CHAPTER 4 - BITCOIN AND P2P MARKETS: PART 1 of 2

HOW BITCOIN ADDRESSES CUSTODY RISK AND OTHER FLAWS OF NATIONAL MONETARY SYSTEMS

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 organisations or employers of the author(s).

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

& Leonard KORKMAZ — PMM Ledger, Co-Founder Quantslab

31st January 2024

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.” — Satoshi Nakamoto, Author of the Bitcoin White paper — October 31, 2008

Bitcoin Advantage vs Fiat Monetary System

In the public perception, the term ‘Crypto’ has become synonymous with trading and financial strategy. Interestingly, its origin lies in the term cryptography, where “Crypto-currency” indicates cryptographic applications to the creation of currency, payments, and new monetary systems.

When the blueprint for Bitcoin (electronic payment system) was initially outlined by Satoshi in 2008 and discussed in the Bitcoin public forum https://satoshi.nakamotoinstitute.org/posts/, one of the key fundamental tenet was the absence of central coordination for the distribution of coins and transactions transmission. The reason was that Satoshi didn’t quite believe that a system based on trust would have worked, especially trust in a central mint or transaction coordinators

(Satoshi direct quote — “A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990’s. I hope it’s obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we’re trying a decentralized, non-trust-based system.”).

Indeed, the trust given to centrally controlled systems not to corrupt the consistency and immutability of monetary data (issuance, and transaction sequence) has been breached again and again throughout history and has been proven to be feeble and easily broken.

Multiple examples are attesting to this fact, from the Roman Empire with the hyperinflation of the ‘denarius’ (the money minted and trimmed! By the emperors back at the time), to recent hyperinflation of the Venezuela Bolivar, Argentina’s Pesos, Lebanon’s Lira and more national currencies joining this list every year.

In 2008, Satoshi proposed a system, built from first principles, designed to eliminate single points of failure. A system based on the axiom that the minting and transfer of coins should not rely on trust. Bitcoin emerged as the missing piece in a broad spectrum of research and product development in distributed computing (e.g. P2P gossip protocol), and file sharing (e.g. BitTorrent) spanning over three decades. Bitcoin introduces a value layer to the internet’s communication layer and provides incentives to maintain the security of these decentralized resources.

Bitcoin has been therefore designed to endure the worst adversarial conditions where attempts to coerce the protocol towards centralization was to be expected.

Why this resistance by Satoshi and other researchers against centralized intermediation and coordination?

They understood that the current international monetary system was and still is too fragile, fragmented, and rigidly bound, to support the global heterogeneous nature, scale, and speed of transactions required by the internet.

They understood that in order for a new monetary system to fit the requirements of a market like the internet it would have needed to be more resilient, and have offered a significant improvement over the prior systems by overcoming their pitfalls.

If we look at current monetary systems most of them come short on several counts when it comes to efficiency and reliability. Most of those issues can be linked to the fact that those systems are centrally controlled. Below are, what I consider, the most critical shortfalls.

High Maintenance Costs:

Even if it seems that our current monetary system is quite efficient in terms of costs and processing time, it is actually quite far from it! By taking a quick look behind the curtain we can quickly realize that the yearly expenditures to keep the system running are quite exorbitant.

If we just focus for a moment exclusively on the cost charged by payment providers for transaction processing (Discover, Visa, Mastercard, American Express etc.), we can see how relevant the cost is.

Transaction fees charged to merchants/users varies between 2–3% on each transaction.

In 2022 alone 625 Billions transactions using those payment systems occurred:

• Number of purchase transactions on global general purpose card brands American
• Average Credit Card Processing Fees and Costs in 2023

With an average of $20 per transaction (a conservative estimate given that recent estimates range between $20 to $50) it amounts to a total value of ~ $13 trillion transacted across 625 billion transactions. A 2% charge on these transactions results in approximately

$260 billion in transaction fees spent annually. Each merchant absorbs this cost by incorporating it into the price charged to the end consumer (us).

Additionally, merchants may increase the price further to cover for the additional costs of the technical equipment required to support credit card transactions, and extra fees charged by banks holding funds.

