Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 6 - Evidence - March 27, 2014


OTTAWA, Thursday, March 27, 2014

The Standing Senate Committee on Banking, Trade and Commerce met this day at 10:30 a.m. to study the use of digital currency.

Senator Irving Gerstein (Chair) in the chair.

[English]

The Chair: Good morning. Today, the committee is holding its second meeting as part of its study on the use of digital currency. As part of this first stage of hearings, the committee is exploring the concept of currency and digital currency generally.

Yesterday, we received a presentation from senior officials at the Department of Finance. During the first hour of today's meeting, we will be hearing from economic historian Dr. Warren Weber via video conference, I believe from Minneapolis, sir.

Warren E. Weber, Economist, as an individual: I'm in Atlanta.

The Chair: Still south of the border.

Dr. Weber has held several positions in public service and academia, including most recently as Senior Research Officer with the Federal Reserve Bank of Minneapolis. Dr. Weber has written extensively on the use of private currencies during the free banking period in the United States and the creation of government-issued currency and was recommended to us as a witness by the Bank of Canada based on past working relationships.

Dr. Weber, thank you very much for accepting the invitation to appear before us.

The floor is yours, sir.

Mr. Weber: I very much appreciate this opportunity to give a presentation to you. This is a topic that's near and dear to me. I've been working on it for the past 30 years.

If you will turn to page 2 of the presentation, I think there's a great deal that can be learned from the past, even though the institutions and technologies have changed a great deal since then.

The case that I am going to talk about today is the case of state banknotes, and these were used as the predominant media of exchange in the United States prior to 1860.

A little bit of institutional detail that's not in the notes is that the banks, during this period, were state-regulated. There was no federal regulation of banks. There was no central bank in the United States at that time, and branching was very limited. Only a few states permitted any bank branching. If bank branching was permitted, it was limited to the state in which the bank was going to exist, and that meant virtually most of the banks in the United States at this time were single brick-and-mortar institutions.

Each of these banks issued something called a ``banknote,'' which looks very much like the currency we have today, but these banknotes had many of the characteristics of privately issued e-money that we think about today.

If you will now turn to page 3, the similarities are that these are bearer instruments, just like currency is today and just as when we talk about e-money, people think it will be a bearer instrument. They were denominated in dollars, and they were liabilities of the issuer. These state banknotes were redeemable in specie — that's monetary history jargon for gold and silver coins. They were redeemable in specie on demand. Each bank was issuing its own notes. These notes were very distinct. You were easily able to recognize what bank issued it. It stated very clearly on them that they were redeemable in dollars on demand.

The differences between these and what people think of as e-money today are that these could be issued for credit. You could go into the bank and ask for a loan, and the bank would give you state banknotes in exchange for the piece of paper you signed. Unlike e-money, no accounts were required at the issuer or the receiver of the e-money. None of those accounts were required for this exchange to occur. In other words, no record-keeping was necessary with these state banknotes, whereas such record-keeping is going to be required with any e-money that comes into existence.

If we now turn to page 4, I'll give you some idea of how many of these state banknotes there were. There was a large number of banks, and each of these banks issued their own distinct notes. There were 320 banks in 1830; there were 602 banks in 1845; and the number of banks in 1860 had risen to 1,400.

Think about it. We have a country of the United States in which there could be as many as 1,400 different currencies circulating at the time. I think there is good evidence that they were widely used as media of exchange. One piece of evidence is I've done an extensive study of the balance sheets of the banks during this period, and for virtually every one of them there's an item listed of ``notes of other banks''; so in their normal course of business, banks have been accepting the notes of other banks, probably to pay off loans.

There's other evidence that they circulated outside the local area. I actually have a couple of notes I've collected, and I can see stamps on them that indicate they have been used outside of the local area. There were publications during that period called Bank Note Reporters and Counterfeit Detectors. They were published by brokers in various cities, and these publications listed every bank that was in existence at the time and the rate of exchange of the notes of that bank for notes of banks in the local area.

I think there's good evidence that these were widely used. They were the predominant media of exchange. Most of the gold and silver coin in existence during that period was in the vaults of banks to be used to redeem notes if they were presented for redemption.

This banknote system had several significant problems: counterfeiting, losses to note holders, which I have called default, and nonpar exchange. I put that in red because I think that may be the issue that people would see as most problematic. But as I mentioned, by 1860, there were 1,400 of these banks. Basically you had a system in which there were 1,400 exchange rates, which were floating. They were not fixed. What I mean by ``non-par exchange'' is that a dollar in one location didn't necessarily exchange for a dollar in a different location during that period.

Turning to page 6, I would like to go through these problems one at a time very briefly.

As you probably guessed, when I said there were publications out there called Bank Note Reporters and Counterfeit Detectors, counterfeiting of state banknotes was widespread. In these privately issued Bank Note Reporters and Counterfeit Detectors, on the first page of them would be a list of the new counterfeits that they had discovered since the last publication. These publications were coming out in some cases weekly but in most cases monthly.

As you got later into these listings of the banks that were in existence in one of these publications, underneath each bank they listed all the known counterfeits of the banks at that time, and you could almost tell how long a bank had been in existence by how long that list of counterfeits happened to be.

In terms of today and e-monies, I would expect that some type of information system about counterfeits would arise. I am thinking a little bit in the past where if you went into a store and handed in your credit card, they might have hauled out a publication that listed all the stolen credit cards or the possibly fraudulent credit cards. I expect some type of information system like that about possible counterfeits of e-money would arise.

I would also expect, though, that with point-of-sale terminals they could deal with the counterfeiting problem much better today. I think it might be an issue with e-money, but I don't think it's going to be a big one. In any case, I think it's going to be an issue for legislation in terms of enacting penalties for counterfeiting or hacking, how many funds are allocated to enforcement, things like that. I don't think this is really a problem that's best addressed by bank regulators.

Turning to default on page 7, there were defaults and losses to note holders with the state banknotes, but I think this is going to be a problem with any privately issued fractional reserve money. I expect that e-monies, if issued, are going to be fractional reserve instruments.

Safety was a very serious problem. As I said, I have done extensive research, and I have come up with 2,384 banks that were in existence at some time during this period, and up to 407 of those, or 17 per cent, failed with possible losses to note holders.

Another way of seeing the seriousness of the problem is that if a bank closed during this period there was about a 50 per cent chance that the note holders of that bank were going to suffer some loss as a result of that bank closing. Some of these losses got as high as 90 cents on the dollar. Most of them were less than 50 cents, but still those are pretty significant losses to take.

What are some of the possibilities that this experience suggests for regulating e-monies? If we turn to page 8, one possible regulatory solution for default would be to require 100 per cent good asset backing. Some states actually did try this. Some states required their notes to be 100 per cent backed by state bonds. These were the so-called ``free banks'' that were referred to in the introduction.

Not all of the banks during this period were free banks. In fact, most of them were not. The idea of free and free banking has nothing to do with laissez-faire. It really refers to the fact that some states passed laws that permitted free entry into banking. If a state did not have that kind of law, if you wanted to start a bank you had to get a special charter from the state legislature to set up your bank.

There were about five or six states that actually had extensive free banking systems, systems that required the notes to be 100 per cent backed by state bonds. One of these states, New York, actually had pretty safe notes, but most of the others did not. The problem was that the state bonds were subject to price fluctuations, and other than specie, there were really no safe assets to back these notes.

