How Finance Began 4000 Years Ago, And Why Blockchain Will Completely Change It

The following is an op-ed on behalf of Blockmatics. To learn more about blockchain, attend one of their featured events at NYC Blockchain Week.

The blockchain, the technological innovation underpinning cryptocurrency, has profound implications for the ability of a state to govern its people. To really understand these implications, one must first understand the complex relationship between the state and money, the role of the state in the formation of currency as we know it today, and the state’s use of money as a tool of governance. Money is not simply a unit of account, a store of value, and a medium of exchange—it is a governance institution, designed to organize, incentivize, and control the people of a state. As early as the fourth millennium B.C., we see the hand of the state setting the rules of the financial system. In Ancient Egypt, gold bullion of a set weight was established by the political authority of the time as the standard measurement of value—the dominant unit of account. The same was done in Mesopotamia with silver.

The state’s role in money only expanded from there.  The minting of coins from precious metals expanded the state’s ability to set the unit of account. By the eleventh century A.D., so-called “free minting” came to be a common practice in medieval England. Free minting, contrary to what the name implies, was a service provided by the Crown for a fee. Individuals could bring gold or silver bullion to a mint and have it melted down and returned in coin form, known as pennies.  The Crown used pennies as the unit of account in which it collected taxes, which forced people to either hold pennies or mint them to meet their tax obligation. This, essentially, created a demand for coined money and gave the state monopoly power over currency minting.

In late 17th century England, the supply of silver coins was running low. War expenses were on the rise, and the Crown needed much more than they were able to collect in taxes. This led the state to partner with the private sector to create the Bank of England—a private institution which had the legal authority to create money in the form of loans to the state. The money would take the form of bank notes, which the state could then circulate through society by spending. The Crown also created a demand for them by collecting taxes in bank notes. This gave people a reason to hold onto this form of currency, rather than immediately exchanging it for precious metals. The Bank of England would receive interest on its loans as well, which incentivized them to make the loans in the first place. This is the birth of the central bank—a private institution granted the legal authority to create money by the state. Central banks synthesize public authority and private investor interest to create a standardized and expandable currency for use in both the public and private sector.

The Gold Standard, the former monetary system of the United States, operated by the same rules. The Federal Reserve promised to redeem dollars for gold on demand.  Thus, the “value” of a dollar was backed up by the state’s promise of a fixed amount of gold. In 1971, President Nixon brought an end to the gold standard in the US (for the second time in the country’s history). The decoupling of the dollar from gold established the era of fiat currency and floating exchange rates, in which the value of a currency was determined by the supply of, and demand for, that currency. A fiat currency is one that has no intrinsic value, apart from its designation as legal tender by the state.

Under the guidance of the state, money transitioned from precious metal coins to government-issued paper, which gave the state monopoly power over currency. With the invention of blockchain-based digital currency, we now have the potential to disentangle the institution of money from the authority of the state, which would take away the state’s ability to directly utilize the financial system as a tool of governance and hand control of the financial system over to the decentralized network of nodes that run digital currency networks.

Decentralizedis a popular term right now, in large part because of the interest in digital currency and blockchain—but what does it really mean? In the traditional financial system, we rely on the master ledgers of centralized organizations (banks, governments, companies, etc.) to keep track of who owes what and who owns what. With a blockchain, there is no centralized ledger. No single entity is managing a master ledger the way a bank or PayPal does. Instead, the task of maintaining the ledger (referred to as “the blockchain”) is distributed across thousands of nodes (computers) that make up the network. Each individual node has a downloaded copy of the entire blockchain that is continuously updating with each new transaction.

