ECON120: Monetary History

A New Denomination

In the digital realm, Bitcoin's software facilitates and clears all transactions within its denomination. It functions like a central bank from the settlement perspective, only instead of central, the software is anywhere that Bitcoin nodes exist. Bitcoin's innovation created an entirely new denomination and payments infrastructure, controlled by nobody. Digital payments were already ubiquitous by 2009 with the widespread use of online credit card payments, PayPal, and other smartphone payment applications used to transact third-layer bank deposits. But until Bitcoin, nobody had figured out how to mimic cash and final settlement on the first layer of money without using a central entity. As the Internet's native currency denomination, payment system, and digital gold all rolled into one, Bitcoin became a force to be reckoned with very early into its existence. It was arguably the most important monetary breakthrough since gold coinage almost three thousand years ago: scarce, mathematically certain, free and open to use, and immune to greed.

Policy makers around the world must heed the connotation of a new monetary denomination. The United States of America in particular prides itself on its freedom of speech, and its treatment of this new monetary technology should be no different. Bitcoin is a form of speech: people should be allowed to transmit a message (send a BTC transaction) as freely as they are able to send an email. Bitcoin is a numerical software, and any attempt to ban or restrict the usage of Bitcoin by governments would be a ban or restriction on math itself. The United States judicial system has already established the precedent that the use of encryption is a requirement to protect free speech in the digital era, and the same ideas should be applied to Bitcoin in every corner of the world that prides itself on the freedom of its citizens. Here is a 1999 ruling by the United States Court of Appeals, Ninth Circuit (Bernstein v. United States), confirming that encryption, like math, is an expression of scientific ideas and therefore a form of speech:

Buying Coffee with Bitcoin

The Bitcoin transaction settlement process is simultaneously consistent and highly irregular. Let's look at an example of somebody trying to use BTC to make a purchase. A woman walks into a café to buy a cup of coffee. The café accepts BTC as payment and charges 15,000 sats (0.00015 BTC, or approximately $5) for coffee. The woman pays with a Bitcoin wallet on her smartphone, but the transaction is technically unconfirmed until it is mined in a block by a Bitcoin miner. Will the café staff make the woman wait ten minutes until they give her the coffee? What if, because mining is a random process, the next block isn't mined for an hour? The café has two options. It can accept the woman's unconfirmed transaction, but it won't be able to trust the money it received until the next block is mined (Bitcoin's shared ledger hasn't updated yet with the coffee transaction). On the other hand, the café can insist the transaction be added to the Bitcoin block- chain before handing over the cup of coffee. This is a totally unrealistic expectation and has led to a widely used, albeit misinformed, criticism of Bitcoin: the network is too slow to function properly as a medium of commerce. In reality, first- layer Bitcoin transactions are not designed for instant commerce; they are designed to keep an entire global network of peers in perpetual agreement on the status of the Bitcoin ledger. Nevertheless, Bitcoin would eventually shed its moniker as a slow network years later with the advent of the Lightning Network, discussed in the next chapter.

If Bitcoin isn't used for buying coffee, what is it actually used for? Bitcoin is used most crucially by people that prefer a neutral, counterparty-free way to store money. Let's give an example of an individual most empowered by Bitcoin's technology. Imagine a young woman in Nigeria. She lives in a rural village and is a talented graphic designer. If she's able to find freelance work online, she can earn money for her family. But how can she possibly use traditional payment methods to receive money? She doesn't have access to a bank account and wouldn't be able to receive cash in the mail sent via international courier. Bitcoin is actually her best option. Using a smartphone wallet, she can generate a BTC address for herself, send it to a client in Zurich, and receive payment. She doesn't care that the transaction takes ten minutes to confirm; without Bitcoin she wouldn't be able to earn at all. With an example like this, we can see precisely how empowering a technology Bitcoin really is. People in the United States and Europe that have purchased BTC primarily for speculative reasons might be catalyzing worldwide adoption by supporting a growing market value, but people in Latin America, Africa, and the Middle East with questionable local currencies and unreliable banking industries wholly necessitate a neutral and digital currency such as Bitcoin.

Satoshi's Intent

What exactly was Satoshi Nakamoto trying to accomplish with Bitcoin? For that, we must dive into his writings and correspondences in the early days of the Bitcoin network. He was desperate to provide an alternative not only to financial institutions, but also to currencies prone to devaluation by governments and central banks, an intent that's evident from his early emails and forum posts. On January 3, 2009, the first Bitcoin block ever mined by Satoshi himself included an embedded message instead of transactions (since none existed yet):

Satoshi placed a British newspaper headline about the ongoing financial crisis directly into the ledger's permanent record. By embedding this cryptic message, he speculated that his system for money and transactions offered a necessary evolution and a potential solution to the bailout-prone international banking system.

After Bitcoin had been up and running for a few weeks, Satoshi provided a little more detail on his motivations for the project and demonstrated an acute awareness of the instability of credit-money systems and lower, fractionally reserved layers of the money pyramid:

Satoshi Nakamoto revealed his ambitions for BTC to exist as a currency denomination, not singularly a payments network. He mentioned fiat currencies to refer to currencies issued on the second layer of money by central banks, regardless of what exists on the first; the word fiat originally means "by decree" in Latin. Satoshi's criticism of fiat currencies demonstrated a cognizance of the instabilities within our fractionally reserved, layered-money system. In hind- sight, the criticism does appear to have motivated him to create Bitcoin. Perhaps the fabricator wanted to provide the world with a new first-layer money that didn't originate from the balance sheet of a central bank.

Visions of Layered Bitcoin

The first vocal advocate for the Bitcoin software after Satoshi Nakamoto was cryptographer Hal Finney. Before Bitcoin's creation and building on the groundwork laid by Adam Back, Finney advanced the application of proof-of-work by designing the reusable proof-of-work system used by Satoshi Nakamoto in the design of his software; Finney's contri- bution to Bitcoin was cemented even before he became a Bitcoin user. Finney was Satoshi's earliest and most passion- ate enthusiast. He was the recipient of the first Bitcoin trans- action, when Satoshi sent him 10 BTC on January 12, 2009. Bitcoin was nine days old, and BTC had no price or market value to speak of.

In 2010, Finney provided a particularly fascinating explanation of how Bitcoin layered money might evolve, a prognosis ahead of its time. His quote almost feels like it was custom written for this book:

Let's summarize what Finney is trying to say within the context of layered money. BTC is a slower moving, first-layer money. A few thousand Bitcoin transactions are confirmed in each block, ten minutes apart. For comparison, the major credit card companies process thousands of transactions every second. In order to speed up Bitcoin's velocity, banks will need to own BTC as a first-layer money and issue second-layer deposits that can move more quickly than Bitcoin's chronologically irregular blockchain allows for. A second- layer Bitcoin would allow economic activity without friction. Fractionally reserved, liability-issuing entities will exist, and the market will price each form of second-layer BTC with an according interest rate. Finney was years ahead of Bitcoin's evolution with this prediction, one that time will prove to be the most prescient early words ever written about it. Bitcoin was redefining money and would take its place atop a completely distinct monetary pyramid. Hal Finney passed away in 2014, but his early insight into Bitcoin's potential as world reserve currency echoes in eternity.

LAYERED BITCOIN

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.

Source: Nik Bhatia: Layered Money
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