The Future of Digital Currencies

In his renown book The Wealth of Nations, Adam Smith explains the idea of “spontaneous order”, which argues that order, in fact, emerges in a society as a consequence of the needs of the people and their voluntary activities as individuals, rather than it being created by the government. This is crucial to the understanding of the free market, as it explains how the needs of the people drive both the local as well as the global economy. When enough individuals find themselves in a particular conundrum, whether it be something extremely complex like a disease or fairly simple such as resting, the market often times will aim at bringing about innovation for the consumers by providing a solution to such problem. This not only benefits the company who is profiting economically by selling their product, but most importantly benefits every consumer who had that particular problem in the first place. As one can see, then, everything in the world is created with a particular purpose, to resolve a certain affair. Digital currencies subsequently are no exception to this rule, as they are a response to the need of people of a decentralized, universal currency, as well as providing an alternative to the government’s intervention in the economy.

The History of Money

In order to further understand cryptocurrencies, however, it is important to address the idea that money, by itself, is nothing more than a piece of paper. Weather it be shells, fish, or coins, money is something that derives its value by being a medium of exchange commonly accepted in society. This allows people to trade goods and services, giving value to money merely because everyone else accepts it as a form of payment. This type of payment system was born out of necessity as people were tired of how complicated and time-consuming bartering, understood as the exchange from one good for another, had become. Because you had to find something specific the other person wanted in order to trade, this rapidly became increasingly convoluted as people had to go in for long periods of time struggling to find the other person’s necessities to get what he or she really wanted. Because of this inconvenience, money is created to speed the process along of doing business with one another, hastily expanding the quantity of products available for consumers.

In one way or another, money has been part of human history for at least 3,000 years, with prehistoric currency goes all the way back to salt and weapons (Beattie). But as these became bigger and eventually harder to carry around, the Chinese switched from using the actual physical item, to just doing replicas of the tools they had for trade in bronze as a way of showing people what they had without having to carry it around everywhere. Because the spades and the daggers were too spiky, however, people started just shaping them in circles, leading up to the birth of the first coins, which were made by base metals. At this point, the bank started releasing “one-foot square pieces of white deerskin with colored borders,” which they used to symbolize the items at home (Reed Edge). As these evolved, however, China moved from coins made from base and precious metals to animal leather, eventually leading up to the birth of paper money in the span of a few hundred years.

As the precursors of this idea, then, they were the first ones to face massive inflation as well, as the currency grew in production and further depreciated the value in and of itself. Mainly because of this, paper money disappeared in China for three centuries, until it became common again, now used among Europeans and other Asians as well (Beattie). In 1816, gold became the standard of value in England as they learned from the Chinese failure and regulated the production of the banknotes, which represented a set amount of gold. Unlike most developed countries at the time, the United States was actually one of the last countries to pass the Gold Standard Act in 1900, which established the Federal Bank as it is understood today and began a monetary system in which paper money was recognized to be convertible to gold (“The Gold Standard Revised”).

However, with the outbreak of the First World War in 1914, political alliances were broken and government finances deteriorated, causing the gold standard that had united and dominated the world system for years now to come into a sort of economical limbo, as it demonstrated its inability to hold through the hard times. As people started doubting the system, then, this brought along popular distrust and economic difficulties, leading people to believe that the world in fact needed a more flexible currency in which to base its economy. As the Great Depression swept people to the streets with the stock market crash of 1929, commodity prices crumbled and completely transformed global economy (Reed Edge). It is no surprise, then, that by 1931, England suspended the use of the gold standard, causing the US to have 75% of the world’s gold by the end of the Second World War (“The Gold Standard Revised”). Nevertheless, the high inflationary environment of the late 1960’s subsequently caused President Richard Nixon to believe that the gold convertibility was not really needed, and by 1971, the last bit of the gold standard system disappeared forever.

The evolution of digital currencies

As time went by however, the technological era evolved evermore until the it eventually paved the way for digital currencies to emerge. The first cryptocurrencies created responded to a perceived fear in the population of typing one’s credit card number into the cyberspace as a way of purchasing goods and services through the Internet. As this innovative system came about, however, this fear was proven unfounded, as people showed no reluctance to doing so, which caused these currencies to disappear almost to its totality. The second generation, however, also referred to as “digital gold currency,” was, once again, backed by “valuable physical assets, currently limited to precious metals” for value, aiming at imitating the gold standard as a payment system with something that was scarce and already held commodity value (Tucker, Peter C). It is with this second generation, then, that the formal understanding of a digital currency came about, explained as a “store of value that is both (A) issued by a private entity and (B) fungible via an established system of exchange on the internet” (Tucker, Peter C).

