Monday, March 31, 2014

Crypto Currency: One of the Problems With Digital Dollars

I was at a family gathering recently and over heard a discussion about Bitcoin and a few common misconceptions were brought up. Rather than drag a family party down into the finer points of crypto currency, I decided to address a few of them here. First let's hit the issue with our current currency.

Counterfeiting is the idea of producing your own currency separate from the source controlling the currency (like the government). With paper dollars and coins we go through a lot of effort to prevent people from being able to create their own currency. But a lot of these measures don't help prevent electronic counterfeiting. Let's look at a scenario.

Until pretty recently most people were paid with paper currency that was backed with precious metals. So, my employer, Payer Inc, would give me $500 in bills. I would go to my bank, Bank Good Guys, and give them the bills. Now I have $500 in my account. Figuring out how much money I have in my account is pretty easy: just look at how many bills are sitting in the box with my name in it (I realize I'm oversimplifying banking. I apologize to any bankers out there).

Simple, right? Now let's use computers to make it way more complicated.

Now a lot of banking is done electronically. Rather than hand me paper bills, Payer Inc has an account with Bank Connman and I have an account with Bank Eville Guys. To pay me, Payer Inc sends electronic messages to Bank Connman telling them they're going to send $500 to Bank Eville Guys to pay my pay check and another message to Bank Eville Guys letting them know I'm being paid. Bank Connman subtracts $500 from the amount in Payer Inc's account, and Bank Eville Guys adds $500 to my account.

What if these banks are true to their names? Perhaps Bank Connman isn't too happy to lose those $500 because it makes their total value go down, so even though they tell Bank Eville Guys I'm being paid $500, they only subtract $400 from Payer Inc's account. Bank Eville Guys decides that it's better for their own interests if I get paid $1,000 because it makes their average customer salary go up.

They've both just created currency. Unlike paper bills, there's no finite number of specially marked pieces of paper that limit the amount of currency in circulation. There's just 0's and 1's that can be changed more or less at will.

We've mitigated a lot of this with good book keeping. Payer Inc audits Bank Connman, Bank Connman audits Bank Eville Guys, the government audits everybody, you know the drill. But the fundamental difficulty is still there: It is very difficult to track dollars when they are not tied to paper bills. In a lot of ways mutual desire for the currency system to keep working is probably a good defense here. The banks want consumers to trust currency and consumers trust currency as long as no one takes advantage of it.