When people ask about what is backing Bitcoin, they’re asking because they expect money to have a mechanism built in by which you can go to a government building and swap your currency with something of value. Or else, what does the expression ‘it’s back by the US government’ mean?
In the case of the US dollar, which is created and governed by the US Federal Reserve and its board of governors, it is backed by the collateral (an asset used to secure a loan in the case of inability to repay the loan) on the books of the Federal Reserve. So what collateral does the Federal Reserve have in its accounts that give value to your US Dollars and why/how does this give value to your Dollars?
The Federal Reserve creates new US Dollars by purchasing assets from its Member Banks (banks that are associated with the Federal Reserve) and paying for these assets with newly printed Dollars (really they just add zeros to the account’s balance sheet on a computer). Most of the collateral is made up of US Treasury bonds that have the value of what will be repaid to the bond owner from the US government and now (since 2008) mortgage backed securities purchased from banks in distress.
An example of this: a bank has US Treasury bonds, just like the ones you can purchase. The Federal Reserve, looking to inject new US Dollars into the economy, will purchase those bonds. It does this by increasing the supply of US Dollars. If there are $1 billion USD currently in circulation that the Fed has created and the bonds are worth $1 million USD, the Fed will take the $1 million USD worth of US Treasury bonds and in turn increase the account balance of that bank by $1 million USD. Yes, those Dollars were not transferred to the bank’s account from somewhere else, the Fed has the authority to purchase assets from Member Banks with Dollars that did not exist before. Now there are $1,001,000,000 USD in circulation. Therefore, while there are $1 million new USD in circulation created by the Fed, the Fed also has $1 million USD more of assets on its books it could later exchange for USD. If it wanted to remove USD from circulation, it could sell some of these assets to a bank and accept USD, which it could then burn and remove from circulation.
During the 2008 mortgage crisis, the Fed, as part of the economic rescue program, purchased hundreds of billions of USD from banks in distress, accepting these mortgage bonds and paying for them with newly printed USD.
However, this explains where ~15% of all USD in circulation come from. ~85% of circulating USD that you use are created by private banks. The process that creates this new money is called fractional reserve lending.
When you deposit $550 USD in your bank, the bank is allowed to lend up to 90% of your account. Your bank may take up to $495 of this money and lend it out to other people or businesses looking to borrow money. Let’s say all loans are paying 5% interest. The bank is now taking money from its client and making a 5% annual return on it after banking expenses. Its cost of capital is whatever costs it takes to convince you to deposit your money, whatever interest it pays you, and whatever costs are involved in handling the money. However, banks are also given a special authority by the Federal Reserve: they can also create new money backed by collateral.
An example of this: your bank lent your $400 to Phil for a home mortgage. Phil must now pay the bank back those $400 plus the interest owed. The bank now has an asset, the money owed to it by Phil, on its books. The authority given to the bank allows it to lend 90% of the collateral to someone else.
Let’s say Ann requests a car loan for $300. The bank will credit her bank account $300 based on the collateral it has with Phil’s mortgage payments.
Then, Sarah requests $100 to pay for her new home. The bank will credit her account to pay for the home based on the $300 Ann owes it.
This can go on and on until either the bank doesn’t find new loan requests or isn’t interested in lending more. However, this process created $300 new USD based on the $550 you deposited in your account. If you decide to withdraw money, the bank needs to ensure it still has 10% of its clients deposited money somewhere on its books in cash. If it doesn’t, it needs to borrow money itself to meet its obligation to the Federal Reserve rules.
An example of where this went wrong: in 2008, as the value of the mortgage bonds the banks were using to create new money become worth less or worth almost nothing due to delinquency in people not repaying their mortgages, these bonds no longer were worth what they originally had been counted on to print new money. Therefore, the banks were not meeting their 10% reserve obligation on loans made based on these bonds as collateral. They also were much more exposed as this system of creating new money multiplies the risk of the banks if the collateral becomes worth less. When the bank creates new money from thin air, it also needs to eventually close that out with money from somewhere. The money your bank lent out to Phil, Ann and Sarah came from your bank account. It owes you your money back. If it lends out all your money and loses it to defaults, then your money is gone and now you are poor. Realistically, in the US, the FDIC would make you whole if the bank was not able to return you your deposited money. However, the FDIC gets its money from taxpayer money, which would end up costing the nation in one way or another. The Fed’s method of salvaging banks with bad loans was printing new money out to purchase those bad loans from the banks so they could have the USD to make their depositors whole and not leave them with an empty bank account (this is Quantitative Easing, in one sentence, by the way). Overall, though, a widespread event where lenders aren’t repaid would cause the value of the money backed by the loans to lose their value in a significant way. If the loans used as collateral to create the money aren’t working, then people will be more reluctant to accept that money for their goods or services.
So what is backing Bitcoin?
