There is a widespread misconception that Bitcoin and tokens that have derived from similar technologies are currencies comparable to fiat currencies like EUR, USD, etc. This post will point out why Bitcoin and other crypto tokens are not currencies in the traditional sense, but rather:
  • A new asset class
    Bitcoin and other native Blockchain tokens that have derived from Bitcoin, have more resemblance with commodity currencies of the past, rather than state of the art fiat currencies.
  • An operating system for a new type of economy
    that transcendents the geographical boundaries of nation states. The protocol of the Bitcoin Blockchain coordinates people who do not know and trust each other across boundaries of nation states without the need for classic centralised institutions and classic legal agreements.

While it might be counterproductive to call Bitcoin a currency, as it sparks a lot of controversy and is not entirely true, Bitcoin does have similarities with money as we know it. The biggest challenge that we face when we are trying to explain or discuss Bitcoin, Blockchain and other crypto economic technologies, is that we are trying to explain new phenomena with old terminology that sometimes don’t do justice to the full range of possibilities that these new technologies have to offer. In order to understand the full range, we need to deep dive into following questions: What are the roles and functions of money? What are Bitcoin or so-called tokens anyway? Can a token economy eradicate the monopoly of nation states to issue money?

Functions of money

*skip this is you already know what money is*
The primary purpose of money is to facilitate an economic exchange of goods and services within and between economies. It makes economic exchange much more efficient than gift economies and barter economies, avoiding inefficiencies of such systems, like the coincidence of wants problem. Here is a list of it’s most important functions:

  • Medium of Exchange
    Money is an efficient technology for intermediating exchange of goods and services, because it provides a tool to compare values of dissimilar objects.
  • Measure of Value
    As a unit of account, it’s a standard numerical monetary unit of measurement of the market value of goods, services, and other transactions: (a) basis for quoting and bargaining of prices; (b) necessary for efficient accounting systems; (c) prerequisite for the formulation of commercial agreements that involve debt.
  • Store of Value
    Money must have the ability to be reliably saved, stored, retrieved — and be predictably usable as a medium of exchange when it is retrieved. Its value must remain stable over time, since high volatility is counterproductive for trade, and inflation reduces the value of money and diminishes the ability of the money to function as a store of value.
  • Unit in which Debt is Denominated
    If money has the status of legal tender, it is a unit in which debts are denominated, and an accepted way to settle a debt. When debts are denominated in money, the real value of debts may change due to inflation and deflation.

Properties of Money

To fulfill its various functions, money must have certain properties

  • Liquidity
    Easily tradable, low transaction costs, no or low spread of buy & sell price.
  • Fungibility
    Units of money must be capable of mutual substitution. Every token (physical or virtual) must be treated equally, even if it has been used for illegal purposes by previous owners.
  • Durability
    Ability to withstand repeated use (not vanish, decay or rot).
  • Portability
    Assets must be easily carried and transported.
  • Cognizability
    Value must be easily identified.
  • Stability
    Value should not fluctuate too much.

Types of Money

Different types of money have evolved over time. In modern economies the dominant type of money are the so-called fiat currencies.

  • Commodity Money
    Is an object which has an intrinsic and standardised value in a local economy. The value derives from a commodity of which it is made of: gold coins, silver coins and other rare metal coins, salt, barley, animal pelts, cocoa, cigarettes, to name just a few examples. The price is determined by a metric of perceived value in conjunction to one another in various commodity valuations or price systems economies.
  • Representative money
    It’s a medium of exchange that represents something of value but has little or no value on its own. It’s a claim on a commodity: like gold or silver certificates, or paper money and coins backed by gold reserves.
  • Fiat Money
    Fiat money does not have an intrinsic physical value like a commodity. It’s face value, which is denominated on the banknote, is greater than it’s material substance.

Fiat Money

Fiat money is established by government regulation, similar to any check or note of debt. It derives its value by being declared by a government to be legal tender, which means that it must be accepted as a form of payment within the boundaries of the country, for all debts, public and private.

The assigned value results from the fact that governments can use their power to enforce the value of a fiat currency. In modern economies, most money in circulation is not in the form of bills and coins anymore, but rather an entry in the digital ledgers of a bank, managing money saved in current accounts, checking accounts, and in form of other financial instruments.

