There are a lot of buzzwords being thrown around the internet these days. There is simply no way to keep up with what's going on unless you spend time reading about cryptocurrencies every day.
We want to equip investors with enough knowledge to be able to tell what's hiding behind the buzzwords - the biggest socio-economic revolution that humankind has ever seen or just an internet scam project that's trying to cash in on the hype and take money from uneducated investors. Feel free to leave feedback and suggestions in the comments under this post, we always love hearing from our readers. We hope you enjoy learning with us.
What is Money?
The thing that differentiates man from animals is money. Gertrude Stein
The words Bitcoin and blockchain both deserve a place in the book of the greatest inventions of humankind alongside with the Newton's laws and the famous Einstein equation. But what is hiding behind those words? What do they really mean? Let's find out!
Bitcoin is a radically new form of money. It's invention is a byproduct of globalisation, increased demand for international trade, and it is simply the latest step in the evolution of commerce. It is not the same kind of money like your US Dollar, British Pound or the Japanese Yen. And yet Bitcoin, or the digital gold as they call it, is money because it successfully fulfills its functions: a medium of exchange, a store of value, global recognition, limited supply and protection from counterfeits.
Unlike gold, Bitcoin has a couple other qualities that make it more useful in the modern digital age. Unsurprisingly, all of these functions stem from the virtual nature of this asset.
Firstly, bitcoin is the first form of money that can be owned by both humans and autonomous computer systems, such as artificial intelligence in the far future (AI) or smart contracts like a decentralized casino, on equal terms. While not immediately practical for our current economy today, Bitcoin opens up the door to a world of brand new opportunities for economic growth in the future.
Secondly, bitcoin is easy to store. It does not take up any space. It weighs nothing. It doesn't go bad on the sun if you don't put it in a fridge like a piece of cheese. As long as you remember your private key or have it written down you can't lose bitcoin. Bitcoin is easy to take with you no matter where you go, and it is just as easy to use it no matter where life takes you. Bitcoin is the best thing that has happened to international commerce.
Thirdly, bitcoin is protected from censorship. The only way to stop bitcoin is to permanently shut down internet all over the globe. If a country decides to ban bitcoin - its residents can simply relocate elsewhere and regain access to their money.
Lastly, bitcoin is impossible to be taken from you without your explicit permission. Your bitcoin is protected by a cryptographic key and an optional password. When used correctly this provides a better level of protection than all the lasers, retina and fingerprint scans that bank vaults use in James Bond movies. This inability to take bitcoin from you by force marks a turning point in societal evolution as well. Owning money should be a sacred basic human right. Money allows you to participate in commerce, to buy things that you need for your survival, and to invest in projects that you believe are going to benefit the society and yourself. Doesn't matter where you were born, what color skin you have, what Gods you worship, what language you speak - you get to decide how you want to spend your money for yourself. It's safe to say that after the people of the world embrace bitcoin we'll live in a much freer society. No government will be able to impose barbaric economic sanctions or embargo rules that end up not hurting the political elite of the oppressed country and yet hurt the people living in those countries greatly.
The Chinese have a saying: To know your future you must know your past. In order to understand why the whole world is caught up in bitcoin mania and what does the word blockchain mean, let's take a look all the way back at our history and trace the evolution of money, from invention to modern days.
Invention of commerce: Barter
The history of money is, first and foremost, the history of commerce. Efficient commerce has allowed humankind to invent specialisation and division of labor: somebody would tend to the crops, somebody would go hunting, somebody was good at making tools or building houses. These people would do what they are best at and then gather together and exchange goods between each other. But sometimes it was hard to find a match for the trade. You'd need a new spear for hunting, but the spearmaker was not interested in meat that day. So you had to find out what the spearmaker wanted, go trade for that item, and then come back later.
Some items that were useful to everybody in the society would eventually become the de-facto money of that age. For example, there are numerous pieces of evidence discovered by archaeologists all over the globe that claim that livestock was used as a common medium of exchange. The problem with livestock though, and most other immediately useful items, is that they aren't a good way to store value long term and have high maintenance costs. And thus the nature of the society and the trade itself has pushed humankind to standardize on a sensible medium of exchange and a store of value. These objects would later become the first money.
