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The Purpose of Exchanges

Exchanges serve several critically important purposes. First, they help sellers and buyers find each other. By bringing lots of sellers and buyers together in one place, exchanges help ensure that goods are sold more quickly.  Lots of buyers and sellers actively trading together also helps ensure sufficient liquidity in markets so that the price discovery process works more effectively.

Second, exchanges provide escrow and custodial services so we need not trust our direct counter-parties in a transaction (as we must in peer-to-peer transactions). Suppose I live in New York and you live in California. If I want to buy your AT&T stock, I can deliver the funds to Morgan Stanley (an exchange of sorts) and you can deliver the stock to Morgan Stanley and we can both be reasonably assured that the trade will “settle” on their books and that we will each be credited what each is due. That’s both much safer and more efficient than you simply mailing me your stock certificates and trusting that I will then send you the funds, or vice versa.

Third and maybe most importantly, trading via exchanges, rather than peer-to-peer, allows us to "prove" ownership of our property by reference to something other than our own (biased) books and records. When I buy a stock, I need to know with a very high degree of certainty that I've obtained clear title to the property and that my title will be honored by lenders and the maximum number of potential future buyers. If my own personal records are the only record of my ownership, the proof is questionable at best.

But when I trade on an exchange, I am able to quickly, easily, and convincingly prove ownership by reference to its books and records. Not surprisingly, people tend to trust the records of a somewhat disinterested third party in such matters over those of a biased first or second party.

The Need for Regulation

The escrow services and independent transaction records offered by exchanges eliminated much of the opportunity for fraud inherent in peer-to-peer trading, but at the cost of introducing new systemic risks. For example, what happens when our “trusted” third-party escrow exchange turns out not to be so trustworthy or competent after all?

In these situations, everyone using the central exchange may lose their money at once. If the exchange is large enough, such losses can bring down an entire economy, which is what we mean by “too big to fail.” Centralized exchanges, therefore, represent a massive systemic risk.

Consequently, and perhaps not surprisingly, we regulate the hell out of them. For instance, we require most centralized third-party exchanges to comply with expensive and sometimes onerous governmental licensing and operating standards. We require their owners to put some of their own capital at risk (via minimum capital requirements), and we subject their officers to registration and background checks. Additionally, we require them to undergo independent CPA audits, and also often audits by governmental regulators, to ensure compliance with prescribed regulatory operating standards.

Similarly, we can’t just assume that the government regulators are competent and uncorrupted, so we also require that their work be periodically inspected by other governmental agencies (such as the federal government's General Accountability Office).

But even that—auditing auditors and regulating regulators—is often not sufficient to gin up enough confidence in these centralized exchanges. So, if the exchange is important enough, we may also demand that governments or quasi-governmental agencies (like the FDIC, SIPC, Fannie Mae, etc.) implicitly or explicitly backstop the exchanges and guarantee their customer deposits, at least up to some limit.

Specialization and Duplication of Exchanges and of Regulation

To complicate matters further, because each industry and profession has its own unique trust issues that result from the nature of its particular function and activities, and because it wouldn't be wise or efficient to burden one industry (for instance, real estate) with the trust and regulatory problems or requirements of another (for instance, a stock exchange), we segregate different types of the property onto different exchanges--e.g., stock exchanges, commodities exchanges, futures exchanges, forex exchanges, property registers of various types, etc.--and we develop different regulatory policies, procedures, and processes for each of these. Consequently, each exchange is overseen by its own specialized regulatory agency and has its own unique requirements.

The Government is So Big and Influential Partly Because They Regulate the Systemic Risks of Various Exchanges

When we consider the above, we can see that one of the primary responsibilities assumed by almost every government (or every democratic one, at least) is ginning up confidence in centralized exchanges so that the people will more readily engage in trade and commerce so the system doesn’t collapse. Governments do this by engaging in the types of regulation described above, by actually operating certain critical exchanges themselves (e.g., the land registries), and maybe most importantly by enforcing contracts and settling property disputes (so as to ensure confidence in the ownership records).

The Cost of it All

And so in our present system we have auditors auditing the exchanges and each other, and regulators regulating the exchanges and each other, and layers and layers of government bureaucracy, implicit and explicit guarantees, and more, all designed to protect against the systemic risks posed by centralized exchanges, or to at least to gin up sufficient confidence that such risks will be adequately contained and managed if they do occur, all so that people will trust the exchanges and engage in more active commerce and trading, all so that the economy will grow, all so that people will be employed, all so that politicians will get re-elected.

