Blockchains, Reserve Banks, and Accounting for Liabilities

Blockchain enthusiasts have occasionally claimed that blackchains allow “an asset without a liability,” a phrase used by Walker and Luu, and echoed by Nic Carter. Despite being a ledger, the blockchain is not money owed by anyone — which is a informal understanding of what a liability is. The claimed advantage of this seems to be that cryptocurrency holdings are akin to a natural resource, like gold or silver, rather than a reserve-bank backed fiat currency.

In many ways Bitcoin and similar ventures do resemble such assets, or even exceed them in important ways. For example, the supply of Gold is “fixed” — modulus mining, which can increase when gold prices are high. The supply of bitcoin, of course, is fixed in a much less manipulable sense. However, not having a corresponding liability is not one of the ways that cryptocurrencies differ from reserve-bank currencies — in fact, it is an incredibly close parallel.

First, it is useful to understand what a reserve bank balance sheet does — it has assets, which are things it purchased, and liabilities, which is principally the money that has been issued. Reserve banks function by running a liability-focused balance sheet — they create money from nothing, which gives them an asset, the money created, and a corresponding liability, which is that the money is actually a debt to itself. If this money is used to buy something, they get an asset in exchange for an asset and the balance sheet balances. But the liability doesn’t mean they owe anything — they can leave the currency issued and never repay it.

If I have a $50 bill, that is a direct $50 liability on the part of the central bank. They don’t owe me anything, but it’s a liability. The way those liabilities are balanced is via a negative equity — the total government debt. That’s because in most cases, central banks are actually paying for things that they don’t receive — the government runs a deficit, and the excess payments by the government creates a debt, which is again, a reserve bank liability. The theory is that the reserve bank could always balance its books by having the government tax to pay for all of those liabilities — but the more common resolution is inflation, insolvency, and often abandoning the currency.

This is fundamentally different than a commercial bank. If I have $50 in a commercial bank, and no debt, that’s a $50 liability that the bank owes me, and a corresponding $50 asset that they have to lend. The money is ALSO a liability on the reserve bank balance sheet, corresponding to the asset the bank has. The bank’s balance sheet for these assets needs to balance, however, unlike the reserve bank. If they hold the cash, they can then lend my $50 (in fractional reserve banking, to three or four people,) but for every dollar they hand out, they gain a corresponding asset — that someone owes them the money. They can become insolvent just like the federal government — if too many people default on loans, they run out of money, and (if the FDIC or equivalent doesn’t step in,) the depositors lose their deposits.

How does a blockchain work? Just like a reserve bank, it gives out money (pre-mined tokens, block rewards, transaction fees,) but it does not get anything in exchange. This is a lot like when a government overspends its assets — the corresponding liabilities turn into money. Here, however, the item purchased with the money isn’t an asset, it’s an intangible — security and transactibility. Until the currency is fully mined, every block mined costs the network money to pay for this security and transactibility.

When I have a bitcoin, it’s an asset balanced by a liability held by the blockchain. Whose liability? It belongs to the network. The network must mine more blocks to allow transactions, and keep these liabilities useful —and this is an ongoing expense.

Cryptocurrencies have associated liabilities, just like any other asset that gets issued. What balances the block-chain debit-sheet? Nothing — just like central banks, which spent money and created liabilities. Unlike central governments, blockchains don’t have the ability to tax to re-balance the balance sheet. By design, of course, most also can’t inflate the currency. If for any reason the blockchain is unable to meet the ongoing expense of mining rewards to provide security and transactability, it does exactly the same thing a reserve bank does, and the money disappears.

“Bearish” on Z-Cash

I recently made my 2017 predictions, and was asked why I was “bearish” on Z-Cash. I predicted a 25% chance that the price would rise, and a 75% chance that the market cap would do so, over the course of the year.

I’m not sure this is really bearish. First, after 2 months, there are currently about 375,000 ZEC minted, of which 300,000 are in circulation. (Block 40,000.) I’m not sure the exact schedule — it should only half after 840,000 blocks, in well over a year — but in 12 months, there should be 7 times as many coins. That means, by the end of the year, at current prices, the market cap would move from $20m to closer to $140m. So the market cap would need to increase significantly in order for the price to stay stable.

