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Diego Zuluaga joins us for a discussion on cryptocurrencies.

Diego Zuluaga joins us for a discussion on cryptocurrencies. We also discuss fiat money, Gresham’s law and the difference between blockchain and cryptocurrencies.

Further Readings



00:07 Aaron Powell: Welcome to Free Thoughts. I’m Aaron Powell.

00:08 Trevor Burrus: And I’m Trevor Burrus.

00:10 AP: And joining us today is our colleague Diego Zuluaga, a policy analyst at the Cato Institute Center for Monetary and Financial Alternatives. Welcome to Free Thoughts.

00:18 Diego Zuluaga: Thank you.

00:19 AP: What is money?

00:21 DZ: So money is normally defined as a generally accepted medium of exchange. What that means is that it’s some contraption, be it just a piece of paper or some valuable item, which by common assent circulates as a means by which to pay for the acquisition of goods and services. Oftentimes, governments are involved in giving some sort of public sanction to money, to the extent that they require it for the payment of taxes, or indeed they might use legislation to make it a legal tender that is obligating everybody in a particular jurisdiction to take that in payment for the acquisition of goods and services.

00:56 TB: Does it matter how widely accepted is, ’cause… Is there some sort of degree ’cause some money may not be accepted outside of…

01:05 DZ: Monopoly money outside the confines of the Monopoly game?

01:08 TB: For example, I guess that’s a really… Yeah, can you use Monopoly money in the Monopoly or maybe you have a very large inner house Monopoly game where you played for multiple months in advance and use it to exchange chores and services and things like that. Could that be nominally be called money?

01:23 DZ: I suppose you might call it money within the environment in which it is meant to be used. But in terms of the general acceptance, I suppose that for most transactions in a jurisdiction, most legal transactions, it would have to be something that is accepted by counter parties. And indeed, one of the issues that cryptocurrencies, to which I’m sure we will get in due course, have faced, is that they are not yet generally accepted. Part of this has to do with the fact that they’re not very stable in value compared to other media of exchange, and that makes people reluctant to either part with them or to accept them in the first place, but scalability and the ability to persuade more and more people to adopt them as a means of payment is certainly an important quality.

02:08 AP: So another term, we hear a lot in the crypto space is fiat. So what is fiat money?

02:14 DZ: So fiat money is probably best defined by contrast to what it isn’t. So if you look back in history, most monies emerged from some item, some commodity or some valuable, which had a number of features that made it particularly suitable to be used as a generally accepted medium of exchange. Gold is probably the most salient example. Why is gold such good money or such a good medium of exchange? Well, first of all, it’s durable, so it doesn’t depreciate or it doesn’t expire after a certain date. It preserves its form with… And it can be passed from person to person without modifying its worth. It can be divided into units that are all identical and equal, and that’s very important because if you’re talking about individual units of things and you want to use money as a unit of account, it’s important that each individual unit be truly equal to each other, and it is recognizable.

03:17 DZ: It can be easily ascertained when you see a piece of that item, how much value it represents. So that is commodity money. And the definition of commodity money is that it has some sort of natural value, some intrinsic worth for which people want to hold it and that is independent of its users or medium of exchange. Fiat money isn’t that. Fiat money is just a piece of paper, usually, issued by some entity, which serves the function of money, but has no intrinsic value. The only value that can be ascribed to it, other than the residual value of the paper that it’s printed on, comes from the sanction it is given by either the people that deal in it or, more commonly in our times, by the central bank, which is the monopoly issuer and by the state, which requires it in payment of tax.

04:05 AP: So then are cryptocurrencies fiat? The bits that make these things up don’t really have any underlying value of any kind, we just kinda decided that these are things we’re gonna exchange as money?

04:17 DZ: Well, we should talk about the utility of the platforms on which you can use cryptocurrencies in a moment, but I’d say that most cryptocurrencies wouldn’t be called fiat, to the extent that they’re naturally scarce. So, when some developers come up with a new platform that will be a software protocol in which you will be able to use a cryptocurrency, when they do that, they often predetermine the amount of units of that currency that will ever be issued, and as a result of that they are foreclosing any possibility to tinker with the money supply.

04:53 DZ: Now, those familiar with the history of central banking will see that one of the major issues with fiat money has been the inability of central banks to persuade people that they won’t tinker with the money supply, that they won’t increase it arbitrarily to pursue other goals. And that’s one of the reasons why a lot of central banks haven’t been credible in sustaining the value of a currency. Now, to the extent that scarcity is baked into the software protocol, you are getting rid of that problem and you are, to the extent that you create a platform in which people want to deal, making those units intrinsically valuable, because the utility of those units in terms of being able to transact has some value to you.

