Background
Ever since humans started trading with each other, humans were searching for better and safer money. After thousands of years of trial and error, most civilizations settled on gold as a store of value and medium of exchange.
However, there were practical difficulties in using gold as a medium of exchange. Carrying a bar of gold presents a new set of challenges. As a solution, merchants started storing gold in vaults and traded the receipt as claims to gold.
Vault operators noticed an interesting phenomenon at this point. Almost no one is claiming the gold from the vault and everybody is trading the paper issued by vaults as if it is gold. Some nefarious vaults started taking advantage of this situation by creating receipts for their own spending, without any gold in the vault. Later, when governments started doing the same, it was organized by setting a reserve ratio. For example, In a gold reserve system, if the reserve ratio is 5%. Then vaults/banks can issue receipts for 20 units of the reserve asset to each unit actually in reserve.
Components of the Reserve Asset System
The different components needed for the reserve asset system to work are
A hard asset agreed upon by the free market.
The reserve asset should be inherently difficult to transact with.
Because of the difficulty, the market participants are willing to give custody of the asset to a common trusted third party.
The asset custodian may then choose to issue claims only for which they have a reserve or chose to issue more claims than they have on reserve. It is almost always the latter.
How it Relates to Bitcoin and Bitcoin Cash
After the invention of bitcoin, the difficulty to transact natively in the reserve asset just vanished. It was easy and cheap to transact in bitcoin up until 2015. Suddenly, there is an asset class that does not need a middleman.
While this innovation is favorable for everyone involved in everyday commerce, merchants and consumers alike, cryptocurrencies pose the greatest danger to the current order of world commerce. If bitcoin is adopted by consumers and merchants then as a result the most powerful custodians and issuers of the previous reserve assets are simply irrelevant.
Second Layer or Crutches?
Interestingly, Around 2015 bitcoin developers started to limit the maximum block size, essentially making it an asset that will be inherently difficult to transact with. The solution for this deliberately created maximum base block size problem is second-layer solutions. Once transactions on the base layer reach a certain level of difficulty, market participants may be willing to give up custody of bitcoin to easily transact.
In the process, many may forget that bitcoin was meant to be an easily transferable asset that didn't require its users to give up custody. Users may end up using a token the custodial service provided while the custodian claims to keep corresponding amounts of bitcoin in reserve. This way bitcoin might end up being just a reserve asset instead of both the store of value and means of exchange. In this scenario, the custodian will have too much control over the ecosystem. We should not forget Bitcoin was meant to be the individual's reserve and asset that can be transferred almost instantly and basically for free without having to trust anyone.
Grim Future
If enough users start transacting exclusively on the second layer then history may repeat itself. Soon, users may not be sending bitcoins but they might be sending lighting bolts backed by bitcoin, and maybe the issuers of second-layer tokens will choose to have bitcoin as a fractional reserve and issue 2000 lightning bolts for each bitcoin. Nothing changes. Business as usual.
A Hopeful Future
Foreseeing the direction bitcoin headed towards, a few developers decided to fork bitcoin and created the bitcoin cash chain. Bitcoin cash doesn't limit the block size of the base layer so bitcoin cash isn't in urgent need of custodial second-layer solutions to function, thus enabling users to keep the fruits of their labor to themselves without having to trust anyone.
Grab the Popcorn
Upcoming years are going to be deciding years for the future of cryptocurrencies. The market will choose either custodial solutions with all their inherent problems or it may finally break free from the shackles of centralized financial entities. Exciting times ahead.
Great article!