Billions of people will soon be using digital money. Unlike the crypto pioneers, these adopting masses will not be driven by politics or profit, but by product. From The Beach to the bank, digital money will simply be better than alternatives.
Working at Blockchain.com means I constantly field cryptocurrency related questions. The most interesting of which don’t focus on price, or mechanism, but the very purpose of digital money: why do we need cryptocurrencies? ‘What’s the point in bitcoin when we already have Paypal and banking Apps? The confusion is not restricted to those outside of finance — I faced similar questions from bankers whilst I was at UBS working on a side-project to develop a form of ‘digital money’ (eventually known as the ‘Utility Settlement Coin’): ‘why do we need this ‘digital money’? Surely all the money we deal with is already electronic?
In the past I’ve tried to explain it as: ‘The aim is to create a decentralized digital bearer asset that enables fast peer-to-peer transaction settlement without a centralized third party using a blockchain and distributed ledger technology’. I recognize that this description is a mouthful and while it may be technically accurate, without a glossary of terms at hand it doesn’t provide much clarity. An inquisitive listener is stuck wondering: ‘so why do we all need that again? Here’s my attempt to explain.
Money on the beach
When considering the role of digital money, I’ve found it helpful to conceptualise different monetary systems. For the purposes of today, let’s imagine a community on a self-sufficient, remote-island society. In my head it looks something like the community in the book The Beach, made famous by Leonardo DiCaprio’s starring role in Danny Boyle’s 90’s film.
Imagine that on this beach Leo and his settler-buddies decide it would be useful to establish a form of rudimentary money and decide to use bags of rice for this purpose. Each of the beach members store their individual rice bags in various locations and when they trade between themselves they physically move the rice bags around as payment. These rice bags are both ‘commodity money’ and ‘bearer assets’ meaning that the person who owns the asset is the one who controls it. Transactions are ‘peer-to-peer’ because they take place directly between two people without any third party involved.
Soon the beach members realise it’s tiresome to store each of their own rice bags and move them around constantly. Leo has better things to do. So they decide to store all the rice bags in the same storage hut, and everybody keeps their own record (on paper) of how many bags each person owns. Every evening the community gathers round a fire and any new transactions and changes in rice ownership are announced, with everyone updating their own records accordingly. If there are any disagreements the beach leader (she’s called ‘Sal’ in the film) steps in and decides who’s right. This money is no longer a bearer asset as it’s now ledger-based, in this case using a ‘distributed ledger’ — as everybody has their own copy of the transaction history and its current state. They have a centralized consensus mechanism for dispute resolution (Sal, the beach leader decides). However, if they were able to come up with a set of enforceable rules for reaching consensus without the need to rely on Sal then this would be a ‘decentralized consensus mechanism’.
A few weeks pass and the group decide that it’s inefficient and boring for everyone to come together nightly to update their individual ledgers. Instead they decide to rely on one ledger that they entrust to the beach leader, Sal. Now, every time a transaction happens the people involved inform Sal and she updates her ‘golden record’. This saves everyone time. Money is still ledger-based, but it’s no longer a distributed ledger.
Every few weeks Sal sails to the mainland to make trades and purchases on behalf of the island community. During one of these trips she has a idea! The rice bags that ‘asset-back’ the community’s money are never used and just sit idly in the central storage hut. So she decides to trade the rice in the mainland markets in return for other useful things like vegetable seeds and livestock that she takes back to the beach. The community members are pretty happy with this arrangement because they are able to grow more food. They keep using the centralized ledger maintained by Sal for recording transactions and they continue to use rice bags as the ‘unit of account’ for their money. Only now there are no rice bags in the storage hut — they have all been traded out on the mainland. The islander’s ‘money’ is no longer asset-backed by anything physical — it has become a ‘fiat money’. It no longer had intrinsic value as it can no longer be converted back into rice bags. The islanders are now not only trusting Sal to look after the money and keep track of who owns what, they are now trusting Sal to also maintain the value of the money itself. For this to work the islanders must trust that the money will always be exchangeable for goods and services on the island and that Sal won’t devalue the existing money by creating more money out of thin air.
This system works fairly well, but because it’s based on a centralized ledger everybody has to continually come and speak to Sal each time a transaction is made. This also becomes tiresome, so Sal comes up with another idea. She starts handing out pieces of paper that represents a claim to exactly one bag of rice from the central storage hut (which of course are no longer there). She personally signs each piece of paper to prevent forgery. Beach members now use these notes as money to make peer-to-peer payments between themselves in whatever manner they like, without involving Sal. Just like the bags of rice at the beginning, these notes are again ‘bearer assets’ as they no longer rely on a ledger and instead it’s the control of the asset (now the paper notes) that determines ownership. We have almost come full circle, only now we have ‘peer-to-peer fiat-money’ rather than the ‘peer-to peer commodity-money’ that we started with.
Money today: trust is key
This example is simplistic but most forms of money used today can be understood in these terms. Just like the beach community, our modern economies have gravitated towards centralised ledgers. The majority of money today exists as electronic ledgers maintained by banks, like the one controlled by the beach leader, Sal. A small proportion of money exists as physical cash, like the notes the beach members used to settle transactions directly between themselves. Almost all this money is fiat money — it’s not ‘backed’ by anything and so it’s value relies on trust.
