Modern Money: Bitcoin and the Digitization of Currency
First it was cattle. Then, coins made of silver and gold. Eventually, it turned into paper. And in the future, it may lose all physical form and become virtual. What is it? Money, of course: a shape-shifting angel and demon, making its slow, steady transformation into an almost all-digital chimera.
Open your wallet and spread out all your money. Lay down those coins and bills, as well as any credit and debit cards. Pay with your phone? Take that out, too. And if you use PayPal, fire up the computer. What’s spread out before you is the current state of money: a grab-bag of 21st century objects with intrinsic value — conduits that invisibly transfers funds from one place to another.
Now, imagine a Chinese man from the Stone Age looking at those contents. He wouldn’t call that assembled inventory money — it means nothing to him. In his world, around 120 B.C., one-foot square pieces of leather are his currency.
He won’t take the bills, but he may smelt the coins for the metals. And those credit cards? He would reel at the idea of flimsy pieces of plastic can tap into something of worth. And forget about that phone and computer. That’s black magic. For our time-travelling Chinese friend, money is tangible objects, physical and inherently valuable.
That reaction underscores a fundamental, yet often overlooked, notion. Currency only works because, through a complex web of cultural codes and historical developments, we all agree that it has value.
That’s the “magic” of money: that system works because we all believe in it, allowing us to put our faith in cash, credit cards and online payments. But the long, slow road to mobile payments reveals significant cracks in the illusion.
As the industry lumbers along, we’ll soon take an even bigger leap of faith — believing in currencies that have their origins in algorithms, passed between computers.
In Bitcoin We Trust
In 2008, a humble white paper appeared out of nowhere, as things often do on the Internet. Posted to a cryptography e-mail list by someone no one had ever heard of — certainly with no academic or programming credentials — it proposed a form of electronic currency that “would allow online payments to be sent directly from one party to another without going through a financial institution.”
It would be called “Bitcoin.”
Little did anyone know, except perhaps the mysterious author, that the proposed system would one day exist as the next stage in the evolution of money — from cattle to paper to data passed between machines. And once a hot topic among libertarians, anarchists and fringe elements, the musings of that lone soul on the Internet are now a very real financial force, slowly seeping into the mainstream world of finance.
“[Bitcoin] just launched itself by its own bootstraps,” Lawrence White, an economist who teaches the history of banking and money at George Mason University, told IEEE Spectrum. “We don’t really understand how that worked, as economists.”
As of March, nearly 11 million bitcoins are in circulation for a total value of over $1 billion. It is a thriving economy. According to the Wall Street Journal, Bitcoin processing firm BitPay said it signed up more than 8,000 merchants — both online and off — since 2011. But no major retailer has yet to take bitcoins as payment. If you need to cold, hard cash, though, Bitcoin exchanges, like Mt. Gox, are just a click away, providing liquidity to turn those virtual dollars into physical, government-backed greenbacks.
A Brief History of Money
The history of money is a journey from the physical to the abstract. In the beginning, we bartered — a direct exchange of resources and services that benefited all parties involved. But that presented a problem: what if your trading partner — say, a hunter with meat — didn’t want your abundant supply of corn or wheat? You had an impasse.
The solution is an object or commodity that everyone could agree to accept. In trade, money is an intermediary between supply and demand, facilitating a burgeoning system of exchange, even in the most primitive of economies.
It can take any shape — and through time, it has been everything from beads to strips of leather. According to Nova, livestock, like cattle and sheep, was the first currency, while cowry shells — first used in China and even Africa — became the longest and most widely used through the middle of this century.
The Chinese were the first to make bronze and copper coins at the end of the Stone Age, but currency didn’t catch on until around 500 B.C. in Lydia, or present-day Turkey. Durable and easy to carry, coins then spread to the Greeks, Persians, Macedonians and later the Romans, who minted their currency from valuable gold, silver and bronze.
Those materials gave their coins an inherent, tangible value, which economists call “commodity money.” Hold a handful of gold coins and you immediately feel richer.
At some point, though, carrying too many coins became inconvenient. Enter paper money. The first bills surfaced in China around 800 A.D., as a way to counterbalance a shortage of copper. The practice continued over the next 500 years, until the government overprinted paper currency and caused severe inflation and a collapse in value.