“The National Retail Federation….claims that swipe fees cost Americans over $1,000 a year through either higher prices or credit card swipe fee surcharges.” — Lyle Daly & Jack Caporal -

To add to this, the cost required for the credit card companies to run their operation is also quite extraordinary, these companies have to deal with daily complaints and claims to the number of billions in charge backs, frauds amounting every year to tens of billions of dollars (36 Billions in 2023)

• Annual Chargeback Report & Statistics
• Concerning Credit Card Fraud Statistics & Facts for 2024

Another crucial cost factor arises from the necessity for each of these payment processors to maintain personnel, infrastructure, and compliance with various regulatory authorities, which often involves additional operational requirements.

Annually, these firms incur substantial expenses for accounting and the implementation of internal controls to ensure ongoing compliance with progressively intricate rules and regulations.

All of this infrastructure and massive cost just to make money move from one person to another, from Buyers → Sellers:

In regard to processing time, current payment systems are not as efficient as we believe to be.

The time it takes to complete a payment can be quite long indeed.

It appears to us that the payment takes a few seconds but indeed what we witness when we pay with a credit card is just the confirmation of the intention to pay (a credit with the promise to settle).

Every time we pay for something we are basically creating credit. What is immediate is the confirmation of payment, not the transferring of money (settlement). The subtle difference is not that subtle after all: until the payment is cleared and settled, the receiver won’t be able to see the money as received on its account and most importantly won’t be able to spend it (this is when you see a transaction on your account in “pending” state).

The settlement of funds could take within a day or even several days depending on the time the banks need for clearing payments, and the parties involved in the payments (level of risk, processes and procedures required to accept the payments) .

So it turns out that what we thought was a very efficient, cheap, and fast means of payment is indeed not as good as we would have hoped for.

More concerning, with the expansion of the internet and with more people willing and able to transact, the scale of processing, and need for efficiency will increase, so the requirements on these networks will become more and more difficult to match.

One last point regarding maintenance costs is energy consumption, which has been a focal point of debate, particularly concerning Bitcoin mining.

While it’s true that Bitcoin mining is an energy-intensive process, it’s important to note that the energy consumption of Bitcoin mining pales in comparison to the electricity used by the traditional financial system infrastructure.

The current financial system, encompassing card networks, buildings, bank branches, ATMs, and all the accompanying infrastructure, is estimated to consume, on average, three to four times more energy than Bitcoin mining.

Bitcoin’s energy consumption is expected to rise, but the competition among miners for cost-effective electricity sources is driving them to seek low-cost energy options, such as excess energy from power plants or sustainable sources like solar and hydro (50% of bitcoin’s power mix now comes from renewables).

For miners, who earn rewards through Bitcoin mining (more details on this later), electricity constitutes a major expense. Therefore, reducing energy costs becomes crucial for improving their profit margins. Miners strive to mine more efficiently, striking a balance between increased mining output and lower energy consumption.

In contrast to the growing energy demands of the traditional banking system, Bitcoin aims to optimize its energy consumption. It effectively transforms otherwise wasted or dissipated energy into stored wealth within the Bitcoin network. This optimization strategy positions Bitcoin as a more energy conservative alternative.

So while the current banking system’s expansion contributes to increasing energy consumption, Bitcoin actively works to enhance energy efficiency, channeling otherwise wasted energy into a valuable store of wealth.

Inflationary Monetary System:

National (Fiat) money is in most cases inflationary, which is a fancy word to say that prices in the economy, measured as units of national currency, rise through time (Japanese Yen being the exception). The rise of units of national currency required to buy goods and services (increase in prices) is a really bad trend as it makes purchases more expensive, relative to salaries which generally don’t grow as fast (salaries are sticky).

In very simple terms this rise in prices (inflation) without an equivalent raise in salaries makes everything more expensive and everyone effectively poorer.

Also, this makes it more difficult to measure the value of stuff (goods and services) being produced in the economy, as the standard of measurement keeps changing.

A good analogy is: measuring the lengths of the furniture that you want to fit in your house with a meter that keeps changing in length, constantly… quite challenging indeed!

