Eswar Prasad is the Tolani Senior Professor of Trade Policy and Professor of Economics at Cornell University. He is also a Senior Fellow at the Brookings Institution, where he holds the New Century Chair in International Economics, and a Research Associate at the National Bureau of Economic Research. He was previously chief of the Financial Studies Division in the IMF’s Research Department and, before that, was the head of the IMF’s China Division.
Prasad’s latest book is The Future of Money: How the Digital Revolution is Transforming Currencies and Finance (Harvard University Press, 2021). He is also the author of Gaining Currency: The Rise of the Renminbi (Oxford, 2016) and The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance (Princeton, 2014). Prasad has testified before the Senate Finance Committee, the House of Representatives Committee on Financial Services, and the U.S.-China Economic and Security Review Commission. He is the creator of the Brookings-Financial Times world economy index (TIGER: Tracking Indices for the Global Economic Recovery). His op-ed articles have appeared in the Financial Times, Foreign Policy, Harvard Business Review, International Herald Tribune, New York Times, Wall Street Journal, and Washington Post.
Welcome back to another episode of our series focusing on cryptocurrencies. In this episode, we dive into conceptual complexities surrounding cryptocurrencies and how this might affect the financial system in future. To help us unravel this nuanced subject is Professor Eswar Prasad, a senior professor of trade policy and Professor of Economics at Cornell University, and a senior fellow at Brookings Institution. He is also a research associate at the National Bureau of Economic Research and was a former head of the IMF China Division. Besides his wealth of experience regarding traditional economies, he is also an authority on cryptocurrencies, which he explains in detail in his book The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. In today’s conversation, we discuss broad conceptual ideas surrounding money and finance, such as the basic functions of money, the difference between outside and inside money, the limitations on creating wealth, how cryptocurrencies work, how cryptocurrencies may disrupt financial systems, why cryptocurrencies need trust to work, the future of cryptocurrencies, and much more. Tune in today to get insider information on cryptocurrencies with our special guest, Professor Eswar Prasad.
Key Points From This Episode:
A brief outline of Professor Eswar Prasad’s professional background. [0:01:14]
Professor Prasad explains what the basic functions of money are. [0:01:59]
We learn if money is a commodity or a social contract. [0:02:33]
The problems associated with fiat currencies. [0:03:00]
What the concepts of inside and outside money are. [0:04:12]
Factors that constrain the creation of outside money. [0:05:34]
Whether mechanically constrained money is good for economies. [0:07:07]
Learn whether commercial banks need deposits to make loans. [0:08:46]
What the definition of fungibility is. [0:10:24]
How and why reserves are usually maintained by a central bank. [0:11:19]
What the differences are between physical cash and electronic money. [0:12:25]
The anonymity associated with each of the payment methods available. [0:13:28]
What the main functions of the financial system are. [0:15:14]
Find out what the definition of shadow banking is. [0:17:01]
How trust in the financial system is facilitated. [0:18:29]
We find out if modern financial systems can be disintermediated by technology. [0:20:33]
The potential effects that intermediaries can have on economies. [0:22:59]
What Satoshi Nakamoto’s 2008 innovation was. [0:25:51]
The resilience of the underlying system for Bitcoin is explained. [0:28:12]
Learn about the three elements that make Bitcoin decentralized. [0:30:12]
How the decentralization of Bitcoin can be overcome. [0:31:39]
Learn about the value of blockchain and emerging validation technology. [0:34:07]
The key reasons why cryptocurrencies have value. [0:36:14]
Ways in which a decentralized system would be beneficial. [0:38:32]
Outline of the downsides to decentralized finance. [0:41:01]
Why trust is also essential to the long-term viability of cryptocurrencies. [0:43:03]
What role unofficial digital currencies will play regarding monetary policy. [0:44:05]
The influence that Satoshi’s innovation had on the development of a central bank digital currency. [0:45:49]
Read the Transcript:
Eswar, what are the functions of money?
The basic functions are to service as a unit of account for denominating transactions as a medium of exchange for actually conducting those transactions. And then as a store of value that is to preserve wealth, allow transactions to take place and allow you to transfer wealth across time and space. So all of these functions typically tend to get bundled in what we think of as money created by central banks. So fiat currencies, but these are the three basic functions that money provides.
Is money a commodity or a social contract?
So at some level one can think about it as a social contract because a commodity tends to have intrinsic value because of some purpose it serves. But of course there are commodities that you might think about like gold that do have certain intrinsic value because they have uses say in industrial production or perhaps even in tooth fillings. But they have value really as independent stores of value that are far above their intrinsic value. If you think about a fiat currency issued by a central bank, at one level it is not backed by anything. The old days even when governments issued money, they usually backed it with commodities or precious metals. Even during the gold standard period in the US and other advanced economies, the US dollar and other major currencies are backed by gold. But right now what fiat currency issued by central bank like the US dollar is backed by is just faith and trust in the central bank.
