiths or temples in exchange
for a claim check (Beattie, n.d.). For example, if one deposits a one-ounce gold, they
would get a one-ounce gold claim check. These claim checks had the same value and
were theoretically redeemable at any time. Naturally, people began using these claim
checks as a form of money.
Fiat Money
Starting in the twentieth century, metallic commodity and commodity-exchange
money began falling out of favor. Ed Moy explains that this is especially true in the
United States during the period leading up to World War II. At this time, the global
economy was suffering from the Great Depression and the world was headed toward war.
Governments wanted more money to stimulate the economy and fund their militaries.
However, due to precious metal reserve limits, they could not print more money. Thus,
money could only be printed if they grew their precious metal reserves (Moy, 2014). As
8
mining new metals is a time-consuming process, it makes sense that these forms of
money would eventually become insufficient.
This deficiency led to the widespread adoption of fiat money. This is money that
has no intrinsic value itself. Additionally, there is no guarantee that it can be exchanged
for a valuable commodity. Simply, governments decree fiat money as legal tender. At this
time, most countries use fiat money and no longer link it to anything of value. Rather, the
value of fiat money is solely based on the confidence in the government that created it
(Gobry, 2013). Because fiat money is not linked to anything of value, more of it can be
printed. Like other evolutions of money, fiat money is not perfect. Since money can be
printed at the will of the government, inflation is always a risk.
Cryptocurrency is a new form of fiat money. Cryptocurrencies are digital
currencies that are decentralized in nature. Because they are not controlled by a central
bank, the value of cryptocurrencies is determined by market supply and demand. As a
result, Bitcoin behaves similarly to precious metals like gold and silver (Nakamoto,
2009). Proposals regarding cryptocurrencies or other digital currencies will be discussed
in greater detail in subsequent sections of this study.
2.3 Modern Central Banking System
Why Central Banking Matters?
Another factor to determining if the path toward a cashless society will lead to a
centralized or decentralized currency is to understand how the modern central banking
system works. As will be discussed, the technology behind digital currencies could
change how money is created and how monetary policy is enacted.
9
What is a Central Bank?
A central bank is an institution that is responsible for overseeing the monetary
system for a nation. From historical practice, central banks have three specific powers.
Central banks control interest rates, control the money supply, and are the lender of last
resort. In theory, these powers enable central banks to work toward policy goals. This
includes currency stability, low inflation, and full employment (Heakal, 2015). Examples
of central banks include the Federal Reserve Bank (U.S.), the European Central Bank
(EU), and the Bank of England (England).
Creation of Fiat Money
To easily comprehend how digital currencies may differ, one must understand
how new units of traditional fiat money are created. To illustrate how money is created,
the Federal Reserve Bank (Fed) will serve as an example. Suppose Congress votes to
increase the Federal debt limit to $5 billion. Congress then instructs the U.S. Treasury to
write interest-bearing bonds for this amount. Next, the Treasury offers these bonds to the
Fed against the taxpayers ability to pay. The Fed buys these bonds from the U.S.
Treasury by crediting the governments checking account. As a result, the Treasury is
able to write checks against the created credit. These checks are circulated throughout the
country and deposited into banks. Next, banks send these Treasury checks to the Fed. The
Fed debits the Treasurys account and credits the banks with the same amount.
Consequently, these credits increase banks reserves. Finally, these reserves are used as a
base by commercial banks to lend out at interest (Kerkhoff, 2013). The diagram below
outlines this process.
10
Monetary Policy
To recognize how digital currencies can disrupt the effectiveness of central
banking, one needs to understand how monetary policy is enacted. Central banks use
several tools to control monetary policy. The Federal Reserve Bank of San Francisco
(FRBSF) discusses some of these tools. Direct policy controls are used to establish limits
on interest rates, credit, and lending. These tools include interest rate controls, credit
controls, and lending to domestic banks. Indirect policy controls, which are used more
commonly by central banks, are used to adjust liquidity conditions of monetary systems.
These tools include reserve requirements and open market operations.
The Fed uses open market operations to influence the supply of bank reserves.
Usually, this consists of purchases and sales of U.S. Treasury securities. For example,
during the Great Recession, the Fed wanted to increase liquidity conditions of the U.S.
monetary system. The Fed accomplished this by enacting a quantitative easing program.
This program is an expanded type of open market operation that targets commercial bank
11
and private sector assets. This is done with the intention of stimulating economic growth
by encouraging banks to lend money (FRBSF, 2004). The diagram below outlines this
process.
2.4 Second Bank of the United States
A historical example of the transition of money is seen in the history of the
Second Bank of the United States (SBUS). During this time period, the United States was
transitioning to a central bank in its monetary system. Unsurprisingly, there was
controversy over who should control the money supply. In this case, the debate was
between state-chartered banks and a federal-chartered central bank. Currently, the world
is transitioning to a cashless society. Bitcoin has started a debate over the use of
centralized or decentralized digital currencies. It is important to discuss SBUS to
understand the overarching significance of the worlds transition to a cashless society.
