Money is something used as a medium of exchange between equal values of work and resources. In this way money can act as a store of value, a unit of account, and as a medium of exchange.
When talking about how Bitcoin functions as both a currency and payment system, it’s useful to understand how society has transferred value historically. Over generations, people have adapted different mediums to transfer value amongst them and each of these methods has responded to perceived inefficiencies in the existing monetary regimes.
Historically, people conducted commerce by trading something they owned for something they desired. The medium of trade ranged from livestock to grains to textiles depending on what groups had in supply or needed from others. There is generally no central authority guaranteeing the values of bartered goods, rather the parties have the obligation to inspect the goods themselves. Similarly there is no traditional manner of recourse if one party changes their mind after the deal. This manner of trade is quite limited because it relies on parties having complementary needs, there may be an absence of a common measure of value, many items are not easily divisible, and perishable goods depreciate in value quickly.
The limitations of the bartering system led to the rise of commodities as a transaction medium. Gold became a primary commodity because people valued its physical properties. These included its scarcity, durability, divisibility, distinctiveness, malleability, and aesthetic beauty. In practice, gold is used much like the bartering of goods. There must be a physical delivery of gold for the transaction to occur, and there is no recourse available after a transaction (excepting the courts). There is similarly no central authority guaranteeing the value of gold, rather people maintain a belief that gold will remain desirable in the future in determining its present value. While more convenient than the barter system, using gold and other commodities still strained commerce because of the physical limitations involved in storing and transporting it easily.
In response to the difficulty of conducting transactions in gold or silver, societies developed paper currencies to act as representative placeholders for easy use. In the United States, cash was traditionally backed by a set amount of gold. So a transaction functioned the same way as if gold were being used, but the parties trusted in the central government to fulfill the guarantee that a paper dollar was redeemable for a dollar’s worth of gold. The underlying trust in the intrinsic value of gold remained unchanged.
This “gold standard” eventually gave way to the fiat value we see in cash today. Instead of a one to one relationship between paper notes and physical commodities, banks began to simply declare by government decree that the paper notes have value. Under this standard, the underlying value of cash is not tied to the value of gold, but is rooted in a trust in the authority of whatever government is backing the currency.
An important takeaway from the development of fiat money is that now there is an unbounded supply of that currency. Governments can create more money at will (devaluing the existing supply) as a political tool to try to influence macroeconomics.
In many ways Bitcoin is a return to a currency that is backed by its own intrinsic value. As gold is valued for its unique physical properties, so too is Bitcoin. It’s difficult to parse out Bitcoin the protocol and network it creates, from bitcoin the unit of currency that flows through this network, when discussing intrinsic value from a monetary stance. Basically, the Bitcoin protocol creates a network that is an open system consisting of a public and transparent ledger of all transactions, that is secured by the underlying cryptography in such a way that financial transactions can be conducted between two untrusting partners in a more trustworthy manner than ever before. In order to participate in this system you need to buy some amount of bitcoin the unit, and it is this access and ability to participate in the aforementioned system that is intrinsically valuable. Thus while the exact valuation of a unit of bitcoin may fluctuate as the system grows and matures, the value of being able to participate in the system is intrinsic.
As we discussed before, historically non-cash transactions have relied upon some degree of trust. In some instances that trust can be in the other party in the transaction, but that is hardly practical when the transacting parties are strangers. For that reason central institutions have taken the role as trustworthy intermediaries in most financial transactions. However, that trust comes at a price.
The dependence on central institutions like banks and credit card companies leads to fairly high costs for a number of reasons.
For one, the infrastructure of these legacy payment platforms is old and expensive to maintain. This leads to institutions having to charge transaction fees simply to cover their own costs to use the systems in place. The transaction fees pass these costs down the line to merchants and consumers increasing transactional friction.
In addition, built into the transaction fees are the costs associated with insuring against credit card fraud, bad debt, paying for customer support, rewards programs, and float (covering cost of purchase before you actually pay your credit card bill).
The 2-3% (or sometimes higher!) charge is split up with the issuing and receiving banks receiving the largest cuts, and the rest going to the payment processor. It’s important to note that these rates have remained relatively the same for decades, with technological innovations doing little to pass savings on to merchants and consumers. Perhaps the primary reason for this has been a lack of competition. With the largest chunk of the cost going to the banks involved, innovations in payment systems that still rely on the banks on the front and back end of a transaction can do little to cut costs.
This is where the decentralized network concept underlying bitcoin is so important.
While the high cost of transaction fees has been a significant drawback to the legacy payment systems, bitcoin is not free of fees. When sending a bitcoin transaction over the network, you depend on one of the processing nodes of the network to actually process your transaction and include it in the blockchain to be published on the ledger. In order to get someone to bother using their computing power to process your transaction you need to include some transaction fee that goes to the owner of that node.
Where this differs from the cumbersome transaction fees of the legacy systems is that the decentralized network essentially creates a fluid open market for these fees rather than having them set arbitrarily by centralized institutions like banks or credit card companies. A transacting party will only end up paying the actual cost it takes for a computer to process their transaction and include it on the blockchain. In the near term these transaction fees are subsidized by the bitcoin rewards that people can get for mining, but as the bitcoin distribution curve levels out then transaction fees are expected to reach an equilibrium approaching the true cost of processing a transaction.
Companies that arise to make transactions simpler and more seamless for consumers and merchants (like exchanges) may charge fees on top of this, but the ease with which people can transact over the blockchain themselves will act as a natural competition to keep these fees at a reasonable rate. In the past this fundamental level of competition has never existed and thus the market price has never been forced down.
In addition to saving costs by reducing transaction fees, bitcoin has an advantage over legacy payment systems by reducing the risk for all parties involved.
Since it is not necessary to entrust any third parties with your personal or financial information in order to make bitcoin transactions, credit card and identity theft are not a risk when using bitcoin.
When accepting cash there is the risk of a purchasing party using counterfeit money. The bitcoin protocol on the other hand has proved immune to counterfeiting, thereby reducing risk and potential costs.
While fraudulent and counterfeit purchases are eliminated with bitcoin, so too are chargebacks. A transfer of bitcoins is irreversible and the spender has no recourse (within the protocol) to undo a transaction. This substantially lowers burdens on merchants who generally bear the cost of chargebacks and their associated fees, but does curtail some consumer protections.
While thefts of bitcoins have occurred in the past, all of these security breaches have exploited weaknesses unrelated to the protocol itself. When using third party services like exchanges or wallets, you are trusting that they can secure the information they store in the same manner as online banking. However, there has never been an instance where the bitcoin protocol itself was compromised in any way.
One of bitcoin’s most promising areas of potential is in transforming international transactions. Currently it can be very expensive to transact with other countries due to large fees involved with exchanging currencies. Bitcoin on the other hand it geographically unbound and thus can reach anyone with an Internet connection. This has the ability to include the unbanked populations around the world to transact on the global stage.
One of the specific international markets that bitcoin is expected to reform is the remittance market. Currently estimates report global remittances at over 500 billion dollars as workers worldwide send money back to their home countries. These money transfers are rife with fees, and the parties receiving the money are often in developing nations where violence and corruption frequently exact their own tax on transactions. Bitcoin alleviates these transactional frictions by allowing the transactions to occur over the Internet.