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JP Koning's blog wrote:Recent posts by Adrian Hope Baille and Sina Motamedi have got me thinking again about the idea of the Federal Reserve (or any other central bank for that matter) adopting bitcoin technology. Here's an older post of mine on the idea, although this post will take a different tack.

The bitcoin ethos enshrines the idea of a world free from the totalitarian control of central banks. So in exploring the idea of Fed-run bitcoin-style ledger, I realize that I run the risk of being cast as Darth Vader (or even *yikes* the Emperor) by bitcoin true believers. So be it. While I do empathize with the bitcoin ideal—I support freedom in banking—I rank the importance of bitcoin-as-product above bitcoin-as-philosophy. And at the moment, bitcoin is not a great product. While bitcoin has many useful features, these are all overshadowed by the fact that its price is too damn volatile for it to be be taken seriously as an exchange medium. This volatility arises because bitcoin lacks a fundamental value, or anchor, a point that I've written about many times in the past. However, there is one way to fix the crypto volatility problem...

Enter Fedcoin

Setting up the apparatus would be very simple. The Fed would create a new blockchain called Fedcoin. Or it might create a Ripple style ledger by the same name. It doesn't matter which. There would be an important difference between Fedcoin and more traditional cryptoledgers. One user—the Fed—would get special authority to create and destroy ledger entries, or Fedcoin. (Sina Motamedi gives a more technical explanation for how this would work in the case of a blockchain-style ledger)

The Fed would use its special powers of creation and destruction to provide two-way physical convertibility between both of its existing liability types—paper money and electronic reserves—and Fedcoin at a rate of 1:1. The outcome of this rule would be that Fedcoin could only be created at the same time that an equivalent reserve or paper note was destroyed and, vice versa, Fedcoin could only be destroyed upon the creation of a new paper note or reserve entry.

So unlike bitcoin, the price of Fedcoin would be anchored. Should Fedcoin trade at a discount to dollar notes and reserves, people would convert Fedcoin into these alternatives until the arbitrage opportunity disappears, and vice versa if Fedcoin should trade at a premium.

As for the supply of Fedcoin, it would effectively be left free to vary endogenously, much like how the Fed currently let's the market determine the supply of Fed paper money. This flexibility stands in contrast to the fixed supply of bitcoin and other cryptocoins. The mechanism would work something like this. Should the public demand Fedcoin, they would have to bring paper dollars to the Fed to be converted into an equivalent number of new Fedcoin ledger entries, the notes officially removed from circulation and shredded. As for banks, if they wanted to accumulate an inventory of Fedcoin, they would exchange reserves for Fedcoin at a rate of 1:1, those reserves being deleted from Fed computers and the coins added to the Fedcoin ledger.

Symmetrically, unwanted Fedcoin would reflux to the central bank in return for either newly-created cash (in the case of the public) or reserves (in the case of banks), upon which the Fed would erase those coins from the ledger. The upshot is that the Fed would have no control over the quantity of Fedcoin—it would only passively create new coin according to the demands of the public.

Apart from that, Fedcoin would be similar in nature to most other cryptoledgers. All Fedcoin transactions would be announced to a distributed network of listening nodes for processing and verification. In other words, these nodes, and not the Fed, would be responsible for maintaining the integrity of the Fedcoin ledger.

Why implement Fedcoin?

The main reasons that the Fed would implement Fedcoin would be to provide the public with an innovative and cheap payments option, and to provide the taxpayer with tax savings.

The public would enjoy all the benefits of bitcoin including fast transaction speeds, cheap transaction costs, and the ability to transact almost anywhere and with almost anyone as long as all parties to a transaction had a smartphone and the right software. At the same time Fedcoin's stability would immediately differentiate it from bitcoin. No longer would users have to fear losing 50% of their purchasing power prior to making a transaction.

Fedcoin's distributed architecture would be both complementary and in many ways superior to Fedwire, a centralized system which currently provides for the transferal of Fed electronic reserves among banks. I won't bother getting into the specifics: see this old post.

By introducing Fedcoin, the Fed would also lower its costs. While I haven't done the calculations, I have little doubt that running a distributed cryptoledger is far cheaper than maintaining billions of paper notes in circulation. Paper currency involves all sorts of outlays including designing and printing notes, collecting, processing and storing them, as well as constantly defending the note issue against counterfeiters. A distributed ledger does all this at a fraction of the cost. As Fedcoin begins to displace cash, and I think that this would steadily happen over time due to its superiority over paper, the Fed's costs would fall and its profits rise to the benefit of the taxpayer.

