In the early 1970’s, the financial industry was transformed by a strange confluence of events. In 1973, The Chicago Board of Trade opened the first options trading floor and, almost as if on cue, a month later the Nobel prize winning Black Scholes options pricing model was published.
Soon after, Hewlett Packard introduced a pocket computer small enough for traders to use on the floor and that, combined with a glut of engineering talent made available by the closing of the Apollo space program, created a wave of revolutionary change that is still being felt even today.
Almost overnight, finance was transformed from a clubby world of cozy relationships to a mathematical one of complex securities, abstract formulas and computing power. Now, a generation later, the financial industry is about to be remade once again, except this time, it is not obscure financial securities that are being transformed, but very nature of money itself.
What is Money?
The concept of money dates back to the beginning of civilization. The Israeli currency, the shekel, was originally a measure of weight (11 grams) and each shekel coin originally corresponded to that amount of silver. Coins were stamped to certify that they contained the required weight, infusing transactions, even among strangers, with an element of trust.
It’s easy to see how money caught on. It was a much more efficient way to transact business than bartering one good for another. Money was also a useful store of wealth, certainly more convenient than livestock or grains. These two core functions—a medium of exchange and a store of value—still define money today.
The nature of money changed after the Bretton Woods Conference in 1944, when most countries tied the value of their currencies to the US dollar, rather than to gold or silver. When the US went off the gold standard in 1971, all currencies essential became fiat moneys, with their value essentially derived from faith in the governments that issue them.
Many people object to the concept of fiat money because of the control governments have over it. Central banks can increase or decrease the money supply at will, giving them enormous control over economic activity. In extreme cases, hyperinflation can ensue, debasing the currency and wreaking havoc.
So it’s not surprising that innovating the concept of money through a digital currency has been a recurring theme in technology circles. Intuitively, it seems that the global financial system should be based on more than the judgments of a small group of central bankers. Yet only recently has digital money actually become possible.
A Mathematical Problem Of Trust
As Marc Andreessen points out in his excellent NY Times piece, the best way to understand digital currency is through the Byzantine Generals Problem. Imagine a group of generals that needs to coordinate an attack, but must do so only through intermediaries. Clearly, trust becomes an issue, because of the possibility that their communication will be sabotaged.
One way of solving the Byzantine Generals Problem is by establishing a trusted third party, which is the role that governments and banks have traditionally played in financial transactions. Yet a third party is not a true solution, because there’s always the possibility that the third party can be corrupted as well. In effect, it merely assumes away the problem.
Another solution would be to create unforgeable signatures, which is what digital technology makes possible (digital signatures have been around for some time). Moreover, in digital form, these signatures can be distributed—both instantly and ubiquitously—making it an ideal vehicle for an alternative currency to fiat money.
These types of currencies are called cryptographic currencies, the most famous of which is Bitcoin. It works through a widely distributed digital ledger, which makes it not only super secure, but also incredibly efficient because payment processing is automatic.
Storing And Protecting Value
The most publicized aspect of Bitcoin is its function as a store of value. Bitcoins can only be created by mining, which is done by solving complicated mathematical problems. The supply of Bitcoin is also capped. So no one, not even its inventor, can create unlimited Bitcoins. There’s no Federal Reserve or other central bank that can intervene.
This made Bitcoin supremely popular among Silicon Valley’s libertarian set who don’t trust government entities. The idea of a currency impervious to debasement, ruled by algorithms instead of humans, has intuitive appeal. Establishment figures initially feared Bitcoin for many of the same reasons.
Yet as it turns out, Bitcoin is not a particularly good store of value. Its popularity led to a massive speculative bubble, rising in value to almost $1000 and then crashing down to under $400. The truth is that algorithms are no better—and possibly much worse— at managing currency than humans are.
Further, it is unlikely that a digital currency will ever displace national ones like the dollar. As long as governments have the power to tax, they have the power to demand payment in whatever form they choose. Invariably, that will be a national currency.
While digital currencies are unlikely to impact national currencies’ role as a store of value, there is vast potential in using vehicles like Bitcoin as a medium of exchange. Consider that Visa and Mastercard make over $30 billion per year in interchange fees and you can see the possibilities. Bitcoin can do a far better job at a much lower cost.
Remember that Bitcoin has a widely distributed ledger, so it’s much more impervious to attack than a centralized institution like a bank. It also transacts business instantaneously, so there is no “float” (i.e. the bank can’t keep your money in limbo while it earns interest on it) and because processing is automated, fees can be lowered substantially.
A recent article in TechCrunch describes another interesting aspect of digital currencies, the ability to program currency to create new financial products with functionality built in. Imagine being able to set up an automated escrow account or a trust on your smartphone, with no lawyers involved.
Digital currency is still a very new concept and these are merely initial ideas. Surely, as the market and technology matures, more useful applications will arise.
The Democratization Of Finance
Money has always been intertwined with centralized power. Only governments could issue it and only banks had the resources to facilitate transactions. That model worked well enough, but had obvious drawbacks. Many were shut out of the system while others earned fortunes as gatekeepers.
The revolution underway in finance going on now has the potential to be even more consequential than the one that took place in the 70’s. While financial innovation forced many practices in the industry to evolve, its institutions remained intact. The financial world today is still ruled by a relatively small cadre of bankers, clearing houses and regulators.
Digital technology, however, is making finance exponentially more democratic. Crowdfunding and microlending have made it possible for people to acquire financing who never could before. New payment systems like Square, Paypal and Apple Pay have made it easier for merchants to accept electronic payment.
Yet digital currency is something else altogether because it represents a decentralized form of money that is more secure, more fungible and more functional than anything we’ve seen before. More than a mere store of value or medium of exchange, digital money has the potential to be more transformative than anything we’ve seen before.
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Greg Satell is a US based business consultant. You can find his blog at Digital Tonto and you can follow him on Twitter.