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This article is part of a series of adapted excerpts from “Bitcoin Is Venice” by Allen Farrington and Sacha Meyers, which is available for purchase in Bitcoin Magazine’s store now.
You can find the other articles in the series here.
“Money will always see a multiple layered expansion as it evolves, and each layer has costs and benefits. You can mine your own gold, but this process is very expensive with a high barrier to entry. You can buy gold coins and bars easily in most parts of the world, but using them for day to day commerce is unfeasible. As a merchant, you can accept gold coins but either have to trust the purity or assay the gold yourself. Once you’re using the paper certificate layers, you now are engaged in counterparty risk, but have easier capacity for transactions. Each layer serves a different function. Base layers are for final settlement, while higher layers are for facilitation of economic activity.” — Nik Bhatia, “The Time Value of Bitcoin and LNRR.”
It seems a peculiarity of the modern psyche to regard the financial services industry as being at once too powerful and yet absolutely necessary. No respectable businessman or woman has not served an apprenticeship at an investment bank or, if his employers are feeling exceptionally charitable, at a management consultancy. An aspiring candidate for political office whose CV does not feature such a role would do well to surround him or herself with others who do.
And yet the industry’s influence is near-universally decried: “Main Street, not Wall Street,” is a common refrain from politicians of all stripes and all sides of all aisles, who, in some or other roundabout way, it turns out are being funded by hedge fund managers. Matt Taibbi likens Goldman Sachs to a “vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money,”[i] and this at-once hilarious, disturbing and essentially accurate characterization is published in Rolling Stone magazine — later sold to Penske Media Corporation, then minority sold to the Public Investment Fund of the Kingdom of Saudi Arabia, in a deal certainly advised by a fair few investment banks, very possibly including Goldman Sachs.
The conspiracy-minded might have a field day with such information, but the fullest explanation is in fact rather bland. In the modern financial system, money is a bank liability.
Therefore, it is impossible to do business of any kind without commercial bank involvement, and commercial banks can only exist at the discretion of a central bank. It is impossible to do international business without investment bank involvement, and investment banks can only exist at the discretion of the global central bank, the U.S. Federal Reserve. As a result, there are very few such banks, their political power as allegedly wholly private enterprises is perhaps unrivaled in the history of capitalism — or anything that can reasonably be called “capitalism” — and their regulatory capture is complete. In fact, it is probably entirely unreasonable to call this “capitalism,” this being the regime of central banks, investment banks and good old regular banks, so perverting the role of capital in modern economic exchange.
Economic historian Raymond de Roover coined the expression “commercial revolution” in his essay, “The Commercial Revolution of the Thirteenth Century,” writing:
By a commercial revolution I understand a complete or drastic change in the methods of doing business or in the organization of business enterprise just as an industrial revolution means a complete change in the methods of production, for example, the introduction of power-driven machinery. The commercial revolution marks the beginning of mercantile or commercial capitalism, while the industrial revolution marks the end of it.
Contrary to the fashionable championing by every tech banker and his dog of “blockchain technology,” we anticipate precisely what de Roover chronicled, or as precisely as history can rhyme rather than repeat: a commercial revolution.
Not a revolution in modes of production, but in business organization and finance. Saifedean Ammous is fond of saying that Bitcoin is the technology that will finally end World War I. We might be so bold as to suggest it is the technology that will end the Industrial Revolution and bring about a second commercial revolution in its place. Fingers crossed that we get another Renaissance as well.
In “Capitalism: History and Concepts,” N. S. B. Gras very nicely frames the delicate issue of the development of the American financial sector (with the modern metonym “Wall Street”) in terms of weighing up its obvious and enormous commercial benefits on the one hand and its obvious and enormous social costs on the other:
Let there be no mistake about Wall Street. The investment bankers who led it were selfish and not public spirited. They were touched off by their own interests. They ignored the feelings of the public. They were negligent of petty capitalists,[ii] including farmers. And, for a long time, they cared little about workers, who were regarded as articles to be bought at the market. And yet, the investment bankers, who wanted profits for the buyers of the securities which they sold, were doing much for America when they provided for the effective flow of savings into business. While emphasizing the fees from the sale of stocks and bonds and their profits from buying and selling stocks, these investment bankers were serving America even more than themselves. In ignoring the feelings of the people they were undiplomatic, but future historians will show that they were more up to date in their business policy than the public in its emotional thinking. In ignoring petty capitalists and neglecting labor, financial capitalists proved themselves short sighted and without a political sense. In going beyond the bounds of ordinary competition in reaching out to get from one another large masses of property in a way that disturbed the smooth operation of business, especially the working of the money market, they uncovered weak links in policy just as the industrial capitalists had disclosed weaknesses in their policies. It was the financial weakness of industrial capitalists that gave to investment bankers, who represented the owners of business as against the administrators, the opportunity they seized. When Wall Street gained control, financial capitalism was born. This does not mean what has been called “security capitalism” — buying and selling securities — which has been developing since at least the fifteenth century. It does not mean simply the building up of firms with colossal assets. That is incidental, not essential. It means the influence or control of investment bankers in the interest of the owners of the securities which these bankers originate and continue to sell.
