Sean King

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San Juan, Puerto Rico, United States

Sunday, January 5, 2014

The Universe Wants One Exchange

The brilliant Oleg Andreev wrote a wonderful piece a while back titled "the universe wants one money".  It's an excellent explanation as to why Bitcoin, or something very much like it, is destined to change and unify the world in ways that fiat currency never has or can.  I highly recommend taking a moment to read it.

Yesterday, Oleg wrote another interesting article titled "Bitcoin Isn't Evil, and Here's What Gives it Value" in which he speculates as to why bitcoins have any value at all.  He concludes that they are simply valued as a collectible, and that that's sufficient for its purposes.  Consequently, he argues that bitcoins have no inherent utility or intrinsic value and therefore no price floor or cap.  Read his article to get the full gist of his argument, but essentially he's saying that bitcoins are not valuable because they are inherently useful for some important human purpose, but rather that they are useful for some important human purpose (trade) only because they are valuable as a collectible for reasons of human psychology.

While their status as a collectible may have originally been why the first bitcoins had some nominal market value, I don't believe that's why they have value today, and it's certainly not why they will likely have value tomorrow (assuming they do).  To explain why this is so, I want to expound upon the logic of Oleg's first linked piece above.

What the Universe Wants

You see, Oleg just didn't go far enough in his "Universe" article.  The Universe doesn't just want one money.  It wants much, much more than that:  It wants one exchange.  Read Oleg's Universe article linked above and substitute "exchange" or "an exchange" every time he says "money", and I think you'll get the point. For example, consider this quote from the article and perform the necessary substitution:

The function of money is to exchange the widest variety of products between each other. 

Or this one:

It seems obvious that the best money is the cheapest and the most widely recognized and accepted one.  

But, until now, until Bitcoin, a cheap and widely-used Universal Exchange has never been possible. And the reason has nothing to do with lacking a shared currency.  Rather, it's all about trust.

The Main Reason We Even Have Third Party Exchanges is Trust

Here's what I mean:

Our present day exchanges have two nearly universal characteristics, both designed to inspire trust (since, till now, there was no other means of doing so):  (1) They are centralized under the control of a "trusted" third party (who, among other things, maintains an accounting of every transaction on the exchange), and (2) they are highly specialized in nature (for instance, today, the ownership of stocks is traded on stock exchanges or on the books of brokerage firms, ownership of currency is traded on the books of banks or forex exchanges, real estate upon the books of various Registrars of Deeds, collectibles in the records of auction houses, etc.).  We use third party exchanges to facilitate transactions primarily because we don't trust our direct counter-party in a peer-to-peer trade, and because we need to be able to "prove" ownership of our property by reference to something other than our own (biased) records.

But, even so, why so many exchanges?  Why do we have so many ways of trading things?  Why not just a single Universal Exchange upon which all goods and services are traded?  After all, when viewed on the scale of our national economy, each of these separate, specialty exchanges has huge overhead associated with it.  And operators of these various exchanges typically earn enormous profits.

And...for doing what?  Well, to over simplify things (but not to the extent that it undermines my argument), seemingly for simply keeping track of who owns what and when.  That is, after all, the primary function of most every exchange.  (Note that I'm using the term "exchange" broadly to include any person, entity or governmental agency that tracks transfers of property between unrelated parties on its own books in exchange for a fee or a piece of the action).    When I buy my house, I need to know with a very high degree of certainty that I've obtained clear title to the property, and that my title will be honored by lenders and the maximum number of potential future buyers.  Same when I purchase a car.  Or a stock.  Or anything else.

And that certainty is primarily what third party exchanges provide.  By using a third party exchange, I am able to prove ownership by reference to something other than my own records or those of my counterparty.

So, we don't pay exchanges for simple record keeping.  Rather, we pay them to vouch for us and for others so as to inspire common trust in property records.  For instance, if I sell my home to you and you claim to have never received the deed, I need to be able to refer you to the records of some trusted third party, such as the Registrar of Deeds, as proof of the successful transfer.  And, when you later go to sell that home, or to borrow against it, you likewise need to be able to point the prospective purchaser or bank to the books of that same third party as "proof" that you own the property.  Simply producing the deed from your own files, without reference to a third party register, would likely be insufficient to prove present ownership since it is trivial to forge such documents.