Trust is Valuable

The point is that, when it comes to commerce, trust in the system isn't just something that matters, it's darn near the only thing that matters. That trust can be "sold" to us (and so expensively!) is near irrefutable proof (if we needed any) that trust is inherently useful in achieving important human purposes. Without trust in each other and the system, the world is a much darker, more dismal, and less survivable place.

Bitcoin's Value Proposition

By this point, anyone familiar with Bitcoin should immediately see its inherent value proposition. Quite simply, Bitcoin is that technology.

Bitcoin is, among other things, the world's first electronic, distributed ownership record. In Bitcoin parlance, the record of transactions and ownership produced by the Bitcoin network is commonly called the "blockchain".

Blockchain is a technology that enables a return to peer-to-peer trading without reintroducing the traditional risks of transacting peer-to-peer, all while also eliminating the systemic risk posed by centralized exchanges. It makes all the embedded costs (massive in amount!) of the legacy system moot. Whereas these costs once served a very important purpose, they are in a post-blockchain world merely dead weight that ensures the legacy system can never complete with the new blockchain-based one.

The Universal Exchange

Consequently, blockchains will be the backbone for the world's first Universal Exchange, an exchange upon which nearly any asset can be safely traded peer-to-peer for any other asset.

Just like a universal computer can theoretically compute any computable sequence, the Universal Exchange can theoretically be used to trade almost anything that's tradable. Because transactions on the blockchain are available for any and all to see, and because each transaction is verified and secured through complex mathematical calculations that are practically incorruptible, the need to trust in others when transacting on the Universal Exchange approaches zero over time.

True, we may still need to trust a counterparty for certain types of transactions, but in most cases far less so than in the current system. And there are ways that blockchains can be used to minimize even this level of required trust.

What is Blockchain?

Though the details are complex and beyond the scope of this piece, at its most basic level a blockchain is a mathematically incorruptible chronological record of transactions. That record is replicated on every single computer that contributes to the blockchain network (e.g, by running the blockchain client software that's easily downloadable for free on the Internet). Thus, there is no central third party or even a central server. Anyone running the client software on their computer, and who also has "signing authority" (that is, some quantity of bitcoins or the native token for that particular blockchain), can enter a transaction into the record. I, or you, can prove ownership of a given asset conclusively simply by directing someone's attention to a transaction on the blockchain.

So, for the first time in history, we (or those of us with signing authority, at least) can now directly control what gets entered on an exchange's (and, in this case, a Universal Exchange's) books and records on our behalf. We don't need anyone's permission to make an entry, nobody can bar us from entering a transaction on the exchange (though the blockchain system itself will prevent it if we don't have signing authority), and nobody can reverse or corrupt an entry once made.

Less Trust, More Opportunity

In short, in a world with a Universal Exchange based on blockchain, the need for trust in humans (be they counter-parties, third parties, auditors, or regulators) is significantly diminished.

And that changes everything. For instance, it makes international trade much more accessible to all. We no longer need to learn to trust or interact with foreign institutions or governments. We can simply trust the blockchain, which runs on the international language of math.

Signing Authority on a Universal Exchange is Useful and Valuable

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It goes without saying that entering a transaction into an exchange is useful. After all, humans pay to do it on centralized exchanges millions of times per day.

And it should also go without saying that the most useful exchange to enter a transaction into is generally one that requires nobody else’s permission, that requires trust in no third party, that is the most secure, the least expensive, the most widely recognized, and accepted, and the most capable of exchanging the greatest number of goods and services.

Would people pay to enter a transaction into such an exchange? Of course, they would. That’s already been proven by the billions and billions of dollars in transactions (and growing exponentially) occurring on blockchain networks every day.

So, Why Are Bitcoins Valuable?

Whenever something is useful, scarce, and tradable, it will have economic value. The usefulness of bitcoins was just established above, but what about their scarcity and reliability?     

Well, not only are bitcoins scarce, they are in fact one of the most, if not the most, scarce assets on earth. There will ever only be 21 million bitcoins in existence, and each can presently be divided to eight decimal places.  See my article titled “Bitcoin’s Perfect Scarcity and its Significance” for more information on this subject.

Naive bitcoin critics insist wrongly that bitcoins are not scarce. They note that anyone can create a fork (copycat) of bitcoin or any other blockchain and therefore inflate their numbers into infinity.