Simply understanding different digital currencies is not sufficient. The history of SBUS
helps put todays transition into perspective.
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Before SBUS was founded, the United States economy was in shambles. First,
there was increased debt due to the War of 1812. Second, state-chartered banks
suspended specie payments of gold. Because of this economic environment, Congress
chartered SBUS for a twenty-year period. Its responsibilities were somewhat similar to
many modern central banks. Essentially, SBUS acted as a clearinghouse and an early
bank regulator. It held quantities of other banks notes in reserve. For example, if SBUS
felt any of its branches were over-issuing notes, they could threaten to redeem those
notes. This meant that these branches would have to pay SBUS in specie to cover the
notes they were issuing. This was crucial because during this time period, money was
backed by gold.
Although SBUS did a sufficient job controlling the money supply toward the end
of its charter, there were many opponents. The most vocal opponent was President
Andrew Jackson. First, he believed that SBUS trampled on states rights. Second, he felt
that too much power was being given to too few private citizens. Third, he disliked paper
money due to a bad business experience. As a result, his reelection campaign revolved
heavily around letting the banks charter expire.
After winning reelection, President Jackson ordered that federal deposits be
withdrawn from SBUS and deposited into state banks. This was done despite his
administrations criticism of this action. In response, Nicholas Biddle, the President of
SBUS, made the divisive decision to limit credit and call in loans. He hoped that by
putting pressure on financial markets, President Jackson would reconsider his decision. In
the public eye, Biddles actions helped to support Jacksons point that power was held by
too few. Due to President Jacksons veto on renewing SBUSs charter, it eventually
13
closed. It would be another 75 years until the United States made another attempt at
central banking by chartering the Federal Reserve. During this period, the financial
system had quite a few crises. It can be argued that a central bank could have prevented
them (Federal Reserve Bank of Philadelphia, 2010).
The main takeaway from the history of SBUS is that whoever controls the money
supply can determine the future of a nation. Clearly, the power struggle between these
two men caused major long-term ramifications for the United States. In todays transition
to a cashless society, digital currencies have the potential to cause major long-term
effects on the entire world. Therefore, it is vital to explore different digital currencies and
proposals to understand what the future of money may look like in a cashless society.
III. Analysis
3.1 Digital Currency vs. Cryptocurrency
Although these terms may seem interchangeable, there are important differences
that must be noted. First, a digital currency is any currency that is not printed on paper or
stamped into metal. It is considered a digital currency because it only exists in the digital
world. However, a digital currency can represent physical currency. For example, most of
the global money supply is digital and not held in physical form.
A cryptocurrency is a decentralized digital currency that uses cryptography for
security. Because of this security feature, it is very difficult to counterfeit. Specifically,
encryption techniques are used to regulate the new generation of units of currency and
verify the transfer of funds. Because of this, cryptocurrencies operate independently of a
central bank. Thus, it is theoretically immune to governmental interference. On January
14
3, 2009, the release of Bitcoin, was the worlds first fully decentralized digital currency.
From Bitcoins success, multiple altcoins, alternative cryptocurrencies, were created.
Since Bitcoin is currently the largest cryptocurrency, it will be the only one directly
referenced in this paper.
3.2 Bitcoin: A Peer-to-Peer Electronic Cash System
As previously mentioned, Bitcoin was the worlds first fully decentralized digital
currency released on January 3, 2009. It was created by a person or a group of people
under the pseudonym Satoshi Nakamoto. This group of people created the first paper
regarding this system in Bitcoin: A Peer-to-Peer Electronic Cash System.
In his introduction, Nakamoto explains that internet commerce is flawed as it
almost exclusively relies on financial institutions serving as trusted third parties to
process electronic payments. He believes that although this works for most transactions,
it still suffers from the weaknesses of the trust based model. First, due to the increasing
cost of mediating disputes, financial institutions increase transaction costs. Because of the
reliance on financial institutions, people are unable to make small non-reversible
payments for non-reversible services over the internet. Second, due to increasing dispute
costs, internet merchants are forced to ask their customers for more information to
validate transactions. With physical currency, these weaknesses can be avoided.
However, there is no mechanism to make payments over the internet without a trusted
third party (Nakamoto, 2009). Bitcoin was created in order to address these issues
without physical cash.
15
Bitcoin Transaction Example
To determine if cryptocurrencies display the three functions of money, one must
be familiar with how a transition on the Bitcoin network works.
Scott Driscoll gives a very technical explanation of how the Bitcoin system works
(Driscoll, 2013). To explain how the Bitcoin system works in a simplified manner,
assume the world only has six people. The world population consists of Bitcoin users
named Tim, Hannah, Amy, Chuck, Menelik, and Patrik. For expanded explanations of
specific Bitcoin terminology, please refer to the Appendix of this study. Note that real
Bitcoin transactions are more complicated than the example outlined below.
