“Proof of reserves,” born out of tragedy, will slowly become the global gold standard for financial auditing.

How bizarre that common criticisms of Bitcoin revolve around the issue of trust, or lack thereof. Perhaps more than any other point, Bitcoin beats most modern standards on the issue of “trust” hands down. As the world wakes up to this fact, the new concept of “proof of reserves” provides a valid contender as the vanguard for a large shift in perception by the public.

But first, let’s look at some of the trust-based concerns that get brought up time and again.

Example #1: We don’t know who made Bitcoin, so how can we trust that somebody won’t just print more of it?

Implicit to this statement is the contention that the purveyors of fiat currency can be trusted to analyze the economy and decide precisely how much money to add or subtract from the market, facilitated by the manipulation of interest rates through open market activities. Maybe they can, but that Bitcoin will maintain the 21 million hard limit is so assured as to be almost 100% certain. Whether this is a good idea may be cause for debate, but that you can trust it to be so is not.

This opinion is simply born out of ignorance for how the blockchain is maintained by powerful incentives that provide distributed security and consensus. There is no governing body to appeal to, no man behind the curtain, and even if somebody were to commit financial suicide by spending the 100’s of millions of dollars necessary to mess with transaction confirmations, they would still fail in coercing the Bitcoin community to adopt and use a currency with a more flexible supply. It’s just not going to happen.

Example #2: Bitcoin isn’t regulated, so we can’t trust that crimes committed involving Bitcoin will be subject to the rule of law.

Up until last year, this argument actually held water, but not because of anything inherent to Bitcoin. Rather, it was a failure of authorities to recognize Bitcoin as property with value (whether currency, commodity, or otherwise). Because it was new, and hard to understand, police who were notified of Bitcoin thefts initially laughed it off as kerfuffles over internet geek points.

But that has all changed. Even without strong regulatory guidance, the powers that be have already cracked down on notorious scammers (or incompetents) such as Trendon Shavers and Mark Karpeles, applying existing law to the process of investigation, prosecution, and restitution. And they didn’t miss the chance to hunt down the anonymous Silk Road kingpin either. Bitcoin has gone mainstream with respect to ownership, theft, money laundering, and acceptable uses. Whether you agree with those laws is a different matter.

Example #3: Banks have to meet certain standards and reporting requirements whereas companies that use Bitcoin can do so anonymously – we can’t tell what they are doing with the money.

Anonymous it may be, but only in the weakest sense. On the contrary, the immutable paper trail of every transaction ensures that Bitcoin is 100% traceable, and 100% transparent at the protocol level. This record is open to any member of the public, and can be viewed and analyzed to no end.

After the fall of Mt. Gox, skeptics were right to criticize the poor business, security, and accounting practices that are now apparent, but while they were still busy bashing Bitcoin, they missed one of the most revolutionary innovations in financial auditing to emerge in the last century: The “proof of reserves.”

Eager to convince their customers that they were solvent, Bitcoin exchanges and brokers worldwide offered a simple yet effective guarantee in the form of a digital signature (a secure cryptographic principle used in all industries). By pointing to an address on the blockchain and then providing proof that they were in control of those coins, they were able to immediately put everyone at ease. Sure, the coins might still get stolen at some point (let’s not claim an early victory), but at least we knew they were there.

Think about the possibilities for proof of reserves, or its cousin, proof of use. How would you feel if, instead of getting a quarterly report from the companies in which you have invested, you actually had real-time visibility into their finances? Companies might not like this idea, but I expect that their shareholders would, particularly in the case of banks or insurance companies.

Or consider the public institutions that we hold accountable with the fiscal health of our nations. Wouldn’t it be nice to see how much money is “in the vault” and where it is being spent? Governments should be in favor of such radical transparency because, after all, as they frequently remind us, if you have nothing to hide then you have nothing to fear…

The possibilities are quite limitless. Even an individual, say a homebuyer, could do away with the onerous process of vulnerably displaying their finances to the lender, who pores over their net worth and questions their transactions. One day you may be able to simply send an email with a digital signature: “My name is Satoshi, these are my coins, and I would like to buy this house now. Thanks.”

Going forward, this will undoubtedly be a consumer-driven process. If Bitcoin exchanges and brokers continue to use this honorable standard, then it won’t be long before the rest of the public wakes up to the bright and trustworthy future that we can engender from the proper application of a humble crypto currency.

Credit cards vs. Bitcoin (Part Two).

[Continued from Part One]

If Bitcoin can’t beat credit cards based on transaction costs alone, then what can it do?

At this point we’ll pull back from the microeconomics of transactional efficiency and take a 30,000 ft. macroeconomic view.

