Money flows with very little friction in our society, and seems to be an effective way to accounting and exchange value.
Anyway if we look at our economic system, it's easy to see that these possibilities come with a compromise: the centralization of the power over money creation.
In the past, it was common for countries to have sovereignty over their monetary policies and the management of money creation. This situation meant that a sovereign country could devalue its currency to meet its economic objectives(for example balancing its imports/exports ratio).
Politics could badly influence monetary policies, because populists were keen to promise unachievable objectives, letting future governors and citizens pay the bill.Central Banks try to externalize the power of money creation from the nations, preventing a single authority to abuse of its political and economical power.
Still money is managed in a centralized way and through Quantitative Easing, banks and nations are deeply connected to a policy level, nullifying the effort of separating these responsibilities.
Having a central authority that manages this system can help to meet some objectives(employment, liquidity..), but is also keen to promote aggressive geo-political strategies(financing wars, violence for the monopoly of precious commodities..).
Having a single authority to manage the system has some further implications: when the situation is unstable(for example liquidity decreases and debts cannot be paid back), this central authority can freeze accounts in order to avoid the default of the banks, and prevent participants from using the system(for example, by preventing the withdrawal of their savings).
Furthermore, fiat money in circulation is created through the process in which a central bank lends newly minted money.This money has to be paid back at an interest rate chosen according to the monetary policies that are considered important to achieve.
This means that for every paper bill we use to exchange value, as a society we accept to repay a debt with money that does not yet exists and will be minted issuing debt.
Using this system, there is no debt-free money.Our production rate is enslaved to continuously outperform itself(also excessively exploiting essential resources).
This seems to be justified by the fact that as our society grows, more money will be needed to be able to exchange the value correspondent to those newly created assets.Through the process of inflation, new money is guaranteed to be into circulation allowing the exchange of goods.
Money is just an abstraction created on the trust of different parties to repay their debt.Economical policies are based on the trust that participants will fulfill their promises, and money is created by the expansion or contraction of this trust.
The misalignment of incentives of our system, can be seen in different elements of our economic system.Central Banks as lender of last resort can affect the risk tolerance of comercial banks, which can use high leverage to reach gains with elevated potential, knowing that liabilities are mostly covered.This misalignment of incentives can let Central Banks buy high risk financial assets in order to bail out private banks.
The tendency of privatized returns and socialized risks are just some of the problems of this fiduciary system, that is constantly affected by the high risks assumed by the private sector.
But what would happen if a widespread lack of trust towards our current economic system begins to materialize?
The type of money we are using now funds its roots on the promise of repaying a debt.It’s just a promise, a piece of paper that attests a future duty.The problem is that when trust comes less, promises can be not valuable at all.
The proprieties of Bitcoin and its differences
Bitcoin is created through a process witnessed by every network participant, and there is no central authority that is in charge for it.It's issuance is limited to a maximum amount, but bitcoin it is also divisible in infinitesimal parts. No single participant has the ultimate power over the network, or the ability to freeze accounts.Also, every participant can witness that the network behaves correctly and prevent anyone from cheating over it.
Bitcoin is created with the qualities of a commodity: it has a fixed amount, it’s creation is decentralized, and it can be used without the intervention of a central authority. Still it is possible to break it down into incredibly small parts.
Savings in Bitcoin are protected with a cryptographic key, which makes the user the ultimate responsable for his wealth.Nobody can take money out of the owner without the correct cryptographic key, and the user is fully responsable for storing it. This freedom implies more responsibility when it comes to managing wealth.
The information of the transactions history (and consequently account balances) is stored in every computer connected to the network, and it is not held by a single authority.No central entity that has the power to change the information in the database or change the rules of the network, penalizing participants. In bitcoin, every node(computer) contributes in keeping the information about the state of the network(the updated history of transactions).Everybody can participate in creating a single truth, by propagating the information that is witnessed.
Instead of trusting a central authority, Bitcoin changes the paradigm: trust no one.If someone has the power to control a system, he will probably abuse it. In Bitcoin no one trusts each other, but everybody trusts the network.The interests of every participants are aligned to keep the network alive. Trust is not reliant on a single party, but on the network itself.Nobody deserves to be trusted when organizing the truth: that is the reason why everybody contributes to create the history of transactions in a common ledger.
How Bitcoin Works
Bitcoin accomplished this through a technology called Blockchain.This technology connects blocks of data through a cryptography(1).Every block of data contains a set of transactions performed by the participants of the network.The latest block that contains the newest transactions is connected to the previous one through a cryptographic mechanism, ensuring that the transactions’ history is coherent.This connection is transparent and witnessed by everyone.
The network builds its own history of transactions by connecting these blocks of data. Every computer connected to the network can be a validator of transactions, and approve transactions that are not already spent by organizing them into blocks of data.These blocks of data are propagated through the network and are verified by participants to ensure that the information is true.The fastest computer which finds the solution to a specific mathematic riddle(2), gains the right to add a newly created block to the previous one. The action of adding the new block to the chain is rewarded with newly minted bitcoins.Once the issuance of bitcoin approaches to its limit(21 millions), the validators will rely merely on transactions fees to compensate their work.