Hannah, an online merchant, decides to begin accepting bitcoins as payment. Tim,
a buyer, has bitcoins and wants to purchase a knitted sweater from Hannah for 5. Both
Hannah and Tim have Bitcoin wallets on their computers. Bitcoin wallets are files that
provide access to multiple Bitcoin addresses. Each specific address has its own balance of
bitcoins. In this scenario, Hannah creates a new Bitcoin address for Tim to send his
payment to. On his computer, Tim tells his bitcoin client to transfer 5 to Hannahs new
Bitcoin address. On a basic level, Tims balance goes down by 5 and Hannahs goes up
by 5. Although this is seemingly uneventful, the backend process that allowed this
transaction to take place is revolutionary.
When Hannah created a new Bitcoin address, she created a cryptography key pair
that consists of a private key and a public key. A private key is similar to a password one
has for their online bank account. Like an online bank account password, only the owner
knows it. The private key Hannah created will allow her to spend the bitcoins she is about
to receive from Tim. Note, that private keys are necessary to spend bitcoins in a wallet.
16
For simplicity, the public key represents Hannahs new Bitcoin address.
When Tim sent 5 to Hannahs address, also known as a public key, he used his
private key as a signature. This verified that he was the actual owner of the Bitcoin
address he was sending money from.
Although not apparent, Amy, Chuck, Menelik, and Patrik played an important
role in completing the transaction between Hannah and Tim. These four other people are
known as Bitcoin miners. Their job is to verify transactions and maintain security of the
Bitcoin network. Their computers are running free software that automatically bundles all
transactions of the past ten minutes into what is known as a block. In order to validate
these transactions or mine the block, the miners computers compete to solve a difficult
mathematical equation known as a hash function. The computer that solves the equation
first further processes that specific block. The winning miner broadcasts this proof-of-
work to the entire bitcoin network. The other miners computers double-check the
proof-of-work and the validity of the transactions. If approved, the winning miner earns a
reward of 25 newly minted bitcoins. This creates incentive for miners to provide
computing power for the network. Finally, the mined block is added to the blockchain.
In this scenario, Amy, Chuck, Menelik, and Patrik competed to solve the hash
function for the block that contained Tims transaction to Hannah. As it turned out, Patrik
was the winning miner. He broadcasted his proof-of-work to the entire network and
Amy, Chuck, and Menelik double-checked his work. As it was approved, Patrik earned
25 newly minted bitcoins in compensation for his computing power. Finally, the mined
block containing Tims transaction to Hannah is recorded on the blockchain. Since the
blockchain is unbreakable, it is proof that this transaction took place. Note, in an actual
17
bitcoin transaction, only the public keys and the amount of bitcoins sent are recorded on
the blockchain ledger. This creates a degree of privacy.
Bitcoin Analysis
For Bitcoin to serve as a sufficient medium of exchange, it must be widely
adopted. Since 2013, there has been an increase in Bitcoin adoption due to widespread
media hype over its skyrocketing value. The largest companies that accept Bitcoin are
WordPress, Dell, Namecheap, Zynga, and Microsofts search engine division, Bing
(Tanasa, 2015). Although these companies are recognizable, mass mainstream adoption
of Bitcoin has yet to be attained. According to information from Blockchain.info, Bitcoin
processes less than 200,000 transactions per day. In comparison, PayPal, a popular online
payments system processes an average of 12.4 million transactions per day (Coins, 2015).
Also, the largest four credit card companies process over 32 million transactions per day
(MasterCard, n.d.). Since Bitcoin has not been officially adopted by any country, private
enterprise will continue to be solely responsible for continued mainstream adoption. In
this case, Amy would not be willing to accept bitcoins for marketing consulting because
she would not be confident others would accept bitcoins from her in the future. As such,
for a new form of money to act as a suitable medium of exchange, there must be
widespread acceptance.
For Bitcoin to serve as a sufficient unit of account, comparing prices must be
relatively easy. Unlike most traditional currencies, Bitcoins are divisible down to eight
decimal places. For example, 1 USD could be worth 0.0043. Compared to normal
monetary units, Bitcoin prices could be very confusing for the average consumer. For
18
example, assume Menelik is an uneducated consumer. He would have difficulty
determining the price difference between a large pizza that costs 0.0645 and a lasagna
dinner that costs 0.044. Although it is possible to discern the difference of fractional
bitcoins, traditional currencies have an advantage in this scenario.
Additionally, prices would need to be relatively stable for Bitcoin to serve as a
sufficient unit of account. Because Bitcoin is not widely accepted on an official basis, its
exchange rates to traditional currencies are still important. Compared to traditional
currencies, the value of a bitcoin fluctuates greatly on a day-to-day basis. Thus,
merchants that directly accept bitcoin have to recalculate prices often. Naturally, Menelik
would be confused if one day a large pizza costs 0.0645 and then the next day it costs
0.0937.
