submitted by jwithrow.
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Journal of a Wayward Philosopher
Bitcoin and the Crypto Revolution
June 22, 2016
Hot Springs, VA
“Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative. ” – Nassim Taleb, Author of Antifragile: Things That Gain from Disorder
The S&P closed out Monday at $2,088. Gold closed at $1,271 per ounce. Crude Oil closed at $48.95 per barrel, and the 10-year Treasury rate closed at 1.70%. Bitcoin is trading around $670 per BTC today.
Dear Journal,
Bitcoin flirted with $800 last week before dropping all the way down to $630. Today it is hovering around $670. Such volatility is usually feared by the general public, and it is often cited as one of Bitcoin’s weaknesses. To me, this volatility is a beautiful example of price discovery in one of the freest markets on Earth.
Of course it is worth mentioning that we are discussing this price volatility in terms of the U.S. dollar conversion rate which is hardly a fixed measurement of value. Much of the global economy is accustomed to pricing goods and services in dollar terms which gives the illusion of price stability, but the U.S. dollar has fallen tremendously in purchasing power over the past several decades. I suspect the day will come when the global economy routinely prices goods and services in bitcoin terms rather than dollars.
Before we begin this entry, I need to emphasize my opinion that Bitcoin is not mutually exclusive. Bitcoin is not a replacement for physical cash, gold, or silver. This isn’t the one ring to rule them all. Instead, Bitcoin is the crest of a Hayekian wave of competing currencies.
There are already hundreds of cryptocurrencies in existence, and a handful of these maintain material market capitalizations. Bitcoin is by far the most popular cryptocurrency at this time, but it is still small potatoes in terms of both market acceptance and economic activity.
This is going to change, and it is going to change drastically. The reason: Blockchain technology.
Hundreds of millions of dollars in venture capital has poured into the Bitcoin ecosystem since the start of 2015, and much of this capital is focused on the development of Blockchain technology. Even the mega banks are now working on integrating the Blockchain into their legacy financial system in an effort to remain relevant.
When they talk about this on television and in the financial publications, they are very quick to state that they are not interested in Bitcoin as a currency; they are only interested in the Blockchain technology. This is obviously a psychological ploy to discourage the consumers of mainstream financial media from exploring Bitcoin.
Here’s a little secret: you can’t effectively separate Bitcoin from the Blockchain because Bitcoin is the unit of account that enables the proof-of-work consensus mechanism within the global Blockchain ledger. The two are a package deal.
You could replace Bitcoin with a proprietary unit of account, and the mega banks will, but you instantly lose the global proof-of-work consensus upon doing so. Then your Blockchain becomes a closed-source ledger that is no longer immutable or censorship-resistant… at which point it becomes vastly inferior to the open-source, borderless, transnational, immutable, incorruptible, censorship-resistant Blockchain ledger known as Bitcoin.
Now the mega banks’ Blockchain project is pretty much irrelevant as far as I am concerned – I mention it only to emphasize the inseparability of Bitcoin and the Blockchain before we talk about the really exciting applications for Blockchain technology.
One of the most important yet overlooked social mechanisms in the developed world is the institution of private property and the accompanying systems for titling land and real estate.
Private property is the foundation of commerce, yet a huge swath of economic activity occurs in places where no effective system for titling property exists. Even in the developed world, the process for obtaining proper deeds and titles is subject to centralization and counterparties which brings with it fees, costs, and taxes that skim off of every transaction.
One of the most fundamental uses for Blockchain technology would be to create a global standard for titling land and real estate. This would literally bring private property to billions of people all over the world who live in countries with corrupt, inadequate, or non-existent land titling systems.
Not only would this be a feel-good story for the liberated individuals, but it could also bring a flood of dead capital into the global marketplace. There is very little incentive to improve property in places where it is virtually impossible to obtain a legal title of ownership. Further, it is impossible to pledge this property as collateral to obtain the capital necessary to create or expand productive enterprises.
The Blockchain can provide cheap access to a land titling system for billions of people around the world which will inevitably drive commerce, spur production, and create wealth in places where very little currently exists.
Moving the land-titling function onto the Blockchain in the developed world would serve to dis-intermediate both governments and settlement attorneys which would make the transfer of these assets much cheaper.
