The Mining Centralization Myth – Part 1

hqdefaultIn this 2-part article, I have decided to address some of the very commonly spread myths in Bitcoin space, namely that of mining centralization, and its effects on the BTC price valuation.  At the end of reading this I hope that you will have a better understanding of the complicated topic of decentralization in terms of economic factors, and also how everything is perfectly reflected in the BTC price.  Also, I hope that you would have a new found appreciation that BTC price is going to continue to fluctuate wildly and even may go to zero, under certain certain scenarios.

But first, to the often repeated, and universally unsubstantiated claim:  That Bitcoin is suffering from miner centralization.  First off, I want to stave off all the thoughts that the proponents of this opinion are thinking now: “You must not have heard of this thing called the Great Firewall of China!”, “You must not understand what the propagation delays are and its affect on orphan rate!”, “You must not know about the mining relay network!”, or my favourite, “Maybe you haven’t heard, but they have this corrupt oppressive government over in China!”.   Rest assured, I know, I have heard all the arguments, and I have well connected business associates in China.

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Is Money the Same as Currency? — The True Nature of Money

It’s a simple question.

But it is one that 95% of people will answer wrong. Don’t feel bad. I would have as well if you were to have asked me 10 years ago.

Ans: They are not the same thing.

Those in power would like you to think of them as the same thing. In fact, we have been taught since we were children that they were the same. That is, if you were lucky enough that they taught you anything at all about money in school (more than just recognizing coins and dead presidents faces that is).

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PoW and the evolution of commodity currency

The last couple of posts were devoted to the complications arising from Proof of Stake coins which I argued serve little purpose other than as a digital equity and move corporate and governmental powers to developers from the bankers and industrial magnates of the real world.  I have since been asked to give more details of Proof of Work and why it and it alone is different and can result in the creation of a commodity money.  Fair enough, so here it goes…

Commodity Money

Commodity money, as I have detailed in the past, is commodity that is naturally adopted by society to serve as a common medium of exchange, i.e. money.  The ability of a  commodity to serve as a money depends mostly on its intrinsic characteristics of divisibility, immutability, fungibility, and scarcity.  But, what makes a commodity, say, different from a credit note, or a bill?  Simply stated, a commodity is an asset or a thing (physical or virtual) that:

1) Required work to produce it

2) Had some initial intrinsic value

Let’s look at each of these in turn.  First, it must have taken some work or energy to produce or to prepare it for use.  That work or energy was consumed in a physical (or computational) process and the process cannot be reversed, or whose energy cannot be otherwise reclaimed.  We innately understand this, as every commodity we produce in the real world is a product of human labour and work, requires energy, and results in an asset produced.  Symbolically:

Work + time * efficiency ==> asset

Expend energy in producing useful work, put in some time, subtract waste losses, and out pops an asset, whether it be a gold bar, plutonium ore, or bitcoins.

The ‘birth by work’ concept is important because the producers of the commodity are 1 level removed from the politics of the commodity’s use as a money.  The producers (or miners) of a commodity are simply interested in improving their ability to extract or mine the commodity and sell it into the market for use as money.  In this way, the creation of the commodity money is pure as it first enters the economy through the free market, regulated and controlled only by the natural forces of supply and demand and price.  Contrast this to fiat money which is regulated and controlled by ‘experts’ in an ivory tower, who believe that they have the magic formulas to make decisions for the economy, because they are smarter than the collective opinions of everyone else.  (To those of you who believe this fallacy, I implore you to watch this: Why Socialism doesn’t work ).  Astute readers will be thinking right now, “hmm… this sounds a lot like all the criticisms you wrote about previously with PoS systems!” and you would be exactly right. Essentially a PoW produced coin is a free market money, whose supply is controlled by the market, while PoS ecosystems are just digital forms of socialism.  Centralized control of a rule-based system, no matter how noble in conception, will inevitably fail, as history has shown us.

The second important aspect of a commodity money is that it must have originally had some intrinsic value to it.  As Ludwig v Mises describes in The Theory of Money and Credit, the value of a commodity money (or the price) derives from its previous value the day before, and the value it had the day before, on the value on the day before that, etc. If one could trace back until the origin of the first exchange of the commodity asset for something else, you will discover the value of commodity money comprised of only the value of it as a asset (consumable) alone.  This initial intrinsic value as a commodity is what initializes the objective exchange value of a commodity money and as it slowly gains acceptance, it acquires value as a money.  The relationship can be seen as:

commodity money value = value as a money + value as a commodity(intrinsic value)

Where the intrinsic value of a commodity money is more or less stable, its value as a money is what fluctuates greatly and rises as it is demanded for in its use as a money instead of as a commodity.