For Bitcoin to serve as a sufficient store of value, two things must be considered.
First, one must be able to spend their bitcoins at any time. Although the Bitcoin network
itself is extremely reliable, there is an inherent weakness with how digital wallets work.
Based on the design of Bitcoin, if someone were to lose their private key for their wallet,
they would be unable to spend the bitcoins within it. Because Bitcoin has no centralized
authority, there is no one that could recover ones private key. In an ordinary banking
system, one can either deposit money at a bank or obtain physical manifestations of
money. If someone were to lose their bank account number, a bank representative could
always cross-reference your identity to give you access to your deposited money.
Conversely, physical cash is the opposite. If someone stuffed cash in their mattress and
their home burned down, their money would be gone. In this sense, bitcoins are like
digital cash.
19
Second, bitcoin must hold its value over time. As in the earlier example, Ahmed
may want to replace his hat in the future. If his salary was exclusively paid in bitcoins
there could be some issues if its value fell. Regardless if Ahmed saved his private key,
Bitcoin may remain an insufficient medium of exchange. By extension, it would be an
insufficient store of value. This is because its value is volatile in comparison to other
traditional currencies.
Although Bitcoin is revolutionary, it is evident that there are many obstacles it
must overcome to be classified as money. The issues of Bitcoin under all three functions
of money are interrelated. They show that Bitcoin must serve as a sufficient medium of
exchange before it can serve as a sufficient unit of account and store of value. As
mentioned before, commodity-exchange money is backed by gold and official fiat money
is backed by a sovereign entity. The current market value of bitcoin solely hinges on the
expectation of others willingness to accept it later at a sufficiently greater value (Lo,
2014). The speculative nature of Bitcoin seems to be a necessary evil to get widespread
acceptance. However, over the last year, Bitcoin adoption seems to have stalled (Chavez-
Dreyfuss, 2014).
Some third party companies have tried to address some of the store of value
issues to make Bitcoin a more attractive medium of exchange. For example, a merchant
wanting to accept bitcoin might consider using BitPay as a payment processor. In
exchange for a very low 1% transaction fee, BitPay allows merchants to accept bitcoin
while receiving a payout in a traditional currency. For example, if a merchant sold an
item on their website for $5, regardless of the bitcoin exchange rate, BitPay guarantees
20
that this merchant will receive a payout of $5 minus the transaction fee (Hajdarbegovic,
2014).
If someone wanted to remove the hassle of backing up their private key, they may
want to consider opening up a hosted wallet with Coinbase. With this type of service, one
trusts a private third party to keep bitcoins safe on their behalf. According to the company
website, they keep bitcoins safe by storing customers private keys in offline safe deposit
storage. Because of this, users are never given private keys to their hosted wallets as
Coinbase is solely responsible (Cawrey, 2014).
Although paradoxical to the main premise of Bitcoin, it is natural that private
third parties would create solutions to improve the practicality of Bitcoin as a medium of
exchange. Despite much media attention, it does not seem that Bitcoin will expand
beyond niche acceptance status at this point. The apparent failure of private third parties
making Bitcoin more mainstream from the ground up, suggests that cryptocurrencies or
other digital currencies would need to be adopted from the top down.
Additionally, Bitcoin shows that in todays world, completely decentralized
digital currencies will not be adopted as a countrys official currency. The design of
Bitcoin would render monetary policy by a central bank useless (Robleh, 2014). Unlike
traditional fiat currencies, a central bank would not be able to control the supply of
cryptocurrency in an economy. As most other countries practice some form of monetary
policy, it would not be prudent for any country to officially adopt a cryptocurrency from
this standpoint.
Despite this, there is still a possibility that other forms of cryptocurrencies will be
created in the future. As Bitcoin is open source software, developers could tweak the
21
code to make it a more attractive medium of exchange. Alternatively, more innovative
systems could be created that address many of the problems discussed above. Although
Bitcoin will probably not be the future of money, this does not mean that blockchain
technology does not have a future in a cashless society. This is evident in the creation of
centralized digital currencies.
3.3 Centralized Digital Currencies
Because of the extreme media hype surrounding Bitcoin and the technology
behind it, economists, think tanks, and private enterprises have been exploring
applications of centralized digital currencies. The following will examine Deloittes state-
sponsored cryptocurrency paper, Yanis Varoufakiss Future Tax Coin proposal, and New
Economics Foundations ScotPound proposal.
3.4 Deloitte State-Sponsored Cryptocurrency Paper
The Deloitte state-sponsored cryptocurrency paper outlines a framework of how
the United States can adopt a centralized digital currency with some cryptographic
similarities to Bitcoin. Note, the title of the paper wrongly implies it is a decentralized
digital currency that would be state-sponsored. This key difference is important to
understanding if the path toward a cashless society will lead to a centralized or
decentralized currency.
