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Trying to Understand Bitcoin, Crypto and the Promise for Africa
Understanding Money and how it will evolve over time
Cash Rules Everything Around Me - C-R-E-A-M get the Money, dolla dolla bill Yo!. Money does indeed make the world go round. So what is money and how did we end up here? The title picture is useful in this regard. It reflects an art installation called “The Comedian” that was worth US$ 120,000. The fact that a banana taped on a wall and can be worth US$ 120,000 is an important framework for understanding value.
To understand money, first you need to understand our history and how society evolved. Yuval Noah Harari’s book “Sapiens” has in my view the best theoretical framework for understanding money and how money became so central to modern life. You could just read chapter 10, here’s a high level summary;
In the hunter-gatherer days, people didn’t need money. Life was simple and most of our needs were met by our immediate society. When our children got sick, the local healer took care of them. In return, if he was hungry, we would feed him from our hunt or harvest. We kept an elaborate system of favours and obligations as our unit of accounting. This would be kept intact by a social system that ostracised those who did not cooperate. Of course, the price for failing to cooperate was social exclusion, which at the time was a matter of life and death. In Africa a number of these systems still exist, in villages, people save by helping others with the expectation that when you’re in trouble, they will help you.
As societies grew more complex and communities grew, the limits of Dunbar’s Number was breached and we needed more complex systems of trading. The agricultural revolution brought about surpluses which led to the creation of cities and governments. Within these new societal structures, we needed stronger modes of conducting exchange and trade. Barter trade could not work because it was inefficient to maintain relative prices for multitudes of items. “If one hundred commodities are traded in the market, then buyers and sellers will have to know 4,950 different exchange rates. And if 1,000 different commodities are traded, buyers and sellers must juggle 499,500 different exchange rates. Clearly a byzantine task that requires a central unit of exchange/value. Enter money!
Systems were created where society agreed on a common, agreeable unit of value that could be exchanged for whatever we needed. Money is therefore the biggest exercise in collective imagination. It is not coins, banknotes or cowry shells. It is whatever people agree to represent the value of goods and services. I think this is a critical point when trying to understand crypto-currencies such as Bitcoin, Ethereum and even Dogecoin. Having this framework, it is easy to see why money has to serve three key functions;
Money as a medium of exchange;
Money as a store of value;
And Money as a unit of account
Money is the magical compound that converts a hot day under the sun lifting heavy objects into a cold, refreshing beer. For those interested in a deeper discussion you can watch this or this both by Yuval Noah Harari.
So we’ve just had a review of what money is from a theoretical perspective - a shared imagined representation of value. It will be useful to understand what that shared representation of value was over time.
The infographic above shows a rough history of the evolution of monetary systems. They advanced with time as societies got more complex and trade relationships grew deeper. Trade particularly has driven the innovation within monetary systems. Starting with Cowry shells which enabled trade between China, East Africa and Arab states to the development of paper money backed by a central store of gold or any other metal with intrinsic value.
Gold was preferable due to its ephemeral qualities, beauty and mystique as well as the chemical fact that it’s a pure metal that does not corrode. This enabled it to be used as a store of value. Paper innovated on top of gold as it was easier to carry and it was divisible. Trust in the government that issued the currency coupled with a shared acceptance of the value of the paper was key to the success of these monetary systems.
The gold standard had the additional quality of being sound money. Governments so long as they followed the rules could maintain a stable money supply thus stabilising prices. Gold was also a natural stabiliser in global trade. This was maintained by the principle that gold could easily move across countries thus stabilising balance of payments. Here is a good breakdown of the gold standard. The only problem was that governments then as in now couldn’t be always trusted to play by the rules.
The gold standard collapsed during the 1st and 2nd world wars largely due to money printing by way of debt issuance to finance the wars. Additionally, there was a global imbalance of gold supply. The Bretton Woods agreement of 1944 thus ushered in a new era where the USA maintained a gold peg whilst everyone else maintained a peg to the dollar. Thus the rise of the dollar standard. This also collapsed as the USA slowly devalued their currency due to a number of factors, the main one being that the US gold supply was not enough to maintain the pegs. In the early 70s, the dollar peg was dropped and fiat money was officially de facto across the world. Fiat money essentially was money whose value was purely by legal decree.
