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Bitcoin: The origin of a new revolution in the financial system

By Douglas Garcia Torres

August 9th 2014

Imagine a world without Banks, a world where Banks are redundant, because

every person is his own bank.

Imagine a world where every payment is electronically made and none is paid

with a currency issued by any government.

In this world, money is distributed peer to peer, directly from the payer to thepayee without the need of some kind of intermediation. You can instantly send

any amount of your own money to any person who lives in any country at any

time you want.

In this world currency is backed up for the simple fact that everyone uses it and

its not easily created. You wont see your money get diluted because of inflation,

frozen by the authorities or disabled in any way. Your money will be completely

out of reach of any banks or any governments. It will never be threatened to lose

its value when the bankrupt government decides to print more bills to pay its

debt.


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Changes in the international monetary system.

Since the appearance of new Exchange rates and the gold pattern, neither

governments nor financial organisms have find a solution to crisis.

Is well known that in 1944, when the International Monetary Fund was created

at Bretton Woods gathering 1 , there were some proposals to create a newuniversal currency2. Those proposals where immediately rejected favoring the

international use of the US dollar. Even in 1987, The Economist magazine

predicted that by 2018 the world would have a monetary union with a unique

world currency.

Today, major economic powers like China and India (and practically the rest of

the world) are pushing for a radical reform to the international monetary

system. Almost everyone is asking for it, except the land of the freedom. And as

the years passes by, it is noticeable the increase in the pressures and the

possibilities for this reform to occur, even if the US opposes.

It is well known that the United States has a privileged strategic position in the

world of finances, just for the fact that its currency is the main instrument of

international reserve. This allows the US government to deal with big

commercial deficit with low impact, as long as the dollar holders overseas

continue accumulating them.

Even so, one of the main lessons we can take from history is that the global

monetary system usually changes, and the world prevailing reserve currency

between all countries has not always been the US dollar.

1Bretton Woods system considers all the agreements achieved at the monetary and financial conference of the

United Nations gathered at the Mount Washington Hotel (New Hampshire, USA) from the 1st to 22nd ofJuly in 1944. There were established the rules for commercial and financial relations among the world majorindustrial states. The main agreements were the creation of the World Bank, the creation of the InternationalMonetary Fund and the use of the US Dollar as the standard international reserve currency.

2During the Bretton Woods conference, John Maynard Keynes who by that time was the leader of the British

delegationproposed an international monetary unit: the Bancor.


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Crisis in the financial system.

It is a little known fact that the major part of the circulating money is created by

banks.

Contrary to what most people think, a bank does not make a loan simply taking

the money from the deposits of its clients. The real thing is that the bank creates

money out of nothing, and puts the amount of money requested in the

borrowers account.

Most people have a little misconception about what a banks really does, which

besides from acting as financial intermediaries between the depositor and the

borrower receiving huge profit from it, they are in the business of creating

money.

After every financial crisis there are usually a lot of debates about how to make

the financial system more secure. And the idea of banning banks from creatingmoney out of nothing is older than we might think.

Consequences of the last financial crisis.

The last financial crisis the subprime mortgage crisishad its boom in 2008 and

was accompanied by numerous consequences and collateral effects. In very

general terms we could summarize them in 3 main consequences:

A quantitative easing of the US Federal Reserve.

A global world recession.

A sovereign debt crisis in the Euro zone.

But beyond all these, there was a feeling of mistrust to the actual financial

system in general population groups and in political and economic circles of most

countries. A lot of people started to question the trust on fiat government

currencies. Some say that it was the perfect storm for the raise of virtual

currencies.

Satoshis revolution.

Back in 1998, 10 years before the last financial crisis and just after the Asian

financial crisis or IMF crisis3a computer activist known as Wei Dai4made an

interesting publication in the famous internet mail list Cypherpunk5

, about asystem of exchange value and contract execution based on an untraceable

currency. That currency was called B-money.

3The Asian financial crisis began on July 1997 with a currency devaluation in Thailand. After that, there was a

domino effect that caused numerous currency devaluation in Malaysia, Indonesia and Philippines, notablyaffecting the economies of Taiwan, Hong Kong and South Korea.

