Shermin Voshmgir: March 17, 2024
This is an excerpt from the book Money, NFTs & DeFi. Other books in this series are: “DAOs & Purpose Driven Tokens” & “Web3 Infrastructure.” Read more on all books and previous editions here.
With the emergence of blockchain networks as the backbone of Web3, money and other tokenized assets including tokenized credit and lending services have now become a native feature of the Internet. A good understanding of what constitutes money and credit is, therefore, a prerequisite for being able to assess and co-create this emerging token economy.
Internet-base Money
In a client-server based Internet, financial institutions and their applications only use the Internet as an interface to the traditional financial system. Financial transactions are settled on a set of private ledgers, which are not interoperable, and need convoluted back end mechanisms to guarantee finality of payments.
Even Web2-based financial services – which have emerged over the past decades and have considerably improved the user experience – require interaction with privately managed servers and other offline systems which are not interoperable with each other.
Blockchain networks, as the backbone of Web3, have fundamentally change this by making money and other tokenized values a native feature of the Internet. The collectively maintained public ledger of transactions of a blockchain network guarantees accountability of all token transactions to all participants of the network, or as Satoshi Nakamoto wrote in his 2008 Bitcoin Whitepaper: "[...] an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers."
As money becomes an increasingly native feature of the Internet – with a publicly verifiable and globally accessible infrastructure – it will be interesting to see how this will impact not only our monetary systems, but also our financial systems and the real economy. Can so-called cryptocurrencies and other tokenized assets replace money as we know it? This question usually leads to highly controversial debates and the answer depends on one’s definition of what constitutes money. Even economists and economic anthropologists differ in their views on the history, purpose and nature of money, and as I mentioned in my introductory remarks of this book, a lack of financial literacy in the general population also means that most people have not understood or even thought about these questions. The intention of this chapter is, therefore, to give an overview of the concept of money and credit, including the history, types and functions of money.
Are so-called cryptocurrencies, such as Bitcoin and other native blockchain tokens, comparable to fiat currencies such as Euro, U.S. Dollar, or Yen, which are issued by central banks of nation states?
The answer depends on the perspective of the observer. While native protocol tokens and some asset tokens have certain properties of money, in my opinion, they seem to have more resemblance with “commodity money,” “representative money,” or some type of “community currency,” but not so much with modern “fiat money.”
The biggest challenge we face when explaining or talking about cryptographic tokens is that we are trying to explain new phenomena with old terminology. Old terminology cannot always do justice to the full range of possibilities this new technology and its tokenized applications have to offer. However, to be able to draw similarities and make accurate distinctions, it is important to understand the purpose, functionalities, and historic evolution of money.
Purpose of Money
The primary purpose of money is to facilitate an economic exchange of goods and services within and between economies. The existence of a universal medium of exchange makes economic exchange across all market participants much more efficient than pure “gift economies,” “barter economies” or a combination of the two.
It is often claimed that a standardized currency can avoid the inefficiencies of such systems like the “coincidence of wants” problem, which refers to the improbability that two parties – each of which has different goods or services to offer – can agree on a deal, unless each party wants the specific good/services the other party offers, at the same time. To mitigate this problem, one can agree on a universal asset of value as a medium of exchange.
Shells, precious metals or livestock were first used in this role to overcome the inefficiencies of barter economies or gift economics. Over time, however, more neutral artificial mediums of exchange developed, which were referred to as “money.” Money has, therefore, proved to be an efficient technology for intermediating the exchange of goods and services, providing a tool to compare values of dissimilar objects. While this theory makes sense, and certainly explains the merits of a universally accepted medium of exchange, heterodox economists don't necessarily agree that pure barter economies or gift economies ever existed.
