Guest post by Bravado Trading

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Banking on bitcoin

In 1998, just as eCash was on its way out, secretive computer engineer Wei Dei proposed a new digital currency system known as b-money. B-money was designed by Dei to be the medium of exchange for a crypto community in which “...the government is not temporarily destroyed but permanently forbidden and permanently unnecessary.”

Unlike its eCash predecessor, b-money proposed a groundbreaking system for verifying the validity of transactions on the network. Rather than depend on a centralized judge to determine whether transactions were true or false, b-money described a distributed, decentralized network made up of many computers in different locations around the globe. These computers would compete to solve computational problems. The first computer to solve the computational problem at hand would broadcast the answer to the other computers in the network resulting in the creation, or minting, of new b-money coins.

With b-money, Wei Dei introduced two concepts that would become fundamental for blockchains and the cryptocurrencies built on top of them: mining and decentralized consensus. These two concepts ushered in a whole new era for the possibilities of decentralized digital money, but a major problem still remained for digital currencies and legacy financial institutions alike.

Digital currencies had yet to find a solution to a famous cryptography problem known as double-spending, and legacy financial institutions had yet to find a way to make themselves trustworthy despite retaining a monopolistic grip on global financial activity.

Double-Spending and the Evolution of Trust

Digital currencies prior to Bitcoin were all plagued by one and the same issue: The problem of double-spending. In theory, digital currencies such as eCash could easily be duplicated much in the same way digital text is duplicated using a computerʼs copy and paste function. The duplicated digital currency could then be spent over and over again, leading to a worthless currency that would lose its scarcity, a fundamental quality of money.

More on Double Spending

There are a couple main ways to perform a double spend:

  • Send two conflicting transactions in rapid succession into the Bitcoin network. This is called a race attack.

  • Pre-mine one transaction into a block and spend the same coins before releasing the block to invalidate that transaction. This is called a Finney attack.

  • Own 51+% of the total computing power of the Bitcoin network to reverse any transaction you feel like, as well as have total control of which transactions appear in blocks. This is called a 51% attack.

Bitcoin StackExchange

Money Is Scarce

If money were easy to get, then surely everyone would have it. And, if money were easy to duplicate, then surely many people would be duplicating it. Alas, money is not easy to duplicate and doing so is severely punished by law. Neither is money easy to get, and the reason for that is it is scarce.

A scarce currency lends to that currency being valuable. The reason for this is simple and is a basic foundation of economics – the more scarce something is, and the more demand there is for that thing, the more valuable and sought after it will be. The demand for money stems from the fact that in order for us to have anything that we donʼt produce ourselves, we need to exchange money for it. The only way to have money to spend is, in most cases, to work for it, which requires time, effort, and many other factors.

The importance of scarcity in a competitive currency

LINKS & RESOURCES

Money Is a Medium-of-Exchange

Money is a medium-of-exchange, which means we use it as a common denominator between each other in order to exchange value. For instance, if we had no money but were all producers of something or another, how would we exchange for the things we needed but didnʼt produce ourselves? Simply bartering the objects we did produce would result in uneven exchanges when one side values the results of their labor too high or the othersʼ labor too low.

To level the playing field, we circulate currencies which we use to create a neutral grounds of exchange, all of which is predicated atop the socially agreed upon value we have placed in those very currencies.

How Does This Relate to Double-Spending?

If money is duplicated, then it canʼt be scarce, and if money isnʼt scarce, then it isnʼt an effective medium of exchange. This is why, from the outset, digital currencies had to grapple with the unique issue of double-spending. Without solving it, digital currencies would stand no chance of becoming adopted.

David Chaumʼs early-version digital cash as outlined in his paper Untraceable Electronic Cash tried to solve the double-spending problem by penalizing double-spenders with a loss of anonymity. So long as users did not double spend, their identities remained anonymous. The moment they did double-spend, however, their identities would be unveiled to the world and they would, perhaps, face some form of trouble.

Unfortunately, this approach wasnʼt a real solution to the problem, it instead simply penalized those who engaged in it. Besides this, Chaumʼs approach was centralized, meaning a third party would verify transactions and determining their validity.

The weakness of centralization is very evident in the context of the double-spending dilemma: Users must simply have faith that the third party who verifies will uphold the truthfulness of transactions. Apart from Chaumʼs digital currency, this schema is also the way financial institutions operate globally – they are all centralized and rely on electronic networks such as SWIFT and ACH to process and validate payments.

There is, however, some major irony in this arrangement. Everyone depends on financial institutions (banks, retirement plan providers, mutual funds, credit companies, payment processors), and yet no one trusts them. The double-spending problem in digital currencies and the mistrust people have of centralized financial institutions are really one in the same issue, however: they are both about a lack of reliable, objective truth between people engaging in an exchange.

Trust, an Invaluable Asset

Trust is an invaluable asset, and that is what Bitcoin provides

With the wild price speculation that accompanies cryptocurrency it can be easy to forget about the invaluable asset they bring to the fore: blockchain-based trust. Trust is a central component in human relationships whether they are personal, financial, or otherwise.

For as long as humans have engaged in business with each other, there have always been accounting systems in place for ensuring at least some degree of trust between parties, but these systems have always been imperfect.

We can point to the invention of the abacus some 5,000 years ago as an early means of calculation and record-keeping for merchants. The Greek historian Herodotus also wrote of an accounting system used between Carthaginians and early Libyans which entailed using stones to keep track of accounts between trades.

The use of tools such as stones, abacuses, or centralized servers in trades throughout history and up to modern times is indicative of the ongoing search for a means of truthfully recording and accounting for exchanges – in other words, these tools all represent the quest for trust. With the advent of Bitcoin and blockchain technology, we have entered, for the first time in history, an era in which trust is not only built into the exchange but is also implicit in the exchange.

What's next?

Check out our next guest post from Bravado Trading: Bitcoin and Intro to Blockchain.