The Future of the Financial System
Before you can predict the FUTURE of the financial system, you need to understand the PAST.
Before There Was a Financial System
Before there was such a thing as a financial system, there was barter.
"You don't need 3 goats. How about you give me one of those kids and I'll make you a pair of boots but you supply the leather?"
"You're the bootmaker, you supply the leather. And a goat is worth much more than a pair of boots. But I'd consider it if you make boots for my wife and shoes for my 5 children as well."
"That would take me 6 months. It's too much."
(thinks) "My wife really wants that goat for the milk and cheese. I need to make a deal here."
"Tell you what. I'll make the boots for you and your wife both. I'll use my best leather and replace the soles after 12 months."
"OK, we've got a deal, but I'll pick which of the 2 kids you're getting. I'll give you the kid as soon as you've finished the boots."
Barter was a huge leap forward from "every person for themselves". It allowed someone with a desirable skill set (the bootmaker) to acquire assets (the goat) in exchange for his or her skill.
But it had its downsides.
First, there was no interim store of value. Although the execution of the deal could be in the future (when the boots have been made) the deal itself had to be made immediately.
It started to occur to people that an interim store of value would allow deals to be made asymmetrically. The owner of the goat could exchange the kid for some interim value and subsequently use that to "purchase" the boots. Maybe he could get a better deal that way.
The second downside was that face to face barter would nearly always be subject to a power imbalance. One party would be more powerful than the other, either because of force of personality or more influence in the village or simply having less riding on the barter's success.
And the third downside was localization. Unless they had a horse and cart, both parties were limited in their barter partners to others in the same village. And there was always an inherent distrust of strangers that could make it impossible to barter outside of the home village anyway.
Of course, there were always enterprising merchants who travelled to far away places where their goods were highly prized and they could trade them for other goods that in turn were highly prized back home.
The successful members of this mercantile class became ship owners and very wealthy. But that's another story.
The invention of currency was a huge leap forward.
And while there were several interim stores of value (cowrie shells were popular in some Pacific nations) the real breakthrough came with metal coinage.
Gold and silver had always been valued and once bronze became readily and cheaply available, it became possible to strike coinage of relatively consistent weight and purity and commonly accepted relative values.
Initially, there was only one Roman coin and so the only way to make change was to cut fragments off the coin that was being used for payment!
The mainstay of the Roman economy was the silver denarius. Along with the gold aureus, valued at 25 denarii and the copper/bronze as (10 - 16 as to the denarius) they allowed more sophisticated trading than simple bartering.
Our goat owner could sell his kid for 5 denarii, keep them until he needed boots and then buy them, perhaps from a merchant just back from Italy, for 3 denarii and 6 as, getting 1 denarius and 2 as back as change.
This system was so effective that it lasted for many hundreds of years and its concepts are still in use today, with some notable exceptions.
The original metal currency had a face value of slightly more than the intrinsic value of the metal itself. If this were not the case, people would melt the coin down and take advantage of the more valuable metal itself, particularly in the case of gold.
This also meant that the issuing authority, such as the Roman government, could make itself richer by diluting the valuable metal when minting the coin.
For example, if they could use half the gold in a gold coin by substituting a base metal for the other half, they could produce twice as many gold coins from the same amount of gold, thereby doubling their wealth as a result of a simple decision, rather than by an increase in work (as would be required to mine twice as much gold, for example). This is why, in movies set some centuries back, you'll see people biting a coin to test its purity. The emperor Nero (reigned 54-68 AD) lowered the weight of gold and silver coins and reduced the fineness of the silver. Successive emperors, always in need of money, continued this debasement until, by the reign of the emperor Caracalla (198-217 AD), the denarius was barely 40% silver.
This was an "aha" moment that governments have been exploiting ever since.
Modern coins have virtually no intrinsic value. The metal is worthless. They have value only because the issued authority (the government mint) says they do AND WE ALL AGREE. The coin itself is a TOKEN.
The next step in tokenizing was the issuing of paper money. A piece of paper with no value at all, but agreed by everyone to have the value printed on it. The downside was that, at least initially, they could be produced by anyone with a printing press. So that now, virtually all of the cost in producing paper money goes into making it difficult, if not impossible to counterfeit.
Originally issued by (sometimes privately owned) banks, which is why they are still called "banknotes, paper money can now be produced only by the government's printing presses.
BUT THEY CAN PRODUCE AS MUCH AS THEY LIKE.
For the first time in history, a government can pay for whatever they want, or repay their debt just by printing money. Great for the government, not so much for the rest of us. The end result is a debased currency and a serious erosion of buying power.
The Ultimate Token?
Coins made from almost worthless metal and banknotes made from even more worthless paper (or linen or a polymer) while definitely tokens, were at least physical tokens that you could hold in your hand.
Modern money is now largely represented by bits and bytes in computer systems owned by private banks and the Reserve (Government) Bank.
