Published Feb 19, 2020 5:18:05 PM
Crypto Assets are, it would seem, a new phenomenon. However, when you look back through history, technologists have been trying to create a solution to enable the trustless transfer of value electronically for decades.
In order to appreciate where we are now and how exciting these new assets are, it is important to understand how the history of money, encryption and the development of the internet have all helped bring us to today.
Money was developed by the leaders of society to document debts, feed armies and to collect taxes. Through time, different methods were developed to record the value of an individual’s assets or debts. The most important aspect of all these methodologies was that society itself recognised the documented position as a true and trusted source.
A great example of recognised value is the story of the stones on the Island of Yap. Yap, an island in the Pacific, has little mineral wealth, so in an effort to find scarce objects to use in the recording of value, they travelled to other islands where large blocks of limestone were worked into shapes and brought back to Yap, the value of which was transferred amongst the Yap islanders through common knowledge and outcry, where truth was the community’s recognition of ownership.
Scarcity, then, was used to define value, but portability also became important: one couldn’t easily carry large stones across borders or maintain the divisibility of such value. Small, scarce assets such as conch shells and then gold coins solved both the portability and divisibility issues. Gold, in fact, with its natural physical properties, became a standard. Despite the creation of even more portable items such as paper notes and the first credit card (issued in 1968), which would unify the recording of debt within the card network, reliance on the Gold Standard only started to wain in 1931 when the Gold Standard in England was suspended, and remained in force in the United States until 15 August 1971, when the convertibility of the US dollar to gold was unilaterally terminated, effectively bringing the Bretton Woods system to an end and rendering the US dollar a fiat currency.
Encryption wins wars, and for many centuries generals have known how important it is to be able to communicate within their armies privately without others, in particular the enemy, knowing their plans. It is recognised that breaking the encryption of the German Enigma machine was a pivotal moment in turning the balance of power during WW2, and might have even won the war for the Allies, though it wasn’t until many years later that the stories of the codebreakers’ efforts were uncovered and finally made public. Since then, governments have continued to spend a great deal to stay at the cutting edge of encryption, making things available to the public only when they really have to. Indeed, the co-founder of Netscape, Marc Andreessen, says the US government’s restrictions on the export of encryption techniques initially forced him to create two products: a secure US version and an insecure global version for export. Unsurprisingly, the insecure version wasn’t a huge success and in an effort to boost commerce the US government slackened the regulation around the export of encryption technology. Enabling encryption within an internet browser was a groundbreaking moment and allowed free and global access to encryption, and the ability to transact privately via electronic methods.
We take the internet for granted today, but it’s worth stopping and considering just how short a time we have had this technology, and that the dot-com bubble only collapsed in 2001. The invention of the internet has been transformational. By enabling computers to communicate, messages could be sent, and files and information could be transferred easily and at very low cost. The internet has gone through a number of discrete phases:
Hypertext – the beginning, a command line interface enabling TCP/IP chat and file sharing
Web1.0 followed, which enabled, through the use of a browser, servers to broadcast and distribute information such as photos, music and marketing materials
Web2.0 not only embraced encryption, allowing people to communicate securely and privately encrypt payment information, but also unlocked a more symmetrical web that enabled video calls and VoIP, and peer-to-peer services such as Napster
Web2.0 was (and continues to be) hugely disruptive, as evidenced by the rise of MP3 files almost destroying the music industry. This is because music on a CD is information, and this information can be copied and sent to millions of recipients for near zero cost. Digitised music proved that information could be reproduced easily into a digital form or asset, and certainly wasn’t scarce.
So if a digital asset couldn’t be scarce, digital money should be impossible. Why? Because you could create as much as you wanted simply by copying the asset as if it were a music file. People would be able to copy their money and then spend it multiple times. This ‘double spend problem’ was a clear stumbling block, and was solved initially through the use of a centralised database that tracked who owned and spent what. The record of ownership must be trusted, and with a centralised database there existed a significant risk that whoever managed the database could help themselves to money and adjust it in their favour. Thus, a trustless system was needed to solve the double spend problem effectively.
From 1989, efforts intensified.
1989: DigiCash Inc. was an electronic money initiative, founded by cryptographer David Chaum.
1993: The Cypherpunk Manifesto sets out the vision of anonymous digital money.
‘We the Cypherpunks are dedicated to building anonymous systems. We are defending our privacy with cryptography, with anonymous mail forwarding systems, with digital signatures, and with electronic money.’
1994: Smart Contracts were defined in an essay written by Nick Szabo.
1996: E-gold was a form of digital gold launched by Gold & Silver Reserve Inc. Users held accounts on the company’s website, with balances backed by physical bullion and denominated in grams of gold and other precious metals, enabling them to make instant transfers to other e-gold users.
1997: Hashcash was a proof-of-work system for spam control developed by Adam Back.
