The Evolution of Money – Part 2

The emergence of crypto instruments has allowed digital monetary value to be held without the need for a trusted intermediary for the first time in history. Crypto currencies – the most common type of crypto instrument today – such as Bitcoin, Ether, and many others demonstrate this fact.

(This is a continuation of my earlier blog: The Evolution of Money – Part 1)

The emergence of crypto instruments has allowed digital monetary value to be held without the need for a trusted intermediary for the first time in history. Crypto currencies – the most common type of crypto instrument today – such as Bitcoin, Ether, and many others demonstrate this fact. Anyone who owns crypto currency has a unique private key (akin to a password) that allows the owner (and only the owner) to mathematically “unlock” or spend the value at an associated public address (akin to an account number). The ledger that records the amount of crypto currency at any particular public address is maintained by a network of computers (called nodes) that run a consensus algorithm to ensure that they are all synchronised.

The ingenuity of this network of nodes working together to validate transactions (and reject any double-spending) is that the multitude of nodes ensures that there is no dependence on any single one to ensure the integrity of the ledger. This is a powerful concept – the way to remove a trusted intermediary is not to get rid of the intermediary, but to increase the number of intermediaries that are maintaining the same ledger so that trust in any particular intermediary is no longer needed. Dependence on any single intermediary reduces as the network grows, and indeed the term “intermediary” starts to become inappropriate and even inaccurate.

To understand the financial world’s fascination with crypto currency and blockchain, we have to examine the nature of money. The traditional textbook definition of money refers to its three major functions in society: a means of exchange; a unit of account; and a store of value. Interrogating this further, however, it becomes apparent that all three functions relate to the concept of money representing value. After all, why accept money as a means of exchange for something else of value unless one believes the money has at least the value of what it was traded for? And a unit of account that measures the value of other products needs to possess value itself, otherwise it would be abandoned as a unit of account (as we have seen in any economy that has witnessed hyperinflation). So if the functions of money boil down to the value it possesses, what determines the value of money?

Six characteristics determine how effectively money performs the functions mentioned above and in turn determine its value. These characteristics are:

  1. Durability – if money is meant to store value and does not last long itself, it cannot function as a very good store of value;
  2. Portability – to facilitate trade, money needs to be very portable, and costs associated with transferring it from one party to another diminish its function as money;
  3. Fungibility – a unit of money should be exactly the same as any other unit, otherwise time and energy would be consumed in comparing tokens rather than promoting trade;
  4. Divisibility – the smallest unit of money must be worth less than every other tradable asset, otherwise another token of money would need to be used to trade something worth less than the smallest unit of money;
  5. Scarcity – the oversupply of any commodity brings its value down, and in the extreme case, where something is overly abundant, it cannot be used to trade for other scarce resources; and
  6. Acceptability – money is accepted because the recipient believes it will be accepted by others when he/she wants to spend it. Without the belief that money will be accepted by others in the future, it would cease to be money.

Crypto currency is a better performing form of money (versus physical cash and digital money) in two significant ways: (1) It is more durable (it’s backed up by many more servers across institutions than traditional digital money that is backed up only by the servers of an individual bank); and (2) it is more portable (as it is more seamless to move money on a single decentralised ledger than across different centralised ledgers). Money is supposed to be the most frictionless asset in society, and crypto currency is the most frictionless form of money to date.

The Evolution of Money – Part 3 coming soon!

by Farzam Ehsani