Is the World’s Financial System Ready to Take On the Challenge of Crypto Currencies?

Today, we will look at the future of cyber currency and ask the million-dollar question (or, in current Bitcoin terms, the 18 Bitcoin question):

Will the world’s financial systems one day do the unthinkable and tear up centuries of reliance on traditional paper banknotes in favor of some form of electronic currency, such as Bitcoin?

To answer this question, we’ll first take a high-level look at the timeline of events in the history of Bitcoin, the most well-known of the cyber currencies. Then we’ll look at the other competing digital coins that have come onto the market more recently, such as Etherium, the stablecoin Tether, the hype-driven Dogecoin, as well as the current craze for investing in these digital currencies that’s led to coin prices climbing to once unimaginable new highs.

The Strange History of How Bitcoin Became an “Overnight Success”

With the price of a single Bitcoin rocketing up to a record high of $63,346 on April 16^th, 2021 (a six-fold increase from 2020), many may consider Bitcoin to be a proverbial overnight success.

Yet, like many “overnight success” stories, the programmers behind Bitcoin struggled for years to develop a workable electronic money framework that would inspire the confidence of mainstream users to accept the new digital currency.

So how did the so-called overnight success of Bitcoin come about?

The Bitcoin story, as told by NYTimes reporter Nathaniel Popper in his book Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money, has many unexpected twists and turns – many of which might come as a great surprise to today’s Bitcoin investors, who seem blissfully unaware of the “unsolved mysteries” quality that characterizes the early Bitcoin backstory.

To start, consider that to this day we are uncertain of the true identity of the Bitcoin project founder, who goes by the online name of Mr. Satoshi Nakamoto. (Nakamoto’s last “official” communication, a note saying goodbye, was transmitted ten years ago, on April 23, 2011.)

Over the years, several individuals have come forward, claiming to know the true identity of Nakamoto – and a few of them have even claimed to be Nakamoto (perhaps an unsurprising development, given that unspent Bitcoin holdings attributed to Nakamoto are estimated to be worth as much as $7 billion dollars). Yet, despite this, no conclusive proof of Nakamoto’s true identity, national origin, education, family life, or work history exists.

We may know more soon. This month the Australian computer scientist Craig Wright, who claims to have created Bitcoin in 2008 under the pseudonym Satoshi Nakamoto, has been ordered to come before a UK court as a defendant in a Bitcoin fraud lawsuit. The court may adjudicate whether Wright is the true author and copyright holder of Satoshi Nakamoto’s original whitepaper outlining Bitcoin’s technical feature set, described below.

Many Early Advocates of Digital Money Had a Strong Distrust of Government, Some Were Even Promoting an Anarchist Political Agenda

Even more perplexing is that quite a few of the early digital currency advocates, such as the members of the influential Cyberphunk group, took inspiration from a 1999 dystopian science fiction novel Cryptonomicon, and, much like the characters in the book, saw themselves as political anarchists fomenting an international revolution by creating an anonymous digital currency to undermine the control of the financial systems held by national governments.

As Popper writes in his book, even the early, non-revolutionary advocates of digital money (such as Nakamoto himself) believed that a digital currency would bring power to the people. They yearned to create a decentralized, peer-to-peer system (much like the internet itself) based on an open-source software system that could manage financial transactions transparently – without relying on the involvement of (or in the views of some, interference by) government officials and traditional financial institutions.

The Early Days of Bitcoin: An Audacious Project with Little Chance of Success

In 2008, the Bitcoin technical “manifesto” was released.

Published in Satori Nakamoto’s name, the seminal Bitcoin whitepaper outlines a fully-formed system based on 11 key interrelated elements that Nakamoto believed necessary to create a successful, workable digital currency:

• Transactions
• Timestamp Server
• Proof-of-Work
• Network
• Incentive
• Reclaiming Disk Space
• Simplified Payment Verification
• Combining and Splitting Value
• Privacy
• Calculations

We’ll skip these technical details for now and save that for Part 2 of this series when we investigate the inner workings of Bitcoin technology, including details of the mining process used to generate new coins.

But, for now, let’s summarize at a high level what Nakamoto set out to accomplish in this 2008 whitepaper.

He proposed an electronic currency that doesn’t rely on the intervention of trusted human administrators – or even any human intervention at all. All financial transactions in the Bitcoin system are handled in a transparent, open bookkeeping ledger (known as the “blockchain”) that’s shared collectedly on a peer-to-peer with other computers on the network.

Nakamoto also values privacy. Users of his Bitcoin system are only identified by their account number (think secret Swiss bank accounts), but the transactions themselves are always public.

The system, like the internet itself, is highly decentralized, allowing for computers to join or exit the network at different times – without disrupting the entire operation.