Money is not transferred physically for goods, services and loans but by near instantaneous updates of computer files representing debit and credit balances in various ledgers. Though there may be more security checks, it takes the same time to transfer a billion dollars as it takes to transfer one dollar.
Although the transfer itself may be near instantaneous, the elapsed time for individuals may be several days or longer. And there are fees that have to be paid. This is because of the number of middlemen involved and the different regulations that have to be satisfied. And, of course, as soon as the transfer is taking place across jurisdictions, both the time needed and the fees to be paid are increased.
If only there were an unhackable, foolproof system that could be used globally and quickly!
Well, that's exactly what the blockchain is designed to achieve. And cryptocurrencies like Bitcoin, live on the blockchain.
I could enough pages about the technical aspects of the blockchain and the volatility of Bitcoin and other cryptocurrencies, but I'm only going to focus on the two that matter:
- Why the World Should Adopt Decentralized Finance.
- Why Decentralized Finance May Not Succeed.
Why the World Should Adopt Decentralized Finance
Extrapolate the History
Have a look at the history from the last couple of thousand years, as described above.
There are two trends:
- Trust is an essential part of the transaction. The owner of the goat must be confident that he and his wife will get well made boots and the bootmaker must be confident that he will own a goat once he has completed the boots. The Roman soldier who gets paid in coinage trusts that he will be able to exchange those coins for real goods and services. And the office worker who logs into her computer system and sees her account balance increase by the amount of her wages trusts that their spending power will be available to her by credit/debit card, check or withdrawal.
- Once the concept of token money was introduced, the trust moved away from the individuals directly involved in the transaction and became invested in the organizations that produced the tokens - banks and governments. And they've let us down badly.
From Roman emperors who used less and less gold in their coins so they could mint more of them to fund their endless wars to banks in the Wild West that disappeared with all their clients' money to modern governments who debased their currency so badly that their paper money is issued in multi-million denominations, it's been an erosion of trust.
There is a limit on the number of bitcoins that can be mined. This is not imposed by anyone but is built into the blockchain design and cannot be changed. It means that the currency cannot be debased by an issuing authority choosing to make more, like paper money or balances in a computer system. The total number of bitcoins that can exist is 21 million. Currently, about 18.5 million have been mined and the process is expected to be completed some time in 2024.
In fact, one country (El Salvador) recently announced that it was replacing its paper-based currency with bitcoin. This, despite a large percentage of the population not knowing what bitcoin is and not having access to a computer network
Other countries that may follow suit are Venezuela, Nigeria and Kenya.
One of the big advantages of bitcoin is that it is decentralized finance. You can transact business anywhere in the world, settlement is almost immediate, there are no middlemen, intermediaries or third parties such as banks, exchanges or brokerages involved and no trust is required. Or more accurately, you trust the blockchain, rather than a person. Where a complex transaction between two or more individuals is involved, such as a group of people lending bitcoin to an individual to purchase a property, a smart contract is created on the blockchain using (most commonly) Ethereum, which was designed specifically for this purpose.
DeFi platforms use a layered architecture that allow you to perform several financial transactions, such as:
- Trading cryptocurrencies
- Lending and borrowing funds, with the interest rate, repayment structure, default penalties all specified in a smart contract
- Risk insurance
- Use derivatives to speculate on price movement
- Earn interest on savings
and so on.
By October 2020, the cryptocurrency equivalent of over 11 billion dollars (a tenfold increase during the decade) was deposited over several DeFi protocols. By January 2021, this had increased to over 20 billion dollars.
You can read Wikipedia's definition of Decentralized Finance HERE.
Why Decentralized Finance May Not Succeed
Decentralized finance deserves to succeed. Our existing financial system is broken and totally oriented towards concentrating power in the hands of the few and making the rich richer by manipulating the currency.
Decentralized finance fixes all these issues. It transcends international borders, it has no issuing authority to manipulate it, it settles quickly, protects confidentiality and is protected by the fundamental design of the blockchain.
Using bitcoin as its most visible example, it's being regarded as more of an asset class like stocks and shares rather than an alternative currency. This gives it a volatility that mitigates against full-scale adoption.
Its value is readily influenced by publicity. Elon Musk announces that you can now use bitcoin to buy a Tesla and the price of Tesla against the US dollar goes up. Elon Musk announces that he's changed his mind and it goes down.
Now, all currency is volatile, just not to that magnitude.
Of course, the biggest threat comes from all the entrenched powers that are threatened by this new financial system. This includes bankers, some but not all stockbrokers and governments, particularly totalitarian governments to whom the thought of their citizens acting independently is frightening.
China was until recently the largest center of bitcoin mining and then without warning banned it completely.
No real problem, the miners simply relocated.
A number of governments are issuing their own cryptocurrencies. These take advantage of the blockchain technology, but are pegged to their native currency and, of course remain under their control.
The next 3 years development is going to be fascinating.
But if I could afford to buy and hold 10 bitcoin over that period, I most certainly would.