Fedcoin would have no impact on monetary policy

Fed officials might balk at giving the idea a shot if they feared that adopting a Fed cryptoledger would impede the smooth functioning of Fed monetary policy. They needn't worry.

The Fed currently exercises control over the price level by varying the quantity of reserves and/or the interest paid on reserves. The existence of cash doesn't get in the way of this process, nor has it ever gotten in the way. Bringing in a third liability type, Fedcoin, the quantity of which is designed to fluctuate in the same way as cash, would likewise have no impact on monetary policy. The Fed would continue to lever the return on reserves in order to get a bite on prices while allowing the market to independently choose the quantity of Fedcoin and cash it wished to hold.

Well, almost none: Interest on Fedcoin and the zero lower bound

Ok, I sort of lied in the last paragraph. While it happens only rarely, there are times when cash does get in the way of monetary policy, and so would Fedcoin if it were implemented. If the Fed needs to reduce rates on reserves to negative levels in order to hit its price and employment targets, the existence of cash impedes the smooth slide below zero. With reserves yielding -2% and paper notes yielding 0%, reserves would quickly be converted en masse into cash until only the latter remains. At that point the Fed would have lost its ability to alter rates—cash doesn't pay interest nor can it be penalized—and would no longer be capable of exercising monetary policy. This is called the zero-lower bound, and it terrifies central bankers.

Fedcoin has the potential to alleviate the zero lower bound problem. Here's how.

As Fedcoin adoption grows among the public, cash would steadily be withdrawn. And while it might not shrink to nothing—the public might still choose to use some cash—at least the Fed would have a good case for entirely canceling larger denominations like the $100 and $50.

Consider also that it would be possible for interest to be paid on each Fedcoin (unlike bitcoin and cash), the rate to be determined by the Fed. And just as Fedcoin could earn positive interest, the Fed could also impose a negative rate penalty on Fedcoin. This would effectively solve the Fed's zero lower bound problem. After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store $5s and $10s available.

So by implementing something like Fedcoin, the Fed could safely implement a negative interest rate monetary policy.

(Lastly, monetary policy nerds will notice that the displacement of non-interest yielding cash with interest-yielding Fedcoin is a tidy way to arrive at Milton Friedman's optimum quantity of money, or the Friedman rule.)

The big losers: banks

Fedcoin has the potential to tear down the private banking system. Interest yielding Fedcoin would be able to do everything a bank deposit could do and more, and all this at a fraction of the cost. As the public shifted out of private bank deposits and into Fedcoin, banks would have to sell off their loan portfolios, the entire banking industry shrinking into irrelevance.

One way to prevent this from happening would be for the Fed to make an explicit announcement that any bank could be free to create its own competing copy of Fedcoin, say WellsFargoCoin. Like the Fed, Wells Fargo would promise to offer two-way convertibility between its deposits/cash/Fedcoin and WellsFargoCoin at a rate of 1:1 to ensure that the price of its new ledger entries were well-anchored. The bank could then implement features to compete with Fedcoin such as higher interest rates or complimentary financial services. Even as Wells Fargo's deposit base steadily shrunk due to technological obsolescence, its base of WellsFargoCoin liabilities would rise in a compensatory manner.

The resulting lattice network of competing private bank crypto ledgers built on top of the Fedcoin ledger would work in a similar fashion to the current banking system. Wells Fargo would make loans in WellsFargoCoin and take deposits of FedCoin as well as competing bankcoins, say CitiCoin or BankofAmericaCoin. Intra-bank cryptocoin payments would be cleared on the books of the Federal Reserve with reserves transfers over the Fedwire funds system, although Fedcoin might eventually take the place of Fedwire. A change in the value of Fedcoin or reserves due to a shift in monetary policy would be transmitted immediately into a change in the value of all private bankcoins by virtue of the convertibility of the latter into the former.

Nor would it be necessary to start with Fedcoin and then introduce bankcoins. Why not begin with the latter and skip Fedcoin altogether? Why aren't private banks at this very moment switching out deposits and replacing them with cryptoledgers?

KYC: Know your customer

'Know your customer' regulations would make implementation difficult, but not impossible.

With bitcoin, the location of a coin (its address) is public but the identity of the owner is not. However, laws require banks to gather information on their customers to protect against money laundering. As these laws are unlikely to change with the advent of new technology, banks would probably require anyone wanting to use bank cryptoledgers to have an account with a regulated bank. This would not be too onerous given that most Americans already have bank accounts. However, it compromises anonymity, one of the key ideals of bitcoin, since each coin would be traceable by the authorities to a real person.

