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 the
payee 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.







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 new
universal currency
2
. 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.


1
Bretton 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 of
July in 1944. There were established the rules for commercial and financial relations among the world major
industrial states. The main agreements were the creation of the World Bank, the creation of the International
Monetary Fund and the use of the US Dollar as the standard international reserve currency.

2
During the Bretton Woods conference, John Maynard Keynes who by that time was the leader of the British
delegation proposed an international monetary unit: the Bancor.



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 creating
money out of nothing is older than we might think.
Consequences of the last financial crisis.
The last financial crisis the subprime mortgage crisis had 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 crisis
3
a computer activist known as Wei Dai
4
made an
interesting publication in the famous internet mail list Cypherpunk
5
, about a
system of exchange value and contract execution based on an untraceable
currency. That currency was called B-money.

3
The 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, notably
affecting the economies of Taiwan, Hong Kong and South Korea.

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

5
Cypherpunk 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.


Ten years later, that proposal was rescued and included as a reference in the
famous paper Bitcoin: A Peer-to-Peer Electronic Cash System
6
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 Bitcoin
addresses 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

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



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.



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 and American 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 of
Bitcoin and virtual currencies in general. Also there are other innovations like the


e-wallets or the crowdfunding that 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 positive
inflation. 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 growing prices 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 currency are 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 been
reduced 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 money
possibilities, dont have those limitations.


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 Buffet
7
or Nouriel Roubini
8
.
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 fever
9
. Or as Nouriel Roubinis opinion, some kind
of 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.

7
Warren Buffet, the famous investor known as The Oracle of Omaha CEO of the conglomerate Berkshire
Hathaway considers Bitcoin a mirage without any intrinsic value. http://www.cnbc.com/id/101494538

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

9
The tulip fever took place on the 17th century in Netherlands where tulip bulb prices reached exorbitant high
levels and then suddenly collapsed.


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 with
the 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 followed
by 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.


10
The 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 monetary
system, and thus the possibility to manipulate the public ledger at its will.


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 electronic
money 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 much
more 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. The
later 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.


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 if
these 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 make
them 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 on
the 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 a
world 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.


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 gives
governments 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 fever are willing to recognize.