Marco Polo famously devoted a whole chapter in his influential book, “Travels of Marco Polo,” to the Emperor of China Kublai Khan and his use of paper. Polo’s account of the currency system — and his idea that Khan had more wealth than any European king who hoarded gold in his vault — provoked skepticism and outrage from the Western world, according to the Foundation for Economic Education.
But Europe began to suffer from metal shortages, its countries integrated paper, spreading even to colonial territories like America. According to The Atlantic, in 1690, after a shutdown of the Massachusetts mint, coins were in short supply. So when the British wanted Americans to fight the French in Canada, it issued soldiers certificates, redeemable for “real money” at a later date.
Out of Nowhere
But what is Bitcoin, exactly? Well, basically, it works like any other currency. But instead of central banks backing its value, cryptography and openness offer security and legitimacy. And rather than exchanging pieces of paper or coins, you send virtual tokens that are “stamped” with a complex key, transferring ownership and value to the other party. A public log, without exception, notes each Bitcoin transaction.
If it sounds like the plot of a James Bond movie, the mysterious origins of Bitcoin are even more fascinating, imbued with its own kind of myth and legend, beginning with that humble white paper posted in 2008. Under the alias “Satoshi Nakamoto,” the author’s aim was to create a currency that didn’t fall prey to the whims and corruptions of banks and governments, according to the New Yorker. In the nine-page paper, he detailed a way to exchange currency between peer-to-peer networked machines without having to go through a third-party intermediary, such as a bank or company like PayPal, all the while using cryptographic techniques to ensure security.
At the time, Nakamoto didn’t just propose a method to exchange currency, but rather, an entire system to create, secure and control its value. To mint new bitcoins, he proposed open-source software to release a predetermined amount every 10 minutes, with the pace halving in increments until around 2140. New bitcoins are minted in a slow, predictable fashion to ensure regular growth of the monetary supply. It also prevents third parties, like central banks, for example, from interfering and causing inflation.
For security, a massive, decentralized network of 20,000 independent computer systems verifies every transaction for entry into a public ledger, bringing an unprecedented level of transparency and trust to its currency. In order to add the transaction to the ledger, systems compete to crack a cryptographic puzzle. The program then releases a 25-coin reward to the first “miner” to correctly crack the puzzle and add it to the public log. Anyone with a computer can mine for bitcoins, but the difficulty of the challenge, which increases with the number of miners participating, requires a bit of brute-force analysis, so more powerful systems have an advantage.
After two years of development, according to MIT Technology Review, in 2009, Nakamoto set the system in motion, combining cryptographic algorithms and digital signatures into what would become Bitcoin.
In the beginning, mining was easier, of course, but the allure of grabbing bitcoins has created another race of sorts, according to the Economist, in which ardent fans build supercomputers of their own — or hijack other machines — to crunch the puzzles in the race to be the first. These days, though, it’s simply easier buy bitcoins on an exchange.
At first, a small band of early-adopters, disillusioned by the financial crisis of 2008, joined the spirit of the open-source project. Then, slowly, others began to contribute to the code or dedicate computers to the resource-intensive system. Nakamoto, for his part, stayed involved on cryptography forums, responding to messages and e-mails about Bitcoin, in clear, perfect English that alternated between British and American spellings and colloquialisms.
But a year later, his involvement began to wane.
By mid-2010, Nakamoto had stopped programming altogether, according to an investigation by Motherboard, and then, in 2011, he hinted to a developer that he had “moved to other things.” Then, just as mysteriously as Bitcoin had appeared, in the spring of 2012, he simply vanished — leaving e-mails from lead developers unanswered.
By then, though, Bitcoin had started to take on a life of its own.
Who Is Satoshi Nakamoto?
The dropout, of course, fueled rampant speculation about Nakamoto’s origins. What anonymous soul — or souls — would invent a system of currency and then suddenly disappear?
Nakamoto claimed to be a late-30s Japanese man living in Tokyo, but careful analysis of the language and timestamps of his messages hint otherwise. For example, Ted Nelson, an early Web pioneer, believes he was an alias for reclusive Japanese mathematician Shinichi Mochizuki, an eccentric genius with both the intellectual might and odd temperament to invent an entire system of currency and then walk away from it. Meanwhile, the New Yorker, which conducted its own investigation, concluded that he was an alias for a group of brilliant computer science students at Dublin’s Trinity College — all of whom categorically deny any association with Bitcoin.
