Blockchain: A New Financial System for a New Age

In the midst of the 2008 financial crisis, most investors were worried about losing their fortunes. But instead of nervously watching the market, Satoshi Nakamoto decided to write. In October 2008, he published a paper that gained little attention.

In the paper, Nakamoto explained an idea that would revolutionise our payment transaction system. His idea has since grown into a US$10.1 billion market.

In his paper, titled ‘Bitcoin: A Peer-to-Peer Electronic Cash System’, Nakamoto describes his idea as ‘a system of electronic transactions without relying on trust.’

The ‘trust’ Nakamoto is referring to represents that which we have in financial institutions to maintain our current payment system.  Now, you’ve probably heard of bitcoin before. The cryptocurrency has risen dramatically in popularity over its short life span.

The first bitcoins ever created in early 2010 were worth less than 1 US cent. Today, a bitcoin is worth around US$636. If you’d invested in bitcoin back in 2010, that’s a return of 63,599%! But the amazing part about bitcoin is not the returns it can offer. The most impressive aspect is the system surrounding bitcoin.

Nakamoto’s innovative system, or something like it, could be the next big step for our financial system.

Governments and central bankers cannot abuse bitcoin, unlike fiat currencies such as the US and Aussie dollars, which they can create infinitely. Fiat currency has no real value. It only has value because we trust that the government will compensate us for the amount printed on our paper money.

Thanks to Nakamoto and bitcoin, we no longer have to rely on trust. Allow me to explain why this is a good thing.

An untrustworthy system

Faith is hard to come by in the current financial system. But faith and trust are the foundations that central bankers and governments, um, bank on.

But if current monetary policy continues, our money might be useless in the future. Creating more money to service more debt, or to inflate asset prices even higher, might only provide temporary growth. Long term, excess money supply could create another financial mess with a defunct economy.

Pumping more money into a system will likely make the problem worse.

In 1944, the US, Canada, Western Europe, Australia and Japan devised the Bretton Woods Agreement. The agreement aimed to create exchange rate stability and economic growth (among these countries in particular, but also globally).

The Bretton Woods system came into effect in 1958. It allowed all countries to settle their international accounts in US dollars. Central bankers could convert their US for gold at a fixed rate. The official exchange rate was US$35 per ounce of gold.

This became known as the ‘gold exchange standard’.

The US backed every dollar overseas. Currencies became fixed to the US dollar, and the dollar was pegged to gold.

But this put the US in a vulnerable position. France started to reduce its dollar reserves from 1959 to 1970. It exchanged US dollars for gold at the official rate.

In doing so, it reduced the US’s economic influence by depleting its gold reserves.

By 1966, non-US central banks held US$14 billion in gold reserves, while the US held US$13.2 billion. Of those reserves, only US$3.2 billion were able to cover foreign holding. The rest covered domestic holding.

The fiscal strain of the Vietnam War prompted then US president, Richard Nixon, to act. He ended the international convertibility of US dollars to gold in August 1971.

People thought this was only temporary; a measure aimed at revaluing the US dollar. Yet no official revaluation or redemption occurred. The US government floated the US dollar.

In December 1971, the US dollar dropped from US$35 per ounce of gold to US$38. This action decreased the amount of gold that central bankers received for their US dollar holdings. But converting US dollars for gold was still restricted.

In October 1973, the price of gold raised again to US$42.22. After the dollar devalued, the US government changed the definition of a dollar. It removed references to gold from statutes (laws). And from October 1976, the international monetary system was pure fiat money.

Trust — rather than gold — would back the value of the US dollar. This simple change removed the disincentive to pump US dollars into the economy, and that’s exactly what happened.

Today, countries like the US, Europe and Japan print money like it’s free. Each time they create a new dollar, euro or yen, it decreases the value of all existing dollars, euros and yen. Money is pumped into every developed economy to achieve inflationary targets.