With bitcoin, and other virtual assets, we for the first time find ourselves lacking the language to properly describe the phenomenon of how a digital commodity money can come into being.  The notions of work being the means to convert some atoms from one state to another (more useful) state don’t apply as nicely.  But if we ignore the physical reality of the creation of a digital asset for a moment, and assume that it is done via some magical mining process akin to the mining of a physical metal, what then, is the initial intrinsic value of a bitcoin?  This is the key sticking point that has prevented the acceptance of bitcoin by many of the hard money advocates and Austrian economists around the world.  This is where I will likely draw a line between them and I, although we hold many of the same beliefs:  I believe that the intrinsic value of bitcoin is in the utility of the blockchain.  The initial value which bootstrapped the digital commodity of bitcoin into the mystical category of money was that it provided a measurable, quantifiable, utility.  Which was this: the ability for the first time to have a shared database owned by everyone and no one, and have it maintained by trust-less parties acting all according to their own interests alone.  The value of an immutable, incorruptible transparent record, is what that initial intrinsic value of a bitcoin represented.  To own one was to take part in an incorruptible public record system, which is something that could certainly have been used many times in human history to solve many disputes, even wars (the corrupt Byzantine Empire may have fallen sooner, to be sure).  The fact that the value of the token derives from the network in which it exists is the reason many detractors may call Bitcoin a ponzi scheme.  Indeed this same feature is present in all crypto-currencies, where the reward in participating in the network is paid for by in-system tokens.  The difference between them though, is that work is expended in their creation, and thus Bitcoin and other PoW tokens are commodities, and not equities.  That being said, the digital commodity we call bitcoin is the only digital commodity to date to have reached a ‘money’ level of valuation and use.

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Centralization: how everyone is trying to ‘solve’ a very old, very hard problem

Several weeks ago, I mentioned that I would explain why Bitcoin is the only commodity currency that can exist.  I am not doing this topic enough justice, but I will touch briefly on this before moving on.  Succinctly, the reason is that commodity currency is always spontaneously created in a locality in order to facilitate indirect exchange in the immediate community that it serves.  This has been shown in the past, with gold, silver, and to a lesser extent, sea shells, jade, glass beads developing as the commodity used for exchanges.  The extent of the geographical usage of a certain type of commodity money, was based on how far its reach extended while still retaining its characteristics necessary to perform as money.  For instance, seashells didn’t have too large of a locality, because pretty soon as the economies that it served got larger and larger, people found out that seashells were actually not scarce enough and hyper-inflation destroyed the value of the commodity as money.  Another issue that physical commodity currencies faced was that due to their physical form, their circulation was very much limited to the extent that they could be passed from person to person. This meant that societies isolated from each other (economically) could individually develop their own preferred commodity to be used as money.  This is how it became the case that some societies settled on a silver standard while others settled on gold.  Both metals possessed all the necessary characteristics required of money, and the only reason that more than one standard evolved was due to the fact that the societies were isolated from each other, and thus had no need for inter-commercial connections.  This fact also illustrates how economies will inevitably settle on one standard, barring physical restrictions.  Bimetallism, where both gold and silver were simultaneously used as the official unit of money only developed, (without the help of any government) due to the limitations in the ease in which gold could be divided into smaller portions, and as such silver facilitated small scale commerce while gold handled the large value transactions.

Fast forward to the age of digital currencies.  The locality of Bitcoin is the internet.  There is no hidden stash of bitcoins to be suddenly unearthed somewhere, so we can rule out a sudden unexpected jump in the supply of the commodity.  This means that, for the first time, we have a commodity which has a very stable well-defined supply curve.  From this it follows, that Bitcoin should at the least have the potential value stability as gold had in the past. Additionally, since the locality we are concerned with is the internet, whose reach is global, Bitcoin will suffer the issue of having competition from isolated societies that can compete for its usage, the way gold had to contend with respect to silver for a long time.  Thus, as Bitcoin already has a very solid economy and usage on the internet, along with the fact that the divisibility of Bitcoin is not an issue given its digital nature (if we ever needed sub-Satoshi value transfers, side-chains would be able to facilitate this), this is why I believe that Bitcoin is the only commodity money that the internet will ever need.

Centralization

A hot topic in crypto currencies circles currently is the topic of centralization.  This topic is hotly debated in both Bitcoin camps and other non-Proof of Work projects.  Collectively I will categorize them as ‘PoS’ systems standing for ‘Proof of Stake’.  The reason this topic is so hotly debated is that any discussion that involves it will inevitably gravitate towards politics, democracy, and the preservation of individual rights and freedoms, and we all remember from our childhood family dinners that when politics are brought up at the table an argument was sure to follow.

