The Engineering of Bitcoin

https://caitlin-long.com/the-engineering-of-bitcoin/

H.T. Person Distinguished Lecture
September 29, 2023
by Caitlin Long, 2023 University of Wyoming Distinguished Alumni
University of Wyoming College of Engineering & Physical Sciences

Money in this internet age is an engineering problem, and Bitcoin is the engineered solution to it.

Today I’ll discuss the engineering of Bitcoin as an IT system that is also a digital money system, and then spend a few minutes on the implications of Bitcoin as a risk management tool for balancing power grids.

This talk is designed for a general audience but with an engineering emphasis. It draws heavily from – and salutes the work of – the many engineers who have taught me how to understand Bitcoin through an engineer’s lens. Special thanks go to engineers Lyn Alden, Andreas Antonopolous, Jameson Lopp, Michael Saylor, the engineering & product teams at Custodia Bank, and especially to the OGs who created the crucial building blocks that laid the path for Satoshi Nakamoto to build Bitcoin:  Adam Back, Nick Szabo, and the late Hal Finney.

And, of course, I salute Satoshi Nakamoto—perhaps the greatest inventor of our age.

I.           The Engineering of Bitcoin as a System That Became Money

Satoshi didn’t invent anything new, per se, in 2008; rather, Satoshi combined existing building blocks in a way not previously combined. Bitcoin was a “path dependent” advance in computer science, and its building blocks spanned multiple disciplines—especially math (i.e., cryptography), computer science (i.e., proof-of-work systems that expend computational and energy resources to generate a digital token) and economics (i.e., game theory).

For the computer science field, Satoshi solved the Byzantine Generals Problem—a problem that the field had tried to solve for decades and considered unsolvable. Satoshi solved it by using game theory, which was Satoshi’s real genius.

What is the Byzantine Generals Problem? In simple terms, it’s this: how would generals fighting on a Byzantine battlefield know that messages they received from other generals during a battle weren’t tampered with during their journey across the battlefield? The problem of ensuring that data in transit was not tampered with while in transit was considered by many to be an unsolvable problem in distributed systems, but Satoshi solved it—by applying game theory.

Satoshi used asymmetric incentives to augment existing tools from math and computer science in a beautifully and carefully balanced system. For example, Satoshi designed Bitcoin so that it’s expensive to add transactions to the Bitcoin ledger, but it’s cheap to verify them once added. It’s prohibitively expensive to attack the Bitcoin network—it would cost an attacker billions just to re-write this morning’s transaction history, for example—but it’s cheap for anyone with a laptop to participate in the network by simply downloading the software and running it.

It took a true polymath—what I call a “systemic thinker”—to concoct such a beautifully-balanced system. There’s a lesson here for all of us:  solutions to problems in our fields might lie outside our fields. Perhaps if distributed systems engineers had spent more time talking to game theorists all along, the Byzantine Generals Problem might have been solved much sooner!

Indeed, the security of Bitcoin as a system is remarkable. It is almost surely the most secure IT system ever built. The protocol itself has never been hacked successfully, and today it secures more than $0.5 trillion in value. It lives in the wilds of the internet, unprotected by a firewall, and attackers constantly probe but fail to penetrate it. How is it so secure? Remember: Bitcoin is a beautiful balance of technology and economic incentives—hackers would need to spend a lot more money to attack it than they would gain from doing so.

As a piece of software, Bitcoin is also remarkable—its network uptime in the past decade is 100%, and all network upgrades are backwards-compatible by design. Bitcoin’s governance as a distributed system is “pull not push”—because node operators cannot be pushed to update the Bitcoin code they run. This means the tens of thousands of node operators around the world choose which version of the code to run and, as a consequence, the node operators really control Bitcoin. To ensconce this decentralized governance model, Bitcoin nodes by design are lightweight and simple enough to run on an old laptop with standard internet bandwidth. This feature distinguishes Bitcoin from most cryptocurrencies, of which the same is not true. And to protect Bitcoin’s decentralization, the Bitcoin community successfully fought a bitter, internecine war in 2017 that could have tipped Satoshi’s beautiful balance in favor of large, powerful elites. Thankfully, it did not. And it’s becoming easier and easier to run a Bitcoin node because data storage, computer processing and bandwidth are improving at a rate faster than the requirements to run a Bitcoin node are increasing. This means the Bitcoin network is becoming even more decentralized and attack-resistant with time.

Satoshi’s beautiful balance—i.e., the engineering that makes Bitcoin money for the internet age because it can securely move scarce value at the speed of light—is a combination of five factors I’ll introduce now and discuss more momentarily: (1) proof-of-work + (2) the longest-chain rule + (3) difficulty adjustment + (4) the ease of running a network node + (5) Bitcoin’s code changes are always backwards-compatible.

Bitcoin is already a juggernaut; the real question is this: how big will Bitcoin eventually become as money?

Let’s dig into that question, examining what makes Bitcoin “the first engineered monetary system,” in the words of Michael Saylor—an engineer who, quite rightly, views money as an engineering problem.

