CHAPTER 2 - THE ROOTS OF CRYPTO MARKETS : EXPLORING BITCOIN’S P2P MARKET ORIGINS

The opinions below are those of the author(s) and should not guide investment decisions or be seen as investment or tax advice. This content is for informational purposes only and might not represent the views of any affiliated organizations or employers of the author(s).

By Adriano BERTINI — Head of Product and Strategy Ledger Enterprise, Bitcoin Association Switzerland Member

& Leonard KORKMAZ — PMM Ledger, Co-Founder Quantslab.com

October 2023

“Everything is theoretically impossible until it is done” — Robert A. Heinlein

A single point in time can be the defining moment for generations to come.

For most in the crypto industry, the birth of Bitcoin is that moment, but when was Bitcoin really born? It turns out that Bitcoiners don’t always agree on that…

For many, the 31/10/2008, the date of Satoshi Nakamoto’s first publishing of the Bitcoin whitepaper, is that defining moment.

For others, that moment came a few months later on Jan. 8, 2009, when the first version of the Bitcoin source code (Version 0.1) was deployed.

For me, the defining moment of every revolutionary technology is its first practical use.

This is particularly true for a technology that serves as money, as its value lies in its use.

That moment that made history came on May 22, 2010, when Laszlo Hanyecz, a Bitcoin source code contributor, completed the first documented exchange of Bitcoin for goods, by buying two Domino’s pizzas from Jeremy Sturdivant for 10,000 BTC (337.9 million USD as of 24/10/2023).

Yeah, I know, it’s a crazy story, $338 M for a pizza… better be juicy :)…

For me, this was the singular moment when two individuals decided to put Bitcoin into practical use, establishing its price for the first time and utilizing it as a medium of exchange — as money.

From a single pizza transaction to a $2.8 trillion market at its peak, Bitcoin has come a long way. And there’s a heck of a lot to unpack about this journey. That’s precisely what we’re diving into in this chapter: the genesis of Bitcoin, how this wild rollercoaster began, and the birth of a market out of sheer passion and innovation.

We’re talking about a system that sprouted from the fringes of the internet to become a global powerhouse. It’s a tale rife with visionaries, skeptics, and groundbreaking ideas. By the end of this chapter, you should be able to grasp the origins of this market, understand the hurdles early adopters faced, and maybe even get a hint of where we are heading.

It’s not just a financial revolution; it’s a testament to human ingenuity.

So, grab your favorite slice, settle in, and let’s journey back to where it all began.

Trust me; this is a story you don’t want to miss.

The Bitcoin Genesis and rise of Digital Peer to Peer (P2P) Markets

When the crypto market first emerged with the creation of Bitcoin, all trades took place directly between individuals — a system known as peer-to-peer (P2P).

Bitcoin was originally designed for P2P value exchanges, and that’s largely how it’s still used. Also, for several years, Bitcoin was the only cryptocurrency around. Essentially, the market was all about using Bitcoin as digital cash.

Much like a farmers’ market , the early BUYERS and SELLERS of Bitcoin would meet in public spaces — these ‘Bitcoin markets’ could be virtual (like digital forums) or physical locations — to discuss prices and close deals.

Back in the beginning, a lot of these Bitcoin trades and conversations happened on an online platform known as the Bitcoin Forum .

The very first recorded Bitcoin transaction was more an experiment: Satoshi Nakamoto , the anonymous author of Bitcoin, sent 10 Bitcoins to Hal Finney, an American software developer and key figure in the early Bitcoin scene. As far as we know, nothing was exchanged for the Bitcoins, the transaction was essentially a test.

In fact, a lot of these initial transactions were just that — tests. The early adopters were trying to see if Bitcoin could work as digital cash in real-world transactions. Hal Finney himself talks about these early days in his piece, “Bitcoin and me ”, a must-read.

Eventually, the Bitcoin community started growing, particularly within groups like the “Cryptography Mailing List ” where Bitcoin first emerged from. This was the hub where many cryptography experts, cypherpunks , and computer science enthusiasts came together. Many of them were convinced of the potential of Bitcoin technology to not just revolutionize internet commerce, but society as a whole. They saw Bitcoin as a way to re-engineer the foundation of public governance using cryptography. The cypherpunk motto was: “Cypherpunk Writes Code”. The group pre-dates Bitcoin and it is the movement from which the initial idea of Bitcoin technology was conceived. The group had as its main objective to preserve privacy on the internet, as a fundamental human right, and doing that using cryptographic technologies.

https://nakamotoinstitute.org/static/docs/cypherpunk-manifesto.txt

The first documented purchase, as mentioned, took place on May 22, 2010, almost two years after Bitcoin’s inception. Laszlo Hanyecz made history when buying two pizzas from Papa John’s with Bitcoin , marking the first recorded instance of cryptocurrency being used to acquire a tangible item. This moment was significant! For the first time, someone determined a public, real-world value for Bitcoin by trading it for something.

Every year, on May 22, the crypto community celebrates “Bitcoin Pizza Day .”

The importance of this day cannot be stressed enough; for the first time Bitcoin had a public price (a measurement of its value) and this event marks the moment Bitcoin began its journey of price discovery , paving the way to the creation of the market we know today.