But then sitting behind the central bank of course, is the government which has the ability to levy taxes and require that the taxes be paid in the fiat currency which is considered legal tender. So that does give the US dollar or any fiat currency, some implicit backing. But again, to a large extent, we use US dollars as money because we know that if we use it in a transaction or if you're to get some US dollars, we can use it pay for another transaction. So at some level the fact that all of us believe that the value of the US dollar will be maintained, becomes very important in its viability as a money.
You've mentioned the US dollar a few times, what is outside money?
There are two concepts of money here. It used to be the case that money that served all of these functions, I spoke about earlier as a transactional medium, as a store of value and so on, was created largely by governments. But then there were periods when private merchants were also creating money and these used to compete with each other.
So right now we have money created by central banks because until cryptocurrencies came along, there wasn't much money created by private agents. But it turns out that in modern economies, a lot of money creation or credit creation, which fuels economic activity is actually created by commercial banks. So every time a commercial bank makes a loan, it creates a corresponding deposit. And that is inside money because it is money that is created by the private sector that creates within the private sector, but it nets out. So if a commercial bank creates a deposit and a loan, then that deposit is the liability of the central bank. But the loan it creates that matches that deposit, is an asset of the commercial bank.
Outside money is created by the central bank and outside is literally outside the private sector. This doesn't cancel out this money that is created by the central bank that is available to the private sector and does not net out on the private sector balance sheet.
What constrains the creation of outside money?
If you think about outside money, in principle there is no constraint other than the fact that if you were to have too much outside money floating around, that would potentially reduce the value of that money. So central bank can go out and in effect, print a large amount of money and certainly many central banks around the world, including the Federal Reserve did that in copious quantities. In the aftermath of the financial crisis and the world and the world's financial systems were craving liquidity. That is basically cheap money in order to keep the financial systems going. But in a normal world that would lead to the reduction in the purchasing power of that money, which would get translated into higher inflation. Some of which we're already beginning to see. Likewise, if you think about inside money, I argue that commercial bank can create loan sort of thin air subject to certain regulatory requirements.
But remember banking is a competitive business. If a bank were to go out and create huge amounts of loans and it provided loans that were not of high quality. In other words, if those loans were not going to get paid back, that bank would run into financial trouble. And of course the bank needs to make money through the margin between the rate that it charges on loans versus what it pays on deposits. So those commercial considerations constrain the creation of inside money. So both inside and outside money can be created in essentially infinite quantities conceptually, but there are in fact in the real world significant constraints on the creation of both.
Is a mechanically constrained money supply, like a gold standard, a good thing?
Logically one might think that the fact that a central bank cannot create money at will, will help preserve its value. And one of the problems with fiat currency that can be created very easily is that governments have tended to be spendthrift for a long time. So if a government takes in a lot less in revenues than it spends, it needs to make up for that somewhere. Raising taxes is painful, cutting expenditures is painful. But one thing a government can always do is to ask the central bank to print money, to pay for that deficit. But that can very quickly erode the value of that money because people start losing trust in that money. If there is a sense that the government can spend as much as it wants and the central bank is going to step in.
If fiat currency issued by central bank was going to be backed by gold, a government has to be disciplined with its taxation and expenditure policies. That is true. But what we have learned over the years is that severely constraints the ability of a central bank to create money when it is most needed. That is at times of great financial and economic pedal of the sorts we've experienced a couple of times in the last 15, 20 years. And even before that. The central bank's ability to create a lot of liquidity that is essentially money to lubricate the financial system becomes very important. This is why the US and the other advanced economies ditched the gold standard because it was taking autonomy from the monetary authorities to do what they needed to do to support the economy and the financial system.
Do commercial banks need to take in deposits to make loans like the fractional reserve banking idea that many people are familiar with?
Answer again, that this is not quite the way modern banking works. There is an element of truth to it. Certainly banks can also passively accept deposits and make loans based on that. And it is true that banks cannot exactly match their loans with their assets. They need to maintain some amount of capital. Capital is basically the financing that is generated by a commercial bank when it issues equity to equity holders. What happens is that equity actually provides a buffer. Let's say a bank has made a lot of loans and has deposits on the liability side of its balance sheet. If some of those loans turn out to be bad, especially in bad economic times such as an economic recession when households are not able to pay back their mortgages easily, when firms cannot pay back their loans easily. If the commercial bank came under a financial threat, that would be a problem because then you might have depositors who are clamoring to get their money back.
