Summary:
Current financial system will be updated either by a egov coin system or by a crypto coin system
Egov system is similar to existing system except for the absence of paper (and coin) currency
Crypto coin system is a radical departure from the existing system
Each of these systems have their own advantages and disadvantages
Read on for more details.
Details:
El Salvador recently became the first country to make Bitcoin legal tender. This means you can use Bitcoin to pay for products and services as also to pay taxes to the government.
This law is the first nail in the coffin of government issued paper currencies. The paper currency approach is the current solution all over the world. Paper currencies have been around since the seventh century when they were invented in China.
But now it’s time for them to die. Why? Because continuing with the status quo is not an option for any country. A country that continues with the existing approach of paper currency will suffer along with its citizens.
Several questions arise.
When will your country get rid of paper currency.
And what will they replace it with? Will your country also make Bitcoin as legal tender. Or will they choose another option.
And if this happens, how will it impact your wealth? Will the wealth that you have accumulated so far all be useless? Or will it lose its value?
So let’s start with these questions in order.
I expect that countries will get rid of the paper currency solution in the next few years. Some countries like El Salvador and Bahamas have already implemented an alternative solution while other countries like China are running trials. And yet others like USA, UK etc are in the investigation phase. The final nail in the coffin of paper currencies will be when countries like USA, UK etc switch away from the use of paper currencies.
So then the next question is about the alternative options. A country has to choose between one of the following two options:
Central Bank digital Currency (CBDC). I refer to this as egov-coins.
Decentralized currency also known as crypto-coins.
These two options constitute what I call the virtual currency approach.
Virtual currencies and their derivatives will be the reason for the next revolution that will focus on finance. This will have a similar if not a greater impact as the Internet revolution that was focused on communication.
The impact on your wealth though is a more complicated question. This depends on the choice made by your country and the way they migrate from the existing solution to the new solution. And if you understand these options, you can take actions to protect yourself.
But before I get into a discussion about virtual currencies, let’s understand the workings of the current financial system. This understanding will help us better understand the concepts of virtual currency and the two types of virtual currencies namely gov-coins and the crypto-coins.
Current Financial System
A high level overview of the current system is shown in Figure 1.
Figure 1: System overview of the current financial system
The current financial system of every country consists of the following components as shown in Figure 1:
A Central Bank.
Several commercial Banks.
Trusted third party networks.
Customers.
I will look into each of these components briefly next.
Central Bank
The central bank is the principal entity here. It decides
Amount of money to have in the country
Interest rates to be used for lending between the various other entities
Amount of paper and coin currency to produce for distribution among other components
Regulations to be followed by the commercial banks and other trusted third parties
The reserves of the country such as the foreign exchange, gold etc.
In brief, the central bank makes all important decisions related to the currency of the country. The central bank is sometimes directly controlled by the central government while in other cases the control might be indirect.
Examples of central banks include Federal Reserve in the US, Bank of England in case of UK, Bank of Japan for Japan, People’s Bank of China in case of China etc.
Commercial Banks
The commercial banks deal directly with the customers. They have three main functions namely
To provide loans to the customers.
To serve as the custodian of the customers money by allowing the customers to deposit money with them.
To implement the monetary policy of the central bank.
These banks maintain deposits of paper currency (or cash) to be provided to the customers when needed. And they also have a distributed database that has details of all the credits and debits associated with the customers of the banks.
Finally in the above system the customers are also allowed to transact between themselves using cash.
These banks are highly regulated by the Central Bank. They might also be connected to third party networks in order to enable efficient transactions.
By the way, it is possible for a person or group of people to start their own commercial bank provided they adhere to the regulations set by the central bank.
There are several commercial banks in the US such as Bank of America, Chase Bank, Wells Fargo etc.
Trusted Third Party Networks
These are entities that make transactions more efficient. The customers have a direct account with these networks. And the networks in turn are typically connected to the accounts of customers at the commercial banks in order to complete the transaction.
These have become more prevalent with the explosion of the Internet to enable the users to benefit from the Internet technology. Some examples of such networks include PayPal, credit card networks etc.
Customers
Individuals as well as corporations make up this component. They make use of the services provided by the commercial banks such as deposits, loans, money transfer etc.
In addition, they might also take advantage of the services offered by the trusted third party networks to facilitate transactions as mentioned above.
And some of the customers might also just deal with cash to execute their transactions. These customers might do this either to preserve their privacy or because they are shut out of the banking system - the so called unbanked.
Issues
There are several drawbacks of the current financial system. Some of these are:
Dependency on central bank: The current financial system requires the central bank to make decisions related to interest rate, money supply, regulations, reserves to be maintained etc. And in the past the central banks have made decisions that resulted in inflation, mismanagement etc causing the population to suffer. Yet countries still continue with this since this is the best approach known so far. And this approach also gives the control to the central government since they typically control the central bank either directly or indirectly.