If you were considering requiring 100 per cent backing of e-monies today, it seems to me that what's going to happen is the result is going to be issuers charging transaction fees to the people who use them to make up for the lost revenue that they could get from issuing these if they didn't have to back them 100 per cent.

The other regulatory possibility, which I'm sure you've thought of, is that you would offer government insurance of e-monies. Actually, there are some interesting episodes in this earlier period. Some states actually did offer banknote protection. Nominally the protection was 100 per cent of notes, but it didn't work out to be that way. The reason that it didn't was really in the laws themselves, and I don't have time to get into that in these opening remarks.

What I see the problem would be today is that it could exacerbate the too-big-to-fail problem with our financial institutions, that if a financial institution is issuing e-money, and it was government guaranteed, the e-money issuer could become more systematically important, and I think that would be a problem.

Let me turn now to page 9 and talk about non-par circulation. What I mean by ``par circulation'' is what I said earlier: a bank in one location would exchange a dollar with a bank in a different location. Non-par circulation means that doesn't occur.

It's slightly different from the issue of fixed versus floating exchange rates. Par circulation is fixed exchange rates at one-to-one. Just as an aside, I've added this bullet on page 9 about the problem of non-par circulation which can occur between any two monies or even denominations of the same money.

We are accustomed to saying, ``I can take a five-dollar bill and get it exchanged for five loonies, but you need some kind of mechanism to guarantee that that is the case.

Today we all have mechanisms, dealing with the Bank of Canada or your treasury stands willing to make those exchanges any time someone wants to, but if there was no entity standing there willing to do that, there's no reason why such an exchange should occur. In one case, they were pieces of paper with fives on them; in another case, just coins that happened to have a one on them.

With the state bank notes, if we turn to page 10, if we look at the data back then, in general the notes of different state banks circulated at discounts to each other and these discounts were time-varying.

To get around this, two solutions were tried during the period. The first solution was to set up a par clearing system, and there's a great example, one that I'm very fond of. It's called the Suffolk Banking System, and it was established in New York between 1825 and 1858. A bank in Boston called the Suffolk Bank established what I would call reserve accounts like the reserve accounts at the Bank of Canada or the Federal Reserve Bank. They established reserve accounts for each bank that was willing to join this system, and then they net-cleared member banknotes at par. So if you were a member of that system and you brought in the notes of some other bank that was a member, it would credit your reserve account with that number of dollars. If somebody brought in your notes, they would debit your account for the number of dollars that you brought in. Basically, all New England banks joined.

The result of this system is that the notes of all banks in New England circulated against each other at par. This did not happen anywhere else in the country.

I think there are two regulatory lessons that come out of this, or two e-money lessons that come out. One is that such a mechanism could be private. You don't necessarily need the government to set up this kind of par clearing system, and the system could arise endogenously; in other words, the government does not have to set it up.

Turning to page 11, there was a second solution, which I have labelled ``Required Acceptance.'' I've given you the names of two cases: the State Bank of Indiana and the State Bank of Ohio. They required their branches to accept each other's notes at par. These are kind of funny systems. They were called state banks and they were said to have branches, but really these branches were independent banks. They just decided to join something called the State Bank of Indiana system, but if you were a bank or wanted to be a bank in Indiana or Ohio and you wanted to be part of this system, you had to agree to accept the notes of any other bank that was part of the system. You had to accept them at par.

The reason I put ``accept'' in red is that all you had to do was take them as payment for paying off a loan or something like that. You did not have to redeem them. You didn't have to give out specie for another bank's notes, but you did have to accept them. The result is that the notes of all of the branches of Indiana and all of the branches of the State Bank of Ohio circulated at par against each other.

What do I take from these two experiences? I take that required acceptance can achieve par exchange. However, to get it, it's going to require some form of regulation. It's just not going to occur on its own.

Turning to page 12, what does this experience suggest about how to achieve par exchange? I think it suggests that a private par clearing entity could do it. There are a couple of problems. The first is that profits of the clearer may cause antagonism. The Suffolk Bank did have basically higher profit rates than any other bank in Boston or in New England at the time and that made a very large number of banks in that area unhappy about it. They were still members of the system because of the benefits, but they would have preferred that Suffolk had to distribute some of those extra profits to them.

The other problem is that they may not arise during this period. It only occurred in New England. It did not occur in New York or Philadelphia. It occurred nowhere else in the country and the question is why? So it may not occur.

Required acceptance could do it, but I see a couple of problems with required acceptance. One is that the e-dollars might pile up at certain issuers or certain locations. It's not clear that things are going to be balanced in terms of where these e-monies circulate, so if you're required to take someone else's e-money you might end up with a whole bunch of their e-money, and the problem is, how do you get rid of it?

I should note — and I have it in parentheses — this is not just a problem for e-money; it's a problem for Bank of Canada notes, for Federal Reserve notes. It's a problem with any currency system.

The third way you could achieve par exchange would be to set up a government clearing house. It would do it. I think there are questions here that have to be answered, which are, who is going to pay for it and how are you going to assess the fees necessary to set it up and keep it running?

My conclusion, on page 13, is that if I look at the state banknote system and I think about it in terms of e-money, what does it suggest? Can a privately issued e-money system operate efficiently? I think the answer from the experience of this period is that yes, it can, but it's going to require appropriate regulation and supervision. I think to minimize counterfeiting you're going to need strong laws and strong enforcement. For safety, you either are going to have to pass stringent backing requirements or you're going to have to have explicit — and I should have put in the word ``government'' — insurance.

I think that you might try to take the position that we will not bail out e-money issuers, but I think that when a crisis arises, you're going to find that the pressure to bail out and give people their means of payment back is going to be extremely strong. I would think that either you're going to need stringent backing or explicit insurance.

If you want to guarantee par exchange, you're probably going to have to step in with some kind of par clearing mechanism, either requiring the issuers to accept each other's instruments at par or else set up some kind of government clearing house.

That concludes my remarks.

The Chair: Thank you, Dr. Weber. It was an excellent presentation for us. We have a number of questions and just over half an hour.

Senator Tkachuk: Thank you very much for that presentation. I have just a couple of questions.

With all the banks having their own currency and at different rates, how did they make it useful in the community? In other words, how did a storekeeper or a person selling a piece of property decide on what currency to take? If someone brought currency from a different bank to purchase, how did they communicate what they thought the currency would be worth?

Mr. Weber: If someone was bringing in a note from a local bank, they probably took it at par. In other words, if something was priced for a dollar and someone brought in a dollar note, then that was fine.

If someone showed up with a note from outside the local area, then probably this merchant had one of these Bank Note Reporters and Counterfeit Detectors underneath his counter. He would pull it out and say, ``Ah, I see the discount is 5 per cent, according to this publication, so you'd better given me a dollar and five cents for that, or no transaction.''

If they did not have one of those, I don't know exactly how they figured it out. They made some kind of guess. Let's suppose this was a merchant in Philadelphia and someone came in with a note from Columbus, Ohio. My guess is that he would think in his head, ``Well, what am I going to do with this note? I'm probably going to take it and give it to my bank. How will my bank cut that note?'' Probably they'll try to figure out how expensive it's going to be for them to get it back to Columbus, Ohio, get some gold or silver for it and get it back to Philadelphia.'' They would do some kind of calculation like that.

What is interesting about reading these Bank Note Reporters and Counterfeit Detectors — and I'll give a plug to my website, through minneapolisfed; I have several thousand issues of these actually. What I'm surprised is how small these discounts actually were. In most cases they were less than a per cent, if it wasn't too far away. But they did vary and they varied a lot, over time.

