(Disclosure: Author holds investments in bitcoin and ether.)
In his fundamental book, Money and the Mechanism of Exchange, English economist William Stanley Jevons explains that currencies address a fundamental economic problem: the double coincidence of wants. The phrase describes the conundrum inherent in barter where the parties of the transaction have to agree to sell and buy each other’s goods. The obvious challenge is the improbability of the wants, needs and events that would enable such a transaction occurring at the same time and the same place. In absence of this double coincidence of wants, the parties need to settle on an acceptable substitute: the medium of exchange. The following is a review of the state of money in general and the media of exchange, and its potential trajectory in particular.
The History Of Money
Media of exchange have historically taken on many different forms and still do to date. Depending on the time and place, gold coins, stones and shells have been used as money. Commodities such as gold and silver coins were followed by commodity-based mediums — usually paper certificates — exchangeable for specific amounts of a valued metal. What these technologies have in common is that the simple transfer of the media from buyer to seller combines the payment and settlement of a transaction; they are bearer instruments.
Today, the medium of exchange is most often expressed through the manipulation of digital entries of an account ledger expressed in fiat money. The latter quality refers to the suspension of commodity backing of money by governments unwilling or unable to settle outstanding commodity obligations. Instead, legislators have invoked legal tender laws, which establish certain instruments as acting as money. As the accounts of buyers and sellers are most often maintained by different financial institutions, these necessarily must cooperate to update the digital ledgers of the parties to reflect the exchange of money. Depending on the banks and technologies involved, this process can take between 24 hours and days — or even weeks for a cross-border transaction. Consumers requiring bearer instruments for peer-to-peer transactions with immediate settlement are mostly limited to IOUs printed as bank notes.
In 2008, the Bitcoin Whitepaper introduced a new medium of exchange referred to as bitcoin. Entries in bitcoin’s ledger are protected from manipulation by a cryptographic scheme, which hashes transactions in time-stamped intervals into blocks. This function inspired the term “blockchain” to describe a decentralized ledger and “cryptocurrency” — “crypto,” for short– for the denomination of entries on such a ledger.
Similar to the architecture of the internet, a blockchain does not rely on a single entity or consortium; entries on blockchains can be created by anybody operating the software. A sophisticated combination of encryption and game mechanics ensure that transactions performed on a blockchain are next to impossible to alter. The latter quality — also present in the other blockchain-native assets, such as Ethereum’s ether — made bitcoin the first ever digital bearer instrument.
Advantages Of Digital Bearer Instruments
Blockchain-based assets — including bitcoin — can be imbued with additional functions through smart contracts, creating a form of “programmable money.” Like their real-world counterparts, these digital bearer instruments do not require users to involve third parties in the exchange. As documented by many block explorers, the blockchain, through its independent network of miners, confirms any transaction between parties inside of 10 minutes at a nominal fee. And, unlike bank transactions, which can take days and sometimes weeks to settle, new entries on a blockchain are final, and the recipient is free to use the funds immediately.
As outlined in a previous article, the term “cryptocurrency” merely describes a small subset of blockchain-derived assets accurately. And even coins and tokens created for the specific purpose of functioning as currencies have found little consumer adoption. A number of projects have singled out volatility as the main problem. This led to the creation of a new category of cryptocurrencies, referred to as “stablecoins.” The most noteworthy entrants in this growing category thus far with market capitalizations (according to CoinMarketCap.com) of $1.9 billion and $356 million as of January 11, 2019, are Tether and USD Coin. These coins are pegged to the U.S. Dollar, attempting to maintain a one-to-one correlation. While it might be too early to judge if stablecoins will increase consumer adoption, it seems doubtful that these instruments can challenge fiat incumbents on their home turf as long as consumers are required to convert fiat money to the new medium, however.
Historically, citizens have turned to alternatives of fiat currencies when the buying power of their government-created payment method weakened drastically due to inflation. While commodities such as gold continue to be a popular choice for wealth preservation, these do not provide much utility for day-to-day expenditures. Instead, consumers have often turned to bearer instruments issued by other nation states. In some instances, a country may even move to the drastic measure of abandoning its sovereign currency in favor of another country’s money — as is the case with Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands and Zimbabwe; according to the CIA’s World Factbook, all the aforementioned countries, list the U.S. dollar as official currency today.
While the global digitization of currencies has seemingly created a level playing field for the world’s fiat money, consumers are reluctant to adopt a new language of trade. When a local currency shows strong signs of failure, citizens are most often turning to a seemingly ubiquitous form of cash such as U.S. Federal Reserve Notes.
Cryptocurrencies will continue to fail in supplementing fiat currencies in a meaningful way until their use is frictionless for consumers. While stablecoins are likely part of the solution, a successful blockchain-based architecture must implement currency as protocol through consumer-facing applications that provide a seamless bridge to legacy fiat technologies. Just as the voice-over internet protocol (aka, voice-over IP, or VoIP) empowered Skype to challenge phone carriers worldwide, this final step — which legitimately defines “money-over IP” — will redefine money.