Bitcoin’s greatest strength is that it has many strengths. But this can sometimes make its message confusing. Is it a currency? It is a payment system? Is it an ownership ledger? Is it a commodity? The answer to all of these questions is “maybe.” It really depends on what happens in the future – what people make of it. Similarly, take an ordinary piece of cloth and ask if it is a blanket, a dress, a sack, or a sail. It certainly could be. It could even be all four. But what is it best at being? Nobody knows yet. People have different opinions, but only the future holds the definitive answer.

Possibility 1: Bitcoin begins acting like a currency.

If Bitcoin fulfills its promise as a means of exchange and a store of value, then it can get an adoption boost by merchants who will discount their prices even further than the transaction cost savings because they expect Bitcoin to rise in value.

The advantage of this dynamic is that it doesn’t matter whether fiat currencies are falling, or Bitcoin is rising. All that matters is the differential. As long as Bitcoin undergoes a steady and prolonged increase in value vs. the dollar, euro, yen, etc., it will be immaterial whether these currencies are falling precipitously against goods and services, staying steady, or even increasing in value.

Possibility 2: Global recession pressures slaughter the credit companies’ cash cow.

Depending on your economic world view, you may believe that the world is teetering on the brink of collapse, or in the early stages of a full blown recovery. Regardless of which scenario you find most likely, it always helps to at least acknowledge the historical precedence for sharp corrections in stock markets, bonds markets, and currency markets.

In particular, some worrisome developments are that the largest banks are about 30% bigger than they were before the 2008 recession – creating the possibility of very large systemic risks, debt to GDP ratios have increased in almost every Western nation, and global stock markets are near all time highs at the same time as underemployment figures – indicating a disconnect between valuation and production.

If the world undergoes a new recession, it may very well be a sovereign debt crisis. At the very least, the “good” credit card customer pool will certainly be diminished, perhaps dramatically so. As a result, in the same way that banks slowly eliminated the interest paid on regular bank deposits from 5%+ to almost 0% over the last 15 years, credit card companies will feel the squeeze and see their earnings become more reflective of transaction revenues than revolving debt. Essentially, the rewards programs will vanish, along with the competitive edge that credit cards have over Bitcoin as a means of payment.

Possibility 3: The only way to beat a credit card company is with another credit card company that uses Bitcoin.

Even if the above two scenarios do not pan out – i.e. Bitcoin doesn’t grow into a proper currency and the world chugs along without hyperinflation – there is still the remaining fact that credit card companies are very sensitive to cost, and that using the legacy ACH/SWIFT banking “tubes” generates a lot of unnecessary overhead.

So this brings us back to the transactional efficiency of Bitcoin. If you can’t beat them, join them. A credit card company that properly integrated the Bitcoin payment mechanism into its business could reduce many underlying costs that it currently takes for granted. As a result, it could pass these cost savings on to its customers in the form of even more generous rewards. If you thought that 1% or 2% was a good deal, how would you feel about 7% cash back?

Surprisingly, in this respect it may not be the merchants, nor the consumer who would benefit the most from Bitcoin, but rather the credit card companies that seem so obviously at odds with the world’s favorite fledgling crypto currency. And once one company executes correctly, the others will have to follow suit to keep up.

Conclusion: Whatever its going to be, it’s going to take a while.

Every day brings us closer to figuring out what Bitcoin will grow up to be. But progress takes time, code takes coding, and business takes building. Wherever Bitcoin ends up in 10 years, I’m sure it will surprise us all (hopefully in a good way).

Credit cards vs. Bitcoin (Part One).

Doing a head-to-head comparison between Bitcoin and credit cards may seem to be a reasonable exercise. At the till, given the choice between the two, what would you use?

Because Bitcoin can enable cheap transfers, merchants have an incentive to accept it over credit cards. On the front end, they are the parties who eat the 1.5-3% commission + $0.xx flat fee (for small transactions), and see it on their balance sheets. So naturally, merchants would be intrigued by a payment option which cuts these fees off at the knees: specifically, a 1% solution from Coinbase or Bitpay, or a ~0% solution using native Bitcoin, but with the associated volatility risk of bitcoin.

It hasn’t happened in earnest yet, but the next step in the puzzle is merchants recognizing that they can afford to offer a discount to Bitcoin-paying customers. But how much is needed before they can compete with credit cards? The unfortunate truth is that it may actually be impossible for Bitcoin to beat credit cards relying on its cheap transaction costs alone.

The headwinds that Bitcoin is pushing against are customer rewards programs. 1% cash back is completely standard nowadays, and depending on an individual’s card usage, or the location of their expenditures, 5% cash back is quite common too. But here we encounter an apparent paradox. For the 5% cash back on Walmart gasoline, even if the merchant is being charged a full 3%, where does the extra 2% come from? Surely the credit card companies can’t afford to take a loss in this manner.