Fast Company reported otherwise, believing Nakamoto to be a trio of patent inventors involved in key areas of encryption, communication and networks. But the most far-fetched, according to Wired, belongs to conspiracy theorists who say the transparency of Bitcoin is a government operation — either by a team at the National Security Agency, or Google, perhaps — setup to allow those in control to someday monitor every single financial transaction in the world.
Whoever Nakamoto is, or was, he left a sophisticated digital currency that has spawned its own economy. Now in the hands of a dedicated, open-source community, the interest and use of Bitcoin is growing among the public. Beginning as a fringe idea, it is infiltrating the mainstream, even popping up as a subject of an episode of hit political drama “The Good Wife.”
The Foundation of Value: Gold
The invention of paper currency was an important step in economic history. The direct, concrete relationship between money and value was severed, and in its place, a disarmingly flimsy object stored value elsewhere.
That cash spread out on your desk has no intrinsic value. According to the Federal Reserve Bank of Minnesota, paper currency, known as “representative money,” derives its value from being able to exchange it for a specific commodity, like gold or silver. It’s essentially an IOU.
Gold was often the standard that underwrote the value of money, but there was only so much to go around.
In the U.S., the Great Depression spurred a phase-out of precious metals, according to a New York Times article from 1933. Since people were hoarding gold during the difficult time, President Franklin D. Roosevelt forbade the hoarding “of gold or silver coin or bullion or currency,” under penalty of $10,000 fine or 10 years’ imprisonment or both. Later, he required all gold and gold certificates to be surrendered to the Treasury, giving the government control over the price of gold and the value of money that it underwrote.
Roosevelt’s legislation further weakened the ties between paper and gold, until Presidents Lyndon B. Johnson, and then Richard Nixon, severed the link once and for all. Both presidents had borrowed billions of dollars from countries to pay for the Vietnam War. And to prevent foreign creditors from cashing in their notes for gold, in 1971, Nixon enacted a series of economic policies, taking the nation off the standard.
Congress made it official in 1978, and the U.S. economy has since leaned on the Federal Reserve to control the value of paper money.
The Magic Act of Money
When you take away that link to precious metals, how does paper money gain value?
Governments that issue their own legal tender, often through central banks, control the amount of money and peg its value. That kind of currency, known as “fiat money,” is essentially worthless, if its government hadn’t given it financial worth, Harvard economist Greg Mankiw wrote in his classic textbook “Principles of Economics.”
You can’t see the inherent, concrete value of fiat money like you can with precious coins. And you can’t redeem it for paper notes backed by gold or silver. Instead, everyone has to agree to its worth to have value.
Through the eyes of our Stone Age friend from China, fiat money is like casting a spell that convinces everyone those printed banknotes are valuable. And there lies the magic act of money: we believe our money is worth something because a national bank, like the Federal Reserve, says it is — and others use and honor it. The strength of a nation’s currency is tied to the strength of that nation’s economy.
As the history of money has progressed, from bartering cowry shells to gold coins to paper notes, each transformation adds an increasing level of abstraction. It is that strange invisible power that also makes us comfortable with innovations like credit cards, which in 1946 first appeared as the “Charg-It” card, according to MasterCard.
Credit cards eliminated the need to carry cash altogether, making it easier to detach from a concrete understanding of value. But that change affected the way we think, feel and act around money, sometimes in troubling ways. According to a 2001 study published in Marketing Letters, we tend to buy more when we pay with cards than with cash. When swiping, we also pay less attention to prices and often forget the amount we spent afterwards.
As a result, as of July, credit card debt in the U.S. has ballooned to over $850 billion, according to the Federal Reserve. On average, each household owes around $15,000. And yet, we continue to spend that virtual money with amazing ease.
The Proof Is in the Software
To take part in Bitcoin, just download and run client software on your computer. It creates a kind of digital wallet that generates a pair of unique, mathematically-connected “keys,” which makes transactions easy to verify and impossible to fake.
A private key is used to “sign” for transactions, while a public one is given to others to receive bitcoins. Most importantly, according to MIT Technology Review, Nakamoto’s cryptography is so advanced that it is impossible to reverse-engineer someone’s private key from their public one, even when armed with the most powerful supercomputer.
But one of the basic problems with designing a virtual currency is “double-spending.” With tangible monies, once you pay, the bills or coins are no longer in your possession. But when currency is just data, what’s to prevent you from spending it again and again?