So the capital that a commercial bank holds provides a loss buffer. In other words even if some of the loans don't get paid back, then the holders of equity in that bank essentially are the ones are going to take some of the hit. Now this is exactly why commercial banks don't like holding a lot of capital. Because it turns out it's more expensive for them to raise financing by issuing equity because it dilutes the ownership shares of those who already are the owners of the equities stakes in that bank. And it is much more expensive than raising money through deposits. In a world right now the traditional notion of banks taking deposits, putting some of it in the central bank and then lending out the rest, that's not quite the way modern banking works.
Can you explain what fungibility is?
If you think about different concepts of money, then there is the notion of fungibility essentially implying that commercial bank money and fiat currencies trade at par when a country or a country central bank issues money that fiat currency essentially trades a par with commercial bank deposits. And that one to one matching essentially means that inside and outside money, money created by commercial banks and by the central banks are essentially substitutable for one another. Although one important distinction is that the money created by the central bank is a liability of the central bank, money created by the commercial bank is a liability of the commercial bank. But because there are regulatory constraints in place to make sure that banks don't go crazy creating their own money, that parity between the two types of money can be maintained, which makes them fungible.
So do commercial banks lend out reserves, the outside money, to retail customers?
Reserves are usually maintained at the central bank for settlement of transactions among banks. If you and I were to conduct a transaction. Let's say I wanted to send you some money, and we are not with the same bank, money is to travel from my bank account to your bank account. And that happens through a netting of various transactions that may take place. Maybe there are some people who are customers of your bank who want to send money to people who have accounts at my bank. So all of this gets netted out and the net transactions are settled through a payment system that is managed by the banks themselves. Or in many cases for large value payments, it is a payment system that is managed by the Fed. So actually reserves are held by commercial banks and the Fed to meet those requirements. And of course the Fed can also provide liquidity when needed. But typically the reserves being lend are directly. But it is true, a central bank can basically create more reserves, which basically makes it easier for a commercial bank to generate inside money.
How is physical cash different from electronic money in a commercial bank account?
These two trade at par. And you might think there is some fundamental difference between the two. And in fact, many central banks are thinking about issuing digital versions of their own currency. So we might have three things at play here. One is physical currency issued by central bank. Digital currency issued by central bank, which is still a liability of the central bank. And then bank deposits. So you could have digital versions of the fiat currency. Perhaps digital dollars, which may be we'll come to talking about in more detail as we go along. Those are going to trade at par with a bank deposit at a conceptual level that is no difference between a bank deposit, which you can use for payments. Or physical currency which you can use for payments. Or if we eventually come to a world where we have digital versions of the dollar, it'll be very similar. So the way in which we conduct our payment transactions, the consumer business or consumer to consumer interfaces may look a little different. But conceptually, these all amount essentially the same thing when it comes to making payments.
What about anonymity of the different payment methods?
Cash has certain attributes that make it very attractive. Cash does provide anonymity. It provides immediate finality of payment transactions and those settlement. In other words, when I walk into a coffee shop with a $10 bill, and it goes into the cashier's till and there is immediate settlement without coffee barista having to know anything about me. But if I were to make that payment using bank account or using say Apple Pay or Google Pay that I can use my phone for, the barista may not know who I am but ultimately there is going to be some trace of it. A digital trace in the payment system. That means that ultimately the person making that transaction is not going to be anonymous anymore because anything digital ultimately leaves a trace in terms of financial activity. But of course the fact that cash payments are anonymous has implied that cash can be used to finance.
Illicit transactions of various sorts can also be used for perfectly legitimate transactions. But once that don't get reported to the tax authority. So of course, if I was to pay somebody working in my garden for a couple of hours, the kids who shovel snow off my sidewalk or a babysitter, in cash, and that doesn't get reported to the government, that's not a big deal. But if you think about more high value transactions being intermediated in cash, that could potentially mean that there is a lot of activity taking place in the shadows. And the shadow economy does have implications for the government's ability to raise taxes. This is not a huge concern in a country like the US, but in many countries around the world, the shadow economy fueled by cash transactions is really a big deal. And the anonymity of cash is a key feature of cash that enables that.
What are the main functions of the financial system?
The financial system plays certain critical roles. One is providing capital for entrepreneurs who may want to undertake activities. It provides loans for people who want to build houses, allows us to borrow against future streams of income. Financial systems also allow us to save for the future in the form of pensions, in the form of savings that we might undertake to get a down payment ready for a house. And basically to transfer consumption from the present to the future. So financial system basically allows for intertemporal aspects of managing your finances. If you're a young student, you might want to borrow some of your future earnings. If you're making a lot of money now you may want to put some of it away. The savings and intermediating those servings into productive investments is one key function. But in addition, financial systems also play important roles in terms of managing risk.
