ECON120: Monetary History

It might make sense just to get some in case it catches on. If enough people think the same way, that becomes a self-fulfilling prophecy.

- Satoshi Nakamoto, January 16, 2009

Bitcoin has become its own monetary pyramid due to its properties as a first-layer money. The pyramid is reminiscent of gold-anchored pyramids of the past, but BTC doesn't derive its first-layer status solely from comparisons and metaphors; Satoshi designed a digital asset that specifically mimicked precious metals in order to attract demand. The exponential increase in Bitcoin's market value only reinforces the thesis of its first believers like Hal Finney. Second-layer BTC emerged for the same reasons second-layer gold did. People were willing to hold claims on BTC just as people held claims on gold. The emerging world of digital assets is anchored by BTC in a similar way that the international monetary system was anchored by gold, as described in the first five chapters of this book. BTC is a neutral, counterparty-free money like gold that people trust as a form of final settlement. This chapter is about the layered BTC-denominated monetary system and how BTC exerts dominance over the entire realm of digital assets.

Owning Physical

Those that strive to own first-layer money often use the phrase "owning physical" to describe the act of owning precious metal in a physical form instead of second-layer gold certificates, shares, or any other promise to pay gold. They are acutely aware of the distinction between first- and second-layer gold and choose to own physical coins and bullion instead of gold substitutes. It comes down to trust: they only trust physical because physical means counterparty-free. Bitcoin has the same international neutrality that gold has; it doesn't depend on any specific people, companies, or countries for it to survive. But Bitcoin has some advantages to gold in the modern age. It exists on computers anywhere and everywhere. It doesn't need to be transported around the world on armored trucks, ships, and airplanes. It also doesn't call for purity testing that enlists expensive equipment, only a Bitcoin node.

Bitcoin's pyramid is anchored by physical ownership of BTC, which begins with the management of Bitcoin private keys. Much like ownership of physical gold relies heavily on vault and security technology, Bitcoin private keys require security precision to avoid loss and theft. The secure and offline storage of BTC is called cold storage; implying that private keys are not generated or stored online in hot wallets.

Cold storage is a booming business. Fidelity Investments, one of the world's largest financial institutions with over $3 trillion in assets under management, launched its own cold storage subsidiary called Fidelity Digital Assets in 2018 to hold BTC on behalf of large clients. Bitcoin isn't exclusively merging the monetary and cryptography sciences; it's also merging the financial and applied cryptography industries.

We must note that with the introduction of large BTC custodians, their customers will not own first-layer BTC. Customers will own second-layer BTC because they won't be in possession of BTC private keys; the custodian will. As the saying goes among the Bitcoin community, "not your keys, not your coins". And of course, custodians will be subject to government regulation within their jurisdictions. Some governments have proven friendly toward Bitcoin as a new monetary technology, but that stance won't be fully mirrored around the world because of Bitcoin's potential to supplant unstable government currencies.

BTC/USD

There is now a wide array of second-layer BTC money-types. Some instruments mirror the financial arrangements of today's traditional financial system, like deposits. Others are novel and only possible since the inception of Bitcoin. The fi rst examples of second-layer BTC were deposits issued by online BTC/USD exchanges, as shown in Figure 14.

Figure 14

During 2010, the earliest Bitcoin exchanges were formed in order to facilitate trading between BTC and U.S. dollars. They demonstrated something very important about Bitcoin: an active market existed between people that wanted trade between BTC and USD. Bitcoin was designed as a currency and was being used exactly as intended hardly a year after its genesis. Another common criticism of Bitcoin is that it can't be used to purchase goods or services because most businesses don't accept BTC as a form of payment. This objection misses the point that BTC can be used to purchase the most important commodity of all: money. On exchanges today, BTC buys its owners USD, EUR, and any other major currency they might choose.

An exchange rate between BTC and USD was established in 2010, which bolstered BTC's liquidity and its perception as a new alternative form of money. Customer balances on Bitcoin exchanges were the initial form of second-layer BTC; the balances were claims on BTC but not ownership of private keys themselves. Some exchanges would build stellar reputations by allowing free-flowing BTC withdrawals upon request and having full, not fractional, BTC reserves against all deposits. Others would default on customer balances just like banks had defaulted on deposits over the centuries, whether caused by a cyberattack, theft, or fractional reserves. Despite some early failures, trust in Bitcoin exchanges developed as a cornerstone piece in the Bitcoin monetary puzzle, and almost immediately, the time value of BTC presented itself: customers with deposits could lend their collateral to other traders at an interest rate.

