If one looks at history of money, they will see steady progression from more concrete to more abstract. From barter to precious metals to paper to modern digital banking, the progression has been about steadily increasing efficiency and frictionless of money. Until recently, throughout its use for payments and as a store of value, the only form of digital money was that of centralized kind – digital ledgers kept at banks and financial institutions. Bitcoin entered scene in 2009 as a new form of value exchange through decentralized peer-to-peer network not controlled by any government or entity. It’s been very successful at that over the past years in its use for international remittance, micro payments and online commerce. As Bitcoin matured, it is now ready for the next stage of its life cycle where other use cases have emerged. Enter brand new asset class. Bitcoin volatility has been decreasing over the years and its liquidity steadily increasingapproaching $1 billion a day through the first half of 2016. Many investment professionals are now considering adding bitcoin to their portfolios, viewing it as a valuable hedge to traditional assets. New bitcoin investment vehicles such as Bitcoin Investment Trust (GBTC) and soon available Winkelvoss Gemini ETF had emerged, making bitcoin investment practical without technical know how of bitcoin cold storage and private key management. It is necessary to point out that, by buying shares in Bitcoin Investment Trust, one would be paying about 50% premium compared to buying directly at an exchange, as a convenience charge. At the time of this writing, GBTC trust share price was $87, which represents 0.1 bitcoin, currently priced at $607. According to this Forbes research, bitcoin is least correlated to any other traditional asset class out there, such as stocks, bonds, real estate, foreign currencies or gold (correlation table). This makes it an ideal addition to most investment portfolios, large and small. Bitcoin is well on its way into the “big league” of investment asset landscape. It’s no longer a matter of if, but a matter of when.
Gold is something we covet, cherish and put on our bodies. Scarce, authentic, easily divisible and aesthetically pleasing, gold has served as perfect private money for millennia. And yet, as this man discovered, gold is not without its limitations.
Try to pay someone over the Internet with gold, of transport any significant amount of it across an international border – and problems will arise. In this day and age of global international e-commerce, could we improve on gold as a private form of money ? Rather than depend on capricious yellow metal, could we re-design gold from scratch to preserve all of its traditional monetary qualities (scarcity and authenticity), but make it Internet friendly at the same time ?
This sounds like an engineering problem. To approach it from an engineering angle, let’s come up with a set of design requirements first.
We would like to design a form of money that is:
- Private (no need to expose personal information);
- Decentralized (distributed with no single point of failure);
- Free or cheap to use (no exuberant fees);
- Secured through advanced cryptography;
- Instant (transferred with a speed of an e-mail);
- Open (transparent ledger of transactions, verifiable by anyone);
- Global (from anywhere to anywhere in the world with Internet access);
- Peer-to-peer (no intermediary taking a cut or interfering with the transaction flow);
- Having no charge-backs and fraud resistant (‘push’ vs’ ‘pull’ transactions).
What is money at its core anyway ? Money is already mostly digital – a ledger of transactions kept and maintained by a financial institution. Centralization brings efficiency, but also introduces security vulnerabilities. Banks are honeypots of sensitive private information and as such juicy targets for hacker exploits as Citibank and JP Morgan Chase might testify. They represent a single point of failure, with “too big to fail” mentality. Can something be done about it ?
The answer is a sounding yes – in software. Quoting Mark Andresen, the creator of the first Web browser Mosaic and venture capitalist, software is “eating the world”, transforming many areas of our day-to-day lives such as telecommunications, transportation and healthcare. But, although younger generation increasingly uses smart phone apps for traditional banking services, the fundamental architecture of the financial system remained largely unaltered by the Internet revolution of the past 20 years.
What about the money itself ? Could we emulate gold through software ? The major issue here is making digital asset scarce and authentic in order to solve the double spend problem.