Is this implausible? No. But it would probably involve cannibalizing much of the dark-web market share from Monero, (and darkweb markets won’t necessarily switch to new coins quickly,) or a speculative price bubble that extends through the end of the year. I am bullish on Z-Cash over the longer term, but it’s riding on speculation now, and I’d be a little bit surprised if it managed to attract that large a market cap within the year. Because at some point, as more coins are generated and speculators stop pouring in money, the fundamentals take over from the speculators. Perhaps only 25% was overconfident — but I’m definitely not certain of an increase.

Expanding definitions and Obsoleting Industries

I’ve already explained why we can’t figure out if bitcoin is “really” a currency. But I think there is a lot more to say — because those 3 characteristics of money (Unit of Account, Store of Value, and Medium of Exchange) are not the only things that make money useful.

What else is needed?

Principally, gold stopped being used as currency directly because it was too hard to carry around as a currency — especially safely! But the gold standard was abandoned because the supply was too inflexible. Country’s economies started to expand much faster than their metal-backed currency, so that the value that existed was in excess of the medium of exchange for that value, and their needs for credit couldn’t be easily supplied with gold. This clarifies that these three tasks are not all a currency can do, nor is it the only thing we might care about. In fact, much before digital currencies, there were lots of things that we need that traditional forms of money don’t provide. Instead, systems were created to fill in the gaps, and these systems sprouted entire industries that software is getting ready to eat.

For example, we frequently need a system for measuring, processing, and communicating transactions. This is traditionally done by bookkeepers (not even necessarily accountants). I’ll refer to it as a “ledger of transactions” (4). Bookkeeping employs a couple hundred thousand people and costs around $50bn in the US alone. Under modern accounting principles, using third party verifiers, this system also allows an owner to provide a “proof of worth” (5) for a company or an individual. That’s accounting, (audit, not tax) and it employs another couple hundred thousand people and costs $100b. Both of these are bonuses that blockchain ledger currencies like bitcoin can provide, for example, using merkel hash tree signed proofs. Because of this, traditional businesses and currencies must rely on those large, expensive systems instead.

Next, we have more ancillary, non-currency systems that provide “tokens of ownership” (6) for non-currency goods, like real estate deeds or stock certificates. In order for these to be liquid and saleable, a “verifiable exchange market” (7) is needed, such as a county clerk for real estate, so that people can reliably sell their property without worrying that someone else will appear with a different deed to the property. If you’ve ever bought a house, you know the “title search” fee of $250+ you pay, instead of a 1 line query of a distributed blockchain database. And then you probably still need title insurance, in case the search missed anything.

The verifiable exchange can also provide a “transaction price log” (8) like the stock market’s ticker, where everyone can see the value of the goods currently being traded, and therefore be able to make decisions about whether to buy and sell. And all three of these can be accomplished using on-chain blockchain tokens, which track ownership, and the blockchain can show the prices paid for them.

We also want a “system of credit” (9) that allows for transactions that are contingent, risky, or require a future payment. This last is closely related to, and requires, a unit of account — but credit cards and most other typical forms of credit use outside systems for their unit of account. This is a feature that blockchain based currencies don’t do well, yet. Some smart contract platforms seem poised to allow, for example, collateralized loans, but the key difficult with extending credit via blockchain is that unsecured credit requires known identities, which blockchains don’t do. (If I lend money to you, then you stop paying me back and just start using a new wallet for your money, it’s not clear what recourse I have.)

Further, built on top of these systems, we have complex systems for many other features of the modern economy that are enabled by these various services and characteristics of money and related market systems. For example, fractional reserve banking relies on a “system of credit” for loans so that banks can have assets in excess of their reserves. For this to be trustworthy, we need (but don’t fully have) a robust “proof of worth” for these banks.

We have a repurchase agreement (“repo”) market that allows “tokens of ownership” (6) to assist the “system of credit” (9) which helps ensure liquidity on the basis of owned assets.

The Future

This large set of needs, combined with a healthy dose of historical path dependence, leads to the current complicated set of systems that are all intertwined. But as one 2016 Nobel laureate said, “The times, they are a changin’.”

Cryptocurrencies and Smart contracts have the ability to do all of these things. Definitions don’t dictate reality, they reflect it. Cryptocurrencies can do things currencies cannot, and focusing on the definitions is a red herring.