Senator Tkachuk: The second question is more on the e-commerce currency. You mention counterfeit or hacking or requirements for insurance and that maybe governments would be involved. Should governments be involved at all? The governments already have a currency. We have our currency in Canada. The Americans have their currency. All countries have their own currency. If there is another currency that's out there, should we just leave them, let the buyer beware and let the risks be taken? Why would we be involved in insuring e-currency that has nothing to do with the currency that the government is backing with its own resources?

Mr. Weber: My answer to that is, there also are demand deposits out there, which are a medium of exchange that has nothing to do with the government, and yet we insure those. The reason we insure them is because when banks start to fail or there's a big chance of banks failing and people have a risk of losing a great deal of money because of that, there is a demand for the government to do something, to protect them.

The reason I think you're going to get involved with insurance is to put it in first so that you could set up premiums and all of that, rather than waiting for a crisis to hit, some e-money issuers get into trouble and now there's this huge demand for the government to do something, ex post.

Senator Tkachuk: The government asked the banks to pay for the insurance.

Mr. Weber: I would expect the government to ask e-money issuers to pay for that insurance.

My answer comes from past experience with demand deposits. I don't think a government can credibly commit to say they will not bail out e-money issuers and therefore put the insurance on.

Senator Tkachuk: Got it. Thanks.

Senator Massicotte: Thank you very much for being with us this morning. This is our second day of testimony on this issue and it's very interesting, but it's also something I'm not sure we fully understand.

You basically dealt with the currency history as it evolved in the United States. However, I want to go back to talk about the bitcoin and determine whether we understand it. Yesterday we were told there are approximately $8.4 billion of bitcoins in circulation in today's valuation, but a lot of that has been created from the fact that people who did transactions were incentivized to do transactions in bitcoin and therefore they were given that electronic currency. Therefore, most of that $8.4 billion is not backed by any hard dollars of any sort of currency, but rather a large part of the $8.4 billion is money created just for the system based upon algorithms whereby they are convinced you won't get a net retraction. They actually project that this will grow for the next 15 to 20 years and will nearly double in size based on some algorithm or re-projected use.

Having said that, if ever there was a net reduction of bitcoin circulation and the net withdrawal is significant, we could find ourselves with no cash available to convert because most of that is not real cash. There is no hard currency or gold or whatever backing up that deemed currency.

Is that a little bit like a Ponzi scheme whereby it's all very good when it grows but it will fall apart if it's reduced in size a little bit?

Mr. Weber: I don't claim to be a bitcoin expert. There is a fundamental difference between bitcoin and the state banknotes. As you point out quite correctly, bitcoin is not redeemable into anything. The state banknotes were redeemable into gold and silver coin.

The rest of your question is excellent. I'm not sure how bitcoin would get withdrawn because it is irredeemable. It's kind of like central bank money, like Bank of Canada notes or Canadian currency. It's not backed by anything. You're right, though, in that there's no regulator out there that will say all of a sudden we should have less of it in the system or more of it in the system because we want to achieve this particular monetary policy goal.

I think if it gets withdrawn from the system it will be withdrawn like Mt. Gox and the failure and losses there. I think there are some other cases, but I forget the name of the institution that also thinks it lost several billion bitcoin.

I really don't have a great answer to your question, but there is nothing in the experience that I know that would directly relate to that particular issue.

Senator Massicotte: You make comparison to currency in Canadian dollars or American dollars. In those cases you have a central bank or a government saying you can trust these notes. Yes, you've got countries like Argentina that publish a lot of currency and then you get inflation, but irrespective of it is the credibility of a country or a central bank saying you can trust it. That's why they were created. That's why the state bank currency as it exists is saying you can trust this. However, with the bitcoin, if I go to the store, there is nobody saying if I take a bitcoin I will be able to buy a television. It seems to me that if that occurred and for some reason the cash was not available at that store, you could see $8.4 billion crumble to nothing with just a news article saying, ``Oh, oh, lack of currency, lack of liquidity.'' There is no central bank supporting it and it could disappear overnight. Am I correct in saying that?

Mr. Weber: You're absolutely correct in saying the following: The reason bitcoin has value is because you think someone else will take it, and if that were to vanish, yes, bitcoin would have no value and that could happen any time.

Senator Massicotte: Much like a Ponzi scheme: When it grows you're doing well but if it retracts there are big problems.

Mr. Weber: Well, I'm not sure I would call it a Ponzi scheme, but I certainly think it's based people's expectations and on the idea that I take it because I think I can pass it on to someone else who will take it. If that expectation crumbles, yes, the whole scene becomes valueless.

[Translation]

Senator Bellemare: I speak French, but I will try to ask my question in English. It may not be completely clear, but I will speak slowly.

[English]

I want to know about the problem of parity in the clearing system, but I'm interested in the bitcoin problem. Yesterday we learned that you can exchange a bitcoin in a country at different rates. It depends on the clearing mechanism. You talked about this being problematic for the 19th century system, but now we have a lot of technology.

Could it happen that a clearing mechanism developed so that some people will buy bitcoins when it's slow and will sell them in Vancouver, or a kind of a speculative system so that parity with the bitcoins establishes very quickly in a country that uses the Canadian dollar, for instance? Do you have some comment?

Mr. Weber: That's a great question. It does relate to the system that I was talking about because you have the same possibilities for speculation with the state banknotes that you would have with bitcoin in two different locations. You would think that someone could take the notes of, for example, banks in Cleveland and take them to Philadelphia and get gold for them there and take it back, but this is costly. Especially back then, transferring gold was not safe. It took resources and time. The same kind of thing may keep exchange rates from being equalized in those two locations.

The other thing that I found, and we studied this, was a revelation to me at first. We took a look at what the discount was on Cleveland notes in New York and what the discount was on New York notes in Cleveland. You would think it was just the cost of transporting them and they ought to have been the same, but we found that Cleveland notes were going at a 5 per cent discount in New York but the New York notes were going at par in Cleveland. We were wondering why. If you are in Cleveland, getting a New York note is really good because you can take it to New York and there are a lot of things you want to buy in New York. If you're a New Yorker and you get a Cleveland note you won't find as many things you want in Cleveland. The one thing that may keep it from quite equalizing is how much you want to spend in that other location. There is more to it than simply transport costs.

Senator Bellemare: You're saying there is more to it than technology. If in a location in Canada bitcoins are not popular then this kind of equalization system could not grow by itself. It needs a market in every place.

You talked about ``too big to fail.'' We guarantee the financial system, the banking system, because it's important. From your historical knowledge, do you see a link between the popularity of e-money and the financial crisis that we had in 2007? Is it something that we have to think about, or is there no link at all?

Mr. Weber: That's a great question. Off the top of my head, I cannot see a link. The financial institutions back then were quite small. There were so many of them and they were very, very small. There wasn't the same concentration that there was in the 2007 crisis.

My comments about ``too big to fail'' really were if you have a large financial institution and they add this e-money capability to it, to me, they become much more systemically important because if they fail, all of this e-money could lose a great deal of value. So the pressure on government to do something would be much greater.

A very big bank, relatively big for Philadelphia, did fail in 1857, and there was no pressure there for any kind of government intervention except to punish the people who they thought had committed fraud, but no ``let's make everyone safe.''

Your question is a great one. It would require a lot of thought and research.