If you think about insurance products, having access to a variety of diversification opportunities, which not only allow you to accumulate and build wealth, but also to make sure that you don't lose that wealth. If say one company that you invest in or one country that you invest in were to go down the tubes. You want to make sure that you have the ability to diversify. So managing volatility and risk is another important function. And then of course there is the payments function. Making sure that an economy can work well in terms of meeting the ability of consumers and businesses to match their needs. Likewise, to enable payments between consumers and between businesses themselves. So financial system ends up playing a pretty big role in terms of allowing modern economies to function smoothly.
And what is shadow banking?
Shadow banking is this term that has this very shady connotation clearly. But it is meant to imply the entire part of the financial system that is not come under the rubric of traditional commercial banks. And shadow banks can come in various guises. One can think of certain hedge funds, private equity ventures, which allow high net worth individuals to find interesting investment opportunities.
There are also other aspects of shadow banking. So if you think about pawn shop or a money lender, we you don't have too many of those in the US anymore. Those could be considered shadow banks because essentially if providing some of the same services as banks, maybe saving instruments, maybe the ability to cash your paycheck without having a bank account, maybe get loans by pawning some of your tangible assets. There is a vast number of institutions that come under this rubric of shadow banking. The regulation of these institutions tends to be slightly lighter than that of commercial banks. And commercial banks play a critical role in modern economies as I mentioned. They're very important in the creation of money. So they tend to be much more tightly regulated, but there is a whole set of other financial services providers that also play an important role in the economy and they come under this rubric. And they tend to be slightly, and in some cases, much less tightly regulated than the commercial banks.
How is trust facilitated in the financial system?
Trust is a key underpinning of a financial system. When you use currency or cash for a transaction, you don't need to trust the person who's giving you that money. All you need to have is trust in that money. So long as you're not worried about counterfeit $20 bills. If somebody gives you a $20 bill, you can have a reasonable amount of faith that that actually represents $20. If we move to a world where you don't have physical currency available, and that physical currency implicitly has trust in either a central bank and or the government that stands behind that central bank embedded in it. But then if you want to undertake electronic transactions, we need to find a way to have an institution that is going to intermediate those transactions. And this is where commercial banks, credit card providers, other payment services providers basically create institutional trust.
So in other words, when I go into a coffee shop and pay in this instance with my credit card, person who's giving me the cup of coffee knows that eventually the credit card company will make sure that they collect the money from me and pay the coffee shop what it is owed. So there is faith in the credit card company.
Likewise, if you think about most commercial transactions buying a house, there has to be an exchange of the title for the house but also an exchange of money. And you want to make sure the person buying the house doesn't run away with the title without providing the money. You want to make sure that the correct title is provided. So we have settlement attorneys trusted third party intermediaries. So these third party intermediaries who are backed up by an institutional framework. Because after all, even settlement attorneys and credit card companies have to play by the rules created by the government. It's an intricate system of trust that involves trusted institutions, but behind that an institutional framework, including a legal framework that is very important in order to maintain the trust that is necessary to make modern economies work well.
Do you think that the financial system can be disintermediated by technology?
So there are many FinTech lending platforms out there. So FinTech is just a fancy term for new financial technologies. And of course, financial innovation is nothing new. The creation of money was the financial innovation. The appearance of ATMs was a financial innovation, but there is something fundamentally different about this new wave of financial innovation that is encapsulated by this term FinTech. And that is the appearance of digital technologies that is transformative in a couple of ways. First, it means that the cost of entry for new financial services providers are much lower because you have to set up an internet platform, but then you don't need brick and mortar branches. And second, it's very easy to scale up these platforms. Because once the platform is there, when you add an extra user, the marginal cost of servicing that user is essentially zero. Unlike a brick and mortar branch, where again you have to pay for the people who are going to be sitting in that branch or going to provide teller functions and so on.
So that is transformative in one very important way. And what this has enabled is the direct connection between savers and borrowers. So right now there are platforms out there where if you have an interesting business project, you can go out and kickstart or even go fund me and say, "Hey world, I have this great project in money." And a saver can potentially say, "This looks like an interesting project." Either out of the goodness of my heart, or because I believe that I can get a good return by investing in this. I can go out and invest and I don't need a trusted third party intermediary.