This is a major reason behind the US housing bubble in 2007. Banks were more than happy to hand people money to inflate asset prices. Indeed, banks were indiscriminately handing out home loans to almost anyone who wanted to borrow. Even borrowers who had no income, job or assets were given loans. But instead of creating growth, it just created high prices — until the bubble burst.

And it’s a large reason why there is little faith in the financial system. The unlimited availability of money is an underlying reason why faith in our current system is hanging by a thread.

And while inflation is low now, what will happen when it does take off? Those of us holding cash will essentially be holding pieces paper that could be worth 10–20% less every year we hold onto them.

If you ask me, we need a whole new system.

The next new currency and so much more

Bitcoin has the potential to replace our entire payment system. Or it could be a stepping stone to an even greater, more sophisticated network. Bitcoin is still subject to volatility. One day your bitcoins could be worth US$636. The next day, they could be worth US$450.

In November 2013, a single bitcoin was valued at US$979.45, before falling to US$638.09 over the next two months. If you were holding nothing but bitcoins, this would have been a big hit to your overall net worth.

Bitcoin’s volatility can be explained by supply and demand, just like almost every other asset. The fact that bitcoin’s value is a measure of US dollars only adds to the volatility. While the amount of bitcoins is more or less fixed at a certain point in time, the amount of US dollars is not. And since the US dollar constantly strengthens and weakens, it affects the value of bitcoin.

Bitcoin is by no means a perfect system. However, it is isolated from the mad interventions of governments and central banks.

Let me explain how bitcoin does this.

First, you need to understand something called the ‘blockchain’. This is quite technical, but I’ll try to keep it simple.

The blockchain is a system built for bitcoins. Think of the blockchain as a public ledger. It records all bitcoin transactions in history. The creation of more ‘blocks’ (transactions) allows the ledger to grow.

Now, imagine various nodes or points within the blockchain. Each node contains a full copy of the blockchain. It holds information about the address of each transaction, the balance of bitcoin holders, who the bitcoins came from, and recently completed blocks.

Bitcoin ‘miners’ (people who ‘discover’ bitcoins using specific computer hardware) confirm every transaction across the entire system. This requires enormous computing power, and ensures every transition between buyer and seller, or payer and payee, is correct.

Miners spend time and money to maintain the blockchain. Therefore, they need compensation. Each time a miner validates and creates a new block, they receive bitcoins. This is how new bitcoins enter the system. Miners receive 50 bitcoins for the first 210,000 blocks they create. For the next 210,000, they receive 25 bitcoins. The reward continues to halve for every 210,000 blocks.

This is a basic explanation of how it all works. But it’s a crucial difference from fiat currencies like the yen, and the US and Aussie dollars, which can be created on a whim.

Bitcoins can be transferred immediately to any other account. They can be converted into any denomination of your choice. And the applications of the blockchain are not limited to payment transfers.

The bitcoin network can also track ownership of digital and physical assets. It can be an alternative voting system as the ledger cannot be tampered with, and can store vast amounts of information. It can create digital contracts for marriages, financial contracts and proof of ownership. Or it could even track the supply chain of various products.

Blockchain technology could be worth US$2.3 billion by 2020, according to MarketsandMarkets.

What makes it so special is that it’s spread over a network of nodes, thus encouraging transparency. It’s a system that works ‘without relying on trust’. And it could be the payment system of the future.

Regards,

Härje Ronngard,
Contributing Editor, Money Morning

PS: Blockchain technology could revolutionise many industries. From the payment system to smart contracts, the blockchain provides greater transparency, and empowers users by giving them complete access to the ledger. But it’s only one type of future tech. Autonomous vehicles, automated construction and enhanced memory are just some of the technologies we could all be using in just a few years’ time.

Knowing about these technologies beforehand can give you a huge investment advantage. By getting into revolutionary tech stocks early, you could potentially earn returns of 400% or more. And this is exactly what tech specialist Sam Volkering does for subscribers of his advisory service, Revolutionary Tech Investor.

Sam’s top three active investments, which are looking to profit from emerging technologies, are up 204.9%, 319.5% and 445.5%.

To find out more click here.

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

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