Note that we have the same issues anytime we buy or sell a car.  Or a stock.  Or anything else.  Can you imagine the chaos that would ensue if we counted on people's own, biased records to prove their present ownership of property?  Or to facilitate its transfer?

When we employ the services of third party exchanges, we attempt to diversify our risk by diversifying our trust.  In a peer-to-peer transaction, we need only trust one person, our counter-party.  But if that trust is breached, we suffer a loss.  By contrast, in a third party exchange transaction we must now trust two--our counter-party and the third party.

In some ways introducing a third party lowers our risk (for obvious reasons), but in others it actually increases risk.  For instance, when our counter-party is (unbeknownst to us) totally reliable and trustworthy, our (misplaced) distrust causes us to introduce a third party to the transaction who very well may not be.  In this way, our risk in a given transaction may actually increase by using exchanges since two people, the counter-party and the exchange, are now in a position to harm us.

The key insight is that these third party exchanges are selling confidence, not record keeping, and little to nothing else.  They are the original con(fidence) men.

Why do we Trust These Third Parties?   

Because introducing a third party can actually increase risk in some instance, we go to tremendous lengths to insure the integrity and competency of "trusted" third parties.  But this "trust" is largely a mass illusion ginned up with innumerable layers of confidence building tricks.  Truth is, we don't really trust these third party exchanges much, if any, more than we trust the original counter-party to our trade.  It's just happens to be easier to oversee and regulate a third party than it is to regulate every single counter-party to every single transaction.  So we centralize trading onto third party exchanges to, among other things, facilitate the oversight and regulation that has historically been so necessary to building the illusion of common trust.

For instance, we require most third party exchanges to comply with expensive and sometimes onerous governmental standards designed to insure the integrity of their systems, and to instill public confidence in them.  Additionally, we usually require that exchanges undergo periodic audits by regulators, as well as independent CPAs audits, to insure compliance with those standards.

Think about that for a second--we are so paranoid and concerned about trust in tracking ownership to our property that we (through higher fees and taxes) pay to have a trusted fourth party (a regulator) and fifth party (an independent CPA firm) regularly check over the work of our supposedly "trusted" third party exchange!

But, it actually gets worse.  Did you know that CPA firms must themselves be periodically audited by other CPA firms in order to insure that the quality of the former's auditing work is up to par? This process is called "peer review".  Similarly, governmental regulators are likewise often audited by a separate governmental agencies (such as the federal government's General Accounting Office) to insure that they do a reasonable job of regulating.

Thus, we have auditors auditing the auditors, and regulators regulating the regulators.  All for the sake of confidence!

But sometimes, believe it or not, even auditing auditors and regulating regulators is insufficient to build enough trust, so we demand even more:  For instance, for industries that are critical to the entire economy or that have sufficient political connections (e.g., banking, insurance, and securities, just to name three), we pay extra (by way of taxes, insurance premiums and/or user fees) to have governments or quasi-governmental agencies (like the FDIC, SIPC, Fannie Mae, etc.) actually backstop the exchanges!  Thus, if all else fails, we are assured that the government itself, or one of its designated agents, will take over the exchange and/or bail it/us out.

Specialization and Duplication of Exchanges

To complicate matters further, because each industry and profession has its own unique trust issues that result from the nature of its particular function and activities, and because it wouldn't be wise or efficient to burden one industry (for instance, real estate) with the trust and regulatory problems or requirements of another (for instance, a stock exchange), we segregate different types of property onto different exchanges--once again, stock exchanges, commodities exchanges, forex exchanges, registrars of various types, etc.--and we develop different policies, procedures and processes for each of these.  Each exchange is overseen by its own specialized regulators and has its own unique auditing requirements.  This diversity of exchanges adds complexity and tremendous cost to the system, but until now it's been the only way to efficiently regulate trade and thus achieve the illusion of trust.

Economically, Governments are Just Regulators and/or Operators of Giant Exchanges

And, what are the largest "exchanges" of them all?  Governments.  Governments pass laws regulating trade that are designed to inspire confidence and thus promote economic growth (i.e., increased exchange).  They issue the "coin of the  realm" in which most all such transactions on exchanges within their jurisdiction will be denominated, and they put the faces of trusted dead people on those notes and coins to inspire confidence in them.  Most importantly, they are the ultimate "third party" that we count upon to enforce our contracts to property and thus instill trust in title.

