Here's why people will keep their Fedcoins in banks
In my previous post I explained why Fedcoin—the idea for replacing dollar bills with a blockchain-based cryptocurrency like Bitcoin—is completely compatible with fractional reserve banking. Much of the discussion of Fedcoin has assumed that
- The Fed would start administering "accounts" for private individuals (they currently only administer reserve accounts for banks)
- Most people would prefer to use their Fed account as primary deposit accounts instead of using private banks.
I think both premises are wrong.
I suppose, in principle, the Fed could start administering deposit accounts for private citizens, but I don't see any reason they would do so. This argument is non-unique—the Fed can already do this if they really want to, and the introduction of Fedcoin doesn't substantially alter the difficulty of doing so. Online-only banking already exists, even without using any cryptocurrencies.
Given the choice between wiping out the entire banking industry and not, my bet is that the Fed will choose not.
The notion of "accounts" or "digital wallets" or "deposits" do not appear anywhere in the blockchain protocol. Raskin and Yermack (2016) seem a bit confused on this point. They say:
The blockchain is known as a "shared ledger" or "distributed ledger," because it is available to all members of the network, any one of whom can see all previous transactions into or out of other digital wallets.
And their fear that an individual's entire "digital wallet" is discoverable through the blockchain underlies John Cochrane's post lamenting the privacy implications of Fedcoin. Although the blockchain does pose some privacy challenges, Raskin, Yermack, and Chochrane overstate the problem. In fact, digital wallets are not part of the blockchain and cannot in general be reconstructed from it.
The exact technical details are beyond the scope of this post, but I think Raskin and Yermack have confused the concept of blockchain "address" with "digital wallet." Addresses are not like bank accounts—an address is really just a fancy word for a serial number, analogous to the serial number printed on each dollar bill in your wallet. Each serial number is cyrptographically related to a different number called a private key, which what you use to authorize the transfer of the bitcoins associated with that serial number to a different serial number. This transfer from one serial number to another serial number is the only information recorded in the block chain. A digital wallet is third-party software that can generate serial numbers and manage their corresponding private keys automatically on your behalf. Importantly, there is no way, using only information in the blockchain, to tell which serial numbers are being managed by which digital wallet—these are totally separate systems.
That's not to say there's no privacy concern. In a Fedcoin world, your employer would pay you by transferring Fedcoin to a serial number you control, and which you communicated to them. Thus, your employer knows that that serial number belongs to you, and they can see that serial number in the blockchain. If you then spend those Fedcoins at a porn shop, for example, and your employer also happens to know what serial number the porn shop is using to accept payments, then your employer would be able to see in the block chain that you spend your paycheck at a porn shop. But at the same time, you can anonymize your transactions pretty easily. For one, after you receive your paycheck from your employer you can transfer those Fedcoins again to serial numbers your employer doesn't know about. The employer would only see that the money was transferred—you might still have them, or you might have deposited them at a bank, or you might have spent them on rent and groceries, no one would have any way of knowing. But also, stores would most likely use different serial numbers for each transaction, so in practice the above scenario—where the employer knows which serial number the porn shop will use—wouldn't ever happen. (As an aside, note that depositing your Fedcoin in a bank enhances privacy!)
Fedcoins are not inherently anonymous, but completely anonymizable. Expect this to be a major topic from now on.
As mentioned above, to control you Fedcoin you need to retain secret private cryptographic keys, and normally you'd manage those keys with software called a digital wallet. Your digital wallet would then be secured by a password, which is up to you to remember. But humans are notoriously bad at passwords. We pick passwords that are easy to guess, but then forget them anyway. We reuse passwords accross multiple services. Many of those services fail to properly secure those passwords, leading to data breaches. We never change those passwords, unless someone makes us. And that's just password-related risk you incur by having Fedcoin in your digital wallet. You still have all the same physical risks as you have with paper-currency. If your digital wallet is stored on a harddrive that fails, you can lose your fed coin that way. Cloud storage can fail too, no matter how many times a day it gets backed up—all it takes is one poor architecture choice and one typo by a programmer (I've seen it happen). Your Fedcoins are not fire proof. Not necessarily water proof. Not even magnet proof.
With a traditional bank, our inability to secure our online lives doesn't cause too much mayhem. Banks have experts to secure their computers, and employ sophisticated fraud detection software that can freeze accounts before much money has been spent. They insure us from fraud and offer us ways to recover our accounts even when we forget our password. They accept your actual in-the-flesh person as proof enough that you are who you say you are. But Fedcoin does not come with any of these protections. Unless you put your Fedcoins in a bank, you are on your own to secure your private keys and if someone should find a way to hack them and spend your Fedcoin, there's no way to ever reverse that transaction or to find the crooks who stole them. If you forget your password for your digital wallet, there's absolutely no way to ever recover those Fedcoins. Indeed, in the case of theft or forgotten password, there wouldn't even necessarily be a way to prove that those were your Fedcoins that were stolen or lost—the lost private keys themselves are the only proof with any credibility in the blockchain world.
All of this is to say that while large sums of Fedcoin are cheaper to store than cash, they are by no means any safer. For this reason, most consumers will continue to prefer to keep their Fedcoins secured by third party institutions, which force us to use proper security in exchange for insurance against liability.
In principle, these institutions need not be depository banks—consumers could instead pay a maintenance fee. However, consumers tend to be significantly averse to fees, and they will almost certainly opt instead for institutions that make money by lending those Fedcoins out, like banks, instead of paying maintenance fees on their balances. In a world where Fedcoin pays interest, banks would need to compete with interest-bearing money and so we'd probably see banks start paying out higher interest rates on deposits. If their returns on lending out a fraction of those deposits are high enough, banks might even match the amount of interest the Fed pays on Fedcoins. However, my guess is that in practice consumers would be willing to accept a lower rate on their deposits—a premium for the insurance against various kinds of risk Fedcoin incurs.