4http://www.weidai.com/bmoney.txt

5Cypherpunk was a popular Internet forum with enthusiast and activists changing ideas of computers science,cryptography, hacking, science fiction and politics. Between those enthusiasts have emerged a lot of famous

personalities and great ideas, as Julian Assanges WikiLeaks.
http://www.weidai.com/bmoney.txthttp://www.weidai.com/bmoney.txthttp://www.weidai.com/bmoney.txt


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Ten years later, that proposal was rescued and included as a reference in the

famous paper Bitcoin: A Peer-to-Peer Electronic Cash System6 published in

2008 under the pseudonym of Satoshi Nakamoto.

Virtual currencies.

Send or receive money or make payments using virtual currencies is as easy as

sending an email. From that simplicity and ease of use comes the recent

popularity they have gained and maybe it will be the main reason for being

widely used in a near future.

The technical details are practically transparent for all users, but in few words,

an electronic currency is represented by a chain of digital signatures resulting of

every transaction made. That chain is known as the Blockchain.

The process of transferring money is really similar to the process of sending

messages using asymmetric cryptography (also known as two key or public key

cryptography).

If Alice wanted to send a payment to Bob, signed and encrypted with

asymmetric cryptography, both of them should have 2 keys: a public key and a

private key. The details are shown in the next picture:

1. Alice prepares the payment.

2. Alice encrypts the payment with her private key.

3. Alice sends the payment to Bob through the Internet.

4. Bob receives the encrypted payment and decrypts it with Alice public key.

5. Now Bob can do what he wants with the money.

So sending and receiving money as virtual currency is as easy as sending an

email. In fact, the same way there are e-mail addresses, there are also Bitcoinaddresses that allows people to send and receive the digital currency. Every

person can generate many addresses as they need for free.

Each one of these addresses has 2 parts: a public part and a private part. The

same public and private keys needed to code a message with asymmetric

cryptography.

A public address looks like this:

1Hg7wA7JMuMtpXbPMLi6XXh1XwrKK4fwUC

6https://bitcoin.org/bitcoin.pdf


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And the corresponding private address would be the next one:

5J1D73SKtkgjtBGUKPL6EASDbGCKJ226prTAPmnhkyByvpU5deC

Everyone who knows Bob public address can send him a payment. They dont

have to necessarily memorize it, they just simply can copy it or even scan the

QR code with a cell phone.

With those addresses the virtual currency gets transferred, the new owner can

verify the source of the funds by checking the transactions resulting chain. But

neither he nor the rest of society have a way to know if the last owner didnt

make two payments with the same money.

The most obvious solution to this problem would be to delegate the task of

verifying the occurrence of double spending to a central trusted authority. The

problem with this solution is that it would give that central authority all the

power over the monetary system, with all transactions going through it. Just like

a bank.

Bitcoin: a new peer-to-peer electronic cash system.

Satoshi Nakamoto thought that virtual money doesnt need an electronic

payment system based on a central authority, instead of that it requires to make

use of cryptographic verification.

With the Bitcoin, Nakamoto proposes a solution to the double spending

problem using a distributed payment verification server which with a simple

timestamp can generate computational proof over the chronological order of

transactions.

In simpler words, he proposes a way of sending and receiving money through

the Internet without the need of trusting a central intermediary and with the

aggregated value of the certainty that the same coin wont be spend twice by

the same owner.


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Can the Bitcoin platform become the Internet of money?

What Bitcoin offers is essentially a way of managing our finances without the

participation of any intermediary. Today we have the banks, the powerful major

credit card companies like Visa, Mastercard andAmerican Express. We can also

use services like Paypal. Those are 3 levels of finance intermediation, and

obviously each level is willing to obtain its own profit for the provided services.

The Bitcoin platform offers the possibility to discard the need of trusting our

money to a third party who works only bank hours, charge extra fees for every

transfer and gambles with the depositors money raising that way a potential

harm to the economy and then the need for been bailed out by the government

with contributors money.