The answer is somewhat complicated, and a bit obscured on purpose by credit card companies that don’t necessarily want to divulge their secret sauce. But the basic answer is that there are three types of customers whom credit card companies serve: good, bad, and risky.

Good customers are the bread and butter of credit card companies. These are people with steady jobs, and decent cash-flow, but who also have a tendency to carry a balance on their credit cards, or to use credit cards when cash is tight to get them through tough spots. This Goldie Locks customer is just right: not too reckless, not too responsible.

Counterintuitively, bad customers are actually those who have great credit. They take advantage of sign up bonuses, pay attention to limited-time cash-back offers, and pay their balance in full every month. In the industry, these people are known as freeloaders, because in the long run, they receive a net-positive financial benefit from the use of credit cards.

Risky customers are the ones who might actually generate substantial losses for credit card companies. These include chronic late payers, people about to undergo personal bankruptcy, and outright scammers and fraudsters. The money and time that credit card companies spend to keep these people away is well worth the money saved.

So now that we understand a bit more about a credit card company’s business model, let’s have a look at the revenue sources. Remember that transaction fees are just one source of revenue for the entire business, and it generally accounts for about 1/3rd of total revenue (depending on the company, of course). The remaining 2/3rds is generated through annual fees, late fees, balance transfer fees, over-limit fees, merchant promotions, and the mother-lode of credit profit: interest charged on balances, which averages 13-24% annually.

At this juncture, our comparison between Bitcoin and credit cards reaches an impasse because we are no longer evaluating apples with apples. If credit card companies made all of their money off of transaction fees, then Bitcoin might have a fighting chance. But in reality, all of the “good” customers are subsidizing the very generous cash-back and rewards programs which incentivize more and more people to use credit cards whenever and wherever they can.

This means that merchants accepting Bitcoin could theoretically pass on the entire amount that they would save in transaction fees as a discount to their customers, and it still wouldn’t beat the cost to consumers of credit cards. That is because the merchant isn’t picking up the whole tab. The remainder is mostly coming from consumers who maintain a revolving credit balance every month.

In part two of “Credit cards vs. Bitcoin” we’ll have a look at how Bitcoin might still be able to create an edge against credit cards in the long run.

[Continued in Part Two]

Why you need dollars

Common among the question posed by those introduced to Bitcoin is that of need.

Why do I need Bitcoin? What benefit does it offer me?

While most Bitcoin enthusiasts embark on a multi-faceted adventure of how Bitcoin may provide benefits in payment costs, or perhaps as a speculative investment, few flip the question on its head and ask why people need dollars (for this exercise, please replace “dollars” with the fiat currency of your choice).

At face value, dollars are needed to operate. It doesn’t really matter whether the transfer costs are low, or the methods are convenient. People accept dollars predominantly, but more importantly, they need dollars to meet their financial obligations. Even more importantly, they need dollars to pay their debts.

Without digressing into monetary semantics, I’ll claim that most currency in circulation arrived on this earth through the issuance of debt. To a layman this may not be clear, but anybody with banking experience, or who has done their research, can confirm that money enters the system as a debt obligation.

What this means is that every (almost every, I’ll admit, but most indeed) dollar in existence has an invisible rubber band attached to it that pulls it back to its issuer. Consider the implication. Even though you may have eliminated your personal debt, and accumulated $10,000, this concept still applies. Somebody, somewhere, owes those dollars to someone. This is not a conspiracy notion. This is a fact.

As a result, we observe a proliferation of debt in our society. Whether an individual suffers from $5,000 in credit card debt, $50,000 in student loans, or $300,000 in mortgage debt, the paradigm is the same. All dollars are debt. And all dollars are owed.

Ergo (and I do hate that word, but it carries the message), the number one reason that people need dollars is to pay off debt, period.

It would be nice if everybody could shift blithely from a dollar system to a digital currency, but that simply won’t happen until the dollar begins to misbehave. Tethered to the dollar is a grand society of people, earners, makers, fathers, mothers, brothers, sisters, and others born into a world of infinite promise, but harsh reality. They toil in earnest, and it breaks my heart.

This debt will never be repaid. I don’t say this as an opinion. This is a mathematical fact. The debt obligations of the world exceed the amount of currency that circulates. Simple. There is not enough currency to pay the debt, because the currency is the debt.

The bad news is that this has happened countless times before, but rarely with a currency so proliferate as the US dollar. The good news is that the world always seems to move on after a currency crisis, picking up the pieces, reevaluating their assets, and carrying forward.

The worse news is that these crises can take decades to wash out. So unfortunately, a Bitcoin enthusiast in 10 years may still have to answer the question: why do I need Bitcoin, when I REALLY need dollars?