Nathanial Popper writes that Nakamoto was reportedly suspicious of politicians pressuring central bankers to print more money in times of economic crisis, which in Nakamoto’s view created monetary inflation by debasing the value of fiat currency.

To prevent this, the Bitcoin system emulates a hard currency backed by precious metals and an innovative method for “generating” new coins.

Unlike a central bank that prints out paper money as needed, new Bitcoin currency is put into circulation slowly and deliberately – without human intervention. Each new Bitcoin “coin” is created through a “mining process.” But, instead of actual miners digging for gold or silver, computers on the network can undertake a “proof of work” effort to solve a complex hashing algorithm, with the first computer on the network to solve the problem being rewarded with one new Bitcoin.

Two quick notes:

First, as we’ll see in Part 2 of this article series, Bitcoin mining operations around the world are a major energy hog that essentially offer no benefits to society beyond generating new coins.

Second, the 2008 whitepaper does not explicitly call out the fact there is a hard limit to the number of Bitcoins that can be mined (21 million coins in total), and we’re approaching it quickly. (Around 18.6 million coins have been mined to date.) The idea behind this upper limit is to create Bitcoin scarcity and sustain the long-term value of each coin. (This is in contrast to, for example, the lower value Dogecoin, which has no upper limit.)

The Bitcoin Project is Saved by Take-Out Pizza Orders

Satoshi Nakamoto launched Bitcoin to the world on January 3, 2009, with the first block on the ledger offering a reward of 50 coins.

But the response was underwhelming.

Instead of lighting the world on fire, only a couple of interested programmers downloaded the software, and even they struggled to make it work. Later that year, a young inexperienced developer named Martti Malmi offered to help with the project, and in time, he became one of the major early contributors, answering potential user questions and eventually maintaining and upgrading the software code.

But despite this, the project nearly died by the end of 2009 with just a handful experimenting with the system.

Things turned around a year later, when Lazlo Hanecz, a Hungarian-born programmer, began to mine new Bitcoins with a high-powered computer. Without competition, he captured nearly all of them, causing Satoshi Nakamoto to reach out and encourage him to sell Bitcoins to other users. An arrangement was worked out, and Hanecz sold Bitcoins to a user in California who paid him back in take-out pizzas delivered to Hanecz’s home.

From these humble initial transactions, Bitcoin got more publicity thanks to a widely read article in Slashdot, a favorite programming website, but the lack of a facility to handle trading Bitcoins for useable dollars proved to be a sticking point.

Mt. Gox Takes Bitcoin Trading to the Masses, but its Ultimate Collapse Brings Bitcoin to its Knees

The solution was to create a Bitcoin / Dollar exchange, which founder Jeb McCaleb christened Mt. Gox, an acronym derived from the role-playing game Magic: The Gathering with “online exchange” appended to the end.

Mt. Gox was initially the savior of Bitcoin but later nearly proved to be its undoing.

To bootstrap the exchange, Jeb McCaleb used his personal PayPal account to accept funds for Bitcoin, allowing purchasers from around the world to buy Bitcoins.

But careful readers will realize this approach violates one of the founding principles of Bitcoin, the avoidance of any dependence on individuals for accessing the coins.

Wouldn’t Satori Nakamora have foreseen the consequences?

He may have been distracted by fixing a major flaw in the code, known as the “1 RETURN” bug. But he also appeared to be fading from the scene, only releasing a brief note announcing the latest version of the Bitcoin software and a warning that denial-of-service (DDOS) attacks were the top threat to the system. By April 23, 2011, Satoshi Nakamoto sent his last goodbye message.

Meanwhile, in September 2010, it all threatened to come crashing down. Mt. Gox founder McCaleb had moved to a beach town in Costa Rica, where he was running the entire Mt. Gox operation on a single Sony laptop, which earned him 0.5% of every Bitcoin transaction made.

But PayPal chargebacks were giving him headaches as well as a hacking attack that stole $45,000 from his account, so he sought investors to take the business to the next level. Eventually, McCaleb sold the company to the French national Mark Karpeles, who moved Mt. Gox’s operations to Japan.

Disaster struck again on June 19, 2011.

Sophisticated hackers attacked Mt. Gox in the middle of the night in a complex scheme that deflated the value of the Bitcoins held in trust to a near-zero value, allowing the hacker’s to transfer them out at a value below the system’s daily transfer limit.

It’s estimated that 25,000 Bitcoins were robbed in this way from the accounts of nearly 500 Mt. Gox users.

Yet, this was merely a precursor of an even bigger failure to come.

Throughout 2013, Mt. Gox, which had sufficiently recovered the trust of its users to handle as much as 80% of the world’s Bitcoin trades, found itself dogged by a series of government investigations, customer lawsuits, and even transaction seizures – leaving the company unable to process exchange transactions in a timely fashion.

