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17-4-14

Assets Backed by Anything – On Cryptocurrency

By Chris Dannen

Ether and bitcoin are beans inside giant, inviolable bean counters: their respective virtual machines. These “coins” are actually more abstract than they sound. They’re not even digital “objects,” in the programmatic sense, but are really just a name, a denomination, for integers representing account balances. In fact, in Ethereum, tokens are created as smart contracts, just like any other smart contract; there is no special “feature” that pumps out “custom tokens.” The “sending” of “coins” from account to account is pure simulation. That’s why this post is called “assets backed by anything,” because in a giant counting machine, you can count whatever you like.

However, the “native token” issuance schemes of these systems are slightly different from one another. Bitcoin is issued for 21 years, at a rate that reduces in stairstep pattern every four years. Ethereum has an inflationary issuance scheme, meaning that ether never stops being created as long as there is proof of work mining; but the amount created in a given time period decreases as a proportion of the overall pool. Ether can be used to pay for computing time on the Ethereum Virtual Machine, which can execute financial contracts (which exchange ether) making it more like a commodity than an asset.

Without getting into the technical weeds, the details above have the effect of giving bitcoin itself value as an asset; it makes sense that it will appreciate continuously until the end of the issuance period, at which point the value will probably deflate, and might even collapse.

The price of ether matters far less, because design choices in the Ethereum protocol make ether less suited to steady price inflation and hoarding. From what I gather ether is not built to be a price-climber. People still speculate on the stuff, but for the most part, ether is like gasoline: you buy what you need to power your smart contracts for the foreseeable future and–unless you’re a hedge fund or commodities trader–you don’t fill your garage with barrels of the stuff in some fatuous bet the price will skyrocket.

The point is, Bitcoin software can be used as an accounting system for anything, but the “bitcoins” we’re all passing around–on the main bitcoin chain–have become a thing unto themselves, and so we forget that the price is greatly inflated for something that anyone can deploy themselves.

For “copycat” Bitcoin chains and Ethereum chains as well, commodity status is a way to find a niche. Today, people are mostly using these blockchains to inventory digital things, in the sense of intellectual property or transaction records, because why not–they’re being created right there on your server already, waiting to be blockchained.

But eventually these “generalized accounting systems” (aka blockchains) might have the effect of creating physical objects encoded with value, stored on a public chain. Whether or not that would fall within natural or likely human behavior is the subject the rest of this post.

What gives cryptocurrencies value?

Because crypto-assets and crypto-currencies are impossible to counterfeit, they exhibit an interesting property as inviolable measures of time. Crypto-tokens such as bitcoin and ether are issued as payment to miners, so they are almost like the rings of a tree in the sense that their manufacture happens by a sophisticated process which cannot be “sped up.” Mining is a literal guessing game which computers play in order to level the playing field among a worldwide network of nodes, all competing to write the “canonical” version of transaction history. The version of history that the majority of miners support becomes real; but not all miners get to vote each time. Only the ones that win the guessing game.  

Thus when trading with someone from a faraway economy, it becomes easy to trust prices denominated in cryptocurrency – because counterfeiting just isn’t possible, no matter how rich or powerful the group you’re trading with. (Unless they have a sophisticated market-making operation…)

So it would make sense that we talk about ether and bitcoin more like other collectibles – say, fine art, which is extremely difficult (if not impossible) to counterfeit, not least because the real one might be hanging in a museum for everyone to see.

Why we need global trustless bean counters for art

Let’s say you print an Ethereum address (ie., a public key) on a physical item, and it belongs to a smart contract. Or more practically, a QR code, which is a machine-readable code in a nested-square pattern.

You can imagine how these QR codes, printed on everyday valuables like clothing, jewelry, artworks, or other physical goods could combine the concepts of high-end derivative contracts, everyday re-loadable debit cards, and collectibles. Think of them like gift cards, which separate the value of the thing – a two-cent plastic card – with the value pre-loaded on it.

In gift cards, the purpose of this bifurcation is anti-theft: it means you can store tens of thousands of dollars of value right next to the store exit, along with the low-value items like gum. Nobody can walk off with those gift cards, because they’re valueless if not activated at the register.

Before going any further down this rabbit hole, let’s encounter some anthropological history courtesy of Nick Szabo, a cryptocurrency pioneer whose prolific web essays influenced many of today’s cryptocurrency enthusiasts and cypher-punks.

