What is Money, and How Did it Get Here?

Money evolved from barter.

Barter is the process that happens between two people when they want to trade things of equal value.

I have two chickens, you have some bread. Want to trade? Deal.

Now, what if I had a bunch more chickens and wanted to get some clay for my house. The problem is, the clay dude doesn’t want any chickens, he wants these special spices.

Now I have to go trade my chickens for special spices- except the spices guy only wants a cows.

So, now I have to go trade my chickens for a cow, the cow for spices, and then the spices for the clay.

In this scenario, you have multiple forms of money. Chickens, cows, spices, and clay.

The overarching problem is you can’t trade between these different types of money easily.

If only there was a common thing I could trade my chickens for that each of the merchants would also accept because they knew they could convert it into whatever it is they personally wanted. This is currency.

It’s important to understand the difference between money and currency, as they are very different things.

Money is a store of value, and it maintains it’s purchasing power.

Currency is a claim check, and it’s basically a representation of money.

How Our Financial System Came to Exist:

Gold and silver have more recently become the favorite choices for money, although back in the day – livestock, grain, clay, and even humans were used as a store of value. The problem with these commodities was that they were difficult to store, carry and trade.

Our modern day financial system grew from the trade of goldsmithing at the end of the middle ages.

Back then, people would go to store their excess gold and silver with the local goldsmith for safekeeping. When gold or silver was put into storage, the goldsmith would issue a receipt as a record of ownership. The paper receipts were easier to carry than a ton of gold or silver, so people just began using the paper receipts for trade instead of going through all the hassle of exchanging the notes into gold, and then exchanging the gold for products / services. The goldsmiths receipts were ‘currency’, or a representation of money (gold). People would accept trades in the currency because they know it’s as good as ‘gold”.

Once they started holding gold for a lot of clients, the smart goldsmiths figured out that they could loan a portion of the gold they held for their clients to third parties and collect interest. If any particular client came to trade their receipt for gold, they would have plenty of gold on hand to fulfill the receipt.

As long as everyone didn’t want to redeem their receipts for gold at the same time, the system would work.

The goldsmiths got even more clever, and instead of lending out actual gold to third parties and collecting interest, they would just loan them the paper receipts that represented gold.

Of course, this type of system is far from perfect. When the economic conditions changed, everyone ran to their goldsmiths all at once and wanted to exchange their receipts for gold.

If the goldsmith couldn’t come up with enough gold to satisfy all the claims for gold, things got messy. A lot of people lost their money (gold) as a result of this.

Fast forward a few hundred years, and Banks are the modern successors to the goldsmiths. The way they operate is basically the same, although currency (USD) can no longer be redeemed for gold.

Commercial banks use the exact same process as the goldsmiths did to create 97% of our currency supply. This debt system is known as fractional reserve banking.

Through fractional-reserve banking, banks keep only a fraction of the currency deposited in the bank and lends out the remainder to collect interest. This practice is universal in modern banking, and is what’s responsible for over 90% of the currency in use today.

So, How is Currency Created?

When a government (congress) wants to spend more money than it has on hand, it asks the Treasury Department to issue a bond. This bond is basically an IOU that says if you loan us ~1 trillion, we’ll pay back that ~1 trillion + interest over 10 years.

These bonds from the Treasury are our national debt, and they’re paid off by the people through future taxation.

Each treasury bond has a ‘face value,’ which is the amount it will be sold for, and a stated rate of interest that it will pay out to the holder. So if you bought a bond with $100 face value that paid a rate of interest of 5%, you’d pay $100 for the bond and get $105 back in a year.

Treasury bonds are sold in regularly scheduled auctions, and a majority of these bonds are bought by big banks, like China and Japan.

After the bonds are bought from the Treasury, those ‘big banks’ turn around and sell a portion of the Treasury’s bond to the US Federal Reserve.

When the Federal Reserve buys Treasury Bonds from Big Banks, they simply transfer currency in the amount of the bond to the bank, and then take possession of the bond. It’s a straight swap – bond for currency.

Now the curious thing is where the Federal Reserve gets it’s money from to purchase the treasury bonds back from the big banks that just purchased them at auction.