But the final catastrophic event for Mt. Gox took place in February 2014. Hackers absconded with an estimated 850,000 bitcoins from Mt. Gox users.

The case still reverberates today. Trust across the Bitcoin ecosystem was lost, even though, technically speaking, the hacking happened in the Mt. Gox exchange, which is outside of the Bitcoin system.

Japanese courts found Mark Karpeles guilty of tampering with financial records, and he received a 2 1/2 year adjudicated sentence. Mt. Gox customer CoinLab still has a $16 billion claim against the bankrupt Mt. Gox.

Analysis: Who Was to Blame for the Mt. Gox Collapse?

The collapse of Mt. Gox, a firm that handled up to 80% of Bitcoin trades, was a huge setback for the Bitcoin project and certainly reinforced the impression among the general public that something was “fishy” about Bitcoin and the concept of digital currencies in general.

But observers taking a more nuanced, informed view of the situation could draw a different conclusion.

In this view, the issue lay not within Bitcoin itself but rather inside Mt. Gox, which, despite Satoshi Nakamoto’s early warnings, had become a traditional financial institution, acting as both a bank and an FX clearinghouse.

Had the users who lost nearly a million Bitcoins in the Mt. Gox fiasco been using the Bitcoin system to trade coins directly (instead of trusting Mt. Gox to handle coins transactions on their behalf), they wouldn’t have lost anything in the 2014 collapse.

Yet, despite this near-death experience, Bitcoin has persevered.

But the fiasco did expose a larger failing of Bitcoin: it was not used for day-to-day transactions as Satoshi had once hoped.

Bitcoin’s Early Success (or Failure?) Begets New Digital Currency Competitors, Collectively Known as Altcoins

Success has many fathers, but failure is an orphan.

Interest in Bitcoin waned during the six years following the Mt. Gox collapse, leading some to speculate that cyber currencies were just a passing fad.

But with Bitcoin on the ropes, new developers (and some Bitcoin veterans) sensed an opportunity to introduce new competing currencies, blockchain systems, and trading platforms.

And why not? If early social media platforms, such as Myspace and Friendster, paved the way for Facebook, the thinking went it was a reasonable assumption that a new digital currency could catch fire and become an even bigger player than Bitcoin ever was.

Even Facebook reportedly wants to create its own digital currency; we’ll take a look at that and other cryptocurrency products still in development in part 2 of this article series.

But for now, we’ll focus on the coins already in circulation, the so-called Altcoins, each of which was introduced in hopes of toppling the market leader, Bitcoin.

In 2013, programmer Vitalik Buterin proposed Etherium, a decentralized open-source blockchain platform that uses “Ether” coins as its native currency. The system went live in 2015, and it has become the most successful competitor to Bitcoin, as measured by market capitalization and coin price.

But Ethereum co-founder Charles Hoskinson had a falling out with Buterin and later started his own cyber currency platform, Cardano, which uses an internal coin named Ada, in honor of the famous woman programmer, Ada Lovelace.

You may also recall the name Jed McCaleb; he was the original founder of the Bitcoin exchange Mt.Gox we mentioned earlier.

McCaleb created the idea behind Ripple, a real-time settlement system that went live in 2012; it uses an internal crypto coin dubbed the “RTX.”

McCaleb later went on to found Stellar, another decentralized cryptocurrency payment network that was funded in part by Stripe CEO Patrick Collison.

Top Cyber Currency Platforms/Coins, Ranked by Market Capitalization (as of late April 2021)

Two other Altcoins are worthy of note.

The first is Tether, which was originally conceived to be a so-called “stablecoin” thanks its value being tied 1:1 to the value of the US dollar. This allowed Tether to promote the inherent benefits of cyber currency, such as lower transaction costs – without the risks — and lack of price volatility – thanks to it being backed by the US dollar. However, Tether suffered a major blow to its reputation when the NY state AG department sued Tether for false statements regarding its reserves, which the AG said fell short of its claims that the coin currency was fully backed by USD funds.

And finally, we get to Dogecoin, whose market cap jumped to $9 billion in February then to $50 billion in mid-April, a staggering sum in the bewildered eyes of Dogecoin’s founder, Billy Markus, who created the meme-based coin design of a grinning gold Shiba Inu dog face. Unfortunately for Markus (spoiler alert), he regrettably sold off nearly all of his remaining Dogecoin holdings back in 2015 to buy a used Honda Civic.

New Cyber Currency Platforms make it Simple for the Public to Trade in Cyber Coins

In addition to the Alt coin trading platforms mentioned above, we’ve also seen the introduction of some wildly popular new financial trading applications, such as Robinhood, Brexit Millionaire, and Coinbase, which went public earlier this month at a market valuation of $85.7 billion.

