Cryptocurrency & the Evolution of Finance

It's not, it's not surprising that solving, uh, sort of replacing centuries old trust networks with computer code is a difficult task. You know, it's a complicated issue. That's not surprising, right? This kind of social trust networks that you and I build as we interact with people. Those are, um, things that humans are very, we're kind of, we've evolved to understand those and how they work and be very good at playing at sort of walking the trust network. Um, when you try to replace that with, with computer code, it's like a fascinating, like really important technological development. Um, but it's going to be complex

Having cryptocurrency be the way that we buy our groceries every week was the initial goal. I think that's actually unlikely to happen in the near term, which doesn't mean that cryptocurrency isn't a massive success. It has been, but I think it's a misnomer when we call it cryptocurrency. These are, these are not in the near term going to replace bank balances and paper dollars, but that doesn't mean they're not valuable. They are assets. There are subsets of the cryptocurrency world that are trying to solve other problems. They're not an asset or they're less like an asset or trying to solve other problems. They're trying to solve cross-border payments problems. They're trying to, um, provide liquidity in certain, very specific markets. Um, those cryptocurrencies then look less like assets. They look more like financial innovation. They look like startups. Um, they happen to have a cryptocurrency, you know, that, that greases the wheels of the project that they're trying to, to engage in or the problem they're trying to solve.

Um, but they look more like startups. They look, you know, they're like, we want to solve the cross-border payments problem. Or we want to provide liquidity in this very specific market where there traditionally has not been very much liquidity. Um, and those kinds of those kinds of cryptocurrencies and the groups associated with them look like a Silicon valley startup that's that's, you know, doing other kinds of startup problems. So, so what cryptocurrency, I think the goal, when we think about it as, as currency, as replacing currency, there's just a technological kind of intellectual problem. When Bitcoin currently is trading in the mid 30 thousands, uh, it got as high as into the 60 thousands. We're not going to buy apples with something who, where one unit of it costs $35,000, right? The, the number of units that you need is so small to buy an apple like that, that doesn't make a lot of sense.

Now, there are other things there, there are cryptocurrencies that are explicitly tethered to the U S dollars. So they trade approximately one for one for that, that might be used in some of those transactions. But typically what we've seen over the last five years is that most of the financial innovation has not been in the space of payments. There's been some innovation in the space of payments, but a lot of it has been in the space of asset market development, different ways to trade different ways to engage in other financial market needs that people have that are not how do you pay for your groceries? Um, so while originally the goal was, this is going to be a currency that replaces dollars, like most technological innovations or like many technological innovations, the use case, which turned out to be most relevant and most useful for lots of people was not the original use case that people thought of.

But this is the story of most of lots of innovation, right? That the thing that you end up now, that's not to say that at some point there might be some improvements and some technological improvements that allow for more of a currency kind of use for this, but at least in the last five years, what we've seen is that there are important problems that cryptocurrency is solving that are not traditional currency problems. It's actually good at doing other things that that may not have to do with whether I can buy my groceries with it, or pay my rent. The beginning of cryptocurrency was kind of a combination of these sociological ideas about, um, about sort of wanting to be decentralized, wanting to cut out the middleman in, in various financial settings. And then the ability to kind of apply these computer science problems to that set of problems, um, was what sort of came together to become cryptocurrency.

So a couple of things will happen in the next five years. The first one is as there is more and more participation in these markets, the really, really dramatic left tail events where it loses 90% of its value. Those will, those will decrease in frequency. Now they may, there may still be some events like that, but, but they're going to be much less frequent than they were the first, you know, five to seven years of, of this cryptocurrency, um, craze or, or excitement, um, as there's more and more market participation, those left tail events will, will go down. We'll also start to see, as regulation is catching up with the technological improvements that went, that came with cryptocurrency, um, we're going to start to see market structure changes. I think the future of innovation, the next five to 10 years in the cryptocurrency world are market specific, uh, coins that are, that are solving a specific set of problems.

So we have seen this example in cross border payments, that there are sets of coins that exist and are really targeted on. We want to solve this problem of making cross border payments cheaper. It's insane that if you and I were banks in the U S I could send you $50 million and it would cost less than a dollar and happen instantaneously, if you and I, our family, one of us is in Mexico. One of us is in the U S and I want to send you a hundred dollars. It's going to cost me between three and $7 to do that. You know, that's crazy. And so there, there exist specific markets and, and financial needs that individuals have. And you will start to see cryptocurrency, um, applications of currently existing cryptocurrencies or new cryptocurrencies that will come about basically to solve these very specific sets of problems.