Here’s a direct quote from the Federal Reserve explaining how this process works: “When you or I write a check, there must be sufficient funds in our account to cover the check, but when the Federal Reserve writes a check, there is no bank deposit on which that check is drawn. When the Federal Reserve writes a check, it is creating money”.

Sweet.

So, now we know that there are two kinds of money out there.

The first is bank credit, which is currency that is loaned into existence through fractional reserve banking. Bank credit is a type of money that comes with an equal and offsetting amount of debt associated with it. Debt upon which interest must be paid.

The second type is currency printed out of thin air by the Federal Reserve.

When we hold our money in dollars, we’re trusting that the Federal Reserve isn’t going print a bunch more dollars and tank the value, or default on the huge debt we have already accrued. This gives the Federal Reserve a huge amount of centralized power – they kinda have us by the nuts.

It’s interesting to note that before 1971, US dollars were backed by money – silver and gold. You could walk into a bank and exchange your notes for actual gold.

In 1971, we left the gold standard, which basically means the US government took away the backing of the dollar with an actual gold supply. Every major international currency has followed suit and no longer backs their currency with gold.

The obvious question is, “Without gold, what does guarantee the value of our money?”

The answer: nothing, really.

To date, over 3,800 paper currencies have been rendered worthless due to mismanagement. Not to say that’s going to happen with USD, but it’s not impossible.

The only reason a dollar, or a Franc, or a Euro has any value is because we have a stable system in which people are known to accept these pieces of paper in return for something valuable. Or, as Nobel Prize – winning economist Milton Friedman puts it, “the pieces of green paper have value because everybody thinks they have value.”

What is a Crypto-Currency?

A cryptocurrency is a peer-to-peer, decentralized, digital currency that uses crytpography to validate the transactions and/or create the currency itself.

A peer-to-peer architecture exists when individual nodes in the network ,”peers”, act as both suppliers and consumers of a resource. This means that no single person has control. Instead of having one central authority who secures and controls the money supply, it spreads the work out across the entire network.

In contrast, our current financial system is centralized, meaning we have the US Federal Reserver which is “in charge” of issuing new currency, inflation rate, debt, etc.

Much like our currency today, the value of a crypto currency is whatever value people feel it’s worth. As people lose trust in the current financial system, they will look for other places to secure their wealth. Cryptocurrencies are a great alternative to fiat money. That said, they are still very early in their lifecycle, and there are still many roadblocks ahead until we can call any one cryptocurrency a “success”.

The most successful cryptocurrency to date, with a current market cap of $2.5 billion (USD), is Bitcoin.

Bitcoin:

Bitcoin really is a new kind of money. You can think of bitcoin as gold.

It’s a new concept in how you can ‘do’ money, in that it is a virtual or digital currency that isn’t issued by a central bank.

It isn’t created by some central corporation. Instead, everyone who is participating in the Bitcoin network is collectively performing the functions that a central bank would normally perform. Those people all create the currency. Those people all make sure that the transactions that happen are valid and that invalid transactions are rejected.

Collectively, together, everybody who is running the Bitcoin software makes the system work. Thats what makes it so resilient and resistant to central control.

It’s resistant to manipulating the money supply. It is resistant to censorship. It is resistant to a lot of other bad things that have happened with our traditional fiat currencies.

Bitcoin could become the main form of money across the Internet: a distributed, worldwide, decentralized digital money. Instantly transferable for fractions of a penny.

All over the world people are trading millions of dollars worth of bitcoin every day with no middle man and no credit card companies.

The technology of email let us send letters for free, to anyone in the world.

Skype lets us make phone calls for free, anywhere in the world.

Now there’s bitcoin.

Bitcoin lets you send money to anyone, anywhere in the world for less than a cent per transaction.

We could be witnessing the birth of a financial system that runs within humanity for hundreds or even thousands of years.

If you think of where we’ll be 100 years from now – realistically we won’t be transacting with paper dollars in space. We’ll have a secure digital currency.

