People often ask me – ‘What is so special about Bitcoin?’ – and one of the answers I give is ‘disintermediation of trust’. In economics, disintermediation is the removal of intermediaries in a supply chain, or “cutting out the middlemen”. In my opinion, money is all about trust – you trust that if you work for X hours a day, your employer will pay you Y amount of money, and for that Y amount of money you will be able to buy Z amount of food etc.
But here is another question, why do we need to trust each other? Evidence shows that we can live better by specializing e.g. I am a much better IT guy than a musician, so if I do what I do best most of the time, I can’t do the other things, but I can exchange my labour for money, and then for other goods and services e.g. buy music; and as a result you get better music and IT than if each one of us did both part time. So if specialization leads to better quality and productivity, then to unlock its value you need a form of exchange.
First form of exchange was barter, but it was pretty inefficient – hard to figure out how many sheep should be exchanged for a cow. In essence the cost of transacting was high, since it took a long time to barter, and it was hard to determine if one side or other got the better deal as the market visibility was poor. The nice thing about barter is that it is hard to double spend (cheat) what you have as there is a physical inspection and exchange of goods. You are still at risk of getting an inferior to what you bartered for product e.g. an ill sheep versus a healthy one.
So money in the form of gold was a big step forward. Gold is limited in supply, so in principle inflation can be controlled, unless a new source of gold is discovered e.g. South America’s gold rush for the Spanish crown. It’s hard to double spend or cheat the system, as like with barter you can perform a physical inspection and exchange of gold. Some people do cheat and substitute cheaper metals for gold or skimp on wieght if possible, so when performing a transaction it is worth checking that actual gold is exchanged, and you need to weigh it to ensure the amount is correct. Again, the cost of transaction is high as you have to check quality and amount, but better than taking a cow along for the ride when you want to buy a coffee.
Next innovation was the minted coin – essentially standard weights of gold, and hopefully a guarantee of quality i.e. you are getting gold not some inferior metal. A central authority, the mint, backs up the currency and guarantees quality and amount standards, enforcing those through punishment of forgers. Cost and speed of transaction is reduced, and there is now someone you can ask to enforce the law if fraud happens – recourse.
Gold is still pretty heavy to carry, even if it lighter than a cow, so paper money was the next invention. Much easier to carry and hence reduced transaction costs and time (friction). Paper money is printed in all sorts of clever ways to ensure that it cannot be forged and double spent.
However paper money was at first a simple proxy for gold reserves. Problem with gold is that it is of limited supply – good to prevent double spend but as the economy growth through more people being born and them becoming more productive, if no new gold is discovered, the money supply is constricted and no longer supports effective exchange of value, either leading to deflation or stagnation. Many argue deflation is bad, others argue that deflation is only bad if you have constrained demand. Go figure. Solution to this gave rise to fiat currencies – money not backed by commodity like gold.
Moving away from commodity backed money meant that governments became free to control money supply as the economy expands or shrinks e.g. quantitative easing etc. It’s a very powerful tool, but places a lot of trust in the government not to print to much money and cause inflation. So, for paper based fiat money, you need to have trust in the government’s central bank to not over or under supply money, and in the mint to create paper that is hard to forge.
Problem with paper money is that it is hard to send it remotely i.e. electronically. Sure you can post it, but that takes a long time. In the new digital age paper money transactions are just too slow and thus expensive. So, how do you send money electronically, and prevent double spend? After all, anything digitally stored is easy to copy and hence double spend. Current answer is to trust a bunch of organizations e.g. retail, merchant and central banks, payment processors etc. not to actually move money around, but for the various parties involved to record transactions in their own ledgers and then sync them up between organizations to achieve consensus.
In essence, it’s the bank’s view that determines how much money you have – that’s a lot of trust. A good article about how money moves around can be found on this gendal.me blog.
All this works pretty well, so why did Bitcoin evolve? Remember 2008? Some people decided that they did not trust the banks all that much after all. So they sat down, and decided to imagine how you could keep and transact money without having banks and payment merchants. Then they wrote some code. Then they got a bunch of people on run that code on their servers. In 6 short years Bitcoin is worth now 3BN USD. Small compared to everything else, but awesome when compared to nothing – and all without a single bank, payment merchant or government body.
You may say – why do I need it, living in UK, CH, US etc? The answer is probably more belief based, rather than practical – with free retail banking it’s easy to transact, and although merchants pay and pass on payment processors fees, you do get recourse in return.
Turns out that it costs a lot of money to maintain all these central services, costs passed on one way or another to users, but only viable if there is a lot of payment volume. Large parts of the world therefore simply have no banking access as putting the required infrastructure there is not economically viable. So what Bitcoin has done, is by disintermidiating retail banks and payment processors via use of new technology, it has reduced costs and unlocked previosuly economically unviable business models.
All you need is a 26 GBP smartphone and mobile broadband subscription (2007 : 4% of world population subscribed, 2010 : 11.3%, 2013 : 29.5%). You are done! No need to open bank accounts or deal with VISA, PayPal etc. Imagine if just half of the unbanked started using Bitcoin – would the rest of the world be able to resist it? Take a look at M-Pesa and see it’s phenomenal uptake in Africa if you are skeptical about demand. And whilst’s Bitcoin’s volatility index is about 7.55% against USD (https://btcvol.info/) compared to gold’s 1.2% and major currencies’ 0.5% to 1.0% range; it’s not that bad when compared to currencies that majority of unbanked transact in.
But let’s assume that Bitcoin the currency will not spread; but instead there will be government backed distributed ledger networks that track fiat currencies – after all how different is eMoney (legal, tried and tested) on a pre-paid debit card and a crypto-pound managed by smart phone app? It’s that very question that the UK government is starting to ask : http://www.theregister.co.uk/2014/11/04/treasury.