Nakamoto’s answer is a real-time ledger of all the transactions that have ever taken place. When bitcoins are transferred — and software performs the necessary mathematical computations to combine both parties’ public keys, private keys and the amount exchanged — the transaction is verified and registered, without exception, with a timestamp into a public log with all 20,000 independent cyber-witnesses. That means if you spend your last bitcoin, you can’t spend it again. But the log needs to be maintained by trusted administrator, or in this case, everyone.
That transparent chain of ownership of every bitcoin ever created makes for a powerful deterrent against crimes, like money laundering. If your bitcoins are stolen, for example, you can track down the thieves. And if you try to spend stolen bitcoins, the system can prevent you from doing so. It also means that to hack the network, you would have to break into over half of the 20,000 computers at the same time.
It is that public ledger that’s what makes Bitcoin so reliable and secure.
Between Legitimacy and Regulation
By all accounts, Nakamoto’s system forms a strong backbone for a thriving ecosystem of services and exchanges. To date, only one major weakness has been found in the software. According to the National Institute of Standards and Technology, in 2010, hackers broke into various Bitcoin exchanges and payment processing centers.
The main software itself — the one responsible for issuing and verifying transactions in that all-important public log — was left untouched, proving remarkably sturdy despite several attacks. It is, perhaps, that delicate balance of security and openness that gives users the trust necessary for any currency’s success and acceptance.
In the past, Nakamoto had acknowledged that his motivation to create Bitcoin was the lack of trust in conventional “fiat” money,” where central banks can overprint legal tender and undermine its value. “The root problem with conventional currency is all the trust that’s required to make it work,” he wrote. “The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust… We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.”
Of course, bitcoins had no value at launch. In the first six months, one bitcoin hovered below 15 cents, according to Wired. Then, as the currency gained viral traction in 2010, increasing demand met with limited supply and began to push up prices. By 2011, the bitcoin achieved “dollar parity,” worth $1.06, before sinking back down to 87 cents.
But as Bitcoin gains prominence, it attracts critics who are wary of its volatile exchange rate — making it an attractive asset to impulsive short-term speculators. In one day alone in April, Bitcoin rates plummeted from a high of $266 to about $100.
“This level of volatility, along with the difficulty of buying Bitcoins in the first place, and the substantial security risks, is what will stop Bitcoin from being a true alternative to state currencies,” Matthew Zeitlin wrote at Bloomberg. “For a currency to work, it needs to be a steady store of value.” In other words, if you speculate, you might become millionaire one day, and a pauper the next, depending on the rollercoaster ride.
In a way, bitcoin mining is like how gold used to be unearthed, in a limited quantity that grows slowly relative to a large, total supply. The software will create a total of 21 million bitcoins, at a predictable, steady pace until 2140. After that, instead of generating new currency, fees from transaction volume will replace rewards from mining.
Having a finite supply of money, of course, keeps Bitcoin from falling prey to inflation, but it also puts bitcoins at risk for deflation, raising the price of each unit in the future. At some point, prices would be so expensive that nobody would be able to opt into the system. Meanwhile, no one would spend them, putting the currency’s long-term viability in question.
Some note that the most bitcoins are actually in the hands of very few people. Cryptographer Adi Shamir, for example, analyzed the public log and found that of the nine million bitcoins minted at the time, only two million were in active circulation, leading some to speculate that the rest were being held by a “Bitcoin one percent.” If these holders cashed out, they may crash exchange rates and destabilize the system.
According to Motherboard, some say many of the bitcoins are being held by Nakamoto himself. If he is sitting on a stash of roughly a million bitcoins, he could be worth around $120 million at today’s average exchange rate.
Still, those issues haven’t stopped many who lean on the bitcoin as their currency of choice, including Argentinians tired of the rollercoaster of their own national economy. In a country where people don’t trust banks or the highly-inflated peso, many are buying bitcoins, according to the Wall Street Journal.
As the virtual currency gains mainstream attention, though, it is also attracting the eye of financial regulators, who are leery of a currency that can so easily be used in illegal transactions. Last Wednesday, a federal judge in Texas declared Bitcoin a currency, and therefore subject to U.S. regulations. The ruling came after Bitcoin Savings and Trust, which was accused of running a Ponzi scheme. initially claimed its Bitcoin investments were not securities subject to U.S. regulation.