Senator Ringuette: I really appreciate the history that you have brought us. We're talking about bitcoin, but yesterday we were told of there is also litecoin, Linden Dollars, Liberty Reserve Dollars, Pecunix.

Senator Massicotte: As of 24 hours, there are Massicotte dollars for those who want them.

Senator Ringuette: There seems to be a proliferation of different e-currencies. Given that and the history and evolution that you described to us, would it not be wise for federal reserves of industrialized countries to issue their own e-money that would be backed just like the physical currency that we're using? Would that not be the next step, considering the history of banknotes in the U.S. that you have just indicated to us?

Mr. Weber: Once again, a great question. To the extent that people get accustomed to using e-currency, if the central banks want to continue to maintain the revenue that they get from currency, they will probably have to get into that business, yes.

Senator Ringuette: From your knowledge, is the Federal Reserve looking into this, sooner rather than later? Or should they, and should Canada?

Mr. Weber: From my knowledge, I don't know about the Federal Reserve system. I have heard that there are institutions in Canada that are looking into this. I know from my time at the Bank of Canada that they are actively researching the question of should the central bank or some other government entity get into the e-money business, but those are really deep, hard questions. Part of it is predicated on what you think will happen to the demand for the standard currency today if these e-monies start growing and become popular. As I said earlier, if they start becoming quite popular and heavily used and the actual demand and usage of Bank of Canada currency or Canadian government currency starts falling dramatically, then I think they will definitely have to get into that business.

Senator Black: Thank you very much for your presentation, Dr. Weber. It has been helpful. I would like to ask you a couple of practical questions to start with and then, subject to your concurrence, a couple of crystal ball questions, if you are comfortable with that.

As you know, we're charged and have taken upon ourselves to review digital currencies. I have taken from your testimony that the suggestion to us would be, by reviewing the state banknotes and the history that you have gone through with us, that there might be some learnings for us around digital currencies. Is that a correct assumption?

Mr. Weber: Yes. If I understood you correctly, I think there is a lot to be learned from that period in terms of setting up arrangements for exchange and for insurance. By studying them more closely, we can learn things about mistakes not to make today or things that should be done today to achieve what I think a lot of people would say are the goals that we should have for those kinds of monies.

Senator Black: That's why your presentation has been so helpful. I just wanted to make sure that we were aligned on that.

When you talk about e-money, is that term, in your mind, interchangeable with digital currency?

Mr. Weber: No, it's more restrictive. Under my definition of e-money, bitcoin does not qualify. It would be a digital currency but there is no claim on the issuer. Here I'm taking my definition really from this committee on payments and settlement systems of the BIS. Under their definition, an e-money has to be a claim on the issuer. Bitcoin is a claim on no one, as was just pointed out, so I would say there is a difference. You could have a digital currency that would not fall under that definition.

Senator Black: Thank you.

Mr. Weber: I focused my comments and title with e-money. I don't see how the state banknote experience applies that much to something like bitcoin.

Senator Black: Can you then help us understand where the two universes overlap? In your definition, where is e- money a digital currency, so we can understand how we can apply the information you've provided us?

Mr. Weber: It's a digital currency in the sense that the value is stored on some device. With banknotes, it was stored on a piece of paper. From my definition of e-money, it's stored on your cellphone, on a jump drive on your computer, something like that, some electronic thing. It is stored in a digital form. That would be where they overlap.

Senator Black: Presuming, then, that we move forward with some form of digital currency and regulation, et cetera, would you have any bars to entry or any regulations around who can enter the marketplace and be a provider of digital currencies?

Mr. Weber: Yes, I think I would. I have to think for a minute about exactly what they would be. Again, it depends. If you are going to insure it and have government insurance, you certainly would want to make sure that the people coming in would be legitimate and could pay for the insurance. If you're going to require that it be redeemable on demand, you would like to be sure that they have the resources to do that. I would vet the issuers.

Senator Black: You would encourage us to look at some kind of regulations around entry into the marketplace.

Mr. Weber: Yes, I think I would, but that's something I would like to think about more deeply.

Senator Black: Would it be appropriate for us to ask that, after you have done some of that thinking, you provide us your thoughts?

Mr. Weber: Sure, I would be happy to.

Senator Black: A couple of crystal ball questions if we can. Going forward with a digital currency, what role do you see it playing in the economy?

Mr. Weber: With digital currency, I am struck by the information advantages that it has over regular currency. With digital currency, you have the ability to carry along a great deal of history about the person who has it in terms of what they like to buy, where they seem to like to buy, things like that, so that it offers the issuer the ability, as credit cards do today, of offering loyalty points or different discounts for where you shop and things like that. You could have some kind of credit history of the person on there so that you might think this person is more credit worthy and therefore you would be willing to do this for them or something else. I see it opening tremendous possibilities for changing the way things are priced and the way transactions are made which may do a great deal for improving economic efficiency. .

Senator Black: That is very interesting.

Mr. Weber: There is some interesting work being done by some people at the Bank of Canada right now, trying to more formally model this. I am kind of stealing some of their stuff in my comment to you.

Senator Black: We will likely be on their trail, too.

From Canada's point of view, is there any advantage to the country in being a global first mover in terms of recognizing and regulating digital currencies?

Mr. Weber: You guys ask fantastic questions.

Off the top of my head, there are some disadvantages, one of which is you might make mistakes, and if you wait somebody else will make those mistakes so you don't pay for them.

On the other hand, you might find that your e-monies can grab a larger share of some international markets because you have been the first there. Again, without more study or more thinking, I can't say which one outweighs the other, but I can see advantages and disadvantages to being an early mover or a first mover.

Senator Black: You have been of tremendous help.

Senator Greene: Senator Black has asked a bunch of questions that I was going to ask you, but I'll try a philosophic question, and that is whether bitcoin or e-currency ought to be regulated at all. They exist on the Internet and the Internet is difficult to regulate. Western countries in particular have an aversion to regulating it. In my view that's a good thing. Bitcoin is kind of a libertarian initiative. On that basis, because it's on the Internet, I think it's likely that regulations are going to be difficult to apply and easy to circumvent. On that basis, do you think we should even try to regulate it?

Mr. Weber: My comments on that go back to the point I made a couple of times. If I thought the government could credibly commit not to intervene if people started taking big losses on these, then I would say fine, stay away; you don't need to regulate or supervise. My fear is that an event could happen that is big enough, and that happens to the people of Canada or the United States, and the hue and cry is so large that the government cannot avoid doing something and the cost would be very high from doing that. However, if the bitcoin issuers or holders had been regulated from the beginning, that event would not have occurred.

That's my fear. It's really all based on what I think the pressure is going to be on the government to do should there be a crisis event, a bad event, in terms of the value of one of these digital currencies.

Senator Greene: Do you think a public education initiative emanating from the government about the dangers of e- currency would do the job?

Mr. Weber: It would certainly help. Would it do it completely? There are instances where people have put money in non-insured savings and loans in the United States. They have gotten into trouble and people said, ``Oh, I thought they were insured,'' whereas they have been told all the time that they were not.

I think the education would help and might lessen some of the need for regulation, but I am sure there are people out there who will still make the argument. Maybe they will not be 100 per cent truthful about the matter and say, ``Yes, I know what you said, but I really didn't understand how big the risks were. Look, you've wiped out my entire life savings. I need help.''

