III. Monetary systems, their evolution, and their problems

1. Monetary System Requirements

A perfect monetary system should have four main features: security, to prevent counterfeiting and theft, scalability, to enable the system to be used worldwide, fungibility to allow for each unit of currency to have the same value, and decentralisation of control, to avoid manipulation for political gain and the endless temptation by issuers to create more currency. Many monetary systems have arisen over the years, but none, until now, have fulfilled all these requirements.

2. Gold Currency System

Historically, exchange of value was conducted in the form of precious metals such as gold and silver. This physical gold system had high security, as it was impossible for any one person to counterfeit gold, high decentralization, as no individual was in control of the supply, high transparency, total fungibility, but low scalability due to gold transactions being inconvenient due to their weight, size, and indivisibility.

3. Gold standard

In 1871 the ‘gold standard’ was created to increase scalability. Banknotes were created as a lighter representations of gold and were redeemable for gold, these were issued by central banks. The notes were created and handled by banks who stored the backing gold and printed the notes. This system had high security, from the consistent value of gold, high decentralization in theory, as gold was still determining the value of the notes, high scalability, as it was much easier and faster to trade notes but low transparency, but low fungibility as banks didn’t declare how much gold they owned and show proof of their reserves. Banks succumbed to the eternal temptation to print currency for which there was no real backing, and therefore eroded trust in the system.

4. Federal reserve

In 1913 the US Federal Reserve was created, which is a private institution that controls all printing of US currency, however, at its inception, each US dollar was backed with a defined amount of gold, physically stored in the federal reserve vaults. This system still had high security, from the secure nature of gold, high scalability, as the notes could now be obtained and exchanged more easily, high transparency, as the federal reserve declared how much gold they had stored and how many notes they were printing. However, it suffered from low decentralization as the federal reserve was in complete control of the printing of notes, and thus susceptible to coercion and control. Because of this centralization, over time the federal reserve was able to leave the gold standard and no longer had any backing for banknotes, leading to the modern fiat financial system we see today. The integration of digital banking improved scalability with high transaction speeds facilitated by many private banks using modern networking protocols, however the public lost trust in the Federal Reserve’s ability to manage money supply responsibly, most notably demonstrated by the dramatic increases in M2 money supply seen since 2020. In addition, fractional reserve banking is now allowed where only 10% of depositor funds are kept as a liquidity meaning 90% can be invested by the banks. This practice causes an increase in the money supply. It also causes banks to be insolvent during an economic crisis as depositors attempt to withdraw their money from a risky bank and are unable to. During the 2008 recession the practice of bail-ins were allowed whereby an insolvent bank can seize customer deposits and convert them to equity.

5. Bitcoin

In 2009 Bitcoin was created to overcome this centralization issue and is known as ‘digital gold’. The Bitcoin protocol is highly secure and has never been hacked, despite enormous incentive by governments and private entities to do so. It has high decentralization as it is impossible for one actor to take control of the network or protocol in isolation, and high fungibility as Bitcoins are all identical. Unfortunately, just like real Gold, Bitcoin lacks scalability as the Bitcoin system can only facilitate 7 transactions per second. Numerous other cryptocurrencies have attempted to overcome the scalability issue of Bitcoin, but none have succeeded in replicating its other attributes.