05:33 TB: I think when I’ve talked, heard people talk about money in the past, some of the the things you discussed with gold, durability, rarity, scarcity, is important to some extent, but it seems also that those aren’t necessary qualifications of money, ’cause you gonna have non‐​scarce money, correct? Like Weimar Republic notes are not scarce. That would be more about bad money versus good money. So, gold may be better ’cause it doesn’t corrode. And at different times when they used tea leaves, I think George Selden told us one time that they used bricks of tea as money at one point. And that seems that could be used, that might be accepted as money, but it’s not very durable. You could have your entire money supply rained out or soggy or something like that. So maybe it’s more bad money versus good money, and then if everyone accepts it, it’s money. But that might be really bad money.

06:24 DZ: Yes, you’re absolutely right. We have plenty, perhaps more than we’d care to remember, plenty of instances in which there is effectively no scarcity whatsoever. And there is unlimited printing of this money, but it cannot remain money for very long, if you have an infinite supply, because eventually people will stop accepting it in payment for things. Or indeed, entire economies will collapse because there’s no way for transactions to take place because there’s no means by which to effect them. And so if you look at countries like Venezuela or others that have experienced hyper inflation in history, they tend to switch to foreign currencies or to other valuables to try and avoid the problems of a completely unlimited supply of whatever the legal tender is.

07:11 DZ: Is that Gresham’s law? Is that what it’s called? The good money drives up the bad?

07:15 DZ: Well, this is Gresham’s law reversed. So Gresham’s law says that bad money chases out good. Meaning that if people prefer one type of money to another, they will tend to hoard the good type of money and only want to rid themselves of the bad type of money. But you also have the reverse phenomenon in society, oftentimes, when the recipient simply doesn’t want to deal with you unless you pay them in US dollars rather than Venezuelan Bolivar.

07:41 AP: So we’ve had virtual money before. In the dotcom boom of the ‘90s there were companies that set up. Beans was one of them, I think, virtual money that you could exchange, but they never went anywhere. So what’s different about cryptocurrencies? Why are these cryptocurrencies seeming to work? Why are people excited about them when the virtual monies we’ve seen in the past haven’t amounted to much?

08:09 DZ: So the contribution of cryptocurrencies, and I think it really is the central innovation that they bring, is that there is no central counterparty that’s managing the supply, verifying the transactions and validating them in making sure the transactions clear. In that when I sell something to you denominated in a particular unit of account that I actually own the amount of money that is required to pay you and that you will deliver the goods to me. What cryptocurrencies do is they, by virtue of the software protocol in which they operate, they create the incentives for peers to help in the validation of transactions, because peers get rewarded. These are the so‐​called miners that we all hear about, right. These are people who have an incentive to spend their time and energy and their computing power helping to validate transactions between third parties, between people who are not themselves. And in exchange for that, they get a transaction fee. And at the beginning of a cryptocurrency’s history, usually they also get rewarded by issuing, the issuance of new tokens for every block of validated transactions or every set of transactions that they help verify.

09:21 DZ: Now, what that means is that, without having to create a trusted party, you have a workable system for people to confidently exchange goods and services, and to be able to do so relatively cheaply. That is from an economic view point a very interesting contribution, because the main transaction cost of exchange is oftentimes trust. Is the fact that you cannot, you don’t oftentimes know the people that you’re dealing with, you cannot easily verify that they are committing to the transaction and what they’re promising to give you is actually what they will, and in the process of enabling for peer‐​to‐​peer validation, these systems are resolving that issue. That’s why the blockchain, which is the term that people usually use to refer to the Bitcoin blockchain, which is the ledger, the original ledger for a cryptocurrency, why people call it a trust‐​less network, because it doesn’t require people to trust one another.

10:20 TB: Now, we asked the… Started off this episode by asking what is money, and we’re using the term cryptocurrencies, but is it accurate to say that, at least now, Bitcoin or any of the other cryptos is operating as money in any large scale way? I can’t go buy something from 7‐​Eleven with Bitcoin? I can’t use it almost anywhere. So that seems, going back to our question, maybe good money and bad money. That if it is money, it’s pretty bad money because there’s 16 people on the dark web who will take Bitcoin. But they might also take something else as money. So maybe we’re stretching the definition too far to say it’s actually money.

11:01 DZ: I think you’re right. I don’t think for the academic… For purposes of the academic definition you could call Bitcoin money, because it’s not generally accepted, but also it’s not stable in value. So the three features that a currency, that a money has to have in order to be considered effective or as a medium of exchange, a unit of account and a store of value. Now, you could argue that with Bitcoin, you certainly have the unit of account and you have the fungibility, that is, each Bitcoin is equal to each other Bitcoin, you have that. You have the store of value, although it’s not a very effective store of value because the price of Bitcoin has fluctuated a lot. So if you’re interested in eventually converting those Bitcoins in anything like the medium term into another unit or another valuable, you probably will find yourself with some level of uncertainty as to how much of that other thing you can buy. But as a medium of exchange, it isn’t widespread yet. On the other hand, network effects certainly do operate in cryptocurrency networks.

