The Doorstep: Cryptocurrencies & Global Decentralization, with NYU Stern's David Yermack

June 18, 2021

NIKOLAS GVOSDEV: Welcome, everyone, to this edition of The Doorstep podcast  I am your co-host, senior fellow at Carnegie Council, Nick Gvosdev.

TATIANA SERAFIN: And I am Tatiana Serafin, also a senior fellow at the Carnegie Council, and so excited to welcome today Professor David Yermack from NYU Stern. He is the Albert Fingerhut Professor of Finance and Business Transformation, but today he is here to talk with us about cryptocurrencies.

I found a paper of yours from 2014, and the question you asked is whether Bitcoin is a real currency. We here at The Doorstep try to bring international stories to our readers and put them in context, and we have been looking at Bitcoin and seeing the news and headlines galvanizing, and we thought, Now would be a great time to ask that question: Is Bitcoin a real currency? What is crypto? Try to explain it for the percentage of Americans who hear it and shuffle it to the back of their minds.

I found a statistic that 14 percent of American adults actually own Bitcoin, which seemed to me pretty high. Then we have El Salvador saying: "Hey, we’re a Bitcoin currency." I don’t know if you have seen the story about "Bitcoin Beach," that is trying to use only Bitcoin currency. I don’t mean to focus on Bitcoin—there are lots of alt currencies that we can talk about—but because of El Salvador and because the Miami mayor after the big Bitcoin conference said, "You can pay your taxes with Bitcoin," we might as well start out with that question. Is it a real currency?

DAVID YERMACK: I think the question is very timely, especially because of what has happened in El Salvador. The national parliament has declared Bitcoin legal tender. Essentially it is one of the national currencies, and it is now mandatory that businesses in that country accept it if anyone presents it to pay for goods or services.

But the data suggests that Bitcoin has rarely been used as a currency. It is really much more of an investment vehicle. When people have looked at transfers of bitcoins from one wallet to another, more than 90 percent of them tend to be from one investor to another and not to a retail shop or an online retail site or anything like that.

There are some clear problems with Bitcoin as a currency. It is basically very slow to book a transaction. With your Visa card it can be done in a second or two when you swipe it at the checkout counter, but for a Bitcoin transaction to be written to the ledger known as the blockchain, it takes ten minutes and sometimes more. There are also capacity limits. There are only seven people per second in the world who can use this network. It does not scale up. It may be very desirable because of its scarcity for investment purposes, which itself is an interesting question, but as a currency it is not built for service of that type. It really was built as I think an experiment 12 years ago that has gotten way beyond the imagination of the founders and the creators and has of course spawned many thousands of imitators, these so-called "altcoins" that you referred to as part of your question.

TATIANA SERAFIN: I saw 10,000 of them, so there are quite a few out there. Ethereum is another big one. Between Bitcoin and Ethereum they make up two-thirds of the market, and I think that is why people are talking about them.

But there is a lot of enthusiasm. Twelve thousand people were in Miami at this Bitcoin conference. Although it is an investment vehicle, a lot of people are also seeing it as a real asset class, and I hear a lot of people trying to include it in their portfolios or at least look at potentially including it. Is this a trend that you are seeing more? What are you hearing on the regulatory side?

DAVID YERMACK: First of all, in the past year there has been a tipping point where many of the mainstream investors—well-known hedge funds and even some big institutional investors—are beginning to build crypto assets into their portfolios or offer it for sale to their clients. There is I think little question at this point that it has entered the mainstream as an asset class.

To be honest, the regulation has not kept up. In Washington they still have not figured out which agency, if any, has the authority to regulate this and whether it should be treated as a security, as a commodity, or as cash the way banks have to deal with liquid assets. There are many agencies that conceivably could have a role in this, but I think the right way to think about it is none of the above. This is something very new. It is not issued by any organization. It is not really backed by anything other than mathematics and cryptography, and the regulators need to reconsider many of the assumptions about risk and return, safety, and investor knowledge that typically inform the regulation of other markets.

What has been interesting is to look beyond the United States. There are more than 200 countries that are experimenting with different regulations, and some of them I think have moved much further ahead. The Swiss and the Singaporeans are the ones often cited as the ones with the most intelligent and far-reaching regulations.

