Cryptocurrency and the Legacy of Money*

In his fundamental book, Money and the Mechanism of Exchange, English economist William Stanley Jevons explains that currencies address a central economic problem: the coincidence of wants - the COW problem for short. The phrase describes the conundrum inherent to barter where the parties of the transaction have to agree to sell and buy each other's goods. The obvious challenge is the improbability of the wants, needs and events that would enable such a transaction occurring at the same time and the same place. In absence of this double coincidence of wants, the parties need to agree on an acceptable substitute: a medium of exchange. While Jevons included the latter function in his definition of money, his thinking was necessary informed by and limited to the technologies of his days (1875). The following is a review of the definition of money, the state of currencies and their potential trajectory with consideration of current technologies, including blockchain-based solutions and so-called "cryptocurrencies".

Currency versus Money

While frequently used synonymous, money and currency have different meanings: currencies are systems of value exchange. Money is most often still defined as medium of exchange, unit of account, standard and store of value, referencing a definition established by Jevons in 1876. Considering that Graham Bell received a patent for the telephone around the same year and that Jevon's could not have known about digital forms of exchange, it seems past-due to re-evaluate the usefulness of this definition of money with respect to solving the COW problem.

Medium of Exchange

Throughout history, media of exchange have taken on many different forms and still do so to date. Depending on the time and place, gold coins, stones and shells have been used as money. Commodities such as gold and silver coins were followed by commodity-backed mediums - usually paper certificates - exchangeable for specific amounts of a valued commodity such as a metal. What these technologies have in common is that the simple transfer of the instrument from buyer to seller combines the payment and settlement of a transaction: they are bearer instruments.

Today, the medium of exchange is most often expressed through the manipulation of digital entries of account ledgers expressed in fiat money. The latter quality refers to the suspension of commodity backing of money by governments unwilling or unable to settle outstanding commodity obligations. Instead, legislators invoked legal tender laws, which establish certain instruments as acting as money. As the accounts of buyers and sellers are most often maintained by different financial institutions, these necessarily must cooperate to update the digital ledgers of the parties to reflect the exchange of money.

Bytes are the default medium of exchange to-date.

Depending on the banks and technologies involved, the process of adjusted these distributed ledgers can take between 24 hours, days or even weeks for a cross-border transaction. Until recent, consumers requiring bearer instruments for peer-to-peer transactions with immediate settlement were mostly limited to IOUs printed as bank notes, commonly referred to as ‘cash’.

Electronic Cash

In October 2008, a paper published under the pseudonym Satoshi Nakamoto introduced the concept of a peer-to-peer electronic cash system referred to as ‘Bitcoin’. As the paper explains, entries in Bitcoin’s ledger are protected from manipulation by a cryptographic scheme, which hashes transactions in time-stamped intervals into blocks. This function inspired the term "blockchain" to describe a decentralized, public ledger and "cryptocurrency" - "crypto," for short - for the denomination of entries on that ledger - a rather unfortunate terminology that has led to much confusion among software developers and regulators alike.

Similar to the architecture of the internet, blockchains do not rely on a single entity or consortium; entries on blockchains can be created by anybody operating the software. A sophisticated combination of encryption and game mechanics ensure that transactions performed on a blockchain are next to impossible to alter. The latter quality - also present in other blockchain-native assets, such as Ethereum’s ether - made bitcoin (the lower case 'b' differentiating the asset from the blockchain) the first ever digital bearer instrument.

Digital Bearer Instruments

Blockchain-based assets - including bitcoin - can be imbued with additional functions through smart contracts, creating a form of "programmable money." Like their real-world counterparts, these digital bearer instruments do not require users to involve trusted third parties in the transaction. As documented by many block explorers, the Bitcoin blockchain, through its independent network of miners, confirms transaction between parties inside of 10 minutes at a nominal fee. And, unlike bank transactions, which can take days and sometimes weeks to settle, new entries on a blockchain are final, and the recipient is free to use the funds immediately.

Store of Value

A short glance at the world’s inflation rate statistics published by the International Monetary Fund quickly dissuades the notion that government-issued fiat money make for a stable store of value. And, while most nations so far have escaped the levels of hyper-inflation afflicting countries such as Venezuela (10,000,000%), Zimbabwe (73%) and Sudan (50%), historically fiat currencies have not lasted more than 25 years.