The world has been run on fiat money since the 1970s. All countries basically have fiat monetary systems where local currency is underpinned by belief in the government. There are many benefits to having fiat money;
Monetary sovereignty - the government can adapt to local economic situations by adjusting the money supply. For instance, during a depression, the government can boost money supply to strengthen the economy and vice versa;
The government can invest in the economy and make long-term investments whilst financing them with debt. Infrastructure such as highways, airports and medical facilities can be financed through monetary mechanisms;
At a local level, fractional reserve banking is a factor of Fiat money - people can borrow based on their expectations of having a brighter future. Most lending is done on the back of positive future expectations, banks typically just hold 10% of total deposits as capital. Humanity can then leverage its greatest asset - our ability to hope;
The government can manage inflation and thus keep prices stable;
At an international level, a country can devalue its currency thus making exports more competitive.
Finally if you have two countries at war, one has a fiat system and the other a gold-standard, the Fiat system is more likely to win the war as it can finance its war expenditure by printing cash;
All these things are great, but ultimately rely on the good will and intentions of the government. In many cases, particularly in Africa, we have come to suffer the negative elements of fiat money such as capital controls, confiscation and seizure of assets as well as hyperinflation as was witnessed in Zimbabwe.
All these issues have created a global new conversation about money and the native currency of the 21st century. Enter cryptocurrency;
Cryptocurrency and Bitcoin
2020 was the breakthrough year of Bitcoin as the term got so popular that you would hear it in the most obscure places such as barbershops and at your local market. Currently Bitcoin is on a tear and is worth around US$ 48,000 per BTC. I will not comment on whether Bitcoin is a good investment or not and what the long-term value of BTC will be. I don’t have any domain expertise on that matter and I genuinely think that nobody does. We can comment on its usefulness or its long-term value but nobody knows. It could get to US$ 1m per BTC or it could collapse. Nobody knows.
Nonetheless, I think the conversation that is useful is around its fundamental characteristics. For this, I think it useful to delve into what cryptocurrency and the blockchain are.
A cryptocurrency is a digital currency that is protected using cryptography i.e. using secure codes and cybersecurity protocols to secure an asset. Most cryptocurrencies are maintained on distributed ledgers based on blockchain technology.
What then are distributed ledgers? Currently, our money is maintained on centralised ledgers. If you deposit money in a bank, the bank teller accepts cash and credits your account with the equivalent amount. This action is done within the core banking system that the bank runs which hosts the centralised ledgers. Often, a second person has to approve that deposit. Most financial transactions occur like this. An action is taken within the core banking system where the ledgers are maintained and there has to be a dual approval system - often called maker checker. This centralised ledger held by the bank feeds information into the centralised ledger maintained by the Central Bank. This way all records on who owns what is maintained within centralised ledgers held at the banks. This typically works best using relational databases.
The main innovation within blockchain and cryptocurrencies is the concept of a decentralised ledger. In simple terms, instead of the ledgers being centralised at the bank level or the higher central bank level, ledgers are held in multiple decentralised ledgers spread across the world. These decentralised ledgers are often called nodes. Rather than the existing system of maker checkers at a centralised institution, blockchains work by the nodes all accepting a transaction as valid. One of the main benefits of this is that once a transaction has been “approved” by the nodes, it is irreversible. Within the blockchain, as opposed to centralised relational databases, each approved transaction is stored as a chain of transactions - think of a list containing all transactions. These chains are then packaged up and stored in blocks thus the term blockchain.
Bitcoin thus sits on top of this system in the sense that it is a cryptocurrency which runs on a distributed ledger using the blockchain technology. If you want to pay someone using bitcoin, you must initiate the transaction then wait for enough nodes to verify your transaction and execute it. This is why Bitcoin can only process so many transitions at a given time.
The promise of Bitcoin and cryptocurrency in general is based on four foundational concepts;
Global permissionless exchange of value at low cost;
Protection of wealth and property rights using digital private keys;
Enforcement of rules reliably and predictably; &
The integrity of the system i.e. the three elements above should be verifiable;
Read this for a deeper analysis. Bitcoin is a permissionless currency which only requires a user to have a bitcoin wallet. New apps such as Coinbase and Binance have simplified the user experience so that anybody can have a digital wallet. Some restrictions may still apply but that is because these apps are regulated. As regards protection of wealth, Bitcoin is arguably the safest asset to own because your bitcoin “account” is protected by private keys (password). You can essentially cross borders with over 1 billion USD in wealth just by maintaining a secret. Due to the fact that Bitcoin works on a distributed ledger, every participant can verify the promises of Bitcoin. It is very hard to rig the system. You could dive into the rabbit hole of how Bitcoin works by reading this and watching this.