In 2002, Szabo wrote about the intersection of physical goods representing abstract value. These collectibles allowed us to engage in bigger, more complex financial transactions.1

Collectibles were crucial in making these kinds of transactions possible for the first time. Collectibles augmented our large brains and language as solutions to the Prisoner’s Dilemma that keeps almost all animals from cooperating via delayed reciprocation with nonkin.

Without a trustworthy collectible to trade back and forth, you might not be willing to trade resources with anyone outside your extended familial network. This doesn’t bode well for peaceful coexistence in larger nation states. 

The function of collectibles in human systems

Keeping track of favors over time is a major function of money: to serve as a closed accounting system for a community to keep track of favors owed and favors given. This gets useful as bigger and bigger groups try to interact and cooperate. 

Using collectibles to count favors is the essence of primordial accounting. Eventually the value of these “favors” became abstracted, leading to the generalized instruments of value such as gold. This accounts for the modern-day association between wealth and esteem. 

Ethereum and bitcoin strike at the heart of a problem that is tens of thousands of years old, which is that reputation-accounting enforcement can lead to violence. Szabo says:

“Reputational beliefs can suffer from two major kinds of errors – errors of about which person did what, and errors in appraising the value or damages caused by that act. In both Homo sapiens neanderthalis and Homo sapiens sapiens, with the same large brain size, it is quite likely that every local clan member kept track of everybody other local clan member’s favors… Between clans within a tribe both favor tracking and collectibles were used.” 

Two clans within a tribe exchanging collectibles within a closed system is something like a private bank database. Or a private blockchain. Between tribes, collectibles entirely replaced reputation as the enforcer of reciprocation, although violence still played a major role in enforcing rights as well as being a high transaction cost that prevented most kinds of trade. Just like the banks of today, groups of yesterday had trouble trading outside their accounting system. Whose money system do you use? Who keeps track of inter-tribe favors? No wonder there was so much bloodshed: the opportunity for cheating is just too persistent.

Early counterfeiting

The solution to inter-tribe trade was to use rare art objects: not just rare earths, but any objects that were not trivial to find or create from scratch. It couldn’t just be any set of beautiful objects. They had to be hard to come by, or the product of skilled craftsmanship, which assured each collectible represented a certain amount of human work-time. And thus we’re back to the concept from earlier: bitcoin and ether as a store of time. As Szabo says:

“It had to have certain functional properties, such as the security of being wearable on the person, compactness for hiding or burial, and unforgeable costliness. That costliness must have been verifiable by the recipient of the transfer – using many of the same skills that collectors use to appraise collectibles today.”

Money, reputation, and status have always been wrapped up together. It makes sense that primitive valuables were things you could wear; think gold jewelry or diamond-studded crowns. After all, why not show off the status that your hard work (or luck!) had bestowed on you?

However, as a society gets wealthier, everyone gets to own a little gold; then a little more, then a little more. A rising tide creates markets for new goods and services that allow the wealthiest people to enjoy themselves in ways which also exhibit their social status. At some point, it’s too much to wear and carry, and people begin competing on abstractions such as brand name of goods, or the particular school where your children go. 
By this point in a society, there’s enough wealth stocked up in the banks that individual account holders begin trading in “banknotes.” How this works is best explained by economic researcher Martin Armstrong.2 He says:

“The distinction between bank notes and deposit receipts issued by goldsmiths was a simple one. A receipt for deposit was transformed into a bank note if the receipt was payable to the “bearer” rather than an account. Therefore, Paterson’s Bank of England cleverly created the circulating notes by de facto since its receipts were payable to the “bearer” thereby creating circulating “bank notes” when there was no provision for such an instrument.”

Bitcoin and Ethereum revise this relationship only slightly by abstracting things one layer and creating “bearer accounts,” that is to say, whomever has the password and private key of an account is by default the owner. Bitcoin addresses, like Ethereum addresses, are not registered to individuals. They are created pseudonymously.

Where is all this going?

The reason for discussing the nature of bank notes is that they are essentially Monopoly money representing the value of the equity of the bank, which is presumably limited by nature. This sets the bank up as a micro-economy circulating its own scrip. Anyone who uses the bank can trade in bank notes, fairly confident that the supply is limited.

In a digital context, this suggests the incredible potential for ether and bitcoin as the platform for digital collectibles: valuable items which can be displayed, worn, or hung in one’s personal space–either online or in real life–and which are not possible to “knock off,” nor easily stolen from its rightful owner.

When most people think of the Internet of Things, they think of sensor motes, self-diagnosing industrial equipment, and driverless vehicles. It may be more useful to think about the potential in terms of valuable artwork, jewelry, fashion, or premium goods which look much like today’s, but feature verifiable provenance and ownership stored on a blockchain.