A. What Pushed Money Into Becoming An IOU, For Which Bitcoin Is The Solution

Money is one of the most misunderstood concepts in society. Money is simply a commonly accepted good through which humans exchange value with each other. The good that humans chose to use as money has changed its form throughout human history—it has variously been cowrie shells, wampum, Rai stones on the Island of Yap, cigarettes in prisons, and, of course, gold and silver. Humans evolved to choose such goods as money mostly because of their inherent physical scarcity—either they could not be counterfeited easily, or could not be counterfeited at all. Their scarcity made them collectibles, and their commonly accepted use in exchange made them money.

Like other collectibles that became money, Bitcoin is a collectible—but it’s a digital collectible that can be exchanged at the speed of light.

A big problem with using physical goods as money is that they are transported at the speed of matter. But data can move at the speed of light. In the financial system historically there has been a speed gap—transaction data has been able to move at the speed of light since the second half of the 19th century (when intercontinental telecommunication systems were deployed), but physical money couldn’t move that fast. Engineer Lyn Alden observes: “This speed gap opened a massive arbitrage opportunity for banks and governments to use, because it gave them custodial monopolies over fast long-distance payments.”1

Alden uses physics terms—data moving at the speed of light vs. money moving at the speed of matter—to describe a problem I’ve long described in operational terms, but it’s really the same problem: settlement risk. When the data and money legs of a transaction don’t settle at the same time, somebody carries an IOU until the money leg settles. This means the financial system is inherently built on credit. 

Kids trading baseball cards know how to settle both sides of a trade simultaneously: both kids simply hold onto both baseball cards, and at the same time they both let go of one card to settle the trade. But the financial system can’t do this because it inherited that speed gap. To deal with the speed gap, over decades the financial system created layers of abstractions away from the physical money (i.e., gold) to speed final settlement. The U.S. dollar itself is a good illustration: the U.S. Constitution (Article 1, Section 10) initially defined the dollar as physical gold or silver coins, but then came the first abstraction—the dollar became an IOU redeemable for that physical gold, and finally the dollar became just an IOU redeemable for another IOU. There are layers upon layers of further abstractions in the financial system, each one an IOU. For example, when Wall Street began to transition from paper to digitization in the 1970s, processing power and storage was expensive—so financial institutions batch-processed transactions and settled only the net IOU with a bigger clearing firm, which then batch-processed more transactions and settled only the net IOU with an even bigger clearing firm, and so forth up the chain. But all these abstractions are forms of credit. Still today, when you send money on Venmo or Zelle, for example, you may think your payment settles instantly but it doesn’t; you’re seeing the data moving at the speed of light, but behind the scenes you don’t see that money leg settles far more slowly. Most U.S. dollar payments are really just credit that settles in 1-3 business days (through the ACH system), and stock trades are also really just credit that settle two days after the transaction date.

Here’s the key point of this section: the structure of this IOU-based financial system gradually pushed money itself into becoming an IOU. That financial systems evolved to become entirely based on credit is what makes them inherently unstable systems, prone to periodic financial crises.

Quoting again from Lyn Alden:

“Credit-based transactions over telecommunication systems only require simple data like Morse code to occur, and thus could be performed in the 19th century. Settlements of scarce value over telecommunication systems require far more complex computation, data structures, bandwidth and mathematical proofs…If I were to describe in one paragraph why money has been broken around the world for so long while almost everything else has improved substantially (energy abundance, technology abundance and so forth), it’s due to this gap between transaction and settlement speeds that the telecommunication era created. For a century and a half, the world has been stuck in a local maximum that has required and incentivized ever more complex forms of centralized abstraction to bridge that gap.”2

These “ever more complex forms of centralized abstraction” have proven themselves not only unstable but also susceptible to capture by powerful elites that benefit from the continued existence of this settlement gap, and which block the adoption of new technologies by capturing the regulatory system to protect incumbents.

Alden sheds light on these troubling trends by reviewing monetary history from an operations engineering perspective: “The international gold standard [began in the 1870s and] worked for several decades during peacetime but was inherently flawed from the start due to how many [IOUs] it enabled to exist on such a small monetary base of actual gold, and it failed its first test as soon as war broke out between major powers in Europe [in 1914]. The [post World War II] Bretton Woods system was even more flawed due to even greater levels of abstraction and managed to fail [in 1971] in less than a decade and a half after full implementation. The modern system of 160 different ever-devaluing fiat currencies loosely tied to one world reserve fiat currency [the U.S. dollar] is highly flawed due to having no inherent grounding in scarcity. The invention of Bitcoin as an open-source fast settlement network with its own scarce units provides the first credible way to close that gap between transaction and settlement speeds…”3

Borrowing again from physics, Alden explains the implications of the status quo financial system’s instability: “Entropy is the law by which physical systems inevitably become more disordered over time, because the disorder imposed by friction and heat loss only moves in one direction. A similar sort of financial entropy has built up in our system, as fiat credit can only move in one direction (higher) without the whole highly leveraged system collapsing.”4

Bitcoin stands in stark contrast. It settles scarce value at the speed of light, with no settlement gap at all.

Bitcoin also decisively flushes entropy from its system every 10 minutes, such as any attempted fraudulent double-spend or credit-type transactions, when the network comes to consensus about the state of the ledger. A good example actually happened this week at block height 809478, when a miner mined a block that contained an invalidly ordered transaction (trying to spend funds from a transaction that hadn’t been processed yet), and Bitcoin node operators swiftly rejected it. This caused engineer Jameson Lopp to observe: “Bitcoin is an impenetrable fortress of validation. No double-spending allowed!” 