Money was created as part of an evolutionary process in the development of human society. It is the greatest invention of our species, as it allows us to efficiently work together towards common goals.
First revolution: invention of coins
At the early stages of standardizing on a medium of exchange people would often pick items that are scarce and have some sacral meaning to them. Mountain countries would often pick seashells as a token of exchange. Hunter countries that had pride in their brave warriors would sometimes pick wolf teeth as a their money. However, seashells were abundant in sea countries and did not hold value in international trade. And countries with other, more boring currencies, would often be grossed out by the teeth of dead animals and would refuse to trade for these items.
It was vital for future development of international trade to find a universally scarce item that everybody would be happy to trade for. And precious metals ended up as the universal medium of exchange. There is evidence that silver and gold were used as money in Mesopotamia as far back as 3500 B.C.
These precious metals possessed two very important qualities that enabled their use as money. The first one is scarcity - it is hard to acquire a new unit of this metal outside of participating in trade or doing useful work. This quality is protected by the laws of physics. The second quality is liquidity - these metals were universally accepted as a counterparty in a trade by virtually any merchant. This quality is based on social laws and is protected by an unspoken social agreement and tradition.
There is one other important quality to precious metals that has played a very important role later. Precious metals are easy to work with, one can mold them into any shape or form. The state was quick to catch up on that and started minting coins of a fixed weight and denomination.
Coins were invented in a country whose name is now mostly forgotten. In fact, not much would have been known about the country if not for the works of the Greek historian Herodotus. This country's name was Lydia, and it was destroyed and wiped off the face of Earth in year 546 B.C.
And yet one Lydian word has managed to find its way into the vocabulary of many a language. As rich as Croesus is said about a person of extraordinary wealth in English, Turkish and some other languages. It was during the rule of Croesus when Lydians have invented coins and embraced their use nationwide.
The first coins, depicted on the illustration above, were made out of a silver and gold alloy called electrum. They were slightly bigger than modern coins, about as big as a grown man's thumb. In order to protect the merchants from forgery the king would personally stamp each and every coin that was in circulation acting as the warrant of quality and value.
By producing coins of equal weight, size and value the king has eliminated a major source of inefficiency in commerce of those days - the necessity to weight and inspect gold before trade. From that moment on the merchants could simply count the number of coins in order to validate that they are being paid a fair price. Neither did you have to have the necessary ingredients, tools and skills for validating whether the gold was real or not - the king's stamp acted as proof of value. Coins have opened up the world of commerce to a wider population and helped establish new forms of business.
Interesting fact: It was in Sardis, the capital of the wealthy country Lydia, where the two most profitable industries after arms trading were invented: brothels and casinos.
At the end of the day Croesus has wasted all his wealth in a way that befits a great king: on buildings and army. In a famous episode of the ancient Greek history Croesus had asked the Delphic oracle for advice before going to war against Persia. The oracle had famously replied: If Croesus goes to war he will destroy a great empire. Croesus interpreted this as a good omen and attacked the Persians. But it was his trade empire of Lydia that was destroyed by this war. The mercenary army of Croesus was no match for the fearsome army of Cyrus the Great. The aftermath of that war was that coins were able to spread further outside of Europe to other civilizations through Persia.
The invention of coins is no doubt one of the greatest inventions of mankind. It allowed to greatly simplify commerce and invite more people to participate in the trading economy. The coins were easy to count, store and trade.
Unfortunately coins had disadvantages too. Coins were easy to steal or forcefully take from someone. It was hard to store and accumulate huge amounts of wealth as the security costs of having to protect the wealth were already high and couldn't be made less that the wealth itself, or the guards would simply steal the treasure. This inability to accumulate and easily trade big amounts of money ended up slowing further economic progress.
Second revolution: Banks
It's worth pointing out that banks were invented a really long time ago. The primary function of a bank is that of a safe vault - to guarantee safety of the deposited funds. However it is to the great success of the Medici family during the Renaissance era that the modern banking system owes its gratitude.
The Medici bank was the largest business organisation of that time. It was dealing in the Western Europe, in the Middle East, and had partnership agreements with organizations all over the world, from Iceland to China. The diverse offerings of the bank covered financial services, logistics, ore mining and even manufacturing. At its peak Medici's bank had greater revenue than most European countries.