Debt aka Mutual Credit
One of those skeptics was anthropological economist David Graeber. In his controversial book “Debt: The first 5000 years” he argues that the concept of debt or credit-based accounting in the form of social debt probably predates money-based or barter-based transactions. While money and barter based economic transactions also existed, Graeber argues that they were limited to low trust situations, typically involving a set of people who didn’t know each other and therefore didn’t consider each other as credit-worthy. Graeber concludes that a "military–coinage–slave complex" replaced the social debt concept when city-based civilizations started to pay mercenary armies with money they created to loot other cities and enslaved their citizens to work somewhere else for free. In Graeber’s opinion - the emergence of slavery combined with the emergence of coinage enabled economic prosperity in remote civilizations - marked the rise of empires such as Greece, the Roman Empire, China, or India. Mercenaries were paid with newly created coins, and citizens were forced to pay taxes in that currency, which ultimately required them to permanently engage in this new type of financial transaction. The European colonization of the Americas and Africa, and the subsequent extraction of gold and silver resources from their colonies, was another example for the emergence of such a military-coinage-slave complex.
Mainstream monetary theory also connects money to debt as it is assumed that money needs certain properties to serve as an adequate medium of exchange, store of value and unit of account in which debt can be denominated. A unit of account is not only important for denominating debt but also to provide a basis for market prices, which is a prerequisite for an efficient accounting system and the basis for the formulation of commercial agreements. “Currency” is an economic term that refers to a system of money that a closed group of people – such as citizens of a nation state – can use as legal tender to settle economic transactions within the digital or geographical boundaries of their group.
“Legal tender” is a legal term that refers to a unit of account in which debts are denominated within the boundaries of a nation state, as defined by its legal system. As legal tender, money is an accepted way to meet a financial obligation resulting from economic activities and to settle debts within the geographical boundaries of that nation state. However, the exact definition of legal tender varies along jurisdictions, and the emergence of a wide range of tokenized alternatives also challenges current definitions. Multiple countries could use the same currency – as is the case for the Euro within all countries of the European Union. The monetary authorities of a country could also declare the currency of another country to be their accepted legal tender. Panama or El Salvador, for example, have declared the U.S. Dollar as their legal tender, and El Salvador most recently also Bitcoin.
History of Money & Types of Currencies
In modern economies, the dominant type of money or currency is currently “fiat money” or “fiat currency.” Before modern day fiat currencies, other forms of money and more or less formalized mutual credit systems were in widespread use. Here is a brief selection.
- MUTUAL CREDIT As mentioned above, David Graeber suggested that economic interactions originated around fuzzy social currencies based on mutual expectations and indebtedness among individual members of a trusted group, where the members of the group are entangled through a web of social bonds through marriage based family ties, gifts and mutual support. These mutual credit systems could be more or less formalized in their system of accounting.
- COMMODITY MONEY refers to any object that has an intrinsic and generally accepted value within a local economy such as gold coins, silver coins, other rare metal coins, salt, barley, or animal pelts. The price is determined by comparing the perceived value of the commodity to the perceived value of other products. Cigarettes have been used as an underground currency in prisons, but were replaced by tuna cans or instant soup packs and similar durable and portable objects in countries where smoking was banned.
- REPRESENTATIVE MONEY is a type of medium of exchange that represents something of value but has little or no value on its own. It is a claim on a commodity. Examples are gold or silver certificates, as well as paper money and coins fully backed by gold held as reserve in a bank. In such a system, a currency is backed by a fixed quantity of precious metals such as gold, silver or a mix of gold and silver, that are held in reserve. Before the gold standard, the silver standard and bimetallism were more dominant. Government-issued banknotes were probably first used in China 1000 years ago, but representative money only became the predominant form of money worldwide in the late 19th and early 20th centuries. More sophisticated financial instruments are promissory notes, checks, or letters of credit..In Web3, asset-backed tokens could be seen as a type of representative money, since they represent a physical object or digital property right.
