What is Money?

The last blog post spoke about two major trends in technology in the last few decades:

  • Centralization of Platforms – leading to a sort of feudalism on the internet
  • The rise of Open Source Software – leading to a democratization of advanced technology

In 2008, a paper published by a mysterious author (or group) called Satoshi Nakamoto led to the launch – and meteoric rise – of Bitcoin, a decentralized crypto-currency whose explicit design goal was that no one company or government could control it. Bitcoin was modeled after commodity money, like gold and silver, and though new coins would appear through “mining”, the rate would slow down exponentially so that the maximum number of bitcoins that would ever be mined would be 21 million.

From 2008 to 2017, the value of Bitcoin went from $0.003 to over $4,000, an increase of 1.3 million times. With an ever expanding set of exchanges, supporting infrastructure, and merchants willing to accept it, the market cap has now steadily grown to above 100 billion US dollars.

Even earlier, a web developer in Vancouver named Ryan Fugger conceived of a different sort of payment network, which he called Ripple. The original idea was based on people extending each other interest-free credit lines, and paying people they didn’t know through intermediaries. These trustlines, as they are called, are a form of credit money rather than commodity money. Credit can expand and contract, depending on how much people are willing to extend to one another.

A Brief History of Money

Before money, people had gift economies, because a coincidence of wants was rare. Then people started accepting gold, or silver, or other rare things, as symbols of payment. Thus, gold and silver became a medium of exchange as more and more people around the world would accept it as payment. It became the first money.

Then institutions and standards arose where people would borrow this money, and promise to pay it back later. The loans could be either secured or unsecured. Either way, the borrowed money was recorded as an IOU, and later were developed into double-entry accounting systems, where each credit had an exactly matching debit. If the borrower defaulted on their debt, then both the credit and the debit disappeared. The property that was held as security for the loan would continue to be used by the original owner, even while they used the borrowed money. However, the lenders did not have the commodity money around for the duration of the loan, so they couldn’t use it.

Banks and other institutions charged with safekeeping of money realized that, most of the time, the money wasn’t being used. So they started started to leverage their credit with the community and issue their own currencies, which led to Representative Money. This type of money was easier to carry to the marketplace and quickly drove out the commodity money from circulation, in a phenomenon knows as Gresham’s Law. The actual Representative Money was additional to the already-existing commodity money, and it was now being issued by the banks. This came to be known as Fractional Reserve Banking, and without oversight many banks flooded the market with poorly backed banknotes. Some banks over-leveraged their credit so much that it caused a run on the bank, and widespread financial panics. This led to the creation of the Federal Reserve System in the United States, which represented a return to Central Banking for the country.

Today, every country has moved away from commodity money and towards a system of Fiat Currency. Fiat Currency is legal tender that is backed by the government which issued it. Legal tender means it’s able to extinguish all debts, public and private. This is usually enforced by laws, which the courts adhere to, so that courts will not compel anyone to pay a debt in any other way. If you go to a restaurant in the USA and eat without giving them anything, they can’t force you to pay by credit card. They have to accept cash.

Today’s circulating money is primarily credit money issued by banks and other financial institutions, with some of that money issued by the government. In the US, official national money is minted as specie (coins) or paper dollars by the Federal Government through the Treasury, a power enumerated in the country’s Constitution. However, the vast majority of money in circulation is not this M0 money. Instead, it’s M1 and M2, including all those credit cards you use, all those paypal transactions, and the trillions moving around the world as nothing but bits in a computer. Every so often, banks settle liabilities between their accounts using systems like ACH which is run by the Federal Reserve System.

Fiat currencies and Fractional Reserve Banking has allowed the money supply to grow and shrink to accommodate the needs of people, businesses and industries. But, ultimately, monetary policy is in the hands of governments, which sometimes leads to inflation, hyperinflation and various other issues. In general, both inflation and a credit crunch are runaway effects, which have the potential to disrupt the economy for a long time. This is a great overview of business cycles under the current system. (And here are two rap songs.)

Decentralized Ledgers

What’s appealing about Bitcoin and other decentralized currencies is that people are able to transact, store value, etc. without anyone being able to stop them. You can think of it as a decentralized Paypal. The bitcoin ecosystem has grown tremendously, and its market cap now exceeds $100 billion. The guarantees of safety and security come from the cryptographic systems that underpin their operation. The lack of control, however, is not so easy: the system depends on a property called Byzantine Fault Tolerance to achieve global consensus in the face of many (possibly up to 50%) dishonest participants at any given time.

A question might arise, why does Bitcoin need global consensus, if it’s decentralized? After all, if I pay you, we can just both cryptographically sign it so that everyone who sees the transaction knows we approved it. The reason is that digital currencies which try to implement commodity (value) money suffer from the double-spend problem. Any actor can pay two people with the same coin, and “neglect to mention” that they no longer have the coin.

The answer, in technological terms, became the Blockchain. It’s basically an ever-growing ledger of transactions, that is periodically signed by some validators and replicated across all the machines in the network. The idea of a chain of cryptographically signed blocks, each one referring to the previous one, is not new or unique. It’s a special case of a Merkle Tree, and it’s used in decentralized systems with no global consensus necessary, such as the Secure Scuttlebutt protocol.

Bitcoin used Proof of Work both as a way to sign the blocks in the blockchain, and a way to “randomly” select the next validator. The ideas is that each transaction will eventually be approved, if not by one validator then by another. The problem with Proof of Work has been the escalating arms race that has wasted tons of energy to the point where validating each transaction takes as much electricity as running an entire household for a day. It’s been called the world’s worst database. And now, in practice, control of the validation has been concentrated in the hands of a few mining pools in Asia, in areas where electricity is cheaper. Bitcoin’s promise of decentralization may have dissipated, leaving room for more innovation.

A global consensus is only necessary to solve the double-spend problem. With credit money and trust-lines, this problem simply doesn’t exist. You are extended credit by those who trust you up to a certain amount (your friends, VISA, etc.) and your balance yo-yos back and forth, but there is no danger of “spending the same coin” because every trustline is separate from every other one.

That was the original idea behind Ripple. But, the project eventually found it hard to get adoption because people can’t be on the hook for large amounts of money for their friends. That’s historically been a job for banks, payday lenders and other financial intermediaries. For small amounts, however, trustlines and sidechains are a major area of research in the Lightning Network and other projects. The Interledger Protocol allows payments between ledgers, trustlines, or anything else, making it possibly the glue between all the different emeging technologies.

Ripple was taken over by the NewCoin project, and has reimagined global consensus without proof-of-work. They got funding from Andreessen-Horowitz, a forward-thinking VC firm that also made investments in Keybase and other crypto companies. They currently work with banks to replace ACH transactions (moving from legacy SFTP systems to their XRP token) and already move more money than the bitcoin network.

Money is an App

If you think about it, the value of a currency comes from network effects, just like any social app. You care about currency X if merchants accept X in exchange for the various things you need and want. Similarly, you care about app Y if your friends are on Y and you can do whatever you need/want with them through Y.

When viewed in this manner, you can see why community currencies would be the perfect fit for the Qbix Platform. It would be like Bristol Pounds, but much smarter. It could implement Unconditional Basic Income as a feature. It could allow communities to pitch in to finance drug research and production, or develop open course materials for students.

If you look at the past few years, you see the meteoric rise of cryptocurrencies. But also, look at the growth of payments through WeChat and AliPay in China, or Venmo here in the USA. These are essentially community currencies backed by fiat reserves. We can use decentralized ledgers powered by e.g. Ripple’s technology to let any community run their own currency. More on that next time.

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