In 100 years when your kids are learning about the history of their financial system, they’ll hear the story about a guy named Shatoshi Nakamoto – the creator of bitcoin.

History:

Bitcoin was first described in 1998 by Wei Dai on the cypherpunks mailing list, suggesting the idea of a new form of money that uses cryptography to control its creation & transactions, rather than a central authority.

On October 31st, 2008, Bitcoin’s design paper was published on cryptography@metzdowd.com. This is considered by most to be the official beginning of the Bitcoin project.

On January 3, 2009 the Genesis block in the blockchain was established. Six days later, the first Bitcoin specification (v 0.1) and proof of concept was published and announced on the Cryptography Mailing List by a person under the pseudonym ‘Satoshi Nakamoto‘.

The Bitcoin protocol and software were published openly so any developer around the world could review the source code or make their own modified version to the original Bitcoin software.

Satoshi Nakamoto left the project in late 2010 – his real identity remains a mystery.

Since the start of bitcoin, there have been some very interesting milestones.

On May 22, 2009: ‘Laszlo’ was the first user to buy pizza with Bitcoins agreeing to pay 10,000 BTC for ~$25 worth of pizza courtesy of user ‘Jercos’.

July 12th, 2010: Beginning of a 10x increase in exchange value over a 5 day period, from about $0.008/BTC to $0.08/BTC

October 7th, 2010: Exchange rate started climbing up from $0.06/BTC after several flat months.

November 6th, 2011: The Bitcoin economy passed US $1 million. The MtGox price touched USD $0.50/BTC.

March 1st, 2011: MagicalTux buys mtgox.com from its founder Jed McCaleb

March 18th, 2011: BTC/USD exchange rate reaches a 6-week low point at almost $0.70/BTC, after what appeared to be a short burst of, possibly automated, BTC sales at progressively lower prices. BTC price had been declining since the February 9th high.

June 2nd, 2011: The exchange rate at MtGox touched 10 USD per BTC.

September 27th, 2012: Formation of the Bitcoin Foundation.

February 28th, 2013: The MtGox exchange rate broke the June 8 2011 peak of 31.91 USD. The first all time high since 601 days

How are Bitcoin Made?

There is a maximum of 21 million total bitcoins that can ever exist.

The process through which bitcoin are created, and transactions are validated, is called Mining.

In order to validate all of the transactions happening on the bitcoin network – it takes a certain amount of computing power.

The way Bitcoin works is that instead of having one central authority who secures and controls the money supply (like most governments do for their national currencies), it spreads the work out all across the entire network. Most of the heavy lifting for Bitcoin is done by “miners”.

Miners collect the transactions on the network into large bundles called blocks. These blocks are strung together into one continuous, authoritative record called the block chain, which doesn’t permit any conflicting transactions.

The way Bitcoin makes sure there is only one block chain is by making blocks really hard to produce. So instead of just being able to make blocks at will, miners have to compute a cryptographic hash of the block that meets certain criteria. This process is called “hashing”.

Hashing requres winning a kind of computational lottery where each hash you perform is like buying one ticket. The Bitcoin protocol currently permits the miner who generates a block to claim 50 bitcoins as well as any transaction fees for the transactions that miner chooses to include.

Most miners mine it what’s called a pool – where they “pool” their computational resources together to increase the chances that their “pool” will win the lottery. If the pool wins the lottery – the coins are then distributed evenly among all the miners in the pool (the amount depending on how much you helped).

Other Cryptocurrencies & AltCoins:

Bitcoin aren’t the only cryptocurrency to exist and gain traction, but it’s the first.

You can view a list of most cryptocurrencies and their market caps here: http://coinmarketcap.com/

Just like you thought of Bitcoin as gold, you can think of these other alternative coins as alternative stores of value – like silver, or copper.

The Silver to Bitcoin’s gold is called LiteCoin.

The main differences between Bitcoin and Litecoin is that LTC can be efficiently mined with consumer-grade hardware, it provides faster transaction confirmations (2.5 minutes on avg). In total, there will be 84 million LTC.

Another interesting altcoin is NameCoin, which gives you a .bit address and acts as a distributed DNS system (outside of ICANN, which is centralized).