For this reason, it's no accident that governments are divided along cultural lines.  In prosperous democracies at least, it's very difficult for a government from one culture to successfully govern the people of another.  Where it's been tried, commerce eventually tends to suffer.  And, the more and different the cultures, the more likely the eventual failure.

Why?  Simply because people have greater trust in the familiar over the foreign.  It's as easy as that.  Americans wouldn't readily trust Russian nationals to regulate American property exchanges, no matter how competent or benevolent the Russians may actually be.  Nor would a Tennesseean as readily observe regulations promulgated by the the California Department of Commerce as by Tennessee's.  It's just human nature.

The EU is dealing with some of these human nature issues presently, and it remains to be seen how that experiment will ultimately resolve itself.  Let's just say that I'm not optimistic, especially about the long-term success of the EuroZone.  It's one thing for Greeks to sacrifice because some trusted and respected Greek leader has asked them to do so, but it's quite another for them to be expected to do so because foreigners from the Troika insist.  Maybe Greek resistance to the Troika doesn't make rational sense, but contrary to prevailing economic theory, humans are not rational creatures.

Trust for Sale

When it comes to commerce, trust isn't just something that matters, it's darn near the only thing that matters.  Without trust in exchanges (and their regulators/auditors), economic activity slows as people become more cautious and less optimistic.  When economic activity slows, politicians don't get reelected.  It's no wonder our society goes to such extraordinary lengths to achieve the illusion of trust.

That trust/confidence can be "sold" by third parties (and so expensively!), is near irrefutable evidence that trust is inherently useful in achieving important human purposes, not the least of which is survival.   Without trust, the world is a much darker, more dismal, and less survivable place.

Bitcoin's Value Proposition

By this point, anyone familiar with Bitcoin should immediately see its inherent value proposition.  In many way, Bitcoin sells trust/confidence cheaper than any centralized/specialized exchange ever can or will.

The Bitcoin (the network, with a capital "B") is, among other things, the world's first, and by far the largest, distributed ownership record.  In Bitcoin parlance, this record of transactions and ownership is commonly called the "blockchain".

The blockchain is, or stands a very good chance of becoming, the backbone for the world's first Universal Exchange (and perhaps that's a far better name for it at this point than "blockchain" or capital-B "Bitcoin" since the former is more intuitively understood by all).

Just like a universal computer can theoretically compute any computable sequence, the Universal Exchange (that is, the Bitcoin blockchain) can theoretically be used to trade most anything that's tradable.  Because transactions in the blockchain are available for any and all to see, and because each transaction is verified through complex mathematical transactions that are also easily verified and practically incorruptible, the need to trust in others on the Universal Exchange is greatly minimized.  True, we can still need to trust our counterparty some, but in many cases no more than in the current system, and there are ways that Bitcoin can be used even to minimize this level of required trust. Regardless, via the Universal Exchange, trust in third parties is now completely unnecessary in many cases, and less important in most others.

Thus, rather than title to property being transferred on the private books of some "trusted" third party exchange, title to most any property imaginable can now be transferred directly, peer-to-peer, via the distributed Universal Exchange, and on books that are open for all to see.  This is a revolution unprecedented in human history.

Though the details are complex and beyond the scope of this piece, at its most basic level the Universal Exchange (the blockchain) is a mathematically incorruptible chronological record of transactions.  That record is replicated on every single computer that contributes to the bitcoin network (by running Bitcoin client software that's easily downloadable for free on the Internet).  Thus, there is no central third party or even a central server.  Anyone running such client software on their computer, and who also has "signing authority", can enter a transaction on the Universal Exchange.  I, or you, can prove ownership of a given asset conclusively simply by directing someone's attention to a transaction on the Universal Exchange, which is available for free and searchable like a database.

So, for the first time in history, we (or those of us with signing authority, at least) can now directly control what gets entered on an exchange's (and, in this case, a Universal Exchange's) books and records on our behalf.  We don't need anyone's permission to make an entry, nobody can bar us from entering a transaction on the exchange (though the system itself will prevent it if we don't have signing authority), and nobody can reverse or corrupt an entry once made.

In short, in a world with a Universal Exchange, the need for trust in humans (be they counter-parties, third parties, auditors, or regulators) is significantly diminished.  Not eliminated, but greatly lessened.