Legitimacy

It only took Bitcoin half a decade to achieve legitimacy as a new global currency. Undeniably, it wasn't the darling of governments or the financial industry because of its disruptive and decentralized nature, but it achieved enough market value, venture capital attention, and legal designations to bring it into the mainstream conversation. By 2014, Bitcoin had become a geopolitical force. As the network flourished, it attracted value, study, and investment, which in turn attracted more value. During this period, entrepreneurs started to build an entire infrastructure and industry around Bitcoin because it had become globally accepted as unforgeable digital money. Events in Bitcoin's early history chronicle its quest to become a force of nature and an eradicable fixture in the world of currency.

In its first year, Bitcoin had no value attached to it whatsoever. It didn't have a price, but it did have people that believed in the project and that BTC was worth the electricity, computing power, and effort invested to earn it. This made it money already, as it was a way to store work that had been performed; proof-of-work and Bitcoin mining can be thought of as a form of labor. The highly publicized, earliest Bitcoin transaction occurred when in May 2010, one Bitcoin software developer paid an online acquaintance 10,000 BTC for a $25 Papa John's pizza order, equating to a BTC/USD price of $0.0025. The transaction valued the total market value of BTC at approximately $7,000.

On February 10, 2011, the tech blog Slashdot posted an article titled "Online-Only Currency Bitcoin Reaches Dollar Parity". Because of Slashdot's popularity among software engineers, many early Bitcoin adopters reference this specific article as the moment they first heard about Bitcoin. After this first slice of internet publicity, barely two years into the project, Bitcoin started to gain serious popularity and attention. A growing community of users all believed in this new monetary form and agreed that the predetermined supply schedule was worth protecting. Soon, enough developers and mind share coalesced around the network, and Satoshi bid adieu. As of this writing, the estimated one million BTC that he mined during the first year of Bitcoin's existence has never been transacted.

The total market value of BTC passed $100 million in June 2011 around the same time as the website Gawker published an article titled "The Underground Website Where You Can Buy Any Drug Imaginable". The Silk Road was an online black market, most widely used for the buying and selling of illegal drugs on the Internet. As a new, online, decentralized digital currency not yet on the radar of law enforcement, BTC was the perfect currency for Silk Road users. In Bitcoin, there was no bank that could flag suspicious transactions, no cash that had to be sent through the mail or exchanged in person, and conveniently no law enforcement to monitor the Bitcoin ledger for transactions. Without any- body looking, Bitcoin transactions might as well have been anonymous. The Gawker article explained that one must first go to a Bitcoin exchange to purchase BTC in order to participate in this online marketplace:

The Federal Bureau of Investigations eventually opened an inquiry and shut down the Silk Road. The FBI seized BTC during its operation and faced new truths about money in the digital era. From that point on, law enforcement from around the world began to monitor Bitcoin's ledger for suspicious activity in order to hunt down criminals. Law enforcement developed ways to associate Bitcoin transactions with internet location data in order to do this. After law enforcement agencies started monitoring the Bitcoin ledger, Bitcoin was no longer the ideal currency for criminal activity, rather far from it. This disassociation boosted the legitimacy of Bitcoin in a pivotal way.

On November 28, 2012, Bitcoin's first halving event took place after its 210,000th block was mined and the mining reward for each block "halved" from 50 BTC to 25 BTC. While the moment passed without any fl are or drama from a blockchain perspective, it was paramount from a monetary one. When Satoshi designed the first working version of the Bitcoin software code, he outlined a monetary policy that stretched out over a century into the future. Then after four years in existence, Bitcoin's network experienced its first supply adjustment without drama, greed, or objection from any of its participants. The predetermined supply schedule, a supply halving after each epoch, and a maximum total supply of 21 million BTC were all stipulations of the network that were observed, not questioned. Satoshi had invented non-discretionary monetary policy wherein human discretion could never alter the supply algorithm of Bitcoin. The awareness of this awe-inspiring invention and strength of consensus drove an investment thesis for Bitcoin; it was a currency that couldn't be expanded in supply or devalued. Bitcoin had arrived as digital gold.

