The Story Of Cryptocurrency And What Problem It Solved

Published: 12-20-22    Category: Insight

MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.

The Story Of Cryptocurrency And What It Solved

With the recent collapse of the FTX crypto exchange due to what really amounts to simple fraud, we thought it might be useful to articulate the difference between the inherent value of cryptography and the cryptocurrency it enables, and the centralized exchanges on which it trades, some of which have fallen prey to fraudulent operators, because there is value in why cryptocurrency was invented. MyEListing is currently exploring ways to eliminate the barriers that slow and often prevent commerce that could otherwise move along, and we expect cryptocurrency to play a dynamic role in enabling better market dynamics in the CRE world very shortly.

What problems does cryptocurrency actually solve?

To answer this question requires some backdrop because understanding what problems cryptocurrency solves requires some understanding of what money does.

While it may seem obvious, money actually has to perform several functions in an economy:

  • It’s a medium of exchange
  • A unit of account
  • A store of value
  • A basis for deferred payment or credit

Back before money was invented, people really had no choice but to barter with each other for trade. Trade is something that is valuable to most people because it broadens what things are available. Lack of trade had the effect of locking value in place, geographically, because if you owned land, and you wanted to move, you couldn’t take the land with you. For anything you wanted to sell, you needed to find someone who had something you wanted, who also wanted what you had, and then you had to agree on a trade structure. Multiply that times the population and it’s easy to see how the establishment of a widely accepted medium of exchange had the effect of unlocking much of that value that was fixed in place. Trade allowed value to become portable, aka liquid, thus solving the problem of trapped value. Money allowed this effect to scale beyond the local environment; if trade put a pinhole in the value tire, money ripped the tire in half.

Having portable value invited its own set of problems, however. Once precious metals began to serve as money, people would shave off a bit from coins here and there, thus creating the first ‘inflation.’ The ever smaller and smaller coins literally lost their purchasing power, because there was literally less of them by weight with people shaving off little bits at a time. People experienced this as rising prices for the goods money could purchase. This was far from the only problem with metal coins and bullion serving as money - just understand we created this huge benefit - we unlocked portable value, at the cost of people monkeying with the technology we developed for the purpose.

Cryptography And Information Security

Humans invented cryptography to encode messages to ensure that information could flow only to intended recipients. That’s the idea of encryption - it’s how your phone sends your wifi password to the router - it’s encrypted - encoded - so anyone who intercepts the transmission can’t see the actual password, but instead sees a meaningless string of characters. That’s encryption.

There are many ways to encode or encrypt a message, and there are ways to attack encryption to attempt to crack it and see the actual message. What we’ve figured out by using modern computer processing to advance cryptography is that by using really long strings of large character sets for codes, we can effectively force attackers to use brute force attacks - meaning they have to try every possible combination of characters, and we can calculate the difficulty of doing that. In this way, we can ensure that the amount of computing power necessary to perform such a task won’t exist for many thousands of years, if ever.

The Problem Of Trust

One of the problems with using metal bullion or coins to complete transactions lies in their bulk. Yes, you could sell your land for gold, and haul the gold with you, but consider how cumbersome that is, not to mention the security risks. So how did we solve these problems? We came up with the financial intermediary, and the certificate of deposit - the first CD.

A financial intermediary functions essentially as a ‘trusted third party’ in the system. Trust between individuals, as well as in groups, is a social phenomenon. We have evolved over millions of years the ability to discern whom to trust, but there’s a problem: it isn’t a perfect mechanism. Individuals can defect from trustworthy behavior. An individual’s word and reputation can only be trusted so far because of this. In fact, any complex behavior contains this embedded uncertainty - cells can go rogue. People can choose to cheat. This mechanism is actually what gives us much of the variety we see in the living world.

