A historical look at the monetary system

The gold standard system started to collapse around the first and second world wars times as countries couldn’t deal with debt repayments. At the 1944 Bretton Woods Conference it was decided that a currency’s value will be US dollar-pegged and its volatility limited. The US dollar was in turn pegged to gold, with an ounce worth ca. $20.

It took 30 years for this system to stop working, which is not to say that it performed well over these years. The dollar’s price, pegged to gold, was getting harder and harder to keep still even though it got corrected and different countries would devalue their currencies to push internal agendas such as increasing export. The 1971 Nixon Shock finally put a halt to the gold standard, starting with the cut of the dollar-gold peg.

The rest unraveled quickly: a fiduciary system and currency value left for the market to establish started to quite literally rule the world. Most of us were content with it, until the 2008 financial crisis highlighted all its flaws. Constant inflation, devaluations caused by money printing, plummeting interest rates – all of that disturbs the trust in the actual value of the currency, savings lose their purchasing power and bank deposits aren’t any better. People run in a frenzy and invest in more “tangible” commodities such as real estate, which in turn drives up its prices. The need to tie the value of money to something is still understandable though, as one wants to stop its almost unlimited supply.

If you’d like to read more on the subject, I’d highly recommend this book for further study.

Cryptocurrencies: disrupting the traditional monetary system

When you take all of the above into account, don’t cryptocurrencies seem like a perfect alternative to the monetary system? A transparent currency whose supply is determined strictly by an algorithm and set on a maximum of 21M (in Bitcoin’s case). That would make eg. a Bitcoin-based system a deflationary one and economists hearing that might get dizzy at first, but it’s a different kind of deflation: one related to the increase in currency’s strength rather than preceding a crisis caused by lower income generated by businesses. 

Since the supply of the cryptocurrency is constant and the number of goods and services goes up, 1 BTC would allow you to buy more and more which would make it more valuable over time – perhaps that’s one of the reasons Bitcoin is reaching an All-Time-High after an All-Time-High All-The-Time lately? There’s also no problem with denomination or divisions since it’s a digital currency with up to 8 digits after the comma. A wealthy person could therefore have a 1/10000 BTC monthly salary and later on get a raise equalling 1/20000 BTC and be able to buy another mansion more with it. :)

Naturally, there are a lot of variables to this potential system, but the world does seem to look for an alternative financial system with more and more ferocity. Cryptocurrencies are among the strongest candidates, and we can say that confidently judging from the number of banks getting invested in them, as well as fin-tech startups receiving impressive funding from well-known investors. Even governments recognize cryptocurrencies and take them into account in law-making (for better or worse... ).

The history and technicalities of Bitcoin

2008 was an all-important year in financial history for obvious reasons, but there was one more: a whitepaper by the anonymous Satoshi Nakamoto describing the first cryptocurrency – Bitcoin – has appeared. Bitcoin is based on the blockchain technology that lets you run transactions in the peer-to-peer (P2P) model, without a centralized intermediary such as a bank. To this day we don’t know who Satoshi Nakamoto is (or even if it’s an individual or a group of people), but I don’t think that it’s about maintaining an air of mystery: rather, the privacy came from being aware of how tightly regulated the financial world is and wanting to avoid potential responsibility.

Bitcoin’s and other blockchains’ foundations lay in various versions of the BFT consensus (Byzantine Fault Tolerance) algorithm, supported by the proof-of-work method (PoW). This is the basis of Bitcoin's chain safety which allows the user (node) to input a new block with transactions (earlier verified by them) only when it solves a challenging computational problem. This mechanism is meant to insert ca. 10-minute-long breaks between added blocks, which is enough time to find and expose a new malicious user. It’s a good safety net, but very energy-consuming and not eco-friendly at all. 

Additionally, the difficulty in mining new blocks is related to bigger and bigger demanded fees for each transaction so that users are eager to add them to the block. Meaning, at the current fee rates Bitcoin is simply no good for micropayments, which was supposed to be its advantage over our traditional currency where micropayments are becoming a severe problem.

