Why crypto currencies do not make sense … Yet

Sometimes distribution channels are more important than products.

Money is generalized means for value exchange.

Suppose Harry, John and Sam live on an island with population three. Harry has farm and he is growing wheat. John does fishing and Sam cuts woods in the jungle.

John gets wheat from Harry in exchange of fish. Sam gets fish from John in exchange of wood. Three of them create value by producing goods. When there is demand for their goods, value is exchanged.

As the island population grows, traditional ways of exchanging value do not scale because everyone may not need the goods other person produces.

Generalized form of value exchange (money) needs a central trusted authority.

Federal Reserve Bank is formed on the island as a trusted service authority. Bank prints currency notes stating, when someone possesses the note then it holds the value as defined on the note.

To ensure value of the note, Federal Reserve Bank maintains some amount of gold as a backing reserve for the value currency provides.

Now any one on the island can exchange the goods by using the bank note. So, John no longer need to get the wheat or wood when he provides fish to Harry and Sam.

Consumer banks facilitates holding the money and assist creating future value.

Surplus money can be deposited to bank and bank provides interest to the depositor. Bank lends money to the trusted businesses that generates more value and pays back interest to the bank. Businesses pay back the loan installments along with interest.

Businesses formed on the island employs people to build homes that can be sold to the people living on island. When home is built, value is created. Buyer can loan money from the bank to purchase a home and pay back the mortgage along with interest.

Exchanging and accounting of money creates overhead in the form of Tax.

As the financial banking system and economy of the island grows, it needs a government to develop and maintain infrastructure as well as rule of law. Tax system is created. Every value exchange transaction is tracked, and some percentage of the money is deposited to the government for the use of general good. People elect the government officials.

Market is created when goods exchange value is adjusted per demand and supply.

On a good rainy and harvest season, John produces wheat more than the existing demand on the island. John lowers the value of the wheat so that demand for wheat can go up and people can consume more wheat than fish.

In drought season, John produces less wheat and there is more demand for wheat than the stock John possess. Now John can increase price of wheat and still sale all the wheat produced.

Demand and supply create price points.

When demand for money grows than available supply then value for money goes up. When demand for goods goes up than available supply then value for goods go up and vice versa.

People with higher expertise, better ideas and willing to take risks generate more value for most of the people on the island. These people accumulate lots of money and called as rich.

New businesses are created to meet the demands of the people living on the island. Banks and rich people invest in these businesses.

As island businesses grows, stock exchange is created so that everyone on the island can invest in these businesses. High growth business provide value to the investors in terms of stock price increase and profit sharing.

Age of industrialization and capitalization is started.

50 years later … age of Internet

In the age of internet, all the information is digitalized and democratized. Knowledge is accessible to anyone. Digitalization creates lots of new innovations.

Software defined and distributed root of trust.

Instead of centralized authorities like Federal Reserve Bank and Government Agencies, all money transactions (or any other documents) can be maintained in an encrypted, distributed and append only file system.

With multiple copies of transactions, each copy needs to be consistent with another mitigating feasibility of deception. Also, every update to this distributed file system generates new authentication signature based on existing data. This eliminates feasibility of modifying any previously created transactions as future transactions are authenticated with past transactions.

Potential for such technology is enormous.

Crypto currencies

Money provided by Federal Reserve Bank have created significant value, however it also possess many disadvantages.

1. Every exchange is taxed adding extra overhead for consumer and producer.

2. Bank transactions are slow as verification and documentation takes some time.

3. Transactions are tracked creating loss of privacy.

4. Value of money is subject to the policies defined by Federal Reserve Bank.

5. Many such Federal Reserve Banks (for each country) creates barriers for businesses.

Crypto currencies with distributed root of trust promises to solve these problems.

Promissory note Vs distributed digital record.

While gold standard is removed for most of the Federal Reserve Bank backed currencies, the existing money holds some assets that backs the value it provides. Banks holds reserve currencies, some percentage of money it issues to general public.

Whereas crypto currencies are just a record of a transaction. The value of this record is abstract.

Practical unresolved challenges with Crypto

1. Lack of operational infrastructure — digital record needs a distributed system that can be used by all users without worrying about of loss of records. This will require crypto digital banks, credit systems, tracking of current and future transaction that every consumer and producer can use.

2. Missing correlation with value creation — money is a system to exchange value, while existing businesses uses traditional currencies backed by Federal Reserve Banks, crypto currencies prices are based on pure speculative factors rather than real economic reasons. Practical use case capability of crypto currencies is still unproven.

3. Security risks — Encryption algorithms security can be venerable given enough time-efforts from malicious operators. Quantum encryption is currently perceived as one of the most secured encryption technology which rely on quantum entanglement. Quantum crypto technology still in infancy and will need to mature in order to support every crypto transaction.

4. Fraud detection — While it can be assumed the intention of businesses is for general good, crypto currencies can fuel illegal activities with lack of any virtual control.

5. Economic controls — Federal Reserve Banks can print money, however there is still a method to madness to control the money supply and credit availability. Crypto currencies lack centralized system for economic control thus potentially creating chaos.

6. Number of currencies — with current speculative asset status, many businesses and organizations issue crypto currencies and lack any inter currency transaction and control system. Money issued by various Federal Banks include international exchange rate system.

7. Transaction velocity — Global economic system is enormous; stock transactions can be done in nanoseconds reaching at the speed of light. While crypto transactions need to maintain consensus, distributed algorithms are much slower especially in case of any network faults.

8. Recovery — If the system fails, the crypto currencies transaction maintainer system need to recover it into fully operational state without any loss of data. Modern cloud systems are backed with reliability up nine 9’s still may not be enough to guarantee reliability for crypto economic system.

Summary

Even though there is lots of valid excitement, Crypto Currencies have long way to go. So are they worth as investment option?

When we discuss the currencies, it’s about entire system or the value chain and not just about the pieces of paper or the bits stored as record.