Dragonfly Partners: Understanding the Birth of Bitcoin from the History of Currency Development

This article was published on Crypto Valley Live, author: Haseeb Qureshi, Managing Partner at Dragonfly Capital, translated by: Li Hanbo.

In October 2008, a pseudonymous programmer named Satoshi Nakamoto published a white paper in which he described a protocol for a decentralized digital currency. He called this protocol Bitcoin. Years later, Satoshi Nakamoto vanished without a trace, but the technology he created continues to change the world.

Bitcoin is now a global phenomenon. But why was it created? Why did it succeed while its predecessors failed?

Starting such a course by discussing cryptography or blockchain is tempting, but if we want to understand these things from first principles, we must start from a simpler place. To understand why cryptocurrencies were invented, you first need to understand what problems they were meant to solve.

So we must first try to answer a simple question: What is money, and why does it exist?

The Origin of Money

Imagine we are two Neolithic farmers. You have some grain, and I have some cattle, and we both decide to trade. This direct exchange of goods is called barter.

Barter sounds lovely in principle, but its efficiency is very low. This is because barter suffers from what is known as the double coincidence of wants problem. For a trade to occur, both parties must want what the other is offering. What if Jim wants a cow from me, but he wants grain from Joe, and Joe wants wool from Sally? In a barter economy, this market cannot clear, and everyone is forced to wait until the perfectly matched trade arrives in the market. This means that many ideally suited trades will never happen.

Anthropologists believe that money is unlikely to have originated from barter, but using barter as a foundational case is still enlightening.

Often, there is one good that is in high demand throughout the economy, and this good begins to dominate trade. This good could be cattle, yams—or, if you are in prison, it could be cigarettes. If this good becomes sufficiently widespread, it actually becomes a form of money known as commodity money. However, most forms of commodity money do not have strong scalability, and the most valuable goods often differ across various early societies.

The earliest observed form of raw money took the form of collectibles. Collectibles are small, mostly homogeneous items, such as shells or beads. Collectibles tend to be durable, easy to store or carry, hard to find or forge, and easy to appraise. This makes them more robust compared to many commodity forms of money like cattle.

Wampum beads. Source: Lise Puyo, UPenn

Using collectibles as money was a key evolution for humanity. Tribes often specialized in hunting a specific species, but due to animal migrations, a tribe might have very little food at certain times of the year. By foraging for collectibles during lean seasons, they could trade with other tribes during bountiful seasons, thus obtaining surplus food. Through the trade of collectibles, food could be distributed more evenly over different time periods, allowing all tribes to thrive better.

Some historians claim that money originated from collectibles, while others claim it originated from credit. Here, credit refers to a simple accounting of social favors. I let you borrow something, and I trust that you will return it to me later. Given the close-knit nature of human tribes, credit could dominate many social relationships.

Even when human tribes settled down in the Neolithic era, villages were often small and tight-knit. Thus, most people knew each other's credit status. When a bartender knows you, your family, and your social standing, it becomes possible to have a long-term tab at the local tavern. Over time, such credit relationships evolved into promissory notes that were traded directly in the local economy.

But informal credit systems cannot scale to cities, as it is impossible for everyone to know everyone else. To coordinate a larger society, you ultimately need a mature monetary system.

So this raises the question: What can become money?

The Properties of Money

The mainstream economic definition of money was first proposed by William Stanley Jevons in 1875. Jevons identified three main properties of money.

• Store of value

• Medium of exchange

• Unit of account

When an asset serves as a store of value, it means you can reliably retrieve the value you paid for that asset. This disqualifies perishable assets like yams from serving as money. If your money rots, it is a poor store of value. Therefore, for an asset to serve as a store of value, it must be durable.

However, durability is a necessary condition but not a sufficient condition. To retrieve the value paid for an asset means there must be the ability to sell it to others at its original price. Thus, the second condition for an asset to serve as a store of value is that it must be continuously appraised by others in the market.

A medium of exchange is the asset we use to settle transactions directly. This is the easiest barrier to clear. You can use Starbucks reward points to buy a latte, so the function of Starbucks points is as a medium of exchange. But of course, Starbucks points are not a very good store of value—people instinctively know this and do not store their savings in Starbucks points. This is not only because it is impractical; people know that Starbucks might change their rewards program, devaluing those points, and there is no stable market to sell accumulated points.