I think the U.S. regulation frankly has been pretty reactionary, especially on the part of the Securities and Exchange Commission (SEC) during the Trump administration, with a real effort to try to kill this off, keep it in a box, and warn people away from it without much real intelligent thought about what role it can play in the financial system in the future. I think there are now different people in charge who are better informed, and maybe we will see more intelligent regulation coming out of Washington, but it is not clear to me that the SEC, for instance, has any role to play in this area unless you can identify certain assets that really are securities, and at this point no court has held that that is the case. There are still some big test cases making their way through.

NIKOLAS GVOSDEV: I would like to go back to a point you raised about scaleability and ease of use starting with Bitcoin but then moving to the other instruments—Ethereum, Dogecoin, and everything that is out there. You mentioned about using Visa cards and the like. They are tied to a national currency. We can go places, and either our currency is accepted, or if it is not, we can go to an exchange and get it translated into currency that will be accepted.

What has to happen with cryptocurrencies for them to hit that level of acceptance, that is, that someone will say: "I will take your whatever coin as payment for this good or service that I am going to give you" or "I will accept it as legal tender for the payment of taxes or fees or the like?" Where are we in that process of these moving, as you say, away from still largely speculative investments to where it becomes something where someone says, "I recognize that this thing you are paying with has value that I am willing to give you the fruit of my labor or the fruit of my factory or farm in return for this coin?"

DAVID YERMACK: I think it is important to understand where the value comes from in cryptocurrency. It really comes from a better degree of security and trust than you have in the regulated financial system. If you use the U.S. dollar, you are trusting the Board of Governors of the Federal Reserve, which is a group of political appointees, not to print too many dollars and not to take their eye off banks that maybe need to be closely monitored and so forth. I think the Federal Reserve has done that job reasonably well, but other central banks around the world have been abject failures. In fact, sooner or later every central bank fails.

But with cryptocurrency you are really trusting algorithms. In the case of Bitcoin and still with Ethereum and many of the others, what secures them is the validation process, that if you spend a bitcoin for a cup of coffee there is something that goes on in the background called "consensus" where all the nodes of the network around the world agree that this is a valid transaction, and the process by which this happens is called "proof of work," where people solve some cryptographic puzzles and invest large amounts of resources that show their commitment to the truth of the data in the ledger.

That is the cumbersome part. The proof of work system requires a fair amount of time and a commitment of capital and resources that is exactly the opposite of what you would need to scale the network up. What has been going on is the search for a better consensus mechanism that would be quicker and cheaper while still providing the same level of confidence and trust.

It is a very interesting problem to try to improve on what the creators of Bitcoin put out there. We still don’t actually know who these people were. There is a pseudonym of Satoshi Nakamoto.

Ethereum right now is planning to transition to something called "proof of stake," which has the potential to be a cheaper, quicker consensus mechanism, but there is still some internal resistance, and this transition is at this point years behind the original schedule, and it is a matter of a lot of academic interest whether this really will be a good idea. In fact, I supervised a doctoral dissertation on this question a couple of years ago. We graduated what we think was the first blockchain Ph.D. in the world. This is my former student, Farhad Saleh, who is now on the faculty at Wake Forest, but he did his Ph.D. dissertation on proof of stake versus proof of work.

It is a very central issue about how you can improve this process of consensus, and it is hardly limited to these two things. There are many other schemes out there—proof of space, proof of importance, and so forth—and I think it may be that the real solution to this problem has yet to be discovered, but with a lot of smart people working on it there is probably going to be more innovation and progress, but it may not be right around the corner. It may be years in the future. We will have to wait and see.

NIKOLAS GVOSDEV: So essentially what gives crypto its value is, as you mentioned before, the unfalsifiableness of the ledger unlike central banks. The problem you have with many investors dealing with the Chinese currency is that the value of that currency ultimately depends upon the whims of what someone in Beijing determines it is going to be, other countries run their printing presses, but this is essentially a closed process that cannot be fiddled with by running the printing press or devaluing the currency. It has its value.

What has to happen in terms of scaling up? At what point is there a tipping point where this becomes more accepted? What about the El Salvadoran decision, for instance? Is this the start of a process, or are some people going to look at this and say, "That’s just a crazy step taken by a small Central American country that does not have ramifications for the rest of the world?"