A Brief Rehash

To briefly recap: Humans invented money, which represents portable value, which unlocked physical value trapped in place, at scale. The thing we used to effect this change was physical, bulky, cumbersome forms of ‘money’ - and these came with a different set of problems. People could counterfeit them, steal them, shave them down and weaken the purchasing power of the metal, etc.

People also created encryption to protect the information in messages, so that only the intended recipient could read them.

Then people created financial intermediaries - trusted third parties - the first banks, really. Now people could take their bulky gold to these places, deposit it, and the bank would give them a certificate of deposit. They could then travel to another city, show their CD to the bank in that city and they could then access gold held on deposit at that bank in the amount they ‘owned.’

Banks Begin To Find How Much They Can Lend Against Reserves

These “banks” (the first banks weren’t actual banks but merchant organizations) then one day realized that they could lend some gold against the other gold they held on deposit. In fact, they could lend out far more than the gold they had on deposit. And as long as all the depositors didn’t come demanding their gold at once, this could really enliven the party. And this worked…until it didn’t. It turns out that when an economy cycles, the length and depth of that cycle are affected by how easy or difficult it is to access capital and transact with it. If you take a cost of a week to transact and multiply it times the number of contemplated transactions in an economy, you can get a sense of how those costs act as frictions to economic activity.

Technology - and by technology I mean a better way of doing things - technology is what we use to create more output with less input. A technology that allowed banks to increase the number of transactions in an economy, aka the ‘velocity of money,’ in a given time period would lead to much greater economic activity, access to capital, and increased specialization and trade, followed by a large depression when the cycle peaked and rolled over. We continue to see this challenge in developing economies as they crest the hill of industrialization.

When banks realized they could lend more than they had on deposit, they created both an amazing and valuable technology and a large systemic risk if everyone came for their gold at once. They also created a structural environment where the money itself became an object of machination - financial technologies invented since include insurance, joint stock corporations, derivative contracts such as options and forward agreements, and really not a lot else, until 2009.

The Bitcoin Algorithm

In that year, someone calling themselves Satoshi Nakamoto proposed a way to solve the problem of having to trust a third party when two strangers want to do business. This is in fact the essence of what bitcoin did that was new: It solved the problem created by the need to trust a third party. The need to trust a third party to intermediate a transaction represents an inherent friction, or transaction cost, somewhat like those in a barter system where one has to locate a counterparty with specific preferences. These third parties contain the same randomness in their behavior that cells, humans, and quantum particles do. They can refuse, for example, to facilitate a transaction for any reason they decide, giving them far more power than their role as middleman would imply. They become de-facto permissioners of transactions.

Problems When Banks Act As Transaction Permissioners

When banks act as permissioners, as opposed to simple middlemen, it defies a certain sense of ownership of value to their customer. If the customer says ‘I want to pay x amount to so-and-so,’ and the bank replies ‘no,’ despite that value being on deposit in the trust of the bank, this falls well outside the bank’s prescribed role. It’s a problem. People don’t like banks deciding for them whom they can pay or even which laws to obey. That’s their choice, not some economic overlord’s to make on their behalf. Of course, as private businesses, banks are free to decline to do business with certain customers, provided they aren’t doing so on the basis of something proscribed in law such as race, sex, disability, etc. Being able to cherry-pick which transactions they disagree with, however, is offensive to a good many people, and represents a cost in itself - an emergent cost with no corresponding benefit to the consumer. Now consumers must have separate ad-hoc financial relationships to facilitate specific transactions, which is more than a bit inefficient because their main bank refuses to allow them to transact with certain counterparties or for particular items. The legal cannabis industry comes to mind, as banks will not ordinarily do business with them the way they do with other types of businesses.

The Bitcoin Algorithm Makes Economic Activity Permissionless

The Bitcoin algorithm applied modern computing power and cryptographic advancement to the creation of currency, and in so doing solved the problem of having to trust a third party to intermediate transactions. The math of this is as close to certain as one can reasonably be in the real world. It is as close to impossible as one can reasonably get, in other words, to counterfeit a bitcoin. Bitcoin is therefore permissionless.