Do we really know the bonafides of the person who's asking for that money? Are they legitimate? Do they have a legitimate business purpose? It's not clear. That's the function that commercial banks are very effectively providing. Essentially the screening of borrowers, but it looks like these FinTech platforms are actually getting at least limited traction. Plus of course you have internet banks, neobanks, challenger banks that are undercutting the very basic business model of commercial banks. So I think there is a lot of change coming in terms of financial markets and institutions and the ability of FinTech platforms to scale up to the extent that their rival, traditional institutions, is the one question mark out there. But over time we are seeing that they are getting a lot of traction.
Are intermediaries necessarily a bad thing in an economy?
Intermediaries actually play a very useful function. There are two key issues, which a commercial bank is much better at sorting out than other institutions. And this is why they've been around for a long time. One is maturity transformation. If you think about putting money in a bank account, you want to be able to withdraw it essentially at any time. So deposits are inherently short term. On the other hand, the loans which sit on the asset side of a commercial bank's balance sheet, those are longer term. If you're building a house or building a firm that takes a while. So the loans are essentially not going to be repayable in the short term. So how do you match the short term liabilities of the commercial bank with longer term loans or assets of the commercial bank? So that maturity transformation taking today's money, converting into something that is usable for a productive purpose, and that's going to get paid back over the long term. That's a key function.
Another function is related to information asymmetrics. The idea that basically borrowers know a lot more about themselves than anybody else does. This basically comes down to evaluating the credit worthiness of a borrower and his or her business idea. The notion of that banks have become much better at this. If you think about small community banks, they have relationships with the people in the community. And that gives them a sense of whether when they make a loan, this person is trustworthy is likely to be able to pay it back. Of course, even the most trustworthy of persons with the best business idea might flounder because you might get hit by a pandemic that forces you to close down a restaurant that was a great concept. Banks take on that risk as well.
Financial intermediaries, such as commercial banks actually do serve very important roles in modern economies. And there is a question about whether FinTech platforms can actually substitute for these functions. And in some cases they're able to do so. There are many payment platforms in China for instance, that are hoovering up data on what sort of purchases their consumers are making when they pay for those purchases. They also have information on the cash flow, a merchant selling products on their payment platforms. And this allows them to aggregate up their information into credit scoring that actually has turned out to be much more efficient and accurate than credit scoring based on traditional models. Even in terms of the core functions of financial intermediate research as commercial banks, it's possible that technology might lead us to much better opportunities.
I want to shift gears a little bit now toward the future of money, the title of your book, Digital Cash. That concept goes back to 1983. From what I could find proof of work goes back to '95 and 2002, blockchained in 1991. So these are all things that people hear about with respect to Bitcoin. What was Satoshi Nakamoto's 2008 innovation?
So let's think about what Bitcoin, which is the original cryptocurrency, was meant to solve. That he wanted to create a medium of exchange that did not require the use of a trusted third party intermediary such as a commercial bank or credit card company, or the use of an official currency such as cash. And to be able to allow these transactions to be conducted using just the digital identities of transacting parties, sort of just like using account numbers that are anonymized without any password information directly attached to them or being revealed. Now the timing of Bitcoin's advent is really important. So the Bitcoin White Paper was released in late October of 2008. This is about six weeks after the so-called Lehman moment in the US. That was the day, September 15th 2008, the iconic investment banking firm Lehman Brothers went under and looked like it might take down the entire US and perhaps even the global financial system down with it.
So at the time trust in governments and central banks in traditional commercial and investment banks was really at an all time low. So this was a very appealing proposition resonated with the libertarian zeitgeist of the time. So if you think about what Bitcoin was trying to do at some level it sounds astonishing and really remarkable. How on earth if I didn't know who I was transacting with, how could I possibly conduct a transaction? Make sure that transaction will be completed. And since this is digital money, how we're going to make sure that those units of digital money could not be respend because after all, if it's all digital, you could just keep spending the same unit of currency again and again. Bitcoin came up with a phenomenal way of solving this. And some of these building blocks that you mentioned distributed ledger technology, proof of work were all important building blocks and there were some cryptographic tools involved as well.
But what is remarkable about Bitcoin is what I would consider a radical transparency. Distributed ledgers that essentially public ledgers and what Bitcoin does is post every transaction ever undertaken using Bitcoin and the transacting identities and digital identities, and post them on these digital ledgers that are visible for the entire world to see. Maintain on multiple computers around the world, which are synchronized in real time. So this is where the security and resiliency of the system comes from the fact that it is a distributed network, where if somebody tried to tamper with one or even a few electronic ledgers, that will be quickly detected and rejected by the system. But you still need to validate transactions. This is where the proof of work becomes important. It turns out the Bitcoin algorithm does, is throw out a numerical puzzle that can be solved only using brute computer force.