Essentially what blockchain technology is, is the ability of a decentralized network system to be able to store a database of information (a ledger) in a synchronized way without any inconsistencies arising from the peer-to-peer nature of the network. Both PoS and PoW systems address the issue of consensus in a P2P network, which is to say, they govern how to ensure the integrity of the data, with peers freely joining and leaving the network.

I will try to address the criticisms for and against PoS and PoW, but first, some detailed explanations of each are in order.

Proof of Stake

Decentralized consensus systems rely on incentive systems to ensure honest actors prevail over bad actors.  Proof-of-stake essentially attempts to solve the incentive problem by requiring actors to ‘stake’ or lock up some of their in-system funds in order to participate in a lottery in which the winner is selected to ‘win’ all the fees from the transactions that were confirmed in the last block or update.  Some variations on this include systems that distribute the winnings in proportion to the amounts that were staked to all participants in the lottery, which essentially amounts to a deposit banking system, where as unneeded cash reserves are locked for a time, which serve to produce an ‘interest’ rate paid to the depositor.  These deposits are not on-demand (they are locked for a time duration) and thus constitute a full-reserve banking system model.  Without the requirement of work, PoS systems promise to be able to confirm blocks at a much lower external cost and faster than PoW systems as there would be no electricity required over the normal amount needed for just running the validating node itself.

Proof of Work

This is the system which Bitcoin uses, and as I described in a previous post, the work involved in creating the coins allows it to mimic a commodity money economy precisely.  In fact, if gold or oil reserves were completely known a-priori, (no sudden discoveries of new reserves somewhere, all reserves on the planet identified) then the evolution of gold from shiny metal to being the world reserve money would have followed the same path as Bitcoin, albeit on a slower time scale given that technologies to mine gold more efficiently took a lot longer to develop and required a lot more capital resources to develop.  This work expended in order to maintain and secure the network consensus, is an external cost to the system (in kW/h in this case) and the reward is paid for in internal network coins (bitcoins).  Unlike PoS, the amount of weight or influence you posses as a securer of the consensus system is not a function of the wealth that you have in the system (represented by your stake) but instead by the amount of external work that you can put into it at any given time (in kW/h and hashes/s). This cost to maintain the network being external, you will see, is the key to why PoW systems are in the long run more likely to succeed in creating a stable money system.  But for now, let’s address the individual pros and cons of each system.

The Problems with PoS

PoS coins are equity, not money.

I have found that a very accurate analogy for PoS systems is that of shareholders equity of a company.  The bigger share you have, the more voting rights or power you have to determine the companies future.  Your voting rights are proportional to your share ownership and dividends are paid out to shareholders.  One important fact that you will note is that while equities definitively have value, that value is tied to the health of the company, and certainly a share has little or no exchange-value/money value, because it isn’t used as a common means of facilitating commerce.  Indeed even if we could trade equity as freely as we can trade bitcoins or cash, I do not believe that it would be usable as a money-substitute, for reasons similar to the one against widespread credit money, simply the lack of people willing to accept it due to counter-party risk, would prevent it from getting widespread adoption.  Now there are some key takeaways here in the comparison of PoS systems to equity in a corporation.  Firstly, corporations are highly centralized entities;  how many of you who have worked at a large corporation and can say that internal politics were not an issue at work?  Fact is, when people are incentivized to expand their own shares in the system then there is a lot of infighting and manipulation of the rules of the system to one’s advantage.  The game inevitably (in a poorly run company) becomes one where the upper management is tasked with keeping the lower ranks of employees complacent and happy while they continue to use the system to enlarge and ingratiate themselves and their friends. If you think this sounds familiar, then you are right my friends, this is exactly how politics of government work. (yes, even in democracies!)  PoS systems mimic this exact system, because the rewards given to those who maintain the system are proportional to the wealth and power the parties hold in the system itself.  It’s the rich getting richer problem that those socialists always rant on about.  Pretty soon, given lack of competition, one ruling party will become incumbent and provide most of the security in the system, and you would have a mirror of our centralized political system in the real world.  This can be the only logical conclusion to any PoS based consensus system.

Advocates of PoS systems argue that unlike government, who’s rules are hard to change, with crypto currencies, they can reserve the right to tweak the system parameters as to avoid the centralization problems we see in the real political world.  I am not convinced that such a solution has ever been found.  Think about it, we as humans have been iterating over many different political systems in the last 6000 years of recorded history.  We have moved from centralized systems of monarchy, to federated systems of feudalism, to socialism, to capitalism, and to date we still have not found a completely ‘fair’ solution which is incorruptible.  Do you believe that a couple of computer science and math academics will suddenly be able to solve this problem which has plagued humanity since the emergence of civilization?  Perhaps, but I’m not going to bet the farm on it.