Dependency on third parties: The current system depends on trusted third parties like credit card issuer, commercial banks, PayPal etc for nearly every transaction that is executed over the internet. But then, we are at the mercy of these third parties for executing our transactions and managing our assets. These parties can decide to block your transaction, seize your money or they can decide to take a large portion of your revenue as transaction fees for the services that they provide.
Opacity of transactions: Cash transactions that happen amongst the customers might be off the record and are hence cannot be accounted for. This can result in issues such as corrupt practices, lack of verification if the monetary incentives reached the intended parties, tax avoidance etc.
Friction associated with transactions: Several challenges are associated when we use the current approach for transactions due to the friction present here. For example, the trusted third parties typically charge fees to provide their services. Such fees increase the cost of transactions which might make several services impractical. Commercial banks might have their own rules making it difficult to open accounts resulting in several unbanked people. And in other cases bank branches might not be easily accessible such as in case of island nations.
Advantages of current approach
The biggest advantage of the current financial system is that it provides privacy of transactions for customers who desire such privacy. By dealing solely using cash, such customers can keep the details of their transactions hidden from others; of course this comes at the cost of convenience since such customers cannot benefit from the internet revolution. And this also has issues described above related to opacity of transactions.
Virtual Currency
Next let’s look at the two options for any country that is looking to upgrade the paper currency based system. These are
Egov coins
Crypto coins
Egov coins
Figure 2: Egov coin based system
This system depends on digital tokens that represent currency. Databases resident in the internet keep track of the ownership of these tokens. These databases are controlled by the various commercial banks and trusted third parties. The customers conduct transactions using these digital tokens. But customers can never control any of the databases.
The entries in these databases change when transactions using egov coins are executed. The system ensures that the entries in any databases can only be modified by the trusted third parties and are consistent. The system does this by depending on trusted third parties such as commercial banks, credit card networks etc to follow the rules.
The Egov coin based system could be similar to the existing financial system except for the absence of cash and any cash transactions in the system. This is shown in Figure 2. Thus this system can have similar components as those present in the existing system.
This approach does reduce the transaction costs in some instances since we no longer have to deal with cash. Yet some amount of friction is still associated with the transactions. This approach though does away with opacity of transactions due to which issues like corruption, tax avoidance, non-delivery of incentives to the intended person etc will not happen.
Such a system though does not provide any privacy in transactions. This is because the trusted third parties, some of the commercial banks and the central bank has full knowledge of every transaction in the system.
Bahamas became the first country recently to roll out such a system. They call their egov coin as the Sand Dollar. In addition, China is running trials of such a system in several cities.
Crypto coins
Figure 3: Crypto Coin based system
The crypto coin system also depends on digital tokens that represent currency. Databases resident in the internet keep track of the ownership of these tokens. Examples of such systems are Bitcoin, Monero, Doge, Ether etc.
However, unlike the current system or unlike the egov coin system, the tokens in a crypto coin system are generated based on cryptographic and economic principles. There is no central bank to make decisions about money supply, interest rates etc. And the databases that keep track of tokens are all expected to have different owners who control the information in the databases.
The entries in these databases change when transactions using crypto coins are executed. The system ensures that the entries in any database anywhere in the world cannot be modified unless a majority of the participants agree to the modification. The system also ensures that the data captured in all these databases is consistent. The system does this by leveraging several concepts from cryptography, game theory, economics etc and without having to depend on trusted third parties. I plan to look at the details in future articles.
A crypto based system is shown in Figure 3. The system is made up of customers who transact with each other. Some of these customers could be running special software that creates token based on known rules and some others could be controlling the databases that keep track of the ownership of the tokens. And finally, we can also have some customers that just want to make use of the system without running any software needed to generate tokens or without deploying any databases to track the ownership of tokens.
A crypto coin based system addresses the issues with the current system pointed out above. There is no dependency on a single entity such as the central bank. There is no requirement to have trusted third parties to facilitate transactions. There is no opacity in the transactions. Anyone can verify the transactions in many of the crypto coin based systems. In fact, in some instances the lack of privacy provided by such systems can be problematic. And finally, such systems also reduce the transaction costs and speed thereby making possible many services that are economically infeasible today.
El Salvador recently became the first country to make Bitcoin as legal tender - this means you can use Bitcoin for your transactions just like you use the US dollar for your transactions here in the US. Before this, El Salvador was using the US dollar as legal tender which continues to be legal tender in addition to Bitcoin.
How will virtual currencies impact you?
You need to understand the dynamics of the virtual currency based solution chosen by your country or by the country that you are associated with either due to travel, or trade or due to other reasons. Based on this you can decide how to benefit from this movement towards virtual currencies.
I will focus on explaining the dynamics of the solutions in future articles so that you can decide what actions to take.
Sign up if these topics are of interest to you.
Subscribe and join me on this journey. And also, tell your friends!