Why was Bitcoin created?

To some, the fact that Satoshi, the “inventor of Bitcoin”, is an unidentified person or group of people, raises some red flags. While their anonymity brings the benefit of piquing further interest, it also delegitimizes the technology in the eyes of others. This is why I think it is important to discuss what could have motivated Satoshi to create Bitcoin.

Question #4: Why was Bitcoin created?

Satoshi Nakamoto wanted to create a “trust-less” cash system.

Satoshi explicitly stated that the reason for creating this digital cash system is to remove the third party intermediaries that are traditionally required to conduct digital monetary transfers. Third parties incur significant costs for conducting these services; these costs are then passed on to end users and can restrict transactions below a certain size. Such costs include:

  • covering back office expenses — the effort it takes to collect and reconcile transactional data;
  • taking appropriate security measures — costs related to the risk of security breaches given that they are centralized repositories of sensitive data;
  • and accounting for fraudulent activity — the costs associated with having to refund money in the case of fraud, among others.

Many of these costs are a fixed amount per transaction, regardless of the transaction’s size. However, since the profit garnered per transaction is largely a percentage of the size, the juice doesn’t justify the squeeze for processing smaller transactions.

In short, banks, card associations (like Visa), and other large incumbents own today’s electronic payments system and impose a lot of fees. (Visa alone generated over 13B USD in revenue in 2015.) Bypassing these players was certainly a motivating factor for creating Bitcoin. But, there is even more to it. In February 2009, Satoshi wrote the following on an peer-to-peer focused online forum:

“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.”

In addition to paying overhead costs, reliance on traditional electronic payments systems has other major implications. These implications require us to take a step a back and think about how our wider financial system functions and the role our government plays in controlling the monetary supply. We’ll focus on the two breaches of trust Satoshi mentions above (in reverse order).

1. Trusting Banks

When we leave our money in banks accounts (for them to transfer on our behalf), these deposits are not actually held there for us. Instead, deposits are used by banks to find opportunities for additional financial return and they are only legally mandated to keep a certain percentage of your money on hand — about 10% for larger banks. One such opportunity is offering lending products (ie. fronting someone else’s mortgage or car purchase) in return for the principal plus interest. Extending credit is not necessarily a bad thing. However, when you add in more players, more complex financial instruments and less transparency, it can lead to unsustainable levels of lending that result in significant losses when markets correct. (For instance, the Great Recession of 2008.)

To explain, let’s use the example of mortgages:

1. A bank originates a mortgage loan to a borrower. They collect information regarding the borrowers credit score, income, value of the loan in comparison to the value of the property, and more.

2. Mortgage information is then forwarded to the secondary mortgage market so that mortgages associated with a diverse set of borrowers, geographies and profiles can be pooled together to create an investable asset called a mortgage-backed security. During the crisis, this was primarily being done by large investment banks.

3. Credit rating agencies “grade” the security so that it is certified as being of a specific risk level ie. “AAA” means very likely the debt will be paid back. Think of it as a credit score for an investment product.

4./5. Pensions funds, hedge funds, and other investors, invest in these securities based on the ratings provided. By investing, they earn the interest payments made by borrowers which are forwarded from the originating bank.

6. Consumers are directly affected by the decisions of these these investors by being their clients, contributing to their pension funds, etc.

7./8. The investment bank issuing these securities, take out insurance to protect against the default of these products in case they are unable to deliver the returns promised to the investors. Moreover, these are the same insurance giants that provide you life, medical, and travel insurance, among other offerings.

The problem with this process is that at each step, parties are incentivized to take overly risky behavior because they are paid in fees to continue lending despite the quality of the underlying product. Banks get paid fees for originating loans which motivates them to be more lenient with their lending standards. Investment banks get paid fees for pooling mortgages together and offering private label mortgage backed securities to investors which leads to selling products they know can’t deliver. And credit rating agencies profit from keeping the business of those whose products they grade.

In the early 2000s, investment banks sold complex financial instruments based off of debt they knew could not be repaid. And when the insurers couldn’t cover the massive amount of default, the government threw the investment banks and insurance agencies a life jacket in the form of bailouts because these financial institutions were “too big to fail.”

This is a very oversimplified example to illustrate one of many ways that our wider financial system is inherently plagued with a moral hazard problem. Financial institutions are all incentivized to take on risky behavior because they do not have to shoulder the costs of possible system-wide failure by themselves. When things fall apart, the burden ultimately falls to consumers and taxpayers.

2. Trusting Central Banks

In addition to bailouts, central banks across the world also employed monetary policy to mitigate the wider economic downturn that was to result from the risk-seeking behavior of these financial institutions. Monetary policy encompasses measures, such as adjusting the lending rate between banks and the amount of money each bank should keep in reserve, that central banks can employ to essentially change the amount of money in circulation. The theory behind using monetary policy to help the economy deal with the impact of unhealthy financial swings related to credit, housing and equity markets, dates back to John Keynes in the 1930s.

Again, government intervention in regards to the monetary supply is not necessarily a bad thing. It can be argued that without increasing the monetary supply post-2008, the Great Recession would have resulted in even more economic turmoil and turned into a Great Depression 2.0. However, there can be other motivations for increasing the monetary supply at the expense of consumers. For example, governments can effectively “print” more currency to help pay off their debt instead of being more fiscally conservative. The U.S. has continued to raise the debt ceiling, in spite of fierce debate, and in 2016 the debt to GDP ratio reached a record high of 106%.

Over the longer term, increasing the money in circulation as a fix for other problems can result in serious economic consequences. Countries like Argentina and Zambia have been plagued with hyperinflation that has resulted in significant loses in quality of life. Moreover, it is in places where individuals cannot rely on the value of their nation’s currency that Bitcoin has the most promise to be used as a means for daily exchange.

Moving to a Trust-less Cash System

Embedded in the Bitcoin genesis block was a message that read: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

This newspaper now sells for $45K. Check out here.

The message was the title of an article on the cover of The Times newspaper that day. Not only does it commemorate the day the block was generated but puts into perspective why Bitcoin was created.

Bitcoins are not issued by governments. The amount of bitcoins in circulation grows about every 10 minutes and will eventually reach a cap of about 21M BTC. Changes to the amount of bitcoin in circulation could only result from reaching majority consensus across participants, not the say of individual governments. Furthermore, you can store your bitcoin for yourself and remove the banks from taking custody of your funds and acting as powerful, risk-seeking middle men.

We are far from a reality where bitcoins are used ubiquitously as an alternative form of payment to fiat currencies issued by central banks. However, this was the libertarian ideal that inspired it. For now, bitcoins are treated as an emerging asset class. More on that next.