12:00 DZ: And the reason Bitcoin has been so successful is because it has enticed a very large number of people to get involved. Right now, many holders of Bitcoin don’t really transact with them, they keep them, because they’re making a bet on the future of the network. Namely, they’re saying, more and more people will come in and take this on as an effective medium of exchange, and that tells you something about expectations and Bitcoin’s ability to eventually become effective money.

12:27 AP: Are cryptocurrencies the same thing as the blockchain? Or I guess another way to ask is, can you have one without the other?

12:35 DZ: Yes, you can. The blockchain or blockchains, because there are many of them; and the blockchain is a confusing term because it doesn’t specify, although it usually refers to the Bitcoin blockchain. They are an electronic log, they are some sort of ledger on which transactions are registered. It’s like an accounting book. And it’s spread around thousands of computers and it’s updated every few minutes, every 10 minutes or so, and all the information is agreed to by all the peers in the network; that’s where the trust‐​less element of blockchains comes in. Now, you can perfectly have that ledger without there being a cryptocurrency. And indeed some companies are using blockchains within their production processes, so they will take some elements of this electronic log and incorporate them in the way that some of their units within their business interact with each other, but they won’t have cryptocurrencies because they don’t need to encourage peers to validate transactions; because all these exchanges are happening within the firm, and the firm, as we know from [13:41] ____, the firm is central… Is a little centrally planned society in which managers tell people what to do so you don’t need to reward people independently.

13:49 DZ: Now, if you want to have what’s called a public blockchain, that is an open entry system protocol in which everyone can be involved, then you are probably going to have to have some unit, some token, oftentimes it will be a cryptocurrency, which rewards people for helping to verify and allows people to transact. It’s difficult to imagine any other way in which you could encourage the consensus and the incentives for virtuous behavior, if you will, that Bitcoin and Ethereum and other platforms achieve.

14:27 AP: Why would a company use a private blockchain? Using a blockchain, using that sort of distributed ledger brings with it, it’s slow… It’s not an ideal solution for every problem, right? And if the problem it solves is that we don’t need a trusted party, but you’re just using it internally in your company, why wouldn’t you just use a database?

14:56 DZ: It’s interesting that you mention that, because there been some companies that have attempted to use blockchains within their internal processes and they’ve given up. DTCC, which is the state central monopoly for securities clearance, they said that they’d done a blockchain experiment and that it hadn’t been successful for them, and they then extrapolated to say that blockchains weren’t in fact that useful. Well, that’s a different story because, as you rightly say, public blockchains are very different from intra‐​firm private blockchains; but I’d say the reason is that they can see… They see scope for reducing the cost of management. Everybody who’s involved in a reasonably large organization knows how difficult it is to manage databases and to keep all the information updated across the entire network.

15:39 DZ: I suppose that there is some value in exploring programs which would update the information across the board and where you would have… You would have protocols in place where things can happen automatically, so that if your computer registers a piece of information coming in, it can automatically react and send other pieces of information to other parts of the network. This is sort of similar to what some people call the Internet of Things, this idea that machines communicate with each other. So there’s this notion of smart contracts, which I think you discussed in a previous episode, and in the idea there is that a lot of the clauses or a lot of the available behaviors, depending on different circumstances, are programmed into the software, so that you know at every contingency, what needs to happen, you being whatever machine you’re operating, so that you can… You don’t have to have a human being monitoring for things. To that extent, to the extent that that succeeds, you probably have scope for reducing transaction costs, but it’s a work in progress. I think part of the reason a lot of companies are using it is because it sells very well with stockholders and it makes it okay and in tune with the time.

16:49 AP: That raises a question our colleague Will Duffield wanted me to ask when I told him we were doing this episode, which is, how… I guess, early do you think we are in the development of this technology or how mature is this technology? Are we talking… This is relatively mature, like the Internet circa the early 2000s or are we looking at the Internet circa the early ‘90s?