It's not exactly clear what those, what those will be. They might be things like, um, like specific international trade, uh, problems that individuals have, or they might be insurance problems related to communities or families or, or others that, that, that financial innovation has allowed, will sort of allow people to find uses for the technology underlying cryptocurrency to solve these problems that previously had more expensive solutions or no solution at all. And I think that's where the real innovation is going to happen. I think it's unlikely. Like I mentioned before, it's unlikely that a cryptocurrency is going to come along and all of a sudden we will all decide like, okay, this is our money. Now. That's not where the real innovation is going to happen, but the innovation will happen and has a lot of potential in these specific use cases where finance has either thought, it's not worth it for us to jump into this, or we don't have the technology to jump into this or something like that. And that's the place where we're going to see these cryptocurrencies really take off

Yeah, so early on and there's still some, um, there's still some policy kind of impetus behind this. There, there is definitely a, uh, a set of individuals in the policy world who feel like cryptocurrency exists to facilitate illegal transactions. Um, we saw, uh, a hearing in the house a couple of weeks ago. Uh, I think it was called America on fire, and it was about sort of the potential in part, it was about the potential for cryptocurrencies to facilitate illegal activity. Um, that definitely happens. That is part of the cryptocurrency landscape. I think it's a decreasingly important part, but initially there were two challenges to the broad adoption of cryptocurrency. The first, well three, I guess the first was the technological challenge. It's just complicated. The second was that there were two classes of kind of, uh, bad PR situations. One was the silk road, the pirate bay, other things that accepted, um, cryptocurrency in exchange for illegal transactions of some form.

Uh, and the second was that in the early days of cryptocurrency exchanges, there were several cryptocurrency exchanges that absconded with a bunch of money from people that engaged in fraudulent behavior. Um, this, we are still very much we're, we're pulling out of it a bit, but for those first seven or eight years, we were very much in the wild west days of that. That always happened in any financial innovation. So when stock markets were invented, you got all kinds of stuff like this. Um, you know, as any new asset that gets traded, there will be these kinds of, uh, very, very, um, high volatility, uh, high innovation periods, where you've got individuals trying to game the system, trying to make as much money as they can. And the regulation is typically slow to catch up. That regulation has begun to catch up.

Recently, there was a crack down on Bitcoin mining and trading in China. And previous to that, a lot of the computational work that goes into keeping these ledgers synced together was happening in China. And so, you know, they refer to this as the great westward migration of hash power. So there are a bunch of computer processors in China that are currently not able to be used to do this kind of processing. So we've seen this demographic shift in how this processing happens. It's now moved outside of China. A lot of that, that computational power is still locked up in China. It's unclear exactly how much of that's going to be able to leave into other markets. Although there have been some, there's been some movement on that. Um, and, and so we've seen this demographic shift, that's going to continue to happen as different governments take different stances on the desirability of having a big Bitcoin presence in their country or in their state, in the U.S., uh, you're going to see some demographic shifting of, of sort of business models.

And some, there will be new opportunities as new companies realize that their country is now a profitable place to engage in, for example, Bitcoin mining, they, they will start to open up to that and other countries will decide they don't want any part of that. And you will see a shutting down of that. Um, Bitcoin mining currently is an energy play where, you know, the, the process, the computational work that the computers have to do to validate these transactions, that computational work is pretty standardized. Um, so now it's a question of who can get the cheapest energy. And, and so as we see policy changes from China or other places that make it now, all of a sudden it's worth it to do it in a, in a place where otherwise the energy might've been too expensive, or there is innovation in getting access to that energy  in a low cost way or an efficient green way. Um, and as those things happen, then we ended up with shifts in the business models for these various Bitcoin miners and other cryptocurrency startups.

Throughout the world, we have lost trust in cash, dozens of times in the last a hundred, few hundred years, you know, that happens all the time as, as countries engage in excessive money printing, but that devalues their currency. That's happened a lot, not in the U.S. so much, but, but in other places that's happened, that's happened a lot. Will cash be less useful? Yes. You know, we've already seen that in the last 30 years that, that, uh, you know, as I, when I give lectures in economics, many times when I get to the money chapter, I have to go to the ATM because I don't have any cash in my wallet to hold up as an example. Um, that's because I don't use it that much, you know? Um, I, I, I don't need cash to engage in the transactions that I, that I usually engage in. Um, and that will continue. It will be easier and easier and easier to use my phone, to use, uh, credit cards, to use other forms of payments to use my watch or whatever. That will, that will increase. So cash is going to be less and less important in developed economies. Um, it seems unlikely to me that we'll lose trust in cash, at least in developed economies, but again, we have lost trust in cash over and over again in, in, throughout the world. If you think about the world.

