Chapter 3 in a series "How to Think About Blockchains".
The first thing blockchains disrupted was money. Understanding what money is and how blockchain based money works is a great way of understanding some of the impacts of blockchains. This article digs into some details of where money came from, the types and forms of money, and its functions, all from a blockchain perspective.
History
It is easy to succumb to what CS Lewis called "the snobbery of chronology", and assume that the way money is now is the way that it was meant to be, and always will be. Even a brief look at the history of money, though, highlights that mistake. Money has evolved from the use of shells and grain to precious metals, deposit receipts that became bank notes, to government issued ("fiat") money. Money is our primary incentive mechanism, and comes in many forms - primarily digital ones in our current world. If you see blockchains - a new form of computing - as just the next step in money's technology, then you are halfway there.
The turbulence around blockchains and money stems from the fact that the first application of blockchains was Bitcoin - a new type of money. Just to be clear here, there are two key characteristics of money I am dealing with. The first is form: how it is represented, e.g. as coins, database entries, or tokens. The second is the type: where does the value come from, e.g. government mandate, trust in the banking system, or digital scarcity. A stablecoin is (in one incarnation) a token representing a traditional US Dollar held in liquid assets somewhere. This is a new kind of form only; representing "traditional" money using new technology. Bitcoin is also a token, but is also a new type of money. Bitcoin is also only a token, whereas the stablecoin is tokenised, i.e. the token references something else.
Let's look at money from this angle, and what blockchains do to it.
Forms of money
As with any new topic, the best way to understand it is often to break it down to its core components. It may help to start by thinking about types of money we already have. If you think of money, your first thought is probably the bank notes in your wallet. This physical cash in the form of notes and coins is usually issued by central banks, and is the only form of central bank money that individuals can hold. Central bank money is generally considered the highest form of money since it represents a claim on the central banks, and central banks don't go bust, at least not in their own currency. Large clearing banks hold central bank money in digital form as balances at the central bank: where the banks have bank accounts.
The second type of money is issued by commercial banks. This is the money that you have in your bank account. Your bank balance is a liability of your bank, and represents a claim on the bank's balance sheet. You can convert it at the ATM to cash, but if a significant portion of customers try the same thing, then the system breaks down, because banks are solvent but illiquid. The bank issues much more in credit than it holds in deposits - this is fractional reserve banking. It feels weird when you first encounter it, but this is how projects and purchases get funded, and it makes the economy tick. In the worst case scenario, if your bank goes bust, then you are in line with other creditors, unless the government offers some kind of deposit insurance, which is the case in many countries. When I transfer funds from my bank to yours, what happens in the background is that the two banks settle that transaction between themselves via their central bank accounts. Ultimate settlement is in central bank money.
On top of central bank money and commercial bank money, many countries have forms of e-money. This is often issued by mobile network operators branching out into financial services. They give you a credit in your e-money app, in whatever form, and that is typically backed by a balance held with a commercial bank. It is a third layer on top of banking. The balance in your MPesa account is a liability of the operator of the system, who must hold 100% backing. Think of it as a cheap and efficient operating layer on top of the banking system.
We tend to think of central bank money, commercial bank money and e-money as interchangeable or fungible in our daily lives. This is fine until it's not, as is evident every time there is a bank failure. These three are all forms of fiat currency, or "sovereign money" as some would have it.
A fully backed stablecoin should be thought of as a fourth form of sovereign money. In digital form, central bank money lives on the central bank's database, commercial bank money lives on the banks' databases, and e-money lives on the issuers' databases. USDC and Tether (USDT) are fully backed stablecoins, and live on several distributed databases, or blockchains: Ethereum, Tron, and so on. The key difference is that these databases are not confined to any single jurisdiction. This complicates regulation, although good stablecoin regulations are starting to emerge, and it also tends to make governments nervous. Ironically one of the most nervous governments, or certainly the one taking longest to craft any useful legislation, is the one that probably has the most to gain from accessibility to digital dollars: the US.
Types of money
These are all forms of money but even stablecoins are not a new type. Bitcoin is. This is where it can get philosophical. I was tempted to repeat above the cliche that all money is credit. It's only a cliche because it's true, and the other one is that "money is a social construct". This is a bit trickier, but again it takes us back to the history. Something has value because it has utility in some form, hence we traded with grain, spices, silver and gold. Later we began to reference these precious metals with more convenient forms, banknotes, so we came to the gold standard - currency backed by gold. In 1971, President Nixon euthanised the gold standard, and so what we have now are national (or regional) currencies that reference ... what exactly? We are obliged to pay taxes in these fiat currencies, and they have something called "legal tender" status, but really they have value because we agree that they have value. We got to that point via a history of using money, building it into our systems, and trusting in its continuing usefulness.