It's worth pointing out that this vast and complex organization did not have access to any of the modern communication technology. Six centuries ago when all of this was happening they didn't have computers, cell phones, internet, printers, airplanes, cars. All the complex financial calculations were done on paper with the help of abacus. Communication between bank branches depended on how fast a horse could go between those cities.
A big factor that contributed to the bank's explosive growth in that era was the Church's change of heart with respect to lending. How could the Church condemn lending when the Pope himself was one of the bank's major clients! The bank was able to lend money that it received as a deposit and charge a certain interest rate.
The bank also popularized another new service. One could deposit a certain amount of money at a bank branch and get a paper receipt. Then, somewhere in another city or even another country this paper slip could be exchanged for an equal amount of money. These paper receipts can be considered the first paper money. The bank's word and reputation were the warrant of the value of the paper receipt.
At a later point in time the banks offered another popular service that has survived until these days. One could buy a share in a large enterprise and be entitled to a proportional share of the company's profits in the future. The East India Company is considered to be the first publicly traded company. In 1602 it got listed on what's now called the Amsterdam Stock exchange and promised a share of future payouts with a 21 year investment horizon. To make the deal more lucrative the East India Company received exclusive rights to benefit from the trade agreements made by the Netherlands with India. While people waited these 21 years they were able to speculate on the returns that this investment would yield them and trade their shares between each other.
Banks have greatly simplified and improved international trade and, as a byproduct, helped destroy feudalism. Before banks power and wealth were measured in how much land you own. During the bank era power is measured in money, assets and shares in investment projects.
Now, obviously the government could not just step aside. In order to get a banking license the government would mandate that all operations on the territory of a certain state be denominated in the state's currency. In return, the state would offer protection and security, alleviating the banks of the need to hire a private mercenary army to protect itself.
Advances in technology have allowed banks to improve and become faster, more profitable and reduce risks of operations compared to pre-bank society levels. However, since the days of the Renaissance the role of the banks and the governments in the world commerce did not change much conceptually. Tools have improved, roles and functions stayed the same, and the actors have fortified their position.
At the moment in history when money dominates the whole fabric of our society, it faces some strange and ominous challenges. In the last decades of the twentieth century, the global money system began to cough and sputter, to jerk and stumble. The currencies of several weaker nations unexpectedly sickened and died in a paroxysm of inflation, while the exchange rates of the strongest and healthiest currencies wobbled and lunged uncontrollably one way then another. After gaining more and more power for almost four centuries the banks suddenly teetered and feel under billion-dollar losses that occurred seemingly overnight in 2008. The United States of America, the largest economy on Earth, keep nursing and growing their national debt that has recently surpassed the 20 trillion dollar mark, and whether intentionally or not they keep the policy of slowly devaluing USD against other major currencies.
Third revolution: Bitcoin
Despite the massive efforts all governments in the world are no longer able to maintain stability of their national currencies. The new generation of ultra-wealthy individuals and multinational organizations now operate outside of jurisdictions of any single government, as evidenced by Panama papers and Paradise papers. Some corporations have more money than not just individual states, but state unions. In fact in 2015 when the EU was struggling to bail out Greece from its unpayable debt a lot of respectable business media suggested that Apple should single handedly bail the Greek economy out in exchange for a preferential tax treatment solidified in the country's constitution.
The governments all over the world want us to believe that when the banks fall we'll see the death of trade or that money itself will die and we'll turn back to primitive tools. But that is simply not true. And while the good old bank money has served us very well and is on its way to the grave we can already see the flickering light of the new form of money on the horizon.
You see it in the soft blue light of the computer monitor. You feel it every time you tap on your smartphone's screen. You hear it every time you swipe a plastic card at an electronic checkout.
The widespread use of personal computers and internet is forcing money to evolve and become as quick as our normal communication channels. The money will evolve into a new form, pure concentrated power that can appear at any point on Earth and is always at your fingertips. The new money will not be tied to successes or failures of a single country. Every human being on earth will be able to control their share of money in a way that they see fit.