Senator Ringuette: As a follow up to all these questions in regard to regulating, I guess the bottom line for the Bank of Canada to look at is this: Is it easier and safer to compete, that is, to issue your own e-money or try to regulate? There is a question of security, and you keep coming back to the fact that, whether the government likes it or not, if this bitcoin or other similar entity grows in the country and they fail, it could create an economic crisis of some kind so that the government would have to intervene. On the other hand, you are indicating that is going to be very hard to regulate.

Is it not the solution to provide our citizens with a securely backed e-money product?

Mr. Weber: You make a good argument for having the government in. It is expensive for the government to get into the business to set up the infrastructure. You have to weigh those costs against the costs that the government would incur should it be all a private system and there is a failure and the government has to intervene. Off the top of my head, I can't tell you which cost is bigger. With setting up government e-money, a lot of infrastructure has to be put in place.

I guess I would not argue for completely prohibiting private e-monies because you might find that the private sector is very good at innovating and might come up with innovations that, if you have a government e-money, they could end up using and making it less expensive. However, in terms of the bottom line you have to say here is the cost of regulating private ones; here is the cost of setting up the government one. Which is bigger? Then you have to go with the lower cost. I do not have the expertise to come up with those numbers and I don't think any one person would right now. I think a lot of study has to be done on that.

Senator Bellemare: From your historical experience and knowledge: We know that e-money is used for exchanges, and it could also be used for storage of value. But could it also be used to promote credit?

Now, as we see it, to get bitcoins, you need value; you need dollars or you need to get the bitcoins. With Canadian or American dollars, you go to the bank and you can have a loan. Do you think that this side of e-money could be developed, or not?

Mr. Weber: Certainly, I think it could. Again, I was using this very restrictive Committee on Payment and Settlement Systems definition, where they did not allow credit, so then they would rule out credit cards. But in some sense, credit cards are a form of e-money with that credit feature you talk about, so we really already have that. One of the questions is: Given there are credit cards out there, how much e-money is actually going to develop? Why don't people just use credit cards instead?

The Chair: That concludes our questions, Dr. Weber. On behalf of each member of the Senate Banking Committee, I would like to express our great appreciation for your participation today. We are on a steep learning curve. You have been very helpful. I must commend the members of the committee for what I would term outstanding questions.

With that, we will terminate this part of the meeting. Thank you again, Mr. Weber.

Mr. Weber: I agree; the questions were great.

The Chair: During this second hour today, we have, via video conference, Dr. Joshua S. Gans, Professor and Area Coordinator of Strategic Management at Rotman School of Management at the University of Toronto. Dr. Gans also holds the Jeffrey C. Skoll Chair in Technical Innovation and Entrepreneurship at the Rotman School.

Dr. Gans' research is primarily focused on understanding the economic drivers of innovation and scientific progress, and he has core interests in digital strategy and antitrust policy. He writes regularly on these topics and has co- authored a paper for the Bank of Canada entitled Some Economics of Private Digital Currency.

Dr. Gans, thank you for appearing before us. The floor is yours, sir.

Joshua S. Gans, Professor and Area Coordinator of Strategic Management at Rotman School of Management, University of Toronto, as an individual: Thank you very much for accommodating me by video conference. As your introduction already showed, my background is as an economist. I'm actually a fairly recent immigrant to Canada, having come here almost three years ago from Australia.

My interests are fairly varied, but I have previously appeared before the committee of the Australian Senate, similar to this one, on issues of credit card regulation and banking competition. What I've been looking at this time has been the increasing interest in digital currencies.

My interest in this began because of my co-authorship with Hannah Halaburda, who was at Harvard University and is now a researcher at the Bank of Canada. We had noted that there was a lot of discussion in the media regarding the role of things that were starting to look like digital currency. These things weren't what I guess we will end up talking about today, things like bitcoins, but in fact things that were associated with platforms.

A great example of this was something called Facebook credits. Facebook credits were virtual things you could buy by sending money to Facebook, which allowed you to purchase extra things in Facebook games. Commentators had looked at that and had looked at Facebook's huge reach and wondered whether Facebook credits could develop into something like a competing currency, whereby you wouldn't just use Facebook credits to buy sheep in farm games or something like that; instead, you would use them to buy real goods and services. The people being paid in Facebook credits could then convert them back into their local currencies.

There was an enormous amount of discussion about this in very reputable media circles, thinking this could be a big challenge, for instance, to the U.S. dollar, so we undertook to look at this as part of the National Bureau of Economic Research's digitization project.

To put it in a nutshell, we found that in order to have a competing currency, you have to be able to take local currencies and convert them into that currency and then also convert them back. Facebook credits and some of their ilk, such as those that have been brought forth by Microsoft in its day, and also by Amazon and others, allowed you to buy those credits but didn't allow you to take them back out. We found that that was for good reason. If we take into account what those businesses were all about, which is getting activity on their platforms, that activity would be maximized by allowing people to buy credits in and not allowing them to take it out. So we predicted that these currencies wouldn't come to dominate the world and would be rationalized and probably subsumed by conventional forms of payments once easy credit card payments and other things were worked out, and that is largely coming true. No one talks about that any longer, even though this research was only done two years ago.

At the same time, of course, bitcoin was starting to get noticed, and we made a conscious decision to ignore it in our paper. That decision was made because it was only a recent phenomenon, and at the time we weren't sure it was going to stick around very long.

Obviously today we can sit back and look at that and determine things have been coming to pass. Bitcoin has at least established some sort of longevity and, moreover, there is a lot of enthusiasm not just about bitcoin itself necessarily but about what it represents in terms of an innovation in digital technology.

I should preface all this by saying there's something very interesting about how people approach bitcoin. Many economists have been very dismissive of it. The argument is very simple: Why do we need it? Traditional currencies are great. Why would we need this other thing, except maybe for nefarious purposes, but even there, cash is still pretty good for money laundering, as is gold or something else.

What I noticed is that the people who were taking bitcoin very seriously were those schooled in computer sciences, and they were very excited by it. I must admit that I've staked my career on occasionally saying that if no economists seem to be excited about something, maybe it's time to take another look. A few months ago, that is precisely what I did and wrote what turned out to be a fairly influential blog post about this.

The main conclusion — and we can take the discussion of this in any direction you might see fit — was that bitcoin itself may or may not be significant, but the innovations that underlie it are very interesting. Essentially, they take away some of the key roles that have been previously played by banks, governments and other financial institutions and decentralized them basically to a peer-to-peer, as they call it, decentralized framework. In other words, they get rid of the middleman in many of the transactions that can occur. This opens up the possibility of reducing the transaction costs associated with the transfer of money between parties. While we have always enjoyed money because it has been fairly easy to transact when people are in the same room, when you get beyond that, it has always been more of a struggle.

What bitcoin and other crypto-currencies may represent is a means of reducing the transaction costs, if not to zero, then very close to zero, and improving the speed of transferring money from 24 hours to mere seconds.

So that's basically where I've come to on this. I'm not 100 per cent sure of the issues that you're confronting, so I leave myself in your hands.

The Chair: Thank you very much for your opening comments. Could you anticipate a situation where virtual currencies really achieve large-scale adoption?

Mr. Gans: I think it's hard to anticipate a situation where they do not, and it's not just me saying it. That was a forecast made a decade to a decade and a half ago by Milton Friedman, who arguably is the greatest monetary economist of the 20th century. He basically said that when it comes down to it, money is not real. Keynes famously said, why would anyone outside of a lunatic asylum believe that money is a store of value? Whenever I think about it or my colleagues think about it, that becomes true.

