Chapter One: Creation of
Bitcoin
The World Before Bitcoin (the Real Estate
Crash Of 2007)
The financial crisis of 2007-2008, also
known as the global financial crisis (GFC) was a severe worldwide
financial crisis. During these hard times, excessive risk-taking by
banks combined with a downturn in the subprime lending market in
the United States and culminated with the bankruptcy of Lehman
Brothers on September 15, 2008 which precipitated an international
banking crisis.
The crisis sparked a great recession, a
global recession, which until the coronavirus recession, was the
most severe recession since the great depression and lasted 8
years. As business and governmental agencies responded to the
crisis, all in an effort to avoid a further collapse, encourage
lending, restore faith in the integral commercial paper markets and
provide banks with enough funds to allow customers to make
withdrawal… were to no avail.
Additionally, while the causes of the bubble
may be disputed, the precipitating factor for the financial crisis
of 2007-2008 is acknowledged to be the bursting of the United
States housing bubble and the subsequent subprime mortgage crisis,
which occurred due to a high default rate and resulting
foreclosures of mortgage loans, particularly in the adjustable-rate
mortgages area.
Some of the leading reasons for this global
crisis:
● Reckless money
lending by lenders such as Bank of
America’s Countrywide financial unit, which caused
t he
Federal National Mortgage
Association , commonly known
as Fannie Mae and
t he Federal Home
Loan Mortgage Corporation ( FHLMC
), known as Freddie Ma c to
lose market share and to respond by lowering their own standards.
[1]
● Excessive Mortgage
Guarantees: This also contributed to one of the factors that caused
the greatest recession of all time. During this period, many of the
subprime loans were bundled and sold to the Fannie Mae and Freddie
Mac, effectively off-loading bad debt to the government.
● Easy Availability of
Credit: Was known to have been fueled by
large inflows of foreign funds after the 1998 Russian financial
crisis and 1997 Asian financial crisis. This led to a housing
construction boom and facilitated debt-financed consumer spending.
(People bought more with cards and loans and less with cash.)
In the years after 1997, as bank began to
give out more loans to potential homeowners, housing prices began
to rise. At this time, loan of various types were easy to obtain
and consumers assumed bought like money was going out of style. The
only partially joking expression at that time was, “As long as they
are breathing, they qualify.”
Why Was Bitcoin Created?
During the global crisis that occurred
earlier in 2007, the idea to Bitcoin emerged. It was raised in a
white paper (document that universities create to propose an idea).
The white paper was written by someone named Satoshi Nakamoto – a
fake name. To this day, we don’t know if that was a single person
or group working in concert.
To some people, the fact that the inventor
of bitcoin is an unidentified person or group of people raised some
red flags. While their anonymity brought the benefit of further
interest, it also delegitimized the technology in the eyes of
others. Adding further to the consternation was that many in the
initial group were, cypherpunks. [2]
Basically, the thought behind the creation
of bitcoin was to enable a secure, digital money system that
removes third-party intermediaries from any monetary transactions.
This is referred to as “trustless” transactions. That means, you
don’t have to trust a third party (bank) to move money for you. You
can do it yourself. Think of this as handing someone cash, only
using a computer.
Satoshi explicitly stated that the reason
for creating the digital money focused mainly on removing
intermediaries between transactions. Moreover, when you think about
it third-parties can charge you significant amounts for conducting
these services: These costs are then passed on to end users and can
make it so that transactions below a
certain size simply can’t be done.
Some of these costs include:
● Creating appropriate
security measures and costs related to risk of security
breaches.
● Covering expenses
because of the effort to collect and reconcile transactional
data.
● Accounting for any
fraudulent activity – the costs associated with having to refund
money in case of fraud, among others.
● Making a profit on
every transaction, or in the case of banks, charging you to hold
your money.
To go further, many of these costs are a
percentage per transaction, regardless of the transactions size.
So, since the profit garnered per transaction is largely a
percentage of the size, the juice doesn’t justify the squeeze for
processing smaller
transactions.