As a system Bitcoin is stable, while fiat currency systems inherently are not.

Yes, the price of bitcoin is volatile compared to the U.S. dollar (for now), but despite that volatility bitcoin already is less price-volatile than some of the world’s other fiat currencies.

Three other properties of Bitcoin are worth noting in a monetary context:

  • First, the supply of bitcoin today grows at less than 1.8% annually, which approximates the annual inflation rate of gold—i.e., the amount of new gold mined every year is approximately 1.6% of the total already in existence. In April 2024, the Bitcoin supply growth rate will programmatically fall by half, to below 0.9%, and then it will fall by half again to approximately 0.4% in 2028, and so forth every ~four years. In other words, while bitcoin’s inflation rate today approximates that of the hardest money used in human history (gold), 7 months from now bitcoin will become the hardest money ever used by humankind.
  • Second, unlike every other form of money used in human history, growth in the value of bitcoin doesn’t cause more bitcoin to be produced. Growth in the value of gold causes people to mine more gold, and growth in the value of oil causes people to drill for more oil. But growth in bitcoin’s price ONLY makes the network more secure, thanks to one of Satoshi’s creations to enforce scarcity by ensuring that no more than 21m bitcoins will ever be mined: the difficulty adjustment. Hold that thought; we’ll revisit it shortly.
  • Third, bitcoin to some users is “freedom money” because it cannot be confiscated. Any individual on the planet can store the fruits of their labor in censorship-resistant, globally portable, scarce money by memorizing a 12-word seed phrase. Someone living in an oppressive regime can simply memorize that 12-word seed phrase and then escape to a regime that respects property rights, restore their bitcoins from the 12-word seed phrase, and begin their life anew.

Let’s next dive deeper into the engineering of Bitcoin to understand how Bitcoin accomplishes all this.

B. Nakamoto Consensus: Proof of Work, Longest-Chain Rule, and the Difficulty Adjustment

Nick Szabo coined the term “unforgeable costliness” to describe what secures Bitcoin. This is an apt term because bitcoins are indeed costly to produce—and this costliness, which cannot be forged, is a fundamental feature that gives Bitcoin its security. One way to think about Bitcoin is as a decentralized database with a changelog that cannot be forged because it’s too expensive to forge it. Without this unforgeable costliness, humankind would not be capable of moving scarce value—emphasis on scarce—at the speed of light and thereby solving the monetary problems we just discussed.

Bitcoin is costly to produce, both in computational resources and the consumption of energy. Both factor into Bitcoin’s consensus mechanism, which is frequently called “Nakamoto Consensus,” and which consists of proof-of-work plus the so-called “longest-chain rule.” Indeed, the longest-chain rule enabled Bitcoin to succeed where previous attempts to create cryptocurrencies using proof-of-work alone failed.

But Nakamoto Consensus requires the use of energy, and Bitcoin’s use of energy is one of its most controversial characteristics. Why does Bitcoin use so much energy? After all, aren’t there multiple ways to create Byzantine fault tolerant (BFT) consensus mechanisms in distributed systems, not all of which require a substantial expenditure of energy? Indeed, and some cryptocurrency protocols have moved away from energy intensive proof-of-work (most famously, Ethereum moved to proof-of-stake last year).

But Byzantine fault tolerance alone is insufficient to guarantee security; proof-of-work plus the longest-chain rule are necessary to guarantee security, and proof-of-work requires energy. 

The longest-chain rule guarantees that any participant’s node may join or re-join the Bitcoin network at will and always be able to catch up to the consensus ledger without relying on any centralized authority to tell it which is the consensus ledger. That is another fundamental difference between Bitcoin and pretty much all other cryptocurrencies: Bitcoin is truly decentralized because Nakamoto Consensus allows each node to determine on its own which is the longest chain (namely, the chain with the greatest cumulative proof-of-work difficulty), and to “catch up” on its own when it joins or re-joins the network. That is not true of partially decentralized systems, such as proof-of-stake, which rely on a trusted arbiter to varying degrees and thus tend toward centralization and the greater risk of being co-opted by elites.

Whether Bitcoin’s consumption of energy resources for proof-of-work exceeds or falls short of the amount necessary to provide sufficient security and decentralization is a topic for another day. The key takeaway is that Bitcoin’s energy consumption is not wasted because users are voluntarily paying for that level of security and decentralization, every minute of every day. “If people find that electricity is worth paying for, the electricity has not been wasted, ” as economist Saifedean Ammous observed

To establish trust today in the traditional financial system, we use an army of controllers, auditors, accountants, trustees, lawyers, transfer agents, registrars, county clerks, custodians, regulators, and myriad other forms of third-party validators, and sometimes we throw in a central counterparty to stand in between, and then we duplicate and reconcile the very same data across each of these parties. A foreign exchange transaction will likely flow through six different banks or central banks before it is finally settled, for example, which means that very same transaction data would hit six different data centers. It’s a tremendously inefficient and resource-intensive way to create trust.