The big issue has always been in making that digital. It has not been that we can have digital ledgers and we can have electronic transactions where we never see a physical form of money or a physical contract; that goes on all the time now.

The big issue has always been: How do we ensure that people are not getting ripped off? Essentially, when I hand you a dollar in cash, you get that dollar and you can use it and I can't. When I send you a dollar virtually, what's to stop me using that dollar again, basically convincing somebody else I've got money when I don't have it? The previous way we solved that with electronic transactions is we have clearing houses or bank agreements and other things that are essentially honouring contracts to pay backed up by real things.

What crypto-currency does, essentially, is solve that double-use problem by verifying the transactions have taken place and ensuring that the ownership of a particular piece of virtual currency or anything digital has actually taken place.

Once you feel that that problem has been solved, it's hard to imagine why we would ever want to carry around physical cash or do any of this stuff physically. Can I imagine it? Absolutely.

Senator Black: Dr. Gans, thanks for being with us and thanks for coming to Canada. This is very helpful. You must be wondering a little bit these last couple of months why you took that decision, but we're glad you're here.

Building on the excellent question of our chairman, taking what we just had a conversation on, let's assume that digital currencies are here to stay. Are you okay with that assumption?

Mr. Gans: Yes.

Senator Black: Help us, then, as senators to understand what role the Government of Canada or the Bank of Canada should play around digital currency.

Mr. Gans: There are a few levels on which we could take this. The first issue is that when these virtual currencies emerge — and bitcoin is a great example — they appear to not have to merge with the backing of any government. On the one level, this opens up the possibility that governments may lose control in the future of the money supply. That may not be a role for government, but that's at least what people have talked about.

Now there's one reason not to be so concerned about that, and that is taxes. If I live in Canada, I need to pay my taxes in Canadian dollars. So as long as the government is saying that that is how we should do things, there will be a role for the Canadian dollar.

At the same time, some of the roles these other currencies might play may disrupt that and they may raise concerns about how easy it is to do transactions outside of the reach of government. We know ever since taxes were invented that people have wanted to be secretive about their transactions from the government. We should expect that somebody is going to work out a means to do so, and if an innovation like this comes along that presents that possibility, then there is a reason to monitor it.

The bitcoin has actually gone through waves. It was initially, of course, asserted that this was a perfectly anonymous way of transacting where you did not have to disclose your identity, so it would be a great means of avoiding the eyes of the government or anyone else. But as it turns out, bitcoin is actually one of the more public ways of transacting than has ever been invented because every transaction is listed in a ledger, as that is central to the way bitcoin works. That ledger has to be verified and updated in order for currency to be transferred. That means as soon as someone identifies you, they don't just identify you right now, but they identify all the transactions you've engaged in in the past. In effect, from that perspective, it's like the government or NSA's dream. You could audit everything. From that perspective, that is maybe not a concern and maybe is a virtue. But there is a watching brief that surely has to be established on this, no doubt about that.

On that same score, I say ``watching brief'' because there is really the potential for a lot of innovation to take place here. This is one of these areas where no one really has a great handle on what is going on but enough people think, ``Oh, there is interesting technological progress being made.'' So in terms of the role of the government, the desire would be not to stifle that. It would be very easy for governments to be concerned about these things and put in regulations that would reduce the development of crypto-currency in their jurisdiction. My hunch is that that would be an error, that at the moment this poses no systematic risk. It's not clear what risks they are to tax revenue, and so being more open and permissive would seem to be the default.

The second broad tranche in terms of what Canada could be doing is why the Bank of Canada isn't taking some of these technologies as a means to launch its own currencies. Why isn't a digital form of the Canadian dollar being considered? Would that be the way to go? In other words, if our concern is that this thing is not government-backed or government-sponsored, there is no barrier to it being so.

Senator Black: Thank you very much. The last point was very interesting, and I suspect you'll hear a bit more on that.

I've asked another witness this: Do you believe there is any advantage, and if so, would you elaborate on the advantages to Canada being a first mover in respect of regulating digital currencies or encouraging digital currencies, from the point of view of innovation?

Mr. Gans: When you use regulation, it has a bad connotation. Encouraging innovation in general is something that I would be thinking about.

I think Canada actually, as is often the case, represents the chance to remove some constraints and foster development. I've seen this here in Toronto and across Canada in the development of quantum computing, which, by the way, is something very complementary to the development of crypto-currencies, mainly because there have been no concerns about technology transfer to powers that might be against the national interest.

I see the development of crypto-currencies as perhaps playing the same sort of role. This is use of digital means for financial transactions in general. Crypto-currencies are only going to be useful to people if other people innovate on the back of them. At the moment, bitcoins are notoriously hard to get. You actually have to go through a lot of effort to get bitcoins, and there's the whole uncertainty and things like that.

The way it has developed has been entrepreneurs acting as intermediaries between ordinary people and being able to transact in bitcoin.

This could happen with other crypto-currencies as well. People could innovate off of the back of them. For instance, let me give you an idea. One of the benefits of crypto-currencies has been that you can develop currencies that can be more limited in their scope of use than ordinary cash. For instance, as a parent, I would like to give my children dollars; I like to give them an allowance. I don't want them spending it on bad stuff, whatever that might be. Some entrepreneur could launch a crypto-currency that allows me to transfer currency to my children but not allow them to buy certain things, and I could do that. We would not want to stifle that sort of innovation. I am thinking of that as a parent but you can imagine how far this could go. This could go all the way to thinking about how instead of my having to claim my child's fitness tax credit every year, the Government of Ontario could hand me some currency that could only be spent in certain ways, a cheap means of coupons. We can think of a lot of different ways this can go, but it's entrepreneurs that will do it, so you want to be encouraging of that sort of thing.

At the same time, there is this sort of merit to government sponsorship as well. The government has a lot of credibility in this space. So the government could think of ways of setting up institutions and verifying them that give people confidence in what they are doing, much as it does with the banks, of course, today.

Now, I have to draw the line a bit. Coming from Australia, one of the things that I found frustrating, both in the United States and here in Canada, is how hard it is to transfer money. In Australia, for reasons that I'm not quite clear of how it evolved, if I want to transfer money from one bank account to any other bank account in Australia, it is dead simple, easy to do. I just have to have the bank account details and it happens overnight every time. The same is not true here in Canada. The same is definitely not true of the United States. So one of the issues we have to ask ourselves is why that's the case, and is there something standing in the way of innovation on essentially legitimate means of payments that the crypto-currencies and what they represent could allow us to think about.

I have to admit I don't know enough about the Canadian banking system to know that. It has a lot of virtues but one of them isn't this part. So the question is whether in the broad review this committee might take of how easy it is just to make payments for stuff, whether it could look at those sorts of things.

Senator Black: Thank you very much.

Senator Tkachuk: Thank you for your presentation. We receive a few background papers from our own researchers, and there's an interesting paragraph in one of the pieces, which states that the supply of bitcoins isn't determined by central authority, but it has increased at the rate of roughly one bitcoin every ten minutes as bitcoin miners verify the validity of the transaction. The interesting thing is, it says that there will be an end where there will be no more bitcoins produced. Is that infinity, or because it's done mathematically, can there be an actual date as to when it no longer will be produced?

Mr. Gans: I believe it's not infinity. I could be getting this wrong, but I think it's in the order of 21 million. It gets increasingly harder as time goes on to mine these bitcoins, and I think the bitcoin system within some decades will reach a natural end and no more bitcoins will be produced. People have forecast that.