In 2013, the price of BTC/USD exploded, rising above $1,000 and giving the network a total market value of $10 billion. The Financial Times, Wall Street Journal, and Bloomberg started publishing articles about Bitcoin and the growing cryptocurrency industry with regularity, and Bitcoin's brand started to gain recognition. Government officials likely belittled the idea of decentralized cryptocurrency because Bitcoin's lack of a central issuer had stoked a discussion about the separation between money and governments.

Bitcoin officially gained recognition in the eyes of the United States government in 2014, progressing toward legitimacy and past the ugly brushstrokes left by the Silk Road era. The IRS determined that ownership of BTC was to be treated as property and that gains realized in USD terms were subject to capital gain taxes. This was an admission by the U.S. government that owning BTC was an unmistakable form of property like real estate or physical gold and should be taxed as such.

Additionally, the U.S. commodity futures regulator ruled that Bitcoin was indeed a commodity and not a currency. It compared Bitcoin to gold in its own research process and concluded that ownership of BTC is possession of a numerical commodity due to the software's reliance on private keys. Bitcoin was starting to morph into its own asset class, despite being difficult to define in the traditional context because of its novel characteristics.

By 2014, even the U.S. government was fully aware of the monetary evolution taking place. Bitcoin attracted savers in countries with poor governing stability and property rights who desired a borderless, seizure-resistant money. It attracted savers within a dollar denomination that had lost faith in the Federal Reserve as a source of monetary discipline. Bona fide demand for Bitcoin existed throughout every corner of the planet. In 2017, Bitcoin's total market value exploded past $100 billion in its most dramatic price surge yet. The exponential growth of Bitcoin had become undeniable.

Tulips

During the seventeenth century and a few decades after the founding of the Bank of Amsterdam, a speculative price bubble occurred in Dutch tulip bulbs. As a beautiful luxury item, tulips became all the rage in the Netherlands as everybody wanted a piece of the highly coveted commodity. Prices of bulbs exploded and then collapsed shortly there- after, as all speculative bubbles do. The word bubble would be used throughout history to describe increases in the price of an asset that seemed unfathomable to many, increases that would unquestionably and consistently end in ruinous decline. Of course, many have fruitlessly tried to associate the word bubble with Bitcoin.

Bitcoin's exponential price rise since its birth continues to bring about cries of a bubble and comparisons to Dutch tulips despite having fully recovered from intimidating 80% price declines now on three separate occasions. The BTC/ USD price is breathtakingly volatile, far outstretching price fluctuations we typically see across other asset classes. Its volatility, however, is not a reflection of asset quality or even excellence. If Bitcoin truly is to grow from an adolescent monetary network to the basis of an international monetary system, surely the ups and downs on its way will mimic a formidable rollercoaster. If the market value of BTC were to equal the market value of all the world's gold, the BTC/ USD price would reach approximately $500,000. It is safe to assume that the journey from less than $1 to $500,000 would come with its fair share of frenetic price swings, both up and down. These vacillations are ingrained into Bitcoin's maturation and will separate early adopters from those who will wait for the price to stabilize in USD terms. None of this volatility, however, precludes BTC from being a store of value and an alternative to currencies based on aging archetypes.

In reality, Bitcoin is nothing like the Dutch tulip mania. Bubbles don't burst three times in a decade and come back stronger each resurgence, and the investing public is finally waking up to this fact. In 2020, some of the most legendary hedge fund investors of this generation, Paul Tudor Jones and Stanley Druckenmiller, acknowledged ownership of BTC. Investment management powerhouses such as AllianceBernstein, Blackrock, and Fidelity Investments made public recommendations for clients to have BTC in their portfolios as a hedge against the devaluation or demise of government currencies. PayPal, the world's largest online payment processor, gave its 300 million global customers the ability to purchase BTC on its platform. It began to become clear to the investing community that denying Bitcoin's place in the future of money was like denying the Internet's place in the future of commerce in 1999. Internet stocks might have experienced a speculative price bubble at the turn of the twenty-first century, but the world's biggest publicly traded corporations today are Microsoft, Apple, Amazon, Alphabet (Google), and Facebook, which have generated trillions of dollars in market value thanks to the Internet.