1998: B-money was Wei Dai's proposal for the first distributed digital scarcity-based cryptocurrency.
1998: Bit Gold – Nick Szabo suggested a protocol whereby ‘unforgeably costly bits’ could be created online without a high degree of dependence on trusted intermediaries. These could then be stored, verified and transferred, again with minimal trust.
2004: Hal Finney created the first reusable proof-of-work system before Bitcoin.
2008: Satoshi Nakamoto released the Bitcoin white paper, combining many of the elements of the above proposals. Bitcoin built on the concepts of electronic money, and using a proof-of-work blockchain, launched in 2008 with the Genesis block containing a cheeky reference to the financial crisis. There is constant speculation on the identity of Satoshi Nakamoto. Both Hal Finney and Nick Szabo have been proposed, yet both publicly denied the claim.
Bitcoin was the first digital asset to check (nearly) all the boxes required to be considered a form of digital money, falling down only on the criterion that electronic money should be anonymous (Bitcoin is not strictly anonymous but pseudonymous). Bitcoin sparked many theorists of money to take interest in what digital money might be, and in 2017 the BIS published The Money Flower, a taxonomy of money.
Electronic: A true digital entity
Peer-to-peer: No intermediary is needed, and no government or agency can prevent a transaction from occurring
Universally accessible: Every single one of the 7.7 billion souls on the planet can use the system without a central party preventing them or denying access
Bitcoin is certainly a cryptocurrency as defined by the BIS. Operating on an open source protocol, anyone can download the software and participate in the network by running their own Bitcoin node. In fact, the greater the number of nodes that operate, the greater the strength of the protocol.
To incentivise nodes to be run, each full node can participate in Bitcoin’s proof-of-work. The winner of this competition receives a reward of new bitcoins, and the winning node then sets the next proof-of-work challenge. This results in a continued competition to solve, validate and secure the network.
And scarcity? Well, the bitcoin reward decreases over time, halving on a periodic basis. The next halving event is estimated to occur in May 2020, and the protocol as it exists will only ever generate 21 million bitcoins. Once issued, that is it. Bitcoin is therefore a scarce asset.
Blockchain solves the double spend issue, because each block incorporates the hash of the previous one and historic transactions are captured within the chain. Although nothing is impossible, a double spend would require a successful attack on the chain – and the cost of attack makes a double spend highly improbable.
The outcome, then, is that Bitcoin is a universally accessible, electronic and decentralised peer-to-peer network to transfer scarce assets, with a very low risk of double spend, in a way that enforcement agencies cannot stop. This is amazing and unprecedented.
But things didn’t stop there, with many of the world’s brightest minds thinking about what this functionality might mean for society. They considered what it might mean if a digital asset could be not only sent but controlled using a Turing-complete computing layer and powerful smart contracts. Ethereum was the first and is still the largest such platform today, enabling smart contracts, token creation (ERC20), and not just scarce but unique tokens (ERC721) on the chain.
Banks and institutions at first criticised open blockchains and instead built closed DLTs, just as they had championed INTRAnets over the INTERnet – failing to learn the lesson that open systems become natural monopolies and leaders.
Now, crypto assets are enabling Web3.0, a decentralised model where privacy can be maintained, the advertising model can evolve and users can pay for what they use easily.
We are also moving away from energy inefficient proof-of-work to open proof-of-stake systems, and tokenising assets from fiat (to create stablecoins) and gold to the revenue streams from rental property. All of these can be sent anywhere in the world almost instantly. We even have Decentralised Finance, or DeFi, which is building on the layer 1 and layer 2 technologies to produce, through over-collateralisation, interest-bearing assets and loans.
Image by David Hoffman
Banks, however, have woken up and have started to look at the tokenisation of assets. Once assets are digitally native they can be managed computationally, reducing operational costs to near zero. We are close to finance having its ‘Skype’ moment. Both governments and banks have already tokenised assets on the blockchain.
Austria has used Ethereum to track up to $1.3 billion in government bonds
Santander has used Ethereum to issue a bond as a native digital token
HSBC has used Hyperledger to undertake the first financing transaction on European blockchain trade platform we.trade (a DLT)
Nike has received a patent to tokenise shoes on Ethereum
Where could we end up? One could imagine the total market for tokenised assets is everything that exists as a paper asset today, the debt and revenue streams that will be tokenised by default in the future, and the assets that will be authenticated with unique tokens. Conservative estimates put the potential value of tokenised assets at USD $100 to 150 trillion, almost a third of the USD $360 trillion Global Gross Net Worth calculated by Credit Suisse in their 2019 Wealth report.
Image from https://www.visualcapitalist.com
Right now, the digital asset sector is a fraction of one percent of this amount – suggesting that despite the intense interest around blockchain and digital assets, the sector is only just getting started.