Blockchain is indubitably one of the greatest technological creations in our time.
It’s easy to grasp the significance of the Internet - another great technological advancement, because we use it every day in many ways - bringing us morning weather reports to evening entertainment, and everything in between. We realize the power of AI because we experience it everyday - searching online, detecting faces in pictures, and product recommendations. We understand these already ubiquitous technologies because we can associate them to the problems they solve in our day to day life. Blockchain is a relatively young kid in the block, so in order to understand or appreciate it, we have to look at the problems it aims to solve.
Blockchain is the technology that enables the existence of cryptocurrency. Bitcoin is the first and most popular cryptocurrency, the one for which blockchain was invented. To understand why Bitcoin was created, we have to understand the drawbacks in our current financial system. For the sake of completeness and to get a sense of how we got to the current system, we will take a quick walk along the history of how money evolved over time. If you wish, you may skip the history lesson and jump to issues with Fiat currencies
People exchanged goods and services directly with each other. For example a farmer with excess produce of dairy or meat could exchange with a fisherman with a surplus of fish. This was likely the first system to facilitate trade - which is always essential, as no one can be self-sufficient at all times.
The problem with this system was immediately apparent when there was no one willing to participate on the other side of the trade - trade is bilateral. In our earlier example, if no fisherman wants to trade fish for meat or dairy, the farmer wouldn’t be able to get fish even though there is value for his meat and dairy. Some of these issues could be solved by involving 3 or more parties in a trade, but it gets complicated quickly - like in the board game Catan.
As time passed, people noticed that certain commodities such as sea shells, salt, corn, copper, silver, and gold are rare and always attractive. People began to quote the value of their everyday items in terms of these commodities. For example:
- a sheep is worth 10 sea shells
- a house is worth 50 bags of corn
This is an improvement over the barter system as people could sell their goods and services for these commodities. And they can buy the goods and services they need using these commodities. The commodities used for trade had certain characteristics: they were widely desired and therefore, valuable. They were also durable, portable, and easily stored. While this opened up more opportunities for trade, there were still issues with the commodities such as:
- Deterioration: certain commodities, like corn, can deteriorate in quality over time
- Bulkiness: Imagine having to go shopping with a cart full of salt
- Indivisibility: some commodities, like seashells, can’t be meaningfully subdivided
People became accustomed to the idea of a medium of exchange for goods and services - aka money. Coins were minted with different denominations and this solved most of the problems associated with commodities. Also, the value of the coin is decoupled from its size and this made the process of moving money around easier. This innovation made it easier and faster to conduct trade.
Merchants and traders were looking for ways to do larger transactions without having to carry large amounts of metal coins, so paper money was created. Bank notes were issued and backed by storing coins of equal value. Anyone holding a bank note could approach the bank and exchange for its value in coins.
The modern paper money such as Dollar, Euro, and Pound are no longer backed by any physical commodity or asset.
Paper money is now issued by a central financial entity in each country and money derives its value from the trust we place in these institutions. This is called Fiat money.
Plastic money was an improvement over paper money. It made it easy to transact on large or small amounts alike. It also opened up a plethora of new possibilities such as credit cards that made short term borrowing easier. Coupled with the innovations on the internet, it created products and services that wouldn’t have been possible without it.
Plastic money is just a representation of paper money that offers convenient means to transact with ease. The fundamental issues, discussed in the next section, apply to all forms of fiat currencies - such as US Dollar, Euro, Pound.
Issues with Fiat currencies
To understand the issues with fiat currencies, we need to take a closer look at its definition.
Fiat money is a government-issued currency that isn’t backed by a commodity such as gold.
Fiat money gives central banks greater control over the economy because they can control how much money is printed. Central banks printing too much over a short period has led to a total economic collapse time and again.
- Hyperinflation in Germany in 1920s
- Hyperinflation in Zimbabwe in 2008
- Hyperinflation in Venezuela in 2016
Just in the last century there were 13 instances of Hyperinflation - Austria, Bolivia, Brazil, China, Germany, Greece, Hungary, Malaya, North Korea, Peru, Poland, Philippines, Soviet Union, and Venezuela. Through no fault of their own, people in these countries had seen their money erode in value as the price of commodities doubled every 14.82 hours (Hungary, July 1946)! All because the central banks hoped to print their way out of trouble. Hyperinflation is an extreme scenario and is typically associated with some form of War.