DAVID YERMACK: I must say personally that I have been taken aback by what has happened in El Salvador. I think even the biggest Bitcoin evangelist would not have expected a nation to adopt it as legal tender as just happened a couple of weeks ago.

Again, consider that only seven people per second can use this network. El Salvador has millions of people. It is a small country, but still there is way more commerce and transaction demand for the currency than Bitcoin could possibly accommodate.

What is going to happen is that people will use synthetic platforms to trade Bitcoin off of the blockchain. There is a well-known service called the Lightning Network, where you can take some bitcoins off the blockchain and then use them in retail commerce maybe at a much higher velocity and then reconcile the net back to the Bitcoin blockchain.

But everything that happens off the blockchain is essentially reverting to the old system, where you are trusting a group of managers who are running a separate company that may or may not keep good track of the money, protect you against fraud, and so forth. There has been a whole network of third parties—wallet companies and organizations that look a lot like banks and brokerages but are not really regulated that way—that have sprung up to essentially provide a layer above the real network of crypto, but the security and the transparency that you get on the true use of crypto is not really present with those third parties. Some of them get hacked. Some of them just disappear in the dark of night.

There is a very unusual tension. People I think believe they own Bitcoin when they really don’t. Some third party has told them that they are holding onto it for them, but there is no real way to validate the truth of that statement, and there have been some catastrophic failures of some of these organizations, such as the Mt. Gox exchange in Japan, which is probably the most famous and is now well into the eighth year of a very controversial bankruptcy case, where hundreds of thousands of bitcoin disappeared.

I think a lot of people are waking up to recognize that the scaleability of this as a currency doesn’t really exist, and they are putting their trust in third parties who may or may not be worthy of that trust but who sooner or later will have to be regulated the way that we regulate banks and brokerages because that is more or less the services that they are performing, just not with stocks and bonds and regular currencies as the underlying assets.

TATIANA SERAFIN: You bring up an important point tangentially—things disappearing and how do you track them. We have to talk about this topic, the fact that ransomware is now asking increasingly for crypto, Bitcoin, and other currencies. It is trying to ask for huge ransoms from hospitals and city governments. We just had a bunch of hacks over the last couple of weeks, and they all wanted crypto.

There is this idea I think also that these cryptocurrencies are making it a little bit easier for ransomware to happen. Do you feel that way? It is transparent, but it is also hidden, right? Because who knows who owns the wallet?

DAVID YERMACK: I think there is a lot of misunderstanding in this area. When somebody’s systems are hijacked and held for ransom—and this happened very publicly with the meatpacking company and with the gas pipeline a couple of weeks ago—it is not because of cryptocurrency. It is because these companies themselves had bad security. It is like if someone steals your car and then tries to ransom it back and you left the garage unlocked with the key in the ignition, and you blame the existence of money. It is not the fact that someone could pay the ransom that got the car stolen. It’s the fact that there wasn’t basic security.

In a lot of these ransomware attacks you read in the eighth paragraph that they were using an eight-year-old version of Microsoft Windows, that they didn’t have multifactor authentication, just the very basic stuff they never took the time to put into place, and there are trolls on the Internet who will just go through thousands of websites until they find one where there isn’t any security, and "Aha!"

The payment of the ransom is quite interesting because on the Bitcoin blockchain you can trace the money, and there are both governments and private forensic firms that do this. We did see this story about ten days ago where the Department of Justice made a very public claim to have recovered 85 percent of the ransom paid in this pipeline hack.

I have a lot of questions, and the first question is: Did the government speak truthfully? Did they really get that money back, or are they just putting that story out there to try to frighten people? And if they did, it must have been either by way of a hack of the malware company itself—there is apparently some Russian organization behind this—or maybe they bribed somebody or somehow got hold of the private keys to unlock the wallet where the ransom was being held. Absolutely nothing has been said about how the government might have gotten all of the keys needed to unlock that wallet. People who are knowledgeable about this are a little bit perplexed by the whole story because it just doesn’t add up. Either they were extremely sloppy on the hacker side, or the government is exaggerating what actually took place. We will have to wait until more information comes out.