But as a medium of exchange for buying coffee, Starbucks points work perfectly.

A unit of account is the unit in which you price things. This is simple: how do you report the price of a house? Is it in dollars, euros, or cowhide? That is your unit of account.

Sometimes, legally recognized money is no longer a unit of account. For example, in 2009, the Zimbabwean dollar was experiencing rapid hyperinflation. As prices soared, it became impractical for businesses to continually price goods in a collapsing currency. Thus, businesses began pricing in dollars and simply listed the daily exchange rate of dollars to Zimbabwean dollars. Consequently, the Zimbabwean dollar was no longer a unit of account and lost its meaning as money.

So what Jevons ultimately tells us is that fundamentally, almost anything can become money, but in practice, very few things are money. If you are looking for candidates, whether they are physical or digital, metal or paper—if they are durable and there is more than one of them, they can become money in the right circumstances.

This may sound like an abstract point. But humanity has many cases that converge on unconventional forms of money, and seeing a concept stretched to its limits often helps in understanding that concept. So next, we will discuss one of the strangest forms of money: the Yapese and their Rai stones.

Rai Stones

Yap Island is a small island in Micronesia. The Yapese have a strange practice that dates back at least 1,000 years: they use "stone money."

These massive limestone discs, shaped like giant donuts, are called Rai stones. The largest stones weigh several tons—too large for humans to move easily, let alone carry in a wallet. So how could the Yapese trade with these enormous stones?

Rai stones. Source: Gerald Zinnecker, Flickr

It's simple: the stones never move. Instead, the Yapese completely "exchange" stones through social agreement.

As long as both parties agree to trade a Rai stone (or a small part of a Rai stone), the Rai stone is considered transferred. The physical location of each stone is deemed irrelevant. This transaction is recorded only through oral history.

Once, a respected Yapese was transporting a Rai stone across the sea. He encountered a severe storm, and the boat capsized, sinking the Rai stone to the seabed.

It was widely believed that this family was too esteemed to have their wealth diminished due to such an accident. So everyone decided that this Rai stone remained valid, even though no one could pinpoint its location on the seabed; it still retained value and continued to "change hands."

Today, the Yapese primarily use dollars, and Rai stones are only exchanged in special circumstances, such as weddings or political negotiations. But the story of Rai stones illustrates an important lesson: as long as there is a stable social consensus on its value, anything can serve as money. While it is good for money to have some intrinsic value, it is not strictly necessary.

As Yuval Noah Harari states in his book Sapiens.

Why would someone be willing to exchange a fertile rice field for a worthless piece of colored paper? People are willing to do these things when they trust the fictional constructs of their collective imagination. Trust is the raw material that forges various forms of money.

Or, as Peter Thiel puts it:

Money is just a bubble that never pops.

Rai stones illustrate an important point: the form of money is arbitrary. What matters is the fundamental function it serves in society.

But let's return to our world. Next, we will trace the historical evolution of money.

Metals as Money

The evolution of modern money actually began with precious metals. The first use of metals as money is believed to have started around 1000 BC, coinciding with the advent of the Iron Age.

Now, the value of precious metals seems obvious, but it is worth asking: why do so many societies tend to use metals as a form of money? There are some inherent reasons why precious metals are more suitable as money than collectibles. Precious metals are:

• Visually striking, suitable for decoration and jewelry

• Scarce

• Durable and not easily corroded

• Difficult to counterfeit

• Divisible

Initially, gold and silver metal blocks were used directly as forms of money. Eventually, around 600 BC, a monetary system began in modern-day Turkey. These early coins were minted from gold and silver alloys.

Lydian coins, circa 600 BC. Source: Romancoins.info

Why mint coins? This seems like a hassle. What’s wrong with using gold and silver pieces directly?

The obvious answer is that coins standardize the quantity of payments. But that is not the whole answer—after all, most small societies operate on credit relationships, and there is rarely a need to settle in gold within local trade networks.

Anthropologists like David Graeber speculate that the emergence of coins was to meet the needs of organized armies and mercenaries. Soldiers traveled long distances and had no long-term credit relationships. Thus, the only way they could be paid was through a form of currency that would be recognized in distant lands. Even if the parties involved did not recognize the sovereignty backing the coins, they would still value the coins themselves for their precious metal content.

