Trust and the Viability of Cryptocurrency

Can cryptocurrency prove to be more trustworthy than fiat currency?

Estimated Reading Time: 9 min

Prologue

Currency relies on trust to function. And yet, fewer than ⅓ of Americans trust the US financial system and over 40% are actively displeased with the state of the economy. 

In my previous series, I described the logic behind a fiat (government-backed) currency. But just as important as the logic of fiat are its limitations and the burden its debt-based system currently places on the average person.

In the face of trust issues with fiat, one can understand being hungry for an alternative foundation to an economy other than the government. It is in part due to this distrust and other objections to fiat that cryptocurrency arose.

A Brief Explanation of Cryptocurrency:

For those who may be unaware, a cryptocurrency is three things: a digital token, a mechanism for creating that token, and a database (also called a ledger or a blockchain) that tracks who owns what token. One of the unique features of this system, that serves as the foundation to what differentiates it from fiat, is that cryptocurrencies are not run by any individual institution. Instead, the database is copied across and maintained by millions of people. 

Why would people spend their time and money maintaining a database for a digital token? Because the act of maintaining the database gives you the opportunity to create that digital token for yourself. That is because the act of maintaining the database and the act of creating (also called mining) the token is one and the same, the result of running the same software program. When a new token is created, the most recent list of transactions is saved to the database.

It’s worth noting that the process of creating a token is a race. Every person mining a cryptocurrency is racing to run their code faster than anyone else and only the winner earns a token. The result is that a miner typically needs to both use specialized hardware as well as partner with other miners in order to successfully win the race and earn a new token.

If you simply want to use a cryptocurrency, you aren’t required to be one of these miners. Instead you simply need to find somebody willing to sell you Bitcoin, agree to the sale, and then log that exchange onto the database by sending the record of the account transfer to the miners. The miners then save the record once the latest token is mined.

What’s the appeal of a cryptocurrency from a trust perspective? 

• The ledger is fully public, so anybody can check the ledger and verify every single transaction that has ever occurred 

• The ledger is decentralized, so there’s no need to trust a single institution

• The ledger has defined rules that require a majority consensus to update, so it’s arguably a democratic system

These features can be used to argue for cryptocurrency as an alternative to fiat currency. But in trading one solution for another, would we actually be moving towards a definitively better solution? Or would we instead be exchanging one set of problems for another?

To dig into this question, we’ll focus on Bitcoin, the most popular of the cryptocurrencies, and compare it with fiat currency in three separate questions.

Who sets the rules?

Any financial system requires some rules for the currency, like how it gets manufactured. As such, a core component of trusting any financial system lies in trusting the rulemakers - trust that the establishment of and adjustments to the rules benefits the users of the currency. Without trust in the rulemakers, present trust in a currency can be eroded by any future changes to the currency.

Bitcoin

With Bitcoin, the rules are set by whoever builds Bitcoin’s software. The mechanism for creating new Bitcoin and the mechanism for maintaining the database are both defined in the Bitcoin code. This means the people who set Bitcoin’s rules are its developers, of which there are roughly 50 in any given month and there have been around 780 in total.

These proposed rules must then be accepted by a majority of miners, the people who maintain the Bitcoin database. These roughly one million miners of Bitcoin are the ones who effectively vote through any new rule to how Bitcoin operates.

The number of people who actually own Bitcoin and trade it is much higher. By one measure, there are tens of millions of Bitcoin traders, which means less than 10% of Bitcoin users vote on its use.

Furthermore, many of these Bitcoin traders can not become voters without losing money. To be able to vote you need to mine Bitcoin, and to do that one needs thousands of dollars to buy the latest Bitcoin mining hardware. From there, turning a profit with this upfront investment requires cheap access to electricity lest you bleed money in the monthly electricity costs. Also, by design, every new person who starts mining Bitcoin makes Bitcoin more difficult and therefore more expensive to mine.

As we are right now, Bitcoin miners use the same amount of power yearly as Chile and create the same yearly carbon footprint as Switzerland. So increasing the number of voters in the Bitcoin blockchain would not only be financially infeasible for many people but would also be environmentally expensive.

Fiat

With a government-based financial system, the rules are unsurprisingly dictated by the government. In the US, this specifically comprises a mix of elected and appointed officials. Presidents and Congressmen are elected by the voting populace, but key roles like Federal Reserve seats and the Secretary of the Treasury are appointed by the President and approved by Congress.

For reference, in the 2020 US general elections, 62% of the voting age population voted. 93% of the voting age population is eligible to vote, so we haven’t reached full levels of representation, although we have a majority of the US represented in our elections.

At the same time, $14B was spent on the 2020 US general elections with only 22% coming from small individual contributors. And in the first quarter of 2020, almost $1B was spent lobbying Congress. From the perspective of politicians, this may be logical since, in Congress, the candidate who spends the most wins more than 80% of the time. But from the perspective of the voters, the outstanding impact of money on democracy can very understandably erode trust to the point where trust in the US federal government currently lies at 20%.

How are currency updates handled?

No financial system to this point has proven itself to produce the perfect currency. Therefore, the potential for change must be baked into any system to account for potential improvements. Sometimes the change may be as simple as defining how much money banks can lend sometimes the change may be as significant as replacing one currency for another. Because of this requirement for adaptability, trust that a currency can continue to function in the face of adaptation becomes crucial.