But few people think twice about the consumption of electricity to secure the banking system or a country’s defense. Yet, when we look at electricity usage by the banking system and by governments, it turns out they’re by far the biggest users of electricity. Dan Held took a crack at estimating the total cost of all those various pieces through which the banking system tries to establish trust, as well as the total power used by governments, in his 2018 paper, “PoW Is Efficient:”

  • Banking system uses 2,340m gigajoules
  • Governments use 5,861m gigajoules

Bitcoin uses 436m gigajoules, using a September 26, 2023 update converted to gigajoules. 

Here’s another comparison: the Bitcoin network today consumes about 8% of the power consumed by our always-on electronic devices.

To estimate Bitcoin’s future power usage, engineer Lyn Alden built a projection model. In one scenario in which Bitcoin has a $5-10 trillion network value, hundreds of millions of users and a per-coin price of $250k to $500k, Bitcoin’s electricity use would represent 0.3% to 0.5% of global energy usage, up from less than 0.1% today. And in an upside scenario, with a network value of $20 trillion or more, billions of users and a per-coin price of $1 million, Bitcoin would represent 0.6% to 1.0% of global energy usage. At that point, she surmises, Bitcoin would be big enough to replace a material quantity of the energy used by the global banking system. In that upside scenario of billions of Bitcoin users, it would consume roughly the same amount of energy as the aluminum industry consumes today.5

But Satoshi designed a balancing feature into Bitcoin that indirectly adjusts up or down its energy use. Called the “difficulty adjustment,” it programmatically adjusts up or down the computation necessary to complete Bitcoin’s proof-of-work. Bitcoin’s difficulty is a measure of how difficult it is to “mine” a Bitcoin block by winning the race to generate a fixed-length code (known as a hash). Every 2,016 blocks (approximately 2 weeks), the Bitcoin protocol programmatically adjusts mining difficulty to ensure that Bitcoin blocks are discovered every 10 minutes on average. When more hashpower joins the network and Bitcoin blocks are produced more frequently than every 10 minutes on average, the protocol adjusts difficulty upward at the next adjustment to keep the average block time at 10 minutes; and vice versa.

The difficulty adjustment is a critical part of the beautiful balance of Bitcoin’s system design, because it helps rate-limit the energy usage based on the real demand for network security and decentralization. It also affects Bitcoin’s use as a monetary system. In the words of economist Saifedean Ammous, “Difficulty adjustment is the most reliable technology for making hard money and limiting the stock-to-flow ratio from rising, and it makes Bitcoin fundamentally different from every other money.”

In certain areas of the digital realm, we want interactions to be frictionless; but in others—especially when securing a ledger of scarce and highly valuable digital property—we need friction to guarantee security, scarcity, and incorruptibility. For Bitcoin, Nakamoto Consensus provides that friction; someone expended energy to produce every single bitcoin that exists. Energy use is a key part of what makes Bitcoin secure, and the fact that people choose of their own free will to pay for it shows it is not wasted.

Next, let’s turn to a discussion of the impact of bitcoin on power grids.

II.          Bitcoin As A Risk Management Tool For Balancing Power Grids

When defining bitcoin “mining” earlier, I used air quotes because the term is a misnomer. A better term, again crediting Lyn Alden, is “interruptible data processing.” Why? Because bitcoin miners can shut off their machines without hurting the Bitcoin network when power prices spike. This helps grid operators balance both temporary fluctuations in demand and supply as well as the intermittency of supply inherent to renewables. Bitcoin miners are not only the ideal candidate for demand response programs run by grid operators to ensure that critical services like hospitals and first responders keep power during supply shocks, but they are also helping grid operators justify developing new green energy projects because bitcoin miners help grid operators handle the intermittent supply.

As Nic Carter and Shaun Connell explain it, “What the miners do is provide a load resource which eagerly gobbles up negatively priced or cheap power (everything on the left side of [a power price distribution] chart), while interrupting itself during those right-tail events [such as a winter storm or a heat spell that causes power prices to spike temporarily].” And it’s not just theoretical: during a winter storm that hit Texas last year, Bitcoin miners “returned up to 1,500 megawatts to the grid, enough to heat over 1.5 million homes or keep 300 large hospitals fully operational,” according to Dennis Porter of Satoshi Action Fund, citing Texas Blockchain Council member data collected by Lee Bratcher.

Bitcoin miners have strong economic incentives to search out cheap power since bitcoin mining is a thin-margin, cyclical business, which is why they are known as the “buyer of last resort for all electricity.” We see that here in Wyoming, with bitcoin miners powered by gas that oil producers would otherwise have flared. As Nic Carter explains: “[The Bitcoin network casts a] global energy net [that] liberates stranded assets and makes new ones viable. Imagine a 3D topographic map of the world with cheap energy hotspots being lower and expensive energy being higher. I imagine Bitcoin mining being akin to a glass of water poured over the surface, settling in the nooks and crannies, and smoothing it out.” 