Perhaps there is still a way to preserve some degree of anonymity. Historically the Fed has always been spared from KYC rules since it has never had to document who uses cash. By grandfathering KYC exemption to Fedcoin, any user who wanted to preserve their anonymity could use Fedcoin rather than any of the multiple bankcoin ledgers, just like today they prefer to use anonymous Fed cash rather than bank accounts to transact.

In summary

So that's a rough sketch of Fedcoin—a decentralized, flexible, and well-backed payments system that grants one user, the Fed, a set of special privileges and responsibilities. Feel free to modify the idea in the comments section.

And just so we are keeping tabs, these are the institutions that Fedcoin could eventually make obsolete: bank deposits, banks (unless the latter are allowed to innovate their own bankcoins), the credit card networks Visa and Mastercard, bank notes, Fedwire, and even bitcoin itself, which would be unable to compete with a stable-value copy of itself.

Bitcoin true believers may not like this post, but perhaps they can take something constructive from it. Fedcoin is one of the potential competitors in the distant horizon. Now is the time for the rebels to figure out how to create a stable-price version of bitcoin, before Darth Vader does it himself. Otherwise they may someday find themselves closing down their bitcoin startups in order to write code for the Empire.

David Andolatto's blog wrote:It was J.P. Koning's blog post on Fedcoin that first got me thinking seriously of the potential societal benefits of government-sponsored cryptocurrency. When I was invited to speak at the International Workshop on P2P Financial Systems 2015, I thought that a talk on Fedcoin would be an interesting and provocative way to start the conference. You can view my presentation here, but what I'd like to do in this post is clarify some of the arguments I made there.

As I described in this earlier post, I view a payment system as a protocol (a set of rules) for debiting and crediting accounts, I view money as widely agreed-upon record-keeping device, and I view monetary policy as a protocol designed to manage the supply of money over time.

The cryptocurrency Bitcoin is a payment system with monetary objects called bitcoin and a monetary policy prescribed as deterministic path for the supply of bitcoin converging to a finite upper limit. I view Bitcoin as a potentially promising payment system, saddled with a less-than-ideal money and monetary policy. As the protocol currently stands, bitcoins are potentially a better long-run store of value than non-interest-bearing USD. But if long-run store of value is what you are looking for, we already have a set of income-generating assets that do a pretty good job at that (stocks, bonds, real estate, etc.). [For a comparison of the rates of return on stocks vs. gold, look here.]

Let's set aside Bitcoin's monetary policy for now and concentrate on the bitcoin monetary object. What is the main problem with bitcoin as a monetary instrument in an economy like the U.S.? It is the same problem we face using any foreign currency in domestic transactions--the exchange rate is volatile and unpredictable. (And our experience with floating exchange rates tells us that this volatility will never go away.) Bill Gates hits the nail on the head in his Reddit AMA:

Bitcoin is an exciting new technology. For our Foundation work we are doing digital currency to help the poor get banking services. We don't use bitcoin specifically for two reasons. One is that the poor shouldn't have a currency whose value goes up and down a lot compared to their local currency.

For better or worse, like it or not, the USD is the U.S. economy's unit of account--the numeraire--the common benchmark relative to which the value of various goods and services are measured and contractual terms stipulated. With a floating exchange rate, managing cash flow becomes problematic when (say) revenue is in BTC and obligations are in USD. Intermediaries like Bitreserve can mitigate some this risk but, of course, at an added expense. Hedging foreign exchange risk is costly--a cost that is absent when the exchange rate is fixed.

And so, here is where the idea of Fedcoin comes in. Imagine that the Fed, as the core developer, makes available an open-source Bitcoin-like protocol (suitably modified) called Fedcoin. The key point is this: the Fed is in the unique position to credibly fix the exchange rate between Fedcoin and the USD (the exchange rate could be anything, but let's assume par).

What justifies my claim that the Fed has a comparative advantage over some private enterprise that issues (say) BTC backed by USD at a fixed exchange rate? The problem with such an enterprise is precisely the problem faced by countries that try to peg their currency unilaterally to some other currency. Unilateral fixed exchange rate systems are inherently unstable because the agency fixing the BTC/USD exchange rate cannot credibly commit not to run out of USD reserves to meet redemption waves of all possible sizes. In fact, the structure invites a speculative attack.