- FIAT MONEY such as the coins and bills we use today, does not have an intrinsic physical value like a commodity. Its face value, which is denominated on the banknote, is greater than its material substance. The money is issued and regulated by a country's central bank in coordination with fiscal policies of their government. Fiat currencies have evolved over time. While bills and coins used to be pegged to scarce commodities like gold and other precious metals in the past, governments worldwide started to move away from a fully backed representative money to only partially backed fractional-reserve banking. Today, hardly any currencies are pegged to precious metals or other commodities. The gold standard was eventually abolished after it had been unilaterally abandoned by the United States in 1971 with the end of the Bretton Woods System. The assigned value of fiat currencies today results from the fact that governments can use their power to enforce the value of a fiat currency. “It derives its value by being declared by a government to be legal tender [...] It must be accepted as a form of payment within the boundaries of the country, for all debts, public and private […] The money supply of a country consists of currency (banknotes and coins) and, depending on the particular definition used, one or more types of bank money (the balances held in checking accounts, savings accounts, and other types of bank accounts).” In a fiat system, different categories of money exist – physical cash in circulation as well as all different types of bank deposits are registered as assets on the private ledgers of financial institutions and can - under normal conditions - be easily accessed by their depositors. The overall money supply consists of the total volume of the different types of a currency held by participants of an economic system at a particular point in time. Depending on the country, different classes of money supply have been defined. In Europe, for example, there are three categories: M1 (banknotes, coins and what banks refer to as “overnight bank deposits,” M2 (the supply of M1 plus various types of longer term bank deposits), and M3 (all the money supply of M2 plus what is know as “repurchase agreements” and “money market fund shares” plus certain types of debt securities). Central banks can influence the money supply in interplay with other authorities and commercial banks through monetary policy instruments such as interest rates, by issuing more or less money, or via a fractional-reserve system enabled by the issuance of debt via commercial banks (we will dive deeper into this later in the chapter). Many economists would argue that fiat currencies, in most stable economies, are backed by the collective value of the underlying economic activity of a nation, measured as its gross domestic product (GDP).
- DIGITAL FIAT MONEY aka BANK MONEY In modern economies, most money in circulation is not in the form of bills and coins anymore, but exists as an entry in the digital ledgers of a bank aka “bank money.” Checking accounts, savings accounts, and other financial instruments are examples of money that only exists as an entry in a digital ledger. In some countries, more than 90% of economic and financial transactions are settled with bank money. Cash money constitutes less than 10% of the overall money supply, and it is decreasing by the year. Starting in the 1970s, credit cards, and more recently, financial applications of the Web2 era, have facilitated the transfer of bank money and have contributed to an increase in the use of digital fiat money instead of cash. In this context it is worth mentioning that if one deposits money in a bank, one usually forfeits control over how the funds are used by the bank. What most depositors across the globe might not know is that, in most countries, the fine print when opening a bank account states that all funds deposited become property of the bank. This means that the bank can loan out the money or make investments, which brings the risk of mismanagement. State-mandated bank guarantees only insure depositors’ money up to a certain amount. In the European Union, these bank guarantees are limited to 100,000 Euro per account; higher deposits are not guaranteed for in the case of bank default. In case of a global financial meltdown, it is uncertain if such bank guarantees can practically be paid out in every case. So called “Central Bank Digital Currencies” aka “CBDCs” are the next level of digitalization of fiat money that are represented by tokens and managed by some kind of distributed ledger. CBDCs will be discussed in the next chapter of this book.
- COMPLEMENTARY CURRENCIES From a nation state perspective, so-called “complementary currencies” are usually not considered legal tender and are not issued by a central bank or other national governmental institution. They are understood as a complement to national currency, which mostly has a regional purpose (regional currency), community purpose (community currency), or institutional purpose (private currencies that are issued by a business or an NGO, possibly also a private individual). Their use is based on a voluntary agreement between the parties exchanging that particular currency, and not mandated by state institutions that usually fulfill the role to guarantee the sustainability of money – in terms of balance between inflation rate, economic growth and other economic factors. The issuing institutions of complementary currencies can vary greatly. Their purpose has been to advance specific political, social or environmental goals. The history of complementary currencies is so long and broad that it could fill a book or several, and many have been written on that topic. A variety of complementary currencies have historically been experimented with. They have had many different purposes and characteristics, such as negative interest rates (aka demurrage). As mentioned in the previous chapter, the regional currency of Wörgl, Austria of the 1930s increased the velocity of money via a demurrage system, which allowed the local currency to circulate more rapidly than the national currency, and encouraged people to spend the money