Beyond the Bitcoin as a currency or a monetary platform, there are lots of

initiatives and great ideas arising from the technology behind it. Major Bitcoin

enthusiast are pretty sure that this new technologies will change the way that

people own and pay for goods and services in a near future.

The technology behind the Bitcoin also could be used to easily transfer the

ownership of bonds, stocks or any kind of financial assets in an optimal way. The

electronic money could be programmed to meet certain conditions, for example,

a payment can only be executed if a third person agrees.

And considering the software protocol behind the Bitcoin, we are facing a serious

proposal of improving dramatically the payment industry. Needless to say that

this industry makes USD$ 500 billion per year just charging fees for providing a

service that basically consist of moving bits through the net. Definitely, it should

be a lot less lucrative and more effective than it is today.

These technologies will surely threaten the profitability of various business

models that today are moving large amounts of money. And this could be a

reason for the financial industry to adopt an active position against the use ofBitcoin and virtual currencies in general. Also there are other innovations like the


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e-walletsor the crowdfundingthat are now competing with banks services. It

is very clear that banks are forced to evolve or they will be gradually replaced by

new technologies.

The detractors say: Inflation will kill the Bitcoin.

One of the most relevant properties of Bitcoin and many other virtual currencies

is that they have been designed to evade inflation prohibiting mathematically the

possibility to generate unlimited quantities of the currency.

But there is a lot of people who assure that deflation will be the premature cause

of Bitcoins death. They argue that deflation will prevent Bitcoins consolidation as

a feasible currency that could replace the traditional ones.

Deflation produce unemployment just for the fact that wages generally dont

adjust downward. Employees dont usually accept a decrease in their paychecks.

That is the main reason for central Banks to promote a low but always positiveinflation. A modicum of inflation greases the economy adjusting workers

remuneration whom paychecks does not follow the same pace as the average

price rising of goods and services. When money supply grows very slowly or

stops growingprices begin to fall and the workforce becomes more expensive.

As a consequence, unemployment grows.

Nowadays, Bitcoin supply continues to grow and miners those who create the

virtual currencyare just halfway from producing the maximum amount possible

of Bitcoins. Although there are some who are pretty sure that deflation is already

a reality for Bitcoin: the recent grow in demand during the past year have been

the responsible of its price boost, so the price of everything else have beenreduced in terms of Bitcoin. Deflation has been generated.

As an example, between September 2012 and February 2013 Bitcoin has

doubled its price from $10 to $20, meanwhile a Starbuck coffee remained

costing $5. But speaking in terms of Bitcoin, that coffee has undergone a decline

in its price.

1 BTC = $10

1 Starbucks Coffee = 0.5 BTC

If Bitcoins doubles its price:

1 BTC = $20

1 Starbucks Coffee = 0.25 BTC

Additionally, knowing that Bitcoin supply is limited could also be an influential

and psychological factor for deflation, because it promotes hoarding.

There are some economist and financial analyst whom assures that Bitcoin

should coexist with traditional currencies as the main medium of exchange,

otherwise that deflationary inflexibility would cause unavoidable havoc.

Meanwhile, central bank supported economies with their endless printing moneypossibilities, dont have those limitations.


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They say that the strength of money lies in its ability to satisfy society needs.

So, this intrinsic deflationary property suggest that Bitcoin would have a poor

performance as a currency.

Enthusiast says: Everything they have told us about inflation is a lie.

On the other side of the debate, prevails the idea that a limited and stable

supply of currency will prevent the appearance of bubbles, and will guarantee a

much optimal financial system that the one we have today.

About inflation disadvantages they argue that the act of creating money out of

nothing and giving it to someone, is basically a bad distribution and

mismanagement of resources. The lucky final recipient of that money created by

inflation, will go to the market and obtain those resources. But there is no way

to assure that those resources will be invested in projects that reflects the

consensus and the needs of society.