The money supply of a country consists of currency (banknotes and coins) and, depending on the particular definition used, one or more types of bank money (the balances held in checking accounts, savings accounts, and other types of bank accounts). Bank money, which consists only of records (mostly computerised in modern banking), forms by far the largest part of broad money in developed countries.

Fiat currencies have evolved over time. While banknotes and coins used to be pegged to scare commodities like gold and other precious metals in the past — as representative money — gold backing has drastically changed during the 20th century. Most currencies today are hardly pegged to commodities anymore. Central bank influence money supply with monetary policy — which means to print more or less money as they see fit. But how is that all related to Bitcoin? And what is Bitcoin anyway?

Bitcoin — A crypto economic operating system

While Bitcoin was originally designed with the purpose to create P2P money without traditional banks, the underlying blockchain technology that makes it happen has proven to be a gateway to a new type of economy (crypto economy), and a new type of distributed governance (crypto governance). Please note that the terms crypto economy and crypto governance are new, not fully defined yet, highly controversial and somewhat complementary or overlapping. In a follow-up blog post will go into the details of those terms. For now, I would like to stick to analysing the functionalities of Bitcoin:

  • Public & Permissionless Payment Network (P2P Network)
    Bitcoin is a P2P payment network between a geographically disparate group of stakeholders who do not know and trust each other, without the necessity of using centralised institutions like banks, credit card companies, PayPal, MoneyGram and the like. It is permissionless, which means that anyone can become part of the distributed network. Either by creating a Bitcoin wallet (Bitcoin account number) and starting to send and receive Bitcoin. Or by becoming a Bitcoin miner, by downloading the protocol and verifying transactions thus potentially mining Bitcoin, which equals earning money.
  • Bookkeeping Tool (Asset Management)
    Furthermore, Bitcoin is a distributed book-keeping tool that keeps track of who owns what, including all transactions ever made, in a public and transparent way. The role of cryptography is to guarantee transparency while maintaining the privacy of individuals. This distributed ledger is a new form of transferring value in a public and transparent way, circumventing the need for data silos.
  • Crypto Economic Governance Tool (Governance Layer)
    The P2P network of stakeholders, as well as all assets, are governed by the ruleset defined in the protocol of the Bitcoin blockchain. Monetary policy is also pre-defined in the protocol. Transactions are automatically enforced if and when the majority of the network agrees that a transaction is true. Crypto economic mechanism design incentivises all stakeholders of the network to verify transactions according to pre-defined rules, by performing computational work — proof of work — that allows them to mine Bitcoin — create new Bitcoin. This mechanism design can be altered in a protocol update, in the form of a soft fork or hard fork. The crypto economic incentive mechanisms including the monetary policy of Bitcoin can be altered by majority consensus of network participants. The conditions of such software upgrade are partly defined in the protocol, partly unclear.
  • Bitcoin is mined to keep the network safe (Security Function)
    Some people who don’t seem to fully grasp how the Bitcoin blockchain works, claim that Bitcoin has no function or value. This is not true. Bitcoin is, in fact, the output of a productive function, governed by crypto economic incentive mechanisms, that makes sure that distributed network of actors who do not know and trust each other validate transactions according to the predefined rules, in an attack resistant, fault tolerant and collusion resistant way. The act of mining bitcoin keeps the network safe!
  • Bitcoin needed to pay for transactions (Commodity/Utility)
    In order to send a transaction from Bitcoin wallet A to Bitcoin wallet B, you need to pay transaction fees in the form of Bitcoin tokens, which will be rewarded to the miner who mined the block where your transactions were included. This means that the token has a utility function within the Bitcoin network. Bitcoin is the native commodity of the Bitcoin network.

