This was originally published on shivendramisra.com/blog
Money. Money is what we all want. Money is what we all need. Money decides how we live. Money decides what food we eat.
But, in our busy lives, have we ever thought about what money is actually?
The 10 dollar bill that you have in your pocket, the gold ring that you’re wearing in your hand, or the plastic card in your wallet?
“All money is a matter of belief” — Adam Smith
While money seems so common today, humanity did not start with money. As we all know, we started with barter. People used to take what they want by giving what the other person wants. In basic economic theory, we call this “double-coincidence of wants.“
But soon, people figured out that the system is flawed. They would not always find someone who has what they want and is also willing to take what they have. Plus, there were other problems like portability and divisibility — a cow is not very portable and cannot be divided into smaller pieces to buy anything.
So people started thinking,
“What is that everyone wants, is portable and divisible?”
Seeds! Dried Corn! And various other commodities.
This seemed like a good option, but the problem is that seeds get perished over time. If the value that your possessions have become zero in some time, why would you want to store your wealth in them?
So what is something that everyone wants, is portable, divisible and can be stored for a long time?
Metal. These commodities acted as currencies for a long period of time. Metals like gold, silver, and bronze had all the above properties and were scarce, which gave them their value.
When people had problems storing the metal coins, they deposited it with temples who then gave them a receipt which was a proof of ownership.
The receipts soon changed into paper currency and the temples were replaced by governments. Paper currency was easier to store and carry for most people. But who was keeping this gold? The government, of course.
Till this point, the paper currency held its value because it is backed by something scarce like gold. This is called the “Gold-Standard.”
So why don’t we see the gold standard today?
Nations started getting richer and wealthier day by day. If this rise in wealth was not complemented by an increase in the money supply (by printing more money of course), the nations would enter a deflationary situation. However, to print more money they had to ensure that all their currency was backed by gold.
If pieces of paper are not backed by gold, what are they even worth? But there was certainly not enough gold in the world to back the money supply of all the nations. Additionally, since America was in a trade deficit, all the gold which America had would be exported to other countries.
Thus, the system was not sustainable for the long run.
Amidst all the spending requirements and the need of nations to generate more money, the gold standard was no more attractive to the developed nations. As a result, they called it a day.
Fiat Currency enters
Soon after the second world war, the Bretton Woods Agreement decided to shift from the gold standard to fiat. Which simply meant that instead of pegging their currencies to gold, the countries would peg their currencies to the US dollar. The US government had also severed all links between the US dollar and gold by 1971.
But if the currency was not backed by gold, how did it get its value?
From tax liabilities.
Governments essentially made it a law for all transactions to take place through a particular currency as well as demand taxes in the same currency. Thus, the value of fiat is decided by the governments and not by some asset having an intrinsic value.
This meant that governments could print as much money as they want. If their expenditures are not met by the tax revenue, they do what? That’s right, they print more money!
Okay, so now all we have is just a piece of paper, with no commodity attached to it. But money cannot exist in a vacuum. Though the government forces us to use fiat currencies for our everyday transactions, it can fail.
Currency notes tend to wear off over a period of time. You cannot carry money to make big purchases. Consider buying a house by giving piles of cash or buying an item worth $100 with 400 coins of 25c each — hardly any seller would accept that. Consider sending $100,000 to someone in a different country just by wrapping it up in an envelope.
I think you get the point.
What we needed is a system to record our ownership of funds and help us store and transfer value easily. Are you thinking about the same thing as me?
Yes, that’s right, we needed banks.
In a lot of ways, banks make our lives easier. They help us have access to credit facilities, store huge amounts of money with them which is impossible for us to store ourselves and also provide us with interest on our deposits. A good deal right?
Banks are not angels from the heaven who exist to make your lives easier (though it may feel so). Banks are businesses at the end of the day and their aim is to make tons of money. The money the depositors keep in the bank is used to give loans to other people. It is just like a money lender who wants more money to lend.
So the banks give us interest on our deposit for the trust that we place in them. The bank then loans that money to other people and earn their income from the difference in the interest received vs the interest paid, called the spread.
But there is one more way banks make money — by selling the loans as financial assets, as we have previously seen in the 2008 financial crisis.
The credit crisis of 1772, the great depression of 1929, the Asian crisis of 1997, the 2001 dot-com bubble, and the most recent financial crisis — the 2008 Subprime mortgage crisis — are all examples that show how poorly banks have handled our trust.
And there is no guarantee that we won’t have a crisis again.
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. — Satoshi Nakamoto
But what choice do we have?
I don’t think you would want to trade cows, horses, and seeds as we did before. We need a new alternative. Someone smart needed to come out with yet another form of money.
