How does Bitcoin differ from traditional currencies

Why Bitcoin is not a traditional currency

What would happen if nation states lost their monopoly on creating money? What if everyone could build their own economic system including their own cryptocurrency in the future? Is it all just utopia? It will take some time until everyone can create their own crypto token so easily and without little prior knowledge, but the future is already here. It just hasn't reached everyone yet.

Bitcoin and the blockchain technology on which it is based seem to be the beginning of such a trend: Almost 1,600 so-called crypto currencies are currently listed on the Coinmarketcap. But what is a crypto currency, what is a token, and can Bitcoin and everything that came after it be compared with conventional currencies at all? To answer that, you have to go back a little:

Between the asset class and the new economy

Bitcoin and other cryptocurrencies are completely new means of payment. Their function oscillates between currency, security and raw material. Our greatest challenge here is that we try to explain phenomena of a new technology in terms of an old world. In this blog post I will point out why Bitcoin is not a currency in the traditional sense, but rather:

  • A new asset class: Bitcoin and other crypto tokens are more similar to the commodity currencies of the past than to our modern fiat currencies.
  • An operating system for a new kind of economy, in which everyone can create their own currency: The Bitcoin blockchain protocol coordinates people who do not know and trust each other across national borders, without traditional centralized institutions such as banks and legal agreements such as contracts. The rules of the game are regulated in the code, offer economic incentives and are automatically executed by so-called smart contracts through a distributed computer network.

Although Bitcoin is not a currency in the classic sense, it still has many of the properties of classic money (fiat money) as we know it. It can be exchanged, saved, purchased and invested. But it is much more than that. The technology on which the blockchain is based can be seen as the operating system for a new economic and social system. To better understand the similarities and differences between Bitcoin and Fiat currencies, it helps to look at the definition of money and understand what Bitcoin actually is.

Function, characteristics and types of money

The most important function of money is to facilitate the economic exchange of goods and services. Money makes economic exchange much more efficient than is the case with an exchange or gift economy. Money circumvents the problem of the so-called coincidence of needs that arise in moneyless economies, restrict trade and are due to the improbability of wants, needs or events occurring at the same time and in the same place.

The most important functions of money are medium of exchange, store of value, unit of account and measure of value as the basis for price information, debts and efficient bookkeeping.

In order to be able to fulfill its various functions, money must have certain properties:

  • Liquidity: It must be easily exchangeable, at low transaction costs and with a small difference between the purchase and sale price.
  • Scarcity and Stability: Money has to be limited. The value shouldn't fluctuate too much. Inflation, deflation and high volatility are counterproductive for trade: inflation reduces the value of money - bad as a store of value. Deflation increases debt.
  • Fungibility: Monetary units must be able to substitute for one another. Any token - physical or virtual - must be treated equally, even if it was used for illegal purposes by previous owners.
  • Portability and General Acceptance: This means that a currency unit must be recognized as a valid exchange object by all participants. And: Money must be able to be moved from one place to another with little effort - land or buildings do not meet this requirement, but cattle, salt, shells or gold do.
  • Divisibility: Despite being divisible, money must not lose its original properties. Example: Cattle cannot be divided in a way that preserves their value, gold, silver or diamonds can.
  • Longevity: The ability to withstand repeated use means that the good still has its original properties even after years and cannot be changed: food or other perishable goods do not do it, gold or silver does.

From medium of exchange to fiat money

In modern economies, the predominant types of money are so-called fiat currencies, but there were and are others. Different types of money have prevailed throughout history.

  • Commodity money: Is an object that, in addition to its external exchange value, also has an intrinsic value, which is preserved regardless of the decision of central authorities and state monetary policy, and which has a generally accepted value in a local economy. The value results from the commodity of which it is made: tobacco, rice, gold, silver, etc.
  • Representative money: This is a medium of exchange that represents something valuable, but itself has little or no intrinsic value: gold or silver certificates, paper money and coins that are secured by gold reserves, such as the gold standard, where everyone can always buy paper money at a fixed rate Can exchange gold.
  • Fiat money: Fiat money has no physical value like a commodity. The face value shown on the banknote or coin is greater than its material substance. Most of the currencies today are fiat currencies.