And, because math is the true "universal language", and its math that validates the transactions on the bitcoin network, international barriers to trust (and trade) begin to fall.  To do business internationally, I know longer need to learn to trust foreign institutions or governments, I can just trust the math of the Bitcoin network.  

Why are Bitcoins Tradable?

So, then, what are "bitcoins" (with a lowercase "b")?  After all, it's these bitcoins, and their price, that get so much media attention.

Well, bitcoins are not money, at least not yet.  If anything, they are simply a readily tradable commodity.   But...why?  Why are they even tradable?

Well, that's the trillion dollar question that started this whole diatribe, and one that I think most people tend to get wrong, including (very respectfully) Oleg and (much less respectfully) Krugman.  Do bitcoins have value simply because they are tradable (as a collectible, for example), or are they tradable because they have some intrinsic value--that it, because they are useful for some important human purpose?  Oleg and Krugman argue the former, and here I'm making my case for the latter.

Signing Authority is Useful and Valuable

Individual bitcoins have value because they, quite literally, are what gives one signing authority to enter a transaction into the Universal Exchange (the blockchain).  Without a least the smallest fraction of a bitcoin in your possession and control (each one is currently divisible to 8 decimal places), it is mathematically impossible to enter a transaction into the Universal Exchange.

And why is signing authority, the ability to enter transactions on a Universal Exchange, valuable?  Given what I've said above, I think the answer should be self-evident at this point.  Among other things, using the Universal Ledger greatly reduces the need for trust, and therefore the usefulness of very expensive "trusted" third parties (and their regulators and auditors, and the regulators/auditors of those regulators/auditors).  To paraphrase Oleg, "it seems obvious that the best [exchange] is the cheapest and most widely recognized and accepted one."  Nothing can compete with Bitcoin in that respect.

In the past, specialty exchanges were formed primarily to facilitate the regulation and expertise that was required to achieve the illusion of trust.  In the future, a single Universal Exchange will be all that's need to (paraphrasing Oleg's quote about money above) "exchange the widest variety of products between each other" in the most efficient, transparent and verifiable manner.  

So, Why Do they Have a Price?

If the reader can't see the inherent usefulness in having the signing authority to enter transactions into such a Universal Exchange, then I'm at a loss.  You can just stop reading now.

But, if the reader does see the revolutionary usefulness of a Universal Exchange, then we must ask another question:  Why does such signing authority (that we call "bitcoins") have a price (currently around $950 USD per bitcoin at the time of this writing)?  After all, many things that are useful for important human purposes (oxygen, for example) are free.

The answer, of course, is scarcity.  In an efficient market, the law of supply and demand dictates that any scarce but sufficiently useful thing will have a price.  And, not just a price, but a price floor also.  That floor will hold unless/until the thing ceases to be as useful to as many people, becomes more abundant, or the unit of account by which its value is measured declines (deflation).

And, infinitely divisible, bitcoins (unlike oxygen) are in fact scarce.  There are currently only a little over $12 million in circulation, and there will never be more than $21 million.  Each is divisible to eight decimal places, meaning that posessing one bitcoin gives one the theoretical right to enter up to 100 million transactions into the Universal Exchange.  (Note that adding additional decimal places in the future, which is possible, will not impact their value anymore than adding a third decimal place on the value of the dollars in your bank account would change its value).  The smallest unit of a bitcoin is currently the Satoshi, which is, again, one one hundred millionth of a bitcoin.

While each Satoshi permits you to enter a transaction on the Universal Exchange, it doesn't permit you to do so repeatedly.  One Satoshi is good for one transaction (ignore mining fees for a minute).  But that Satoshi doesn't disappear once you've used it to enter a transaction.  Instead, when you enter a transaction in the register, you technically transfer at least one Satoshi to another person (or at least another bitcoin address).  Among other things, this insures that for every debit in the system there is a credit.  It also prevents spam and serves many other purposes.  Don't get lost in the details, just understand that every time you use your signing authority to enter a transaction, you effectively pass that signing authority on.

Or, said another way, signing authority is transferrable, and transferring signing authority is a requirement to enter a transaction on the Universal Exchange.

Why Both Oleg and Krugman are Mistaken

Since bitcoins (singing authority) is both useful and scarce, it will have a price.  This is the key insight, and the failure to see this is why both Oleg and Krugman get tripped up in their analysis.