Earlier this year, the Financial Crimes Enforcement Network, or FinCEN, the arm of the Department of Treasury that enforces laws against money laundering, issued guidelines that required certain trading parties in the Bitcoin economy to register with the government as “Money Services Businesses.” That means, under U.S. law, they must begin to collect customer information about Bitcoin members and take steps to combat money laundering.
As growing regulation gives the virtual currency wider acceptance, it also goes against Nakamoto’s original spirit. Bitcoin was created to stem corruption from the minting and exchange of currency. Or, to put it another way: a way to escape central banks, governments and other third-party interlopers that secure and facilitate the exchange of money.
Instead, Bitcoin places its trust and power in algorithms and the community.
Signs of Resistance: Mobile Payments
We accept the increasingly electronic nature of money as a fact of life, thanks to cards’ ubiquity and relative security. Today, digits that represent money race between computers, payment terminals and banks. Even now, we’re comfortable sending and paying for goods online through services like PayPal, which in this year, announced revenues of $1.6 billion in the April-June period.
And yet, some innate distrust of that virtual state of money still lingers, judging by the slower than expected adoption of mobile payments. EMarketer expects mobile payments to rake in $1 billion in this year, and skyrocket to $58 billion in just four years. The ability to pay by phones has long been anticipated as a game-changer, but so far, it has yet to reach those blockbuster levels.
Why has it taken so long?
“Delays and adoption issues facing numerous mobile wallet initiatives, as well as a congested landscape of competing technologies,” EMarketer wrote in the report. In addition, a fragmented industry, with several competing solutions, ranging from e-card reader for Apple devices to the Isis consortium, as well as online juggernauts like PayPal, are vying for a lucrative slice of the pie. No one solution has emerged dominant, able to unite companies, merchants and banks and gain mainstream acceptance.
And that patchwork is only confusing consumers and eroding trust — that central and magical element of monetary exchange. Consumers only seem to trust low-cost mobile transactions, like ordering daily lattes, EMarketer added. And security is a concern, as well, especially as high-profile hacks continue to make headlines.
Some players hope to break through, though. Isis, the mobile payment venture that’s backed by AT&T, Verizon and T-Mobile, in tandem with banks and credit card companies, plans to roll its service in this year, after nine months of testing, according to Bloomberg. The app will launch on multiple platforms, including the iPhone, Windows and the latest BlackBerry devices, as well as a limited number of Android models.
With support from three of the four major carriers, Isis stands a chance, despite taking time to emerge from behind the curtains.
Still, we are reluctant to part with our cash and cards. Even though they have no intrinsic value, they’re still concrete, solid objects that physically connect us to a sense of worth, wealth and value. In a world where we do an increasing amount of reading and relating through electronic screens, you can’t underestimate the importance of physicality and the attachment to it.
But history is an equally inexorable force, and the trajectory of money is marching relentlessly towards an increasingly virtual, abstract form. Once, we held gold in our hands. Then, paper bills. Now, carriers, banks and tech companies would very much like to keep our money in e-wallets. Within that arc, currency itself will soon emerge from the vaporous twilight between computers and terminals, as algorithms create value out of bytes of virtual currencies.
It sounds like a hacker’s notion, but when looked at in the view of the larger history of economics, it is a likely next frontier.
Nakamoto’s Legacy
Nakamoto remains a tantalizing mystery. Many in the community assume he is out there somewhere, watching his work from afar. “He could kind of step in and say, ‘This is bad.’ It could happen,” a Bitcoin developer told Motherboard. “And he would absolutely have enough sway. His word is pretty much bond, especially if he were to come out from reclusiveness after all those years.”
His legacy, though, may not be bitcoins, but the larger acceptance of virtual currencies. Rivals like Ripple, run by a for-profit company, and MintChip, powered by the Royal Canadian Mint, are springing up to offer digital equivalents to paper fiat money.
It is worth remembering that the original currency of the U.S. — the Continental dollar — failed the first time. Only after a federal bank was created, underwriting its value, did the dollar take off. The future of Bitcoin’s success rests on its willingness to play by the larger, more established rules — but who knows if the community will step in and keep that from happening.
Still, Nakamoto’s marriage of peer-to-peer networking, cryptographic-based security and public transparency will catch on in other permutations, which will take aspects of his ideas and practices and run with them in different directions.
No matter what it looks like — or whether we call it bitcoins — his strange, cryptic gift will help bring money into the twilight, vaporous future, allowing people to transfer money through algorithms between machines, freeing us from dollars and cards at last.
