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Why the Fed is more likely to adopt bitcoin technology than kill it off


Paul Krugman has a recent post in which he casts bitcoin as a retrogression from our current fiat system. He's wrong about this. In the next few years, I put decent odds on the guardian of our fiat system, the Federal Reserve, adopting the very bitcoin technology that Krugman finds so dubious. Here is Krugman:
One thing I haven’t seen emphasized, however, is the extent to which the whole concept of having to “mine” Bitcoins by expending real resources amounts to a drastic retrogression — a retrogression that Adam Smith would have scorned.
Krugman has taken bitcoin's colourful jargon a bit too literally. It's best to think of "bitcoin" as a distributed ledger, or a record, and not as physical coin. And while Bitcoin miners do "mine", they're not performing a function that is analogous to gold mining. Rather, they're contributing to the tending and maintenance of the information that makes up the bitcoin ledger. The mining community listens for ledger transfer announcements, processes and verifies them, and then updates the distributed record. The reward for being the first to successfully add to the ledger is new bitcoin. Distracted by this reward, Krugman misses the underlying verification process it represents, thus drawing an incorrect analogy between bitcoin miners and gold miners.

It's better to think of a bitcoin miner as a gold assayer who verifies that a circulating gold coin isn't a fake, or, in our fiat world, as part of the verification process in a credit card payment. A bitcoin miner listens, processes, double checks, and polices the distributed ledger. Protecting a ledger is a valuable use of resources.

Rather than being retrograde, let's see how bitcoin technology could be adopted by the Fed.

The Federal Reserve owns one of the world's most important ledgers. The Fed's 3,000 or so member banks maintain accounts at the Fed. Put differently, they own allocations in the Fed's ledger. Every business day banks trade Fed ledger space amongst each other. The name for the system that facilitates these transfers is Fedwire and the name for the ledger space being transferred is "reserves".

The quantity and size of Fedwire transactions is breathtaking. In the fourth quarter of 2012, 33.8 million transfers were made with an average transfer value of $4.45 million. A total of $150 trillion in ledger space, or reserves, was exchanged.* Many types of transaction are carried out over Fedwire. When company A buys out company B for a billion dollars, the payment will probably be made over Fedwire. If the Fed conducts an open market purchase of $5 billion, it'll pay for that purchase by transferring ledger space over Fedwire. (The size of a single Fedwire transactions is currently limited to $9.99 billion). When John Doe wires a college $80,000 to pay for his daughters tuition bill, ledger space is being moved from John Doe's bank to the college's bank via Fedwire. The lifeblood of the US commerce pumps through Fedwire.

The Fedwire infrastructure is currently hosted at the Fed's East Rutherford Operations Center (EROC) at 100 Orchard Street, East Rutherford, New Jersey (see map below). While most of the world's attention is usually focused on the Fed's Washington headquarters at 20th Street & Constitution Avenue, the importance of Bernanke's office pales in comparison to 100 Orchard Street. All vital information pertaining to the Fed's ledger is maintained on computers at EROC. If a bank wants to transfer ledger space to another bank, the payment is routed to EROC where it is processed and the Fedwire database updated. This system is a hub and spoke system, with EROC serving as hub for its member bank spokes. In the picture at top, it is the system on the left, a centralized network.


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Because Fedwire is so important, it needs to be resilient. Should disaster strike at the East Rutherford hub, a secondary back up data center at the Federal Reserve Bank of Richmond is designed to resume Fedwire operationality 60 - 90 minutes later. A third backup center exists at the Federal Reserve Bank of Dallas.** The weakness of the system is that if the hub is destroyed (and the second and third backups) then the entire payments infrastructure disintegrates.

An alternative (and perhaps cheaper) way to build a resilient payments system would be for the Federal Reserve to adopt a bitcoin-style distributed ledger. The Fed's ledger would no longer be stored at EROC. Rather, all member banks would hold a copy. Much like a bitcoin miner "mines", a member bank would be an independent node responsible for helping to maintain the ledger's integrity. Should a bank want to exchange ledger space, the transaction would be announced to the network of member bank nodes who would in turn poll each other to verify the legitimacy of the transaction. Once a consensus has been arrived at, the payment would be processed and the Fed's ledger updated. As a condition of membership in the Federal Reserve System, banks would be required to act as verification nodes.

What would be accomplished is a decentralization of the information contained in the Fed's ledger. The ledger would be everywhere rather than at one spot. Transfers of ledger space would no longer be patched through the central processor at EROC but would be handled by a distributed network of cooperating nodes. Whereas the current hub and spoke system has two levels of redundancy, Richmond and Dallas, a distributed system has no central hub and therefore much more layers of redundancy. It would be very difficult to destroy it. Such a system is represented in our top chart by the network on the right, in which no entity is more important than the other.

All of this is an exercise in speculative economics, of course. But I like to think there's a grain of truth in it. Whether you agree with me or not on the possibility or likelihood of the Fed adopting a bitcoin-style distributed ledger as the basis for Fedwire, at least you'll see why Krugman has been too hasty in writing off bitcoin as a retrogression. Distributed ledgers are cutting-edge and will have many applications in the future.


PS. In the burst of attention over the last few weeks, the press and pundits have all become a bitcoin experts, just like they were Cyprus experts in the previous news cycle. There are three blogs worth reading that offer more stable and permanent bitcoin fare. Peter Surda wrote his thesis on bitcoin, so do go by and check his blog The Economics of Bitcoin. Jon Matonis has payments industry experience and has been following bitcoin for far longer than myself or any journalist. He blogs at The Monetary Future. Finally, Mircea Popescu owns and operates MPEX, the largest bitcoin stock and options exchange, and knows all the excruciating detail of the system's inner functioning. He blogs at Trilema.


* Fedwire statistics
**Payments, Clearance, and Settlement: A Guide to the Systems, Risks, and Issues by the General Accounting Office (1997) PDF
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