One of the main criticisms I hear about Bitcoin is that it is “not backed by anything.” Anyone in the crypto space is familiar with the conversation that follows. We point out that the US dollar is “not backed by anything,” and that even gold itself has no intrinsic value.
While it is true that the value of money is by definition inter-subjective (more on this in a minute), such an answer does little to describe what makes Bitcoin unique. The goal of this post is to examine Bitcoin in the context of currencies that we use today as money.
What is money? How does money today compare to money of the past? What is Bitcoin and why is it special? All good questions. Let’s dive in.
A brief history of money
“Money was created many times in many places. Its development required no technological breakthroughs — it was a purely mental revolution. It involved the creation of a new inter-subjective reality that exists solely in people’s shared imagination.” - Yuval Noah Harari
On the origin of money
In the beginning, we had no money. As hunter-gatherers, we sourced and manufactured almost everything we required. Occasionally we would engage in simple barter for rare items like shells and flint.
As we settled into villages, we became specialized in different tasks, and bartering became essential to everyday commerce. Villages grew into cities, and this created a problem: barter is convenient for the exchange of a limited number of goods, but quite cumbersome for a complex economy.
In a barter economy, consumers and producers must keep track of the prices of each good against every other good. If 100 goods are traded in a market, then there could be 4,950 exchange rates (100 x (100–1) / 2)! Wouldn’t it be convenient to have a single money — a unit of account — to price all goods and services?
Another problem is liquidity across so many exchange pairs. What if you want to trade a chicken for a clay pot, but can’t find someone who wants to make this trade? You’d either have to make a multi-party deal or else a series of trades.
Money solved both of these problems in the marketplace. Price everything in a single money, sell your goods for that money, and then use your money to buy any other good. Voila, the coincidence of wants problem was solved!
The nature of money
Money is something we use to represent the value of other things for the purpose of exchanging those things. Money is a unit of account and a medium of exchange. Furthermore, we can hold on to money over time, conveniently storing value in it.
Across the ages we have had many different types of money. Before paper currency and modern coinage, we used coins made from precious metals, and before those coins we used all kinds of things, such as shells, beads, salt, grain, livestock, or just large rocks.
Now money is mostly digital — 90% of all money exists only on computer servers — while physical banknotes and coins are threatened with extinction. The vast majority of transactions today are executed by updating electronic records at one or multiple banks.
In his essay “Shelling Out: The Origins of Money”, Nick Szabo traces the history of money and our relationship with it back to proto-money and collectibles. In addition to facilitating trade, these tools reduced the need for favor-tracking, and enabled human institutions of wealth transfer such as insurance, inheritance, bridewealth, tribute (hint: tax), and dispute resolution. Furthermore, collectibles reduced the need for favor-tracking, and facilitated reciprocal altruism.
According to Szabo’s research, for a particular commodity to become a valuable collectible used in trade and wealth transfer, it would have had these following qualities, on a relative basis:
- Secure from loss and theft (eg. portable and easy to hide)
- Hard to forge
- Easy to approximate value (eg. by simple observations or measurements)
Collectibles typically satisfy #2 but not #1 and #3. On the other hand, precious metals in the form of jewelry are better at satisfying all three conditions. Coins were a further improvement due standard weights and appearance.
King Midas’ touch
Starting around the turn of the 6th century BC, the Lydian kings became the first major issuers of coins minted from precious metals. Compared to collectibles, the value of coins could be easily estimated in the marketplace, and the government could enforce anti-counterfeiting measures by controlling the minting process.
Coins were a superior medium of exchange, making both markets and taxation much more efficient. More efficient markets gave rise to increased trade, which in turn allowed for increased taxes, making the Lydian kings very rich.
From coins to paper
Coins were still relatively difficult to use in commerce. The weight of coins made them problematic to securely transport and store. Another inconvenience was that coins were indivisible, so gold and silver coins were typically used side by side. Imagine trying to buy lunch with a $370 gold American Buffalo, you’ll need some silver dollars too!
Paper money was first invented by the Chinese during the Tang Dynasty (618–907 CE). Originally, this paper was in the form of promissory notes which represented a claim on deposited coins. Paper was much easier to transport and secure from loss and theft. Now merchants could carry paper instead of precious metals, how convenient!