Bitcoin, a case study

The most recent example of this type of digital commodity is the decentralized currency, Bitcoin, which innovatively uses peer-to-peer networking to self administer the system. Instead of it being backed by gold, it is backed by a mathematical algorithm which enables the creation of more Bitcoins until its maximum of 21 billion, making the currency scarce. Although known by most as a money-laundering payment method that allows the evasion of taxes and trade of illicit goods, Bitcoin has proven to be much more beneficial to the world than just as a criminal haven. Created in 2009 by an unknown person who goes by the cyber-alias of Satoshi Nakamoto, Bitcoin is the world’s first digital currency not to be backed by any government to its entirety. With an economy larger than some of the worlds smallest nations, Bitcoin has grown shockingly fast since it was released to the internet for the first time, reaching a record high of $1,242 per coin (Christensen). Although this rise in value was due to a variety of factors, one of the most important one is the fact that Bitcoin works as a payment system as well as as a currency. Before Bitcoin existed, online transactions always required a third party intermediary, like PayPal or MasterCard, so that online money could not be spent twice. With the invention of Bitcoin, however, the double-spending problem is solved without the need of third party intervention and no government regulation; left entirely open to the free market. Because the value does not derive from government fiat or gold, it is solely based upon the value assigned to it by people, traded in the free market just as the exchange between any other world currency.

Through the clever use of cryptography, transactions are verified and bitcoins are being mined at the same time, preventing the double-spending phenomena that has haunted secure online transactions for decades. What is unthinkable to most is that there is no central authority in charge of creating the currency or overseeing the transaction, but rather all this is down via the mathematical algorithm. “Miners,” or Bitcoin producers, are computers with an enormous processing power solving an increasingly hard algorithm over and over again until the established cap of 21 billion Bitcoin is reached. As a result, the network depends on these math-solving users as a way of not only producing more Bitcoins, which are given to the miner as an incentive to keep producing, but also to verify the transaction is being recorded and time-stamped, to be displayed publicly on the internet. Of course, the fact that there is no government behind it causes a sense of uncertainty to most people, followed by the fear or lack of faith on the success of such a payment system. However, once surpassed this dilemma, a whole new door opens up of possibilities, both positive and negative.

Pros

First of all, Bitcoin transactions are cheaper and faster than most all other payment systems. Because there is no third-party intermediary, no one is getting any profit for the transaction, and therefore service costs are eliminated entirely. As a consequence, this has potential to drastically transform lives, particularly in less developed countries with currencies that become increasingly devaluated, as it leads way for people to change Venezuelan Bolivars, for example, to Bitcoins, and use it as the “unofficial” currency, effectively supporting Venezuelan economy. This can also be seen in regards to global remittences, as one is able to avoid all the charges companies like Western Union, among others, implement, by virtue of converting one’s currency into Bitcoin and later transferring the money online. As expressed by the World Bank, “in 2012, immigrants to developed countries sent at least $401 billion in remittances back to relatives living in developing countries” (World Bank Payment Systems Development Group).This will help alleviate poverty in less developed countries where a family’s sole income is the remittance sent from their relative abroad.

Because of its low costs, then, Bitcoin attracts individuals from various different fields, ranging from small business owners, who often have to pay a variety of authorization fees, costumer-service fees, transaction fees, among many others, to migrants, whose money is earned and delicately counted to send as remittances to their struggling families in their home country. Bitcoin has also been successful in engaging a wide sector of online commerce, particularly because of the lower prices some of these companies are able to enforce. For example, in online market, Bitcoin store, a Samsung Galaxy Note tablet is merely $480, almost half than what it costs on Amazon, $779 (Bitcoin store listing for a Samsung Galaxy Note tablet). Because of its decentralized nature, then, Bitcoin has the potential to improve the lives of world’s poor, mainly by providing these people with an inexpensive access to financial services they would have otherwise been unable to afford. In this sense, it provides an alternative for those people in countries that hold strict monetary policies, such as Argentina, for instance, whose population have adopted Bitcoin “in response to the country’s dual burdens of a 25 percent inflation rate and strict capital controls” (Brito). Because the total number of Bitcoins that can be mined has been capped to 21 billion, this allows for an escape route for people when their country’s currency has been devalued or in a frozen capital market. This also allows for financial innovation, since Bitcoins are mere packets of data, and so therefore they can be used to transfer not only currencies, but stocks and other sensitive information. Some of these features are already being worked out by start-ups, as the financial platform is all they really needed to start sharing private files (Brito).

Cons

Just like cash, if misplaced or left unprotected, Bitcoins can be stolen in the cyber-world by hackers. Bitcoins are kept in Bitcoin wallets, which if left unprotected — or without any encryption — they can be stolen through a malicious software, used to disrupt computer operations and gain access to sensitive information. However, these types of events are no stranger to any other regular currency, which can be stolen or lost by mismanagement of the user. Just like the world did with other currencies, then, it will take trial and error practices for Bitcoin users to learn how to protect their wallets and acquire knowledge as to how to take care of security concerns.