In 2021 a midwestern utility itself began to mine bitcoin as a means by which to avoid ramping down production from its “peaker” power plants when demand is low and ramping up again when demand is high—which, counterintuitively, wastes energy and stresses the plants. The key is that it takes more energy to fire up a power plant than to keep it running on low output, which is why energy companies themselves are starting to mine or strategically partner with bitcoin miners. When I first saw this news in 2021, it struck me how these arrangements can be win-win-win—for the bitcoin miner and the power producer, as well as for the utility’s end consumers—and that this is the beginning of a trend of vertical integration of bitcoin mining into the energy industry. Nic Carter agrees: “Bitcoin mining is converging with the energy sector with amazing rapidity, yielding an explosion of innovation that will both decarbonize bitcoin in the medium term, and will dramatically benefit increasingly renewable grids.” This convergence is attracting some of the best engineering talent, including hyper-scale data center engineers, to the bitcoin mining industry. I’m fortunate to have had a seat in the arena to watch the professionalization of bitcoin mining and to witness miners deploying load-balancing software that optimizes their power costs—including balancing out the intermittency of renewables.

III.         CONCLUSION

I can’t close this speech without paying homage to the engineer who had the greatest impact on my life—my late father, Francis Long. He was an electrical engineering professor here at UW for nearly 40 years. Oh boy, do I wish he were alive to talk Bitcoin! The grid balancing characteristic would have been of special interest to him, since one of his early professional achievements was helping the City of Seoul rebuild its electrical grid after the Korean War. After serving in the U.S. Army Corps of Engineers he stayed in Seoul after the war, and as special recognition for his work the utility awarded him the ring I’m wearing in his memory today.

And last, special thanks go to UW. In 2018, its Computer Science Department partnered with a few of us Wyoming Blockchain Coalition folks to create the first-ever hackathon in Wyoming. Now in its 6th year and overseen by Steve Lupien, the event brings hundreds of software developers and company sponsors to UW’s campus every year—and one or more billionaires have attended each year. This event is a win-win-win for UW, Wyoming, and the blockchain industry. It has helped put UW on the map globally, helped spur UW to become the first U.S. university to offer its students a minor in blockchain, and has raised $3.1m for UW in its 6 years—which, for UW, is meaningful size. The hackathon punches far, far above its weight class in prize money available for competitors, thanks to UW generously providing the venue at cost. 

The whole effort at UW is now interdisciplinary, just like Satoshi’s beautiful interdisciplinary invention. But at the core of it is engineering.

And with that I’ll close with a final observation from engineer Michael Saylor: “Humanity advances by engineering – civil, chemical, biomedical, metallurgical, mechanical, nautical, electrical, aeronautical, astronautical and now monetary. #Bitcoin”

  1. Alden, Lyn. Broken Money. Timestamp Press, 2023, p. 300. ↩
  2. Alden, Lyn. Broken Money. Timestamp Press, 2023, p. 301. ↩
  3. Alden, Lyn. Broken Money. Timestamp Press, 2023, pp. 301-302. ↩
  4. Alden, Lyn. Broken Money. Timestamp Press, 2023, p. 292. ↩
  5. Alden, Lyn. Broken Money. Timestamp Press, 2023, pp. 385-389. ↩

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Here Come The Fintech Banks!!

https://caitlin-long.com/here-come-the-fintech-banks/

Fintechs have been waiting for years for a U.S. federal payments charter, which has been tried and blocked twice. But a newly disclosed precedent reveals such a charter already de facto exists – and in more than half of the 50 U.S. states, no less. Courts will determine the degree of the charter’s traction in the coming months because the Fed is unlawfully blocking nine applicants that currently hold the charter, and the Fed is facing lawsuits from two of them to force the Fed to comply with the law and let them in.

Background:  Why A Version Of The Federal Fintech Charter Already Exists

Five U.S. states have offered uninsured bank charters for a while, and in late June it was revealed that a sixth U.S. state joined the effort by preliminarily approving a payment company to become an uninsured, non-lending bank under its traditional banking law. That state—Idaho—used its traditional bank chartering statute, which enables (but does not require) its banks to be FDIC insured. The charter applicant said Idaho’s bank regulators agreed that its payments-only, non-lending business model did not require FDIC insurance. Roughly half of the 50 U.S. states use similar bank chartering statutes, which allow but do not require banks to be FDIC insured. Consequently, payment fintechs that do not lend – which can already choose from uninsured bank charters in Connecticut, Maine, Nebraska, Vermont and Wyoming – now have up to ~25 more states that could charter payment banks without insurance under their existing statutes, and all it takes is the governors or banking commissioners of any of these ~25 states to decide to follow Idaho’s lead and start attracting fintechs to their states by chartering them as payment banks.

It’s no surprise that the U.S. states would step forward to charter payment banks—because state banking regulators already know how to regulate payment companies. They’ve been doing it successfully for years, albeit under a different license (namely, state-issued money transmission licenses).

What’s In It For The Fintechs?

Two things: streamlining the 50-state licensing process and eligibility for Fed “master accounts.”

First, uninsured state bank charters are portable into more than half of the 50 U.S. states without additional licensure, depending on the bank’s products and customer base. So, becoming an uninsured state-chartered bank would lighten the workload for a payments company licensed today as a money transmitter.

Second, uninsured state-chartered banks are eligible for direct access to federal payments systems via Fed master accounts, which cuts the cost, settlement time and counterparty credit risk faced by payment fintechs that use partner banks today. More on this below.

There are costs, though. Upgrading from a licensed money transmitter to a chartered bank entails a significant increase in required capital, regulatory compliance (higher examination frequency and intensity and stricter Bank Secrecy Act/Anti-Money Laundering standards), risk management, core integration costs and other factors.