Bearer instruments introduced by federal mints such as pennies, dimes and quarters, bought daily products and services (the Daily Times was sold for one penny in 1900). Today, these instruments have mostly lost their usefulness. Even though most US coinage today has become impractical for purchases, and several coins are even being produced at cost greater than face value (more here), coins are being created at great cost to tax payers who would be better of collecting these for their metal value.

Cryptocurrencies

As outlined in a previous article, the term “cryptocurrency” at best describes a very small subset of blockchain-derived assets accurately. And even coins and tokens created for the specific purpose of functioning as currencies have found little consumer adoption. A number of projects have singled out volatility as the main problem. This led to the creation of a new category of cryptocurrencies, referred to as "stable coins." The most noteworthy entrants in this growing category thus far with market capitalization according to CoinMarketCap of $3.4 billion and $343 million as of June 16, 2019, are Tether and USD Coin. These tokens are pegged to the U.S. Dollar, with the objective to maintain a one-to-one correlation (so it might be more accurate to call these tokens 'USD Pegs'). While it might be too early to judge if stable coins will increase consumer adoption, it seems doubtful that these instruments can challenge fiat incumbents on their home turf as long as consumers are required to convert fiat money to the new medium.

Unit of Account - Money as Language

Cryptocurrency exchanges and wallets throughout various countries, show subtle, albeit significant differences, when displaying blockchain-based assets. Even though most applications may default to English as lingua franca, users may see a conversion of their digital holdings to their local legal tender. As such, ‘money’ might also be thought of as an individual’s ‘language of trade or value’. If presented with a number pre-fixed with a symbol that is not part of a person’s daily vernacular, he is forced to translate the value into the familiar denomination. While tokens pegged to fiat might not require such as translation, there are few counter-parties to-date willing to accept these ‘pegs’.

Historically, citizens have turned to alternatives of fiat currencies when the buying power of their government-created payment method weakened drastically due to inflation. While commodities such as gold continue to be a popular choice for wealth preservation, these do not provide much utility for day-to-day expenditures. Instead, consumers have often turned to bearer instruments issued by other nation states. In some instances, a country may even move to the drastic measure of abandoning its sovereign currency in favor of another country’s money -- as is the case with Ecuador, East Timor, El Salvador, Marshall Islands, Micronesia, Palau, Turks and Caicos, British Virgin Islands and Zimbabwe; all the aforementioned countries, list the U.S. dollar as official currency today (more here).

While the global digitization of currencies has seemingly created a level playing field for the world’s fiat money, consumers are reluctant to adopt a new language of trade. When a local currency shows strong signs of failure, citizens are most often turning to a seemingly ubiquitous form of cash such as U.S. Federal Reserve Notes.

Conclusions

Historical definitions of money and currencies do not account for the current state of technology in general and blockchain-based solutions on particular. Money - as unit of account - can be understood as language, without regard to a particular store of value function. As such, there is sufficient evidence by now that "cryptocurrencies" will continue to fail in supplementing fiat currencies in a meaningful way as "money" - similar to the failed approach of introducing an artificial world language (Esperanto). While stable coins - in form of fiat-pegs - might play a small intermediary role on the way to a solution, a successful blockchain-based architecture must implement currency as protocol through consumer-facing applications that provide a seamless bridge to legacy technologies created for fiat. Just as the voice-over internet protocol (VoIP) empowered Skype to challenge phone carriers worldwide, this final step -- which legitimately defines "money-over IP" -- will redefine money.

Similar to written letters and postage stamps giving way to email messages, legacy systems of money, and their representatives (i.e. banks) will consequently be relegated to the obscure corner of technology inhabited by rotary phones and dispatchers. The solutions to the COW problem are to be found in client applications which push the use of middlemen and legal tender to the fringes, converting actual stores of value to mere fiat ledger entries only when needed as a short term exchange mechanism to legacy systems limited to accepting these inflationary debt certificates.

*I publish these thoughts for peer review - not kudos. After I wrote the initial version of this article in December of 2018 it was published on Forbes.com under the title The Future Of Money: From Cryptocurrencies To Money-Over IP in January 2018 as 1,000 word version. The above version is about 60% longer and I will add to it and revise as I get more insights and feedback (last revision: 10/11/2019). My last article on investing in blockchain can be found on Forbes.com. - If you prefer videos over long-form text, please watch my last talk on Investing in blockchain from OnChain19 below.

P.S. This thoughts are part of a multiyear effort to establish valid theses for our blockchain venture fund, that will also be published as book under the title Streaming Money in 2022.