There are actually tons of altcoins, and anyone can create a new one. Each altcoin has its benefits and shortcomings, which ultimately dictate how many people will buy the coin, and how valuable it will be.

The Future of Payments:

It’s obvious we’re going to have a lot of different types of fiat & cryptocurrencies in the future, which may make transacting in a global economy a bit confusing.

Remember when humans were trading chickens & spices? We had a bunch of different types of money, but no single currency to transact between each of them seamlessly.

If I have YEN and I want to buy something someone is selling for Euros, there’s a lot of work I need to do in order to get my Yen into the correct currency.

Things get even more complicated when I have fiat money (yen, usd, euro) and want to purchase something in a cryptocurrency (btc, ltc, nmc).

We need a single “currency” for all this “money” – and that’s where protocols like Ripple comes in.

Ripple is a open source protocol that aims to fix this problem, and in my mind is the clear frontrunner in becoming the future of payments.

With Ripple (and others like it), buyers & sellers won’t need to agree on a particular currency in order to do business with each other.

They can transact in whatever currency they want, and through ripple, all the currency conversion happens seamlessly in the cloud.

I can purchase something from you in YEN and you can receive the payment in Litecoin, or Bitcoin, or any other cryptocurrency or fiat currency that may exist in the future.

In addition to being able to convert between any currency, the Ripple wallet is fiat agnostic, meaning you can hold, convert and transact in both fiat and crytpocurrencies.

With Bitcoin, you get a bitcoin wallet. This wallet only holds Bitcoin – it doesn’t hold litecoin, or namecoin, or feathercoin.

With USD, you get a US bank account. This bank account only holds USD – you can’t put YEN or Euro into your US bank account, you’ll need to open another bank account.

With Ripple, your wallet can hold USD, Bitcoin, Yen, Euro, Litecoin, Feathercoin, and more.

It’s like a universal bank account that lets you hold any type of fiat currency or cryptocurrency that people are willing to buy / sell.

If you want to exchange a few of your Yen for Euro in your Ripple wallet, you can do that instantly and it only costs a fraction of a penny.

How does Ripple work?

The thing that makes all of this possible within Ripple, is the cryptocurrency called XRP.

XRP is the oil that makes the machine work.

Instead of “mining” XRP like Bitcoin, all of the XRP ever in existence have already been created by Ripple Labs and are documented in the public ledger.

There are 100 billion ripples that can ever exist and they are currently owned by Ripple and Ripple Labs.

Ripple the company gifted Ripple Labs 80 billion XRP.

55 Billion XRP are to be given away for free through giveaways designed to bring new users into ripple and activate their accounts.

25 Billion XRP are kept by Ripple Labs to fund the operations and upkeep of the api and ripple client.

20 BIllion XRP were kept by Ripple the company (the founders).

Each transaction that happens on the ripple network “costs” a certain amount of XRP. Instead of anyone getting these XRP, they are simply destroyed.

This makes Ripple an inflationary currency in the short to mid term while Ripple Labs gives away large amounts of XRP to fuel the network.

Once the XRP are given away and a certain transaction volume is reached, XRP becomes deflationary.

In order to activate a Ripple wallet, your account needs 100 XRP sent to it from another account. This stops spammers and bots from creating tons of ripple wallets and clogging the network with spam transactions.

The amount of XRP needed to activate your Ripple account changes as the value of XRP increases / decreases and is decided by a network consensus.

Previously it cost 300 XRP to activate your account which at the time was worth about $1 USD. As the price of XRP has increased, the amount of XRP needed to activate your account has decreased and stayed around $1.

Ripple is a fascinating protocol, and the frontrunner in the search for a fiat agnostic cryptocurrency.

Closing:

To check out an interesting debate about Ripple between myself and u/maunion, view this Reddit Thread: http://www.reddit.com/r/CryptoMarkets/comments/1rahn8/banks_bitcoin_the_future_of_payments/

If you’re interested in purchasing Bitcoin (BTC), Ripple (XRP), Other AltCoins (LTC, FTC, NMC), or just want to chat more, feel free to contact me.