Monkey Cage: Bitcoins financial network is doomed

Tim Lee at Vox argues that Bitcoin is destined to succeed not as a currency but as a financial network.

Its a mistake to think about Bitcoin as a new kind of currency. What makes Bitcoin potentially revolutionary is that its the worlds first completely open financial network. Think about the internet. It didnt seem like a very practical technology in the 1980s. But it was an open platform that anyone could build on, and in the long run it proved to be really useful. The internet succeeded because Silicon Valley have created applications that harness the internets power while shielding users from its complexity. Bitcoin applications can work the same way.

The Bitcoin network serves the same purpose as mainstream payment networks such as Visa or Western Union. you want to build a business based on one of those networks, you have to get permission from the owner. And thats not always easy. To use the Visa network, for example, you have to comply with hundreds of pages of regulations. The Visa network also has high fees, and there are some things Visa wont let you do on its network at all. Bitcoin is different. Because no one owns or controls the network, there are no limits on how people can use it. One obvious application is international money transfers. Bitcoin is a payment network that happens to have its own currency, not the other way around.

This looks, initially, like a plausible and attractive argument. But from a political science perspective, it misses something very, very important. There is a reason why you have to comply with hundreds of pages of regulations to use the Visa network that goes beyond Visas selfish corporate interests. That reason is government. Governments regulate payment networks very heavily, for a wide variety of reasons, which include making sure that people dont use these networks to support activities that governments dont like. They use financial intermediaries as points of controlthat allow them to control who does business with whom. The Obama administrations undersecretary for terrorism and financial intelligence, David Cohen, delivered a speech four days ago that copiously illustrates this point.

Over the past decade or so, one important way that the United States has protected our nations core interests, projected power, and exercised leadership on the world stage is through the increasing use of financial measures. Far from just focusing on terrorist financing and money laundering, my office in the Treasury Department is now regularly called upon to help advance a variety of U.S. national security and foreign policy goals. financial measures have become far more powerful tools of statecraft, and their effects are multiplied in a world defined by economic interdependence.

Compare, for example, Jeffersons failure to our ongoing efforts to use sanctions to prevent Iran from obtaining a nuclear weapon. Together with partners around the world, we have imposed what many believe is the most effective set of financial and economic sanctions in history. Carefully designed and customized to maximize pressure, they have impeded Irans ability to acquire material for its nuclear program, isolated it from the international financial system, drastically slashed its oil exports, and deprived it of access to a sizeable portion of its oil revenues and foreign reserves. Not surprisingly, the impact on Irans economy has been dramatic: its budget deficit and inflation have spiked, the value of its currency has sharply declined, foreign investment has all but dried up, and overall economic activity has stagnated.

The reason that the U.S. can do this is because it has a lot of effective control over financial networks. It can put pressure on banks (including foreign banks, which have been fined billions of dollars for not complying with the U.S. sanctions regime) to isolate Iran from the international system. In Cohens words:

Put simply, financial institutions everywhere need dollars to serve their customers, and thus require access to U.S. banks through correspondent accounts to settle their customers transactions. That means that foreign banks are especially attuned to our sanctions.

Because so many international transactions are (a) settled in dollars and (b) settled across payment systems run by banks and other financial intermediaries that are vulnerable to U.S. pressure, the U.S. can use these systems to exert political control. Now, imagine the likely response of the U.S. (and the E.U., and, for that matter, China) to a payment network which is designed from the ground up to be decentralized, so that it is impossible for any specific intermediaries to really control payment flows from one actor to another. Such a network would be impossible for states to control. The U.S.wouldnt be able to use it, for example, to squeeze Iran out of the world financial system. If such a network ever showed signs of really becoming established (rather than being a relatively small-scale thought experiment, and money suck for libertarians with more ideology than good sense), the U.S.would ruthlessly act to isolate it from the international financial system.

And that is the story of Bitcoin. Up to this point, regulators have largely tolerated Bitcoin as a curiosity and experiment. While Bitcoin allows consumers to buy illegal drugs on Tor Hidden Services sites like Agora and Evolution, they dont do so on a sufficiently large scale to really cause enormous alarm. Regulators still dont know quite what to do with Bitcoin. But if Bitcoin were ever to threaten to become a truly decentralized payments network, owned by no one, and with no one e.g. capable of implementing Know Your Customer rules, regulators would know very well what to do with it. Theyd introduce regulatory guidances and pass laws to freeze it off from the regular financial system. Very possibly, Bitcoin could still survive at the margins (as the Hawala system has survived). However, it would be isolated, and in no position to threaten Visa or Mastercard, let alone the underlying payment and messaging services that really underpin the world financial system.

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Monkey Cage: Bitcoins financial network is doomed