The name of this power is Bitcoin. Bitcoin, along with other cryptocurrencies, will change the way we earn and spend money. It will create new classes of wealthy and poor. It will change the way we finance our for-profit and social investment projects. It will shift the political power balance and will redraw the world map. It will create new forms of organizations that were previously unheard of. Bitcoin is both a tribute to the past, and yet it's the most sophisticated and technologically advanced form of money that humankind ever created.
How does Bitcoin work?
Bitcoin is often called digital gold. What do people mean by this? Clearly, you can't touch bitcoin, you can't make jewelry out of it and you can't use it for manufacturing superconductors. But, looking back at the history, we know what it's not these qualities that made gold into universally accepted form of money. The physical and chemical properties of gold are certainly important, but the use of gold in manufacturing did not play a deciding role.
The value of gold is contained within these five properties:
- Scarcity. There's limited supply of gold on Earth. When all the gold has been mined one will only be able to obtain it through trade, which makes gold a fair tracker of the global economy's health and an individual's trading ability.
- Longevity. Gold does not oxidize in the vault, it does not melt in water, it doesn't burn in fire. A gold reserve can safely be stored in a secure place and simply wait for its hour. This is one of the reasons why gold has historically had more value than silver. Silver does oxidize and get darker with time, while a gold bar looks as shiny as ever no matter how long ago it was made.
- Resistance from forgery. Various methods of verifying whether an object is made of real gold have been known to mankind for hundreds of years. This quality preserves the important scarcity attribute.
- Independence. Gold has no master that can simply make more of it. The best minds of humankind, including Sir Isaac Newton, have tried to create the so-called philosopher's stone that can turn other objects into gold. And yet all their efforts were in vain as chemists have proven in the twentieth century.
- Fungibility. Two thousand years ago the Roman emperor Vespasian has said his famous Pecunia non olet, or money does not stink. In terms of its value, a kilo gold is equivalent to any other kilo of gold regardless of its origin.
Out of all these five qualities scarcity and independence were the hardest to acquire for a piece of software.
In January 2009 someone under the pseudonym Satoshi Nakamoto has presented a new type of software that has all these five qualities mentioned above - the blockchain. It is this technology that has been the last piece of the puzzle for creation of internet money.
Blockchain is a new way of storing information and a protocol for adding new records to this data storage. It has the property that this storage is append only - no single entity, even the inventor of the blockchain, can rewrite the history of the blockchain. It is the culmination of hundreds of years of scientific research in mathematics, cryptography and information theory.
To some extent you could say that bitcoin is like an economic game, where each move is a transfer of value to some other address. You can draw some parallels with chess. A game of chess can be recorded as a sequence of moves on the board. Same thing for bitcoin: the blockchain stores information about all the money transfers that have ever happened in the network. Whatever money you have now is the result of applying all these transactions to an empty ledger in the right order.
The real breakthrough came from a system that does not let any single actor add invalid transactions to the blockchain, as well as rewrite its history. This is unlike any other piece of software in the world, which can easily be copied and modified by the owner of the physical machine. The distributed nature of the storage engine ensures that nobody can cheat the system.
However, if enough users want to modify the rules of the blockchain, they are free to start a blockchain of their own either from scratch or from an existing snapshot, like Litecoin or Bitcoin Cash. If something would ever happen to the original Bitcoin blockchain, the blockchains of the other altcoins will remain safe and sound.
To summarize, bitcoin is a new form of money, free from centralized control. The first monetary evolution was coin, and its value was guaranteed by the mint - the king himself. The second monetary evolution was the bank, and the value of its money was guaranteed by the mint - the small cohort of banks approved by the government. The third monetary evolution is bitcoin, and its value is also guaranteed by the mint - anybody who is willing to participate in the network.
Bitcoin is impossible to forge. You can't touch bitcoin or feel its weight - it's 100% virtual and it exists entirely on a peer to peer network on the internet, in thousands of copies of the blockchain stored on computers and hard drives all over the world.
In order to fully understand what bitcoin is, how it works under the hood and what possibilities this new form of money creates one needs to understand how blockchain allows information to possess the qualities of scarcity, longevity, resistance from forgery, independence and fungibility. We'll describe the inner workings of the blockchain in the second article of the series - How does blockchain work?