But in Europe, some payment fintechs have made the upgrade. Klarna and Adyen, for example, upgraded to bank charters in 2017 in order to speed payment settlement and “displace their banks,” according to Adyen’s CEO. Note that Netherlands-based Adyen leapfrogged all the American-based fintechs to become the only fintech included in the Fed’s initial FedNow participant group (because, as a foreign bank, Adyen was able to back into a Fed master account in 2020 – curiously, though, before it established the U.S. branch of its bank in 2021).

Are Uninsured State Bank Charters The Path To A Fed Master Account For Fintechs?

The Fed’s recently disclosed database of master account holders revealed that 414 uninsured entities hold Fed master accounts. It also revealed that nine uninsured state-chartered banks have applied for Fed master accounts. All nine of these payment banks have different business models focusing on payments – some are already operating as fintechs that are upgrading to a bank charter, while others are not yet operating – and they number four from Wyoming, three from Connecticut, one from Idaho and one from Vermont.

Source: https://www.federalreserve.gov/paymentsystems/master-account-and-services-database-access-requests.htm

The Fed has unlawfully delayed or blocked all nine of these applicants. Two recently denied applicants sued the Fed shortly after their respective denials in recent months (including Custodia Bank, of which I’m the CEO), asking courts to enforce the law that requires the Fed to serve all eligible depository institutions. So now, each time the Fed denies a master account to an eligible depository institution, it’s likely to face another new lawsuit.

The newest lawsuit against the Fed was filed in late June in the federal court circuit that includes California, which is where most U.S. fintechs are based. If this plaintiff prevails, the Fed could see California-based fintechs relying on that precedent to obtain uninsured state bank charters within the Ninth Circuit and become eligible for Fed master accounts en masse.

It’s ironic – and it’s also un-American – that a European fintech was able to leapfrog all American fintechs to become the first and only fintech among the initial FedNow participants, at the same time as the Fed continues to block American payment banks from gaining access. Thankfully, a handful of U.S. states are stepping forward to help solve this problem by chartering payment companies as banks, thereby restoring the balance of power to the states within America’s dual banking system. Now it’s up to the courts to determine whether the Fed must follow the law and let these states’ lawfully chartered – and eligible – banks in.

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Why Defending The Right of States to Charter Banks Without Federal Permission Is Critical

https://caitlin-long.com/why-defending-the-right-of-states-to-charter-banks-without-federal-permission-is-critical/

Throughout U.S. history, states could charter banks without federal government permission. Recently that changed when federal bank regulators stealthily voted to give themselves a veto over certain state banks. They did so by purporting to exercise “discretion” to decide which state-chartered banks can open an account at the Fed, through which banks join the U.S. dollar payment system. Of course, without payment system access a bank is nothing more than a vault. That the states remain free to charter banks, and that those banks in turn have access to the payment system, is one important way for states to counter a disturbing trend that originated in Washington, D.C. – the politicization of banking.

Most of us want simple things from our banks: to keep our money safe, to know that we can access our money whenever we want it, and to bank wherever and however we choose to bank. We do not want our banks to become political pawns.

Until a decade ago, it was unheard of that a bank would stop serving entire groups of customers or the people in lawful — if controversial — industries. It was also unheard of that banks would be blocked from accessing either of the two federal utilities in the banking industry: (i) deposit insurance and (ii) the U.S. dollar payment system (which the FDIC and Fed operate, respectively). Indeed, legislative history shows that Congress took great pains to keep the operation of these two utilities standalone and fully separated from the power to charter banks. As a check and balance, Congress wanted all chartering work done exclusively by the states or the lone federal agency that can charter banks, the OCC. Access to the two utilities was automatic for eligible banks, albeit with bank-specific insurance premiums and overdraft restrictions.

In recent years, though, that long-standing paradigm changed. The Fed began to veto payment system access for certain state-chartered banks, thereby overriding the states’ chartering decisions. Entire industries (and some of the people in them) faced the loss of bank accounts in reaction to FDIC pressure on banks regarding “reputation risk” – a subjective standard that factored into a 2013-17 FDIC program called Operation Choke Point. Recently, federal banking agencies have cooperated with a White House policy to move against even the law-abiding parts of the digital asset and fintech industries.

Historically, states have acted as a check against federal overreach in banking. There is a key reason why: the mission statements of state banking agencies usually require them to support both safety and soundness AND economic development, while federal bank regulators do not have economic development within their wheelhouse. This creates a healthy tension and explains why innovation in banking often originates within the states. The Fed and FDIC have no veto power over state chartering decisions. 

This approach originated with President Abraham Lincoln, who united the U.S. behind a single national currency – the U.S. dollar – in 1863, and enacted a system in which both the states and the federal government have equal power to charter banks (the “dual banking system”). Lincoln created that delicate power balance between Washington, D.C. and the states in banking, and it remained in place for more than 150 years before the recent incursions on it that emanate from Washington, D.C. Congress maintained that delicate balance when it created the Federal Reserve in 1913 and the FDIC in 1933, by choosing to give the Fed and the FDIC exclusive authority to operate their respective utilities but not giving either of them any role in bank chartering. Congress again respected the delicate balance in 1980 when it further clarified the utility nature of the Fed’s role as payment system operator by requiring the Fed to provide services to all eligible banks on a non-discriminatory basis

In recent years, the usurpation of state power has been the subject of multiple lawsuits against the FDIC (here) and the Fed (here, here and here). 