We find this observation to be remarkably astute and readily transferable to our predictions of the impact of Bitcoin on financial organization. What Gras points out above is the short-term benefits to business financing of the pooling of capital for investment projects, but the long-term costs to social relations of the necessary centralization introduced by this process when carried out as vastly and quickly as happened in late-19th century America.
It is fashionable and easy to predict rampant decentralization on the back of hyperbitcoinization. We sympathize but disagree in part. “De-financialization” is a better meme, and a point we will return to often in the remaining excerpts of this series: what follows is a prediction not of sweeping changes to everything but of gradated changes to all forms of social organization such that they return to whatever size is most natural. We predict not that everything will be small but rather that not everything will be big, will have to be big or will aspire to be big. We will have an essentially novel form of financial capitalism that is at once industrial, informational and global, and yet financialized and securitized at as local a level as is efficient or necessary to begin with.[iii]
That said, none of this is to downplay how dramatic we believe many of the changes will be. Bitcoin gives us the opportunity to replace a closed, political, analogue, client/server system with an open, apolitical, digital, peer-to-peer one. Part of the wave of superior and essentially novel competition will involve a reduction of human processes to code and obsoleting many threats of violence with cryptography — but not all.
We caution the reader in general not to get overly excited about the prospects of “smart contracts” as somehow constituting omnipotent, floating code. Bitcoin is not a “world computer.” It is a network for settling value and protecting it with adversarial, escrowed computational expense. Its computational capabilities are deliberately limited to ensure it will always perform this core task well. A two-page screed on Bitcoin magically replacing macro-bullshitters will not cut it at the big boy table. We must think more carefully and with greater technical appreciation both of the protocol and the analogue mechanics of legacy financial services.
For example, the Lightning Network may present the only feasible alternative to the “risk-free rate” that is all-important in contemporary finance despite emerging from economic nonsense. There will be no bitcoin lender of last resort and no return-generating enterprise perfectly free from risk. There will be nowhere to park idle bitcoin that transforms the maturity of the owned asset, contributes to capital formation and can promise, beyond all doubt, a given safe return … except, perhaps, the market-clearing rate for operating Lightning channels. The Lightning Network requires sunk working capital at least as large in value as the largest expected net credit flow of those taking part. In fact, we get the impression it is often not appreciated just how expensive the opportunity costs of Lightning are, for all its benefits.
But it is a very different type of “expense” to what readers might normally understand this to mean. There is no consumption involved, and at maturity there will arguably be next-to-no risk, either; there will just be tied-up capital. The “expense” is purely an opportunity cost, but for would-be lenders looking for a low, but guaranteed return, sinking capital in this way benefits the entire ecosystem; opening the channel involves a transaction fee that secures the mainchain, the payments layer is provided with extra liquidity and the “lender” gets a modest return for routing payments. We foresee, in conclusion, that Lightning routing fees become the de facto “risk-free rate.”
Lightning is often lazily described as a kind of clunky workaround to the limitations of the timechain. Elizabeth Stark has vigorously rejected this notion on the technical grounds that layered architecture is simply optimal engineering.[iv] Cramming all the features of Lightning, Liquid, RGB, DLCs, RSK and so on, into the mainchain is not only probably technically impossible, but in a more conceptual sense — arguably an aesthetic sense — is just an obviously bad idea. It would introduce unknowable attack vectors and hence holistic fragility. The naïve view is that this compounds the utility of every functionality.
The mature view is that it compounds only the vulnerabilities; each functionality is primarily affected to the extent it has become more vulnerable, and utility dramatically decreases, both at the level of individual functionalities and the protocol as a whole. If TCP/IP had been configured to enable video streaming, for example, it would have broken immediately, if it had even worked at all. This is a feature, not a bug: It reflects the mindset of a prudent and humble engineer.[v]
We believe this general principle is not one of software engineering so much as engineering entirely in general, yet as elegantly applied to software. “This clear specialization ensures performance, reliability, and scalability of the internet,” as Thibaud Maréchal puts it in “A Monetary Layer for the Internet.”[vi] This design principle could well be thought of as an adaptation of federalism from one institutional setting to another. Or, perhaps federalism is yet another special case in the realm of political philosophy, government and business administration of a still higher principle?
Back in the realm of economics, we would argue that layered money[vii] is simply good social and institutional engineering. This might seem like an argument in favor of the Lightning Network from an oddly axiomatic basis — and almost a fatalistic one along the lines of software eats the money. A candidate axiom may well be Gall’s law, from John Gall’s Systemantics:
A complex system that works is invariably found to have evolved from a simple system that worked. The inverse proposition also appears to be true: A complex system designed from scratch never works and cannot be made to work. You have to start over, beginning with a working simple system.
However, this rough idea has ample historical precedent that predates software by several centuries — probably precisely because the key insight is one of institutional design, transcending software entirely and of which software is one special case among many.