Essentially you have to guess a solution. You cannot solve the problem using any cool analytical methods. So the more computing power you have, the more likely you are to solve this problem. And the first computer to solve this problem gets the privilege of validating a block of transactions. So that block of transactions, once it is validated is then linked using computer code to all the previously existing validated blocks of transactions. Hence the term blockchain. And the blockchain it turns out is very secure because in order to override these transactions and to sort of create a new history of transactions, you would need to devote an enormous amount of computing power. That is you would have to prove that you created even more work than already exists on the blockchain. So that's where the security of the blockchain comes from. And at some level it is a truly remarkable innovation.
Unfortunately it turns out that Bitcoin is terrible at what it was supposed to do. It's got very volatile value, so it's not a good medium of exchange. It turns out it's not anonymous as had been thought. And so that it's not very efficient in managing transactions because it turns out that on the Bitcoin blockchain, you can validate only about six to seven transactions per second. Compared to hundreds of thousands or millions on the Visa or MasterCard network. And it takes about 10 minutes for the transactions to be validated. But the technology that it has given us, blockchain technology, I think is going to be the real lasting legacy of Bitcoin.
Is Bitcoin truly decentralized?
It is a decentralized architecture, which essentially means one computer managed by one institution maintaining the public digital record. It is distributed across a large number of computer nodes around the world. There is a decentralized consensus mechanism as I just described. There is no single party that is authorized to validate transactions. This takes place through this approach that is in turn based on proof of work.
But in addition, there is decentralized governance. There is no single agency that is running Bitcoin right now. It is just running on its own using this algorithm that is created by whoever. Turns out that some of these parameters, how many Bitcoins will ever be created, how many transactions can be fitted into a particular block, these can all in principle be changed if the entire community agrees upon it. So these three elements, decentralized architectures, decentralized consensus and decentralized governance are all underpinning a new movement that is called decentralized finance. But Bitcoin, the initial version of decentralized finance, Bitcoin can be traded on centralized exchanges. You can go to your Bitcoin ATM and through your bank account, convert your US dollars into Bitcoin. So you might think of that as being centralized to some extent. But at its core, Bitcoin is truly decentralized.
Do things like the concentration of mining power and ASICs, do those affect the decentralization of Bitcoin?
One could argue that if you did enough of a concentration of computing power, that would essentially allow you to override the other members of the community. So in principle if you owed 51% of the overall computing power that is dedicated to Bitcoin mining, which is this process of validation of transactions I referred to earlier, you could override the system. But there is a strong self incentive of people who already accumulated Bitcoin to keep the system from melting down. Because once trust in the system is lost, all the money that you notionally have in terms of your Bitcoin holdings would be lost. There used to be a concern even a year ago, that the concentration of mining power in China in that the Chinese government could run away with a lot of Bitcoin. But here again, the self-interest of Bitcoin miners comes into play here because if you start running over Bitcoin people lose faith in Bitcoin. The value plunges to zero in no time at all.
So ASICs are essentially specialized devices that are used for cryptocurrency mining. You can do cryptocurrency mining, even using your Garden Variety laptop. You might get lucky and be the one to guess the solution to the problem that the Bitcoin network throws up. But the probability is very small.
If you have a massive amount of computing power and you have specialized devices dedicated generating these guesses, it's likelier that you will be the one to first solve this numerical puzzle and therefore to get the reward in terms of coin. But the problem here is that given rise of Bitcoin, the financial incentives to mine Bitcoin and the competitive element mean that there is an enormous amount of computing power devoted to cryptocurrency mining. Which means you need energy, electricity to run the computers, to cool them. And because these ASICs and no other purpose other than for cryptocurrency mining, and because they run essentially nonstop 24/7, they burn out very quickly. So you create a lot of computer decorators as well. This proof of work mechanism that is used to validate transactions on the Bitcoin blockchain, is at some level a conceptual marvel. But it has created a huge environmental problem for the world at large, with by some estimates the Bitcoin and cryptocurrency mining operations consuming between half to 1% of worldwide electricity consumption. It really is an environmental disaster.
Are public blockchains immutable?
Once you set blockchain, it becomes very difficult to alter that blockchain. But what sort of consensus mechanisms are used to validate transactions on the blockchain becomes very important here. I spoke about proof of work and how it is conceptually marvelous, but a disaster in terms of efficiency in the environment, has led a search for other consensus protocol. There is one called proof-of-stake for instance, which is not as computationally intensive. Is much more scalable in terms of being able to validate a lot of transactions relatively quickly. The second largest cryptocurrency by market capitalization, Ethereum, is in the process of moving to this new consensus mechanism.
So that is going to make change built on that consensus mechanism much more trend. There are some questions out there in the cryptography community about whether proof-of-stake is as secure as proof-of-work. Some of my colleagues at Cornell University are working hard on precisely these sorts of questions. Public blockchains that are built on proof-of-work have typically turned out to be quite secure. Especially the more mature blockchains.