In our society, you first need to trust the institutions that issue the money and maintain the ledgers (i.e. that banks won’t go bust, or mess with the ledger to take your funds). Second, you need to trust the value of the fiat money itself. Just as the islanders had to trust that the Sal’s money would continue to be exchangeable on the island and on the mainland, we must trust that the money we own will be forever exchangeable for goods and services in our economies. We must trust that people will always be willing to accept our money and that banks won’t create too much of it.. We trust (hope!) that there will continue to be demand and not too much supply to ensure that the value (price) is maintained over time.
But sometimes this trust is lost. Beach leaders like Sal can make mistakes or sometimes be downright cheats.
What happens when trust disappears?
Institutions and banks can fail. This month marks the 10 year anniversary of the 2008 Global Financial Crisis which demonstrated quite clearly that the money in banks was not as sound as many had assumed. Banks had created money out of thin air by using borrowed money to create loans. But these loans turned out to be bad. Imagine if Sal had borrowed the rice bags from the storage hut and traded them in on the mainland for seeds and livestock that turned out to be rotten and totally useless. This is essentially what happened in 2008 — people realised the assets the banks had were worthless and so trust and confidence in the economy was lost. As a result, banks became insolvent, people were unable to withdraw money and in some cases funds had to be frozen.
Fiat money can lose its value. Economics 101 tells us that if you create too much supply without enough demand prices, will fall. Money is no different: if a country prints too much money but the economy does not grow to generate demand, the the value of money will fall. We call this inflation and right now there are high levels of inflation in countries like Venezuela, Argentina, Turkey, Iran and Zimbabwe. The impact means people don’t have easy access to stable currencies or safe haven assets and so their options for wealth preservation are very limited — in many cases their life savings disappear. Imagine a mother in Venezuela trying to save money for her children’s future. She’s been carefully storing cash in a safety deposit box for years, but now due to hyperinflation the money is essentially worthless. Savings that used to be enough to pay for tuition fees are now worth no more than a some toilet roll.
Digital money can solve trust problems
In cases where people have limited trust in centralized institutions or a way to store wealth then cryptocurrencies can offer an appealing alternative. Cryptocurrencies like bitcoin can be understood as the digital equivalent of the beach members coming together around fire to collectively come to consensus as to which transactions are valid and then each updating their own individual ledger at the same time. This may be more time consuming than just relying on the golden ledger controlled by Sal. But, if you lose trust in your beach leader then this a compelling alternative given that the system is completely decentralized — no one needs to trust Sal to maintain the ledger or the value of the money itself. Bringing this back to the present, as of the time of writing, the Argentine Peso and Turkish Lira both lost half their value vs. the US Dollar in the last 12 months. Bitcoin has increased by 50%. A Venezuelan holding a 1000 US dollars worth of bolivars a year ago has seen the value of this holding evaporate to basically zero — had that person been able to swap those bolivars in bitcoin a year ago, they would now be able to exchange this bitcoin for 1500 US dollars today. Of course, ideally the alternative to local fiat currency would not be a currency as volatile as bitcoin currently is. This is why we need viable alternatives to local fiat currencies that include stable digital assets that are as universally accessible.
But this is only part of the story. Remember how Sal decided to issue paper notes so that Leo and his pals could engage in peer-to-peer transactions without having to constantly inform her? Well, the same thing is about to happen on the internet. Right now when you send money to a friend (via an app, using Paypal or otherwise) what you are really doing is sending a message telling your bank to make a change in their centralized ledger. This is really limiting as everything is constrained by the need to plug-in to the bank’s centralized ledger. Alternatively, ‘digital cash’ refers to electronic money which can be transferred between two people directly (peer-to-peer) over the internet without the need to constantly go via a centralized ledger. Just like physical cash in the physical world, digital cash is untethered from legacy constraints and is ‘free’.
Digital cash will create value, driving use
The existence of ‘digital cash’ will completely transform the way in which value is transferred over networks because it enables any amount of money to be sent to anyone (or thing) at any time, for free. Not only this but the money itself will ‘programmable’, meaning it can literally do anything a programmer is able to fathom.
To make it real, imagine a scene back on the beach. Leo is lying in his hammock, sipping out of a coconut whilst reading a Medium article about cryptocurrencies on his smartphone. Rather than pay the $5 per month subscription (he doesn’t have a bank account), his digital wallet ‘streams’ digital cash directly to the London based author in real-time as he reads. Leo enjoys the article (especially the parts that mention him) so he shares it on Twitter. He’s especially incentivised to do this because the author has applied some basic code that pays Leo a small amount of digital cash everytime one of Leo’s followers click on the article link. This is one type of model, and better payment models will soon harness this ability for money to flow across the internet as freely as information does today.
Millions of people, maybe even hundreds of millions of people may become attracted to cryptocurrencies as an alternative to trusting centralized forms of money. However, the driver for billions of people to use digital money will not be ideological, political, or due to a breakdown in trust. It will be because this digital money will be fundamentally more useful than anything that went before it, both at the beach, and at the bank.
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