The flurry of endorsements preceded the BTC/USD price reaching a new all-time high at the beginning of 2021 as the total market value eclipsed $600 billion. What was once a digital token attached to a hobbyist software worth less than a penny in 2010 had become a $34,000 commodity only a decade later. The famous $25 Papa John's pizza trade would be worth $340 million on Bitcoin's twelfth birthday, January 3, 2021. Figure 15 shows the meteoric rise in BTC's total market value since 2010.

Figure 15

Lightning Network

Lightning Network is a technological enhancement to Bitcoin that positively transforms it from a slower-moving commodity like physical gold to a currency moving at lightspeed. And the key ingredient to the Lightning Network is the smart contract. Generally, smart contracts are programmable agreements capable of anything that can be coded into software. For the objective of Bitcoin, smart contracts are most importantly capable of escrow and multiple-party coordination. The smart contracts in Lightning Network, Hashed TimeLock Contracts (HTLCs), have scaled Bitcoin into a monetary network capable of processing millions of transactions per second. Let's take a closer look at how Lightning Network evolved.

In the first couple years of the Bitcoin network, a small contingent of Bitcoin enthusiasts contributed their own ideas and improvements to the project. They fixed some critical vulnerabilities that could have abruptly ended the network before it caught momentum. These software engineers and cryptographers worked on Bitcoin because they had conviction in the technology, owned BTC, and wanted the net- work to succeed. They weren't receiving an income from any employer; they were working out of belief in a new denomination. Over the years, they graduated Bitcoin from a project to a legitimate global monetary network.

The most crucial updates that transitioned Bitcoin to a smart contract platform occurred from 2015 to 2017. These Bitcoin Improvement Proposals (BIPs) turned one-dimensional Bitcoin transactions into wildly customizable financial contracts, without changing any of Bitcoin's fundamental rules.

In 2016, a paper from software engineers Joseph Poon and Thaddeus Dryja called "The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments" built upon all the smart contract innovation happening on the Bitcoin soft- ware. The paper was a proposal for a new type of Bitcoin smart contract (HTLCs) that enabled instantly settling payments without having to wait for the next block to be mined. Lightning Network not only infinitely increases Bitcoin's capability as a medium of exchange but also allows for innovations such as paying for online streaming by the millisecond. And in the digital age of streaming everything, why shouldn't money stream as well?

Lightning Network also brings a new dimension to the time value of BTC. Users that provide BTC as collateral to Lightning Network in order to facilitate transactions can potentially earn income from providing this liquidity. This is a historically unprecedented way to earn a return on capital without ever relinquishing custody of it because collateral providers don't actually part ways with their BTC when dedicating it to Lightning Network. Interest rates derived from this type of activity could function as a reference rate in the Bitcoin world because of Lightning Network's uniquely counterparty-free nature. The very concept of the time value of money is changing as these new technologies permeate the monetary landscape.

Alternative Cryptocurrencies

Bitcoin copycats were inevitable. Bitcoin is a free and open- source software, which means that the software is free to download and open to view by anybody. On multiple occasions, Bitcoin has resisted fundamental changes to its rulebook from developers that were out of consensus with the majority of Bitcoin users. Alternative versions of cryptocurrency to Bitcoin emerged, whether copied directly, tweaked, or reimagined. If ideas better than Bitcoin existed, capital would gravitate toward these alternatives and away from Bitcoin. So far, however, no cryptocurrency has challenged BTC over any sustained duration, measured in both market value and hashpower. Alternative cryptocurrencies exist on a lower layer within the BTC money pyramid due to a price relationship, much like national currencies existed on a layer below the dollar after the Bretton Woods agreement of 1944. Like the USD acts as the base price for currencies from around the world, BTC acts as a base price for all digital currencies.

