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Global Rates & FX Research

11 February 2014 John Normand (44-20) 7134-1816 john.normand@jpmo rgan.com

cases, users value the medium because employing it is more efficient than bartering. A

unit of account

is a way of measuring value from a common reference point , thus also facilitating commerce because goods can be compared more easily. (Recall the euro’s usefulness in this regard since now prices in E urope are comparabl e across 18 countri es.) A

store of value

is just a way of holding wealth until it is exchanged for goods and services or lent or given to someone else.

For centuries p recious metals , or paper curren cies conv ertib le int o metal at a fixed ra te, serv ed these thre e functions.

But follow ers of financial hist ory know the limitation of a system based on a fixed or slow -growing money supply: it imposes uncomfortable financial discipline on governments, households and corporates. Hence the progressiv e debasement of pure gold coins wit h alloys; the global abandonment of the gold stan dard during the financial strains during World War I; and the US government’s suspension of the dol lar’s gol d conve rtibility given fiscal and balance of payments pressure from the Vietnam War.

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Today most countries employ fiat currencies, or paper and coins with no intrin sic worth whose perceived valu e stems from government declaration

(or fiat

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)

and collective belief.

The government creates demand for a currency by declaring it

legal tender,

meani ng it mus t be accepted as payment for all debts and it will be used in any transactions between the government and other agents. Consumers and corporates accept this fiat currency because it is a requirement for settling all debts public (paying taxes) and private. The government attempts to guard the value of money by mai ntai ning a monopo ly on its prod uctio n to avoid counterfeiting, and by establishing a central bank with a mandate to manage its supply respon sibly over time. While thi s syste m may sound like blithe existence in The Matrix, this relationship amongst government, central bank, households, corporates and fi at cu rrencies is mu ch mor e efficient than an alternative like barter. It also makes macroeconomic shocks much easier to manage than an alternative like the gold standard (recall the deflation of the Great Depression and more recently peripheral Europe).

Bitcoin as better money

Bitcoin proposes an alternative, however.

If – desp ite their mandates – the world's biggest centra l banks risk inflation and currency debasement via the rapid expansion of their balance sheets (chart 3), and if even European

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Foreign exchange market participants should celebrate this day in August 1971, since it led to the collapse of the Bretton Woods system of fixed exchange rates and the advent of floating currencies.

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The Latin command meaning "let it be done".

Chart 3: Amongst the G4 economies, only the ECB’s balance sheet is shrinking

Central bank assets in the US, Euro area, UK and Japan indexed to 100 in 2006

Source: J.P. Morgan

governments still impose capital controls (Cyprus), couldn’t a non-state entity more responsibly supply a fiat-like currency to the world? And if this currency were created and exchanged digitally amongst peers of consumers and corporates, it would have the additional advantage of avoiding the fees imposed by financial intermediari es as well as the loss of privacy inherent in third-party payments systems.

Hence the purported appeal of a virtual currency:

a medium of exchange, a unit of account and a store of value without the alle ged recklessness, capriciousness, siphoning and snooping inherent in traditional systems. Even leaving aside this caricature of bitcoin's underlyi ng philosophy, there is something compelling about the idea.

Simple in th eory, but more compl ex in practice.

Consider the infrastructure of a traditional monetary and payments system to highli ght what bitcoin attempts to replace. A traditional financial system is a national network comprising a central bank owned by a government, which creates money by physically printing currency and minting coins, or by electronically creating bank reserves

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. That money is used by households, consumers and the government to facilitate trade and investment via a payments sy stem of banks and other financial intermediaries (think PayP al, Visa, Western U nion and in some countries, the post office). Financial intermediaries provide numerous services of varyi ng complexity, but their role in the payments system is simple: verify that Customer A has sufficient funds to pay Cus tomer B, then securely transfer ownership of that money between accounts. For

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Quantitative easing practiced by the Fed, BoJ and Bank of England created bank reserves (a liability of the central bank, just like cash) to purchase financial assets, thus boosting money in circulation.