That was in 2009. Today we are still using trusted third parties when we don’t have to. The adoption of cryptocurrency is taking off, but it is doing so with many participants misunderstanding the value of the technology. And as you can see in the graphic below, it is well ahead of the pace of internet adoption over similar time periods.

adoption of crypto compared to internet

Bitcoin itself has become more of a risk asset than a currency, and that’s because rather than fulfilling the various roles it would have to play to constitute ‘money,’ it fulfills some while failing at others; but this is likely to change. While Bitcoin can function as a currency, it has suffered from the same problem gold once did, namely that it does not function as a good store of value. It is energy-intensive to mine, and expensive to spend. It has been adopted in such a way that substantial holders and early adopters have a decided advantage over newcomers and smaller holders. This is changing, however. There is a huge amount of inefficiency in a system that relies on third-party intermediaries when the technology exists not only to eliminate them but to do so with greater fidelity than with them. There is great value to consumers in many respects in this happening.

Markets Work Best When Freedom To Transact Voluntarily Is Maximized

That core value lies in the bitcoin algorithm and its core function of enabling trust between strangers through cryptography. I won’t get into the technical aspects of it here, but I will discuss the effects. One effect is that we now know how to eliminate the need for third-party intermediaries in transactions. This is important because there’s a principle at work: markets work best where freedom to transact is maximized. In other words, if you want to buy a widget, there are widgets for sale, and you agree to transact voluntarily, you shouldn’t need anyone’s permission or approval to buy a widget.

What About Enabling Bad Actors?

Of course, there are the arguments that say ‘but we don’t want child pornographers or money launderers to be able to easily send funds to each other.’ Granted. Nobody wants that. But guess what? They can already do that. Moreover, deciding that no one can transact without a third-party middleman to decide whether one of the parties is a child pornographer or money launderer comes at a massive cost to all of us. We move one unit along the x-axis and get only a tiny or no, or even a negative incremental move along the y-axis. That’s called overpaying for effect. This effect is actually the job of specialized personnel we generically term ‘police.’ Not other businesses, and not third-party intermediaries. Police work is supposed to be hard. Being able to solve crimes given the constraint of people’s protected rights is supposed to be very challenging. But the correct path when the police reach an impasse is not to enlist private businesses under threat of force to help them do their jobs. It’s to be better at their jobs. The US legal system is littered with these errors where law enforcement fails to enforce laws effectively and lobbies lawmakers to force consumers and businesses to do their jobs for them (see: Patriot Act, Money Laundering Control Act) rather than training harder or more frequently and getting better at the necessarily difficult work they’re tasked with performing.

This started to become a problem the more governments acted outside the interests of the producers in their economies, and became coercive in their use of force to make people pay for debts they wouldn’t have incurred voluntarily. This gave rise to the perceived need for something permissionless. If the government went out and bought 50 million beanie babies, and sent you a bill for them, and you refused to pay for their stupidity with your hard-earned money, you now had at least one new lever. You could remove your money from the banking system they controlled, and hold and use it outside that system. You diminished their power to coerce you. And governments, which only some of us are, really don’t like that. But private citizens, which we all are, do.

Government Responses To Perceived Monetary Threats

Governments have responded to this perceived problem on their end by threatening to regulate cryptocurrency, and have effectively contained the genie by the use of threats against the few choke points - exchanges - that exist between the two worlds of crypto and fiat (regular government-issued money). These exchanges have in turn become defacto government agents in some ways, conforming to government insistence they ‘know their customer,’ (despite being under no actual requirement to do so) and causing them to exercise coercion over exchange participants in exchange for being allowed to exist, in essence. But what they cannot do is restrict what someone may do with their cryptocurrency once they have it off-site from an exchange. This permissionlessness is a key feature of cryptocurrency. It is essentially the reason it was invented. And there are very sound economic reasons behind this idea - recall that the greater freedom to transact, the better. Cryptocurrency represents the ultimate option in that respect.

