Could Digital Currency Make Our Money More Secure?

This is the second installment in a three-part interview with Stanford Business School professor and economist Susan Athey on digital currencies. In part 1, we discussed what Bitcoin is and what potential applications are, and part 3 explains how MIT students, the poor and criminals will all benefit from Bitcoin.

Today, we’ll look at the security pros and cons, and what adoption hurdles cryptocurrencies face.

Do you think digital currency is secure?

Some parts of the architecture of digital currency are vastly superior to existing systems. When you pay for something with a credit card, you are giving someone all the information they need to know to buy something online.  What an idiotic way to architect a system — that if I pay someone, I tell them everything they need to spend my money. If I’m paying you, you shouldn’t have to know how to buy something with my credit card. You should have to know how to receive something with my credit card. It was a decades ago stupid mistake to make it work that way. At the time, alternatives might have been harder because you didn’t have good computer systems to keep track of everything and generate new numbers, but fundamentally, it was a stupid way to architect a system. Similarly, if I’m going to wire you money, you need to give me all of your bank account information, which is the same information I would use if I was going to pretend to be you and wire your money to someone else. Generally, if this kind of fraud occurs, your bank will back you up, but they’re not legally required to.  

Bitcoin is not architected that way. If I know your address, I can send money to you, but I can’t take money out. And that makes a hell of a lot of sense! We wouldn’t have the Target security breach if all Target had was an address without any way to use those credit card numbers. The credit cards are moving in that direction. Within a couple of years, they’ll use something called tokenization so the numbers you use to send are not the same as the numbers you use to receive. When I run my credit card, they’ll store a code that isn’t the same as the one for buying something, so the merchants will no longer be subject to a Target-type security breach. 

However, Bitcoin is architected like that from the beginning. Another big advantage, if you’re receiving money through Bitcoin, is that once it comes to you, it’s yours. Once it shows up in your account, no one else can get it from you. If you’re a merchant, you don’t have to worry that the customer will call the bank say, no, no, no, I didn’t make that charge. It’s a really big difference to think you maybe have money and to know that you absolutely have money.  With Bitcoin, within 10-30 minutes, you know you have the money. You can walk away. You never have to see that person again, and you can go and spend it. You don’t have to keep as much of a buffer in your account. 

You also don’t have to worry about your bank going out of business.  If your bank goes out of business now, eventually, you’d get your money back with insurance but there would be a big delay. An advantage with Bitcoin is that there’s no trusted third party who, if they go away, will cause you to lose money. The fundamental backbone of digital currency is a ledger that keeps track of who has what. As long as your money is on that ledger, and as long as the whole system hasn’t broken, that’s your money. You don’t have to trust anyone to give it back to you. So those are security positives.

What are the dangers of digital currency?

If you haven’t entrusted a Bitcoin company to help you keep your money secure, then there’s nobody to complain to if things go wrong and there’s nobody to give you a refund if you make a mistake. Say you lose your password for the money, the security key. The money in principle is completely gone. Or if you ask a computer program to do something with it and that computer program goes haywire, you’ve lost your money. There aren’t as many protections for consumers. 

You can protect yourself by not keeping lot of money in your online wallet. You could have two wallets — an offline wallet where you keep physical copies of numbers — and an online wallet which you keep on your laptop. That way if your laptop crashes or someone hacks it, they’ll only get what you have online. That’s what bigger Bitcoin businesses do to avoid the threat of being hacked. They copy down the passwords, don’t store them on a computer, and then only put them back on a computer when they’re ready to use them. So there are ways to protect yourself, but there are also lots of ways to screw up.

Firms can provide you protection — for instance, a company could keep the backup of your key — but then you have to trust the company won’t lose your key or let it get stolen. So there’s a tradeoff for consumers. Who do they trust? If you trust yourself more than anybody else, you have the option to keep money without interacting with any third party. But if you think that it’s more likely you’re going to lose your key and have your computer crash and not have a backup, then you might prefer that the company keep track of your key and passwords. There’s no one best answer for consumers, but in principle, if you choose the path that has the least trust of companies but the most trust of yourself, you could lose money very quickly. You could lose your keys or get malware on your computer that could somehow observe your keys and empty your digital wallet. In both cases, you wouldn’t have any protections. But the neat thing about digital currencies being programmable is that there are also technological solutions to those problems.

For example, another application of smart contracts is what you might call multisig. It used to be that if a company was going to write checks, the president and treasurer had to sign them to help prevent embezzlement. Nobody does that anymore. People don’t use checks now, so multisig has gone away. But for digital money, you could have a program that refused to take money out of your wallet unless two people both put in their passwords,  and that would help prevent someone from stealing all your money by stealing your key or hacking your specific computer. Another risk for consumers was, suppose you had $100,000 in your digital Bitcoin wallet and people knew you had a lot of Bitcoin, someone could come and hold a gun to your head and ask you to empty your digital wallet. If you did empty the wallet, there would be no bank to refund your money and no good way to trace where your bitcoins had gone if the people were very smart about laundering the bitcoins quickly. So it would be dangerous if you walked around with access to a phone that had $100,000 in bitcoin and people knew that about you. The protections against that would be, first of all, not walking around with the key to $100,000, and second, if you have large amounts of holdings, using these technological add-ons like multisig.