Staking incentives are economically biased

Being a proponent of free market economies, another issue that I see with PoS systems is that the staking process is inevitably linked to the fiscal health of the system.  What this means is that how much people will stake to help secure the network is akin to the decision of how much value would you save in the bank vs invest vs spend.  As we have seen, staking is essentially locking up an amount of value for a certain period of time, such that you can earn a return or interest on that amount.  This boils down to a lenders vs savers game.  As staking can be seen as a risk-free rate of return that the network gives you, as the demand for cash in the micro-economy rises (interest rates and investment returns rise), then you will see less people staking and the security of the network is adversely affected.  Also, as there is a greater incentive to stake with the more stake you own, you will see a gradual gravitation of large holders of the coin to simply stake and ‘collect rent’ from the network.  In the real world, as money becomes cheap, interest rates fall (it becomes increasingly easy to obtain capital from investors) and as such the deposit rates at savings institutions fall in step, thus reducing the incentive to park your money in a bank.  This creates a balancing effect between the supply and demand for money because as more people demand money, the supply of it becomes more available.  On the contrary, in a PoS system, where the ‘interest’ on deposits are paid for by fees of transactions, the more transactions that are processed, the more interest would be paid to stakers.  Thus, quite backwardly, the more money which is used up in fees and thus increasing the demand for money, then the less likely it would be made available by the people who control large sums of it, because they can increasingly make more money by just locking in with the richer risk-free rate of return obtained by staking.  This creates an economic bias to hoarding over spending.  The rich will in general hoard more while the rest will be forced to spend more (in an attempt to become rich).  As a student of free market Austrian economics, I do not believe putting any bias on the side of spending or hoarding is a good thing.

The incumbent whale problem

Another problem that PoS suffers heavily from is what I call the incumbent whale problem.  What this means is that a sleeping whale, with a lot of stake in the system (be it that they were an original founder, or an initial adopter who made a lot of gains in the system) can then immediately become an influential player in the stability of the system.  Imagine if a founder of a PoS coin (whether it be an individual or some foundation) with a significant amount of coins comes into the system and becomes a large part of the validating power due to the large stake that they are willing to devote to the staking process.  This means that at anytime, a large player can jump into the staking game, and adversely reduce the profit of all the little players who were in the stake pool.  This makes the process of staking your coins a very volatile and risky one, and this would likely discourage many would-be stakers from putting in too much of their value into the staking process, which reduces the security of the consensus process.  Compare this to a PoW system like Bitcoin, where even if the largest stake holder (presumably Satoshi Nakamoto) were to come into the system now, there would be nothing that he could do to affect the system stability directly.  The only thing which is in his power to do would be to sell off his large hoard of coins, into the market and depress the price of the coin.  This is a perfectly legal and valid activity from the free market perspective, and the size of his stake had no direct bearing in his ability to harm or profit directly from the system itself.  This is exactly the same reason why hard money advocates sing the praises of the benefits of gold over fiat currencies.  A large holder in gold has very little influence over the gold mining industry.  There is one argument that examines the risk of a large holder in gold paying off the gold miners not to mine, and we will address this particular criticism later on.

A secondary issue with the whale problem is that when an actor who has a large stake in the system, if caught attempting to defraud the system, will lose only their staked amount.  This means that an actor with a very large pool of coins can statistically always win over those with less stake.  This is similar to a game of Texas Hold’em poker where going ‘all-in’ is not permitted.  Basically the whale on the table only needs to out-bet his competitors by the minimal amount in order to ensure that he continues to maintain (and increase) his lead over the others.  Of course in this case you don’t win the stakes themselves but only the fees of the processed transactions in the block, though the premise is the same.  Additionally, if you were to blatantly commit fraud somehow either by filtering transactions that do not pay you or your conspirators, or by deliberately not relaying some transactions and you are caught, you only lose your stake, and are free to continue to try again next time with a new stake.  Compare this to a PoW mining pool which is caught in act of outright fraud; they would lose all their members immediately and would be forced out of business.  This is the situation I mentioned above where a rich gold holder pays a mining company not to mine, which of course we have not seen successfully employed in the real world.

Defenders of PoS will claim that they will and can enact rules into the system that would punish those who break the rules so as to provide enough of a deterrent to these would-be bad actors from doing so.  Even if that were true, (which once again, would be a remarkable breakthrough in legal and political systems that have yet to be solved in real life) that inevitably mixes the monetary system with the legislative, judicial and enforcement systems.  If we have a hard time agreeing on making small changes in just the economic rules of a cryptocurrency, then I don’t have much faith in the ability of a couple of math nerds to come up with the right rules of criminal justice.  And even if they did manage to come up with a perfect set of rules, we have already devolved our system into one that relies on a central body (the developers) to make the rules.  To say that a PoS system can come up with a set of rules to make sure people act fairly is to give up on the notion of a decentralized currency completely.  