First practical design of such a system of electronic cash has been suggested seven years ago to date by a person (or a group of people) named Satoshi Nakamoto. Bitcoin – the protocol – is designed to emulate some of the best properties of a precious commodity – scarcity and authenticity – but without the limitations of a physical metal. Money emission is known for decades to come, inflation rate is algorithmically determined. The system is secured through proof of work, making it prohibitively expensive to cheat.
Bitcoin has decentralized architecture, with no single point of failure. There is no company behind it, no office, no CEO and no servers containing sensitive identifiable personal information waiting to be hacked. The best way to avoid personal information leakage is not to collect it in the first place.
Today is the seventh anniversary of the release of the original Bitcoin white paper. In the years since Bitcoin achieved significant traction, with cumulative computing power of the Bitcoin network exceeding that of 500 top world’s supercomputers, combined. The number of Bitcoin users, wallets and transactions has been climbing steadily.
A lot of venture capital firms are backing and investing in the technology, alongside with such big names as MasterCard and American Express. Total investment in Bitcoin startups has surpassed investment in the early Internet circa 1995 and is on track to exceed $1B this year.
And Bitcoin is just getting started.
(*) Programmable money is a new concept enabled by Bitcoin. It allows creation and execution of automated and unbreakable smart contracts.
There is a well known satirical novella by Edwin Abbott called “Flatland : A Romance of Many Dimensions”. It tells a story about strange creatures that are confined to two dimensional world looking like a boundless sheet of paper. The story continues describing a world occupied by geometric figures, whereof women are simple line-segments, while men are polygons with various numbers of sides. Two dimensional existence leads to some very interesting implications. For example, two dimensional creatures cannot process food the way we do, as any digestive tract going through would cut such a creature in half. These creatures’ living is governed by all kind of rules and limitations unfamiliar to us.
Similarly, the world of finance has significant number of limitations – some of them historical, some technological and some nonsensical.
Here is a list of questions one may be asking :
Why can’t I easily send $20 to my friend in Kenya ?
Why am I one of the 2.5 Billion people in the world who can’t get a bank account and are confined to transacting in cash ?
Why can’t I pay my two cents (literally) to YouTube to rid myself of having to watch those annoying Uber ads (disclaimer : I love Uber) ?
Why can’t I buy a single article from New York Times and have to shell out $149 for an annual subscription ?
The “whys” are many.
Enter the brave new world of Bitcoin.
How does Bitcoin add additional dimensions (read : degrees of freedom) to the world of finance ?
Let’s go over some of them.
- Trust-less escrow. In traditional escrow services an escrow agent has full custodial access to the escrowed funds. Meaning – yes – they can (and sometimes will) take off with the money. Bitcoin allows implementation of escrow in such a way that control over the funds is distributed among several parties. Using multisignature transactions, signatorial authority can be distributed among up to fifteen parties, thus completely eliminating counterparty risk. In its simplest form, two out of three signatures (the buyer’s, the seller’s and the escrow agent’s) are required in order to move the money. If the buyer and the seller agree on the deal, escrow provider is not involved at all, thus significantly reducing cost of escrow. In a case of a dispute, escrow agent can decide in favor of either the buyer or the seller, and that’s all they can do. They can’t take the money for themselves.
- Reversibility of payments and “hardness” of money (aka May Scale of money hardness) (http://blog.stakeventures.com/articles/2012/03/07/the-may-scale-of-money-hardness-and-bitcoin). We are used to thinking of payments as a singular event, while in reality every payment process is a sort of a state machine involving several steps. Should any of these steps fail the transaction as a whole has to be unwound within a certain timeframe. Your credit card payment can typically be reversed for up to 90 days, allowing for buyer protection. But what if you are dealing with a sketchy buyer as a merchant or transact in real estate or digital goods where true payment irreversibility is required ? Up until Bitcoin came to scene, the only truly irreversible form of payment was physical cash. Not very practical if you are transacting online or internationally. Bitcoin provides “hard core” of trust necessary for true electronic payment irreversibility. Other forms of payment similar to credit and debit cards we use today can be built on top of Bitcoin by “softening” Bitcoin’s hard core and providing the necessary consumer and/or merchant protection. But it is not possible to “harden” the mushy trust we have in existing payment systems today.
