Crypto: The Big Picture - Part 1
There is so much hype, jargon and fundamentally new concepts in the world of crypto-currencies and blockchain that its difficult for most people to understand what is really happening. Is it just a big bubble or something more profound? This is the first in a series of articles attempting to make sense of the big picture.
What is money?
The first thing to understand is that our current form of money is quite new. National fiat currency unbacked by gold such as Dollars (US, Australian, Canadian etc), Euros, UK Pounds, Israeli Shekels etc - has only been around for less than 50 years, since President Nixon abandoned the gold standard in 1971. Before that, the Bretton Woods System (1944 - 1971) used national currencies backed by gold and the gold backed US Dollar.
Throughout history there have been an enormous variety of systems of money including the familiar gold and silver coins (of declining percentages of actual precious metal as empires aged) and such unfamiliar devices such as tally sticks (which the British Empire used for over 700 years), rai stones and cowrie shells.
Money can be anything that people accept as money. It is one of the many collective myths that have allowed humans to dominate the planet, as popular author Yuval Harari has noted.
The three main functions of money are as a medium of exchange, a store of value and a unit of account, but not all money needs to fully perform all functions. It is not uncommon for complementary forms for money to co-exist within one financial system (eg gold/silver coins and tally sticks within the British Empire).
Cryptocurrency - a new form of money
A workable form of natively digital money has been the dream of science fiction authors for almost a century and of serious computer scientists for many decades. The key problem to solve is that things in the digital world can be copied costlessly, without destroying the original. This is a problem because the essence of money is that if I pay you, I haven't got the money any more. In computer science terms this is called the “double spend problem”.
In 2009, the mysterious Satochi Nakamoto created Bitcoin, which used existing public key encryption techniques, a data structure called blockchain and a form of distributed consensus to solve the double spend problem and create a workable, decentralised natively digital currency.
Bitcoin and many other crypto-currencies that have followed in its wake adopt a distributed, decentralised model where the entire operation of the monetary system (money creation, transaction verification, processing and ledger updating etc) occurs according to fixed rules locked in computer code that is distributed among very large numbers of unrelated participants spread across the world.
Changes can only be made if the vast majority of participants agree to change the code running on their computers. Proposed changes with substantial opposition are either abandoned or lead to forks, where the crypto-currency splits in two with one set of participants following the original code and the others following the new code.
Importantly, with Bitcoin and many other crypto-currencies, scarcity is guaranteed by the code. New coins are only issued gradually in a pre-determined manner. This is commonly by issuance of a small amount of coins each time a block of transactions is processed and added to the blockchain.
These coins are issued to the miner who won the right to add that block by solving a complex mathematical puzzle that can only be solved by the use of brute force computing power. This is called Proof of Work and is what secures blockchain.
New blocks are added regularly (seconds or minutes) and different miners win the right to add new blocks each time. Over time, the number of blocks won by miners will be proportional to their computing power but over the short term the process is random.
Now that we've got the basics of money and cryptocurrency down we can start looking at the big picture.
A disruptive transition
Throughout history technological developments have sometimes led to disruptive transitions which sweep away old established organisations and practices and usher in new ones. These disruptive technological changes often also alter our collective myths. In more recent decades the pace and frequency of such disruptive transitions has quickened. Indeed technologists such a Ray Kurzweil have argued that technological change is on an exponential curve, getting faster and faster all the time.
Natively digital money (cryptocurrency) will have as great a disruptive impact on the banking and finance industries as digital music, photos video and websites have had on the arts, media and advertising industries. But while these are important peripheral industries, banking and finance are at the heart of the world economy and thus the disruption and alteration of our collective myths will be far greater.
We are still in the relatively early stages of this disruptive transition. The current market value of all cryptocurrencies is around US$0.5 trillion. While large, this is still a tiny fraction of the amount of fiat currency on issue. US dollar money supply M2 alone is almost US$14 trillion US$ and global broad fiat money supply is around US$90 trillion.
In the next instalment of this article, I'll deal with common criticisms of crypto-currency and how things such as underlying value, bubbles and volatility should be properly understood.
Crypto: The Big Picture - Part 2
A disruptive transition
In the first part of this series I provided a background regarding the history of money and what cryptocurrency is. In this instalment I deal with the nature of the transition and answer some criticisms of cryptocurrency.
Throughout history, technological developments have sometimes led to disruptive transitions which sweep away old established organisations and practices and usher in new ones. These disruptive technological changes often also alter our collective myths. In more recent decades the pace and frequency of such disruptive transitions has quickened. Indeed technologists such a Ray Kurzweil have argued that technological change is on an exponential curve, getting faster and faster all the time.