Paper money, however, would not appear until 1000 AD, a full 1600 years later. The first paper money was invented in China during the Song Dynasty and later exported to Europe by Marco Polo. This paper money is an interesting case.

The paper money of the Song Dynasty was originally redeemable at fixed rates for gold, silver, or silk. But in practice, it was never redeemable. Thus, paper money was essentially traded without any commodity backing. Therefore, the first form of paper money could also be considered the first form of fiat currency.

What is fiat currency? The term fiat literally means "by faith." Fiat currency refers to money that has no intrinsic value; it is valuable only because the parties exchanging it agree on its value, or because a third party uses its power to maintain that value. This sharply contrasts fiat currency with commodity money, which has intrinsic value. Without the implicit backing of a third party, fiat paper money is essentially worthless scraps of paper.

This raises the question: why didn’t money appear earlier? Printing fiat currency is much cheaper than minting gold coins. Of course, paper was invented in China and only reached Europe in the 13th century, but you don’t necessarily need paper to create fiat currency. Today, one-cent and five-cent coins are fiat currency because their base metal value is less than their face value. Why didn’t they emerge sooner?

David Graeber speculates that the reason fiat currency first emerged in China is that China was the only centralized government strong enough to implement top-down control over its domestic economy. Remember, history often overemphasizes kings and their kingdoms—after all, they dominate history books, but kings and their affairs have little impact on the daily lives of most people. As an ancient Chinese proverb says, the heavens are high, and the emperor is far away. Therefore, the currency circulating in local economies was usually not minted by the government.

Over time, due to technological advancements and more developed bureaucracies, government control over domestic economies significantly increased. As control strengthened, economic standardization also extended to sovereign currencies.

The History of Modern Banking

Today, most financial transactions are mediated by banks. But banks are a relatively new invention in the history of money. Currency exchange, usury, and deposits have ancient roots, but the first modern banks were established during the Renaissance in Italy, operated by merchant families like the Medici. During this period, bank failures were common, and most banks did not survive long.

Paper money finally arrived in Europe in 1661 in the form of Swedish banknotes. Before central banks, all banks were privately owned. Each bank issued its own banknotes, which were usually redeemable for gold in the bank's reserves.

Given that the dollar is now the world's reserve currency, it is worth reflecting on the history of American currency. At the founding of the United States, the federal government was responsible for minting silver and gold coins, and the dollar was defined as a fixed-value precious metal. However, most of the currency circulating in the economy was private banknotes issued by various commercial banks—at one point, there were over 5,000 different types of paper money in circulation. In 1861, the U.S. briefly printed paper money to fund the Civil War, but then returned to currency backed by precious metals.

Twenty-dollar private banknote. Source: Commercial Library

Because most notes were issued by private banks, the structure of the financial system was very loose. This led to frequent bank panics and runs. To stabilize the banking system, the U.S. established an independent central bank in 1913, called the Federal Reserve. The Fed was granted the exclusive right to print dollars, with the explicit task of preventing bank panics and currency crises. It was initially required to have 40% of its circulating notes backed by gold.

After World War II, the U.S. emerged as a global financial superpower and leveraged this power to establish the Bretton Woods international monetary system. Under the Bretton Woods system, all major world currencies fixed their exchange rates to the dollar (with about a 1% margin), and the dollar itself was pegged to gold. This stabilized the exchange rates between the world's major currencies.

However, the enforced stability of the Bretton Woods system would not last. In the 1970s, as the U.S. economy boomed and the government increased spending on the Vietnam War, the dollars printed by the Federal Reserve exceeded the gold backing. This led to the dollar being overvalued under the Bretton Woods system. Foreign governments began to withdraw from the Bretton Woods system and exchanged their excess dollars for gold, depleting the U.S. gold reserves. Nixon realized that if this continued, it would trigger a crisis. So in 1971, Nixon abandoned the Bretton Woods system, eliminating the dollar's convertibility to gold internationally, permanently breaking the gold standard and turning the dollar into pure fiat currency.

Front page of The New York Times on August 22, 1971. Source: The New York Times

With the dollar becoming fiat currency, the Federal Reserve gained greater freedom to determine the nation's monetary policy, which largely also determined the world's monetary policy. Since then, all major currencies in the world have also become fiat currencies, centrally managed by their respective central banks.