Every time any amount of data moves, these nodes are hard at work checking their individual copies of the blockchain to prevent any fraudulent activity. When the validity of the transaction is confirmed via a consensus between multiple nodes, that transaction is added to the ever-expanding blockchain. Instead of relying on a single master ledger held by a trusted, third-party, such as a bank, the network distributes thousands of copies of the ledger across all of its nodes, which means there is no single point of failure that could be targeted by hackers. Even if a malicious actor were to gain control of a node with the intention of altering past transactions, that malicious actor could only comprise that single node’s copy of the blockchain. If this were to occur, the other nodes on the network would immediately be able to recognize that the comprised node was trying to defraud the system and would disregard that node’s falsified copy of the blockchain. This is the fundamental innovation of the blockchain: It distributes its ledger across a decentralized network of nodes. This replaces the need for a centralized third-party to verify the authenticity of the ledger. It eliminates the need for trust. It also democratizes the money transfer process. Rather than relying on an oligopoly of banks and payment processors to safeguard master ledgers, it allows anyone with a computer and an internet connection to participate in maintaining the distributed ledger.

Blockchain technology also democratizes the process of money creation through this same system. Nodes on the network generate, or “mine,” new bitcoin by utilizing their processing power to group the most recent transactions together and package the transaction data into a new “block” on the blockchain. This is subsequently broadcast out to the entire network, so that every node can verify the authenticity of the transactions in the new block and add it to their copy of the blockchain. Since running nodes is vital for adding new blocks to the blockchain, which is necessary to process new transactions, there is a two-fold incentive structure built into the protocol that promotes mining. The first incentive is that the first miner to solve the cryptographic puzzle necessary to parcel together the newest block receives a reward. The second incentive is that the first miner to parcel together the newest block also receives a fee (paid by the sender) from each transaction it bundles into a block.  Since mining requires large amounts of electricity and computational power, these incentives are necessary to offset the costs of running a node and ensure that the network will always have computational power available to process new transactions.

The transaction confirmation process is, as I said, referred to as “mining.” It takes the power to introduce new money into the economy and to manage the existing money away from governments and banks, and gives it to the people. Mining also importantly serves as a way to imbue digital currency with value. If resources are needed to produce something, that thing can be valued based on the cost of those resources. If mining did not demand the amount of electricity and computational power that it does, or in other words, if it were free, then digital currency would be free to obtain—and in a market context, free is worthless.

Of course, no system is perfect, and blockchain-based digital currencies are certainly no exception. Concerns abound about scalability, high transaction fees, long transaction processing times, traceability, and the environmental impact of the networks’ energy demands. Then, of course, there is the price volatility—although that has nothing to do with the protocols of the system. There are also concerns that the industrialization of mining has lead to a concentration of network power in large “farms” which employ special computers designed solely for mining. The result of this is that, unlike in the early days when digital currency could be mined off of a desktop computer, it is now virtually impossible for an individual to simply mine on their home computer. To mine (and actually earn something from it), one now needs thousands of dollars worth of hardware. Essentially, a segment of society has been priced out of Bitcoin mining. The concentration of mining power in these Bitcoin farms marks a turn toward network centralization, which is cause for concern when the promise of an asset class is its decentralized nature.

Regardless of one’s opinions on the benefits and drawbacks of disentangling money from state authority, the fact remains that it is one of the most important implications of blockchain technology. However, it is important to remember that this technology is still in its infancy, and it is still very much an experiment. At this point in time, it is impossible to predict exactly what effects blockchain will have on the governing capacity of state authorities. The potential of blockchain to allow individuals to store and transact wealth outside of state control is, though, already being realized in countries that lack a stable national currency. In Venezuela, for instance, thousands of people are choosing to mine and hold digital currencies as an alternative to earning and holding the hyper-inflated bolívar. Naturally, the notion of a form of money that exists outside the control of the state holds the most promise for those who can’t trust their state’s fiscal judgment.

As the blockchain experiment continues to unfold, the popularity of blockchain-based financial instruments in regions without a strong national currency will likely grow. As more and more people choose to use blockchain technology to conduct their financial affairs outside of state control, it will be of vital importance to observe the effects this has on the ability of a given state authority to govern. The potential for financial freedom and individual sovereignty offered by the blockchain is unparalleled in the history of money, thus it is uncertain what will come of the paradigm shift that this technology is initiating. Regardless, we can be almost certain that this technology will have an undeniable impact on the global financial system and the authority of governments around the world.