Bitcoin is not what you think

BitcoinBitcoin has been one of the most commented-on and reported phenomena in the financial industry recently. Reports, papers and articles range from the excellent, like the articles recently published by the Bank of England [1], to the fanciful and spurious.
 

In this mountain of data and opinions, it is important to clarify some points:

Bitcoin is not a currency, not even a “crypto-currency”. It is a commodity, a digital commodity, which behaves and is valued in real currencies as a commodity.

  1. The notion of “mining” for creating or manufacturing Bitcoins is inefficient, expensive and resources and energy intensive without mentioning the effects on the environment.
  2. Bitcoin is not anonymous, it is exactly the opposite. It is the most public way of keeping the transactions as the Ledger (the “block-chain” in Bitcoin parlance) is distributed and maintained by everyone.

Bitcoin and all the similar “crypto-currencies” that have emerged around it are based on two basic pillars.

The first is standard, well-known cryptographic techniques guaranteeing not only that transactions are secure but also that the amount of goods (Bitcoins) are not stolen, “double spent” or multiplied.

The second pillar is the brilliant idea of a distributed ledger. To this ledger a second layer of security is added with the “proof of work”. No participant can add a transaction to the ledger without solving previously a set of complex mathematical problems. This “distributed” system is radically different from the present financial infrastructure which is based on a centralised “trusted custodians” being central banks, CSDs or banks that not only take care of the records but also avoid any risk of “double spending” or theft.

But the technology behind Bitcoin makes it possible to do away with any centralised authority by:

  1. Distributing all the transaction information between the participants
  2. Avoiding issues of theft and “double spending” with standard cryptographic techniques and by giving to every unit of Bitcoin a unique “serial number”.

This technology of serial number can be used for any financial instrument: bonds, equities or even derivatives. It can be used also for “real” currencies like dollars, euros or renminbis thus making possible the use and transfer of currencies outside the traditional banking and payment systems through a distributed ledger.

The technology behind Bitcoin can be used to really transform the post trade infrastructure for currencies, bonds and equities from a centralised infrastructure controlled by banks and CSDs to a distributed infrastructure controlled or owned by the users and/or the owners of the securities.

Bitcoin itself may not survive very long. There are other payment systems and currencies that are more efficient, secure and convenient. However the mix of cryptography and a distributed ledger will have a hugely transformative and disruptive effect on banks, post trade infrastructures and exchanges.

[1] See http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q301.pdf and http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q302.pdf

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