17:15 DZ: I would have answered about a couple of months ago that it was the Internet in the 2000s, but a lot of people who know a lot more about the Internet than I do, and in fact, some of them were around even before the Internet was around, they say that it’s much more like the Internet in the 1990s, to the extent that this is still relatively fringe. It’s not a retail… Cryptocurrencies are not, cannot really be described as a retail product yet. Usually the type of people you find who are in… There are three types of people who are involved, they’re the people who really understand the technology and are involved in the business of cryptocurrencies, if you will, making money from them, or people who are very enthusiastic about it, maybe because they’re libertarian and they like the idea that you have an anonymous peer‐​to‐​peer network that doesn’t require any sort of centralization, or the third group of people are the sort of the clueless ones who just chase quick money, and those are arguably the kind of people that regulators often worry about, finding themselves trapped into something they don’t understand, but although they’re doing it of their own volition.

18:18 DZ: So those are the three groups of people. But you don’t find quite yet a big retail public using these protocols, and certainly you don’t find most people necessarily understanding the technology well enough to be able to operate as market participants in a useful way. I think to that extent we’re looking much more at something that’s specialized, that’s technical, that’s more like the Internet in the ‘90s.

18:44 TB: If Bitcoin is not a money in the way we discussed previously, if it’s not being effectively used as a money, does that matter? It was billed originally as a possible money, but with all the sort of links to the blockchain and different discussions that have come up, is it fatal to Bitcoin or somehow a problem with the platform if it can’t be used to buy a cup of coffee, for example?

19:08 DZ: I don’t think it is, the fact that it’s survived for nearly a decade now and through disagreements within the market participants, and we can talk about this later, but there was a split a few years ago where a different protocol was created, because not everybody among the developers of Bitcoin agreed as to how the network should evolve. It’s survived all of those things, as well as massive fluctuations in value. And some people keep coming back, and a lot of people have very high expectations from what it can achieve. And if you look at very reputable valuations of where Bitcoin can get, based on the supply, on the available supply that we can expect in the future, and the applications that you can get from the software, and these are plausible applications, like remittances systems, intra‐​American payments, you’re talking about valuations anywhere between $2,000 and $20,000 per Bitcoin, right? Given that last time I checked, Bitcoin was at what? $8500, it’s a perfectly plausible rate.

20:14 DZ: Now, it doesn’t mean that it’s a good retail investment product for most people, because that kind of volatility a lot of people wouldn’t want to even countenance, but it doesn’t mean that as a payment system it won’t succeed in the future, and these valuations that I’m giving you a fairly conservative, to the extent that they don’t assume that Bitcoin will eat up the world, as some people say, it will just become an effective competitor to PayPal and TransferWise and the Swift bank payment system, for example.

20:42 TB: How much of the volatility of the price, I guess is a result of the fact that due to technical limitations and then the costs that are a result of the technical limitations, namely, we can’t do that many transactions per second. And so the transaction fees in order to get your transaction included in some reasonable amount of time are relatively high, how much of those contribute to that fluctuating price? So if there’s technology that’s in testing right now, or is going live right now that would allow radically more transactions and so vanishingly small transaction fees, will that simple ability for people to use it cost effectively as a medium of exchange help to stabilize the price at all?

21:29 DZ: I think that most of the volatility actually comes from a lot of uncertainty as to the applications, that’s a clear one, sort of, how much economic value can be generated through this platform or can be transacted through this platform, what’s the maximum feasible volume of transactions? That will determine how much each unit is worth, because the amount of units is limited. I think that’s a prime factor. The second one to me is the fact that a lot of people are holding units and are not transacting in them. So actually, it’s quite a liquid market. Only a small amount of the outstanding units are transacted with every day. And that means that if there is a sudden spike in demand, you are going to see it in price quite quickly, because you might well see a doubling in what’s called the velocity of money, the rate at which people exchange Bitcoins, and that will be reflected in the price very quickly. I think those are the two primary drivers. What you were referring to in terms of transaction fees, there is volatility in transaction fees.

22:29 DZ: But I wouldn’t say that that would necessarily determine the price, to the extent that people expect that transaction fees come down over time. And from what I have seen in the last few months, they have come down quite significantly from the peaks at the end of last year, to the extent that people expect that those will go down, that will only increase the popularity of the network.

22:53 TB: But again, I can hold gold and if it’s just a store of value, just pure gold, I guess, is not money. You could have a brick of gold, although someone would probably take it if you shaved off some shavings. But it’s not really money. You could probably exchange it for a car or something like that, but it would be really hard to exchange it for a cup of coffee, ’cause the person is gonna be like, “What am I gonna do with these shavings of gold, I have to find someone take this gold,” and gold is in the marketplace, people like it. Some people swear by it. Maybe Bitcoin can operate more like that than something you could ever transact on a small level with.

