Money, Trust & Bitcoin

Money, fundamentally, is a way of converting value from one currency, such as labour, into another currency, such as shoes, pies and holidays. Historically, that currency has been gold: a good ‘store of value’, being rare & immutable, but too heavy & malleable to be a practical ‘medium of exchange’. Fiat (Latin: “Let it be done”) currency was invented to solve this dilemma. Thus, the ‘paper money’ we use today is easy to carry and imputed with value by central authorities as the accepted currency for transactions.

These two systems, gold and fiat, differ in one very important respect: trust.

Gold is a trustless currency because its purity can be independently verified. Fiat currency, on the other hand, requires one to trust the central authority that issued it.

In the past, central banks and governments have tried to mitigate this trust issue by storing gold equal to all the currency in circulation. However, over time and for various reasons, governments have steadily depleted reserves and decoupled their currencies from gold making them vulnerable to manipulation.

BITCOIN & CRYPTOCURRENCIES

The nature of money and trust was dramatically exposed by the 2008 financial crisis. That same year, a pseudonymous inventor, Satoshi Nakamoto, created a value protocol, akin to digital gold, named Bitcoin. Instead of mining rocks for elemental gold, Bitcoin miners hack away at mathematical puzzles to generate Bitcoins until all (capped at 21 million) will have been mined. Whereas Visa hosts a central ledger to record transactions, every node of the Bitcoin network verifies and hosts its own version of the ledger. To ensure consensus between nodes, transactions are grouped into blocks that are cryptographically linked to previous blocks before being broadcast to every other node. Each node verifies that the ledger balances before adding the latest block to its own chain. In addition, new blocks can only be produced by a significant expenditure of processing power, making it prohibitively expensive for rogue actors to try to alter blocks and create new chains. This system is known as a Proof-of-Work (POW) blockchain.

Being entirely trustless and effectively immutable, Bitcoin can function as gold - store and transmit value - with a speed and accuracy impossible for base metal.

But just as Bitcoin could usurp gold in world finance, so a more advanced blockchain could usurp Bitcoin, and this is already happening.

As a quick overview, Monero is a blockchain that uses advanced cryptography to keep all transaction details private. DASH utilises a second-layer ‘masternode’ network to speed up transaction times and provide governance. Ethereum enables the writing of ‘smart contracts’ that execute transactions automatically based on sets of conditions. These and many others are engaged in a technological ‘gold-rush’ to establish themselves as the default currency. Yet, so far, none is perfect: Bitcoin transactions are becoming slower and more expensive. Its transparent blockchain means that coins may be tainted by association and cease to be truly fungible. Monero’s transactions are magnitudes larger than Bitcoin’s, making scaling its blockchain difficult. DASH’s masternode network is not entirely trustless and some regard as oligarchical. Ethereum was not designed as a currency and its technology is experimental even by its developers’ admission.

Nonetheless, with currencies that cannot be debased, Gresham’s law (‘bad money drives out good’) no longer applies, meaning that the most fungible cryptocurrency - the best unit of account, store of value & medium of exchange - ought to drive out all others eventually. The experience of MySpace vs Facebook shows that even the largest of network effects can be swiftly overcome by superior tech and low barriers to entry.

CRYPTO BUBBLE VS FIAT BUBBLE

Cryptocurrencies are not immune to tulip-mania, but if the fiat paradigm itself is the bubble, then its popping and the subsequent flight to sound money would be seismic. Less dramatic but equally significant would be the effect that sound money has on labour valuations. At present, labour denominated in fiat currency is valued at ~2% less each year due to inflation. Money printing compounds the loss by inflating asset valuations. Labour denominated in Bitcoin is immune from this fate, which should help to rebalance the labour / asset return disparity that Piketty & others have lamented.

Despite the growing pains, the world has changed. The cryptocurrency market is valued at ~$80bn and is increasing exponentially. World affairs such as Venezuela’s implosion, India’s war on cash and America’s $4.5tn of money printing are only hastening the capital flight to a trustless value protocol.