There is a very clear delineation between the things that the developers of Bitcoin need to deliberate on (what size of the block to use, what confirm cycle time to use) and those of what a PoS system must decide on (how to detect, determine guilt and punish those who stake and defraud the network) An analogy would be that one is tasked with deciding on how wide to make the roads and railway tracks for practical reasons, while the other is tasked on deciding what is illegal and what rights of the participants in the system must be protected, and how so.  To mix these into the same bucket is to ignore the fundamental socio-political issues surrounding PoS staking.

The criticisms of PoW

Now that I have thoroughly elaborated on the criticisms of PoS, I shall turn to the common criticisms of PoW systems, which have been so emphasized by many media outlets, that they should come to no surprise to the reader to see them represented yet again.

PoW mining pools breeds centralization

Many people will say that due to the centralization of mining pools, this creates a centralized PoW system.  (We will assume for the moment that all proof of work algorithms will inevitably centralize for the sake of debate).  The truth is yes, while PoW does not guarantee the system to be free of centralization, much like the gold mining cartels of yore, if a magnate gold tycoon were to buy up all the mining companies they would indeed enjoy a monopoly over the production of gold, and thus the money.  But if that were indeed true in theory, then why did it not happen in our history?  Surely we had enough time since the onset of modern civilization to observe this happening if it indeed was possible.  Perhaps it was actually attempted several times in the past, but it failed and thus we never heard of it.  A clue to why it doesn’t happen can be seen in the diamond industry.  DeBeers owns a monopoly on the mining and sale of diamonds and that has severely limited it’s use as a money. Nobody wants to hold too much ‘storage value’ in a medium which has one controlling party at the reigns.  Correction, that’s exactly what we have with the Federal Reserve Note.  The difference is that with fiat we have the government’s legal tender laws forcing our acceptance of it.  So we can see that centralization of control of a commodity money will destroy its value and thus its use as a money.  PoS defenders however will rightly say that although it has never happened, it cannot be mathematically proven that it cannot happen in the future.  This is a constant source of debate between the mathematicians and the economists.  Take for example, the historical fact that we don’t need to prove that hyperinflation can happen to know that it will happen given the right conditions.  The systems in economics depend on the subjective behaviour of billions of individual actors, and to assume that we would be able to accurately model them with any degree of accuracy is a fool’s bet (at least given current computational resources).  To say that it cannot happen because we cannot prove that it will is an mistake.

PoW doesn’t solve the problem of centralizing powers, but it at least decouples the miners so that they are incentivized only to keep their business running.  If they sellout and defraud the network, then miners lose their users.  Significantly, mining pools are businesses.  These businesses exist to turn a profit (whether in Bitcoin or fiat).  If a business is found to be a bad actor, there is an extremely effective deterrent that has been employed over the centuries that has proven more effective than any government regulation ever could: the boycott.  Pool operators are businesses with clients.  Their clients are the actual miners.  If the pool operator ‘sells-out’ to a bad actor, for instance, by leasing out or lending their hashing power to a secret party for the purpose of a 51% attack, then they risk losing all of their clients when they are found out.  Indeed they would be incentivized to keep the value of the coin as high as possible in order to profit from the fees they are collecting.  The key here though, is that they are running a for-profit business.  In a PoS system, the large staker may be an individual, and has no business model or revenue stream to protect.  In addition, they can recover from a failed attempt to defraud the network and try again later on, losing only their staked portion for the failed attempt.  From the perspective of the miner/staker, the risk of defrauding the network is much greater for the miner of a PoW system, as it is represented by the capital investment in their mining farm hardware (paid for by external fiat money), and the future revenue stream in the fees.  For the PoS staker, it is just the amount of in-network coins that they have presently staked.  It doesn’t take a lot of analysis to conclude that a staker will have much less at risk than a large miner when trying to defraud the network.

PoW isn’t perfect solution, but at least it is one that has been shown to work historically in the past with gold.  We know that commodity money can become the world reserve currency on its own merit alone.  That is, at least until a government comes along and makes it illegal and forces us to use their paper fiat money instead.