22
Deloitte Paper Transaction Example
The following is a repurposed example showing how a transaction would work in
this system. For simplicity, lets refer to money in this proposed system as a crypto-dollar.
As in the Bitcoin transaction example, Hannah decides to begin accepting crypto-dollars
as payment. Tim a buyer, has crypto-dollars and wants to purchase a knitted sweater from
Hannah for 5 crypto-dollars. In order to make this transaction, Hannah visits a registered
entity such as Bank A. Bank A obtains Hannahs Tax ID, SSN, Address, etc. in order to
verify her identity. The bank will store this information securely and confidentially. Bank
A creates and approves a cryptographic key pair consisting of a private key and a public
key for Hannah. Tim initiates a transaction to send 5 crypto-dollars to Hannahs address
by using his private key as a signature. This verifies that he is the actual owner of the
address he is sending money from. Instead of miners in the Bitcoin system, regulated
banks would compete to verify transactions. They ensure that both Hannah and Tim have
a valid private key in the ledger, as well as confirm that the sender has enough funds for
the transaction. In this case, Bank A is rewarded a small fee for verifying the transaction
first. Finally, the confirmed transaction is posted to the public ledger. This makes the
transaction transparent, auditable, and irreversible (Symes, 2015).
Deloitte Paper Analysis
The transaction process described above shows that this theoretical digital
currency would work very similar to Bitcoin. Note, that because this part of the process
would be decentralized, transactions made on this network would be irreversible.
23
Despite the many similarities, there are a few key differences. First, financial
institutions would not mine for crypto-dollars. Rather, their sole responsibility would be
to verify transactions. Second, unlike Bitcoin, there would be no cap on the money
supply of crypto-dollars. Only a central bank could add or remove crypto-dollars on this
distributed ledger. Thus, transactions in this system are verified in a decentralized manner
but the creation of new crypto-dollars is centralized. In the Bitcoin network, both
processes are completely decentralized. Third, users could deposit crypto-dollars from
their wallets to interest-bearing bank accounts insured by the FDIC. Fourth, if someone
were to lose their private key, a bank would be able to retrieve it on their behalf. Thus,
one could never lose crypto-dollars stored in their wallet. Finally, a crypto-dollar would
have the same legal tender as a physical dollar. For example, a crypto-dollar could be
exchanged for par value with a physical dollar. Thus, a crypto-dollar is not a new
unfamiliar digital currency. Rather, it is just a new medium of exchange for an existing
currency that is backed by the full faith and credit of the U.S. government.
Unlike Bitcoin, crypto-dollars would allow monetary policy to exist. In this
scenario, the Federal Reserve could expand or contact the crypto-dollar money supply
through open market operations. They could do this by transferring crypto-dollars from
their wallet using their private key to different financial institutions wallets. The
following chart from this paper shows what roles each institution would fulfill in a
potential state-sponsored cryptocurrency environment.
24
This Deloitte paper emphasizes that it is important for a digital currency to be a
sufficient medium of exchange from its inception. As crypto-dollars would be backed by
the U.S. dollar, Amy would be willing to accept them for marketing consulting because
she is confident others would accept this money from her in the future. By extension, this
proposed digital currency would be a sufficient unit of account. Since crypto-dollars
would be exchanged for par value for physical dollars, Menelik would easily know the
difference between a large pizza costing $10 and a lasagna dinner costing $15. Finally,
this proposal states that banks would provide interest-bearing accounts insured by the
FDIC. This could make crypto-currency a sufficient unit of account. In this case, Ahmed
could safely deposit crypto-dollars in a bank account with the intention of replacing his
hat later this year.
Despite this proposal addressing many of the issues of Bitcoin, it is unclear if
consumers would be comfortable using a digital currency where transactions are
irreversible. Additionally, like any other new concept, there would be a learning curve.
25
Since crypto-dollars would be used alongside traditional fiat currency, this system would
be completely voluntary. As such, the adoption rate could be slow in the consumer
segment.
This proposed framework seems better suited for business-to-business
transactions. For example, assume Company A and Company B has a strong business
relationship. In this case, both companies are unconcerned that transactions with crypto-
dollars are irreversible. The decentralized aspect of the crypto-dollar system would allow
for faster and potentially cheaper remittances than those settled through the Automated
Clearing House network (ACH). There is a clear need for this type of a system in the
private sector. For example, Bank of America recently filed a patent for a similar
cryptocurrency wire transfer system (Rizzo, 2015).
As this paper outlines the potential benefits of using a centralized digital currency
with cryptographic features as a new medium of exchange, it supports the idea that block
chain technology could be used in some form in the future. However, the concept of
digital currencies supplanting or working with traditional currencies is too new. Although
this proposed framework is intuitive, it does not answer the question whether the future
of money will be centralized or decentralized.
