ECON120: Monetary History

BTC and CBDC Price Relationship

The underlying thesis of this book is that BTC will stand alone on the first-layer of money in the future. If only one word about Bitcoin could be used to describe why, we'd have to choose one coined only a few years ago in 2014 by author and seminal economic thinker Nassim Nicholas Taleb: anti- fragile. Here is how Taleb defined it:

Bitcoin is antifragile because it thrives off global monetary disorder within the dollar pyramid and is resilient to the threats, slander, and legislation from dismissive bureaucratic entities. The plain truth about Bitcoin is that nobody controls it. It has become the first-ever government-free, universally accessible digital currency. And for these reasons, all currencies in the purely digital realm will face price discovery in BTC terms. This means that all digital currencies, from cryptocurrencies to CBDCs, will be measured in BTC, just like the Bretton Woods agreement in 1944 mandated all currencies be measured in USD. Figure 18 elucidates a future in which BTC is the world reserve currency and only first-layer money.

In order for this type of BTC-denominated layered money system to evolve, a few technological details need to fall into place that might sound far-fetched but are already in development within central banks today. The last piece of the puzzle on the path to BTC becoming world reserve currency will be the atomic swap.

Figure 18

Atomic Swaps

Understanding the atomic swap and its role in the future of money requires the amalgamation of three elements discussed in this book: Lightning Network, Hashed TimeLock Contracts (HTLCs), and Distributed Ledger Technology (DLT). We'll quickly review the key aspects of each, and then show how they all fit together. Lightning Network is a net- work of BTC users that can transact instantly with each other instead of having to wait ten minutes for the next block to be mined. This is possible thanks to smart contracts called HTLCs. Separately, Distributed Ledger Technology (DLT) is a term that mainstream academia and central bank research departments use to describe Bitcoin-inspired software.

Now here's how all the terms are bound together. DLT software equipped with HTLCs that are compatible with Bitcoin's Lightning Network will be used by central banks to launch their CBDCs. If the smart contracts are compatible across digital assets, it would enable a world of atomic swaps.

An atomic swap is, at its core, a trade. It's a smart contract that allows for the trade between digital currencies without using a third-party exchange. This is absolutely revolutionary in the world of finance and trading, and let's use an example of buying shares of Apple to illustrate why. Say you want to purchase 100 shares of Apple at $100 each. You deposit $10,000 into a stock exchange. Those wanting to sell their shares will deposit them as well. The exchange is required in this situation to ensure that both the buyer and the seller have the money and assets necessary to complete the trade. Without a third party, traders would have to trust each other every time they traded. But with an exchange, that is not the case.

Atomic swaps fundamentally change these basic ideas of trading. They are programmed to execute the trade for both parties or for neither, eliminating counterparty risk, exchange risk, and default risk altogether. It's important to understand that atomic swaps will only work on central bank digital currencies that are built using DLT software outfitted with the same type of smart contracts present in Bitcoin's Lightning Network. However, this doesn't necessarily mean that a central bank issuing a CBDC on a distributed ledger would cede any control over the underlying currency.

Several implementations of DLT already allow for atomic swaps. Here is a real-life example of the work being done on atomically swappable central bank digital currencies. In 2019, the Monetary Authority of Singapore, the Bank of Canada, JP Morgan, and Accenture announced a successful atomic swap between Canadian dollars (CAD) and Singapore dollars (SGD) across two separate DLT platforms using HTLCs "without the need for a third party that is trusted by both jurisdictions". The transaction's setup was incredibly complicated from a software programming and computer science standpoint and took much time and care to execute, but this is the type of research monetary authorities around the world are conducting right now to explore the future of money. The Canadian central bank used a DLT called Corda, and Singapore's central bank used a DLT called Quorum, both solutions offered as products by private enterprises. The two DLTs have several fundamental diff erences but are compatible where it counts: they allow for HTLCs with each other. Central banks will need an increasingly large applied- cryptography contingent amongst their senior ranks in order to iron out all the technical details to CBDC implementation. Whether they decide to use a banking software solution, an alternative cryptocurrency, or Bitcoin itself, central banks have an array of options when it comes to their ultimate launch of digital currencies. If central banks want their digital currencies to thrive in the Bitcoin era, they will issue CBDCs that use DLT software with HTLC capabilities in order to join the atomic swap club. With BTC as the only first-layer digital currency, every other digital currency, no matter how powerful the issuer, will ultimately be measured against BTC.