Externalities

In conclusion, the differences between PoS and PoW boils down to one of externalities.  In a PoS system the costs and rewards are internal, while in a PoW system the costs are external, while the rewards internal.  This complete disconnect with the outside world found in a PoS system lends to dishonest gaming due to ‘free simulation’ (it costs nothing or very little to attempt to game the staking process in your favour), and an incentive system that rewards those who have ample resources in the system more than those who have scant resources.  PoS hardliners and I agree on one thing, which is that PoS systems tightly couples the stakers with the health and welfare of the system, while in PoW the miners are somewhat isolated from the politics of the system and are driven only by for-profit motivations.  Where we disagree is that I believe that this separation is what keeps the number of bad actors in PoW miners to a minimum.  They will not do anything that would serve to undermine their future revenue stream of their mining business.  In comparison, the tight coupling of the PoS staker to the network and his individual influence within it incentivizes him to manipulate the system to increase their own stake and thus power within the network.  Thus PoS runs up against the exact sociological problems that we experience in present day political/corporate systems.  Though they argue that they will be able to contrive rules and punishments in the system to deter any such bad behaviour, (indeed the exact behaviour which a PoS system implicitly encourages if a rational economic actor were to try to maximize their profits and stake) we have seen that no satisfactory system of governance has ever been developed to control corruption in the real world, and the simple fact that we have to create governance rules in the system itself implies that the developers have central control of the system and can be bribed or corrupted themselves by the bad actors.  (Or a worse, and more likely scenario is that the large stakeholders in the system are the developers themselves).  This is essentially why I do not see any possible future where a PoS system can become a global money system.  PoS systems may enjoy some usefulness (and thus their coins some inherent use value) as an application coin, but by no means I see a PoS or a stake based coin ever becoming accepted as a universal currency.  The reasons for which are not technical, nor mathematical, and need not be proven.  They are economical in nature and in such things, as in those relating to human nature, history is the best predictor.

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Why you should be a Bitcoin Maximalist

I have been struggling for the last couple of months with trying to explain the phenomenon known as Bitcoin maximal-ism.  Essentially it is a movement that is focusing a lot of effort primarily into advocating the support of Bitcoin as the blockchain solution at the expense of all other crypto projects.  Being a pragmatist myself, I was at first very skeptical of the absolutist ideals that they seemed to advocate.  However, time has a way of cutting away the flash obscuring the truth behind wisdom, and I have come to appreciate the maximalist position more recently after much consideration.  This story starts and ends in exactly the same place, which is the theory and value of what we call money.

What is money?

Now, bear with me here, as I know I am bound to lose about half of you with boring economic terms reminiscent of the Econ 101 class that you took in university.  I promise that it is worth it.  One of the sources of confusion in crypto space which many people struggle with is that cryptocurrencies are a hybrid of the financial and economic discipline, with computer science and mathematics.  Surrounding this whole thing is the concept of money, and it doesn’t help that most economists can’t agree on the exact nature of money, specifically the objective exchange-value of money.  If you were to ask 10 people on the street the question “What is money?” you will inevitably get 10 different answers and 9 of them will be wrong.  The truth about money and why not many people understand what it is, is no accident.  Great lengths have been taken to ensure that this topic is never sufficiently taught in schools, and confusing or conflicting terminology is used in various different circles which compounds the problem.  So to begin to understand what money is we need to be very meticulous about the terminology that we employ so that we can begin to unravel the overlapping layers of meaning and obfuscation.  We shall start with the simple description of what money is; which is simply a medium of exchange, which can efficiently facilitate the indirect exchange of goods between parties.  If Bob is a Baker, and Will a wheat farmer, Bob can certainly exchange bread for wheat with Will.  But in the case where Will doesn’t want bread, and needs corn instead, and Charlie, the corn farmer doesn’t want wheat but wants bread, then Bob can exchange bread for corn with Charlie, which he can then exchange for wheat with Will.  In this simple example, the corn that Bob bought from Charlie was acting as the money, which is to say it had no value to Bob aside from its use as a facilitator of indirect exchange.  Indirect exchange in turn allows for efficient division of labour, so that people can specialize in baking, corn farming or shoe making, without having to learn all those skills for themselves in order to produce these products for their own consumption.  Money then, is simply a medium of exchange that facilitates the indirect exchange of goods.

Types of money

There are essentially 4 different types of money which have been used over the history of human civilization. Commodity money, credit money, fiat money, and money-substitutes.

Commodity money we are all familiar with.  It was the first money to be ‘invented’ by mankind.  It is simple a commodity that possessed certain qualities that made it amenable to be used as a medium for exchange, this involves properties like divisibility, immutability, easily verifiable, and impossible to forge.  Commodity money of antiquity, like gold and silver, were created spontaneously by the market.  It is in fact the only trust-free money that can be created by the market.  Nobody decreed that gold should be used.  It was used, and the task of governments in the past was to just verify and regulate its authenticity through the system of standardized minting and measurements.  Commodity money is created by expending work or labour in order to extract it from its natural state, and prepare it for use as a money.  This effort (and the entire industry that surrounds it) acts as a natural buffer to fluctuations in supply of the commodity, and thus a damper on the exchange-value of the commodity money.