Natively digital money (cryptocurrency) will have an enormous disruptive impact on the banking and finance industries. It will be as great a disruption as digital music, photos video and websites have had on the arts, media and advertising industries. While these are important peripheral industries, banking and finance are at the heart of the world economy and thus the disruption and alteration of our collective myths will be far greater.
We are still in the relatively early stages of this disruptive transition. The current market value of all cryptocurrencies is around US$0.5 trillion. While large, this is still a tiny fraction of the amount of fiat currency on issue. US dollar money supply M2 alone is almost US$14 trillion US$ and global broad fiat money supply is around US$90 trillion.
Only perhaps 20-35 million of the world's 7.5 billion people are using cryptocurrency and a majority of people on the planet are unaware of its existence. It is roughly at the stage the internet was in the mid 1990s and the computer was in the mid 1980s.
Criticisms of Cryptocurrency
Many traditional financial experts posit criticisms such as:
“Cryptocurrency has no underlying value”
“Bitcoin is a classic bubble”
“Crypto-currencies are too volatile to uses as money”
“You can’t buy much with Bitcoin so its not really money”
“Intial Coin Offerings (ICOs) are mainly scams”
While there is some truth to each of these statements, they miss the forest for the trees. Lets examine each of them in turn.
What is underlying value?
As noted in Part 1, neither national fiat currencies nor crypto-currencies are backed by any asset with underlying value such as gold. In the absence of hard asset backing, the underlying value of a currency is a simple function of supply and demand. Supply is about how much of the currency is on issue and demand is about how many people want to use it.
Unfortunately for the underlying value of fiat currencies, all the major central banks have massively increased the supply of their national fiat currencies over the last decade or more while population growth was flat or declining. In the fiat currency system there is no limit on how much and how fast a nation can increase the money supply and thus no certainty as to what future supply will be. Because of this fiat currency has ceased to be useful as a reliable store of value.
In contrast, for bitcoin and most other crypto-currencies, the basis upon which supply increases is fixed in the computer code and thus is certain and predictable. Most cryptocurrencies adopt a low or very low rate of increase in money supply, with Bitcoin taking the extreme approach of the rate of new currency issue decreasing over time towards a fixed 21 million bitcoin limit.
On the demand side, the working age population of the First and Second World is now entering a long period of decline and with it the number of people with economic capacity to use substantial amounts of fiat money. Conversely cryptocurrency demand is expanding from a very small base. Over time its expansion will further decrease demand for fiat currency.
Thus the critics have it upside down. Fiat currency has no underlying value because of massive actual and potential oversupply and decreasing demand while bitcoin and many other cryptocurrencies DO have underlying value because of their scarce supply and increasing demand.
When is a bubble not a bubble?
A classic investment bubble is when speculation, rapid price rises, herd mentality and fear of missing out pushes the price of an asset way beyond its underlying value. A some point smart money takes profits, the psychology reverses and the price collapses, eventually returning to something close to underlying value.
But classic bubbles are premised on the fact that the large numbers of new investors and large price increases characteristic of a bubble do not impact the underlying value of the asset. A tulip bulb does not become more economically productive just because everyone wants one. A company does not become more profitable just because investors rush its shares.
But with crypto-currencies the situation is different. The underlying value of a currency is related to how many people believe in and use one or more of its functionalities as a store of value, medium of change and/or unit of account versus its scarcity. Its about how many people believe in the collective myth.
Every new FOMO investor in the “bubble” is another actual user of crypto-currency as a store of value and a potential user of it as a medium of exchange and unit of account. A bubble investor who takes a little time to understand what they have bought and properly secure their investment in a software or hardware wallet becomes a person much more likely to accept crypto-currency in exchange for the goods or services they produce or other assets they wish to sell. Thus what might initially be herd mentality in a bubble, actually creates real value.
Secondly, the development of a huge range of new online services by thousands of startups in the crypto field is substantially funded by cryptocurrency holdings and issues. When the price goes up, these startups are much better able to afford the people and services they need to successfully implement their vision. This vastly increases the functionality and usability of a wide range of crypto based services which in turn drives crypto-currency adoption.
Thus both the increase in the number of people and the increase in price characteristic of a classic bubble have the effect of increasing the underlying value of the crypto-asset.
In the next instalment of this article, I'll deal with more criticisms of crypto-currency and talk about the impact of this disruptive transition on the established order in the tech and financial sector.
Originally posted at: https://steemit.com/cryptocurrency/@apshamilton/crypto-the-big-picture-part-1 &
https://steemit.com/crypto/@apshamilton/crypto-the-big-picture-part-2