One of the features of the complex web of financial and banking relations in Renaissance Florence was the practice of “offsetting” — noncash and nonbank payments between merchants by flow of credit and debit. Richard Goldthwaite describes in The Economy of Renaissance Florence that “one could draw on his credit by written order for transfer to a third party, and the transfer could be passed on to a fourth party and even on to others by mere book entry.” These “payment channels” were clearly private, and a final link to Lightning is to realize this assumed a kind of going concern. In other words, that it was worth costlessly keeping credit channels open and updating them rather than closing them at cost, which would involve settling either in bank transfer, or with true final settlement in specie.
While the mechanical allusion is intriguing, Goldthwaite goes on to place offsetting amid the diversity of financial customs:
Local banks did not have a commanding position in the local credit market. On the supply side of the market, the weakness of these banks in attracting deposits was exposed by their failure to provide an outlet for the savings that began to accumulate in the hands of artisans and shopkeepers in the second half of the fifteenth century. The depositories opened by the Innocenti, Santa Maria Nuova, and the Badia, in contrast, responded to this void in the market, signaling the new direction banking was to take in the following century. But it is when we turn to the demand side of the market that we can see banks’ relative inability to attract capital. Local banks and especially pawnbrokers served the general public as sources for direct loans, but they were hardly the only conduit to credit. Direct loans were also readily available outside of banks. Evidence for loans from private persons abounds in the city’s oldest notarial records […] Moreover, debits and credits recorded in these official documents could be reassigned through another notarial act, although it is difficult to say that traffic of this kind constituted a secondary market.
Although by no means Goldthwaite’s point, an obvious lesson from this historical analysis in comparing the merchant-driven, hard-money economic system of Renaissance Florence to the finance-driven soft money of modernity — and with an eye on a Bitcoin standard in the near- to medium-term future — is that financial institutions and payment methods alike will mold themselves to the heterogeneity of time preferences, commercial requirements and interpersonal customs to be found across society.
There will not be “the bank” as a gatekeeper to all finance. There will be a supply and demand of capital, liquid and illiquid, short term and long term, risk-seeking and risk-averse, financial and production, personal and professional, payment and settlement. Moreover, in Florence, this diversity of capital was priced and kept honest relative to the store of value of elemental gold. Gold itself was therefore disconnected from the possibility of debased coinage or even confusing alternatives for units of account. Gold was for final settlement, not for payment, credit or capital. Of course, as effective and elegant as this system was, Bitcoin is even better. In this light, Lightning is not clunky or bizarre in the slightest. It is natural, complimentary, healthy and aesthetically and institutionally sound, as will be all other successful and differentiated extensions of the base layer.
This is a guest post by Allen Farrington and Sacha Meyers. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.
[i] Matt Taibbi, “The Great American Bubble Machine,” Rolling Stone, April 5, 2010.
[ii] Earlier in the essay, Gras defines “petty capitalists” as those engaging in capitalism on a deliberately small scale with no expansive or acquisitive ambitions, and those who may not even think of themselves as “capitalists” but more likely as “merchants” or “artisans” — this is all simply to clarify that Gras implies no moral connotations by this word choice.
[iii] It will be fascinating to contrast whatever does emerge along these lines with Carlota Perez’ analysis in her excellent Technological Revolutions and Financial Capital. We keep this mention to an endnote as we don’t want too much of a tangent in the main text. But for the curious reader, Perez’s short book — deemed by many a contemporary classic — provides a compelling theoretical overview of the shifting roles of production and financial capital (using essentially the same terminology as Gras). Perez convincingly (in our opinion at least) applies the framework to the major bursts of investment and output growth since the Industrial Revolution. We don’t have a precise prediction in terms of Perez’ analysis beyond that it strikes us as reasonable that “financial capital” may come to be permanently disenfranchised given the entire period Perez analyzes (which, recall, is all that has, in fact, existed since the Industrial Revolution) progressed from minimal to arguably non-existent (or certainly, incomparable) central bank intervention in financial markets to its recent all-time high.
[iv] Among many others, of course, but given both Elizabeth Stark’s position and her bank of knowledge and experience, we are inclined to consider her the intellectual leader of this train of thought.
[v] A natural complement to humbly constrained layering is openness: build one thing at a time but make it as simple and well-defined as possible to interact with what you have built externally. This is less technically interesting as it may well be imagined as an obvious design default, but it may equally be thought of as more psychologically interesting, and it arguably even better captures humility. If you make simple building blocks that are open for others to build on, you never know what they will come up with and, in fact, you incorporate the essence of a peer-to-peer network right into the engineering of what may well itself be a peer-to-peer network!
In How the Internet Happened, Brian McCullough recalls how Marc Andreessen had essentially the above dispute with Tim Berners-Lee over the design of early web browsers. Berners-Lee wanted tight control over how HTTP worked and for what it would be used, very much in line with his closed-design vision, whereas Andreessen instinctively understood the merits of the above argument and wanted the protocol to be more of a platform to which others could contribute with novel insight and experimentation.
[vi] See, https://bitcoinmagazine.com/technical/a-monetary-layer-for-the-internet.
[vii] Nik Bhatia, Layered Money (Self-Published: 2021).