BTC also acts as a monetary constraint on lower layers of its own pyramid because it's unforgeable, but this doesn't prevent the issuance of second-layer BTC or any other digital asset. Whether classified as copycats or money-grabs, a volcano of cryptocurrencies erupted after the early success of Bitcoin. Exchanges added cryptocurrencies to their plat- forms which notably traded against BTC, not USD, as their base currency. A new asset class of digital token-based cur- rencies is here, and BTC functions as the final form of settlement within that digital realm.

BTC will never be alone as a digital asset; it will always have both ancillary and auxiliary assets. But it is the one unit of account on which others in the digital universe can rely on for incorruptibility. The Bitcoin protocol's dominance as the primary value-transfer protocol of the Internet will likely endure for decades to come, much like how the Transmission Control Protocol, Internet Protocol, and Hypertext Transfer Protocol (TCP/IP/HTTP) dominate our digital interactions every day when we connect to the Internet or browse the web.

Stablecoins

A rapidly growing second layer within Bitcoin's monetary pyramid is a new type of digital asset called stablecoins. Stablecoins are liabilities issued in the form of digital tokens by private sector companies. These stablecoins are supposed to trade at a "stable" value relative to dollars, for example. The moniker of "stable" is a bit of an oxymoron in this case because as we've learned, monetary instruments on lower layers of money rarely possess enduring stability. Stablecoins: digital coins that are stable until they aren't.

Stablecoins were invented because exchanges needed an easier and quicker way for customers to convert between BTC and USD. In essence, exchanges create their own cryptocurrencies that represent USD in a bank account but are transacted with private keys and addresses just like Bitcoin.

The most famous stablecoin is one that has yet to launch: Facebook's Diem (originally called Libra). Its intent is to be backed by U.S. Treasury Bills and other dollar-denominated monetary instruments. Whether or not Diem launches, Facebook's announcement of a stablecoin in 2019 was a major landmark for digital money. The moment Facebook attempted to encroach upon the world of money was the moment central banks knew they needed a formal response to the merger of money and cryptography. Private sector banks are also looking to capitalize on the demand for dollar- pegged, ledger-based digital tokens: J.P. Morgan launched its own stablecoin, called JPM Coin, in 2020.

In January 2021, the U.S. Treasury issued a definitive guidance on the legality of cryptocurrencies and stable- coins in a report from the Office of the Comptroller of the Currency (OCC). The guidance names both cryptocurrencies and distributed ledgers independent node verification net- works (INVNs), formally defines the word "stablecoin" exactly as we have in this section, and approves both of them for use by banks to digitally transact value as long as banking laws are followed. The ruling was proof that the future monetary rails would be built with the backbone of cryptography:

Commodity Futures

Though New York is the banking capital of the United States, Chicago has always been its commodity hedging capital. During the nineteenth century, Chicago standardized the world of forward and futures contracts, allowing farmers to contractually sell their crop before it harvested. In 1898, standardization of butter and egg futures contracts led to the formation of the Chicago Butter and Egg Board, the predecessor to the Chicago Mercantile Exchange (CME), which today is the world's largest derivatives exchange. The CME would add practically every commodity imaginable to its range of futures products over the years, from live cattle futures in 1964, to silver futures in 1969, to Bitcoin futures in 2017.

In 2016, when the CME announced plans to publish Bitcoin price data in preparation for a launch of Bitcoin futures the following year, the weight of Chicago as the worldwide authority on commodities was thrown behind Bitcoin and significantly added to its legitimacy. CME Bitcoin futures help financial market participants translate between BTC and USD, which will directly contribute to Bitcoin's adoption. Businesses can engage in BTC-denominated activity knowing that they can actively manage away unwanted exchange rate risk. Additionally, Bitcoin futures off er a second-layer BTC to participants that operate only within the dollar pyramid and simply want exposure to changes in the price of BTC, not possession of Bitcoin private keys. CME's product brought Bitcoin forward on its path to full integration with the traditional financial system.

Layered Bitcoin

As worldwide adoption of Bitcoin as a currency and as a monetary mindset continue, Bitcoin's second layer is blossoming with a variety of BTC-based promises, alternative cryptocurrencies, and stablecoins. Figure 16 shows that Bitcoin is at the top of its own novel monetary pyramid, with some second- layer monies stemming from balance sheets and others from price relationships.

Figure 16