During times of crisis - be it war, economic collapse, or pandemic such as the one we are in now, central banks issue unprecedented amounts of money in a short span to support and boost the recovery of the economy. As cool (and unwise) as it would be, this newly created wealth is not dropped from a blimp.
The government decides which institutions will receive a bigger chunk of that wealth - in the name of aid, bailout or a rescue package. In the 2008 financial crisis, it was bailing out banks, despite their own faults for the situation - as these banks were “essential to keep the financial system running.” A similar situation in the 2020 crisis. In the US, large corporations get 25% of the $2 trillion stimulus package. Fiat money gives this unprecedented power to the governments or central banks to do such massive redistribution of wealth - further widening the income gaps in the society, reinforcing the saying:
The rich get richer and the poor get poorer
The issues related to the handling of the 2008 financial crisis was the reason Bitcoin was created. On 3 January 2009, the bitcoin network came into existence with Satoshi Nakamoto mining the genesis block of bitcoin. Embedded in this block was the text:
The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.
To summarize, Bitcoin was created in the hopes of building a new form of money that is not controlled by a single central entity - such as the central banks. A system where no single person, company or even government has the capacity to manipulate the supply of money. Bitcoin runs on a fully decentralized system. New coins are issued at a defined rate and are distributed in a well-defined structure.
Issues with Bitcoin
Like any currency, Bitcoin has its own set of problems:
Not widely accepted: There are not many merchants - online or offline, that accept Bitcoin as a mode of payment. This is like the classic Chicken-and-egg problem. This applies to any currency - digital or otherwise, in its infancy. While fiat currencies could draw upon the trust people have in their governments to enjoy wider adoption. The case for digital currencies is yet to unfold.
No valuation guarantee: Since there is no central authority backing Bitcoins, no one can guarantee its minimum valuation. Bitcoin relies on mathematical properties to earn trust and its value is linked to its adoption by a growing base of users, merchants, and startups. If a large group of merchants decide to “dump” Bitcoins and leave the system, its valuation will decrease greatly. This will immensely hurt users who have a large amount of wealth invested in Bitcoins. The decentralized nature of bitcoin is both a curse and blessing.
Volatile valuation: The value of bitcoin is highly volatile. This makes it harder to use it for exchanging goods and services. For example, if Alice sold a car for 1 bitcoin on 17th Dec 2017 (1 BTC = 19,166 USD) and decided to use that money to pay for the new year party 2 weeks later on 31st Dec 2017 (1 BTC = 13,060 USD), the value of her car sale has eroded significantly (in real dollar terms) in just under 2 weeks!
Irreversible transactions: This is both a strength and weakness of Bitcoin. When a transaction is made using Bitcoin, it is irreversible. In the current banking system, if your card was stolen and used for fraudulent purchases, or you made a purchase and the seller didn’t send the product; it is possible to reverse the transaction. All transactions with Bitcoin are irreversible so there are no fraud protections.
Deflation: The total number of bitcoins is capped at 21 million. This will cause deflation - the value of money increasing over time. Each bitcoin could be worth more and more as the total number of Bitcoins maxes out. This system is designed to reward early adopters. Since each bitcoin could be valued higher with each passing day, people will be more inclined to save it as an asset; rather than spend it like a currency. Despite its initial intentions, this makes it more of a digital asset than a currency. Infact Bitcoin is now often referred to as Digital gold.
Not all cryptocurrencies are deflationary. Ethereum, the second largest cryptocurrency does not have fixed supply - a maximum of 18,000,000 new coins are issued annually.
One major difference between physical and digital forms of money is that a digital token can be duplicated or falsified and spent over and over - called the Double spend problem. This applies to both digital versions of Fiat currencies and cryptocurrencies such as Bitcoin. Fiat currencies use a trusted central entity (bank), which keeps a record of how much money each person has and every time they try to transact, their account is checked to make sure they have enough balance before approving the transaction. With Bitcoin there are no central entities that can provide this service so, a novel technology called blockchain was invented to workaround the double spending problem.
Although blockchain was invented for supporting a new form of decentralized money such as Bitcoin, the technology can be used for many applications beyond creation of cryptocurrencies. The original version of the Internet was created to allow multiple computers to communicate on a single network, and today it has evolved into something much bigger than anyone could have imagined. Blockchain has the potential to be something much bigger! The next post will discuss how blockchain works and how it can be used to power many new types of applications.
I hope you enjoy reading and learning from this series as much as I enjoy writing it.
See you again on this channel soon!