A Quest to Find a New Form Of Money
“I do sense that the financial system is under the gun. In order to keep our system and economies moving globally, there’s the need to create new money” — Henry Kaufman, President of Henry Kaufman & Co.
David Chaum, in 1982, gained a doctorate in computer science and business administration from the University of California, Berkeley. Little did he know that he would go on to be an influential personality in the cryptography industry by inventing the Blind Signature Technology.
In 1983, using this technology, he then designed a system wherein the government, banks or any third party could not see information about the transaction happening online and also made a mechanism to solve the problem of double-spending. This lead to the creation of a cryptographic money called e-cash.
He incorporated his company Digicash in 1989 and implemented e-cash through his company in 1995. However, in the United States, only one bank — The Mark Twain Bank in Saint Louis, implemented Ecash to use it as a micropayment system. Things were not favorable for the Bank as it was only able to signup 5000 customers in a large period of three-years.
The credit cards eventually took a toll over the economy as a preferred method of payment due to which the company went bankrupt in 1998.
There were three more key instances which helped in the development of digital currencies after e-cash:
- In 1996, NSA entered the scene by publishing a paper called ‘How to Make Mint: The cryptography of anonymous electronic cash’ in an MIT mailing list and also in The American Law Review. This paper clearly defines electronic cash and how it is different from any other electronic payment scheme due to the application of cryptography in the system.
- In 1998, Wei Dai published a description of “b-money” — an anonymous, distributed cash system. Satoshi Nakamoto has also referenced b-money while creating bitcoin. When originally published on Cypherpunks mailing-list in 1998, Dai proposed two protocols out of which the first one used a proof-of-work function for creating money, similar to what bitcoin uses today.
- Soon, Nick Szabo, a computer scientist, and cryptographer made bitgold, which was an electronic currency system which required users to complete a proof of work function with solutions being cryptographically put together and published to the network. Though bitgold was never implemented it was called a direct “precursor to the Bitcoin architecture.”
The solutions though pretty impressive were never implemented and failed to create any impact whatsoever.
Was anyone smart, and at the same time courageous enough to challenge the existing financial system?
“The reason we’re all here is that the current financial system is outdated” — Charlie Shrem, BitAngel, BitPay, Bitcoin Foundation
In 2009, a cryptography enthusiast and researcher (or researchers) released a white paper called titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” The paper outlined Satoshi’s vision,
“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers.”
By using advanced cryptography and introducing the concept of blockchain to store the bitcoin transactions, he (or she or them) proposed a system wherein people could transact with each other without the need for a central authority to maintain trust between the parties.
The trust was instead built into the network as all the participants maintained the network security and stability.
New coins were created not by the government but by a process known as mining, which is open to anyone and only requires investment in machines with high computational powers. The system also has incentive mechanisms to reward creators of bitcoin (miners).
So, bitcoin is portable and divisible (up to 8 decimal places), like no other currency. In addition to that, the supply of Bitcoin is capped at 21 million which means that it is scarce and thus has some value. As has been popularly said, bitcoin is essentially “digital gold“, except it is easier to mine, carry and store.
Since then Bitcoin has gained a lot of popularity and has become the “King of Cryptocurrencies.” While nations have had mixed responses to bitcoin, it is highly likely to thrive in the future. The network cannot be shut down (unless, of course, you shut the Internet).
Bitcoin’s market cap, which is close to $ 110 billion, has been increasing ever since its launch, though it had its own share of problems.
I’ve written a complete introduction on Bitcoin for anyone who does not understand it. You can find it here.
Can Bitcoin Replace Fiat?
So Satoshi is our guy! He invented something which pretty much has all the characteristics to be called as money. But can it ever be used in that way?
The question, in my opinion, does not have a concrete answer as of now. We’re in the very early stages of the ecosystem and it has only been a decade since the technology has been invented.
However, let’s try to analyze various aspects of bitcoin and see if it has the ability to render the financial system ineffective.
According to Wikipedia, money is an item or verifiable record that is generally accepted as payments for goods and services and repayments of debt in a country. (Remember this definition, we’ll return to this later).
If you remember high school basic economics, money is :
- Medium of Exchange — Acts as an intermediary in the exchange of goods and services, thereby removing the problems of barter system. (No need to find a cow for your horse)
- Unit of Account — It is a standard measure of value to determine the value of goods and services in an economy. Barter made this impossible.
- Store of Value — As the name explains, money should be something in which people can store value and something which does not deteriorate or fluctuate over time.
Bitcoin can perform all of these functions easily. Before you jump on me saying that bitcoin is too volatile, wait till the article ends.