23:32 DZ: Absolutely. So one of the functions that banks used to serve before the advent of central banking was in the management of transactions between individuals, right? Because at this time, there were no peer‐​to‐​peer networks to speak of. You had to rely on intermediaries. And what they did was exactly that, they held gold in their vaults, and they would issue paper notes which were a promise that these notes could be redeemed for gold if the bearer wanted to. Now, most of the time, they weren’t redeemed for gold. They might have been in clearing transactions between banks, but certainly not among individual people. Simply the promise of redeemability was enough to make the notes a circulating medium and generally accepted, and actually quite stable in value. I think it’s perfectly possible that we will find derivative applications of Bitcoin for that purpose, where there’s a redemption for Bitcoin that is promised, but most people use notes. Now, one issue that does raise is that you’re probably presupposing an intermediary again.

24:37 TB: Who’s gonna do that? That you have to trust that intermediary, I guess.

24:41 DZ: Exactly. And it’s no longer exactly peer‐​to‐​peer. Even now, most people have a profile on a digital wallet, which is what stores, what they need in order to transact in Bitcoin, so to that extent there is already an intermediary.

24:53 TB: Like Coinbase?

24:54 DZ: That’s right.

24:55 TB: Yeah, and I know people who are really into Bitcoin think that holding your stuff on Coinbase, which I do, it sort of violates the entire ethos of Bitcoin in some way, ’cause you’re trusting Coinbase. Which is why they invented this thing in the first place so you don’t have to trust anyone.

25:09 DZ: Yes, well, the intermediation’s different, right? They are doing the job of doing some programming for you and giving you an easy‐​to‐​deal‐​with user interface. They’re not actually doing the transaction and the clearing. So the intermediation’s different, and I would argue that the dis‐​intermediation of the movement of value from A to B is what’s interesting there, and probably what’s the most high transaction cost element of the whole process.

25:34 AP: What role in all of this do these so‐​called hard forks play? So you mentioned one, I think I remember, there’s the Bitcoin cash split. What are those? And what effect do those have on the value of these things or the stability of these things or the long term use of cryptocurrencies?

25:54 DZ: So we were talking about the credibility of money earlier, and we were talking about the extent to which people are willing to adopt these peer‐​to‐​peer networks and become involved in them. And that is based on commonly agreed at the outset rules of the game, so that people know they won’t be cheated, so that they know when they’re paying for something that the elements within which they’re gonna be operating are reasonably fixed. It’s an equivalent of the rule of law in civilized society. In order for people to transact confidently and for economic life to happen in good fashion, you need to have some sort of stability in the rules of the game. And a hard fork is a modification in the software and the rules that govern a peer‐​to‐​peer network that fundamentally changes, for example, how many units will ever be issued, or how many transactions will be validated for a given time period.

26:51 DZ: What a hard fork does is it makes the network no longer recognize everything that happened before. New rules apply. And to an extent the governance of the network changes, and the consensus doesn’t happen in the way that it used to before. Now, what that does is, if it hasn’t been announced and agreed upon by everyone, it will probably disappoint some people. It will destroy value for some people, and it will, and it may, push some people out. But oftentimes hard forks… They’re first of all quite rare among these networks because having them all the time would sort of defeat the purpose. It would be like when a central bank says, “Well, we’re linking the… 1,000 Venezuelan Bolivars is $1,” and then next week they say 2,000 and then 4… If that happened all the time they would have absolutely no credibility; this is similar.

27:42 DZ: So that first of all they are quite rare, but then secondly they try to serve a useful purpose. So a hard fork that happened with Bitcoin and created Bitcoin cash a few years ago stemmed from the notion that Bitcoin wouldn’t be scalable enough so long as transactions remained so expensive and costly in terms of time. And so some people were saying, “Well, why don’t we change the protocol so that more transactions can take place during a given period of time?” And that’s how Bitcoin Cash came about. Now, what that means for the networks is that you suddenly have competition, and people will choose whichever they think has greater viability and is better suited to the purposes for which it was created.

28:21 TB: Now, in terms of we have Bitcoin cash, and we have hundreds… I don’t even know how many other cryptocurrencies we have out there, tons of them. But people can use Bitcoin generally, but overall there’s a lot of cryptocurrencies, and a lot of them are founded to purportedly solve a problem like speed of transaction, or anonymity, or something like this. But there’s a lot. I keep hearing the term, I think the technical term, is Shitcoins. There’s a lot of these that are supposed to be kind of scams in their own way. So can you talk a little bit about the other cryptocurrencies out there? And sort of what they offer and different from Bitcoin?

29:01 DZ: Sure. Some of the salient, probably the most salient competitor to Bitcoin is Ethereum, which was created in 2014 by someone called Vitalik Buterin, who’s a very charismatic Russian, a very young Russian‐​Canadian programmer, and it billed itself, Ethereum when it started, as the world’s de‐​centralized computer. So if Bitcoin was simply a payment system, Ethereum’s selling point was you can conduct any manner of transactions by using the blockchain that we will be developing for this. And as a result of that a lot of people have adopted it because it’s seen as more flexible, less costly in terms of conducting transactions, and it has created a number of standardized protocols whereby people can come in and create individual coins for particular purposes relatively easily, and people can understand what’s the technical design behind them because there’s some sort of standard.