So to sum up: we invented money to unlock frozen value and make it portable. We invented cryptography to keep our business our business. And we married them together to maximize the freedom to transact, and the speed with which we can do it, meaning without the frictions of having to get permission from some unrelated third party.

But somehow we have not seen the value of these maximized so far, and this is for two reasons, in my opinion. One is that people don’t understand the function, the value of what cryptocurrency and blockchain technology actually do - which is a big reason for this piece. What things do they enable, and how can you benefit from them? - but another is that in addition to not having a firm grasp of the possibilities, people are clouded by the gambling aspect of buying cryptocurrency for the ‘price appreciation’ versus the dollar or other fiat currency. And that’s fine, but if you understand the actual value while others are using the technology to buy bored ape NFT’s, then you can better navigate the landscape to your benefit.

What Is A Block Chain

A blockchain is effectively a ledger that’s held on every computer in a network. Imagine you and nine friends all have an excel spreadsheet you can all edit, and once three members of the network check a new entry against a known figure, they pronounce that new spreadsheet entry a valid ‘block.’ That’s effectively what a blockchain is. Except in this instance, once an entry is called a block, it can never be erased. It’s immutable. This immutability feature is a large part of what makes cryptocurrencies work.

Now, about blockchains, they’re a bit like customer relationship management tools in that they need to be populated with data to be halfway effective. If you ask any sales manager what problems they see with their CRM, they’ll tell you that salespeople don’t enter all the correct info into it, despite being told to do so. It’s very similar with blockchains. You can’t just create a computer network, put a ledger on each node, and then tell people under threat of force they have to record things to it (in bitcoin’s case, this would be to mine coins and validate transactions). They have to have a positive incentive. The way the bitcoin algorithm solved this was to enable mining, and a ‘proof of work’ consensus mechanism. Each new block of coins gets created when one computer in the network becomes the first to solve a very difficult cryptographic problem that is open to the entire network to solve. The first node to solve it receives a new block of coins as its reward for the work on the solution. This participation by the network in creating the elements recorded on the chain is an integral part of the process, and it’s why many corporate blockchains without such built-in incentives have failed - no incentive to record data to the chain. Incentives are provided by allowing the network to create the fuel that powers the chain, and just like in the real world, negative incentives tend to get circumvented. People don’t like to be coerced. They love to work toward things that make them better off, and will do so voluntarily. Easy math.

Fungibility VS Non-Fungibility

What we have as a result of all these innovations is a functional network for many different sorts of cryptocurrencies and blockchains, but we still need to develop the more robust use cases easily visible on the horizon for years. For example, NFTs - non-fungible-tokens. Fungible means exchangeable on a one-for-one basis. If I have a hundred-dollar bill and you have another one, and we swap bills, we still each have $100, because $100 bills are fungible. A share of stock in Microsoft is fungible with other shares of the same class, but not with shares of Exxon. Bitcoins are fungible with each other. Ethereum tokens are fungible with each other. US Dollars are fungible. But a NON-fungible token is a one-time creation. Nothing else is fungible with it. If you stop and think about why that might be valuable, you get all the benefits of cryptocurrency and blockchain technology.

Non-Fungible Tokens Can Protect Private While Revealing Necessary Information

Still, they all protect the value of just one thing - making that one thing even more valuable since no one can obfuscate its ownership. This one thing could be your identity, the ownership chain of your house, or the chain of custody for courtroom evidence. The NFT could be programmed to reveal certain information without revealing any more than necessary. For example, you could have an NFT as your identity document, and it could reveal information about you for others to know - whether you’re registered to vote, for example, or qualified to drive, without revealing anything else about you - your name, your address, etc do not need to be known to anyone. They only need to know whether you’re ok to perform whatever task you’re trying to perform, not what your name is or where you live as those would have to have been verified to receive the ok in the first place. NFTs would make perfect (from the consumer’s point of view) instruments for ID. They perform the same function as cryptocurrency - any transaction that relies on a third party to establish trust can be done without the third party. So in the case of an ID, the third party is the government or organization that issued it. With an NFT we can have much greater security because governments and other organizations can be gamed. Strong cryptography cannot. The same mechanism that allows us to know a new block of coins is valid with 100% certainty can tell us something similar about qualification and identity.