Credit money is also created by the market, and it is essentially the use of an IOU as a money.  This money, however requires trust, in that every IOU comes with it a certain amount of counterparty risk.  In stable and strong markets, this risk is minimal, but in developing markets where corruption or insufficient legal systems exist to properly enforce contracts, this risk can be appreciable.  Credit money is characterized by the exchange of present goods for future money (or present money for future goods).  Credit money is used quite prolifically in American society in the last 50 years due to the success of credit networks such as VISA and Mastercard.  Credit money, being an IOU only has value so long as it is tethered to another type of money backing it.  In simple terms, IOUs are claims on an actual assets somewhere else, this can be future value in the case of interest bearing bonds, or simply warehouse warrants, or gold certificates.  It is important to note that before 1930s, the US dollar was a credit money, due to the nature of it being a claim to a certain amount of gold held by the national treasury, which was redeemable on demand.

Fiat money is the money that only has value because it has been decreed to have value by the governing state or body.  It has no intrinsic value, and in fact would in most cases be nothing but worthless paper if it were not for legal tender laws and the threat of imprisonment awaiting those who refuse it accept it as an instrument to extinguish any debts by other parties.

Money-substitutes are the last type of money.  Though it is probably more fair to call it a subclass.  It only exists when the conditions surround it such that they can be easily and readily redeemed for any of the other 3 types of money.  Bank deposits and token coinage is an example of a money-substitute.  Token coinage of course is used in most countries.  It is called ‘token’ and not the same as commodity money because it by itself is not intrinsically money.  For instance, if you were to take a quarter and melt it down to the elemental nickel/zinc, it would not have the value of 25 cents, nor would you be able to buy bubblegum with it. (the price of bubblegum being more than a quarter notwithstanding).  Another common money-substitute is poker chips at a casino, and food-stamps in the US.

So what is Bitcoin?

So where does Bitcoin sit in these definitions of money?  Well I know I would be in disagreement with many gold bugs and hard money advocates like Peter Schiff when I say this, but I believe Bitcoin is clearly a commodity money.  Sure, it is virtual.  It is by no sense ‘hard’ in the visceral or tangible sense, but it is clearly a commodity money in so far as the characteristics that economists such as Ludwig von Mises had set out to so meticulously define 80 years ago.  It requires work to produce, it costs money to produce, and the mining or production industry is not directly influenced by the politics and monetary policy of the day.  In fact, the only thing that should incentivize the producers is good old fashioned capitalist greed.  Greed is in fact one of the most pure and predictable of incentives.  It was very likely that in past centuries many environmentalists lamented at the fact that so many gold mining companies were wasting vast resources and energy in digging this yellow metal out of the ground.  They may have even lobbied their governments to put restrictions on the gold mining industry “for the collective good of mankind”.  “Look at all the wasted effort and energy that they expend just to ingratiate themselves”, they would have said.  I tell you definitively that these people did not understand the market and the mechanisms that work within it nor the forces that naturally control the flow of supply to meet demand. (The demand for money).   I digress, however, as I think you will agree that the point of Bitcoin having all the characteristics of a commodity money have been shown, and thus should therefore act exactly as one in the economy.

Altcoins

So why all the altcoins?  To date I believe the number is in the thousands if one were to count every type of digital currency created since the advent of Bitcoin.  But why do they exist?  Why do perfectly logical smart people devote so much time to creating them and promoting them?

Simply put:

1) People are greedy

2) People do not understand money

3) People do not grasp that blockchain and Bitcoin is an experiment in money, as much as, or perhaps more than it is an innovation in technology

People are greedy

The first requires little explanation.  People are motivated by greed.  Ponzi schemes are great for “redistributing wealth” from people who do not possess the same information or reasoning capabilities as you may have.  It is easy to mask a new altcoin in a thick blanket of rhetoric singing praises of “equality of opportunity”, “common good” or “freeing the people from oppression”; you know, socialistic sounding marketing phrases that any reasonable, even-tempered bipedal on the planet would agree to.  Start a coin, premine it, or create a fixed supply of money which only you control, and enjoy all the benefits of the central bank, which is to say you use the same mechanism of wealth distribution used for centuries, except with you at the top of the pyramid instead of the government.