Why Bitcoin is not comparable to Fiat

  • If anything, Bitcoin is commodity money, not fiat money
    While Bitcoin has certain properties of money, it is rather comparable to commodity money and not fiat money. As long as people use the Bitcoin Network for services, that need to be paid in the native commodity (Bitcoin Token), the token has a value in itself as it is used to pay Bitcoin transactions. The commodity aspect of so-called cryptocurrencies becomes more evident with Bitcoin derivatives like Ethereum (where you need to pay for computation in ETH) or the Sia Network (where you pay for storage with an SIA), since those networks where not designed for P2P remittance (like Bitcoin), but P2P computation (like Ethereum) and P2P file sharing (like Sia).
  • Decentralised production, price determined by supply & demand:
    The nature of commodities is distributed control, much like Bitcoin. No single government or other entity controls the mining of gold, silver, oil, etc. Production is distributed, and prices of those commodities are determined by supply and demand on commodity markets, much like the price of so-called cryptographic tokens are determined by the supply and demand on crypto exchanges like Kraken, Bitfinex, Ploniex, Coinbase and the like. As opposed to fiat currencies, no single centralised entity like governments and central banks can influence the price of Bitcoin or other Crypto-tokens.
  • Higher Liquidity than classic commodities
    As opposed to classic commodities that are traded on classic exchanges, cryptographic tokens (Bitcoin, Ether, and the like) have higher liquidity, due to the nature of Blockchain based P2P remittance. Exchange and remittance easier, faster, and cheaper. And if you don’t use 3rd party services like banks or stock brokers, entirely P2P.
  • Price Fluctuates
    Bitcoin is not regulated by a centralised institution, but determined by supply and demand on markets, and is currently highly volatile. While fiat currencies of most modern economies have fluctuating interest rates that are determined on forex markets, national institutions can perform currency intervention, aka foreign exchange market intervention or currency manipulation as a monetary policy operation of the government. Governments or central banks can buy and sell currency in exchange for their own currency to manipulate the market price. Why? Governments usually prefer stable exchange rates, as excessive short-term volatility erodes market confidence, generating extra costs and reducing profits of firms, forcing investors to make investments in foreign financial assets. Therefore the biggest difference between crypto currencies/assets and fiat currencies is price volatility. With hedging, stablecoins etc. on the rise, price fluctuations might be a non-issue in the near future.
  • P2P Payment Network
    In addition to having many similarities with money, the underlying payment network allows you to circumvent classic banks, credit card companies, PayPal, Money Gram and the like. So it is money without banks and bank managers. The role of the bank in money remittance is substituted by the smart contract of the Bitcoin Network.
  • No centralised institution that governs Bitcoin
    The Bitcoin token is the currency of the “distributed internet tribe” called Bitcoin, monetary policy and all other governance rulesets are determined by the governance rulesets in the protocol of the Bitcoin blockchain. The code can only be upgraded by majority consensus of network actors. Details are more complex and beyond the scope of this post. While the original vision lined out in the Bitcoin White Paper was more decentralised, reality has proven that network actors can collude to gain more control (eg. Bitcoin Mining pools versus individual miners).

Token Economy – The Future is here

To sum it up: Bitcoin is a new asset class, and has pioneered an operating system for a new type of economy where it has become feasible for everyone to issue their own purpose oriented token by either forking the Bitcoin protocol an creating their own purpose oriented native Blockchain token, or even simpler, by creating an application token on top of the Ethereum Blockchain with a few lines of code. With this new technology it is now possible to create completely new types of economies, where we can model behavioural economics into a smart contract with the purpose of incentivizing certain behaviour  – like incentivizing people to plant trees instead of cutting them by mining “tree tokens” (aka marking money), or to incentive people to save CO2 emission by using a bike instead of a car, or use solar energy instead of energy that comes out of a coal mine, by mining “Co2 tokens” (making money) when saving CO2 emission.

Cryptographic tokens are also a technology that allow us to create a digital representative for physical assets – so-called asset-backed tokens – with the result that these assets can now be traded at much lower transaction costs, some of which might have higher liquidity than on current markets (commodities like gold, petrol etc, but also real estate and many assets that have been less liquid in the past).

The future is already here. But most people are not aware of it yet. As of January 2018 around 1400 so-called cryptocurrencies (all with different properties and purposes) were listed on Coinmarketcap. However, we are still at the very beginning of this revolution. There are a few challenges ahead of us:

  • Price fluctuation of crypto assets
  • Sustainable mechanism design for purpose oriented app tokens
  • General education about the potentials and also threats of the token economy.
  • Unclear and balkanized legislation
  • Definition of money as we know it.

Outlook

Recently Venezuela and Kodak have announced their own ‘cryptocurrency’. While this is not entirely unexpected, it is way sooner than I personally would have expected. If 2017 was the year of ICOs, 2018 will be the year of tokenising everything. Things are changing and they are changing fast. Only time will tell how this will impact the role of money as we know it.

 


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