There could be few reasons causing inflation but the most common, consistent, and problematic through time is “money supply inflation”, the tendency of national governments to print and pump money in the economy in order to sustain trends of low economic activities or to finance expensive initiatives (war, economic recovery plans etc.).

The temptation of central governments to debase the currency (by printing) to pay for ever growing debt, instead of reducing spending and reinvesting into more productive industrial endeavors, is way too high to be controlled in the long run.

So governments tend to push the money printing machine button more often than not, when they need to “balance their budget” (pay for their debt). By then creating money that doesn’t have an equivalent amount of value produced by the economy: more money chasing fewer goods, and therefore reducing the value of money itself vis-a-vi the value of people’s earnings and savings.

Inflation eats up the earnings of individuals that effectively see the value of what they have earned from their produce being eaten up by shadow taxation. A tax that you don’t see but nonetheless makes you poorer.

This makes most of the national currencies poor as stores of value, and units of account for value produced, two of the critical properties of money.

Lack of Privacy and Control Over Your Money:

Every transaction we make daily using a credit or debit card is recorded in central databases managed by financial institutions such as Visa, Mastercard, American Express, Discovery.

Payments occur at the merchant via Point of Sales (PoS) systems, either physically (by swiping a card) or online (by entering personal data). This information is constantly transmitted from the PoS system or the website to the credit card companies, banks, and institutions responsible for processing transactions and transferring funds from the buyer to the merchant.

This process exposes your personal and financial information to a significant risk of information leakage, either because the information is compromised during manual processing or due to payment systems or databases being hacked.

Despite billions of dollars being spent annually to build and upgrade security systems, standards, and procedures to ensure the integrity of these networks and the data transmitted, multiple security breaches are reported every year.

You can find more information about this here:

• 10 Biggest Data Breaches in Finance [Updated August 2022]

The issue lies in the fact that the current systems are designed based on centralized servers. This design provides an incentive for hackers to search for and exploit vulnerabilities, as they only need to compromise a relatively small number of services.

The vast majority of hackers are incentivized by profit, and measure an attack based primarily on ROI and risk associated.

If the expected return from their attack exceeds the cost of the resources required to execute it, they will launch the attack.

So the constant challenge for institutions securing financial data is having to perpetually improve the security architectures and procedures around systems processing and storing financial information, so that it is economically unfeasible for a hacker to launch an attack.

As you can guess this is an ever-growing problem, as attacks continue to become more and more sophisticated with the increase in economic value processed vis-à-vis economic incentives.

So centralized servers securing financial information are destined to increase spending to strengthen their security architecture or fail trying. Not very efficient, quite fragile, and prone to fail in the long run.

The final point relates to maintaining control over your money. While, at first, this may seem a philosophical point, it has very tangible and real consequences.

In a system where payments are controlled and authorized by a centralized server, such as a credit card company or payment service, these institutions possess the authority to halt a payment if they deem it necessary.

For example they can consider a payment to be “not compliant” because it violates some of the rules defined in their system. Now the question that should be asked is “which rules?” of “which country?”, in “which contest”, “who would be ultimately responsible for setting up those rules in an ever connected international marketplace like the internet?”.

These questions are not trivial and mine the foundation of the concept of money, and free markets.

Money technology works if permissionless and personless, if this is not the case then the conditions on which money can be spent are no longer uniquely defined by people’s individual utility but by arbitrary rules that supersede individual preferences, and necessities, which then begs the question: are this money really “yours”?

If you don’t have control over it, how can you trust money to preserve your value, and since the current system is based on trust, what happens if this trust is lost…we had a glaring example of what happened during the financial crisis in 2008–2009. Interestingly coinciding with the first release of Bitcoin software and related whitepaper.

It seems as if current monetary systems failed to safeguard from a critical risk that we have covered in the prior chapters: Custody Risk.

But if the trust in the current financial systems is eroded, people’s trust in the monetary system is lost and money stops working as a medium of exchange as we have seen in hyperinflationary countries like Venezuela, Argentina, Lebanon and more.

Then what would be the alternative medium to transact?

Would we go back to barter?

Would we let the great economies and wealth we built in the last few centuries disappear?

We will address those questions in the second part of this chapter.

Stay tuned!