Bitcoin can even be used to simulate the gold dollar standard monetary system.This idea represents a possibility to once again adopt the conception that money

supply should be backed up by limited precious metals instead of populist

governments with unflagging paper money printers. The difference in this case is

that the material of support wouldnt be metals, but financial instruments whose

value and scarcity are based on mathematical models: the virtual currencies.

Putting aside the ideological or economic factors that led to design virtual

currencies in a way that their money supply would be finite, the technology

behind it makes possible that this property could be changed in the future. So

the money supply limit can be extended.

Forcing people to adopt Bitcoin is like making every country to speak

Esperanto.

Between Bitcoin detractors and those arguing that virtual currencies will replace

the traditional ones, we can find great thinkers and personalities in financial and

economical spheres, like Warren Buffet7or Nouriel Roubini8.

Those discussions really question the viability of Bitcoin and virtual currencies.

On one side, Warren Buffet thinks that Bitcoin is a mirage without any intrinsic

value. Meanwhile others thinks of Bitcoin as a big bubble in the financial system

only comparable with the tulip fever9

. Or as Nouriel Roubinis opinion, some kindof Ponzi scheme that will fade away when the community that supports it simply

stops growing. A phenomenon merely driven by its user in a similar way that

Napster did in the musical industry.

7Warren Buffet, the famous investor known as The Oracle of OmahaCEO of the conglomerate Berkshire

Hathawayconsiders Bitcoin a mirage without any intrinsic value.http://www.cnbc.com/id/101494538

8Nouriel Roubini about Bitcoin. http://www.businessinsider.com/bitcoin-middle-ground-2014-3

9The tulip fever took place on the 17th century in Netherlands where tulip bulb prices reached exorbitant high

levels and then suddenly collapsed.
http://www.cnbc.com/id/101494538http://www.cnbc.com/id/101494538http://www.cnbc.com/id/101494538


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There are also more technical arguments that dig deeper into the possible

causes of a future failure in the Bitcoin platform. Beyond the tech weaknesses

and security holes that have often come to light recently, there are a few

systematical paradoxes. Some warn about a possible agreement of Bitcoin

miners that could make the payment validation network no longer distributed.

That group of miners would arise spontaneously as a centralized authority withthe power of making decision to their favor in the virtual monetary system 10.

The same power of decision that central banks or big private banks have

nowadays.

Bitcoin platform still generates a lot of doubts and probably is not yet suited for

most people. Maybe is the tech analphabetism that makes it relatively difficult to

use and understand for old generations, or its unstable computer security that

makes us prone to individual or massive theft. Although these are the same risks

we have with our traditional finances, the difference lays on that in the actual

financial system we already have established security layers and guarantees

recognized by everyone.

Why has it been so successful recently?

One of the main causes of the recent impressive Bitcoin demand has its origins

in China. If a person who lives in China wants to take his money out of the

country, must confront the legal affairs that limit the capital flow between

frontiers. In this context, Bitcoin is a technology that offers the possibility to

transfer money out of China at a very low cost.

A similar scenario took place in Cyprus during the bank crisis of 2013. That year

on March, the Cypriote government announced a massive bank bailout followedby the freezing of depositor savings. This situation immediately led the

depositors to convert their money into Bitcoins as a safer store of value or as a

bridge to another financial assets.

10The 51% attack: if a single entity takes the responsibility of doing the major part of mining activities currency generation and transaction validation in the network, it would have total control of the monetarysystem, and thus the possibility to manipulate the public ledger at its will.


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If a person wants to send remittances from one country to another, Bitcoin can

be a very good way of doing this without having to pay illogical expensive fees.

And if the same person wanted to incur on illegal activities, Bitcoin is obviously a

better option than using the bank.

One way or another, Bitcoin has managed to carve a niche on the electronicmoney market, and has achieved that millions of people think of it as a useful

financial asset or an effective service to transfer money.

This notorious demand has caused it to be under the loop of public opinion

around the globe, and beyond that its popularity has generated distortions on

the perception of its real value. Manly because a lot of people has taken

advantage of it as a medium of speculative investment.

In consequence, it is widely known as the digital currency with a volatile value

that has fluctuated savagely during the last two years. But there is so muchmore material beyond its role as a currency. There is an extremely valuable

novelty apart from the technology that makes possible to transfer money with

no need of any intermediary.