If these are shorter blockchains, you know of new cryptocurrencies that have just come up where there is not that much computing power devoted to them yet, you could imagine malevolent actors very quickly accumulating computing power that allows them to override the network. But again, that will be self defeating because if people don't trust your cryptocurrency, it's never going to get much traction. You can also have blockchains that have different kinds of read and write permissions. You could have a blockchain that is visible to everybody, but where the right permission of writing transactions are changing them is with a centralized authority. So there is talk for instance about using blockchain technology to provide land registry say in India, in a manner that is easily visible, that can be very easily updated. But all the updating is done by a government authority. The blockchain simply becomes a mechanism through which everybody has very easy access, a set of public records that they can trust.
Why do you think Bitcoin and other cryptocurrencies have value?
As I just argued Bitcoin is not working well in terms of the purpose it was designed for. So it really has no intrinsic value. There are other cryptocurrencies like Ethereum could end up having value because the Ethereum blockchain, once it moves to proof-of-stake would provide for a lot of new products, such as smart contracts, flash loans, and so on. Which are very cool products that can be built and executed on the Ethereum blockchain. Bitcoin devotees will tell you that there is one fundamental proposition underlying Bitcoin's value, which is that of scarcity. There is a hard cap into the algorithm, which states that there are only 21 million Bitcoins that can ever be created. About 90 million of those have been created so far. So there are about two million to go. So the notion of Bitcoin, it would seems to be, this is scarce even though it is digital. On the other hand, a fiat currency, like the US dollar can be printed at will.
And during the global financial crisis, during the initial period of the COVID pandemic, the Fed went out and printed huge amounts of money. So surely something that can be printed and essentially infinite quantities is going to lose value relative to something that is scarce. To me, that is a dubious proposition just because something is scarce it's not obvious that it should have value.
Ultimately, the value of Bitcoin seems to rely on what came to be known during the lead up to the global financial crisis, as the greater full period that you could buy a house. Even the price seemed insanely high because you thought that all you needed to do was find one fool greater than yourself, who would be willing to pay a higher price for that and you'd be okay. Some of that faith in Bitcoin seems to underlie its value as well. And I think there are lots of tail investors who again, get taken in by the razzle dazzle of the new technology who see their neighbors, friends, kids makes even fortunes by buying Bitcoin or those coin and they don't want to miss out. So the fear of missing out may be another aspect. But I view that know something like Bitcoin becoming financial asset as one that is built largely on speculation. And I worry that it's not going to end well.
You mentioned some of the uses of Ethereum, what gets better with decentralized monetary financial systems compared to the existing system?
Decentralized finance does have some appealing features to it. One, is that you don't have the legacy institutions that can essentially out compete new entrants. If you wanted to go out and set up a bank because you felt it would provide services much more efficiently, it's actually very difficult getting a banking license. It's also difficult to get around the regulatory aspects. So you need to set up a big compliance department. You need to hire a lot of people just to deal with the regulatory aspect. So it becomes very difficult for new entrants. It becomes difficult to introduce new products and services. But if everything isn't done in a decentralized fashion, it makes it very easy to do all of this. You can provide a product on a blockchain, and depending on how persuasive your products pitches and the services it provides, you could have decentralized finance becoming an alternative to the traditional banking system.
There is also the sense that you could create a democratization of finance right now, if you are the sort of person who keeps a million dollars in the bank, the bank is very happy to serve you. If you walk into the bank with $25 and probably going to put a dollar or two there every month, the bank is not interested in you because the cost of servicing you are just too high. You have a few thousand dollars to invest and you walk into an investment manager's office and saying, "Please help me figure out what to do with this?" They're not going to spend their time on you. But with decentralized finance, you could offer basic banking products for credit, for insurance, for savings at scale with very low fees. And you could even provide bespoke that is carefully tailored financial products and services, even to low net worth individuals and households.
So there is the prospect that decentralized finance could in fact democratize finance in many of these ways. There are also exciting new products being created on decentralized finance built on decentralized blockchains. For instance, you can conduct transactions using smart contracts, using a trusted intermediary, such as a settlement attorney for a real estate transaction. If you can tokenize the ownership of your house, post it on a blockchain, tokenize money and put it on a blockchain, both of which are feasible already. You can conduct transactions that securely swap out one financial asset for another or one financial asset, or even real assets such as money or a house or a car, for another. There are possibilities that are opened up by decentralized finance.
Are there downsides to decentralized finance?