Why Are People So Myopic About Use Cases?

So why are people still using NFT technology to show ownership of cartoons? I’d submit it is because there are conflicting interests that absolutely rely on there being ‘trusted third parties’ in the system. The government is the biggest of these, and it relishes its role as a “trusted” third party. Governments would love nothing more than for us to rely on them for more, not less. So anything that reduces our reliance on government necessarily runs into friction because that artificial value they supply represents a critical pillar of perceived need. The government needs to be the ultimate authority in matters of law, rights, finance, security, and opportunity provision so that it alone can shape society and the economy in ways that benefit the continuation and expansion of government. But that’s not how it’s supposed to work. Government is supposed to be by, for, and of the people, but when the size of government gets past a tipping point, too many of ‘the people’ actually work in government, and therefore develop a severe conflict of interest. Their interests as government employees are to create more pay, shorter hours, and better perqs for themselves and to facilitate this as far into the future as possible. Their interests as ‘the people’ are to limit the growth of government, and to maximize their own freedom to act without permission. This is a problem that is not really discussed, let alone in the process of being solved, but that day is coming.

The Bigger Applications Of Cryptography For Citizens

A big issue in today’s world is that we have learned to artificially separate our economies from our societies from our polities; except that this only happens in theory. In reality, these are just different ways we organize things in our minds so we can better understand them. The real world is all of it, at once. We don’t exist in a society without an economy. They are both parts of the same reality.

But these artificial constructs do allow us to contemplate solutions to complex problems a bit more easily. One of these has to do with the form of government we aspire to have. What do we want it to do, and at what ideal cost? Who should benefit from the government, and at what cost to them? Another has to do with big incentives such as the way we allow economic power to translate into political power. Billionaires, for example, don’t need to vote. They can just hire lobbyists. They can fund entire influence campaigns to get others to vote people into office who protect their interests. This isn’t available to average voters. US citizens are guaranteed the right to petition their government by the constitution, but today this is essentially a mute function. No average citizen can petition the government and actually get measurable, repeatable, positive results. There are better ways to govern than we’ve experienced so far, and cryptographic means could empower the average citizen to own their own being in its entirety rather than simply be subject to the whims of the state, regardless of how those whims may negatively impact him.

With so many technological means for ‘authorities’ to enforce compliance on private citizens, cryptography offers the individual citizen a means of protection against misguided bureaucratic zealotry. An NFT-based ID system could encrypt on a blockchain all the relevant data about who ‘you’ are, and only release what you tell it to release to relevant entities. So when you went to vote, you could tell your NFT to reveal your voter qualification status, and it could reveal only this information without compromising any other information. Yes, this person is qualified to vote, and may vote. That’s all it needs to know, and this information would be impossible to fake. It couldn’t, in other words, say you’re qualified when you’re not. It could also record that you voted, where you voted, how you voted and keep this information entirely in ‘meta,’ meaning it is only connected to an encrypted, nonsensical string of characters. This keeps ‘your’ vote a secret, but the vote total in the open. We wouldn’t have to wait for ballot boxes to be emptied or counted. Literally every vote would be tabulated on a block chain as it is cast, and it would have to be validated by other computers in the network. The code for all this would be open source, and available to anyone to view or edit, subject to consensus.

The point is this technology exists, right now, today. People just don’t see the potential use cases. Any transaction requiring a trusted third party can now be completed without that third party. That is the operative information you need to have. With it, you can define your own use cases and begin to implement them. And that, ladies and gentlemen, could change the world.

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