One of the banks caught up in the recent federal dragnet against digital assets is Custodia Bank, a new bank I founded that is not yet accepting deposits. It is a state-chartered bank that was recently denied access to both of the federal banking utilities (FDIC insurance and the U.S. dollar payment system). In denying payment system access to Custodia, the Fed cited Custodia’s lack of FDIC insurance and lack of a federal regulator among its reasons for denial and, in doing so, the Fed improperly created for itself the unilateral power to require all state banks to be both insured and federally regulated. 

This overreach is new, and it caused Wyoming’s Attorney General to move to join Custodia’s lawsuit against the Fed’s Board of Governors and the Kansas City Fed. In its court filing, Wyoming’s AG noted the Fed created a “Kafkaesque situation” where a Wyoming-chartered bank is denied access to the U.S. dollar payment system “because it is not federally regulated, even while it is also denied federal regulation.” Wyoming worked closely with the Fed to create its new bank charter, holding more than 100 meetings with Fed officials before the charter went live and the first four banks, including Custodia, earned charters.

Historically, the choice whether states would require their banks to be insured or federally regulated rested solely with the states, not with Washington, D.C, and until approximately 1990 most state laws were silent on the topic. Banks simply chose to be FDIC insured and federally regulated, and the Fed and FDIC routinely granted them access. But five U.S. states held back, keeping flexibility for themselves and a check on potential overreach by federal bank regulators. The five states – Connecticut, Maine, Nebraska, Vermont and Wyoming – enacted bank charters that neither require insurance nor federal regulation. Such uninsured state banks are prohibited from lending (either explicitly by law or functionally), and therefore hold 100% cash to back customer deposits plus up to 8% of deposits as an additional capital requirement. 

In other words, the existence of uninsured state bank charters is an insurance policy for these five states to ensure that their citizens and businesses – including politically disfavored ones – can retain banking system access regardless of the whims of the party in power in Washington, D.C.

Federal bank regulators in recent years have upended the decades-old, delicate power balance between the states and the federal government in banking. Congress tasked the Fed and FDIC with running utilities; it did not give the Fed and FDIC veto power over U.S. states – and, in turn, power to block the responsible innovations that state banking authorities create as they fulfill their economic development mandates. By usurping state power, the Fed and the FDIC are politicizing what should otherwise stay an apolitical industry. 


Congress tasked the Fed and FDIC with running utilities; it did not give the Fed and FDIC veto power over U.S. states – and, in turn, power to block the responsible innovations that state banking authorities create as they fulfill their economic development mandates.


A Brief History of the Dual Banking System:

  • States were the only bank chartering authorities in the U.S., from America’s inception until 1863 (except for the U.S. central banks).
  • In 1863, Congress created the OCC, a federal bank chartering authority, in the National Bank Act. From that time, banks could choose whether to be federally or state-chartered, and both types of banks equally shared the same national currency system pursuant to the National Currency Act of 1863.
  • In 1913, Congress created the Federal Reserve. Among other things, it administers the U.S. dollar payment system.
  • In 1933, Congress created the FDIC in response to Depression-era bank failures. 
  • From 1933 to roughly 1990, most U.S. states did not require their state-chartered banks to be FDIC-insured. Most banks voluntarily became insured.
  • Following the bank failures of the late 1980s, many U.S. states chose to require their state-chartered banks to become FDIC-insured (and, consequently, federally regulated). At the same time, three states – Connecticut, Maine and Vermont – enacted parallel uninsured state bank charters to keep flexibility. Of these, Connecticut has been the most active.
  • In 1994, Congress enacted the Riegle-Neal Act to enable state-chartered banks to do interstate banking. 
  • Until Operation Choke Point began in ~2013, FDIC insurance was readily available to all state-chartered banks.
  • FDIC insurance was not available to banks serving the digital asset industry, prompting Wyoming and Nebraska to enact uninsured state charters in 2019 and 2021, respectively. 
  • The Federal Reserve has blocked payment system access to a Connecticut-chartered uninsured bank since August 2017 (TNB) and to a Wyoming-chartered uninsured bank since October 2020 (Kraken Bank), both of which remain pending. In March 2023, the Federal Reserve released its order explaining the denial of both a master account and membership to a Wyoming-chartered uninsured bank (Custodia Bank), defining the new requirement in its order that all state-chartered banks must be insured and must have a federal regulator (either the FDIC or the Fed itself).
  • On April 11, 2023, Wyoming’s Attorney General filed a motion to intervene in Custodia Bank’s existing lawsuit to challenge the new Fed requirement that state-chartered banks must be FDIC-insured and federally regulated. 

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Why Can’t We Just Have Safe, Boring Banks?

https://caitlin-long.com/why-cant-we-just-have-safe-boring-banks/

Amid the current financial panic, calls for “safe banks” are once again pouring in – but this time they’re coming from mainstream voices like Harvard Business Review, Silicon Valley entrepreneurs/podcasters, macroeconomic analysts, the CEO of biotech company, and individuals on social media. All such calls echo a similar sentiment: why can’t my money in the bank simply be there when I need it? Answer: your money can be made safe in your bank, even above the $250,000 FDIC insurance limit. Ironically, the Federal Reserve is blocking the path to make it so.