Bitcoin

As mentioned before, whenever the rules of a cryptocurrency get updated, every miner has to decide whether or not to adopt those new rules. In practice, miners almost always choose to adopt, in part because if you fail to adopt the latest code, the latest rules, you effectively lose access to the ability to mine Bitcoin.

But if enough people, let's say 50% of miners, refuse a change while the other 50% adopt it, we now have what is known as a hard fork. What this means is that, at one point in history, both halves agreed on the rules as well as the history of all transactions, but since the fork, the two halves have been in complete disagreement.

With this split the entire database cloned, which means every Bitcoin user account is cloned. The cloning of every account results in twice as much Bitcoin, since the cloning of accounts means the cloning of account balances. Twice as much Bitcoin means every Bitcoin is worth half of its pre-split value on any exchange, assuming both copies can be traded on an exchange. This example is by no means hypothetical; BitcoinCash, BitcoinSV, and BitcoinGold are all hard forks off of the original Bitcoin.

It’s worth noting that if a fork ever dies, if miners ever stop maintaining the variant cryptocurrency, any money invested in that cryptocurrency dies with it. Why? Without miners, transactions can’t happen. When people buy your Bitcoin for USD, they are transferring Bitcoin from your account to their account and paying you USD for the transaction. But without the ability for transactions to be logged on the Bitcoin database, this exchange cannot happen and your money lies dead in your account.

Fiat

Completely replacing a country’s currency is not a common event but, given the significant scope of such a change, it is worth focusing on it as an example of how governments handle such an event as well as the effects on the consumer.

When the Euro was created, countries in the EU didn’t start using the new currency overnight. How could they, with the different countries’ citizens all holding and using different currencies? Instead, a time limit was set to stop using separate currencies and switch to the Euro, with central banks providing the means of exchange.

This transition wasn’t flawless. Many companies took advantage of the transition by pushing up prices far beyond normal, to the point where many Germans referred to the Euro as the “Teuro” in reference to the German word “teuer” which translates to “expensive''.

Furthermore, in the experiments leading up to the Euro, the UK in 1992 famously failed to maintain their exchange rate with other European countries, leading to the UK government losing billions of pounds almost overnight.

At the same time, because the exchange is backed by the government, civilian protections exist in some countries to make sure that change isn’t crippling. In Germany, for example, the Deutschmark can still be exchanged for Euros at a fixed rate, despite being out of circulation for almost 20 years. That being said, countries like Belgium and France offer no such indefinite exchanges and you can no longer exchange their old currencies for Euros.

What protections are provided?

A core part of consumer trust is a sense of security - security of the secondary institutions that manage the storage and usage of currencies. With fiat currency, most people don’t hold all of their money in raw cash, but rather store their money in bank accounts. Similarly, with Bitcoin, a large number of  users don’t maintain their own Bitcoin Wallets, but rather hold their Bitcoin in some third party account. Trusting the currency requires trusting that one’s currency is safe in these institutions.

Bitcoin

Coinbase, one of the most popular crypto platforms, has insurance for 2% of its customers’ cryptocurrencies that it uses to buy and sell on behalf of customers. So if Coinbase were hacked, that 2% would be paid back. Everything else is lost. And if your personal account ever were to get hacked, you lose 100%.

Is there any reason that Coinbase couldn’t have insurance for personal accounts or more than 2% of its assets? In theory, no. But given the risk of cryptocurrencies becoming worthless as well as lack of ability for the insurers to create more of the currency (as is the case with fiat), you can imagine that insurance premiums could be prohibitively expensive.

Also, we mentioned before that if a fork of Bitcoin stops getting maintained, any money invested in that fork vanishes. That’s also true for any of the more than 2000 different cryptocurrencies currently in existence. For reference, there are comparatively 180 currencies in the world that aren’t cryptocurrencies, so it wouldn’t be unreasonable to assume that many of the cryptocurrencies that have been created may end up dead.

Fiat

A government, being the printer of fiat currency as well as the one setting its rules, is able to provide consumer protections that only such an institution uniquely can.

Protections like FDIC insurance, wherein money held in US bank accounts, are insured by the government up to a limit of $250,000. This insurance is funded by fees paid by the banks, but backed by the ability of the FDIC to borrow from the US Treasury and the Federal Financing Bank.

Similarly, if you hold stocks or bonds at a brokerage protected by the SIPC, up to $500,000 of your assets are insured in the case of a brokerage going bankrupt. Similar to the FDIC, the SIPC is funded by brokerage fees and can also borrow from the US Treasury.

Government protection isn’t just limited to storage of money and assets, though. With the Fair Credit Billing Act, if somebody steals your credit card and makes an unauthorized charge, the most you can be forced to pay is $50 as long as you dispute the charge. In this way the law set by the government protects not just how consumers store money, but also how they use their money.

Conclusion

Needless to say, both cryptocurrencies and fiat currencies struggle with consumer trust issues. Neither come out spotless beneath a blacklight, and replacing one with another is by no means a clear-cut decision. However, there’s no need these two systems need to be at odds.

If implemented strategically, the places where one system struggles with trust could be covered, at least in part, by the other system. Fiat could gain the transparency of cryptocurrency, while cryptocurrency could gain the protections of fiat. Even outside of the issue of trust, serial entrepreneur Balaji Srinivasan provides a detailed argument of 10 reasons why India should adopt this type of hybrid system.

Trust is crucial to the viability of any currency. Separately, both cryptocurrency and fiat have noted flaws regarding trust, but the two combined may be able to achieve a more optimal financial system.