Digital Cash Part 2 - Challenges of Digital Money

In the first part of our blog about digital cash, we examine the initial idea behind Bitcoin and how its predecessors and successors have tried to tackle it. Some solutions are better than others but it turns out that other problems were discovered along the way and peer to peer payments are just one challenge out of many.

The issues outlined in the intro of the Bitcoin whitepaper are eclipsed by a broader scope of problems with money as we know it today and the risk that can be anticipated with a digital payments system. The central banking system allows for (sometimes unchecked) creation of money which decreases its value. Digital transactions of value on the other hand face a difficult challenge in preventing unchecked duplication of value. This is called the double spend problem.

The double spend problem

Digital assets are inherently easy to reproduce. This is a good property when it comes to software and assets that are difficult to reproduce in real life. On the other hand, value should not be that easily reproduced. This poses a problem that physical assets and cash do not have. If a cash bill is spent at the grocery store, you can’t spend the same bill at the gas station.

In digital transactions there is always a risk that the same digital asset is spent more than once and this is called the double spend problem.

Proof of work

Satoshi Nakamoto came up* with the idea of proof of work (PoW) to mitigate this issue. This system requires that a certain non-trivial amount of computational power is spent on solving a cryptographic puzzle which is then easily verifiable. The verifiers in this system are called miners. Whoever solves the puzzle is rewarded with newly minted coins.

This system has grown since its inception and has become problematic due to its high energy demand as some have pointed out.

*He actually points to an earlier paper from 2002 titled: Hashcash - A Denial of Service Counter-Measure

Proof of stake

A more energy efficient system is proof of stake (PoS) where validators are called forgers. Users who want to participate are required to lock a certain amount of coins into the network to get a chance of earning an incentive. When a node is selected to forge the next block it will sign the block and add it to the blockchain.

Double spend in PoW and PoS

There are a few ways to double spend on PoW based systems as described here. The main problems arise when accepting transactions without a confirmation (or too few confirmations) or when the majority of miners behave in a malicious way (51% attack). Both systems incentivize good behaviour and in some cases punish malicious attempts. The 51% attack is possible in both cases but it requires control of either 51% of all the hashing power or 51% of all the coins in circulation. In general, a transaction can be considered finalized when the cost of subverting it would exceed its value.

Consensus

Some networks like the XRPL prevent double spend by using a consensus process, where a majority of nodes have to agree on what transactions are accepted into the next ledger. While PoW and PoS systems “mine” new transactions in blocks, distributed ledger technology (DLT), transactions are usually a part of the ledger of accounts. The last ledger also holds the full state of the network so if older ledgers are lost, this does not affect the latest state of the ledger. The nodes that make consensus possible are called validators.

The process is intricate but can be boiled down to two steps 1) collection of transactions and 2) validation where consensus by a supermajority needs to be reached before a new ledger is created.

The verdict

All of the systems described above have their advantages and weaknesses. Those in favor of incentives for participation will likely argue for PoW and PoS. We could argue that consensus has an edge when it comes to open participation. The key takeaway is that there exist solutions to the problem of double spend.

It seems very likely that all the listed solutions will continue to exist as we see more projects spawn to tackle even more complex challenges.

The value of money

The second challenge that is only implicitly addressed by the Bitcoin whitepaper is inflation and the falling value of traditional (fiat) money. This is due to excessive growth in its supply. In Bitcoin the supply is fixed and the maximum supply is known in advance. This is described in the Incentives chapter of the whitepaper.

In short, incentives in the form of block rewards are given to the miners. Honesty is incentivized through this same mechanism. Satoshi supposed that playing by the rules would be more profitable than fraud which would drive the value of the system down.

The most impactful feature is the steady and fixed addition of new coins into the system. This circumvents the main issues of the traditional financial system where a central authority (central bank) has the power to arbitrarily add or withdraw money from circulation, thus manipulating its value. A key advantage of Bitcoin over traditional money is that it’s value can’t be manipulated through addition or subtraction of circulated coins.

Good money

Money serves three basic functions that are:

• Medium of exchange - it can be used to intermediate the exchange of goods and services. For example, this circumvents the inefficiency of the barter system when direct exchange of goods or services is not possible.
• Unit of account - it can be used as a standard monetary unit of measurement. It can denominate the relative worth of items and is necessary for the formation of commercial agreements that involve debt.
• Store of value - it can be reliably saved, stored and retrieved and predictably used as a medium of exchange. Its value should remain stable over time.
  

A deeper explanation of these characteristics is available here and an even deeper breakdown here.

Fiat money and Bitcoin both have these characteristics. We could make the case that most cryptocurrencies also have them.

Cashless transactions are seeing steady growth and are expected to grow even more. Government issued currencies such as USD and EUR are already mostly being transferred digitally and there seems to be a push towards digital central bank digital currencies (CBDCs). Trustless currencies will coinhabit this digital world and likely compete for a share of all the digital transactions.

Closing thoughts

To trace back to the initial idea. There is no doubt that the Bitcoin whitepaper is a seminal work and arguably the most important paper about digital money.

The double-spend problem is a key problem that any new digital money system needs to address first. Developers have PoW, PoS and Consensus and other methods at their disposal. Ethereum, for example, is pivoting from PoW to PoS to address the cost and scalability issues it has been facing due to heavy DeFi traffic. This is one factor that is sure to influence network participation. It will be interesting to see what technology is used by CBDCs.

The minting and distribution process is a bit more open as we can plainly see if we look at all the projects that exist in the field. ICO’s and the recent Flare distribution are just a few examples. Bitcoin had a so-called “fair launch” where no coins were “pre-mined” and distributed to early investors. This is another significant factor for adoption. The creators must carefully consider the ins and outs of supply, distribution, investor participation, incentives, lockdown periods and so much more.

Make sure to read about the inception of digital cash in part one of this blog here.

For now, Bitcoin reigns supreme as the top currency by market capitalization and recognition. Many alternatives do exist though. For anyone that wants to get a good feel of how it all began and a deeper understanding of Bitcoin and the resulting philosophical implications, the Bitcoin whitepaper is a must-read.