more quickly. The “Transition Towns” movement in the UK is a more modern example of regional currencies. They included additional social and environmental goals into the monetary policy parameters of their currencies, for example with the Brixton Pound and the Bristol Pound. The Salt Spring Dollar in Canada or BerkShares in the USA are other examples. Local currencies have been advocated to strengthen regional economic activity – favoring locally produced and locally-available goods and services – and have often been able to benefit depressed regions, as these currencies cannot be spent elsewhere, which means that money is kept in local circulation with the purpose to benefit the local economy. However, critics argue that local currencies create unnatural long-term economic barriers to monetary policymaking on a nation state level and are not sustainable in the long run. Another type of alternative currency are currencies based on the concept of mutual credit, which can be either issued as time-based credits, or by using price as a measure of value as in a Local Exchange Trading System (LETS). LETS is a system that provides a directory of offers and needs of goods and services. Each participant receives a line of interest-free credit and the IOUs of each participant are then logged in a ledger which is visible to all members. If one member defaults on their debt, the loss of value or units is absorbed equally by all others. Members may earn credit by doing eldercare for one person and spend it later on childcare or tutoring services with another member of the same network. LETS thus resolves the coincidence of wants problem by creating a mutual credit network. The Fureai Kippu system that was introduced in Japan of the 1990s had the social purpose of incentivizing local eldercare work against the issuance of credit notes. The idea was that family members who lived far from their parents could earn credits by offering care work in their local community. Their collected credits could then be transferred to their parents and redeemed for local assistance. The concept was adopted in China and became even more popular there. Frequent-flier miles issued by airlines and similar loyalty programs are also a form of complementary currency, which have the purpose of incentivizing customer loyalty in exchange for free or discounted products or services on their internal marketplace.
- CRYPTOCURRENCIES In the wake of the global financial crisis of 2007-2009, the Bitcoin Whitepaper introduced a new form of Internet-native money that resolved the double spending problem. But Bitcoin was only the beginning. The concept of a collectively maintained ledger of transactions that is publicly verifiable spurred an avalanche of cryptoeconomic innovation. Since Bitcoin’s original developers published the Bitcoin protocol as open source code, anyone could take the Bitcoin code, adapt it to their own needs or preferences and start their own digital currency collectively managed by their own community-maintained digital payment infrastructure. An array of digital currencies and tokenized fiat currencies, tokenized commodities, and other tokenized asset classes have been issued over the past 13 years. At the time of writing this book, 8810 fungible token types (cryptocurrencies or crypto assets) are listed on coinmarketcap.com, and this does not include the multitude of non-fungible tokens that are being traded on a growing ecosystem of specialized NFT marketplaces. This sector of tokenized currencies, commodities and other tokenized asset types creates new economic dynamics that challenge our current concepts of money, finance, economic assets and maybe also our general understanding of what constitutes economic value creation. Most traditional economists would classify cryptocurrencies and other tokenized assets as some form of alternative currency, but only time will tell if these old classifications and the accepted monopoly of government over money creation will hold.
Properties of Money
To serve as a useful medium of exchange, unit of account and store of value, money must have certain properties. It needs to be fungible, liquid and generally accepted, durable, portable, recognizable, and stable. Money also needs some inbuilt anti-counterfeiting measures to avoid forging and maintain trust.
- FUNGIBILITY refers to the fact that units of money are equal. Every token of that currency must be treated equally, even if it has been used for illegal purposes by previous owners. This is to protect the rights of innocent recipients of those tokens, who might not have known of the illegal activities. In blockchain networks, the fungibility of currency tokens is challenged if a token can be censored or blacklisted based on the behavior of previous token holders. At the time of writing, contrary to common belief, Bitcoin is not fully anonymous, only pseudonymous. Only privacy-preserving blockchain networks can provide fungibility comparable to analog money systems. Tokens that represent assets with unique properties, such as paintings or real estate objects, are non-fungible by design. However, if an NFT is fractionalized, these fractional tokens of the unique asset would represent fungible fractional shares of that asset.
- LIQUIDITY in the context of money refers to the fact that the technological substrate that represents the type of money (whether physical or digital) must be generally accepted and easily tradable at low transaction costs. Blockchain networks can only provide greater liquidity if the cost related to each token transaction is low enough to make micro transactions feasible, which, depending on the type of distributed ledger, may or may not be the case for daily financial transactions. How easy it is to exchange a unit of a currency to or from other assets might also depend on the transaction size. Cash, for example, is very liquid in smaller amounts, but large amounts of cash are generally harder to exchange for other assets. In blockchain networks, where tokens have to pay transaction fees to the network nodes, liquidity depends on the transaction volume and on whether there is a flat or a percentage-based fee for network transactions.