At first glance, the transition to fiat currency seems strange. One day, the dollar is valuable because it can be exchanged for gold. The next day, its value is because …?

What gives fiat currency its value? Just like Rai stones, is its value simply because we all believe it has value?

This is partially correct. And the dollar certainly has value because American businesses prefer to pay in dollars, and many people want to buy things from American companies. But what could prevent the U.S. economy from being standardized in another currency? Technically, American businesses are legally free to accept payment in any currency.

The dollar maintains its value because the U.S. government makes two important guarantees regarding the dollar. The first guarantee is that the U.S. government and the Federal Reserve will take reasonable actions to maintain its stable purchasing power in the market. The second guarantee is that U.S. taxes can only be paid in dollars. Therefore, because many people need to pay taxes to the U.S. government, the demand for dollars will be high (this also complements the demand for petrodollars). These guarantees fundamentally underpin the value of the dollar as a currency.

Fast forward to the 21st century, many things have happened since the end of the gold standard. In 2008, we witnessed a financial crisis that threatened to destroy the global banking system. In response to the wave of bank failures, central banks around the world rushed to bail out financial institutions, printing vast amounts of money and engaging in large-scale asset purchases—this practice is known as quantitative easing.

Amid this financial turmoil, a pseudonymous programmer named Satoshi Nakamoto was tinkering with the Bitcoin protocol. And during the financial crisis, as the UK was bailing out its banking sector, the genesis block of Bitcoin was born.

Cover story of The Times on January 3, 2009. Source: The Times

But we are not yet fully prepared to understand Bitcoin. To fully grasp the reasons behind the emergence of cryptocurrencies, we must not only look at money but also at the history of payments: how money has been transferred throughout history.

The Development of Payment Technologies

Since the emergence of money, there have been many convenient payment technologies: paper money, checks, and letters of credit all have ancient origins.

But modern payment technology truly began to develop with the invention of credit cards. Although credit cards existed as early as the 1920s, early versions were issued by individual merchants for use in their own stores. It wasn't until the 1950s that the idea of credit cards as a universal payment solution emerged.

Original Diner's Club credit card

The first commercially successful credit card was the Diner's Club in 1950. The original credit card was made of cardboard and was accepted at only 27 restaurants in New York. As consumers began to adopt cashless payments, this number quickly expanded. Visa was established in 1958, and MasterCard was founded in 1979. Given that credit scoring and financial monitoring were not common in the early days of credit cards, many credit card networks guided consumer adoption through direct mail campaigns, effectively mailing a card to every address in a postal code.

By the 1980s, credit cards had become ubiquitous in American society. They quickly spread to Europe and other regions, sparking a cashless payment revolution.

The next iteration of payment technology would be initiated by the internet, which began to gain mainstream consumer adoption in the late 1990s. In the early internet, almost all payments were made via credit cards. This was because the credit card networks were already quite robust, and nearly everyone had a credit card. But internet-native payment solutions would eventually emerge, such as Cybercash and DigiCash. The first widely successful online payment company was PayPal, which went public in 2002 and was later acquired by eBay for $1.5 billion.

Today, there is a wide variety of ways for consumers to make online payments. In most countries, including the U.S., consumers prefer to use credit or debit cards. Other common methods include PayPal, e-wallets (like AliPay or Skrill), and in some countries, cash on delivery. With the emergence of cryptocurrencies, this landscape has further evolved.

The Birth of Bitcoin

Throughout human history, there have been many evolutions surrounding the forms and incentives of money. Of course, the history of money is vast, and we cannot cover it all in this brief article. But any history of money must now conclude with the same final chapter: the invention of cryptocurrencies.

Since its launch in 2009, Bitcoin has taken the world by storm. In 2010, one Bitcoin was worth $0.003; by December 2017, Bitcoin reached an all-time high of nearly $20,000, a staggering increase of 60 million times. Today, Bitcoin's price hovers around $7,000 per Bitcoin. It is estimated that Bitcoin has 25 million holders worldwide—while this is a small number globally, it continues to grow.

This is an astonishing story. However, the story of Bitcoin is not just about price: its origins are deeply rooted in ideology. We will now turn to another aspect of how cryptocurrencies emerged: from a subculture known as cyberpunk. In the next lesson, we will learn about the cyberpunks and their previous attempts to establish digital currencies. We will analyze why they failed while Bitcoin succeeded.