As we talk about upgrading the world to a better financial system, it’s also important to consider the forces that currently control our money, and the pros and cons of the current system. So we’re taking you on a tour of the Evolution of Money: where it comes from, why we use it, the forces that dictate its behaviour, and what it all means for you.
In this story, we’re looking at currency: the money systems used around the world as a medium of exchange.
In the UK, all banknotes include a little statement that’s a good starting point for this exploration of the history of currency: “I promise to pay the bearer on demand the sum of twenty pounds.” Even if you’ve never held a British banknote, that statement is still relevant to the money you use on a day to day basis.
So, what does it mean? When you think about it, that doesn’t make much sense. When you pay for something with a banknote, aren’t you paying the seller that amount of money, rather than giving them a sort of IOU note?
To understand what that statement means and how it connects to Bitcoin, we need to look at the history of currency.
A (very) brief history of currency
It’s difficult for any single person or family to meet all their own needs and it’s more productive to divide up labour and give tasks to whoever does them best. People have always solved that problem through trade.
But different goods and services require different amounts of time, materials, and effort.
In theory, they can barter. Someone builds a home for another person, who supplies them with meat for two weeks. But what happens when the home builder wants meat, but no one needs a new home? Or if there’s a storm and suddenly many people want new homes, but the builder doesn’t need that much meat?
We need a shared system for transferring intangible value between people.
Enter currency. At some point, people realised exchange made their lives better, they just needed a more efficient system. This was especially important as trade links built between cities and countries.
Early currencies were commodities like salt or livestock which were useful in themselves. If someone gives you a cow as payment, you can keep it for breeding and milk, slaughter it for meat and leather, or use it to pay someone else.
But although commodities were better than bartering, they were still tricky to divide and pass between people. A cow is fine as payment, until you just want to purchase something small, or the other person doesn’t want it. It’s also tricky to transport, can get sick or die suddenly, and will suffer from being passed around too much. Plus, you need to feed it and somewhere to keep it.
Hence the need for currency: a transportable, divisible, interchangeable, trusted system for exchanging value.
Disparate stores of value in different parts of the world gradually converged towards coins: discs of metal, with gold, silver, and copper being popular choices to this day. Precious metal coins are scarce, not too bulky to transport, available in a range of denominations, and have a defined value.
Still, precious metals are a pain to carry around (especially for larger transactions) and can be stolen. So we gradually moved towards currency that represents a certain amount of precious metal, then currency that isn’t valuable in itself but is trusted as a medium of exchange and store of value.
The rise of representative currency
Representative currency is like a receipt for a precious material. It’s:
- Made from inexpensive materials like paper or copper
- Represents a set value in precious metals, usually gold or silver
- Issued by a government or bank who store the precious metals it represents
- Can be passed between people in exchange for goods and services.
So, the words “I promise to pay the bearer on demand the sum of twenty pounds’”on a £20 note once meant you could exchange it for £20 worth of precious metal.
This system is believed to have originated in China, over 2500 years ago, as people began using deposit receipts for precious metals as payment. A merchant who accepted a receipt knew they could cash it in for the corresponding store of value, therefore it effectively had the same value. After centuries of this, the Chinese government started issuing formal banknotes and eventually developed a national system.
Precious metals may have been a lot more practical than commodities, but banknotes were exponentially simpler to use. Paper is light and much safer to carry around.
But, as we’ve already seen, you can’t walk into a bank today and exchange a note for a lump of gold. Why not?
Because we’ve moved from representative currency to fiat currency.
The next step: fiat currency
The local currency in your wallet or bank account right now is known as fiat currency. It’s no longer backed by any sort of precious metal. You can’t exchange a £20 note for gold because banks don’t hold an amount of gold equivalent to the circulating currency.
Why bother storing gold in a bank vault when you can enjoy the same benefits in your day to day life without ever owning any precious metals? We developed this system because banks realised many people weren’t returning to collect their deposits and made payments with the receipts instead.
Fiat currency has no intrinsic value in itself.
Governments create scarcity by limiting the amount that can be printed. If they print more banknotes, their real world value (the amount of stuff you can buy with them) drops.
This has happened a few times throughout history, sometimes reaching the point where people needed a suitcase full of money to buy a loaf of bread. In extreme cases, a currency can become so worthless that a nation has to scrap it completely and start again.
The value of fiat currency is entirely based on perception. Because banks agree to accept it, we see it as having value. Because other people accept it as payment, we see it as having value.
This isn’t some conspiracy- it’s a smart system that makes our lives easier in many ways.
Without representative and fiat currency we wouldn’t have our modern financial system.
Seeing as so few people collected their deposits, banks started printing banknotes exceeding the total value of their precious metal holdings. This meant they could make loans, building a profitable industry from the interest they earned.
Only if all of a bank’s customers tried to withdraw their deposits at once (known as a bank run) would the whole system collapse (known as a bankruptcy.)
When you deposit currency in the bank, you give them permission to loan it to other people. The profits they make from this are the bank’s payment for keeping your currency safe.
Your currency isn’t sat in a vault somewhere. It’s travelling around the world, helping someone else to buy a house, start a business or dip into their overdraft.
A currency needs to be divisible, scarce, durable, transferable, and interchangeable
Anything can count as a currency, provided it has five features:
- Divisibility — divides into smaller units (e.g. a pound divides into pence)
- Scarcity — must be a limited supply (e.g. the supply of gold is limited by the amount we can mine)
- Durability — lasts well even as it’s passed between people (e.g. modern banknotes are waterproof)
- Transferability — simple to exchange between people (e.g. you hand someone a banknote and it’s theirs)
- Fungibility — individual units need to be interchangeable (e.g. any £1 coin has the same payment value as any other.)
Currency isn’t a particular material or design or anything like that. If people can, and want to, use it as a means of exchanging value, it’s a currency.
Trust matters too
A currency can only survive if the people using it trust the issuer and trust it will hold its value. During times of uncertainty (including hyperinflation), many people turn away from government issued currency and towards other stores of value, like precious metals. And that brings us to Bitcoin.
Bitcoin — the next step in the evolution of currency?
Bitcoin is considered by some to be a logical next step in the evolution of currency. It fulfils those key features perfectly, but it’s also better suited to our interconnected, global world than fiat currency. Bitcoin is:
- Divisible — one Bitcoin divides into units as small as one hundred millionth
- Scarce — the total supply is limited to 21 million Bitcoin which gives it value
- Durable — as Bitcoin doesn’t exist in physical form, it can’t wear out
- Transferable — Bitcoin is digital so you can transfer it to anyone, anywhere in moments
- Fungible — any particular Bitcoin is equal in value to any other Bitcoin.
For someone used to paying for their groceries with salt, the idea of using a gold coin would be crazy. For people used to the gold standard, fiat currency was a huge shock and sent many economies reeling.
Changes to the way currency works have always been challenging.
Bitcoin remains controversial because it’s new and different to what we’re used to. But if you look at how currency has evolved over time, you’ll see that people have always moved towards whatever system made the most sense at the time. Right now, cryptocurrencies make a lot of sense. At Luno, we believe it’s time to upgrade the existing financial system to something cheaper, faster, safer and more equal.