As you said, though, you can trace with a fairly high degree of precision where these crypto assets move, but what you need to know is: Who controls the wallet? Who has the so-called "private key" that can unlock the wallet? That requires an entirely different type of detective work that is sometimes easier and sometimes not so easy. In the future there is going to be a high premium on people who have the skills to be able to do this kind of tracing and maybe conduct these reverse attacks on hackers and so forth.

Let’s see if these malware things start to slow down. Let’s see if the meeting between Biden and Putin has any kind of effect on getting the Russians to step up their game and police this territory a little bit more. Apparently North Korea is a big player in this area as well. It is hard to believe what you read and to take it at face value without asking a lot of follow-up questions, and I certainly have quite a few about the events of the last several weeks.

NIKOLAS GVOSDEV: It is interesting that you mentioned the Biden-Putin meeting because apparently in the back-and-forth, Biden raised the question of: "Well, these attacks keep happening. It would be a bad thing if suddenly oil pipelines in Russia started locking up. You wouldn’t like that." I think the message there is: "Hey, it’s all fun and games until you start getting a degree of retaliation and acceleration back and forth, and it’s in everyone’s interest not to see this take off."

You are talking about wallets, who has the keys, we have talked a bit about scaleability, and the ease or non-ease of using some of these currencies, which I think leads to the question of some of the large private tech companies looking at quasi-cryptos. Is that going to be something we see, where Amazon, Facebook, and Alibaba will come up with some sort of e-currency that you can use for purchasing goods and services from them? Then, assuming if they are taking it, can they pass it on to their venders and say, "We’re going to pay you in our currency?"

Is that a direction, that we may see a halfway house between the pure cryptos, particularly with Bitcoin as you mentioned at several points, with the difficulty in scalability, and the time it takes to get a transaction moving through versus maybe Amazon says, "Look, we’re going to create Amazonia or some kind of Amazon-based currency?" Is that something that we are likely to see, those kinds of private company entrants coming into this as a way to bridge the gap between the pure cryptocurrencies and between—other than perhaps the dollar or the euro—a variety of national currencies that may not be seen as particularly stable or desirable to use?

DAVID YERMACK: I think this is almost certainly going to happen because it has already happened in China. We have seen what is the second largest economy in the world more or less have the payment system taken over by two social media companies, by Alibaba and a company called Tencent, which has a platform called WeChat Pay. The Alipay and the WeChat Pay have grown very, very quickly and basically pushed the banks to the sidelines of the payments industry in China.

Really out of fear the Chinese central bank has launched its own cryptocurrency. It went live as of last year and is being scaled up and rolled out across the country, but you now see what is basically a competition in China between the private money issued by Alibaba and Tencent and the cryptocurrency being issued by the People’s Bank of China.

I think this very quickly is going to go around the world. You are going to see a digital euro, a digital dollar, and you are going to see companies that have billions of customers on their platforms—Amazon I think is the most likely, but Google, Facebook, and even folks like Netflix and so forth—probably issuing their own payment vehicles, their own money basically, and in the long run there is going to be an interesting question of whether you trust Google and Amazon to issue the money more than you trust the central banks of the euro area, the Federal Reserve, and so forth.

I think there are many advantages that the social media companies would have in this contest: They have far more customers, billions instead of hundreds of millions; they have, as far as I can tell, much better cybersecurity; they have the ability to attract people and get them to come onto the platform and enjoy themselves multiple times a day, which I don’t think people do with their banking websites.

And ultimately the issue of trust. Do you trust Jeff Bezos and Mark Zuckerberg, or do you trust the leadership of the central bank? You can look at all the lunatics that Trump tried to put onto the Federal Reserve Board of Governors in the last administration to see how fragile that system really is. There were real attempts to repurpose the central bank as a vehicle of god knows what, one of many crazy things that happened in the last administration.

I think the private companies that are motivated by profit in the long run are going to be more intelligent and more wise about the creation of money, and they may be able to steal this franchise from the central banks and governments of the world, which would have huge implications for not only public finance but the very nature of the nation-state.

There is some academic debate that in the future maybe you will think of yourself not as a citizen of the United States or of the euro area but as a citizen of Google, a citizen of Facebook. You would be part of a social media currency area where the economic policy is really being run by a private company that also does chat, navigation, search, and all the other things that you get on the platform. They will just integrate payments into all sorts of applications that you are already using very happily.