With some respect, this argument is ill-informed. To see why, imagine a world where counterfeiting US dollars was legal. Anyone is free to do it any anytime. However, in this magical world, every single counterfeit is instantly recognizable as such. They look just like US dollars, they smell just like US dollars, they are made of the same ink and paper as US dollars, but by some magical process everyone in the world can instantly recognize that they are not, in fact, US dollars but rather counterfeits.

In such a world, are you (or is anyone else) going to accept the obvious counterfeits in exchange for real goods and services?

Of course not! And why? For at least two reasons. First, you know that the person trying to pass off the counterfeit never gave real value for it. Rather this person is trying to get something for nothing. They are trying to game the system and this offends your natural sense of fairness.

Second, you know that others are very likely to feel the same. Meaning that if you accept the obvious counterfeit, you’re likely going to get stuck with it. Nobody else is going to give you real value for your fake money.

And what defines what is “real” and what is “fake”? Human consensus enforced with network effects.

In short, bitcoins are scarce and always will be.

But…are they tradable?

Yes. Since they are capable of being sent peer-to-peer without anyone’s permission using open source software downloadable from the Internet for free by anyone, they are among the most easily tradable assets on earth.

It's important to realize that I am not employing circular logic here. I'm not saying that bitcoins (which represent signing authority to the universal exchange) are useful because they are valuable. Rather, they are valuable because they are useful. Bitcoins are valuable not because you can trade things for them (as money), but rather because you can trade things with (via) them by simply entering a transaction into the Universal Exchange. Thus, bitcoins are not (yet) the medium of exchange, they are the method by which things are exchanged in exchange for the medium of exchange. Or, at least they will be once the Bitcoin infrastructure is more built out and widely known.

The Price Floor

Given that bitcoins are useful, scarce, and traceable, they must have a price and a price floor. So, what is the inherent price floor of a bitcoin?

Hard to say, just as it is about any commodity. For instance, what's the inherent price floor of an ounce of gold (given its desirability for use in jewelry and not as a "reserve")? I've seen estimates of around $250 per ounce, but nobody knows with certainty what lower value it would trade at as a mere trinket (if it lost its historical status as a store of value).

Thus, the inherent value, and therefore the price floor, of bitcoins collectively is, in my mind, far, far greater than the inherent value and price floor of all ounces of gold collectively. Each's additional worth as a reserve or "store of value" is a different thing entirely.

So, Will Bitcoins Ever Become Money/Currency?

Respectfully, I think this is the wrong question to ask since everyone tends to get caught up in the very political and philosophical definitions of money and currency. And, in my mind, whether bitcoin ever becomes money is totally irrelevant anyway.

The fact is that people will (and already do) regularly and frequently (many on a daily basis) trade bitcoins for goods and services. Once something becomes easily transferable (and once acquired, almost nothing is as easily transferrable as bitcoins), it tends to be used to acquire other goods and services. For instance, stocks are regularly traded for other stocks. Sometimes entire companies are acquired for nothing but stock in the acquiring company. Real estate is (less) regularly traded for real estate. Currency is regularly traded for other currencies. Etc.

What it Means to be a Universal Exchange

And this is especially true with the tool that makes all that possible, bitcoins themselves. Since bitcoins represent the universal, inalienable (though transferable) right to enter a transaction, any transaction, into a Universal Exchange of sorts, and since bitcoins themselves are readily tradable on the exchange itself, an exponentially increasing number of things will come to be bought and sold for bitcoins, and not just with (that is, via) them.

You can call such trading of goods and services for bitcoins "barter" if you want (so that you don't have to acknowledge bitcoins as "real" money or currency), but the result is the same either way. They will be used to purchase goods and services regularly on the Universal Exchange.

In short, a Universal Exchange will facilitate a barter economy like the world has never before seen. For the first time, barter transactions will be nearly as easy as cash transactions (and in many cases even easier). This will have a great many revolutionary impacts.

It will impact "trusted" third parties (e.g, banks, exchanges and money transmitters) the most and soonest, but it will also impact governments, human relationships, law, accounting, economics, and a many other fields. And, perhaps most of all, it may just eventually make the medium of exchange function of  "money" somewhat obsolete.

With a Universal Exchange, a common currency (being a store of value, medium of exchange, and unit of account), is hardly necessary. When any asset or combination of assets can be directly traded for any other asset or combination almost instantaneously on a single exchange, all you need is a common unit of account by which you can establish the relative value of each asset. The store of value and medium of exchange functions of traditional “money” become increasingly irrelevant.

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