A note on Bitcoin foreign exchange

Bitcoin has been extremely volatile of late.  That doesn't speak well for its potential as a currency, but the  Economist's Free Exchange blogger makes a good point:  Volatility is only a problem to the extent you have to exchange with other currencies.  If the virtual nation of Bitcoinia can transact its business in pure Bitcoin, then it matters much less how many dollars people think a Bitcoin is worth.  Even so, the examples of volatility cited in that article, as much as 20% in a matter of weeks, are far, far below what Bitcoin has experienced over the past month or so.

Right now we don't seem very close to such a scenario.  There don't seem to be a lot of places where goods or services are priced purely in Bitcoin.  Rather, the real price is in some reserve currency and the Bitcoin price is based on the going rate.  For at least some period of time, transacting in Bitcoin will generally involve converting to and from reserve currencies.  Bitcoin foreign exchange, if you will.

That's a bit of a problem.  To use one of the several existing Bitcoin exchanges, you have to provide an account in conventional currency, subject to conventional banking regulations and so forth, which is pretty much the opposite of what Bitcoin is supposed to accomplish.  Besides that, having a single point of failure that can bog down or fall over at any point (and is more likely to just when the need for it is most urgent), seems silly.  Finally, I've seen complaints that exchanges can tend to charge fairly heavy transaction or withdrawal fees, which Bitcoin is supposed to eliminate.  Can we do better?

It shouldn't be a problem to track bids, offers and trades in a distributed manner.  Bitcoin already does much the same with its blockchain, and there are various flavors of distributed hash table running around.  I'm sure someone could come up with something.

The bigger problem, I think, is escrow, since this is all supposed to be pseudonymous.  Suppose I call myself Mr. Blue and I own a Bitcoin wallet.  Ms. Green is willing to give me $X for one of my Bitcoins.  We can both make sure the world knows this without going through a central exchange.

But how do we actually settle the trade?  I need to give Ms. Green one Bitcoin.  Bitcoin makes that easy.  I initiate a transfer and few minutes to an hour later the Bitcoin world agrees that that Bitcoin is hers (or, more precisely, is now in the wallet whose identity she gave).  Ms. Green then disappears and I'm one Bitcoin poorer.

To make this work, Ms. Green needs to put $X in a safe place.  At that point, the dollars are no longer hers, but neither are they mine.  When the Bitcoin transfer settles, and only then, I get access to the dollars and transfer them to my account.

What we need, then, is is a way of moving currency from one conventional bank account to another, securely, anonymously and cheaply, without having to trust any particular third party.

I don't know if that's technically feasible or not, but if it is, it's not clear why we would need a virtual currency.