Also, remind yourself about inflation that reduces the value stored in fiat currency. Is 1 USD worth the same as it was 50 years ago?
Let’s dive into the details and see how bitcoin and fiat perform in relation to the 6 characteristics of money:
- Portability — Money should be able to go wherever people can. With fiat, you need to have hard cash in your wallet when you go to the market or have an access to bank accounts with credit/debit cards. With Bitcoin, you just need a phone and an Internet connection.
- Durability — Money needs to be something which can be used repeatedly and not wear after some time. With fiat, notes can get torn pretty easily and I don’t think you’d like all your cash in the form of coins. With Bitcoin, nothing is physical! It exists forever since it is recorded on the blockchain and cannot be changed since the data is immutable.
- Uniformity — Though notes in the fiat currency look the same, they still can be distinguished on the basis of their number. With bitcoin, you cannot tell if the bitcoin you sold to someone has come back to you after some trips. All of them are completely identical.
- Divisibility — While fiat can be divided, there is a limit to it. Plus, as I mentioned above, you wouldn’t like to use 400 coins of 25 cents to make a purchase of $100. With Bitcoin, you can divide it up to 8 decimal places and other cryptocurrencies stretch it even further. The flexibility that crypto offers far outweighs that offered by the traditional currency.
- Limited Supply — The government prints currency at its own discretion. If there are not enough taxes received, it is not a big deal for them to get some more money printed. Bitcoin, on the other hand, is limited to 21 million coins. This scarcity makes it extremely valuable.
- Generally Acceptable — Now comes the interesting part. Fiat is accepted because we have governments who enforce it. They make laws for its acceptance and also demand taxes in the same currency. With bitcoin, no one can force anyone to accept bitcoin. Though many governments have not made it a legal tender and merchants in crypto-friendly nations have not yet started to accept crypto-payments at a large enough scale, the landscape is changing rapidly. The situation might turn out to be completely different 5–10 years down the line (People might laugh at us for using cash to pay for a cup of coffee)
After having a look at the above points, it seems that the only reason bitcoin is not adopted widely is its low acceptability and volatility.
But, why is bitcoin so volatile?
The financial system as a whole has characteristics of a Ponzi scheme if we look at it fundamentally — Tim Lee
According to the Wikipedia definition that we saw above, money should be accepted as payments in exchange for goods and services. Thus, money’s worth is determined by the goods that it can buy.
Do we determine the worth of Bitcoin in terms of the goods that we can buy from it? No. We value Bitcoin by considering the amount of money we get after selling it.
Hence, the value of Bitcoin is essentially tied to the value of fiat. Fiat, on the other hand, is not stable either.
If you spend time in the forex market you’ll get to know that currencies are actually valued against each other and the exchange rates fluctuate a lot. If you went to a foreign nation and return after some time, the value of your money may not be the same due to the change in exchange rate. The change is not minor either — it can fluctuate anywhere around 10–20%. Now that’s massive!
But, the volatility of fiat is also controlled by the government — by adjusting the demand and supply to keep the price stable.
None of those privileges are available to bitcoin today. No central authority can control the prices at their discretion, and no one can force merchants to compulsorily accept payments in bitcoin.
So technically, bitcoin feeds off of the volatility of fiat. The volatility of fiat, as well as Bitcoin itself, makes it so volatile.
We’ve come a long way from barter to blockchain and bitcoin.
No system of money has proven to be the best and every time we settle for one system, we start to discover its inherent flaws. Fiat, though seems a good way of transacting, also has potential pitfalls that most people don’t see (or don’t want to see)
“The financial system has been turned over to the Federal Board. The Board administers the financial system by authority of a purely profiteering group. The system is private, conducted for the sole purpose of obtaining the greatest possible profits from the use of other people’s money” — Charles August Lindbergh, ex-U.S Congressman
Bitcoin has given us an alternative way to transact, but the fall of fiat still seems too big of a task to be accomplished.
Taking into account all of the facts, it is likely that bitcoin can play its role as a currency when there is wider adoption and people have more places to spend their bitcoins apart from exchanges.
As more and more businesses start to accept bitcoin, it’s growth is likely to increase and the uncertainty about bitcoin’s future will decrease.
Without arguing much, it is best to go with the flow. Humanity naturally gravitates towards the best solution sooner or later.
Hope you got some interesting insights from this post!
If you like it, you can clap upto 50 times ;)
I am passionate about making products and building businesses. I’m highly interested in upcoming technologies and the business opportunities that follow. I like sharing my thoughts with like-minded people through speaking and writing on my blog. Have something interesting to work on? Let’s collaborate! LinkedIn
Originally published at http://shivendramisra.com/barter-to-bitcoin/ on November 8, 2018.