Many years ago, it was really easy to get bitcoins, really easy to mine them. It has been progressively difficult.

The mining has this other element that it takes a lot of computing power, which uses electricity, and it's not clear that is something we want. It might be just plain wasteful.

The broader issue that people have discussed with regard to crypto-currency is this money supply issue. To tell you the truth, we economists are all supposed to know something about money, but as soon as we start to think about it, we know we don't know very much. The people who designed bitcoin actually knew quite a bit about it. It's quite astonishing to me when I think about what they have done.

But the one issue that has come back is what happens if there is just a fixed supply of it? There is a fixed supply of money and people start using it a lot more, so doesn't that mean that the price of that money goes up, which means, effectively, from an economy-wide point of view, in terms of that money we get deflation, and no one likes deflation. Deflation is the sort of thing that seems to be associated with recessions, depressions and other problems.

So traditionally we have expanded the money supply — Canadian dollars, U.S. dollars, et cetera — to keep abreast with the amount of transactions so we have some stability. If you have one of these decentralized currencies with a finite limit, what happens? Are they inherently limited by that deflation?

Generally speaking, economists have been saying things work themselves out, don't worry about it, and they would be right. The alternative is in order for one of these currencies to work and be relied upon, they have to foster price stability. If there is built-in deflation, that's just as bad as built-in inflation. Maybe the crypto-currencies and digital currencies that take off are ones that are managed carefully to ensure that doesn't occur. Maybe it will turn out that while a lot of things can be decentralized about these things, we do need some central backing. It's not a big leap to say that that backing should be a government or a central independent monetary authority that's disinterested rather than a private player that's interested.

Senator Tkachuk: If there is an end, could they say, ``Well, that's that ledger, let's start again from zero''?

Mr. Gans: There is no reason why there couldn't do many of these things. We have a lot of assets that are valuable now. We have Canadian dollars. I can happily hold U.S. dollars; I'm not worried about that. It's harder to find people to pay around here, but it is not impossible. I can hold gold, silver, platinum, stocks and bonds. There are all sorts of things that are currently assets that we can use to pay one another. There is no reason to suppose there couldn't be multiple currencies that are valuable in this regard.

You're right; if bitcoin had inherent deflation, you have to say deflation with respect to what? Would other currencies and things come up and play that role? I'm not so sure about that. We're in a new world.

There is this other residual concern about can we really have these multiple currencies or is there some scale of economy or what they call network effect that drives us all to have one currency? Will that end up being one of these virtual ones? I'm not sure about that.

History has told us that while there are great local reasons to have a similar currency, there is no necessary reason why different regions can have different currencies, and they can be multiple competing things. I'm not sure whether we will get dire scenarios from that or it is going to stifle innovation, but precisely what the world will look like is hard to say.

Senator Ringuette: We have a saying that necessity is the mother of innovation, or invention, but do you find that all these crypto-currencies have come about, yes, because of innovation and technology, but that there is a requirement in the marketplace for an easier trading currency?

Mr. Gans: I think your starting point about necessity being a driving force is an apt one. There is a sense in which thinking about ordinary people transacting in ordinary ways with credit cards, debit cards, and other things, what's the big deal?

It's another matter when people have to transact across international boundaries. With respect to small businesses, if you have a small Canadian business exporting to Asia, one of the things they have to worry about is remittances; currently they can lose several per cent of their revenues in just transacting internationally.

We have to ask ourselves in this day and age why that should be the case. Why should we be taxing it? This is not a concern for big companies. Big companies have been able to get this down to what the banks can get. At the moment, small companies have to pay their local bank, and whoever they are transacting with has to pay their local bank. All those fees add up. It may only look like a few per cent, but a few per cent is a few per cent, and that's enough to give people pause.

International transactions are an area where innovation in virtual currencies seems to have the greatest potential payoff.

Let me just add one thing: That is an innovation that may interest Canadian banks as much as independent parties. While Canadian banks may be able to charge fees at this end, the amount of transacting is reduced because somebody has to pay a fee at the other end to another bank. I can imagine a world where Canadian or U.S. banks or something else would be interested in these innovations themselves because it reduces the cost of transacting and attracts more business their way.

Senator Ringuette: We have to give very serious consideration for the Bank of Canada to move forward in their own crypto-currency that would be backed and secured for the citizens and business transactions. With the bitcoin model, we would be removing the Canadian chartered banks from the scenario.

Mr. Gans: That is one way to think about it. The other one that would require more of an expert in computer science is whether that's necessary at all if the Bank of Canada were going to do it.

The hallmark of bitcoin is that there is a ledger of transactions to verify that things have been exchanged. We have those ledgers currently residing within banks. The Bank of Canada has its own ledger, and we have physical money as well.

What would happen, just to speculate, if the Bank of Canada were to launch a currency and the Bank of Canada were to hold and verify the ledger using the current techniques that have been solved to set up bitcoin? It could be secure; there will be a vault; it will pass through the Bank of Canada. So there will be no issue of those sorts of problems. We can go crazy on this.

I can imagine the people at the Bank of Canada would be salivating over the prospect that every transaction in the Canadian economy would go through the Bank of Canada. It might not be attractive to everybody, but there are a lot of people it would be attractive to, and so Canada would know its GDP every minute.

Senator Ringuette: Wow. Thank you.

Mr. Gans: There is something going on here. Don't stop. The worst thing that could happen is that the Bank of Canada investigates this and finds that it can't make it work. But there is so much potential upside here that there could be a legitimate set of transactions.

Also the Bank of Canada is part of a legitimate, stable world government of which not every government in the world is, and it could become a clearing house for many transactions in that way. So there could be even more to it than that, just to go crazy on thinking about that.

The Chair: I might indicate that the Bank of Canada will be before us next week.

Senator Tkachuk: With the Bank of Canada getting into it, the Bank of Canada and the Government of Canada have a very close relationship. The reason that people want currency outside the system is they want governments not to be involved in it. As soon as governments get involved in it, it's no longer a currency that's outside the system. It's a currency that governments can tax, manipulate, create more of than is necessary, inflate. They could do all the things to a digital currency that they presently do with paper currency.

Mr. Gans: That is true. I guess this is where you stand. I'm not a libertarian and I know a lot of supporters of bitcoin are. There are a lot of people who like to do things like transacting outside of the government eye, and there will always be a demand for that. That doesn't mean there isn't a lot of gain to a government actually adopting new technologies transact money and other things associated with it. It may be a completely separate deal. It may be something for people outside the system or never want to be a part of; so be it. That's never going to change.

But there are a lot of transactions that occur precisely because there is a government stamp of approval, because banks are regulated by the government. That's one of the hallmarks we have, that the banks are accredited.

One of the things we're seeing in some of these bitcoin exchanges, which have operated outside of financial regulations, is that they have had exactly the things occur to it that we have those regulations for, such as basically not being secure enough, maybe even not being secure enough with respect to the people who are running them, but we have banks that are regulated to ensure that doesn't occur.

So when I say that the Bank of Canada could adopt these things, I'm saying it from the point of view that if you are in the business of government-sponsored currency, then there is nothing wrong with the idea of government-sponsored crypto virtual currency.

Senator Tkachuk: The banks are all regulated.

[Translation]

Senator Bellemare: I will ask my question in French, and then I will repeat it in English.

My first question is about the limit of bitcoins that can be created. We know that in the case of regular money, there is a formula, MV = PQ — where money and velocity equal price and quantity. In the case of bitcoins, can the velocity of money be increased? Did you understand my question?