3.5 Yanis Varoufakiss Future Tax Coin (FT Coin) Proposal
The Greek debt crisis is another realistic example of where the technology behind
cryptocurrencies could potentially be used in a centralized digital currency. Before
explaining how this technology could be enacted, it is important to have a basic
understanding of this ongoing crisis.
26
In a nutshell, constant government borrowing over the years to fund promises by
politicians caused Greeces cash crunch. As a result, Greece defaulted on its loan from
the International Monetary Fund on June 30, 2015. This led to the discussion of whether
or not Greece would exit the Eurozone. At the time, there were a few options Greece
faced. First, they could have negotiated new bailout terms to stay in the Eurozone.
Second, they could have reached a deal for an amicable departure from the Eurozone
while remaining in the European Union. Third, Greece could have made an unplanned
exit from the Eurozone. Greece ended up negotiating new bailout terms to stay in the
Eurozone. If Greece had left the Eurozone, they could have reintroduced the drachma as
their currency.
As outlined by Yanis Varoufakis, Greeces Finance Minister at the time, the
technology behind cryptocurrency could have offered a unique medium-term solution to
this crisis. He speculated that a parallel digital currency could be created to pay
pensioners and public-sector workers. This would be done by creating a centralized
digital currency that would be backed by future tax revenues and denominated in euros.
This system could be run using cryptography to ensure safe, transparent, and efficient
transactions. In theory, this would preserve scarce euros to pay the countrys creditors
while offering much needed liquidity in the Greek economy. Most importantly, this
national supply of euros would be legal in the context of the European Unions treaties.
As such, Greece could adopt this digital currency while remaining in the Eurozone
(Varoufakis, 2014).
27
Similar proposals from Bitcoin enthusiasts suggest that Greeces illiquid assets
could be tokenized and be used to back up a parallel digital currency. In theory, the result
would be similar to Yanis Varoufakiss proposal (Kelly, 2015).
The FT Coin proposal is very similar to the crypto-dollar framework in the
Deloitte paper as it would prioritize money as a medium of exchange. However, it is
different because it would not be a voluntary form of payment. As a result, it is
reasonable to argue that it would become a sufficient medium of exchange. Varoufakiss
proposal does not make it clear if FT Coin would become a sufficient unit of account or a
sufficient store of value. However, assuming it has similar features to the crypto-dollar
framework, it could satisfy all three functions of money.
The FT Coin proposal shows that centralized digital currencies can provide a way
for countries to manage their debt. This potential use is another reason why
cryptocurrencies could play a part in a cashless society. However, at this point it is
unclear whether the future of money will be centralized or decentralized.
3.6 New Economics Foundation: ScotPound Proposal
The popularity of Bitcoin has accelerated discussions regarding the transition
toward a cashless society. However, not every innovative proposal or framework uses
Bitcoin as a template for its digital currency. It is important to examine these alterative
proposals to determine if the future of money will be centralized or decentralized.
New Economics Foundations proposal suggests that Scotland should adopt a
centralized digital currency called the ScotPound (S) alongside the existing pound
sterling. The goal of this currency would be to create an economic boost for Scotland,
lower business costs, and be socially inclusive. They propose that a new public-interest
28
institution called BancaAlba would be created. This third party would become the sole
issuer of ScotPound. Additionally, they would be responsible for managing and operating
ScotPay, the payment system that ScotPounds are transferred between individuals or
businesses.
During the implementation process, everyone on Scotlands electoral register
would have an account opened for them at BancaAlba. BancaAlba would distribute the
citizens dividend of S250 per person. Once an individual reaches the age of legal
capacity, BancaAlba would open an account on their behalf and distribute the citizens
dividend of S250. In effect, this would constantly add more units of ScotPound to the
money supply.
To incentivize businesses to accept ScotPound, the payment system itself would
be free for everyone. Transactions would be carried out using the internet or mobile
phones. The New Economics Foundation proposes that the initial operating costs of
ScotPay would be covered by the Scottish government. In order to increase acceptance of
this currency, public services would accept payments in ScotPound.
To encourage spending, one would not be able to accrue interest on saved
ScotPounds. This is because unlike traditional currencies, new units of ScotPound would
not be created from debt. Due to inflation, idle balances of ScotPound would lose value
over time. As ScotPound would not be convertible to the pound sterling, it would force
spending within Scotland. Lastly, spending ScotPound would be relatively easy as its
currency units be equal in value to the pound sterling. The following chart from this
proposal graphically depicts how this digital currency differs from traditional fiat
currencies (New Economics Foundation, 2015).
29
ScotPound Analysis
It is clear that the goals of the ScotPound proposal are very different than the
original premise of Bitcoin. The idea behind cryptocurrencies is to provide users a way to
safely, efficiently, and cheaply transfer value over the internet without a third party.
Whereas, the main goal of ScotPound would be to stimulate the Scottish economy
through the introduction of an autonomous and nonconvertible digital currency.
