It is an innovation which could change the rules of the modern world; undermine the authority of the existing systems. It may not be a big breakthrough for humankind like the invention of wheel, but still it is an important breakthrough in modern history. But we don’t know the name of the innovator. Such anonymity is unsurprising considering the medium through which the innovation came into existence.

Let us consider the first paragraph as a puzzle. Can you solve it? If not, continue reading. If you think you had found the answer, continue reading to verify your answer.

The innovator(s) go by a pseudonym — Satoshi Nakamoto. The innovation — Bitcoin. The medium — a combination of networking, cryptography and coding.

Let us not be in a hurry. We have to trace the origins of money in its modern form, before elaborating about Bitcoin which might be a probable future candidate of currency systems.

Transactions between ancient people were carried on by barter system. But barter system has a very romantic problem — the double coincidence of wants, which is a rarity. So, coinage system came into being to build a standardized transaction system.

Early forms of coinage depended on the perceived value of commodity upon which they were based. Units of cowry shells, salt, livestock were used as money. With the emergence of civilisation and economies of massive scale, standardized coinage emerged where the value of money is based on metal as well as the guarantee of sovereign or trading authority issuing it. This coincided with the invention of writing which from then on, was used to record various trading transactions.

Modern day coin system operates similar to paper currency. But how does paper currency operate? How are we accepting paper currency’s face value? Modern paper currency had severed its links with Gold. Now the paper we hold on to is only backed by guarantee of the issuing Central Bank and the sovereign authority. This type of currency is called fiat money — backed only by guarantee of the sovereign authority.

This paper money has a unique problem. It will incur costs on the issuer- both printing costs and transaction costs. Reserve Bank of India has estimated that in 2015, totally Rs. 21000 Crores were spent on Currency operations cost by itself and commercial banks. This problem exists because India is a cash intensive economy. India has cash to GDP ratio of around 12.3%. Wear and tear of paper currency and issue of paper currency of lower denominations are imposing considerable cost on exchequer. So, there is an urge to move towards low cash intensive and electronic transaction incentive economy.

Every scheduled commercial bank has now established a stable electronic transmission system which helps in moving the money just from one electronic ledger to another without physical movement of paper money, thereby reducing transaction costs significantly. Much of India is digitally unconnected; even most of Indians who are connected tend to be sceptic about electronic transactions. Hence electronic transactions are comparatively lower though steadily growing.

Banks, as intermediary to these payment services, charge around $1.7 trillion globally for their payment services and to cover their transaction costs. World Bank has estimated that cost of sending currency to another country is very high — at 8%.

Various payment services have emerged to take over the traditional intermediary role of banks. Vodafone’s M-Pesa is such a service completely based on mobile, where money is transferred from a mobile number to another mobile number. Also, credit is provided to the customers based on their transaction records.

This payment system has significantly reduced the transaction costs. (State Bank Buddy, a product of SBI is modelled on similar lines as M-Pesa, where money can be transferred from one mobile number to another) Such mobile-based transactions are considered very secure with the combination of PIN and mobile ownership.

What is the next big step? Enter Bitcoin.

Bitcoin is the brainchild of Satoshi Nakamoto, who identified himself as a Japanese man. He seemed to have developed distrust in modern financial system following Global Financial Crisis of 2008. No one knows his true identity, but many people have made logical assumptions about his identity.

1. He is probably a person from a commonwealth nation since his English is flawless.

2. He is well versed in cryptography and computer programming.

3. He has studied the international monetary system with remarkable thoroughness.

His real identity still remains unknown. But his innovation is now well known and has few lakhs of enthusiastic followers around the world.

He had introduced a currency system which does not require trust to work, but relies on cryptographic proof based upon timestamping of digital signatures and a network of nodes to verify each transaction.

To elaborate, most of the digital currencies will suffer from the problem of double spending, (i.e., spending the same money twice) since electronic files can be easily replicated. To break out this from Bitcoin introduced the solution of Blockchain.

In this system, each transaction is signed with digital signatures of the previous owners in addition to which a timestamp is added and is widely published in a shared ledger to verify if there is any double spending.

Bitcoin implemented the proof of work method with One CPU- One Vote, rather than One IP- One vote. The block produced by time stamping a digital signature cannot be tampered with easily as redoing one block will also means redoing the blocks which follows it. In this type of secure system, Bitcoin will remain tamper proof unless majority of the computer nodes and CPU power in its network is held by attacking computers.

Here comes the interesting part. A greedy attacker who can assemble the required number of nodes can either use them to steal back his payments by redoing the block chain or may use it honestly and to get incentives in the form of bitcoins by adding new blocks.

With such a secure system, Bitcoin has remained tamper proof and largely successful as a digital currency. But its success as a currency is questionable.

Bitcoin remains a highly volatile currency with its value reaching as close to 75000 INR and falling to lower than 25000 INR within a year. Now Bitcoin is trading at nearly 78000 INR. This volatility in exchange has made it unattractive and a lousy store of value.

Further, the designer(s) of Bitcoin has limited the number of Bitcoins that can be mined. There would only be 21 million Bitcoins, to be mined over 130 years. As the number of Bitcoins increase, the difficulty of mining a new Bitcoin increases too. The number of bitcoins the miners will earn also will be halved now, thus increasing the price of Bitcoin as they need to keep their margin safe. Currently estimates say it takes $400 to mine a Bitcoin and its value ranges around $1200

Bitcoin’s volatility and limited availability has made it endearing only to a group of technolibertarians rather than common masses. Also, Bitcoin will find it immensely difficult to remove the entrenched trust which people place upon fiat money unless a major political or financial catastrophe takes place.

While modern monetary pundits like Raghuram Rajan finds the idea of Bitcoin fascinating, the technology underlying it — the blockchain is considered to be more realistic by them. Modern monetary system operates based upon a central ledger which monitors the transaction whereas in blockchain type, a decentralised ledger is shared between various nodes, thus making P2P transactions more efficient and with reduced transaction costs.

IMF and Central banks of several countries are studying the idea of blockchain to implement it in their payment systems, whereas Bitcoin finds no takers among central banks. But Bitcoin enthusiasts believe that without using Bitcoin, blockchain technology will be irrelevant.

The question of future is — whether modern currency system assimilates the blockchain system into itself or succumbs to Bitcoin. The answer depends upon people’s trust, which gives value to modern currency.

P.S: A recent judgement by the Miami- Dade Circuit court in United States declared that Bitcoin cannot be considered money and it has a long way to go before being considered as a money equivalent.

References:

1. Nakamoto, Satoshi (24 May 2009) “Bitcoin: A peer to peer electronic cash system”.

2. Davis, Joshua (10 October 2011) “The Crypto — currency”

3. Lanchester, John (16 April 2016) “When Bitcoin grows up”

4. The Guardian Website

5. The Economist Website

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