FREEDOM OF CURRENCY DENOMINATION

Since the creation of the Bank of Amsterdam in the seventeenth century, monetary instruments and governments have been linked to each other. But in the digital age, money and state don't necessarily mix anymore. To many, the entire concept of government money is becoming obsolete as the rise of Bitcoin bellows in antithesis. Because Bitcoin is software, mathematics, and speech, it should be considered a human right. Bitcoin embodies freedom of currency denomination because it gives people the ability to denominate their earnings and savings away from government association. Whether people have changed their unit of account to BTC from their local currencies because of political ideals, nonviolent protest, or a belief that technology enables a novel form of money, they are naturally endowed with the freedom to choose how the fruits of their labor are measured. Bitcoin gives people around the world the first genuine alter- native to their national currencies, a trend which is impossible to reverse now that over 100 million people own it globally.

A Vision of the Future

Here's an outline of how our monetary future might play out in the context of layered money. Today, central banks employ trading desks in order to buy and sell their currency in the foreign exchange market in hopes to maintain exchange rate stability. In the near future, they'll add BTC trading capabilities to their open market operations in hopes to guide their digital currency's exchange rate in BTC terms.

Bitcoin has caused a seismic shift in the monetary balance of power away from governments, even as central bank digital currencies wait in the wings. China will launch its CBDC in preparation for the 2022 Winter Olympics. The European Central Bank, Federal Reserve, and other major central banks will be testing CBDCs by then and will follow with launches of their own.

Banks will issue stablecoins that off er advantages to holding CBDCs, such as higher interest rates or cash-back membership benefits. If friction is minimal when trading between one digital currency and another thanks to atomic swaps, the stablecoin universe will thrive as the source of credit elasticity, or lending. Banks will issue loans, record them as assets on their balance sheet, and issue stablecoins instead of deposits as liabilities. Banks can dramatically increase transparency and rejuvenate trustworthiness by using DLT, and transition to a dynamic balance sheet that allows the investing public to see live capital ratios instead of heavily window-dressed static quarterly reporting. In order to join the monetary order of the future, banks must issue stablecoins that are atomically swappable with other stablecoins, CBDCs, and BTC.  Banks will become masters of the atomic swap, making markets between digital currencies in order to pursue arbitrage and generate profit. With atomic swaps and instant settlement between digital currencies, a path forward exists for the transition to a Bitcoin-anchored monetary system.

Governments and corporations around the world will purchase BTC and hold it as a cash reserve because it reduces reliance on the current dollar system, indicating that the era of global dollar denomination is eroding in the direction of cryptocurrency, instead of any other government currency like the renminbi or euro. Gold will continue to serve as a trusted neutral money, but it has no realistic capability to serve as the rails for a digital financial system. This is not to dismiss gold as the best form of counterparty-free money the world has ever known: Bitcoin has only captured 6% of gold's total world- wide market value. Furthermore, gold's international monetary role has returned with a vengeance since 2007; central banks around the world have increased gold asset holdings dramatically as a hedge to the dollar system's instability and fragility. Gold is considered an insurance on monetary disorder and disarray, one that tends to work best during earth- quakes in the dollar pyramid. But gold's physicality falls short in a digital world where Bitcoin thrives. Eventually, Bitcoin will likely replace gold as the most desired neutral money and exceed it in total market value.

For the public, all money will be digital tokens that will be held in digital wallets. People will simultaneously hold an assortment of currencies: BTC for a neutrality, CBDCs for paying taxes and collecting benefits, and stablecoins for earning interest. Many will rely on second-layer CBDCs and do away with third-layer bank deposits altogether. A growing number of people will survive exclusively on non- government cryptocurrencies like BTC and never subject themselves to counterparty risk.

Money of Choice

Our multipolar world is looking for a monetary rebirth, and Bitcoin offers exactly that. Countries will resist, and some central bankers and politicians will succeed at keeping Bitcoin out of their countries because it threatens their power. But freedom of currency denomination will eventually emerge, whether it comes from banking havens in Europe, off shore money centers in the Caribbean, or the United States of America itself. Gone will be the days when an individual only uses the currency of the country where he or she resides. No currency in the digital realm will ever be able to prove itself as resistant to corruption as BTC, wherein trans- actions once confirmed are impossible to override, making Bitcoin the ultimate tool of financial freedom anywhere in the world. Bitcoin is where the Internet collides with money to bring about change in the same transformative way it did with communication and commerce.

Looking back at Bitcoin's origin through a layered lens, we can see that a new first-layer money had been invented. It was something the world desperately needed, and we are only beginning to understand its impact. In the future, the currency you use will not merely reflect your birthplace or country of residence, but your preferences. Use this map of layered money to emancipate yourself from the boundaries of traditional finance and explore a world of currencies without geographical confinements. Reference the layered money design to see exactly where your money exists in the monetary landscape and empower yourself to achieve freedom of currency denomination by navigating toward your money of choice.

Source: Nik Bhatia: Layered Money
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