- DIVISIBITY & PORTABILITY refer to the fact that money must be easily transportable. This was not always the case – take commodity money such as a barrel of oil. While it is theoretically divisible and durable, a barrel isn’t easily portable. A bar of gold is equally durable and easier to transfer, but divisibility comes at a high cost, given the process of melting and minting it into smaller units. This is why alternative forms of money, such as representative money or fiat money, were eventually introduced: they provided easier divisibility. Distributed ledgers allow for even higher levels of divisibility and portability at much lower costs. The process of creating digital ownership certificates is comparably easy and allows for almost limitless fractional representations of any virtual currency, fiat currency, commodity, and other asset. Tokens have the potential to provide much more divisibility and portability, not only for currencies but also for any other tokenized asset type, creating more liquid markets for previously illiquid asset types.
- ANTI-COUNTERFEITING MECHANISMS Every form of money needs measures to ensure that it cannot be copied, forged or double-spent. Anti-counterfeiting mechanisms are important so that participants in an economic system can rely on the fact that the money they have will be accepted by a potential counterparty. Depending on the type of money, the system can be more or less easily cheated. Gold coins can be diluted with other metals of similar density, paper money can be forged, digital systems can be hacked. Authorities issuing money, therefore, need to make sure that forging and cheating the system is not possible, or at least made prohibitively expensive. Anti-counterfeiting mechanisms are an integral part of blockchain consensus protocols, and a native feature of Web3, which is why tokenization is such a paradigm shift for the Internet.
- DURABILITY refers to the ability of an item to withstand repeated use so it can serve as a store of value. Money must have the ability to be reliably saved, stored, and retrieved, and to be predictably usable as a medium of exchange when retrieved. This means that the substrate of that currency should not easily vanish, decay, or rot. Metals or durable foods such as wheat, flour, and sugar have high durability, and were therefore often used as commodity money; they were considered precious to almost all members of society. However, divisibility, portability and therefore liquidity posed a challenge, which is why commodity money was eventually replaced by representative money. Representative money is equally durable but much more portable and divisible. Blockchain networks allow for repeated use of tokens that can withstand time. However, durability could be compromised as a result of security issues of the underlying blockchain networks, security issued of the applications interfacing with the respective token, or if users abandon a network to such a degree that it becomes inoperable in practice. The Solana network is unfortunately one example for such problems. Solana is a blockchain network with smart contact functionalities that was very popular and being hyped as a potential Ethereum competitor for a while. It introduced a variation of the Proof-of-Stake consensus mechanism, which the creators refer to as "Proof-of-History." On various occasions in 2021 and 2022, the Solana blockchain went offline for a variety of reasons. Such repeated security issues could lead to the abandonment of user accounts and network nodes in the long run, which could challenge the usability of the network as a whole and therefore the durability of the tokens in the network.
- STABILITY refers to the lack of price volatility of a currency. It describes the exchange value of a currency which – ideally – should not fluctuate too much. Otherwise that currency will not be able to serve as a reliable store of value. Without a reliable store of value, economic planning of individual households, companies, and governments is difficult. High price volatility – such as inflation or deflation – is counterproductive for trust in future prices, salaries, debts, and therefore trade. Inflation reduces the value of money and, as a result, its ability to function as a store of value. If price levels rise, each unit of currency buys fewer goods and services. Deflation, on the other hand, decreases general price levels of goods and services. With fiat money, it is the role of the central bank together with other government authorities to maintain a good balance of economic factors to contain inflation or deflation. In Web3, stability of a token depends on the type of token and whether or not a stability mechanism has been included in the token protocol.
- RECOGNIZABILITY refers to the fact that the value of a currency token must be easily identifiable, which poses a challenge for commodity money that cannot be minted as a coin. The authenticity and quantity of the commodity money or representative money needs to be apparent to potential users, or else it will be difficult for them to agree on the terms of an exchange. The issue of recognizability was resolved with the introduction of first representative money and later fiat money, where the value is simply engraved on the coin or printed on paper. In the digital world, both with digital fiat money as well as crypto, the value of a currency token is easily identifiable through the user interface of the financial application representing the digital money.