Essentially, this digital currency would be a new form of quantitative easing. Because
BancaAlba, a third party, would centrally control this system, they would have the power
to expand the ScotPound money supply as they see fit. In other words, during times of
30
austerity, they could distribute more dividends to eligible citizens accounts. As this
digital currency is autonomous to the pound sterling, BancaAlbas monetary policy
would not add to Scotlands debt.
Like the Deloitte paper, the ScotPound proposal emphasizes the importance of
money as a medium of exchange. First, every eligible citizen would receive an initial
dividend. Second, the free ScotPay payment system would entice companies to accept
ScotPound. These qualities could potentially make ScotPound a sufficient medium of
exchange. However, it is not clear how fast businesses would adopt ScotPay.
Additionally, as the world is globalized, people may not want to spend money
exclusively in Scotland. As a result, Amy may be willing to accept some of her salary in
ScotPay for marketing consulting because she is somewhat confident others will accept
this money from her in the future. Because this proposed digital currency would be equal
in value to the pound sterling, it would make an excellent unit of account. In this
scenario, Menelik would easily know the difference between a large pizza costing S10
and a lasagna dinner costing S15. However, because interest cannot be accrued on saved
ScotPounds, it would make an insufficient store of value. Thus, if Ahmed were only paid
in ScotPound, he would be incentivized to replace his worn out hat sooner than later.
It is unclear if the ScotPound would make a viable long-term currency. The idea
behind ScotPound seems better suited for short-term monetary policy goals. For example,
this type of digital currency could have been very effective in stimulating the economy of
the United States during the Great Recession of 2007. Assuming a third party existed and
infrastructure was in place, every eligible citizen could have received benefits without
31
adding to the United States debt. As it would be an insufficient store of value, people
would naturally move back to using the U.S. dollar as the economy improved.
This proposal outlines the potential benefits of using a third party centralized
digital currency as a medium of exchange. Although this type of system would not be
directly controlled by a central bank, it could be used in tandem with traditional
currencies and digital currencies similar to the crypto-dollar. Nevertheless, the ScotPound
proposal offers clues of how the world may transition to a cashless society.
IV. Conclusion
It is evident that none of the existing or proposed digital currencies discussed in
the analysis section are perfect. First, examining these digital currencies using the theory
of money shows that each of them have strengths and weaknesses as a medium of
exchange, unit of account, and store of value. Second, considering these currencies
impact on central banking raises the question of what role government plays in a cashless
society. Third, understanding the incentives for consumers and businesses to use these
digital currencies give clues to whether they can be feasibly adopted. At this point it is
not clear if the worlds transition to a cashless society will lead to a centralized or
decentralized currency in the long-term.
Cryptocurrencies in their current form are far from a perfect form of money. For a
decentralized digital currency to ever be adopted at an official level, every country would
have to give up sovereignty over their own currency. At an unofficial level,
cryptocurrencies like Bitcoin could continue to exist in their current state indefinitely.
Although cryptocurrencies are unlikely to be adopted officially, it is clear that the block
32
chain technology behind it has the potential to change many industries. For example,
block chain technology can be used by stock exchanges or auditors to verify transactions
between people (Swan, 2015). The possibilities are truly endless.
The Deloitte framework shows how the technology behind Bitcoin can be used in
a centralized digital currency. On the surface, this framework is very reasonable as it
satisfies all the requirements of the theory of money. Additionally, central banking would
work similarly to todays system. Also, the framework was designed to fix many of the
practical issues of Bitcoin. However, the incentives for consumers to adopt such a
currency are dismal. Although not apparent, most money that exists today is both digital
and centralized. Perhaps, most consumers do not care or understand the implications of a
centralized digital currency. Also, it is not clear if consumers would want to use a digital
currency where they do not have the ability to get refunds or submit chargebacks. Despite
this, the Deloitte framework provides a new way for businesses to transfer money without
the need for ACH or a wire transfer.
In structure, the FT Proposal is very similar to the Deloitte framework. However,
the key difference is it would not be a voluntary medium of exchange for some
constituents. In this proposal, the Greek government would pay public servants and
pensioners with this new currency. In theory, it could work if it is implemented.
However, the lack of consumer choice could be politically problematic. This proposal
shows that a country could have the power to force a digital currency as medium of
exchange in dire circumstances. Nevertheless, it is not clear if this would happen as this
technology has never been adopted at an official level.
33
Finally, the New Economics Foundations proposal discusses a third party
centralized digital currency known as the ScotPound. As they prioritize money as a
medium of exchange, the ScotPound is an inadequate store of value. Essentially, it is a
new form of quantitative easing. Assuming the infrastructure of this payment system is
put in place, there are clear incentives for both consumers and businesses to use
ScotPound. However, it is unclear if this would work in the long term because there are
no similar digital currencies being used countrywide.
