Here’s why Bitcoin-the-network needs Bitcoin-the-currency

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.

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15 Responses to Here’s why Bitcoin-the-network needs Bitcoin-the-currency

  1. mike robbins says:

    Yeah the only people that are against this is old people and there old ways! Pay pal Slow as heck if you ever want to get your money back from them! There for no PayPal for me. Master card is ok for buying stuff from businesses! But does us no good to send money to individuals. As for the whole mt gox That started this nonsense! Why do you need a bit coin exchange That was the bitcoin mine right there and that company is responsible for the loss of bitcoin. If i were to set up a exchange like that it would half to be set up so no outsiders can get in only insiders as it should not even be connect to the internet for anybody to hack. the algorithms could of been uploaded to a separate server off line the second any transactions happened. there for they would of still had the coins and proof of them but they did not do such a thing. Anyways the world need a new payment system And a cloud peer to peer lending system separate from current financial system. And a private market systems that anybody can and run as long as there not doing something totally immoral old way of doing things needs to come to a end as it only ever benefits the ones that can afford to set it up the old ways. but what do i know!

  2. Coin4Brains says:

    The credit card companies represent a combined drag on our economy of 4-5%! Honest merchants are forced to shoulder most of the burden for fraud from thieves through charge back. The promise of Bitcoin that I am most interested in is the ability to liberate the US economy from this drag, which represents about 2 to 3 years of GDP growth.

  3. Treeman says:

    This article made bitcoin no clearer for me. Can anyone explain how my money would be safe in bitcoins? Who is going to prevent fraud if no one is in charge? I am an engineer and where are the graphs or the equations to explain this financial system?

  4. Anonymous says:

    Mike robbins, good insight!

  5. Anonymous says:

    “Master card is ok for buying stuff from businesses! But does us no good to send money to individuals. ”

    That one!

  6. Ethan Glover says:

    As Bitcoin becomes more popular, the stories out on it become less informed and more poorly put together.

  7. Jim Parker says:

    Mike Robbins would be more credible if his writing skills were better. How does he operate in society with the writing skills of a 5th grader? Why should anyone care what he says if he can’t spell, use correct grammar, or form a properly composed sentence?

  8. nik says:

    Speculators see a coin. Innovators see a ledger.

  9. Das says:

    21. century’s Ponzi scheme.
    I only hate the fact that I didn’t believe in the bitcoin marketing a few years back. I could have been one of the winners. At least I won’t become a sucker either.

  10. JVM says:

    Do you know about Ripple? It’s decentralized but allows transactions in any currency.

  11. thomas jones says:

    But as useful as a cheaper or better payment system is, I’m reluctant to use it if the currency also has the property of being chaotically volatile. I’d rather the transaction costs of a stable currency than to get paid in a currency that could be worth half (or double) what it was worth the week before. So I think I might agree if the damn thing stabilised.

  12. Jon says:

    Much of Mr. Lee’s piece seems to rest on bitcoin processors not having “pressure to comply with a variety of legal obligations…”. This sort of situation surely won’t be tolerated by governments nor their citizens.

    The idea that a Bitcoin decentralized network will allow more innovation in fraud detection and prevention as opposed to the conventional payment systems is rather strongly contradicted by real-world experience. Bloomberg uses a fingerprint reader for its terminals. Bank of America offers “safe pass.” Some banks use various data mining technologies to identify fraud. Systems for paying by phone are also being developed.

    Furthermore, Mr. Lee ignores that while hobbled by bureaucratic inertia, large companies have the advantage of providing an existing reliable platform as well as plenty of resources to pursue new innovations.

  13. Mark in CA says:

    I fear a significant portion of the innovation will go into devising schemes to defraud others. I think there may be a middle ground between a wholly-own network like Visa or MasterCard and a libertarian free-for-all like bitcoin. One system currently in test phase that may be a model for this is the Canadian MintChip scheme, which is issued by the Royal Canadian Mint, is pegged to the Canadian dollar and yet retains many bitcoin-like characteristics, such as anonymity and fast, free or almost free transactions. At this point, it is still unclear how close the technical underpinnings of MintChip resemble those of bitcoin, but the system has evolved from its original physical card-based implementation to one that is purely digital.

  14. David Kennerly says:

    CAN government forcibly regulate Bitcoin given Bitcoin’s decentralized and ephemeral structure?

    Or can it only attack nodes on the network, so to speak as well as wreak havoc with its integrity by attacking the network through Stuxnet-like trickery? Of course, this may well be enough to kill it.

    I guess my question really is: can Bitcoin OR ANY OTHER IMAGINABLE virtual currency sustain itself if it does not bend to the will of government?

  15. Jon says:

    There are many ways governments could regulate bitcoin, as has already been demonstrated by the government’s arrest of an official of the foundation. The government can tax or demand reporting from any entity that exchanges bitcoins for currency, or just forbid various transactions involving bitcoin.

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