Bitcoin is currently the largest cryptocurrency by “market capitalisation”, however there are other cryptocurrencies such as Ethereum and Dogecoin. Ethereum is a very interesting crypto in that it is much more programmable than Bitcoin and is actually built to maintain smart contracts i.e. digitally native contracts. There are also stablecoins which run on blockchain technology but are backed by existing dollar reserves. Mpesa can be thought of as a stablecoin as well, it’s a digital currency backed 1 to 1 by Kenya Shilling reserves held at a Trust account and monitored by the Central Bank.
So why should we care about Bitcoin? It’s important to have the following frameworks;
Money has evolved along with society - from cowry shells to silver coins to the gold standard to our existing fiat system where 90% of the money exists in electronic ledgers - could Bitcoin be the native currency of a digital world? There are two ongoing experiments regarding the future of money in the digital world in my view. The likes of Stripe and Square who are creating digital plumbing for existing systems and on the other hand, cryptocurrencies and De-Fi projects;
Money also is ultimately what people accept it to be. The robustness of any currency is proportional to how many people believe its worth. It’s an issue of collective imagination and acceptance. If Bitcoin acceptance increases, then it is money whether you’re a skeptic or not;
Money has to serve three key functions - It has to be a store of value, medium of exchange and unit of account. So far Bitcoin seems to be operating more as a store of value nonetheless Tesla recently announced that it purchased US$ 1.5 billion worth of Bitcoin as a treasury management activity. Additionally, it will start accepting payments for Tesla’s using Bitcoin. This announcement adds validity to the unit of exchange and unit of account credentials. Of course, the issue is that with the extreme volatility represented by Bitcoins prices over the years, it is almost impossible to be a valid unit of exchange. Nonetheless Bitcoin enthusiasts argue that if you measure Bitcoin using Bitcoin then there’s no volatility;
For emerging and frontier markets, Bitcoin can be very useful as a wealth protection mechanism due to our poor property rights systems. Already this is evident, this article shows that adjusted for internet penetration and population; Nigeria, Kenya, Russia and Venezuela are some of the biggest purchasers of Bitcoin. Bitcoin is thus working as Satoshi intended;
More philosophically, I think that Cryptocurrency and smart contracts could be a great equaliser as regards global wealth redistribution. Being born in Africa is the equivalent of losing the ovarian lottery. You are at an automatic disadvantage as an African largely due to the quality of your leadership in which in many cases you don’t have a say. Global widespread adoption of cryptocurrency and smart contracts can equalise opportunities when it comes to elements of trade such as getting bank guarantees, letters of credit, cost of credit etc. With cryptos such as Ethereum, apps are being developed that will enable lending at very low rates secured by your crypto holdings. Existing global trade is skewed against the common African citizen. Think of countries such as Zimbabwe where sanctions exist, why does a Zimbabwean who has nothing to do with the government lack economic opportunity? It seems unfair to me and it only perpetuates existing inequality. Ping An in China has worked on a block chain that enables trade in Asia.
There are existing projects by global central banks such as the Peoples Bank of China (PBoC) as well as the ECB to create digital RMB and Euros. However, I don’t know how they will incentivise distributed nodes to participate in the system. Without this element, are they truly different from our existing systems? Already, 90% of our money is digital. In my view, especially in the Chinese system, I think the digital RMB experiment is a way of asserting control given that in principle Alipay and Wechat with their massive user bases could launch their own currencies. There is also the existing Facebook Libra project which is essentially a stablecoin backed by a basket of currencies. It would make Facebook the most important company in the world.
Bitcoins and cryptocurrencies in general are very young. In Africa, I see immense opportunity. The issue of course is that Bitcoin and its volatility will always be used as an argument against Bitcoin and no central bank will cede control. However, it doesn’t have to be Bitcoin, another cryptocurrency that solves the volatility conundrum could emerge in 5 years. Remember, Bitcoin is just one of many cryptocurrencies.
In a nutshell, I believe in the promise of cryptocurrency more than existing central bank digital currency frameworks. I believe true innovations have the zero to one element described by Peter Thiel. Areas such as remittances, trade, lending and asset management and custodianship could be dramatically impacted by cryptocurrencies and the blockchain. Could we see the jump from fiat to crypto in Africa like we did with the Telecoms revolution of the early 2000s?
As always thanks for reading and drop the comments below and let’s drive this conversation.
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