It’s a huge problem. I think if the Western central banks and media companies are not careful, there is every chance that the Chinese platforms could migrate. Alipay and WeChat Pay are in dozens of countries already. Especially in the Eastern Hemisphere you encounter them everywhere that you go. It is an issue that I think has snuck up on politicians.

The Facebook Libra project took a lot of heat, but without people really seeing the big picture of what’s at stake—and I think Facebook in many ways is a stalking horse; they are not really a retail company the way that Amazon is, and if Amazon launched its own currency and gave people a 0.5 percent rebate every time they used it, it is not clear why you would want to use the dollar anymore. Let’s see where this goes. But I think the complacency and lack of foresight by some of the governments in this area has been a little bit surprising. People are very naïve about the risks of the media companies usurping the financial system.

NIKOLAS GVOSDEV: That really speaks to something that Raj Kumar has talked about, the "decentralization epoch," where, as you noted, the nation-state maybe doesn’t become the framework by which people organize their economic lives, their business lives, and their political lives, where what corporations or what media ecosystems you are part of defines you in a greater sense, and I think that is a very interesting development in how that would play out. As you said too, what happens if the media and retail companies are moving into this space in a way that traditional banks and governments are not paying attention to, and then the unexpected consequences of that down the road.

DAVID YERMACK: Yes. In fact, you look at what has happened in China, and I think one day the great dictator Chairman Xi woke up and realized he was the second-most powerful person in the country and that he was really working for Jack Ma and not the other way around. He got very angry and called Jack Ma in for a meeting, but I think even the Chinese realize that they need Alipay more than they are willing to ever publicly admit, and they are going to have to work out some kind of entente. I think in earlier times they might have just taken Jack Ma out and shot him, but they are not doing anything like that. They are trying to accommodate and figure out how to keep the best of that system. I would say that Alibaba is not cooperating in a friendly way but only with some grudging acquiescence.

But you are going to see this replayed in the West. I think the Chinese situation is a very interesting preview about what may lay ahead with the behemoths—the Amazons, Googles, and so forth—that have enormous power to enter this space.

Whether this would be a good thing or not, I don’t know. There are certainly many problems with the financial system as it now exists, but would it be a better system if it were run by the media companies? I have a sense that the security would be better and the financial decisions might be better, but there are all kinds of other issues about privacy and data harvesting, and the very nature of liberty and your individual identity are going to need to be reconsidered. China has a different culture than many Western countries. Privacy has never been that important, for whatever reason. It is going to be very interesting to see how it unfolds.

The people who created Bitcoin and launched it 12 years ago have just unleashed these forces that greatly exceed anything that they ever could have imagined. We have been offering this course at NYU that, just in the seven years we have had it, the agenda has changed vastly and has scaled itself up into these areas that really are of critical importance in terms of not just people’s financial life but their personal lives and their security as well.

TATIANA SERAFIN: While we are on the topic of China, I would be remiss not to talk about Bitcoin mining and the effects on the environment and the fact that China recently is trying to kick out some of the miners. Where are they going to go? Kazakhstan, Texas? They need energy. Could you talk about the energy aspect of mining? And, speaking of how the world needs to focus on the environment—and that is not just a national interest; that’s an international interest—where do we go from here on that?

DAVID YERMACK: It’s a very interesting situation. I have never understood why the mining industry got so big in China in the first place. We talked a few minutes ago about the proof of work security that requires you to spend a lot of time solving cryptographic puzzles to provide security to the network, and this takes energy. You need supercomputers that do trillions of calculations a second, and people build these bunkers and warehouses.

But the key to where you are going to locate these is where the cost of energy is the cheapest. In the end your variable cost is what you are paying for electricity, and the only electricity that has the minimum variable cost is renewable energy. You could put a Bitcoin mine in Iceland and get free geothermal power from the earth and not do any damage to the climate. You could go to Northern Canada and get hydropower and wind power. People are now going to Texas because apparently it is very windy in certain areas of Western Texas. But the economics pretty ruthlessly push you to go to renewable sources, where the marginal cost of the energy is zero. So, burning coal or connecting to the local electrical grid is never going to work because you will end up paying more than your competitors, which will drive you in the long run right out of the business.

