It all comes down to trust. The modern world’s financial system is built on a foundation of trust, and supported by the framework of law. I remember very clearly the first time I saw a trader execute an over the counter transaction, thats when two traders at different institutions agree on a trade over the phone or in this case instant messenger. With all of the computers we have I assumed that process was done through some kind of shared system, that immediately resolved the transaction and settled the obligations of both parties. It doesn’t work anything like this. Each trader marks their side of the transaction in their firm’s ledger, and then at some point in the future a settlement process occurs. So if I sell you a million barrels of oil, you take my word for it, enter it into your system and go on with your day. This system is entirely based on trust, and the penalty for voiding an agreement is never being able to work in trading again.
When a bank sends another bank money via Swift (the international payments clearing mechanism) they deduct the amount from their local books, enter the amount into swifts system, and the foreign bank adds that amount into their system. Both parties are trusting Swift to clear and settle that transaction. If the transaction goes south for some reason and cannot be resolved properly the system falls back on legal remedies. Trust permeates every aspect of our digital lives. We trust the government to back the US Dollar, that is a trust obligation to the people holding currency and investing in US bonds. We trust the bank to be able to deliver us currency even though they only hold a small portion of your money in the bank (a 5% fractional reserve rate is standard). We trust counter-parties to deliver goods and services, we trust payment companies to settle transactions, we trust brokerage companies to hold and manage stock certificates. Even the simplest payments are built on a network of trusted parties, and a web of legal and other agreements that connects them.
Trust has overhead. You can’t simply trust someone else can you? A bank can’t just take the word of another bank it doesn’t know anything about. In order to solve this we build banking associations, and government oversight committees, and employ legions of regulators, and auditors. We need accountants to compute both sides of the ledger, and lawyers to fall back on when things go south. We need tax accessors to make sure the government gets its cut, and don’t forget the police when you don’t honor your obligations. A framework of trust requires an elaborate system of checks and balances, every step in that process adds to the cost of doing business, and ultimately is passed along to consumers in the form of service fees and more expensive products.
Bitcoin solves the problem of trust. It does this in three ways. First, it enables the transfer of information between two parties in an irreversible way without either party having a pre-existing relationship. When you get paid, you get paid. Second, it allows anyone to audit transactions both in real time and historically, this provides a fact-in-time ledger, which allows us to know with certainty when events have occurred. Third, tokens representing money or other information can not be fabricated, counterfeited or otherwise copied, you can’t just magic up some Bitcoins out of thin air.
So potentially we have a new technology that is capable of replacing vast amounts of our financial infrastructure. The key is that unlike our existing system, if you can facilitate trust-less transactions you can do them programatically. This lets us push the legal, regulatory, accounting, and other rules that run our society into computer code. The same wave of automation that changed us into a post-industrial society, can now be leveraged to push us into a a new information age.