The Internet of Trust

The greatest thing about cash is the simplicity of transactions. You just hand it over and receive something. Nobody asks your name, address, phone number, date of birth, social security number, salary, how long you've been in your current job Cash produces instant trust between buyer and seller.�

Because it's impractical to move large amounts of hard cash around, paper-based and later electronic payment systems were created. However, establishing this trust without cash is complex and expensive. Acquiring a credit or debit card requires the applicant to answer numerous questions-and the issuing bank to verify the answers and the applicant's credit. Using the card demands a complex infrastructure to ensure that transactions are fast, reliable, and safe-and costs the merchant a percentage of each sale.�

Domestic transfers between banks depend on payment systems operated by central banks, while international transfers may involve other commercial banks between the sender's and the receiver's banks. Furthermore, these transactions can take several days. As another example, although we associate modern stock markets with nearly instantaneous electronic trades, settling transactions can take two to three days and requires additional players, including custodians, notaries, clearinghouses, and central securities depositories. Until the transactions have settled, financial institutions must set aside significant amounts of cash or other liquid assets to cover their positions if someone along the line does not pay.�

Simpler and cheaper

Could technology make things simpler and cheaper again? Enter bitcoin, the digital currency that some claim will spell the end of banks but others view as a Ponzi scheme and a financial vehicle for criminals. Bitcoin-or more precisely, the underlying technology that allows it to function, called distributed ledgers, or blockchain-could allow what many see as radical rewiring of the financial sector (see Box 1).� Bitcoin's story is well known: it started when Satoshi Nakamoto-the name used by the inventor, whose actual identity is still uncertain-posted a paper and software on an email discussion list of activists who believed that cryptography could bring about social and political change ("cypherpunks"). Others became interested and soon started to develop the idea online. Bitcoin started trading in 2009, with an exchange rate against the U.S. dollar of $0.0007 per bitcoin. In February 2011, it reached parity with the dollar. In November 2013, the value of bitcoin peaked at $1,242, and it has been trading above $400 for most of 2016. The value of bitcoin in circulation is about $6 billion (compared with about 1.5 trillion U.S. dollars in circulation worldwide).�

In the beginning, bitcoin grabbed the imagination of libertarians who wanted to get rid of, or at least have an alternative to, banks and central banks. While the exchange rate surge triggered something of a gold rush, bitcoin's relative anonymity and ease of trading attracted drug dealers and other criminals, leading to a heavy law enforcement crackdown during 2013 and 2014 that landed some early entrepreneurs in jail and gave the whole initiative a bad reputation.�

Tech entrepreneurs and the financial industry soon realized that the real news was under the hood-bitcoin's underlying distributed ledger technology. Essentially, this is a technology for verifying and recording transactions on a peer-to-peer basis without a central authority. It upends a very basic tenet of payment systems: having one central, independent, and trusted bookkeeper that stores and validates all transactions-a role often played by central banks (see chart).�

Spreading the burden

With bitcoin, everyone on the Internet can validate and record transactions in their own copy of the ledger. They group the transactions during a given period into a block, which is followed by a tamperproof stamp. Each transaction block links to a block for the previous period-hence the term "blockchain." Completing the block for a period requires some computational work, with a reward in bitcoin-so the people competing to complete blocks are called "miners." Thus bitcoin, by combining a peer-to-peer approach with cryptographic security, became the first successful digital currency, after several decades of failures.�

So how big a deal is that? U.S. entrepreneur Marc Andreessen explained it this way: "Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate," he said in a New York Times article in January 2014.�

Andreessen was an Internet pioneer, who while still in college in 1993 founded Netscape, the first widely used Web browser. He now runs Andreessen Horowitz, one of Silicon Valley's most influential venture capital funds. Venture capitalists make money by finding the next big thing before it's even a thing. Andreessen and many other venture capitalists who funded the creators of the Internet as we know it are now betting on bitcoin and the underlying blockchain technology. They see this technology as a breakthrough that can establish, between unknown and physically separated participants, the same trust as a cash transaction. Some predict that this capability to disintermediate any trusted third party will be the most disruptive technology since the Internet. The (overused) word "disruptive" refers to new technologies that shake up, or even destroy, traditional business models. Think Amazon and bookstores, or Uber and taxis. Disrupting the financial industry, the most regulated business in the world, is a whole different game. It is possible and even desirable, as the Financial Times' Martin Wolf wrote recently, given the industry's many shortcomings, but very complicated in all aspects: legal, fiscal, financial, and operational.�

Traditionally, the financial industry has tried to solve the problem of creating trust by acting as a trusted intermediary between individuals and companies who do not know each other, with central banks and regulators backing up this trust by supervising banks and through deposit insurance. Individuals and companies pay banks to conduct their transactions, for example through credit cards and wire transfers, because other banks and the central bank recognize each other as trustworthy counterparts. It's great business for them: according to a McKinsey&Company report, banks extract an astonishing $1.7 trillion a year, 40 percent of their revenue, from global payment services. Even more surprising, despite all technological innovation, the cost of financial intermediation in the United States has not changed significantly since the beginning of the 20th century, according to research cited by the Bank of England's chief economist, Andrew Haldane, in a recent speech. In a 2012 report, the European Central Bank (ECB) estimated that, aside from the fees everybody pays, the indirect costs are as high as 1 percent of GDP, which in the European Union alone translates to about Euros 130 billion a year. And the cost of sending remittances to another country is even higher-nearly 8 percent according to the World Bank. However, a number of start-ups, many using bitcoin, make sending payments as simple and inexpensive as sending an email (see Box 2).�

Source: IMF

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