So why are people in China in the first place? Years ago—it may be a myth or an urban legend—apparently someone built a hydroelectric dam in Inner Mongolia without permission from the local government—they didn’t bribe the right people—and they had all this energy that they couldn’t do anything with. So the Bitcoin people heard about this and they said: "Free electricity? We’re there."

You do see people mining Bitcoin at the free Tesla charging stations on the Merritt Parkway and in Caracas, Venezuela, where the great dictator Maduro gives free electricity to the people. The Bitcoin people will come anywhere where there is free electricity. But I think in China that ship sailed a long time ago. If someone ever did build a dam that shouldn’t have been built, it would have been sorted out many, many years ago, but the miners are still there, and apparently a lot of them have been using coal-fired energy that is bad for the environment.

So they have now been told to leave. I am not sure that I believe this because they have been given six months, three months, or whatever to sort things out—which means to me to find the right people to bribe—but I think in China in particular, Bitcoin mining has probably persisted to enable capital flight. I think there are a lot of rich people in China who want to get money out of the country. They can’t do it legally through the regular financial system, but they can do it through Bitcoin. So I think people have actually been losing money on Bitcoin mining but making it back by selling the bitcoins locally to people who want to move money out of China. That’s my hypothesis.

Now at a certain point the Chinese government decides to crack down. How serious they are and whether this is a permanent crackdown remains to be seen because they have reversed themselves many, many times in financial regulation, but I do think the economics are pretty clear that they shouldn’t be in China in the first place. In the long run you are going to see most of the Bitcoin mines up near the tundra, where you can get essentially free wind power, and maybe in little niche markets like western Texas, where there may be abundant land and good connectivity and cheap energy, but these are basically going to be areas where people don’t want to live and you are not going to be displacing people from the electrical grid because the conditions are likely to be very harsh and people are setting up turbines just because it is extremely windy there.

Again, it is not China. To me, China never should have been as big in crypto mining as it ever got, and I think it does interact with issues like capital flight that are of great concern to the national government because the financial system there is pretty shaky by Western standards, and they are very worried about people getting wealth out of the country, and I think crypto has enabled that for a number of years. It is a story that I think is going to require months if not years to unfold, and it will be interesting to watch some of the updates.

TATIANA SERAFIN: We have talked on The Doorstep a lot about how environmental impact and policy are super-important, and I think this angle that Bitcoin and other cryptocurrencies are getting reamed because of their environmental impact—Elon Musk saying, "We’re not going to accept it until you have thought it out."

DAVID YERMACK: That was rich. The guy is an engineer. He wakes up one day and "discovers" that it takes a lot of energy to mine a bitcoin?

I think there is a value judgment here that one has to be careful with because we can say: "Look at all the energy being used to validate crypto transactions. What good is this for the world?" We could ask the same question: "Look at all the energy used by JP Morgan to keep track of people’s payments; why is this good? Look at all the energy people use to wash their dishes? Is this really—" 

We decentralize these problems to markets. We put a price on electricity. We let people bid for it with supply and demand, and we really don’t question whether you using it for an electric razor is better than someone else using it to operate a motor vehicle and someone else to play a video game. All of these things consume energy, and that energy is paid for, and if we think people are consuming too much, we can tax it. There are many ways to regulate the market.

I am not sure that value judgments about the social utility of crypto as compared to some other use that also takes electricity are justified. If people want to make those investments as a private entrepreneur, I am not sure there is a case for stopping that. But if you think that too much energy is being used, put in a carbon tax. There are all kinds of ways to meter it or to ration it. That to me is a much more interesting story than how much is used by Bitcoin. We could go to air travel, we could go to all kinds of other things and point out egregious uses of energy, and how we are going to allocate the scarce resources is really an economic problem. It is not a problem for value judgments.

TATIANA SERAFIN: This has been such a fascinating conversation, so many great topics that I look forward to exploring in the future. We would love to have you back as this story develops.

DAVID YERMACK: Thank you very much for the invitation. It has been interesting to watch how this has grown and the types of questions being raised. I think the importance of this will only be higher a year from now or ten years from now. It is a very fun area to think about the impacts on society, governments, and our financial system.

TATIANA SERAFIN: Absolutely. Thank you so much.

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