People do not understand money

The second point deals with the fact that most people don’t understand what money is, and there for do not really understand what it takes to create a money.  I have previously explained what money is and the types of money that exist.  In order for a thing to be a money, it must clearly fit into one of these categories.  Anything less would be equivalent to Monopoly(TM) money.  It may be money-like, but it is not a money.  This point is where we lose a lot of smart minds wasting their time working on POS (Proof of Stake) systems which aims to either “solve” the distribution issue of Bitcoin or the mining energy expenditure issue.  The fact that I use the word “solve” in quotes belies my opinion on the matter.  They are not problems.  As I have explained in the previous example of gold, complaining that Bitcoin mining firms will ‘go berserk’ if left to its own devices and spend half the world’s energy supply in mining is ludicrous and only serves to illustrate to the astute reader that the speaker does not understand economics.  For even the most devote Keynesian would admit that the free market will find the correct price such that a given activity is profitable.  Miners who expend capital to increase the supply of Bitcoin when the demand for it stays the same or does not increase the same amount will soon find themselves losing money, and at some point they will stop their mining activity.  There is no need for a “government” to step in to regulate the market**.  Ever.  The market is self-regulating by the forces of greed vs fear alone.  As for the question of fair distribution, I ask what is “fair”?  Is a old panhandler who found gold in the rivers of California and subsequently made a fortune by fishing the nuggets out of a river doing anything unfair or unconstitutional?  Would we rather see a law passed that forced all gold miners who profited from the gold rush to relinquish a portion of their gains to the public? (Yes!, I suppose, if you are a communist)  The problem with trying to hand tailor a distribution of money is that you need to control a fixed supply.  A fixed supply virtual asset which is created from nothing and distributed to people, has no value, no more than monopoly money has value.  Sure there may be some token value created by a few people buying it on the promise of future gains, but in truth it is no more valuable than money printed by Parker Bros.  This is because any POS coin is in fact, a fiat money.  Or rather, a bad attempt at creating a fiat money.  Fiat money only works when you can force people to attribute value to it, and use it.  If you hold no such power, you may as well be handing out orange $200 bills as people pass “GO”.

Bitcoin is an innovation in money, more so than technology

This is the crux of it.  The issue is that most computer geeks think that Bitcoin is an innovation in technology.  Accordingly, they see iterative improvements on it as a positive thing, like how cell phone technology improved over time with different companies contributing innovations to the craft over the years.  I cannot remember how many times I have heard developers defend the idea that innovating with different blockchain implementations can only be a net good thing.  “Look at how Apple improved upon Microsoft” they would say, or “look how TCP/IP improved upon frame relay networks!” they would shout.  I say this: these people are categorically misunderstanding what the essence of Bitcoin is.  It is not so much a technology innovation as it is an innovation in money.  Let that fact brew in your mind for a couple of seconds. Bitcoin is an innovation in money.  Money has not seen any real innovation since that fateful day almost 100 years ago at Jekyll Island when the industrialists and bankers got together and designed the Federal Reserve system in order to “solve” what they saw as a problem with the elasticity of money.  Bitcoin created a new sub-category of commodity money: /money/commodity money/digital. Due to the nature of Bitcoin being a money innovation, and the fact that commodity money has a very particular way in which it can come to be accepted as a money (the mining or work process in extracting and preparing the commodity for use) this essentially means that a lot of technologists are wasting their efforts in trying to build better versions of it because they only see it for its technological implementation.  If they only realized what many of us with financial backgrounds have realized, which is that Bitcoin is a new money, then they would be more likely to better spend their efforts building technology on top of this new money network, instead of trying to build their own version of it.

The Cultural Divide

What the crypto space now is suffering from is a divide; a divide in mindset, background and thinking.  It is into this gulf that all altcoins find their existence.  On one side you will find the computer scientists, the mathematicians, the nerds.  On the other you will find the economists and the financiers.  Neither side respects the other enough to actually consider listening to what the other side is saying.  You have folks like Peter Schiff saying that Bitcoin is geek money and isn’t real money. You have Bitcoiners saying that economists and bankers are dinosaurs and this new digital technology will disrupt and break all the rules of the old regime. Both are wrong. Both are right. Both are too blinded by their own arrogance to realize this.

So geeks, computer scientists, developers everywhere. Please stop wasting your time on self-gratifying Ponzi schemes, POS currency systems and other lessor coins and help contribute to making Bitcoin better. It’s an open source code base. Use your brain power for good. Support the only internet money.  Trust me, I’ve sat on both sides of the fence being an engineer working at big bank trading floors for over 14 years, the race is over and Bitcoin has won.  Time to fight the real war, which is the separation of money from the state. Let’s all help make this experiment in new money work.

Next time, I will explore the reasons why there can only be one digital commodity money in world, and why that money is Bitcoin.
** The only time a market should/may be restricted is when it is a question of morality or human decency, and even then, some atheist, anarchists would disagree on that point.  The debate of which is beyond the scope of this topic.
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