- Custodial access and true ownership of money. With commodity money such as gold and silver, ownership equals custodial access (also reflected in a popular saying “possession is 90% of the law”). In contrast to that, all fiat money other than physical cash today are in full custody of a financial institution entrusted with their customers’ accounts. Overseeing them is an army of auditors and regulators providing the necessary checks and balances in order to prevent fraud and abuse. Most banks are also required to carry FDIC (government) insurance to helps mitigate the risk for account holders. This still does not change the overall custodial relationship for the customers though – as far as custody of money is concerned, customers have none. With Bitcoin, custodial control of funds can be spread around so that financial institution does not have full custodial control therefore significantly reducing regulatory burden and bondage requirements. This innovation alone is significant enough to have prompted California to redefine monetary custodianship by adding a notion of “full” vs “partial” account control in their version of future Bitcoin regulation.
- Payment scale. There is a plethora of payment systems in existence serving various payment needs depending on the scale required – Credit and Debit Cards for retail payments, SWIFT and SEPA for international bank transfers, FedWire for domestic interbank settlements and so on. There is currently no system for electronic micropayments – transactions involving sub-dollar amounts. Apple iTunes is able to process $0.99 payments thanks to special agreements with MasterCard and Visa but the fees are high (up to 30%). Bitcoin treats all transactions the same -independently of the payment amount – in a way that makes sub-penny transaction undistinguishable from multimillion dollar transaction as far as speed and accessibility are concerned. It is analogous to transport protocol of the Internet – global, frictionless and fully content agnostic.
- Non monetary uses. Bitcoin protocol can be used to move other sorts of financial assets around – stocks, bonds, coupons, frequent flier mile points and gift card tokens. Nasdaq is currently experimenting with putting stock and bond trades on the Bitcoin blockchain (tee zero dot com). Colored Coins, OP_RETURN and Factom enable other uses of Bitcoin blockchain unrelated to money. For the first time in history there exists a completely open indisputable database of records that can not be modified or altered – only added to. Besides implementing money, it can also be used for keeping track all sorts of public records such as property and land ownership titles, criminal records or even college transcripts.
- Access controls.Traditional financial system has several levels of access controls built in concentric circles. In the outer circle customer only has access to his / hers account, while bank higher-ups have complete visibility into everyone’s account information. Unlike in a traditional system, security of Bitcoin network does not result in from access controls but rather from digital signatures and cryptographic proof of work. Bitcoin protocol allows for unprecedented level of visibility and accountability while being completely open and secure at the same time. One can send bitcoin transactions in the open via insecure WiFi, instant messaging or Skype Chat without compromising security. This is so because in Bitcoin protocol access control is pushed to the periphery of the network by entrusting individuals with safekeeping of their own private keys. This architecture eliminates meaty honeypots of massive storage of sensitive information which hackers love so much (Target, Home Depot, Chase and Citibank all know this first hand). This represents fundamental difference between architecture of traditional financial system and Bitcoin. It makes Bitcoin protocol much more robust and tamperproof.
- Machine to Machine payments. “Hi, I am Data Computer and I’d like to open up an account at your bank”. The clerk will probably check the date and, seeing that it is not April 1, just hang up. Yet with Internet of Things(IoT) becoming a reality and more and more devices coming online, there are use cases where machine-to-machine payment is required (e.g. your fridge reordering milk autonomously). A self-driving car could be operating its own taxi service by quoting rates to potential clients, buying gas and scheduling its own maintenance – provided there is appropriate payment network not involving human operators. Bitcoin makes this possible. In fact, it’s already happening – a new product from 21, Inc. to be released next month mines its own bitcoins and is designed as a platform for selling digital goods and services online, all paid frictionlessly with bitcoin. Exiting times ahead, indeed.