In the future, the ownership, value, and provenance of a physical thing may never be “forgotten” as long as the blockchain where it was inventoried is still up and running. There will be no Antiques Roadshow on TV in 100 years if this reality comes to pass; everyone will know the provenance of every limited-edition thing.

The future of design objects

The impact of divorcing the physical value of a thing, and its abstract value, has implications for the world of art and design.

Let’s say a famous designer makes a limited run of 50 chairs. The actual production cost of the chair is about $75, but the chair will retail for $800. Now what happens when we take a private address containing 100 bitcoin (approximately $75,000 as of this writing) and engrave the public key on the chair. The private key–which is needed to move the bitcoin to another account–we print and seal in an envelope. The buyer of the chair gets the envelope, making him the owner of both the bitcoin and the chair.

What is the value of the chair? Presumably it is $75,800. But without the private key–which is probably stored in the owner’s safe–you can’t recover the $75,000 of bitcoin. And for all we know, bitcoin will increase in value, along with all the items made by this famous designer. So there is opportunity for both the object to appreciate and the asset to appreciate. It can also be thought of as a hedge; perhaps the bitcoin goes down a bit, but the chair goes up, negating the loss.

Without the private key, the stolen chair’s provenance and ownership can’t be verified, and the vast majority of its current value as an asset is inaccessible. This changes the economics of the merchandising of physical things by using trustless global virtual machines as an inventory and authenticity system with anti-theft features.

Cryptocurrency’s role in merchandising

With its ability to execute smart contracts, Ethereum is even better suited to digitally-inventoried collectibles. As previously discussed, ether is less prone to hoarding and can be considered a layer of value that is one level abstracted from a real payment medium.

For example, let’s say the same famous designer creates the same chair. Except this time, he or she engraves the public key to an Ethereum contract address. To that contract address, they upload a smart contract that enumerates a dividend payable from the buyer to the seller. Now the chair-as-financial-product looks like this:

  • Chair cost: $75
  • Chair retail: $800
  • Engraved value: $6,250 USD for 12 months
  • Now we have a financial contract instead of an asset (bitcoin) underlying this chair. The contract is written in Solidity and deployed on the Ethereum Virtual Machine, but the price of the payments is denominated in US dollars.

What’s important is that the cryptocurrency here is used abstractly as a unit of value which simply represents dollars. The result is a software-enforced guarantee of verifiable invoicing and payments on a collectible item. The cool part is, nobody needs to pay for this infrastructure; it’s just there. Crucially, the maker of the chair is making a profit by offering the EVM’s service, monetizing something he or she doesn’t have to pay for in overhead costs.

Brass tacks of the “Ethereum Chair”

In the example above, the idea is to use an Ethereum smart contract to dictate the terms of a payment plan. In other words–no trusting the artist to pay that dividend every month. How can we make this work, despite the ever-fluctuating price of ether as a commodity?

The easiest thing to do would be to create an escrow contract that requires collateral from both parties, payable in a more stable ether subcurrency. Eventually, program trading will reduce price volatility in cryptocurrency, as will higher transaction volume and more use worldwide.

With any luck, the price of ether will stabilize as Whisper and Swarm come online, and dapps become a reality. Til then, the Ethereum Chair will remain a dubious proposition–but one which shows the potential of cryptocurrency networks to provide trustless digital services with very little overhead on behalf of retailers. 

1. Nick Szabo, “Shelling out: the Origins of Money,” http://nakamotoinstitute.org/shelling-out/, 2002.

2. Armstrong Economics, “Money and the Evolution of Banking,” https://www.armstrongeconomics.com/research/monetary-history-of-the-world/historical-outline-origins-of-money/money-and-the-evolution-of-banking/, 2016.

About the Author

Chris Dannen is a partner and founder at Iterative Instinct, a hybrid investment fund focused on cryptocurrency trading and seed-stage venture investments. He was formerly a corporate strategist for Fortune 500 companies. A self-taught programmer, he holds one patent; this is his fourth book. Chris is an avid traveler who has trekked across 20 countries, bicycled from Rome to Barcelona in 30 days, and summited Mount Fuji in under six hours. He was formerly a Senior Editor at Fast Company and today consults on technical content for major publishers. He graduated from the University of Virginia in three years and now resides in New York, NY.

This blog post is based on an excerpt from Chris Dannen’s book Introducing Ethereum and Solidity (ISBN 978-1-48422-534-9). You can find Chris on Twitter @chrisdannen.