Bitcoin confounds the Fed’s understanding of digital currencies

Economists at The New York Fed just realized that the old definitions of currencies don’t apply to Bitcoin.

The Fed thought it had it all worked out when it came to digital currencies. There are “account-based” digital currencies, where systems verify accounts (like inter-bank transfers) and “currency-based” systems, where vendors verify currencies, like dollar bills or Fortnite’s V-Bucks.

Then Bitcoin came along and muddled everything up, economists from the Federal Reserve Bank of New York complained in a blog post yesterday. 

Bitcoin and the hundreds of other cryptocurrencies that use public-key cryptography constitute both an account-based system and a token-based system. This is “problematic,” grumbled the Fed economists. 

First, Bitcoin is an account-based system. “The account is a Bitcoin address, and the private key is the proof of identity needed to transact from that account. Every time a Bitcoin user wants to spend Bitcoin, that user must verify their identity by using their private key.” That’s just like bank transfers, which rely on the bank’s ability to verify the identity of the account holder. 

Second, it’s also a token-based system: “When someone wants to spend a Bitcoin, the protocol verifies its validity by tracing its history. The current transaction history is used to verify the validity of the ‘object’ being transferred.” Just like cash, which “is only valid if it is genuinely issued from the central bank.” Or like Fortnite’s V-Bucks, issued by the game’s publisher, Epic Games. 

The Fed’s minds, upon realising this, blew up. The distinction is often raised when discussing how to create a state-rolled digital currency, also known as a central bank digital currency or CBDC. But Bitcoin proves that two seemingly-contradictory ideas can be true at once; the rules that guide those conversations are broken. Kaput. 

“If a digital currency can be both token-based and account-based, then the classification loses its power to meaningfully distinguish between new and existing methods of digital payments,” they said.

They implored that clinging on to the distinction may “slow down progress” when understanding different digital payment technologies. In a huff, they concluded: “Perhaps these terms should be retired to avoid further confusion.”