Something else than has astonished most is the system’s anonymity, particularly when while signing up for a wallet, people are not even asked to provide any other information besides an email and a password, not even a name. This in turn, produces a series of numbers that will become one’s identity in the Bitcoin world, through which people will recognize one’s own transactionsin the public sphere. Mainly because of this, some scholars argue Bitcoin is not in fact anonymous, but rather pseudonymous, as one’s identity in fact becomes those numbers (Brito). Because everyone has a public key, this can always be tracked back to the IP address which made the bitcoin exchange and have a better perspective as to where the person made the transaction. Although this does not reveal the identity of the user, “one study found that behavior-based clustering techniques could reveal the identities of 40 percent of Bitcoin users,” as one can track a number’s history of transactions and eventually find their locality. Some argue that once Bitcoin is formally introduced into the economy, it will be forced to be fully compliant with the banks’ secrecy regulations required for traditional financial intermediaries, and so Bitcoin will become less and less anonymous, as these intermediaries will likely be forced to collect more personal data on consumers.

It is mainly this anonymity, nonetheless, which makes Bitcoin the easy target for crimes such as tax evasion, money laundering and the trade of illicit goods and services. A renown case is that of the Tor website called “Silk Road”, which sold online drugs and other illegalities such as fake identity documents, and many others. Thanks to the pseudonymous nature of Bitcoin, this was the currency of choice by the website and made it rather easy for people to do online shopping for these illegal items and get them delivered straight to one’s home. This allowed people to purchase illegal goods, just as people have been doing with cash for hundreds of years, only online, making it easier and more convenient to the consumer. Although this is a reality, it is also important to note that Silk Road transactions were estimated to be around $1.2 million monthly, which is a small drop in the $770 million Bitcoin economy (Christin, and Brito). Besides from its uses on global online commerce, scholars are also afraid of Bitcoin’s possible uses in financing terrorism and money laundering. Although this fear has proven to be more hypothetical than evidential, it is a reality the must be faced, as this is indeed a possibility. Although understandable, however, it is one of the same problems that apply to cash, as it has historically been the anonymous medium of choice for those involved in criminal activity.

The future

“We have gold because we cannot trust governments,” said President Herbert Hoover as a statement to Franklin D. Roosevelt in 1933, envisioning the elimination of the gold standard in the United States (Ganesh). Just like he suggested, then, after the elimination of the standard in 1971, currency got incredibly complex, as the value of it is now determined in comparison to the value of other global currencies. This highly impacts global trading, since a currency that is stronger will be able to buy more goods from a country whose currency is devaluated. Because of this, it is not uncommon that countries would purposefully devalue their own currency by overproducing it in order to export more of their goods and services to countries with a stronger currency. Countries with a stronger, more stable monetary system are usually more developed nations, as the difference in price within the different monetary units reflects the local market conditions and helps currency traders get a better overall calculation of the future of such economy. As a country produces more of its own currency, then, the monetary unit looses value and creates an inflationary trend that is incredibly hard to impede. Because the currency looses value but the prices on products stay the same, people loose purchasing power as a result, and are therefore degrading their own lifestyles. As governments produce less of their currency, however, it eventually becomes unsustainable to afford a better life as well, since the currency is worth so much, everything becomes more expensive.

As a result of this dissatisfaction with the current currency exchange, fluctuating and constantly affecting the globe economically, there is a want for a more universal country that is not backed by a particular government but rather by the free market. Although Bitcoin is the most effective of them all, digital currencies overall bring to the table an alternative that did not previously exist, and which fulfills the need of having a currency that does not depend on a government’s policy-making abilities. Particularly for someone concerned with the government’s direct intervention in the economy, digital currencies like Bitcoin offer a response to the desire of a private currency, which can prove universally effective. Although it is very fluctuating at the moment due to the different mining speeds available, cryptocurrencies have proven to have potential to do great things for the world economy. Bitcoin, along with many others, are becoming increasingly innovative and what today is highly fluctuating and unreliable, tomorrow, through innovation, it has the potential to be stable and beneficial. Digital currencies’ time might not be right now, or even the 21st century, but it is the future, and as such, we must be aware of the endless possibilities that await us and try to understand them as much as possible.

Works Cited

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Brito, Jerry, and Castillo, Andrea. Bitcoin: A Premier of Policy Makers. Fairfax County, Virginia: Mercatus Center at George Mason U, 2013. Google Books. Mercatus Center, George Mason University, 2013. Web.

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World Bank Payment Systems Development Group, Remittances Prices Worldwide: An Analysis of Trends in the Average Total Cost of Migrant Remittance Services (Washington, DC: World Bank, 2013). Web.

Christin, Nicolas. “Traveling the Silk Road: A Measurement Analysis of a Large Anonymous Online Marketplace.” Carnegie Mellon CyLab Technical Reports: CMU-CyLab-12–018, 30 July 2012 (Updated 28, November, 2012). Web.

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Beattie, Andrew. “The History Of Money: From Barter To Banknotes.” Investopedia LLC, n.d. Web. 04 Dec. 2014.

Bitcoin Store listing for a Samsung Galaxy Note tablet, accessed May 29, 2013. Web