I think the notion that technology will solve all problems might be a bit of a mirage. Certainly there are technological vulnerabilities. When you hear about things like smart contracts and ocean conducting transactions involving large amounts of money without any trusted intermediaries being involved in doing this in an anonymous fault. Sounds like it's a recipe for failure. It actually works quite well. It's more secure than you might think. But there are problems still. There are technological vulnerabilities. And even though the community can fix the open source code very quickly to take care of these vulnerabilities, sometimes very sophisticated hackers, and you need really a tremendous degree of sophistication to get around these technological protocols. There are other kinds of problems. It's all very well to say that decentralized governance, governance by the community is a wonderful thing to have. But if there are problems with a particular protocol, if there are concerns that a particular group is trying very hard and potentially at risk of taking over the governance logical protocol, there is no authority that you can appeal to avoid that outcome.
Plus blockchains are closed ecosystems. So if you want to trade products in the blockchain, let's say futures contract, you need prices of the underlying commodity or underlying asset. And you need to use what are called price oracles that essentially allow for communication between on chain or on that blockchain products and services with off chain regular financial system prices and protocols and so on. And those oracles again are becoming quite secure, but there are some vulnerabilities there as well. So there are technological vulnerabilities, potentially some financial vulnerabilities, but in addition governance issues. What is amazing to me is how far decentralized finances already gone. Even though you might think that all of these are deal breakers, it would allow you to never get off the ground. Issues like the decentralized governance, they're not going to be easy to fix.
So it doesn't eliminate the need for trust?
Ultimately, trust is going to be very important. And the question becomes, what do you place your trust in? Is it in the government? Is it in a financial institution, which in turn is backed by the government or in essentially computer code that is managed and maintained by a community. The notion of people's power is very well, and it is quite powerful in terms of how well it is being executed so far. Even with these mechanisms, you are going to need governments to play a role. You can think about tokenizing a house, tokenizing your money, exchanging them for one another. For all practical purposes the ownership of let's say your house gets transferred to me, but if I then show up at your door and you and your family are still living in the house, you need an authority such as the government to make sure that property and contractual rights are properly enforced. So I don't think even with decentralized finance, you're going to able to get away from needing an authority that you can place your ultimate trust in which might be the government.
Could unofficial digital currencies affect the ability of central banks implement monetary policy?
It could create some complications. So there are decentralized entities like Bitcoin that are not backed by anything. And like I said, they're not working well as mediums of exchange. That has led to the creation of new cryptocurrencies called stable coins, which get their value ironically enough by being backed up by reserves of fiat currencies. And these could work efficiently if you have companies like say Amazon or Facebook, which abandoned a stable coin project recently, but might revive it at some point. If you have stable coins floating around that could create some complications. But more importantly, if you have commercial banks becoming less important than the financial system as a consequence of these new technological developments, that creates a real risk. Because commercial banks are very important not only in the creation of money, but in the transmission of monetary policy.
Right now, when the central bank changes interest rates, it usually changes interest rates on the very short term cost of borrowing for commercial banks. That then gets affected in their deposit and lending rates, that then gets transmitted to the things that central bank cares about, which is economic activities such as GDP, employment growth and employment and also inflation. If banks become less important, if FinTech platforms start playing a bigger role in financial systems, we have no idea really whether they'll be sensitive to changes in central bank interest rates. So the implementation and transmission of monetary policy could become a whole lot more complicated than it already is.
One more question for you, Eswar. At the Federal Reserve Bank of Boston and MIT, they've come out with a central bank digital currency paper, Project Hamilton. They did not use blockchain from what I understand. They said it meet the goals of their project. Does Satoshi's innovation have anything to do with the development of central bank digital currency?
It's had one important goal, which is it has catalyze central banks into thinking about digital versions of their own currencies. Because the reality is that cash fast disappearing in countries like China and Sweden is already at a level where it is barely used in retail transactions. Many other developing countries and advanced economies such as US, where we still use cash to significant extent, the use of cash is disappearing. So I think this was inevitable that central banks would start thinking about issuing digital versions of their currencies.
But the appearance of cryptocurrencies, the appearance of stable coins has really lit a fire under central banks to start thinking about CBDCs. But for reasons I mentioned earlier, the blockchain technology is hopelessly inefficient in terms of being scaled up to manage a large volume of retail transactions. So the technology underlying CBDCs is going to be quite different from that underlying cryptocurrencies. The emergence of cryptocurrencies, I think has played a pretty important role in getting central banks moving more quickly in this area than they otherwise would.
Eswar Prasad, that's our last question for you. We really appreciate you joining us on the podcast.
It's been my pleasure. It was a great discussion. I had a lot of fun and I hope your listeners enjoyed as well. Thank you so much for having me on.
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