That novelty is called The Blockchain: the resulting chain of a financial

transaction. An accounting book that records all transactions ever made. It is

property of everyone, can be checked by everyone, but cant be controlled by

anyone. It is like a giant spreadsheet which every person has access to and that

confirms that every coin of digital credit is unique.

It is important to establish a difference between Bitcoin and the Blockchain. Thelater helps us to unravel the debate of what Bitcoin is. A discussion that has

been trying to determine if it is a currency, a commodity or a techno-financial

protocol.

Perhaps we could compare the Bitcoin and its financial revolution with Napster

and its musical revolution. At the end of the day, with Naptser we realized that

the innovation that had a true intrinsic value, was the digital audio compression

format: the MP3. Finally Napster failed, and although there were a lot of

predecessors trying to emulate its brief success, none of them achieved to be

more than merely a user driven phenomenon, just fashion. What really shocked

the entire music industry was the MP3.


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If we take history as a guide, we could predict that Blockchain technology will be

successful. We should remember that just two decades ago, when millions of

people went online with the web browser invention, all around the world there

were a lot of experts with their opinions predicting a nearby unavoidable

Internet collapse. But over time, weve been witnesses of how technical fixes

little by little solved all problems and demands. This makes us believe that ifthese new technologies failed, similar proposals and innovations will surely be

taking their place.

Futurology.

Can a better technology come along and wipe Bitcoin out of the map?

The most reasonable answer is: of course.

Its possible and highly probable that something way much better will take its

place. That is what always happens with technology, because its a tremendous

force that disturbs every status quo in society in order to simplify things or makethem better.

While its always a good to be skeptical with emerging technologies, especially

with those heavily advertised, we shouldnt make the mistake of ignoring them

just because we suspect them to be fads or bubbles before even analyzing the

value they can bring to society.

If we try to predict the future, we could easily imagine a world in 10 years from

now, where metal or paper money is a rarity, a completely obsolete way

payment. Every financial transaction will be made with virtual currency or virtual

assets, probably through a similar technology to the Bitcoin platform, based onthe theory of asymmetric cryptography. Is not unrealistic to predict that every

electronic transaction will be almost free of charges and that all payment

methods used today will remain just in our memories. The check, the bank

transfer, the credit cards and the debit cards as we know them today will be

slightly remembered. Every individual will have his own virtual wallet, and

thanks to technology, we will have various funding possibilities that only few

people can imagine today; from which probably the crowdfunding will be the

standard.

As we reflect about the possible consequences of a financial revolution in its

highest expression, one of the most impressive scenarios we can imagine is aworld without banks, even without the central ones. This is the scenario that

virtual currency ideologist dream of and preach of in every debate.

Going back to the analogy between Bitcoin and Napster, the Blockchain and the

MP3; we have been witnesses of how the MP3 revolution broke multiple business

models and the music record industry seems to be slowly dying or at least

desperately trying to evolve in order to survive. But just because of this

phenomenon we must not take for granted that is equally feasible that the

banking system and the monetary system will have the same destiny as those

broken business models. The financial industry and the banking industry are not

comparable to the music record industry; the main difference lays on the fact

that the first ones practically control todays world.


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The future of sovereign monetary systems on every country will also be

challenged after the rise of these new technologies and the increasingly latent

possibility of using them in order to integrate the monetary systems and the way

all commercial transactions are made today. But is also clear that as long as

governments have the power to enforce their tax laws, people will still be in

need of using sovereign fiat currencies. And fiat currencies is what givesgovernments the power to never fall into bankruptcy o to run out of money.

As for today, the reality is that the Bitcoin or the Blockchain doesnt have to

shock the actual financial system in order to be a success. Today we have a lot

of financial processes for which the current system is not totally appropriate and

these innovations could provide interesting solutions.

We can see that these new technologies have a lot of potential to provide

solutions, more than his detractors those who speak of Ponzi schemes and the

new tulip feverare willing to recognize.

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