Later during the Song Dynasty, authorities took control of this system and issued the world’s first government-produced paper money, which was theoretically backed by gold and silver, although in practice convertibility was not allowed. The currency was also supposed to be recycled every 3 years, but new currency was issued without retiring the old, leading to price inflation.
In 1279, the Song Dynasty fell to the invading Mongols, who issued their own paper currency, one that was not backed by gold and silver. The Mongol Yuan Dynasty printed increasing amounts of this currency, leading to runaway inflation. Soon paper money disappeared from China, and it didn’t return until the 1800's.
Private then public
Paper money became popular in the form of banknotes issued by private commercial banks who held gold and silver deposits. At one point there were over 5,000 types of banknotes issued by different banks in America.
Banks regularly issued much more currency than the value of gold and silver held on deposit, resulting in frequent bank failures. Similarly, today multiple companies are issuing stablecoins backed by dollars (or not fully backed, in the case of USDT).
Over time banknotes issued by private commercial banks were replaced by paper notes issued by national governments. This currency was still backed by gold, for example a US dollar could be redeemed for an amount of gold held in the national reserve.
End of an era
This legal redemption right was completely severed over time by governments eager to take control of the money supply to fund government spending at home and abroad.
In 1971, US President Richard Nixon ended international convertibility of the US dollar to gold. This was meant to be temporary, but convertibility never resumed. In 1976, the US government finally changed the definition of the dollar and removed references to gold from the statutes. From that point onward, the international monetary system has been made of pure fiat money, so called because its use is established by government decree, or fiat. For more information about the international abandonment of the gold standard, check out Wikipedia.
Throughout the history of human civilization, money has been valuable only because we’ve believed in its value. Why should anyone trade livestock or land for pieces of shiny metal? People are willing to do this because they trust that money has common value. In this way, money is a system of mutual trust.
With fiat money, this trust requirement is extended greatly. We now must trust our governments not to extend the money supply too much, thereby destroying its value through inflation. Fiat money is a relatively new phenomenon, but already it’s short track record is littered with examples of failure and broken trust.
“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.” - Satoshi Nakamoto
A primer on payments
Now let’s briefly examine how payments have evolved alongside money.
What is a payment? A payment is a transfer of value. The simplest payment is a transfer between two parties in a transaction, for example, when a consumer hands money directly to a merchant. Payment could be in the form of shells, beads, coins, or dollars.
A payment system connects many end parties, allowing these parties to transact with one another. Traditional payment systems are variations of a hub and spoke model, meaning that end parties are connected to one or more centralized entities, which clear and settle payments between end parties.
Promissory notes like those used by merchants during the Tang Dynasty were among the first payment systems. These notes involved a third party, a trusted custodian who held merchants’ coins. Merchants made payments to each other by passing around notes, which could then could be redeemed for coins from the custodian.
Similarly, bills of exchange were used in lieu of gold by European traders from the 13th to the 17th centuries. Using a bill of exchange, a trader could make a payment to another trader by instructing a third party to complete the payment. Prior to paper currency, bills of exchange were commonly used as a means of exchange.
If bills of exchange sound similar to checks, it’s because they are! Early checks began as a specific type of bill of exchange, which was drawn on a bank. As checks grew in popularity, banks created clearing houses to facilitate the exchange of checks among banks.
As a happy consequence of their custodial role, over time banks have helped build new and convenient ways for us to make and receive payments. Today we have card systems (credit, debit, and prepaid), the automated clearing house system (ACH), and wire transfer systems. These systems each work differently, but all are variations of the hub and spoke model.
Banks aren’t the only ones to facilitate payments. Additional payment systems have been built on top of the financial infrastructure that banks provide. Western Union began offering money transfers in 1871. Today Visa and Mastercard are no longer owned by banks, but are themselves some of the largest publicly traded companies in the world.
Since the turn of the century, payments have become a hot space for technology companies. FinTechs like PayPal are hub and spoke payment systems built as a second layer on top of traditional payment systems such as ACH and debit cards. Each new FinTech payment app is more convenient than the last ‒ apps like Venmo and Cash App in the US, or WeChat Pay and Alipay in Asia. So fast and convenient!
Centralization of payments
Today your money is represented by an entry in a bank database somewhere. You can’t spend or withdrawal it without your bank’s permission (which can be a problem). Furthermore, with digital money we’ve lost the privacy that was enabled by spending coins or banknotes (another big problem).