Bitcoin can be used as money because it can easily be transferred, is standardized, has a secure system of creation so someone cannot multiply the supply of it and dilute its holders, and people have given it a value. People’s faith in Bitcoin is primarily driven by the fact that its inflation rate is programmatically set. While the Federal Reserve tomorrow could decide to purchase every asset on the face of the Earth and credit everyone’s accounts for their assets, multiplying the supply in a significant way that would devalue your own USD, Bitcoin’s protocol sets a finite amount of new Bitcoin that can possibly be created every month. Someone who understands the protocol can precisely tell you how many more Bitcoin will exist in 2020 based on how many there are now and how many the protocol will allow to be created by 2020. Nobody can tell you how many USD will be in circulation in 2020. The other major aspect of Bitcoin that allows it to function as a money is its acceptance as money. If nobody accepted Bitcoin for anything else, then nobody else is going to accept it either as a currency. As a shop owner, you aren’t going to give someone something of value from your shop in exchange for something that nobody else is going to accept from your later on. If the pizza shop owner cannot pay for pepperonis with Bitcoin, he won’t accept your Bitcoins for the pizza. However, it is also because people will accept Bitcoins that others accept Bitcoins (initially for illegal activities like purchasing drugs, now far more universal in its acceptance, with an increase in its price to reflect this).
In Venezuela, for example, it would be wise to accept Bitcoins rather than Bolivars as the Bitcoins you receive for your pizza may fluctuate 10% overnight but your Bolivars will likely lose 95% of their value overnight. If your Bitcoins lose 10% of their value, you can only buy 90% of the pepperonis but with Bolivars you will only be able to purchase 5% of the pepperonis. In the US, the USD has become diluted to 25% of what they were worth in the 1970s. This is more stable but still is damaging to thrifty savers interested in holding wealth in money.
What about the rest of us?
Why are banks allowed to print the money we use out of thin air and make money on it by lending it out? The reasoning would be that banks are regulated, controlled and audited. The Federal Reserve and other authorities regularly review banks to ensure they actually have the collateral they claim they do backing the USD. The banks are governed and staffed by people that understand how lending works and how to manage the risk of lending to several people that will pay back their loans. On the other hand, as financial downturns show us, these mechanisms have their major faults. Loan officers can be corrupted or malincentivized. Shareholders are seeking greater volume of business rather than proper vetting of risk. Regulators cannot scale their operations to properly review enough of the financial market to know whether rules are being followed.
Currently, if you tried, you may be able to ask a bank for a new loan based on collateral in the form of a loan you have given someone else. If they approved it, you would be using the bank to print you out new money based on your assets. The bank is in essence regulating you since they are regulated and need to make sure this loan to you is secure.
The main project in the blockchain space moving in the direction of solving this issue is called MakerDAO. On their platform, you can mint new tokens called Dai by locking up collateral in a digital, on-chain smart contract. The minimum reserve requirement is governed by a network of MKR token holders who vote to decide what the requirement should be. The requirement is currently set at 33%. If you end up not meeting this requirement, someone can come along and close out your contract, liquidating your assets and taking a share of 15% of them. Since the contracts and transactions around them are all on a public blockchain, you can see the information on them no matter who you are.
This is intended to keep the Dai tokens pegged to USD and worthy of being used as money. This means they can be lent out. If someone is looking for a car loan, you can lend your new Dai tokens to them with an interest rate. Once you agree to the loan terms and tokenize the debt (you receive a token for your loan which gives you access to the repayment over the time of the debt), you can use this token as a form of collateral to lock up it up and mint new Dai tokens. These Dai tokens, in turn, can also be used to lend out and make a return on your money. In this way, with the 33% reserve requirement, you can print 1.7x in Dai tokens to the value of the collateral you originally placed in the smart contract. This multiplies the amount of money you make lending from the money you originally had. For this service, MakerDAO as a platform currently charges 2.5% per year on its smart contracts. This amount is paid out to the MKR token holders at the closing of the smart contract.
A potential (and likely) attack vector is to debase the peg to USD with a significant short on the position and sell-off of Dai to break the orderbook price away from one USD. This would be similar to George Soros’s move against the Bank of England and the Thai Baht. It’s widely accepted in circles of economists that pegging currencies to other currencies, unless substantially collateralized with the currency being pegged to, eventually fails. Unless the supporter(s) of the currency being pegged has enough currency of the currency being pegged to, someone can eventually knock it off its peg and cause a crash in the price of their currency.
So far, MakerDAO has not accepted any other form of collateral other than Ether, the native token of the Ethereum blockchain on which it runs. However, this still allows you to hold onto more Ether than you otherwise would have (2.7x as much), which can be used to make more money on speculation if you think the price of Ether will increase relative to another currency you value. It would also work for you if you are lending Ether to others and earning a good risk adjusted return on those loans.