Fiat money is set by government regulation and gets its value from being declared legal tender by a government. The assigned value arises from the fact that governments have the power to enforce the value of a paper currency. It is an object with no intrinsic value and which nonetheless serves as a medium of exchange, much like any check or promissory note.

A country's money supply is made up of all banknotes and coins as well as the sum of all balances in current accounts, savings accounts and other financial instruments in a country. Bank money - which consists only of electronic records - makes up by far the largest part of the broad money in developed countries today.

In summary, one can therefore say:

  • Most currencies today are fiat currencies. These are no longer tied to scarce raw materials such as gold, if at all.
  • Most of the money these days is just an entry in a financial institution's database and does not even exist in physical form.
  • Central banks influence the amount of fiat money through their country's monetary policy - that is, they put more or less money into circulation, depending on what they see fit.
  • History has shown that fiat money is accepted as a means of payment as long as there is trust in the issuing institution.

Bitcoin and cryptoeconomics

Although Bitcoin was originally developed with the sole aim of creating peer-to-peer money without traditional banks, the underlying blockchain technology opens a gateway to a new way in which society can organize itself based on specific goals - decentralized and supranational. The different aspects of Bitcoin are:

  • New public payment network: Bitcoin and similar cryptocurrencies are so-called P2P payment networks. They allow people who don't know and don't trust each other to send money to each other without centralized institutions like banks, credit card companies, PayPal, Moneygram and the like. Anyone can become part of this distributed network without the permission of a central authority (bank). By using a Bitcoin wallet (Bitcoin account number) I can send money from A to B directly and faster than with conventional banks. In the conventional system, the bank first has to give me permission to open an account, which most people around the world fail because they do not have the necessary identification documents or creditworthiness or cannot afford the account management costs. Furthermore, anyone can become a Bitcoin miner - also without the permission of central authorities - and verify transactions, mine Bitcoin and earn money.
  • Decentralized accounting and administration machine: Bitcoin is also a distributed accounting machine, and it is public and transparent. Everyone can see the account book and all transactions that have ever been made. On the one hand, cryptography ensures transparency for all participants and, on the other hand, guarantees the privacy of each individual. This new technology avoids data silos and inefficient data interfaces.
  • Crypto economy: Bitcoin is also an operating system for a novel distributed economy. The P2P network of stakeholders as well as all underlying values ​​that are managed on a blockchain are subject to the game theory incentive mechanisms that are predefined in the Bitcoin protocol. Monetary policy is also predefined in the protocol. Transactions are automatically executed when the majority of the network determines that the particular transaction is valid. These incentive mechanisms ensure that Bitcoin miners have an economic incentive to truthfully verify transactions, as they can mine Bitcoin and earn money with them. Manipulation of the network is possible, but this mechanism makes it disproportionately expensive. Bitcoin mining is therefore the result of a security function that enables such a decentralized network to function reliably in the first place.
  • Management and control by majority decision: The control mechanism, including monetary policy, of these new, blockchain-based decentralized companies is defined in advance, mapped in the blockchain protocol and linked to the respective cryptocurrency - also known as tokens. These mechanisms can only be changed by a majority vote of all network participants. In the case of Bitcoin, the conditions for such a software upgrade are partly defined in the protocol, partly unclear and must be discussed in the community.
  • Internal currency: Bitcoin has another function: every time a transaction is sent from A to B, transaction fees are incurred in the form of a fraction of Bitcoin tokens. This means that Bitcoin miners are additionally rewarded for transaction costs (operating costs, traffic costs) that can only be paid in Bitcoin and represent an internal currency of the network.