What are the main hurdles to getting digital currencies widely used?

There are really two hurdles. The first is figuring out the use cases and finding applications that create enough value to all parties in the transaction that it’s worthwhile to them to use the new technology. It takes time and a little bit of money for me to send money from my bank account to yours, and there’s some fees to sending money internationally, but I can do that today. So the question is: does this new technology help me do something enough better that I’m willing to adopt it? 

In some of these cases, there are network effects. If we want to split money for a cab, we both need bitcoin in order for us to split it using bitcoin. So far, there’s not enough adoption where it’s useful for that circumstance. Merchants would love to have an alternative to credit cards because they pay fees, but consumers pay the same price whether they use cash or credit card. And high-end consumers get rebates when they use credit cards, as well as a whole host of consumer protections. There’s not a lot of reason for consumers to switch away from their credit cards. So the first hurdle is just you have to create value for all parties, which hits against network effects: If you want to send money to your friends, they have to have bitcoin too, and if you’re going to use it for payments, both the merchants and consumers have to want it. 

The second hurdle is that the regulatory framework hasn’t gotten worked out. A lot of Bitcoin businesses are trying to get going, but they have trouble getting banks accounts, because banks are afraid they’ll get into trouble for banking Bitcoin businesses. A lot of Bitcoin businesses are cash only or pay their employees in bitcoin because they literally cannot get a checking account to write paychecks.  Why is that? Because the rules are not entirely clear for how a Bitcoin-based business can comply with the law, or for how a bank can comply with the law and regulation for banking a Bitcoin business. Because of that uncertainty, it’s too risky for a bank to open an account for a Bitcoin business. You only make a small amount of profit per customer, and if that one customer is going to cost days of legal expenses plus the risk of a major regulatory intervention, it’s just not worth it for the bank. So the existing financial services industries are afraid to support the new digital currency ecosystem. The sooner the regulations are clarified, the sooner the businesses will be able to plug into the existing financial system.

Going back to the point about credit cards and network effects, Apple Pay is linked to your credit card. If it takes off, consumers will become even more dependent on their credit cards.

When starting payment platforms, there’s a chicken-and-egg problem. You need consumers to get merchants, and you need merchants to get consumers. The way that Apple Pay is organized made it easy to enter at large scale because consumers already have credit cards and merchants already accept them. Eventually, Apple, like everyone else, would like to cut out the credit card companies and work directly with merchants, but that’s a very difficult way to start. Another interesting thing is that merchant associations are trying to create their own payment system that would eliminate the banks as a middleman. 

Are you talking about CurrentC? But a lot of people said it wasn’t user-friendly because you need to open an app — it’s not one-touch or biometric.

The merchant solution solves the merchant aspect of the chicken-and-egg problem, but it also needs to attract consumers. If it’s a poor user experience, then it won’t succeed. But since credit cards are not very friendly to merchants, the merchants would rather find a way to bypass them but they can’t because so many consumers use them. What you’ll see over the next couple of years is a lot of firms trying to compete with credit cards, bypass them or start new payment systems. Some of them might start out using credit cards initially but hope to bypass them. 

Some other examples of that strategy would be Paypal when it entered -- it ran mostly over credit cards. Consumers would pay with credit cards but they made it possible for small merchants to accept payments. It came in and said, we’re going to have digital money and displace the credit cards and make it easy for individuals to send money between each other. They built on top of credit cards, but their ultimate goal was for everyone to have Paypal balances, so if two people with Paypal balances sent money to each other, they would never have to go through a bank or credit card company. They would just keep an internal spreadsheet within Paypal without costs or delays or anything. Square had a similar strategy. Both Paypal and Square had the aspiration to ultimately cut out the credit cards, but neither of them succeeded.  Paypal never got its costs down as low as it had hoped. It’s very difficult to compete with credit card companies.

But Paypal also accomplished some things. It allowed small companies that had been priced out of accepting online payments by the credit card companies to enter the ecommerce market. So it basically enabled ecommerce for hundreds of thousands of entrepreneurs, and that’s really exciting because it allowed a much wider range of individuals to participate in the internet revolution. 

It also made a lot of other things very easy. If you wanted to collect raise money with your marathon or send a little bit of money to the Red Cross — activities where you don’t actually want to do a wire transfer or expose your bank details with a charity you just read about on the Internet that could be a scam — Paypal allow you to make these small payments safely and cheaply. Now, could banks could have provided those services before? Could credit card companies have charged lower fees to small businesses? Sure, they could have. But they didn’t. It took Paypal’s entry to make those things happen.

I think about digital currency in a similar way. When I tell you about the things digital currencies could do, a lot of them could already be done or are too expensive with current prices. Competition from digital currency will help bring the fees down and enable even smaller things to happen, even smaller micro-payments or transactions that need to happen more quickly or among a wider group of people because Paypal doesn’t work in every country and the fees can be high for certain countries. So digital currency will do what Paypal did, but on a larger scale in a larger set of use cases. It will expand the market to include a much wider set of market participants and they’re going to do things they couldn’t do before. Now we’re waiting to see what are these high-frequency, low value, international types of transactions, and which will be most valuable. 

Be sure to catch Part 1 of the Q&A with Susan Athey, on how digital currency could transform our lives, and Part 3, which explains how MIT students, the poor and criminals will all benefit from Bitcoin.