If banks were “money warehouses” that simply hold your deposits for you, the financial system would be far more stable than it is today. 

Assume you park your car at a valet garage and come back from dinner to find that the garage has rented out your car to an Uber driver and pocketed the earnings. You’d of course be angry. And if the Uber driver crashed your car, you’d be livid because you would face an unexpected financial loss. Instinctively, most of us recognize the unfairness of this scenario. Yet, that’s exactly what banks do with our money every day, legally – they rent it out and pocket the earnings, while you bear the risk of loss. Until very recently, we accepted this as normal. But it wasn’t always so. 

Throughout most of human history, banks were just “money warehouses” that stored money and charged customers a fee for the service. What we think of as banks today – both a lender and a depository together – is comparatively new. Why? Because both storing and lending the very same customer money is inherently an unstable proposition – its stability could be fleeting because it rests on the idea that not all customers will want their money back at the same time. 

Such a system inherently is prone to periodic crises, the amplitude and frequency of which tend to increase over time. In today’s era of easy access to information and online banking tools that make the analog bank runs of the It’s A Wonderful Life era appear quaint, the notion that banking system stability rests on the shared confidence that everyone won’t withdraw simultaneously has proven to be a dangerous idea.

The U.S. had no central bank between 1836 and 1913, which meant banks during this period survived or failed on the basis of their own success. There were no government bailouts and there was no government lender-of-last-resort. Fraud and many bank failures happened, for sure. But during this period American banks – without any government backstop – successfully financed the industrialization of America, which brought improved living standards and a burgeoning middle class.

America created a backstop for the banks in 1913 when Congress authorized the Federal Reserve. Banks evolved away from the “money warehouse” model toward the riskier model of “borrow short-term and lend long-term” – i.e., banks both storing and lending very same customer deposits

In the thick of today’s social media-accelerated, online-banking accelerated banking crisis, that “borrow short-term and lend long-term” model is less stable than it has ever been. And it’s about to become even less stable – because the speed of money movement in the U.S. is scheduled to accelerate this July, when the new FedNow payment system comes online. Intended to replace Fedwire, FedNow will allow depositors to access their bank deposits 24/7/365. Just imagine how much worse today’s banking crisis would be if panicked depositors could move their funds during the news-filled weekends. Borrowing from Hoover’s famous Depression-era statement, deposits would be flinging around “like a loose cannon on the deck of the world in a tempest-tossed era.” 

It need not be so. The solution to the problem is simple: some banks need to become “money warehouses” again – specifically, to hold *cash* to back all deposits that might be withdrawn on short notice. In other words, the solution need not involve a new government guarantee of uninsured deposits. As a new Harvard Business Review article correctly points out, vital payments like business payrolls frequently exceed the $250,000 FDIC-insured deposit limit. (The FDIC’s deposit insurance fund has only $128.2 billion of assets, compared to $17.6 trillion of deposits in U.S. banks.) Were non-lending “safe banks” to be able to offer such payment accounts, they would need no government backstop from the Fed, the FDIC or otherwise. Such non-lending bank charters already exist in several states, including Connecticut, Wyoming and Nebraska. 

Unfortunately, the Federal Reserve has been blocking non-lending banks from accessing Fed payment systems, though, which means the “safe banks” either cannot operate at all or cannot provide the very “safe banking” services that consumers want. But loud calls for “safe banks” from many mainstream places indicate they represent an idea whose time has come.

Two questions arose during recent social media conversations about “safe banks“:

  1. How would “safe banks” make money? Answer: fees instead of net interest margin. Such “safe banks,” by definition, would not be low-cost providers. Depositors could vote with their feet based on their own cost/benefit tolerance. 
  2. Wouldn’t such a bank trigger the very deposit run that traditional lending banks fear? Answer: No, because “safe banks” cannot afford to pay competitive interest rates to depositors (since “safe banks” do not lend). On the contrary, the entrance of “safe banks” would likely impose a healthy market check on lending banks by forcing lending banks to pay competitive interest rates to depositors to compensate them for credit risk — which they are generally not doing today. In other words, consumers would win. Depositors could choose between safety and yield based on their own preferences. Two additional factors would act as brakes on how big “safe banks” could grow during banking system panics:

    (a) the high capital requirements that apply to all banks, which means “safe banks” would need to turn depositors away if they did not have enough capital to handle a sudden deposit influx, and

    (b) deposit concentration limits that limit the per-depositor balance at a “safe bank.”

The Harvard Business Review article summed up the case for “safe banks” well:

“The reality is that the U.S. banking system has become much less dynamic since the global financial crisis [of 2008]. Entry is nearly non-existent. While the number of U.S. banks may be high relative to many other countries, the truth is that we don’t need more traditional banks — we need different kinds of banks. Crises are terrible things to waste, and this one could lead us to a much safer banking system by recognizing the problem of the uninsured depositor and creating a home for them.”

Mihir A. Desai and Sumit Rajpal, How “Payment Banks” Could Prevent the Next Bank Collapse,
harvard Business Review, March 17, 2023

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