29:56 TB: So it’s like new coins on top of the existing Ethereum blockchain?

30:00 DZ: That’s right, yes. So the term is a bit vague. They’re sort of on top of the Ethereum blockchain. But the idea is that you function… You use the peer‐​to‐​peer network of Ethereum in order to be able to transact in a peer‐​to‐​peer way for the exchange of a particular asset. It could be real estate or it could be storage space or it could be…

30:22 TB: You mean like on your computer, not like in a storage space unit?

30:27 DZ: Yeah. Most of the applications so far are digital, although you could, so long as titles exchange and there’s a recognition of the titles having changed, then the physical delivery is perfectly possible, and to the extent you can register certain things. So for example, a lot of people are thinking about sharing economy applications or ride‐​sharing applications that can be done on blockchains. To the extent that the devices you’re using are somehow connected to the network, you can have a lot of the automatic protocols, these smart contracts take place. So if the GPS locates the ride‐​sharing car in a particular location, a particular point in time, it charges me because it reads that I’m about to take it, whether I’ve ridden on it or not, I committed to it, whatever it is. So there are ways to check and to fulfill these conditions in the physical world as well. But you’re right that most of the applications are digital so far.

31:22 DZ: So Ethereum is the best known because it’s considered flexible, right? Then there’s Litecoin, whose proposition is to clear transactions with less energy costs and in a smaller period of time than Bitcoin. There is Monero, which works on privacy. So the idea is to try and improve on the faults that some people see in existing cryptocurrencies, or to try and apply blockchains to something that hasn’t been disintermediated yet. And indeed, what you see a lot in these blockchain applications is people planting flags, ’cause the first mover, the first comer tends to remain the only person in that space for a period of time.

32:03 TB: Is it problematic that for cryptocurrencies in general if there’s some sort of hope or possibility that one day we’ll supplant money, which we can talk about whether that’s likely, but is it problematic that there are so many out there and that some of them are really bad? Does that present a problem for just the future of cryptocurrencies in general?

32:24 DZ: I don’t think it presents a problem from a policy perspective. It’s good to have variety in competition. It presents a problem to investors, because it isn’t likely that all of these will remain in circulation. There’s an optimal sort of scale for a lot of these platforms and, even though you might tell me that your platform for exchanging bikes is the best that there is and massively reduces transaction costs, will I really be wanting to hold a token which I can only use for bike sharing when I could hold my assets in Bitcoin and have some sort of protocol on the Bitcoin blockchain that allows me to do what I do on your platform in some cheaper way and with less uncertainty?

33:08 DZ: A lot of these smaller players will probably over time disappear. So if you’re an investor in these things, you do have a tremendous amount of uncertainty. And then, of course, being an exciting field and one that’s relatively new and to even policy makers unknown, is that you do have a lot of scams. But that’s just the nature of highly innovative platforms and services. I think the right attitude to take is an educational one, where you should never invest in something that you don’t understand. That’s investing 101. Now, greed may drive people to ignore that dictum, but it doesn’t mean that there’s any sort of cost‐​benefit rationale for having massive regulatory involvement in this space at all. People should beware and there’s still caveat emptor, buyers beware. And even the prospect of great riches carries with it the need to be informed and make sure that you know what you’re dealing with.

34:06 AP: So that concern about the scams and then about the tokens that only have very narrow utility in a specific space brings up the thing that’s been the talk for the last part of 2017, it seems like, and on in, which is ICOs and the government’s response to ICOs. So what is an ICO?

34:26 DZ: It’s a very unfortunate term, because it resembles IPOs. And so people who are steeped in the IPO world, which the IPO, by the way, is an Initial Public Offering. It’s when a company lists on the stock market and offers shares and people can subscribe to the offering and buy some shares before they start trading on secondary markets, right? And that’s the traditional way in which at least large firms would raise capital. ICO is reminiscent of that. ICO stands for Initial Coin Offering. But it is fundamentally different, to the extent that I appear to be a platform, I have no share ownership in the platform, I’m a developer who’s coming up with a protocol. And what I’m saying is I need to fund my development of this platform for the next 12 months. Because there is no ownership, because this is peer‐​to‐​peer, I don’t have shareholders. I cannot go to prospective shareholders and say, “You will have a right to the cash flows that this platform generates or the profits that it generates,” because there isn’t a centralized entity that manages it.