The costs to transfer real estate are very small relative to the value of each real estate transaction, but the economic effect is cumulative. If you add up all of the fees, costs, and taxes from every real estate transaction then you will find that a very significant amount of money is siphoned off of real estate transactions on an annual basis. Put that money back into the economy instead of into the hands of the intermediaries and I think you would see good things happen.
Mind you, I don’t have a major issue with the real estate transaction fees as they currently exist. Recording and protecting private property is one of the few defined roles of government in the industrial world. We would all be much wealthier if governments had been mostly limited to this function over the past few centuries. Needless to say, I won’t lose too much sleep over Bitcoin reducing the role of government in everyone’s life.
As for settlement attorneys, I have found them to be most pleasant on every occasion, and they certainly deserve a fee for providing trusted escrow services. But I also found the people who used to pump your gas for you at full-service gas stations to be most pleasant also… that didn’t stop technology from rendering their job obsolete.
I suspect settlement agents will share similar obsolescence. All this means is that those individuals will have to reinvent themselves and their business, as will many others in the digital age. Nothing stays the same forever. The good news is that the world will have extra money with which to demand additional goods and services thanks to their real estate cost savings with Blockchain technology. This creates entrepreneurial opportunities.
Now let’s turbo-charge these cost savings.
Governments in the developed world are currently extracting tens of billions of dollars from their populations, and they are sending those funds to governments in the developing world as foreign aid. Since we just used the Blockchain to bring private property and the means for wealth creation to billions of people in the developing world, there would be no more excuses for foreign aid to corrupt and ineffective governments. What if we take those tens of billions of dollars and leave them in the hands of the people who earned them? I imagine economic activity would shoot through the roof…
So at this point Bitcoin has demonstrated that it can perform the money function and the land-titling function better than those currently providing these services. Let’s now set our sights on the enforcement of contracts and dispute settlement.
Because the Blockchain provides a permanent public ledger that cannot be altered or controlled, it is a terrific mechanism for recording and enforcing contracts.
Enter: ‘smart contracts’.
Smart contracts are self-executing contracts, stored on the Blockchain, that use access to external data feeds and a cryptocurrency payment network to emulate the logic of contractual clauses. Here’s how this works:
Party A contracts Party B to perform a service for 3 BTC with delivery required within 1 month’s time. The terms of the agreement are input into a smart contract which is placed on the Blockchain and party A puts 3 BTC in escrow.
If the agreed upon terms are completed prior to the expiration date and then recorded as verified in the Blockchain then the smart contract will be triggered to release the escrow funds to Party B. If the terms are not completed by expiration then they will be recorded as failed on the Blockchain and the smart contract will be triggered to release the escrow funds back to Party A. This dis-intermediates expensive attorneys from the equation entirely.
Now if the contracting parties would like to have a concrete mechanism for dispute settlement in addition to their smart contract, they can hire a moderator to provide arbitration services should the need arise. This would be built into the smart contract right up front as the moderator would be required to decide who gets the funds in escrow if the terms were not recorded as completed. The moderator would take a small fee if his or her service were required.
Now Party A and Party B have dis-intermediated the government court-system from the equation as well. Just like earlier, the net cost-savings effect of this is cumulative. What if you took a huge portion of all attorney fees as well as costs related to the court system and you put that money back into the economy instead?
This list certainly isn’t definitive – there are some 180-odd applications suggested for the Blockchain – but let’s look at one more application in the interest of brevity.
Patrick Byrne, the CEO of Overstock.com, gave the keynote speech at the Mises Institute’s Austrian Economics Research Conference last year. In his talk, Patrick asked the audience members to raise their hands if they owned any stock… many hands went up.
“Every single one of you with your hand up is incorrect – none of you own any stock. That’s not how the system works.”
Patrick went on to explain how the system of securities settlement in the U.S. has divorced the transfer of money from the transfer of securities.
Anyone invested in the stock market has a broker – either full-service or discount online broker – who handles settlement for them. Most people think that these brokers just move money and stock around between the accounts of buyers and sellers. Indeed, that’s how the system did work prior to 1973 when brokers would transfer physical stock certificates and keep real-time ownership records.
Everything changed in 1973 with the creation of The Depository Trust & Clearing Corporation (DTCC). Settlement for securities transactions in the U.S. is now centralized within the DTCC, and all brokers involved in U.S. financial markets are plumbed into this private organization. So money and securities do not actually move between the accounts of buyers and sellers; they move between accounts housed centrally within the DTCC.
