Why Trustless Systems Are Building The Future Of Value

As we talked about yesterday, financial systems founded on a trust-based model fail to provide predictable economic assurances.

Specifically, under a financial system:

1. Value should be exchanged globally and freely.
2. Wealth should be owned wholly and protected.
3. Rules should be enforced reliably and predictably.
4. Integrity of the system should be verifiable.

We covered how trust-based systems fail to provide the first two assurances, and now we’ll cover the latter two.

Finally, we’ll wrap this into the case for Bitcoin as a trust-less system that satisfies all of them.

Where The Trust-Based System Fails

Assurance 3: Rules should be enforced reliably and predictably.

Why the trust-based model fails to meet Assurance 3: Centrally controlled institutions can enforce and change rules arbitrarily.

Because they enforce rules in unpredictable ways, centrally controlled institutions can endanger a system’s integrity. Central banks exemplify the problems associated with unilateral and unreliable rule changes. In the 18th century, the widespread adoption of fiat currencies imbued monetary authorities with the ability to control their money supplies. Introduced as an alternative to commodity-based money, fiat money was and is issued by the state, backed exclusively by the full faith and credit of issuing governments.

Monetary authorities typically manipulate the supply of money to smooth business cycles, ensure price stability, and/or minimize unemployment. Through open market operations, they swap financial assets, typically short-term government debt, for central bank deposits. Seeking to increase the supply of money, they can purchase government debt which lowers interest rates, increasing the liquidity and lending ability of commercial banks.

As short-term interest rates approach zero, central banks can choose more unconventional policies like quantitative easing, purchasing financial assets other than government bonds to expand the money supply. In 2000, the Bank of Japan (BoJ) began an aggressive quantitative easing program to curb deflation, adding private debt and stocks to its purchase of Japanese government bonds. Since the Global Financial Crisis (GFC) in 2008, unconventional policies similar to those in Japan have proliferated around the world, with no restrictions on the amount of money printed.

In the face of unpredictable changes in monetary policy, individuals typically have to grapple with the fallout. If a central bank mismanages its country’s money supply, fiat money can lose its purchasing power to inflation, if not hyperinflation. Since the advent of fiat currency, hyperinflation has destroyed purchasing power 29 times, often with a cascading impact on weaker monetary regimes. In the last century, three monetary policy changes cascaded, cutting the purchasing power of almost half of the world’s currencies by 50%: the creation of the Federal Reserve in 1913 and Europe’s decision to abandon the gold standard in 1918, the US shift from the gold standard to the gold-exchange standard in 1933, and US abandonment of the gold exchange standard in 1971., as shown below. Could the Fed’s recent response to the coronavirus pandemic have similar consequences?

Assurance 4: Integrity of the system should be verifiable.

Why the trust-based model fails to meet Assurance 4: Centrally controlled institutions lack transparency and auditability.

A monetary system that cannot be verified is unlikely to meet the first three economic assurances. Little transparency suggests that institutions have no incentive to be accountable. In a more consumer-friendly regime, participants would be able to audit and verify the integrity of the monetary system, evaluating whether or not the enforcement of assurances is consistent and objective.

Highlighting the importance of verification was the lack of transparency associated with commercial bank capital requirements leading up to the GFC in 2007-2008. Banks were undercapitalized to such an extent that auditors could not verify enough capital to cover the risks of default. Unable to audit them, investors and customers had to rely instead on third parties during one of the worst financial crises of the modern era.

Commercial banks must maintain cash reserves against customer deposits, determining not only their ability to create credit but also the customer funds they put at risk. While they have the legal obligation to return deposits on demand, banks may not be equipped to do so: no bank has enough reserves to satisfy the withdrawal of all deposits at once. Moreover, in the US today the minimum reserve requirement for deposit institutions is zero.

Indeed, since 1995 the average bank reserve requirement globally has dropped by nearly 80%, as shown below.

Bitcoin: A Financial Institution Eliminating The Need For A Trust-Based Model

To a significant degree, the financial system’s weakness today is a function of a trust-based model controlled by centralized institutions. Human bias and error exposes participants to mismanagement, creating an unpredictable environment for economic activity.

Enter the Information Age and a new economic order unleashed by computer science and cryptography. During the Global Financial Crisis in 2009, the Internet birthed Bitcoin, a financial system without a centralized authority.

Bitcoin fundamentally shifts how a financial system distributes trust, eliminating the roles of several institutions that rely on centralized authorities, and creating an ecosystem based on computer science and cryptography. In contrast to a central bank that controls monetary policy, or a commercial bank that controls the custody of assets, or a payment processor that controls consumer transactions, the Bitcoin network and all of its participants oversee all such functions, as shown below.

To round out this piece, let’s go back through the four assurances of a financial system, and show how Bitcoin satisfies them where trust-based systems did not.

Starting with the fourth assurance — that the system’s integrity should be verifiable — it’s easy to see how Bitcoin satisfies this assurance because it’s a fundamental aspect of Bitcoin’s “operating system”, the blockchain network.

Essentially, Bitcoin embeds native verification tools, allowing everyone to see almost everything (Bitcoin’s network is pseudo-anonymous).

All nodes house Bitcoin’s history, tracking the balances of all accounts. Each node is equal to another in its capability to verify and audit. Today, any individual can download a Bitcoin client, install a node, and audit/verify every transaction with little more than a computer command. Bitcoin’s decentralization is a function of the low barrier to entry associated with running a node. Today, thousands of globally dispersed nodes verify Bitcoin’s integrity inexpensively. Its native verification tools enable financial auditability, encouraging entities building services on Bitcoin to be transparent about their operations.

Bitcoin not only protects participants from harmful rule changes, but also enforces and verifies the first three assurances. Unlike in traditional financial institutions, individuals can fact check every claim Bitcoin makes. Specifically, a Bitcoin node provides native verification tools that ensure the enforcement of the other assurances, as shown in the table below.

Bitcoin’s Case As A Valuable Investment

We started this journey yesterday by asking the question, “why does Bitcoin have value?”, followed by asking a more directed question of, “why Bitcoin?”

After these forays into deep questions, the answers are both fascinating, but also the source of further questions and exploration.

What is self-evident is that Bitcoin is creating the possibility of a global monetary system controlled not by nation-states . . . but by individuals.

By eliminating the need for a trust-based model, Bitcoin is calling into question the current foundation of economic organizations and is paving the way for a more predictable financial system.

Bitcoin presents investors with a unique opportunity, not only by presenting a unique value proposition,  but by seeking to redefine value itself.

While many investors question its merit, in our view bitcoin is the most compelling monetary asset to emerge since gold. In a future newsletter, we’ll explore and analyze Bitcoin as an emerging monetary asset, and how that’s shaping the discussions to come in this new decade.

Stay tuned.