35:29 DZ: So I say, “Well, there will be tokens that will be required in order to transact on the platform that I’m developing,” whatever it is that I’m setting it up for. “And because those tokens will be scarce and this is how many of them there will be, I promise to give to you this certain amount of tokens, 1,000, 10,000, 100,000, in exchange for some monetary value now, so that I can feed myself and fund my computing costs and all the rest of it as I develop a platform.” Now, that to some people may sound a lot like capital raising, but it’s fundamentally different because I’m appealing to customers. I’m saying to customers, “This is a good or a service that you’ll probably want to buy in the future, or you’ll probably want to use in the future. I’m giving you the opportunity to buy the right to operate on this platform, probably at a discount, because I expect it to be very valuable to people, it’s going to be very successful. So you have, here’s a chance for you to get in early and acquire those goods and services at a discount in the future.”

36:27 TB: Feels like Kickstarter.

36:29 DZ: Yeah. To an extent it is. It is like that. Of course, this is, perhaps I’m assuming that people are less profit‐​oriented than they are. A lot of people don’t want the goods and services. They just see an exciting investment opportunity and they see a lot of people wanting to get involved in this stuff, and they just wanna speculate in it. But even if I’m a speculator, ultimately, I have to hold something that someone will want to use. Otherwise, you’re just in 1637 Netherlands with your tulips, and the whole thing comes crashing down. Again, there’s a discussion to be had as to what the responsibility is of the person, the last guy to buy the tulip, and whether he can really be described as someone who was vulnerable and didn’t know what he was doing or she was doing. But it isn’t obvious that a bubble can be sustained in itself and that this is all a scam. There’s some underlying value happening.

37:28 AP: I think one of the things that’s really neat about these ICOs and this method of fundraising is that it allows you to raise money for open decentralized protocols in a way that… So the Internet is all based on open decentralized protocols, but they were built in universities or by the government and then given away for free, and those were, I guess, organizations with pre‐​existing funding sources. But if you’re gonna build these things outside of academia and outside of the government, in the past, we didn’t have a technical means for you to make money, which meant that really cool things that we’d love to have people have access to, like VPNs or Tor, had to be developed in this way that limited their ability to be open, or limited their ability to be really spread out, and didn’t incentivize people to then participate. And so I think, from my perspective, this particular funding mechanism and technology is one of the most exciting things to happen in the digital space in decades, because it can allow us to create these really cool new platforms without having to be like the next Facebook who’s gonna sit in the middle of it and scrape money from advertising or whatever. But you can’t do that without having these tokens to transact with.

38:49 DZ: That’s right. And the analogy to Facebook or Google, I think is a valuable one, to the extent that you have different types of users on Facebook and Google, as much as you do on cryptocurrency platforms. On Google you will have advertisers who are interested in reaching customers and customers who are interested in reaching their friends or finding out information about the weather or what pair of shoes to buy and so on. They don’t want to interact with each other, at least not both sides. The advertisers certainly want to interact with the users, or the retail users or the consumers, but the consumers are not interested necessarily in most of the advertisements. And the cryptocurrency platform is similar, to the extent that I want to give you, Aaron, some Bitcoin in exchange for something else, and there’s somebody else operating in the network who’s running these massive computers to make sure that our transaction can take place, but he couldn’t care less as to whether our transaction is fruitful or whether you benefit and I benefit or whatever.

39:49 DZ: They benefit themselves. And in that way, you can get a network going in a very effective way without anybody being involved in the business of anybody else, other than tangentially wanting the network to succeed. And I think that is very interesting. It was one of the reasons that people praised Google at the outset so much is because it had managed to create software that incentivized everyone to behave in the way they were supposed to behave for the network to succeed. And some people didn’t even have to pay for it. In the case of Bitcoin, you have to pay a small transaction fee. But most of the reward right now to the miner comes from the generation of new coins. The hope is that by the time the supply becomes fixed and no new coins are issued, the network will be large enough that the transaction fees, because the transactions are so plentiful, the transaction fees will be enough to justify the work of the miners even then. But we’ll see whether that happens or whether some other more cost effective platform can do a better job.

40:47 TB: So maybe because of the initial coin offering sounds like initial public offering, the SEC seems to be interested in ICOs now, which, the way you’ve described it, it seems like a poor fit. It’s not really a security. It’s not on the New York Stock Exchange or any of these things. So what is the SEC interested in ICOs, or why are they interested?

41:11 DZ: So the SEC is concerned, and I think partly they have a point, that this issuance of tokens, what are called ICOs, are being used by people to market investments as something else, and avoid or ignore the securities regulations. And in that way, you are circumventing protections that are intended to be beneficial to consumers. That is the way they tell the story. There have been instances in which what’s been marketed as a token issuance was only very thinly marketed as a token issuance. It talked about profit. It talked about an investment opportunity. It talked about guaranteed returns, a lot of the things that you tend to see in investment and often in very dodgy investments. Whenever you see guaranteed returns anywhere, they say run, run for the hills.