Is Bitcoin Money?
While Bitcoin (BTC) was originally designed with the purpose of creating P2P (“peer-to-peer”) money without banks, it really is much more. The underlying P2P protocol that enables this novel kind of P2P electronic money has proven to be a gateway to a new type of economic value creation. The consensus mechanism defined in the protocol incentivizes individual contributions to a collective good – a public and permissionless P2P payment network.
Using the vocabulary of a computer scientist, the protocol provides an operating system for a new type of internet-based economic network. Using the vocabulary of a political scientist, the protocol represents the constitutional foundation for a distributed Internet tribe that collectively operates a public good.
Bitcoin tokens can be considered legal tender of the Bitcoin network and its participating stakeholders such as BTC holders, developers, miners, application developers, and many more. Within the Bitcoin network, Bitcoin tokens are the only accepted form of payment (equivalent to legal tender in nation states). All economic transactions within the network are paid for in Bitcoin, such as transaction fees to the miners. They cannot be paid with fiat money like U.S. Dollar, Euro, or other cryptographic tokens. The price of the network token is expected to reflect growth and resilience factors of the payment network, such as usability, stability, manipulation resistance and ecosystem growth – very similar to how the value of fiat currencies should reflect the resilience of economic activities of a country.
The monetary policy parameters are encoded in the Bitcoin protocol and automatically enforced by all nodes in the network. The same is true for other blockchain protocols and their native protocol currencies. Monetary policy rules may differ from network to network.
- PROTOCOL TOKENS such as Bitcoin tokens (BTC) or Ethereum tokens (ETH) have certain properties of money – however, they seem to have more similarities to commodity money or representative money than to fiat money. The production process is distributed (similar to real life commodities) and the price is determined by supply and demand for network activities and network tokens and thus subject to fluctuation (similar to market mechanisms on commodity markets). Protocol tokens also have certain similarities to fiat currencies, because they steer an economic network and are the legal tender of the respective network. The blockchain protocol has functions of an automated central bank where the token creation rules and supply policy are encoded. While a blockchain protocol is a point of centralization, it can only be changed by majority consensus of all network actors in the form of a software upgrade. As opposed to fiat currencies, policy setting and policy enforcement are therefore distributed, much like in the case of commodities, where no single government or other entity controls the mining of gold, silver, oil, etc. How much control a user has in the system is subject to the token creation rules defined in the protocol, and differs from blockchain network to blockchain network. As opposed to fiat currencies, no single entity – such as governments or central banks – can influence the price or the accessibility of protocol tokens. Influencing the price, however, is one tool for governments to stabilize the price of their currencies. Most protocol tokens of blockchain networks have no stability mechanisms built into their protocols.
- ASSET TOKENS can be very different from protocol tokens since they are often issued by one centralized entity, a private company, or a foundation. Such asset tokens can represent any virtual or real asset and therefore also have similarities to commodity money or representative money, but no similarities to fiat currencies. Unlike protocol tokens, they have no monetary policy tied to the token creation rules. Asset tokens simply represent real or virtual assets such as commodities, stock, real estate or art, and their price and price fluctuation are determined by supply and demand for these assets. They are usually not designed to steer an economic network to collectively maintain a public good. Their relative price stability depends on the price stability of the underlying asset.
As of today, most Web3 tokens do not fulfill some important properties of money – such as stability, and to some extent, also fungibility. Stable tokens using “central bank smart contracts” could account for a more adaptive monetary policy than that provided by Bitcoin and similar network tokens. Usability and scalability are other entry barriers to potential mass adoption of Bitcoin or similar protocol tokens as a medium of exchange for daily transactions.