These platforms appear to be targeting younger, first-time investors who are getting caught up in the excitement of stock trading – for example, by bidding up the likes of GameStop stock to unimagined heights after being egged on by Reddit forums and encouraged by “brovester” posts from social media influencers, such as Mark Cuban promoting Dogecoin during an appearance on the Ellen TV talk show, or Elon Musk tweeting himself as the “Dogefather” leading up to his role hosting Saturday Night Live.

The trading craze is not limited to stocks. NFTs and cryptocurrencies have also rocketed to new heights.

For example, in the days leading up to the so-called “Dogeday” on April 20, the Robinhood crypto trading app crashed due to a massive frenzy in bidding up the price of Dogecoin.

Elon Musk is in the thick of it.

Musk provocatively announced he would use Tesla’s cash reserves to invest in Bitcoin and promptly made a handsome return, albeit one that detractors say is actually propping up Tesla profits. Musk has made more claims as well, such as justifying his Bitcoin investment as a way to prove its liquidity as a cash alternative.

Will Musk – and Tesla – get stung by the Bitcoin downturn?

The market is not concerned, according to Bloomberg reporters.

But this underscores how the outcomes for sophisticated “bro-vestment” influencers, such as Elon Musk, can be different from much less sophisticated investors, who may get burnt and suffer long-term financial damage after being encouraged to put their last available dollars into cyber currencies, such as Bitcoin or Dogecoin.

Are Cyber Currencies the Future of Money?

As we come to a close of Part 1 in this two-part series, let’s return to our original question:

Are Cyber Currencies the Future of Money?

To answer this, let’s first tally up the advantages and disadvantages of cyber currencies, such as Bitcoin.

Recap: The Advantages of Cryptocurrencies, such as Bitcoin

• The software ledger maintains an accurate, public accounting of transactions
• Transactions are instantaneous
• Transactions are lower cost thanks to automation (no human involvement required)
• Transactions are public, but coin holders identities are somewhat private (but can be deduced in some cases)
• If designed properly, the currency cannot be debased (creating monetary inflation) by expanding the number of coins
• In the last two years, Bitcoin (and many other cyber coins) have been an outstanding investment, creating fortunes for early investors

Recap: The Trouble with Cryptocurrencies, such as Bitcoin

• Most members of the public cannot figure out how to manage Bitcoin wallets directly, leading some to incur massive losses due to lost passwords
• Some Bitcoin holders have been subject to extortion, compelled to hand over the credentials to their coins
• The creation of new Bitcoins wastes massive amounts of energy and computer resources that could be better used elsewhere
• Hardware such as graphics cards are in short supply due to Bitcoin mining purchasers
• History of loss and fraud by major coin holding / trading companies, e.g. Mt. Gox, others
• Criminals can take advantage of the semi-autonomy of Bitcoin holdings to sell illicit items or demand ransom payments

And we conclude with the last two points, which may be the most critical determinants of the future of cyber currencies.

• Unlike regular cash, cyber currencies are rarely used by consumers for regular purchase transactions
• Cyber currencies offer minimal profit for traditional financial institutions as they can’t make money on transaction fees

So, will today’s digital currency replace traditional paper money?

We say the verdict is no, at least not in their current state.

Why?

For one, today’s cyber currency technology isn’t easy enough for everyday consumers to use. In other words, it’s not ready for prime time use.

The underlying reason for this lack of progress on the usability front may be the fact that most financial institutions (outside the cyber coin trading platforms) can’t make money on digital money transactions, so traditional players, such as banks and credit card companies, have little incentive to give up their hold on consumer transactions where they earn a percentage of each sale.

Second, many cyber currency deposits continue to be bedeviled by fraud, such as the Turkey-based cyber coin platform Thodex, whose CEO fled the country (but was later reportedly found in Albania) after it was reported that hundreds of millions of dollars were stolen from coin holders on the exchange.

Third, given the recent massive increase in the hype about rising coin values, there may be another financial crash in the value of cyber currencies on the horizon, which would probably set back cyber currency adoption for years to come.

Nikolaos Panigirtzoglou, global market strategist for J.P. Morgan, comments on whether there’s a correction ahead for bitcoin and cryptocurrencies.

In closing, now is probably a good time to reread the modern classic This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff, which highlights the circumstances of each major financial crash over the last 800 years. The next one may be closer than you think.

Coming in Part 2 of this series, we will look at the more technical side of Cyber currencies, including the process required to mine Bitcoins – as well as the long-term roadmap for future digital currencies, including the possible introduction of a digital pound from the Bank of England, a digital Chinese Yuan/RMB, and a new cyber currency from Facebook.

Stay tuned for that next week.

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