Validators of the network get rewarded for their effort of keeping the network safe.The requirement of solving the mathematic riddle is just a way to prevent multiple computers owned by one single entity to act as different parties, each voting for a fake transaction to be true and cheating on the network.This means that who is willing to order the latest transactions into a new block has to perform a specific computation and spend electrical energy to proof his work.
In this way, unless an attacker holds the majority of computational resources of the network(hashing power), the network will be safe.
Cheating the whole system would require spending a huge amount of resources, but every participants would notice that the network is under attack.By then, the attacker would have wasted his resources just to gain the control of a useless currency(3).Instead, using those resources to play by the rules and secure the network, this person would be compensated with an economic incentive.Actors are then incentivized to use resources to play according to the rules and validate the network to gain the rewards.
The paradigm shift
Trust is not given to a central entity, because no entity needs to be trusted.The trust relies in the network, where participants are incentivized to behave accordingly to the rules.Every participants has a copy of the network, and contributes in creating a single decentralized truth. The network notices and discards corrupted copy of its code, isolating the participants which try to cheat the system.
Bitcoin is an independent and autonomous system: just a single computer running the Bitcoin software makes the network be alive.Until there will be someone willing to use it, the network will keep living.
The Bitcoin token is the reward for this decentralized database to justify its existence and sustain itself.No intermediary is needed to grant its survival, because the network is able to sustain itself rewarding the participants who are willing to secure it.
Bitcoin is a type of money that does not rely on a specific country welfare to survive, and exists without the need to be enforced by an army or aggressive international policies to keep on living.
Propriety is not protected by a legal system supported by an army: in this new mechanism, propriety rights are defended by cryptography.
Bitcoin succeeded in allowing propriety rights to be independent from the protection of central authority that need to be trusted to sustains its social contract.It succedes in detaching itself from the political system, allowing each individual to have fully control over his propriety.
The history of the network is unchangeable, and rules are transparent.
In this way bitcoin created a system of exchanging value which is not based on debt.
There is not an interest on the creation of it that implies that has to be paid back with money that still does not exists.
Bitcoin owners have the full control over their money.Nobody can freeze accounts and prevent withdrawals if the economical situation gets messy: users are protected by cryptography
In this new breakthrough money is decentralized, and every participants is guaranteed that the rules are played fairly.
Bitcoin is efficient: no need to wait days to clear a payment transference, and rely on high fees. Huge amount of money can be moved way faster, more secure and cheaper than the current system.
Furthermore, all the unbanked people in the world have now the possibility of exchanging value with a smartphone
Bitcoin is a technology that can be used to build complex economic layers: based on a decentralized network, consumers could be able to obtain the highest control over their propriety
On top of this new concept of money, different economic mechanisms can be built.Policies can be obtained through a decentralized process, preventing a single point of failure.Loans can be backed by cryptographically secure currencies that act as a commodities and ensure the fulfillment of debts through smart contracts.The code would enforces the fulfillment of the promises, which are always anchored to cryptographic commodities.
Welcome to the Internet of Value.
Notes:
1)Transactions in a block are hashed together into a Merkle tree: transactions are the leaves of the tree, and they are hashed together obtaining a root hash.This root hash is hashed together with the hash of the previous block, creating an indissoluble chain of data blocks (blockchain).In order to check the validity of the blockchain, is then enough to check the block header.
2)In the specific, validators hash the transactions of the block into a Merkle tree, and hash this string with the header of the previous block.Validators then append a number(nonce) to the previously obtained hash, and then hash everything again.If the new hash contains a certain number of zeros(000..), then the block is valid and it is added to the chain. The number of zeros required is established by the current difficulty rate of the network.
If the block is not valid, the miner increases the value of the nonce and hash again.This process is repeated until a valid nonce is found.The nonce has to be the one that hashed together with the hash obtained by hashing the previous block header and the current block transactions creates an hash that has the number of zeros required by the current difficulty rate.
In order to find the right nonce there is no other way than to try it out, meaning that the solution has to be obtained by brute force, spending electric energy.
3)This type of consensus mechanism is called Proof of Work.There are different consensus mechanisms available in cryptocurrencies to prevent a single party to cheat the network.An alternative consensus in cryptocurrencies is Proof of Stake, which requires validators to lock up some coins in order to validate the network transactions.If the validator behaves correctly, it is rewarded with a profit on its investment.If the validator tries to cheat the network, the investment is lost. In this way, an effort is needed to validate the network, and participants are prevented to cheat.The only way the network can be cheated is the case in which they own 51% of the value of the network. Anyway, for an actor which owns so much resources, it is not productive to cheat the network, because the whole currency will lose value(affecting the attacker’s resources).Also, reordering the network after an attack it’s easier with PoS, organizing a community-driven hard fork and blacklisting the attacker.Reorganizing the network after an attack is quite easy in PoS, while the attacker would loose resources every time he tries to take over the network. In every good consensus mechanism, incentives of participants are aligned in order to let them play according to the rules.Other consensus mechanisms relies on giving trust to a specific number of validators, voting for their election as a validator with their cryptocurrency holding(Delegated Byzantine Fault Tolerance).
Resources:
https://www.imf.org/external/np/pp/eng/2010/052710.pdf