- STABILITY Bitcoin and similar blockchain protocols simply regulate and limit the amount of tokens minted over time. Their protocols do not provide a sophisticated economic algorithm that guarantees price stability; their exchange rate is determined by supply and demand on markets and is often highly volatile. While fiat currencies of most modern economies also have fluctuating exchange rates that are determined on foreign exchange markets, national institutions can perform currency intervention via foreign exchange markets or other currency manipulation. In such an intervention process, governments or central banks buy and sell currency in exchange for their own currency to manipulate the market price. They do that in order to avoid excessive short-term volatility, which makes economic actions hard to plan. Stable tokens have been designed to account for this challenge: the monetary policy defined in their protocols contains adaptive price stability mechanisms. This topic will be addressed in more depth in the next chapter of this book “Stable Tokens: Tokens with a Stable Value.” Some believe that in the future – with the progress of tokenization and when decentralize-finance-based trading and hedging options become mainstream – price volatility will become a non-issue: algorithms will balance all our tokenized assets so they can be instantly swapped for other tokenized assets, and the wallet application will just display the unit of account of one’s choice (i.e. EUR, USD, ETH, BTC, SOL, etc.). It is unclear whether, how and when such solutions will gain mass market traction. Until then, stable tokens will be needed to provide a means for better economic planning, so cryptocurrencies can serve as a medium of exchange.
- PRIVACY Most tokens today have no inbuilt “privacy by design.” Potential traceability destroys the fungibility of a token and therefore makes it unsuitable as a reliable medium of exchange. For a token to potentially serve as a medium of exchange, it needs to be fully fungible. If you can taint addresses, as is the case for Bitcoin today, the token will not serve as a medium of exchange in the long run. Even though Bitcoin addresses are pseudonymous, simple chain analysis of the ledger can link the data flow from a particular address with other data points outside the blockchain, and identify who is behind a Bitcoin address. While this requires time, effort, and access to other data points, it can be done. Read more on the technical and political aspects of token privacy and privacy tokens in another book of the Token Economy Series titled “Web3 Infrastructure.”
- SCALABILITY Current settlement infrastructures of public blockchain networks are secure, but not very scalable, which means that not too many token transactions can be settled at the same time. Alternative distributed ledger solutions have better scalability, but tend to be more centralized. This is due to the “scalability trilemma,” the trade-off between security, scalability and decentralization. Lack of scalability means two things: the network is too slow and too expensive to settle urgent transactions or micro transactions, which means the network is not suitable for day to day payments. While scalability is still a big issue, many solutions are already on the horizon and it is only a matter of time until these issues can be resolved. Read more on blockchain scalability in another book of the Token Economy Series titled “Web3 Infrastructure.”
- USABILITY Wallet usability also has a long way to go. In the first years of crypto, most wallets supported only a handful of tokens, some only one. As a result, one often needed a separate wallet application for each token, or type of tokens, which was not very user friendly. It was, and still is, very development intensive to support many different blockchain networks (which all have different technical security requirements) with only one wallet application. This is not only time consuming and expensive but also makes the wallet application process heavy and incompatible for mobile devices. At the time of writing this edition of the book, the situation has shifted a bit. Wallet developers today find it easier to develop applications for the Ethereum network and other blockchain networks that are compatible with the Ethereum Virtual Machine (EVM), since most token use cases have been built on the Ethereum blockchain or other EVM-compatible networks. As a result, non-EVM-compatible blockchain networks – such as “Cardano,” “Solana,” and many others – are often ignored by wallet developers. This centralization tendency towards the biggest player defies the decentralized paradigm of Web3. Furthermore, at the time of writing, key management is still a nightmare: if you lose your key, you lose access to your funds. If that issue is not resolved, hosted wallets in the custody of trusted third parties, such as online exchanges, will continue to be used by most people who prefer to outsource secure key management and give up sovereignty over their funds. This, however, undermines the whole idea of autonomous asset management in the sense of P2P electronic cash, as originally envisioned by Satoshi Nakamoto. Tokens that are managed in the wallets hosted by a financial service provider don’t grant the same sovereignty over one’s assets, as accounts can be frozen at any time or one’s assets can become subject to mismanagement or hack on their infrastructure. You can read more about this topic in other chapters of this book, “Decentralized Finance (DeFi)” and “Token Exchanges & NFT Marketplaces.”
Source Money, NFTs & DeFi. Other related articles:
REFERENCES
This link will lead you to a website that contains all the references to the source materials used for the research of the chapter, and should also provide a reading list for all those who are interested in a deeper dive into the topics presented.