42:01 DZ: That has happened with some of these tokens. There was a couple of years ago, a platform called the DAO Token, the Decentralized Autonomous Organization. They were meant to be an investment fund that was peer‐​to‐​peer, where the protocol was designed in such a way as to enable any holder of a token to vote for a particular set of investments that the fund would make. Now, that’s clearly a financial institution, to the extent that it deals in the way that other securities brokers deal. It probably should be subject to the same rules, whether we agree with the rules or not. And so the SEC told them to withdraw this offering. There have been a couple of other instances, the point being that some people are using the legal uncertainty and the legal void and the excitement about these things to do things that do not strictly meet the definition of a token. That’s why the SEC justifies its becoming involved. The problem is that the SEC runs an environment in which it’s very difficult to become operative as a small player with a relatively small capital base.

43:08 DZ: On one hand, you have the large public companies that are able to engage in IPOs and have to pay four to five, to seven, eight or anywhere to the tens of millions of dollars in fees just to list on the public markets. That’s simply insurmountable for a lot of these startup firms, or you can only make an offering to basically rich people and venture capital funds and hedge funds, who only most of the time only work with rich people. And so what you have is an environment in which either some firms aren’t allowed to list, or if they’re able to raise some amount of capital to develop, it’s skewed to… The high returns that might come from this are skewed to the people who are already rich. If you believe in some sort of economic equity and equal access to things, or if you believe that startups are important to have innovation and dynamism, both of which are perfectly plausible, the existing environment isn’t very good. So the obvious response to the SEC is, “Well, okay, SEC. You’re concerned that these things might be securities, why not change the securities rules so that these things can happen more easily and people are not engaging in this regulatory arbitrage that is neither beneficial to you nor to the economy?”

44:17 TB: Going forward, there’s gonna be, of course, many more discussions about cryptocurrencies, and everything that they can be doing and which ones are gonna be used for money laundering and all these things. Do you see the government in general probably upping its involvement and maybe just impeding cryptocurrencies, or do you think it will continue to be somewhat a free environment until maybe some tipping point happens, that there’s some… I don’t know what it would be, that Bitcoin breaks 100,000 and people are getting murdered over it, or something like that. And they’ll just sorta let it go as a security, an investment tool before really getting involved and maybe corrupting it or destroying it.

45:00 DZ: My libertarian instincts tell me that governments will want to get involved, and they’re already trying to as soon as possible. And indeed, if you have the spectrum of most repressive to least repressive governments, you tend to find that the more repressive ones are the ones that have intervened first. So China clamped down last year on cryptocurrencies and ICOs. There are other countries that have talked about intervening more heavily in monitoring transactions. There’s some concern about the criminal use of peer‐​to‐​peer networks because they’re anonymous and they’re decentralized and they’re outside of the control of governments. Perhaps some of those concerns are plausible. They certainly don’t indict most of the transactions happening on the network. But a lot of people, with good intentions, will cling to those. And a lot of people who stand to benefit from blocking these new innovations will, I’m sure, join them. And those coalitions tend to be very powerful. We see this in almost every prohibition that we have in modern society. And I see that as a very stark looming threat to the development of these things.

46:04 DZ: On the other hand, the technology is so powerful and the use of distributed ledgers, blockchains, seems to hold such great hopes for reducing the cost of a lot of activities that now, either because of regulation or because the technology isn’t very good, are expensive and restricted to a small set of people. That I think the incentive for people to use them privately will only grow, and indeed the growth is already exponential. How many of these platforms are being created every day, how much money is being transacted and how many people with capital are interested in becoming involved in this stuff? They will also put pressure. And the nice thing about this stuff is that it’s very difficult to shut down, because the network is distributed. So you cannot go to a building and say, “Okay, this place is now closed down.” It’s somewhat emergent and organic and to that extent, you cannot erase it by statute. Here again, the analogy to bad central banks comes to mind. You can completely debase a currency and you can, in the short run, make a lot of people poor, but you cannot in the long run force them to deal in whatever it is you issue. One way or another, because they move away, or because they start dealing in dollars or whatever, people will move to something else, or find alternatives. And I think that’s what will happen if there’s a serious clamp down on this stuff.


47:28 AP: Free Thoughts is produced by Tess Terrible. If you enjoyed today’s show, please rate and review us on iTunes. And if you’d like to learn more about Libertarianism, find us on the web at www​.lib​er​tar​i​an​ism​.org.