Bitcoin and derived technologies are so difficult to explain because they are not simply revolutionizing payment transactions, but because the creation of money, monetary policy and financial management of these new decentralized crypto-economic systems represent a paradigm shift and differ fundamentally from economic and monetary policy organized by national states has worked so far.

Goodbye Fiat, hello token?

Since Bitcoin's code is public, anyone could take that code and create their own better, faster, safer, more anonymous version of Bitcoin. Over the years hundreds of alternative cryptocurrencies have emerged, some of which have also experimented with completely new functions. Ethereum was an important turning point in this development series, as this new blockchain now makes it possible to create a cryptographic token with simple programming knowledge at the application level, without having to program a complex blockchain.

Nowadays anyone can create their own token on a relatively small budget. Many start-ups take advantage of this opportunity. In 2017, ICOs (Initial Coin Offerings) became socially acceptable. Around four billion US dollars have flowed into crypto tokens from various start-ups worldwide. But how do these tokens differ from conventional means of payment?

  • Comparable to commodity money?
    While Bitcoin has certain properties of money, it is more like commodity money, not fiat money. As long as people use the Bitcoin network for services that have to be paid for with Bitcoin tokens, the token has value in itself. The commodity aspect of crypto currencies may become clearer with Bitcoin derivatives such as Ethereum, where you have to pay for decentralized computing power in ETH tokens, or in the Sia network, where you have to pay for decentralized storage with an SIA token.
  • Lower transaction costs, higher liquidity
    In contrast to classic raw materials that are traded on exchanges, crypto tokens (Bitcoin, Ether and the like) can be traded with fewer entry barriers and at significantly lower transaction costs than with conventional exchanges, which is due to the nature of the blockchain-based P2P transfer . Crypto tokens are therefore much more divisible and liquid than classic “raw materials” and can therefore also be used as a means of payment, even if their original function is not that of money.
  • Decentralized production
    The nature of raw materials is distributed control and decentralized production, similar to Bitcoin. Not a single government or other body controls the mining of gold, silver and many other raw materials. Production is distributed, the price of these tokens is determined by supply and demand on crypto exchanges.
  • Monetary policy
    One could say: Bitcoin is the currency of a distributed internet tribe called Bitcoin. Monetary policy is defined by the rules of the game in the Bitcoin protocol. There is no centralized institution that regulates Bitcoin. Code can only be changed if there is a majority consensus among network actors. The role of the bank in transferring money is being replaced on the one hand by so-called smart contracts of the Bitcoin network, on the other hand by the role of miners.
  • Volatile exchange rates
    However, the price of Bitcoin and other tokens is currently volatile as it is not regulated by a centralized institution, but rather determined by supply and demand in the markets. Although this is disadvantageous for retailers, it may only be a short- and medium-term problem, as solutions are already being worked on to counteract this problem (stable tokens, hedging, atomic swaps, etc.).

The control mechanisms behind every crypto token differ greatly and are in some cases still very experimental. It is still unclear which mechanisms will be established and which will not. Behavioral economy, attention economy and much more can be mapped for the first time at significantly lower transaction costs, since automatically executable code in the form of smart contracts greatly reduces the administration costs of such alternative systems and becomes economically profitable for the first time. It is clear that in a token economy the transaction costs of the exchange of value are radically reduced and a classic definition of money no longer holds up.

outlook

As I was writing this post, I read two announcements on Twitter that surprise even me and are proof that the future is already here: Venezuela has launched the Petro Token, Kodak in partnership with Wenn Digital the KodakCoin. It is not the nature of the announcements that surprises me, but the fact that established companies and classic state institutions are jumping on this new technology so quickly: a technology that was originally created and propagated by anarchists in order to abolish banks and central national authorities. The next five to ten years will show how tokens will affect our understanding of money and exchange of value. (Shermin Voshmgir, June 25, 2018)

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