On the other hand, financial institutions,
card associations (like Visa), and other large companies that own
today’s electronic payments system impose a lot of fees. (let’s
give PayPal a pass on this for now) By-passing these players was
certainly a motivating factor for creating Bitcoin. But there is
even more of a reason for creating the bitcoin.
In February 2009, Satoshi wrote the
following on an online forum:
“The root problem with conventional currency
is all the trust that’s required to make it work. The central bank
must be trusted not to debase the currency, but the history of fiat
currencies is full of breaches of that trust. Banks must be trusted
to hold our money and transfer it electronically, but they lend it
out in waves of credit bubbles with barely a fraction in
reserve.”
In addition to paying overhead costs,
reliance on traditional electronic payments systems has other major
implications. These implications require us to take a step back and
think about how our wider financial system functions and the role
governments play in controlling (or not) the monetary supply.
To understand better, let’s dive into the
two breaches of trust Satoshi mentioned.
● Trusting a Bank :
Let’s review. We save our money in the bank. Then we us them to
transfer on our behalf. The problem is that “our” money is not
actually held there for us. In fact, you actually lent your money
to the bank and they aren’t legally obligated to give it back to
you. They take your deposits and find opportunities to invest it
for additional financial return. They are only legally mandated to
keep a certain percentage of your money on hand for business or
other purposes. That percentage is lowered year by year. In early
2020, the requirement was removed entirely. Now the banks don’t
have to hold any of “your” money. It’s all theirs.
As you know, one “opportunity” they offer is
lending products (fronting someone else’s mortgage or car purchase)
in return for the principal plus interest. While extending credit
is not necessarily a bad thing, but when you add in more players,
more complex financial instruments and less transparency, it
eventually leads to unsustainable levels of lending (a bubble) that
results in significant losses. A good example is the Great
Recession of 2008.
● Trusting Central Banks : Remember, Central Banks
are corporations that have been granted a special contract with the
government. They are not a part of the government! Their job – is
to employ monetary policy to slow the wider economic downturn that
results from the risk-seeking behavior of these financial
institutions. Of course, they also participate in bailouts – or
not.
Monetary policy includes adjusting the
lending rate between banks, specifying the amount of money each
bank should keep in reserve, and the amount of currency that is
available (Printing Money). Meanwhile, the theory behind using
debt-based monetary policy to help the economy deal with the impact
of unhealthy financial swings related to credit, housing and equity
markets, dates back to John Keynes in the 1930s.
Again, central bank intervention in the
monetary supply is not necessarily a bad thing. It can be argued
that without increasing the monetary
supply post-2008, the Great Recession would have resulted in even
more economic turmoil and returned into a great depression as said
earlier.
It can also be argued that there are natural
cycles to any economy, and if left alone, the cycles are neither as
long nor as cataclysmic as we now see with central bank
involvement.
Diverting to A Trust-Less Cash System
Bitcoins are not issued by any company or
government agency. Bitcoin is a distributed, trustless system.
We’ll talk further about that that exactly means, but for now,
think of it this way: There is nowhere in the world that is the
“official headquarters” of bitcoin. There is no building, there is
no company. Bitcoin is run on millions of machines around the
world. They all talk to each other and create new bitcoins until
the last one is created.
The number of bitcoins in circulation grows
about every 10 minutes and will eventually reach a cap of exactly
21,000,000 (21 Million) Bitcoins. At that point, no more Bitcoins
will ever be created. That will make it the scarcest resource in
the world.
The BTC is an abbreviation for Bitcoin.
Furthermore, changes to the rules regarding bitcoin can only be a
result of winning a democratic vote (reaching majority consensus)
across computers running the bitcoin node program. For individuals
or governments to have more than 51% of the voting power is no
longer possible.
Satoshi had far reaching vision. BTC is
designed for an individual. You can store your bitcoin for
yourself. People can send it to you, you can send it to them. If
you purchase something, you can pay in bitcoin without ever asking
a bank or card company. Now, we are not there for most people. The
day will come, probably within 4-8 years, where bitcoins will be
used as an alternative to your normal credit card and bank
accounts.