Bitcoin is often talked about as "digital gold". It has a scarcity, like gold, but enforced by code rather than by nature. It has utility as money because it exists as a token, and is accessible anywhere with an internet connection. It is increasingly considered to have value, and it is getting built into our systems; witness the record breaking ETF launches in the US, or the steadily growing adoption of Bitcoin by people and organisations.
What are the key characteristics of this new type of money? Well, it is purely digital, as noted, so only exists in code. That sounds daunting until you recognise that your bank balance only exists on the bank's computer; Bitcoin is distributed across thousands of computers. Then Bitcoin is decentralised, so it is not subject to the actions of a single authority; it is therefore censorship and seizure resistant. This sounds unimportant until you recognise that many countries have seen government debasement of their currency, many people have had assets frozen, and even the US has been known to ban ownership of gold (from 1933 to 1974, by Executive Order 6102). For a global and digital world, a global and digital currency might be something useful, or even necessary?
Functions of money
Money in its various types and forms performs one of three famous functions. These come from the work of English Economist William Stanley Jevons, specifically "Money and the Mechanism of Exchange", published in 1875. This book is amazing, delivering insights on all sorts of things from the origins of banking to what money should physically be made of. It also illustrates how basic principles don't change over time, which is why we often end up breaking things down into the basics like this. Jevons identified four functions of money, now generally condensed to three. They are: a medium of exchange, a common measure of value, a standard of value, and a store of value. The medium of exchange is the thing that we are all happy to receive in payment - initially many things including salt or silver, and now money. From this comes the second, since everything comes to be measured for its value in terms of the medium of exchange: this bottle costs $5. The last two are usually condensed into a store of value, being the standard that I use to measure value into the future, e.g. the discharge of a debt; and the store of value being the thing that I can use to preserve value or transfer it easily over distance.
The benefit to going back to 1875 is that it helps us to think about what money is really for, and how we found ways of combining those functions into one type and a handful of forms, as discussed above. Jevons describes the medium of exchange coming first, then leading to the measure of value and then the standard and the store. This seems like a logical progression, but I don't think it will be repeated as we fully embrace digital money.
It is interesting to look at Bitcoin here to see why. It is currently finding a use as a store of value more readily than as a medium of exchange or a measure of value. Perhaps this is because it appeared in a world that already had effective mediums and measures, but that has space for new stores of value. As more people choose to store value in Bitcoin and other tokenised forms of saving, and as the automated mechanisms for swapping one form of value for another become cheap and fast, what happens?
It is possible that we will see blockchains become a Babel fish for money. As you ought to know, the Babel fish is a fictional device from Douglas Adams' masterpiece - a fish you can put in your ear that translates foreign sounds into language that you understand. A combination of multiple stores of value and the ability to convert between them on the fly can do the same thing for money. If I choose to store my value in Bitcoin, and you prefer to store yours in Euros, then it doesn't matter. I will see prices in Bitcoin, and come to judge value in Bitcoin over time, but when I pay you, you receive Euros. The store of value thus becomes the only function of money that matters. It is obviously more complicated than that, but this example serves to illustrate how this technology can change behaviour.
Blockchain based money
So imagine that your bank used the same database as mine, and that database could be used by anyone: individuals, merchants, organisations, even machines. Transactions could be fast and almost free. We could programme the behaviour of our money, automate financial activities in a way that is currently impossible. That's cool - probably cooler than we can imagine yet - but it pales in comparison to the next step. What if other forms of value were also on this database, this blockchain? Maybe equities, property, loyalty points, anything? Do we end up with an explosion of value or money types, or do we consolidate on a few? How would the liquidity work between different types, and how do we engage with this system in the different things we do? These are all questions that are still being answered, and those answers will evolve over the next few decades. We are still living in that process of evolution with the web and its impact on business models and human behaviour. You couldn't look at yahoo.com and predict TikTok; you can't look at the current web3 offerings and predict the end game.
What we can do is project a bit from what we can see now. What happens when (nearly) everything is a token? That's the next article in this series.
Comments