Digital currencies can be hard to take seriously. What makes them valuable? They are not backed by anything? They are not issued by a government? They are virtual and live inside a computer?

“The pieces of green paper have value because everybody thinks they have value.” Milton Friedman, Economist

It gets interesting when you start comparing them to the currency we use everyday.

Cash is king right?

Since the 1970’s all government issued currencies are fiat money meaning they are not backed by gold or any other scarce commodity — the money has no intrinsic value. Furthermore the vast majority of money in circulation is not issued by governments. Private bank computers, create money by a process called fractional reserve lending, where they keep a fraction of their customer’s deposits (typically 10%) and lend out the rest.

Digital currencies embody all the properties that economists expect from money; they are a medium of exchange, a store of value, and a unit of account. In fact many central banks are looking at creating their own digital currencies or digitising their national currency. Bitcoin and other digital currencies are disruptive because they are an alternative to fiat money and the traditional banking system.

So banks are dead? Not quite.

In reality, bitcoin has struggled to find mainstream adoption over the last 8 years. Recently it’s adoption has grown but most are using it for investment speculation rather than its utility. Companies like TenX and Monaco aim to increase utility by making digital currencies spendable anywhere (via Visa/Mastercard). Bitcoin and other digital currencies face a crossing the chasm issue; they are transitioning from early adopters to early majority users but these groups have very different needs. Early majority users require more education, better usability, and demand more value. The situation is gradually improving but organic growth will not be enough to reach critical mass.

It is more likely that progressive businesses will be the catalyst for mainstream adoption because blockchain technology will create an efficiency advantage. FinTech startups will use digital currencies to create exciting products and end-users will be oblivious to the fact they are using digital currencies.

The Ethereum blockchain is leading the way in delivering this efficiency advantage with smart contracts.

Smart Contracts

A smart contract is software that runs on a blockchain. It enables self-executing and self-enforcing financial agreements between parties. Imagine, automated commercial interactions that lower transaction costs, and reduce counter-party risk.

Smart contracts are incredibly flexible, in fact most financial service functions such as deposits, credit, insurance, wire transfer, investment and notary could be made more efficient or completely replaced by smart contracts running on a blockchain. Any scenario where you have multiple parties engaged in complex financial transactions, in theory could be modelled using smart contracts.

Tokens

By far the most popular use of smart contracts today is to implement tokens. Tokens are digital assets that can be bought, sold and traded. Each token has its own purpose but they can be roughly categorised as:

Asset Representation — where tokens represent an illiquid physical asset — effectively the tokens become a financial derivative that are easily tradable.

— where tokens represent an illiquid physical asset — effectively the tokens become a financial derivative that are easily tradable. Utility — to use a product or service, customers acquire utility tokens giving them some ability within the product. The token’s exact use depends entirely on the product and service.

— to use a product or service, customers acquire utility tokens giving them some ability within the product. The token’s exact use depends entirely on the product and service. Equity/Profit Share — tokens are issued to customers and investors to harness network ownership effects. As the product gains traction the value of its token increases (similar to a company stock). Some companies are also using the tokens to disseminate profits and customer rewards.

Tokens are changing the way companies are funded. Startups are using a form of crowd-funding called an Initial Coin Offering (ICO). ICO funding has raised over $1.7 billion (USD) so far this year. What is impressive is how quickly the money is raised. Some ICOs have raised millions of dollars in a matter of minutes. Sadly, ICO funding is rather controversial because it is unregulated and a large number of companies provide very little in terms of a business plan.

Digital Currency + Smart Contracts + Economics = New Business Models

Controversy aside, tokens have huge potential for innovation. Tokens incorporate economic incentives to align customer and business outcomes, facilitating amazingly creative (and experimental) business models.

Scalability

Financial service applications require high performance to deliver the responsiveness that customers demand. A typical financial trading platform processes thousands of transactions per second. Currently the Ethereum blockchain has a 7 transaction per second capacity (Bitcoin around 4 transactions per second). Private blockchains where the participants are trusted can reach higher capacities but there are trade-offs with this approach. There are plans to dramatically increase blockchain and distributed ledger capacity so it will be interesting to see what the future brings.

That said, there are many financial service applications where sub-second performance isn’t important especially where separate legal entities are involved in long-running financial agreements — these are perfect for blockchain.

Conclusion

There are lots of ambitious projects in the blockchain space, many will work but many are not currently feasible.

Timing is important.

The blockchain space is like the Internet in the 90’s; it has huge potential but the technology is still maturing. Once it reaches a tipping point there will be an explosion of innovation and the world will never be the same again.

As a product creator and developer now is an exciting time.

Exploring the possibilities, failing, learning and trying again.

Innovation is about anticipating the wave and being ready to capitalise at the right moment.

Next: Organisation

In the next article I will dive into how blockchain technology will change how we organise ourselves as a species.