In contrast, the issue of running out of USD or Fedcoin to maintain a fixed exchange rate poses absolutely no problem for the Fed because it can issue as many of these two objects as is needed to defend the peg (this would obviously call for a modification in the Bitcoin protocol in terms of what parameters govern the issuance of Fedcoin). Ask yourself this: what determines the following fixed-exchange rate system:



Do you ever worry that your Lincoln might trade at a discount relative to (say) Washingtons? If someone ever offered you only 4 Washingtons for your 1 Lincoln, you have the option of approaching the Fed and asking for a 5:1 exchange rate--the exchange rate you are used to. Understanding this, people will generally not try to violate the prevailing fixed exchange rate system. The system is credible because the Fed issues each of these "currencies." Now, just think of Fedcoin as another denomination (with an exchange rate fixed at par).

Now, I'm not sure if Fedcoin should be a variant of Bitcoin or some other protocol (like Ripple). In particular, I have some serious reservations about the efficiency of proof-of-work mechanisms. But let's set these concerns aside for the moment and ask how this program might be implemented in general terms.

First, the Fedcoin protocol could be made open source, primarily for the purpose of transparency. The Fed should only honor the fixed exchange rate for the version of the software it prefers. People can download free wallet applications, just as they do now for Bitcoin. Banks or ATMs can serve as exchanges where people can load up their Fedcoin wallets in exchange for USD cash or bank deposits. There is a question of how much to reward miners and whether the Fed itself should contribute hashing power for the purpose of mining. These are details. The point is that it could be done.

Of course, just because Fedcoin is feasible does not mean it is desirable. First, from the perspective of the Fed, because Fedcoin can be viewed as just another denomination of currency, its existence in no way inhibits the conduct of monetary policy (which is concerned with managing the total supply of money and not its composition). In fact, Fedcoin gives the Fed an added tool: the ability to conveniently pay interest on currency. In addition, Koning argues that Fedcoin is likely to displace paper money and, to the extent it does, will lower the cost of maintaining a paper money supply as part of the payment system.

What about consumers and businesses? They will have all the benefits of Bitcoin--low cost, P2P transactions to anyone in the world with the appropriate wallet software and access to the internet. Moreover, domestics will be spared of exchange rate volatility. Because Fedcoin wallets, like cash wallets, are permissionless and free, even people without proper ID can utilize the product without subjecting themselves to an onerous application process. Finally, because Fedcoin, like cash, is a "push" (rather than "pull") payment system, it affords greater security against fraud (as when someone hacks into your account and pulls money out without your knowledge).

In short, Fedcoin is essentially just like digital cash. Except in one important respect. Physical cash is still a superior technology for those who demand anonymity (see A Theory of Transactions Privacy). Cash does not leave a paper trail, but Fedcoin (and Bitcoin) do leave digital trails. In fact, this is an excellent reason for why Fedcoin should be spared any KYC restrictions. First, the government seems able to live with not imposing KYC on physical cash transactions--why should it insist on KYC for digital cash transactions? And second, digital cash leaves an digital trail making it easier for law enforcement to track illicit trades. Understanding this, it is unlikely that Fedcoin will be the preferred vehicle to finance illegal activities.

Finally, the proposal for Fedcoin should in no way be construed as a backdoor attempt to legislate competing cryptocurrencies out of existence. The purpose of Fedcoin is to compete with other cryptocurrencies--to provide a property that no other cryptocurrency can offer (guaranteed exchange rate stability with the USD). Adopting Fedcoin means accepting the monetary policy that supports it. To the extent that people are uncomfortable with Fed monetary policy, they may want to trust their money (if not their wealth) with alternative protocols. People should be (and are) free to do so.

Postscript, February 06, 2015.

A number of people have asked me why we would need a distributed/decentralised consensus architecture to support a FedCoin. In the talk I gave in Frankfurt, I actually made two proposals. The first proposal was called "Fedwire for All." This is basically digital cash maintained on a closed centralized ledger, like Fedwire. It would be extremely cheap and efficient, far more efficient that Bitcoin. But of course, it does not quite replicate the properties of physical cash in two respects. First, as with TreasuryDirect, the Fedwire accounts would not be permissionless. People would have to present IDs, go through an application procedure, etc. Second, the Fed is unlikely to look the other way (as it does with cash) in terms of KYC restrictions. So, to the extent that these two latter properties are desirable, I thought (at the time I wrote this piece) that we needed to move beyond Fedwire-for-All to Fedcoin. There may, of course, be other ways to implement these properties. I'm all ears!