Based on these findings it is too early to speculate if the path toward a cashless
society will be centralized or decentralized. This is because no alternative digital
currency has been implemented at a national level. Despite this, a few things can be
determined from this study. The technology behind Bitcoin accelerated the debate over
the future of money. The Second Bank of the United States shows that the control of the
money supply had a significant impact on the course of American history. As todays
world is more globalized, any sort of digital currency would have worldwide
consequences. This demonstrates that the worlds transition to a cashless society must be
taken very seriously. Further research must be done to determine how future digital
currencies play a part in a cashless society. While this answer may be unsatisfying, this
unique study outlines some of the important economic questions policy makers must
consider before proposing a new digital currency.
34
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Appendix
The following are common Bitcoin vocabulary sourced from Bitcoin.org:
Address -
A Bitcoin address is similar to a physical address or an email. It is the only information
you need to provide for someone to pay you with Bitcoin. An important difference,
however, is that each address should only be used for a single transaction.
Bit -
Bit is a common unit used to designate a sub-unit of a bitcoin - 1,000,000 bits is equal to
1 bitcoin (BTC or B ). This unit is usually more convenient for pricing tips, goods and services.
Bitcoin -
Bitcoin - with capitalization, is used when describing the concept of Bitcoin, or the entire
network itself. e.g. "I was learning about the Bitcoin protocol today."
bitcoin - without capitalization, is used to describe bitcoins as a unit of account. e.g. "I
sent ten bitcoins today."; it is also often abbreviated BTC or XBT.
Block -
A block is a record in the block chain that contains and confirms many waiting
transactions. Roughly every 10 minutes, on average, a new block including transactions
is appended to the block chain through mining.
Block Chain -
The block chain is a public record of Bitcoin transactions in chronological order. The
block chain is shared between all Bitcoin users. It is used to verify the permanence of
Bitcoin transactions and to prevent double spending.
38
BTC -
BTC is a common unit used to designate one bitcoin (B ). Confirmation -
Confirmation means that a transaction has been processed by the network and is highly
unlikely to be reversed. Transactions receive a confirmation when they are included in a
block and for each subsequent block. Even a single confirmation can be considered
secure for low value transactions, although for larger amounts like 1000 US$, it makes
sense to wait for 6 confirmations or more. Each confirmation exponentially decreases the
risk of a reversed transaction.
Cryptography -
Cryptography is the branch of mathematics that lets us create mathematical proofs that
provide high levels of security. Online commerce and banking already uses cryptography.
In the case of Bitcoin, cryptography is used to make it impossible for anybody to spend
funds from another user's wallet or to corrupt the block chain. It can also be used to
encrypt a wallet, so that it cannot be used without a password.
Double Spend -
If a malicious user tries to spend their bitcoins to two different recipients at the same
time, this is double spending. Bitcoin mining and the block chain are there to create a
consensus on the network about which of the two transactions will confirm and be
considered valid.
Hash Rate -
The hash rate is the measuring unit of the processing power of the Bitcoin network. The
Bitcoin network must make intensive mathematical operations for security purposes.
39
When the network reached a hash rate of 10 Th/s, it meant it could make 10 trillion
calculations per second.
Mining -
Bitcoin mining is the process of making computer hardware do mathematical calculations
for the Bitcoin network to confirm transactions and increase security. As a reward for
their services, Bitcoin miners can collect transaction fees for the transactions they
confirm, along with newly created bitcoins. Mining is a specialized and competitive
market where the rewards are divided up according to how much calculation is done. Not
all Bitcoin users do Bitcoin mining, and it is not an easy way to make money.
P2P -
Peer-to-peer refers to systems that work like an organized collective by allowing each
individual to interact directly with the others. In the case of Bitcoin, the network is built
in such a way that each user is broadcasting the transactions of other users. And,
crucially, no bank is required as a third party.
Private Key -
A private key is a secret piece of data that proves your right to spend bitcoins from a
specific wallet through a cryptographic signature. Your private key(s) are stored in your
computer if you use a software wallet; they are stored on some remote servers if you use
a web wallet. Private keys must never be revealed as they allow you to spend bitcoins for
their respective Bitcoin wallet.
40
Signature -
A cryptographic signature is a mathematical mechanism that allows someone to prove
ownership. In the case of Bitcoin, a Bitcoin wallet and its private key(s) are linked by
some mathematical magic. When your Bitcoin software signs a transaction with the
appropriate private key, the whole network can see that the signature matches the bitcoins
being spent. However, there is no way for the world to guess your private key to steal
your hard-earned bitcoins.
Wallet -
A Bitcoin wallet is loosely the equivalent of a physical wallet on the Bitcoin network.
The wallet actually contains your private key(s) which allow you to spend the bitcoins
allocated to it in the block chain. Each Bitcoin wallet can show you the total balance of
all bitcoins it controls and lets you pay a specific amount to a specific person, just like a
real wallet. This is different to credit cards where you are charged by the merchant.