Bitcoin: Disruption vs Status Quo

Partner Content via Seth DeGroot

When thinking about bitcoin and its potential, it’s important to first understand the structure and history of the current state-backed monetary system used throughout the developed world. This system can be traced to the establishment of the first ‘central bank’ in 1694. In return for lending the English government gold bullion (to build a navy to fight the French), the Bank of England acquired the exclusive right to print paper money. That paper money could then be used by ordinary people to pay their taxes. It’s at this point that banks, money and the modern state become fused together.

The reason a lot of people are excited about bitcoin, is that for the first time there is a genuine possibility of disrupting the state-backed monetary system.

Bitcoin was launched in a paper published on 31 October 2008 by a pseudonymous person calling himself Satoshi Nakamoto. The paper outlined an electronic currency, based upon a foundational technology called a blockchain. The Bitcoin blockchain is simply a register of all bitcoin transactions that have ever happened. Every time a bitcoin moves from one bitcoin address to another, the transfer is registered, or ‘added’ to a block, which once verified, is added to the blockchain. Every single bitcoin transfer ever made is recorded in the blockchain.

Upon initiation of a bitcoin transaction, the transaction is broadcast to the network, where it takes its turn with other transactions waiting to be compiled into a ten-minute chunk of transactions, known as a ‘block’. This is where the miners come in. Miners take the block of transactions (each transaction combines the two addresses of the parties to the transaction, the quantity of bitcoin involved and a time stamp), and run the block of transactions through a ‘hash function’. Hash functions are cryptographical algorithms for encoding information: the one bitcoin uses is called SHA-256. Miners don’t just use the transactions in a block to generate a hash. They also use the hash of the last block stored in the blockchain. Because each block’s hash is produced using the hash of the block before it, it becomes a digital version of a wax seal. This protects the block chain from tampering.

In addition, the miners must run the hashed block through a mathematical problem, which when solved, results in a ‘proof of work’. There’s no short cut to this process. The entire point of the ‘proof of work’ is to show that the miners have put in the necessary effort involved in finding a solution. The procedure serves both verification and anti-inflationary purposes. Once a proof is produced, all miners vote to accept or reject the latest block. Miners understand that they are following a natural consensus and that, if they are lucky enough to generate the next block, it will probably be accepted for the same reasons that the current block will be accepted (i.e. because it’s difficult work and the community tends to reward this effort by voting to accept). The general rule is that the first block mined is not self-interested because no one can plan on being first. One can only be first by luck. Any hold-outs are suspect because to generate the block, the miner had to make a choice to reject a perfectly good and presumably altruistic alternative block. Thus, the proof of work and miner acceptance protocols add a important layer of validation to the system.

Put that all together, an for the first time in human history, we have a monetary register that does not need to be underwritten by some form of authority or state power, other than itself. It’s a decentralized, anonymous, self-verifying and completely reliable register. It fulfills many traditional banking functions, without needing banks.

The financial industry has closely followed the development of bitcoin. The industry has concluded that it’s possible for bitcoin (and it’s underlying blockchain) to be a source of disruption and disinter-mediation of their business. As such, a number of banks are rushing to develop and patent finance-friendly versions of blockchain technology. A consortium called R3Cev is backed by 42 financial companies and seeks to develop what would in effect be a private blockchain; Goldman Sachs, one of the firms behind R3Cev, has also filed a patent for a private blockchain-backed currency called SETLCoin; Digital Assets Holdings, another blockchain company, is run by Blythe Masters, the English former J.P. Morgan executive who was the chief pioneer behind the credit default swap, the financial instrument which was a huge success until it nearly imploded the entire global financial system.​

The very first sentence of Satoshi’s original paper reads as follows: ‘A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.’ If the banks have their way, those very same financial institutions are going to use blockchain technology to keep themselves right where they are: in the middle of every possible transaction, extracting all the fees they can.

Bitcoin purists believe the blockchain will never succeed apart from the currency. The problem is, in order for bitcoin to succeed, it needs to achieve significant penetration into people’s everyday lives. It has been almost eight years since Satoshi released the initial bitcoin code, and bitcoin has yet to make meaningful inroads as a mainstream currency. It’s time to take that step, or blockchains could become merely a new technique to ensure the continuation of banking patrimony in its current form. That would be one of those final plot twists which leaves everybody thinking that although they enjoyed most of the show, the ending was so disappointing they now wish they hadn’t bothered. Alternatively, in conjunction with peer-to-peer lending and mobile payments, bitcoin could have an impact as great as the impact of central banking introduced in England in 1694. That trifecta of technologies has the potential to revolutionize and democratize monetary systems as we know them; moving away from the 325 year old state-backed system to a technology enabled, international, decentralized, self verifying monetary system, with built-in anti inflationary mechanisms, allowing for instantaneous inexpensive transactions (from micro-transactions to large sums), without a banking bureaucracy to slow the system and charge inordinate fees. Here’s to hoping for the later.