Mar 1, 2019
What problems do cryptocurrencies solve? Here’s Six.
News about crypto and blockchain is everywhere these days. A question I’m commonly asked by my friends is “why do we really need cryptocurrencies like Bitcoin?” I’m sure many people probably have similar questions, so I hope this write up can help understand how cryptocurrencies are structurally much superior to fiat currency (i.e. government issued paper money).
In particular, I’ve focused on solving problems with our current money system that are uniquely possible with cryptocurrencies. I hope you’ll like and learn.
1. Inflation (aka Currency Debasement)
- A dollar today doesn’t buy what it used to. A fundamental problem with fiat currencies is that governments and central banks can manipulate interest rates and issue bonds (debt) to easily increase the circulating money supply of any currency. This tends to temporarily inject liquidity into markets, but the additional supply dilutes the purchasing power of anyone holding that currency.
- How bad is this erosion over time? The astounding image below visualizes the debasement of the US dollar over the last century:
The inverse relationship between the purchasing power of the USD and its circulating supply can also be illustrated by the below image, which focuses on a more recent period of time:
In many ways, inflation is a hidden form of taxation, used to fund political promises. If it’s possible to print more money, the currency supply will continue to be inflated.
Unlike fiat currencies, cryptocurrencies offer the ability to have a fixed creation schedule, and a hard capped maximum supply. Two top cryptocurrencies, Bitcoin and Decred, have a max supply cap at 21 million. A currency with a fixed supply that can’t be diluted is a breakthrough innovation that is simply not possible with fiat currencies.
Scarcity drives value. Gold has retained its place as a store of value for 5,000 years, in part due to perceived scarcity. Yet there is no greater assurance of scarcity than a mathematically capped supply, which has now been made possible with cryptocurrencies.
2. Foreign Exchange Fees
Imagine if every retail store had its own currency, and in order to use the currency in the store next door, you had to forfeit 30% of the value. At a macro level, this is analogous to what happens with fiat currencies. There are 180 currencies recognized by the United Nations, and these people owning different currencies are dis-incentivized from transacting with each other. Foreign Exchange fees are possibly the most unnecessary surcharges on people transacting with each other, and were unavoidable — until now.
Central bank issued currencies are artificially constrained by geographical borders. If you’ve ever traveled to another country, you’ve likely returned with spare change which is essentially unusable. Cryptocurrencies on the other hand, are border-less by nature. The next time you are charged foreign exchange fees or find yourself with worthless foreign spare change, remember that there is a better alternative now available to us.
3. Inefficient transfer of payments
Fiat money is inefficient to move around. As a result, we have to rely on various intermediaries, who each take a share of profits in order to relay money to the next recipient. Working in financial services, I’ve observed up close how inefficient today’s correspondent banking system is. If you’ve sent a wire transfer to another country, it may take up to five days (!) for the recipient to be able to access the money. These high fees and long settlement times are justified to us by saying these intermediaries are the trusted guardians of the walled money system.
Unlike fiat currency, which requires middle men to move around, digital currencies have a built in payment and settlement network. You can directly send hundreds of millions of dollars to someone across the world using Bitcoin in a matter of minutes, for the price of a coffee. This kind of difference is basically insurmountable for fiat currencies, although companies like JP Morgan and Ripple are developing blockchain based payment solutions for institutional clients.
4. Limited divisibility and incompatibility with micropayments (future use case)
What’s the smallest unit of a dollar? Under the current paper and coin based money, the answer would be $0.01, even though mathematically the number can be smaller. These are artificial constraints, because technically we should be able to transact in half cents, a tenth of a cent, or even a smaller fraction.
Unlike fiat currencies, a bitcoin can be divided into one hundred million units (0.00000001 BTC, also known as a Sat). The use for micropayments is not obvious today, but there are burgeoning signs with IoT where smart machines will transact with each other. As an increasing number of smart devices are connected to the internet, there will be opportunities to monetize microevents. Imagine a world with autonomous vehicles where you could put a price on each car that bypasses each other. These and other high frequency fractional transactions can be unlocked by better payment facilitation through cryptocurrencies.
Another use case for micropayments is virtual goods and video games, for which there is massive opportunity in the gaming space. Imagine playing your favourite video game, where you can spend one tenth of a cent to level up to a special character trait. Interested in more Candy Crush lives and add-ons?
5. Threat of Confiscation and privacy of asset ownership
For many parts of the world, the threat of your savings being seized is a real concern. Most of the world population (4 billion people) still lives under autocratic rule where property can be confiscated. This isn’t just a problem for citizen’s fleeing war torn countries. Even authoritarian leaders themselves can have their bank accounts and Gold holdings seized by others.
For the wealthy, this has given rise to the offshore banking industry, which is worth over $30 trillion dollars. Most of the world does not have access to the offshore banking industry today, and you can argue that the real global value of an unseizable store of value should actually be higher. Cryptocurrencies offer a non-sovereign censorship resistant store of value that is impossible with fiat currencies.
6. Financially including the globally unbanked
While we take access to bank accounts for granted, over 2 billion around the world still don’t have a bank account. Infrastructure and paperwork requirements prevent large number of people from participating in global commerce.
An example of the profound opportunity for banking the unbanked is the case of girls in Afghanistan who use their phones to get paid in bitcoin, without having to ask for male colleagues to accompany them to the bank for safety. Cryptocurrencies offer a reduced way to store and move value that is free of guardians that has never been possible before.
Conclusion
Most people first get interested in crypto because it can make you rich. I’ve deliberately stayed away from any price discussion or predictions, because price is a function of demand, and demand is generated and sustained by value. And cryptocurrencies offer value propositions today that are impossible to compete with.