But the system takes centralization one step further. U.S. stocks are registered in the name of an organization called Cede & Co., which is a subsidiary of the DTCC. This means that Cede & Co. is the legal owner of the vast majority of all U.S. equities.
Unless you take the necessary steps to register the stock in your name, you do not technically own it. What you own is a contractual right, or I.O.U., to that stock.
Actually, it is even more complicated than that. Because there are several layers of counterparties, you really own a contractual right (your broker) to a contractual right (DTCC) to a contractual right (Cede & Co) of the stock that appears in your brokerage account.
Now this was all set-up during a time when records were not kept in computer databases, but on pieces of paper in filing cabinets. Record keeping in the financial markets had become extremely costly, inefficient, and problematic when this system was established. That’s why this system was set up.
Regardless, this system deliberately separates investors from their ownership rights which is antithetical to what a market-based society stands for. Not to mention, this system is extremely inefficient and fragile by our standards today as it is based upon forty-year old technology at its core.
Additionally, this separation of money and securities settlement is what enables the high-frequency trading machines to thrive in the equity markets. These are high-powered computers that run sophisticated algorithms programmed to move in and out of equity positions very rapidly over and over again aiming to profit from very small price movements – sometimes one cent or less per transaction. By all accounts, high-frequency trading has become a very large segment of all market volume. I have seen estimates placing high-frequency trading as high as 90% or so of all volume in the U.S. stock market.
Is this wrong?
Probably… High-frequency trading certainly boosts liquidity, but it also distorts market fundamentals. It seems to me that if you only acquire stocks with strict limit orders, and if you only base your stop-losses on closing prices then you can effectively cut through most of the high-frequency trading noise. But those retail investors who are still buying stocks with market orders and fretting over intra-day moves in prices are probably being fleeced by the high-frequency traders pretty consistently.
Well guess what? Securities settlement – both in the equity markets and the bond markets – is a fantastic application for the Blockchain. The Blockchain can return securities ownership directly to investors and enable peer-to-peer settlement in which the buyer sends money directly to the seller who delivers the security directly to the buyer. Peer-to-peer settlement on the Blockchain renders high-frequency trading, front-running, and market manipulation impossible.
Sounds pretty good right? Here’s the kicker – if you move the financial markets onto the Blockchain then you cut most of Wall Street right out of the picture and you make the SEC, FINRA, and most of the financial regulatory apparatus obsolete. There’s nothing for them to regulate because the Blockchain cannot be gamed or corrupted.
If you cut out the intermediaries and the regulators then you also cut out most of the commissions, fees, taxes, and overhead associated with the financial markets. Again, these costs are relatively minor for each individual transaction, but the cumulative total is gargantuan. If the Wikipedia entry on the DTCC is accurate, the company settled nearly $1.7 quadrillion in value worldwide in 2011. Even if total settlement costs including taxes average one quarter of one percent per transaction, we are still talking about more than $4 trillion in cumulative commissions, fees, and taxes.
Imagine what the world looks like if that $4 trillion worth of investable capital is left in the markets rather than siphoned off by Wall Street and government’s regulatory complex!
So we have just taken Blockchain technology and used it to provide a number of core civil service functions in a way that is vastly superior to what exists currently. We have saved trillions of dollars worth of fees, costs, and taxes in doing this, and those trillions of dollars will be left in the economy to drive economic growth – including in previously under-served areas.
You can only do these things if you have a global ledger that is open-source, borderless, transnational, immutable, incorruptible, and censorship-resistant. Right now that means Bitcoin is the only option. One day there may be a better open-source cryptocurrency option, but there will never be a better closed-source proprietary option.
What this means is that Bitcoin would be the unit of account for the Blockchain titling network, the Blockchain contract and dispute settlement network, and – probably most important for pricing – the Blockchain financial markets network. Essentially, the market value of everyone’s financial assets (stocks and bonds) would be priced in Bitcoin in this scenario. I am sure there would be conversion services available, but Bitcoin would be the default currency.
This alone tells me that Bitcoin’s potential for mass adoption and thus massive price appreciation is huge. Which is why I am buying the dips, and I am very bullish for the long-term future of human civilization despite all of the immediate challenges…
More to come,
Joe Withrow
Wayward Philosopher
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