Centralization underlies each and every payment system we use today. From their earliest iterations, payment systems were centralized systems controlled by financial intermediaries. New payment systems are just additional layers built on top of existing payment systems.
The whole stack, from top to bottom, is controlled by centralized entities. Institutions can close your account, freeze your funds, empty your account, or just go offline. All these scenarios can and do happen. No one thinks they will happen until they do.
In the US, it is relatively easy to brush off these concerns, ‘sure, banks make mistakes’ or ‘I’m a good customer, no bank would fire me.’ Consider elsewhere, in authoritarian countries, where centralized payment systems are used to outright control and spy on citizens everyday.
Wherever cash disappears and people migrate to digital payment systems, they have no choice but to implicitly trust the governments, banks, and fintechs that hold and control their money.
Could this have all been different? Not likely. It seems inevitable that history would repeat. We’d collect things, then use metal coins. Coinage would be replaced by paper, then governments would go off the gold standard, taking control of the money supply. And finally, banks and corporations would build centralized payment systems that undermine personal agency and privacy.
Enter Bitcoin, a breakthrough in financial technology.
A new specie of money
“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.” - Satoshi Nakamoto
Bitcoin is sound money, like gold. No government can increase or decrease the supply of bitcoins, removing the need to trust governments to responsibly steward the money supply. For a deep dive on Bitcoin and the history of sound money, read The Bitcoin Standard by Saifedean Ammous.
Bitcoin is digitally native. You can hold it digitally, both securely and conveniently, without trusted intermediaries. Unlike with digital dollars, there’s no need to trust a bank to hold your bitcoin.
Bitcoin is a payment system itself, although it’s more akin to a settlement system. Bitcoin can be sent anywhere in the world without the need for trusted financial intermediaries. More specialized payment systems can be built as additional layers on top of Bitcoin’s decentralized foundation.
Not beanie babies
Using Szabo’s framework, Bitcoin scores very high on all three measures of collectible value:
- Easy to secure and hide: A bitcoin holder can simply remember 12 seed words.
- Hard to forge: Forgery is not possible with current cryptography assumptions. Control of the majority of Bitcoin hashing power is required to double spend bitcoins.
- Easy to approximate value: Divisible down to a satoshi. Anyone can download Bitcoin’s software to verify the authenticity of their bitcoins.
People have been collecting bitcoins for 10 years. As a collectible, Bitcoin is very valuable — $125 billion in total at the time that I’m writing this. Said another way, $125 billion of value is stored in bitcoin.
Billion dollar companies, exchanges like Binance, Coinbase, and Kraken have been built to serve a market of traders and collectors, alternatively called speculators or hodlers. These platforms have helped Bitcoin become a store of value by facilitating exchange and price discovery.
The path ahead
“Historically speaking, such a generally esteemed substance as gold seems to have served, firstly, as a commodity valuable for ornamental purposes; secondly, as stored wealth; thirdly, as a medium of exchange; and, lastly, as a measure of value.” - William Stanley Jevons
The next step for Bitcoin is to transition into a medium of exchange, and this is already happening. At The Lightning Conference 2019 in Berlin, 600 developers, entrepreneurs, and investors gathered to promote the development and adoption of the Lightning network, the first trustless and instant payment system. From the presentations there, you can see for yourself how quickly Lightning is maturing.
The Lightning network is a second layer payment system built using Bitcoin smart contracts — enabling instant and inexpensive peer-to-peer Bitcoin payments. Combined with the Lightning network, Bitcoin is a digital version of cash, but with predetermined scarcity instead of a government-controlled supply.
Lightning payments are trustless and decentralized, making Lightning unique compared to traditional payment systems that rely on trusted and centralized entities (bonus: a comparison of Lightning and Visa). With Lightning, no bank or financial institution holds or controls your money. Furthermore, Lightning provides a degree of privacy, which can be increased as the technology improves.
At Galoy, we believe decentralized payment systems like the Lightning network will grow to capture significant value from incumbent, traditional payments systems. We will be a part of this future by building a company that incorporates bitcoin as a store of value and medium of exchange.
We stand on the doorstep of a new future, one in which we have for the first time a digital cash. Together Bitcoin and Lightning provide us with a decentralized money and peer-to-peer payment system. A bright future awaits.