It's important to realize that I am not employing circular logic here.  I'm not saying that bitcoins (signing authority) are useful because they are valuable.  Rather, they are valuable because they are useful.  And, what are they useful for?  For buying and selling things in exchange for them?  That is, as money or currency?  No!  (Though that is a very, very convenient side effect, as we shall see).  

No, they are useful because (among other things) they replace, or at least significantly diminish, the role of "trusted" third parties in maintaing ownership records to property, and all of the centralization, regulation, oversight, and audits that exist to inspire trust in those third parties.  With bitcoins, and only with bitcoins, I can enter transactions into the universal, incorruptible, global property exchange.

In short, bitcoins are valuable not because you can trade things for them (as money), but rather because you can trade things with (via) them by simply entering a transaction into the Universal Exchange. Thus, bitcoins are not (yet) the medium of exchange, they are the method by which things are exchanged in exchange for the medium of exchange.  Or, at least they will be once the Bitcoin infrastructure is more built out and widely known.

Bitcoins thus have value as a method for avoiding or diminishing the need for trust, and the expensive infrastructure built up to instill it, and not merely a collectible or as money.  Trust is valuable, and few things are more demonstrably trustworthy than a public blockchain.

The Price Floor

Given that bitcoins are both useful and scarce, they must have a price, and a price floor.  So, what is the inherent price floor of a bitcoin?  Hard to say, just as it is about any commodity.  For instance, what's the inherent price floor of an ounce of gold (given its desirability for use in jewelry and not as a "reserve")?  I've seen estimates of around $250 per ounce, but nobody knows with certainty what value it would trade at as a mere trinket (if it lost its historical status as a store of value).

But, what I can say with confidence is that the inherent utility of having signing authority on the Universal Exchange will soon be far more useful for important human purposes in the future than having a pretty gold ring on one's finger.  Eventually, and sooner than most think, it will be the primary means by which we exchange title to property and certify ownership, including gold itself.  Thus, the inherent value, and therefore the price floor, of bitcoins collectively is, in my mind, far, far greater than the inherent value and price floor of all ounces of gold collectively.  Each's additional value as a reserve or "store of value" is a different thing entirely.

So, Will Bitcoins Ever Become Money/Currency?

Will bitcoins ever be money?

Respectfully, I think this is the wrong question to ask since everyone tends to get caught up in the very political definitions of money and currency.  And, in my mind, whether bitcoin ever becomes money is totally irrelevant anyway.

The fact is that people will (and already do) regularly and frequently (many on a daily basis) trade bitcoins for goods and services.  Once something becomes easily transferable (and once acquired, almost nothing is as easily transferrable as bitcoins), it tends to be used to acquire other goods and services.  For instance, stocks are regularly traded for other stocks.  Sometimes entire companies are acquired for nothing but stock in the acquiring company.  Real estate is (less) regularly traded for real estate.  Currency is regularly for other currencies.  Etc.

But, note that on a Universal Exchange, the barriers to trading in-kind fall dramatically.  On a Universal Exchange I could just as easily swap stock for a car as I could stock for stock.  Or real estate for stock as easily real estate for real estate.  On a Universal Exchange, everything becomes readily tradable with everything else!

And this is especially true with the tool that makes all that possible, bitcoins themselves.  Since bitcoins represent the universal, inalienable (though transferable) right to enter a transaction, any transaction, into the Universal Exchange, and since bitcoins themselves are readily tradable on the exchange itself, an exponentially increasing number of things will come to be bought and sold for bitcoins, and not just with (that is, via) them.

You can call such trading of good and services for bitcoins "barter" if you want (so that you don't have to acknowledge bitcoins as "real" money or currency), but the result is the same either way.  They will be used to purchase goods and services regularly on the Universal Exchange.

In short, a Universal Exchange will facilitate a barter economy like the world has never seen.  For the first time, barter transactions will be nearly as easy as cash transactions (and in many cases even easier).  This will have a great many revolutionary impacts.  It will impact "trusted" third parties the most and soonest, but it will also impact governments, human relationships, law, accounting, economics, and a great many other fields.  And, perhaps most of all, it may just eventually make the whole concept of "money" unnecessary and obsolete.  With a Universal Exchange, a common currency, in the traditional sense of the word, isn't hardly necessary.

The above post was EDITED on the evening of July 29th to correct typos and improve readability.