This week I was making the argument on Twitter that it’s more helpful to think about Bitcoin as a new kind of payment network than a new kind of currency. Multiple people asked variants of the same question: if the goal is to create a new kind of financial network, why base it on an alternative currency? Why not just create a new payment network based on a conventional, stable currency like the dollar?
It’s a good question, and I think the answer comes in three parts:
1. Bitcoin’s potential for innovation comes from its openness. Anyone is free to create Bitcoin-based software or services. That will allow more experimentation and faster innovation than with conventional payment networks like Paypal or Mastercard.
2. That openness comes from the fact that no one owns or controls the Bitcoin network. If there were a “Bitcoin Inc.” with authority to oversee the Bitcoin network, that company would come under immense pressure to comply with a variety of legal obligations, for example policing the network for fraudulent transactions. To deal with those obligations, the company would be forced to become increasingly picky about who was allowed to participate in the network and what they’re allowed to do.
3. If there’s no company controlling a financial network, then there’s no way to guarantee that the unit of account inside the network is pegged to some stable unit of value outside of it. Dollars in Paypal are worth a dollar because the Paypal company has promised to pay a dollar to anyone who wants to withdraw their funds. But in a peer-to-peer network, there’s no one to perform this function. So a fully decentralized financial network necessarily needs to use its own unit of account that floats against conventional currencies.
Paul Haahr had an interesting response to this line of argument: for Bitcoin to be useful, doesn’t it need to integrate with the conventional financial system? And won’t those points of integration make the consumer-facing parts of the network just as bureaucratic as a conventional payment network?
I think the answer to the first question is clearly “yes.” Answering the second question is complicated.
Every consumer-friendly financial network needs to have some kind of strategy for combatting fraud. Ordinarily, this takes the form of the network operator accepting liability for unauthorized transactions and then establishing rules that minimize the amount of fraud that occurs. But there are many possible strategies for detecting and combatting fraud.
In a centralized network, the whole network has to adopt a single unified strategy for fraud prevention. Because the network operator is on the hook for any losses, those rules tend to be pretty conservative. To become a Visa or Mastercard merchant, for example, you have to participate in a lengthy approval process and comply with a variety of complex requirements. This is not very conducive to innovation.
In contrast, an open financial network allows different payment processors to adopt different strategies for combatting fraud. Some might require consumers to adopt sophisticated techniques like two-factor authentication before they can spend Bitcoins. Others might set fairly low limits on how much consumers can spend in a day.
Some might only allow payments to merchants that agree to refund payments that later prove to be fraudulent. Others might use sophisticated machine learning algorithms to try to guess which transactions are likely to be fraudulent. Still others might cater to large organizations who already have elaborate systems for controlling payments. And of course, payment processors could use these techniques in any combination.
It’s true that in the long run, many of these consumer-facing payment processors will be forced to take the same kinds of elaborate precautions that conventional networks like MasterCard and Paypal do. But the barrier to entry is much lower for a Bitcoin-based payment processor. Thanks to the standardized Bitcoin protocol, a new Bitcoin payment processor can immediately send payments to everyone else on the Bitcoin network. So there can be a constant stream of new companies bringing new ideas—and a fresh willingness to ignore the rules while pioneering new approaches—to the network. In contrast, a company like Paypal has to build its network from scratch, a much more daunting proposition.
There’s an obvious parallel to the Internet here. Large Internet companies such as Google and Yahoo are required to comply with laws around the world regulating libel, indecency, copyright infringement, the sale of Nazi memorabilia, and so forth. Yet the Internet’s decentralized architecture makes it a much more hospitable place for freedom of speech than it would be if there were a single Internet, Inc. that could be held legally responsible for everything that appears on the Internet. If major Internet intermediaries were held liable for website content, there’d be an elaborate rulebook every website operator had to comply with before he was allowed to start a website. In that environment, services like YouTube or Facebook would have never gotten started.
So that’s why Bitcoin-the-network needs Bitcoin-the-currency. Innovation requires openness. Openness required decentralization. And decentralization is only possible on a network with its own unit of account.