These initial transactions held vital importance because they demonstrated to Bitcoin’s users that it worked as a “value exchange technology” capable of powering commerce: someone was willing to give the equivalent of 41 USD worth of pizza for 10k Bitcoin (10,000 BTC = 41 USD).

This sparked curiosity among more people, encouraging them to use Bitcoin to engage in exchanges or use it for commercial transactions.

Such enthusiasm led to the development of various distributed micro-markets, bringing together individuals interested in buying or selling Bitcoin. Driven by the necessity to find trading partners, these communities expanded organically, with more people meeting online or in-person to trade products or services for Bitcoin.

The early stages of this marketplace evolution included platforms like “Bitcoin Marketplace ” and “Bitcoin Forum,” among others.

Imagine the dynamics of a farmer’s market ; similarly, the peer-to-peer structure provided Bitcoin users with a simple and effective way to discover others’ interests in buying and selling, facilitating value exchange. In essence, places like the Bitcoin Forum and Marketplace served as public squares for trading.

Why P2P trading was first adopted as a method to use Bitcoin to exchange value?

You might wonder, why was P2P trading initially chosen as the preferred method for transacting with Bitcoin. Peer-to-peer markets, as it happens, are incredibly efficient for exchanging value. They’ve been utilized for centuries and continue to be widely popular globally in various trades, including commerce and financial transactions.

These markets are indeed one of the most efficient forms of value exchange because they present several significant advantages:

P2P Market Advantages

1. The cost of conducting a transaction is near 0:*

In a P2P transaction, only two parties are involved: a BUYER and a SELLER. There’s no third party or intermediary, which essentially eliminates direct costs associated with the transaction. The only “cost” is the time it takes for both parties to agree on a price and settle the assets.

NOTE: One important assumption here is that both parties in a P2P transaction have the same level of information on publicly available prices and no prior price-relevant information that the other party transacting doesn’t have (information advantage), as we will see this might be a strong assumption for P2P markets as information on public prices might NOT always be available.

Transacting at a higher price than the best available one can be detrimental to one party.

This concept, known as “Information Asymmetry,” refers to any situation where one party in the transaction might have more or better information compared to the other. The cost of information asymmetry in P2P transactions can be quite substantial.

2. Transactions are ‘semi’-private (using pseudonyms)

In a P2P exchange, only the buyer and seller are aware of the transaction details. Crucially, it’s up to them to disclose this information. This aspect is particularly relevant for cryptocurrencies like Bitcoin, where transactions are recorded on public blockchains, creating permanent, accessible records. If someone can link identities to blockchain addresses, all associated transactions — and potentially the wallet balance — become public.

Losing privacy could allow malicious actors to analyze spending patterns and anticipate intentions, exposing participants to various threats. These could range from business competitors seeking insights to scammers planning digital or physical attacks.

Privacy is a key component for fair and efficient markets, and the cost of not having transaction privacy can be substantial.

We will describe this point in more detail in a later article.

3. The trade is instantly settled:

In P2P exchanges, the terms are enforceable immediately, with settlement happening as soon as there’s an agreement (on average ~ 10 mins) . For instance, at a farmer’s market, once a buyer and seller agree on the price for a certain number of oranges, the exchange happens on the spot.

The same applies to face-to-face Bitcoin transactions. The seller provides the goods (e.g. Oranges) or services (e.g. a Haircut) only after seeing proof that the Bitcoin transaction has successfully occurred (demonstrated by confirmations on the blockchain).

For non-face-to-face P2P transactions, instant settlement is also the norm, but there’s an inherent risk: one party may not fulfill their part of the agreement. Specifically, the buyer might not send the promised Bitcoin, or the seller might not deliver the expected asset, leading to what’s known as “settlement risk.”

This risk is a significant concern in both crypto and traditional finance trading.

In the next Chapter, we will discuss the inherent risks in P2P trading and how the industry has attempted to mitigate these issues with minimal cost and effort.

SUMMARY — UNDERSTANDING THE VALUE AND CHALLENGES OF EARLY P2P BITCOIN TRANSACTIONS

Bitcoin allowed the start of a new kind of market-based on the peer-to-peer (P2P) exchange of digital assets. Here’s what makes those early Bitcoin trades special :

1. Direct Exchange of value, No Intermediaries

Participants engage directly, eliminating intermediaries. P2P transactions echo the directness of cash exchanges at a farmer’s market, albeit in the digital realm. This method cuts out the middleman, facilitating a straightforward and efficient exchange of value between parties.

2. Privacy Preserved

Engaging in P2P transactions means you’re not broadcasting your business to unnecessary third parties, keeping the details between you and your counterpart. Since you’re always in control, you can choose to reveal only what you want.

3. Instant Settlements on P2P transactions

Bitcoin provides near-instant settlement with on average ~10 minutes for confirmation.

Near-instant settlements in Bitcoin come with some risk. In virtual transactions, the absence of face-to-face interaction leads to the possibility of counterparty not respecting the terms of the exchange and not settling their side of the trade.

As we explore further, early challenges faced by P2P markets significantly influenced the evolution of technologies to improve market dynamics, all aimed at safeguarding participants’ interests without undermining the core principles of cryptocurrency.

NEXT ??

In the next chapter, we will review the risks present in both traditional and crypto transactions, emphasizing the innovative solutions that the crypto market has developed to address these challenges while preserving the fundamental essence of direct, decentralized exchange.