Another place for massive improvements are the scripts. Bitcoin is based on a very simple script language which was meant to mainly verify if the transaction party sending the means has the right to them (if they are the owner of means sent to them in the previous transaction, which are being used for the current one). To achieve that, the Bitcoin script checks the signature using cryptography and asymmetric keys. Actually, the script language could perform some more complicated procedures here, but still fairly limited compared to modern programming languages. Also, it can process data present in the current transaction only.

All in all, Bitcoin got popular and proved to be useful in many ways very quickly, but as is usually the case, after a while the inconveniences and other drawbacks of the solution start to come up and there is space for new and improved solutions.

The rise of Ethereum

One of the aforementioned solutions is Ethereum, meant to elevate cryptocurrencies and their functionality. When Ethereum entered the scene, Bitcoin was still mostly unregulated and not suitable for use as a payment system, all the while the future of crypto was fairly uncertain. Coupled with the modest script language which restricted Bitcoin to P2P transactions (to be fair, it was designed precisely for that) and it became an investment/speculative asset only.

And here comes Ethereum: created to escape the P2P only model. Ethereum blockchain’s architecture was severely modified compared to Bitcoin’s, the biggest change being a possibility to write scripts in languages similar to today’s high-level ones (with Solidity as the most important one) and to insert such a script in the blockchain under a known address – creating the so-called smart contracts. That’s what allowed for peer-to-smart-contract transactions, meaning you can send money (Ether) to the smart contract’s address, demanding the launch of one of its functions. It opened a whole new chapter in the world of IT: dApp (Decentralized Applications). Since then, we’ve been able to create advanced apps deployed in the blockchain, which functionalities are distributed over the whole Ethereum chain (and all the nodes plugged into it) – everyone who has an Ethereum wallet can use them.

Another improvement is the possibility to create your own cryptocurrencies (so called tokens) easily. That, together with dApps created a huge potential and we didn’t have to wait too long for new apps to emerge, which could also be financed by newly-introduced tokens. Whoever trusts in the application’s potential can buy the token, turning this whole process into a classic crowdfunding. This process is called ICO (Initial Coin Offering) and it resembles the classic stock exchange IPO. 

Among the most popular ones in 2020 there have been DeFi (Decentralized Finance) applications – financial instruments without a centralized subject, such as decentralized token exchanges (DEX – Decentralized Exchange) or loan systems etc. These apps pathed the way for a number of new investment instruments. They also influence the rise in Ethereum’s and its tokens’ price, because more and more financial institutions and banks started to invest in DeFi – sometimes creating short-investment bots which grew the number of transactions in the crypto world.

All of that makes Ethereum a very usable blockchain, but just as Bitcoin, it has its problems. It’s also based on the same proof-of-work consensus, doesn’t scale well and the growing interest and movement increased the fees value. So, again, we have a cryptocurrency not really suitable for micropayments. Another drawback, coming from – paradoxically – the improvement in the form of smart contracts, is how complicated the fee itself is. In Bitcoin it’s simply a tip of sorts, left for the block miners. It increases because if the queue gets bigger, a higher tip lets you skip it – therefore its value can be predicted. On the other hand, in Ethereum the scripts are basically apps and must be launched on the miners’ computers. Therefore, their energy consumption and completion time will differ, while some may even never finish at all (be it because of the user’s malicious intent or a bug). It generated the need to create a safety net in the form of a complicated fee system – each Ethereum transaction consumes the so called GAS, without you ever knowing how much of it will be needed this time. So, instead of one factor – the size of the fee – we have two: the size of the fee expressed by the GAS and the price of the GAS itself.

These problems put Ethereum in a similar category as Bitcoin, namely an investment instrument (although Ethereum’s possibilities are notably much bigger). Its issues are currently being worked at though and the programmers from Ethereum Foundation (our very own Kamil among them) are going to release Ethereum 2.0 in the foreseeable future (with the first part of this version released already not too long ago).

If you got the impression that cryptocurrencies are doomed and gloomed, wipe your tears. That’s obviously not the case. Not only are they developed further to account for the identified problems, but we have new solutions and blockchains coming up as well. With the past of the crypto world discussed, let’s look ahead and focus on the future – that’s what I’ll do in the upcoming article on the latest blockchains. See you then!

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