So one of the cons of a decentralized banking system is for thinking about the problems that, that cryptocurrencies were originally set out to solve. A lot of it has to do with replacing these trust networks, right? So the reason that Visa and other large sort of the financial intermediaries exists is because two random individuals meeting on the street, um, don't have a relationship. They may never interact in the future. It's difficult to tell whether they should, one should trust the other. And so if they operate through a trusted third party, then, then we can have that. So, uh, cryptocurrencies do a lot of technological computer science, cryptographic, uh, work in order to not mean that to, to reconstruct a proxy for that trust network in situations, it's not surprising then that that's a really difficult and, um, energy intensive, computationally, intensive process, right? Like those, those trust networks are complicated and we've been, you know, we've dealt with those for thousands of years.

It's not surprising. It's difficult to completely replace those, um, in situations where those trust networks already exist naturally exist. For other reasons, cryptocurrency may be overkill. You know, we're doing all of this computational work. The cryptocurrency, for example, the computational energy use associated with Bitcoin has been estimated to be about the same as the country of Venezuela. You know, so we're, we're using a fair amount of energy to, to replace these trust networks and situations where the trust networks already exist. Anyways, it might be inefficient to be doing all of that computation. If I know that I'm going to interact with this person regularly all the time for the next 20 years, I have reason to trust them otherwise. And I probably don't need to integrate, you know, to interact using Bitcoin. For example, if my partner and I trade off paying for rent, um, that's a, that's a financial interaction. I don't need to pay her back with cryptocurrency because she knows that I'm going to pay her in something that's valid. I'm not going to cheat her out of that. So cryptocurrency is probably overkill for interactions like that.

Suppose that I want to buy an apple, right? So if I own some units of, of a cryptocurrency, suppose I own Bitcoin, I want to buy an apple. Uh, I go to the grocery store. What does it mean to buy an apple traditionally? Right. So traditional in traditional finance systems, payment systems, what happens is I go to the store, pick out an apple, go to the front. I give them my debit card or my credit card and what happens? Well, uh, they contact the bank or the, or the credit institution, Visa, or whoever it is and say, this person's trying to buy something that costs a dollar. And that request goes to my bank and they take a dollar out of my account and they put a dollar into the store’s account. That's sort of traditional finance, the same ideas happen with cryptocurrency in this case.

However, for this example, I might have a copy of the ledger and the ledger says how many dollars or how many Bitcoin I have. And it says how many Bitcoin the, uh, the store has. Okay. So when I go to get an apple, um, I take the apple to the front. And in this example, the store says to themselves, okay, I'm gonna, I'm going to submit a change to the ledger and the change to the ledger that I submit that, that the store submits to their copy of the ledger says, reduce, um, reduce this guy's account by the equivalent of $1 in Bitcoin and increase my account to the equivalent of $1 in Bitcoin. Okay. But now his ledger and my ledger are out of sync, right? And so the difficult sort of mathematical computer science problems that, that cryptocurrency and Bitcoin specifically are trying to solve is how do we then get those ledgers back in sync?

So there's a system for Bitcoin. It's called proof of work for others. It's proof of stake or some federated consensus algorithms. Um, there's this computer science problem that involves each of these computers doing some amount of work or verifying that the transaction that's requested by this, by the store changed. The ledger in this way is reasonable. And doesn't violate some, some typical principles. Like I have enough in my account and also that it's not a fraudulent, um, a fraudulent transaction request. And that's where a lot of the difficult computer science work goes is in verifying that this is not  fraudulent. And then basically they, they require the store to do a bunch of work that wouldn't be worth it if this were a fraudulent request in general. Um, and so those computers do a bunch of work and there are other computers in the network that also helped to do this.

And together they reached consensus that, okay, you should take a dollar in Bitcoin out of this guy's account and add it to this other, to the stores account. And we, that allows for this transaction without having to go to a trusted third party. Now, the store has their copy of the ledger. I have my copy of the ledger after we've done all this work that are back in sync and everybody in the world agrees is everyone in this network. And this payment network agrees that I'm now a dollar poorer and an apple richer, and the store is a dollar richer and an apple poorer. Uh, although of course the apple is not in the ledger system. They just keep track of Bitcoin or the cryptocurrency.