[English]

Mr. Gans: That's a very astute question. If I have to pick the question that keeps me up and thinking about this issue, it's that one — velocity. The quantity theory of money, that income has to be measured in the money we measure it in, is a fundamental. It's not a theory, it's a definition.

What that means is that income is generated as we pass around the stuff, and if we pass around the stuff quicker, we can generate more measured income. That's enough to blow your mind right there in terms of trying to think about what we're doing. Everything we do in monetary economics relies on us assuming that that velocity stays the same. If it doesn't stay the same, it becomes harder to predict the relationship between the money supply and the income generated.

If we get the situation where we have a fixed money supply but at the same time there are things speeding it up, then we have the same outcome as if we have an expanding money supply and nothing speeding it up. That is definitely true.

As near as I can tell, no economist understands the velocity of money. Nobody understands it. We don't know. This is this limit of the knowledge.

I've had people come to me who want to set up private versions of crypto-currency, more legitimate versions of bitcoin, with the hope of transacting better, and they get stuck at this velocity question. I don't have an answer for it.

One thing that's happening with bitcoin at the moment is the velocity is a bit limited because the transactions actually have to be verified and that can take between 10 minutes and an hour depending on the computing power available, so that's limiting the velocity right there. But the other thing that's limiting the velocity of bitcoin is that most people who have bitcoins are holding on to them. They have stuffed them under their mattresses. That also affects velocity as well. They are not using them to transact; they're using them to speculate; they're using them as an asset. All money gets used that way. That's why we have no great prediction of this.

I would love to come to you and say that I have thought about this and worked it out. I haven't. I don't know anyone who has. Maybe this entire episode will cause people to finally understand it.

This is a big, big question mark — a great question mark but a big one.

[Translation]

Senator Bellemare: My second question is about miners. I do not quite understand the notion of ``mining'' in the money creation process. However, I think I understand that individuals are involved. There are people referred to as miners, who have to solve algorithms.

If I have understood correctly, the people whose job this is are paid in bitcoins. If virtual money, digital money, was developed, would those people be numerous? Would they replace those who are currently working in financial institutions?

This question has more to do with the labour market. Who are these people working behind the scenes?

[English]

Mr. Gans: One of the fascinating things about bitcoin and the way it was designed by people unknown is that they built in this system to have more bit points created. That was the reward for solving — and I can't give you more of an explanation of this because I just don't know — complex problems in cryptography that are related to the verification of these transactions taking place, and they get increasingly harder all the time. They are rewarded in bitcoins, so if bitcoins are more valuable, people will devote more of their energy and computing resources to mining them. If they are less valuable, they will stop. It's great in that way. It has a nice equilibrium.

The reason is because they are exactly like gold miners. We have the same issue. When the gold price goes up, all of a sudden people are running around, looking to mine gold. Even in Ontario there are people looking for gold, because the gold price is currently so high. When the gold price goes down, they stop. It's the same principle.

Actually, when you think about it, it's just as wasteful. It's not clear why we go running around mining gold for monetary purposes. Mining gold to actually use in stuff is one thing. Mining gold to have it as currency is another. Some very bright economists have suggested that the best thing we can do with gold is identify where the mine is, work out where the gold is, and just leave it there and put up a fence. This is the same issue with bitcoins.

Is this going to replace labour? I hope not.

I think this is one of the flaws in the system. Canada currently prints money. It issues money. It has become cheaper all the time. We have better money now that's plastic in nature and things like that. If a government were to set up a crypto-currency, it wouldn't have this mining process. It would just have a process by which it releases currency. In fact, because it's a government, it would just say, ``You're going to have to trust us.''

If a private firm did so — and there is one in California called Ripple Labs that has tried to do this for the purposes of improving transactions. They won't issue their currency. They just said we'll issue this much currency and that's it. They hold some of the currency themselves, presumably to use for the purposes of stabilization, but also to somehow earn money from it, which becomes problematic.

I think that the bitcoin mining boom is an anachronism, something built into the system. Can we do it without it? It seems like we should be able to do it, but I don't know the precise mechanism by which that will occur.

Senator Greene: This has been most interesting. Up to now we've been discussing the impact of bitcoin on Canada and the United States and the established currency in countries. I'm wondering if a Third World country could use the bitcoin as a tool of economic development. Suppose a country in Africa or Cuba, for example, would declare bitcoin to be its legal tender. What kind of impact would that have on a country and on the currency?

Mr. Gans: That's a fascinating idea. In countries where the currency is not stable, adopting something more stable is a good way to go. Already the U.S. dollar is used in that method around the world because of its stability, but it's hard to use it electronically in the same way. That's where it gets really tricky. It's hard to have a bank account in U.S. dollars and things like that.

A country could adopt bitcoins. The International Monetary Fund might see this as a tool of economic development. There are pros and cons to that. One of the pros, of course, is stability, and allowing these transactions to take place would be terrific. The con would be, of course, if there is any benefit at all to a country having some control over its own currency that gets taken away. At the moment the control isn't there, but in the future it might be there. Most of Europe has already ceded that control away itself and we can argue about the pros and cons of that, but that would be the balance being made.

At the moment there's a sense of ``it can't hurt.'' There's a sense of if somebody develops something more stable — and I don't think bitcoin is it yet — one suspects that that currency will get adopted, that that will facilitate those payments in countries where there are unstable currencies. I think that is the first impact we'll see, and once that spreads it will be all for the better.

The Chair: Dr. Gans, one of the things you haven't talked about is the illicit use of crypto-currencies. Can you comment a little? There is a tendency when we talk of bitcoin and some of these other digital currencies that the entire focus seems to end up on the issue of money laundering, terrorist financing, anonymity, et cetera. Could you comment on that whole area?

Mr. Gans: The wonderful thing — and I mean ``wonderful'' in the sense of constraining it — about illicit use of currency is that you lose the trust mechanism that comes from the non-illicit use of currency. You're right; one thing bitcoin or a crypto-currency can solve is a way of engaging in trust. It gives you some means of facilitating a payment, having verification of that payment taking place, and it facilitates trust. The stereotypical version of the Swiss bank account is the right analogy here. One expects that innovations on this front will make those transactions easier and simpler.

At the same time, right now the way in which bitcoin works is a very public one. As I said, in order to solve this trust issue of when has somebody exchanged a piece of digital property, there has to be a public ledger than anyone can look at and say, ``Oh, yes, this bit of thing has moved to this person and they can say they are now the owner.'' You have to see that publicly, though. Whenever there is that possibility, there is the possibility to verify not only the transaction itself but the entire history of transacting.

Yes, one could imagine that people engaged in illicit activities could develop this sort of currency and do that, but ultimately in order to give that value they have to buy goods and services and trade wealth, and that means interacting with legitimate economies at some point.

That barrier is going to be there for quite some time. I just don't see a world in which the currency takes over, everything becomes anonymous and that works. I don't see that occurring because most transactions want to occur where we identify the parties and they are happy for others to see that identity. I don't think that will change.

Is there some other mechanism or dire scenario whereby this could occur? I don't want to rule it out because you never know with monetary things. All sorts of funny things have occurred in the past, but I'm not fundamentally afraid of it.

The Chair: Dr. Gans, thank you very much. This concludes our questions. On behalf of each one of the members of the Standing Senate Committee on Banking, Trade and Commerce, we greatly appreciate your appearance here today.

Mr. Gans: It has been my pleasure.

(The committee adjourned.)