One of the dirty secrets of the bitcoin world is that we are still in the 11th century of online exchange. Today bitcoiners are dealing with the classic issue that plagued humanity since at least the 7th century BC when the first piece of coinage were found. Coins, as all physical objects, are subject to physical theft, confiscation, swindling, fraud, and debauchment; but most of all, outright violence to seize it. These issues continue to this day; however there are apparatuses that as groups of people we can use to defend against such issues: Banks.

The Evolution of Banking

Banks from their earliest origins have functioned quite autonomously of the state. Developing out of the rise of italian merchant class in Italy during the 11th century, banking evolved far beyond the meager protection of precious metals into financialization. I highly recommend reading Nick Szabo’s two essays, “Origins of the Joint-Stock Company” and “The Birth of Insurance” for an in-depth look how this process occurred.

At this time, lending and banking was not a concern of the Sovereign–He had the power of taxation, and war–this was how he would raise funds if need be. However, war economies don’t work if you are on the losing side, and this is where the english crown found itself at the conclusion of the Nine Year’s War. England had been crippeled by france at the Battle of Beachy Head where the Royal Navy was decimated. William the III could not raise the funds at the time, and so he developed something very, very sneaky: The Bank of England. Of intersting note, this bank was built physically on top of a Roman temple of Mithras–how fitting.

As a private corporation, the BOE was given the sole power to issue bank notes in england on behalf of the crown. This allowed for lenders to give cash bullion to the bank, who could then give a loan based upon a promise of repayment from the Crown in the future. The Crown essentially invented war bonds to raise funds for the transformation of england into the naval superpower it would later become. And this was all thanks to the seditious revolution of banking.

Moving from a coinbased economy as the main mode of exchange, to a reserved-based note system, is what allowed for substantial economic development to occur in England in the generations after. This was specifically due to the technological development of new kinds of financialization which were never used before, which gave england a substantial economic advantage over other states.

Slowly and insidiously this version of banking took over the whole world! Using this system states could create money that did not exist yet; one could spend tomorrow’s promise of repayment today! A revolutionary development, but as we see today, when stretched beyond the limits of the markets, it can, and will create havoc.

Transitioning From a Coinbase Economy

Today in the bitcoin world, were are shuffling about our bitgold forged into coins from the process of bitcoin mining. You can read more about the production process of forging bitcoin in my previous post bitcoin as commodity money for a more detailed explanation of this process. While this does have many, many benefits over contemporary banking, fiat money, and governmental interference in economics; it also has substantial problems–mainly incompetence. From the Gox fiasco, to the most recent Bitstamp compromise, it is the golden age of digital highway robbery, with the Black Barts of the digital age having the time of their lives.

Attempting to move from a coinbase economy to a fractional reserve one does have some appeal, but we all know how problematic, and antithetical this is to bitcoin. However, with the developments going on over at Blockstream, I think there is real hope to create something that will straddle the lines between a coinbased economy, and a fiat economy: transparent reserve banking.

Sidechains and Collateralization

The team over at Blockstream has assembled a ‘Manhattan Project’ scale of crypto experts to develop sidechains. The sidechain project is one to essentially be able to create a two-way peg between coins deposited, and the creation of new assets. There are two reason I believe this is such a critical development:

1) Using bitcoins deposited via sidechains a new assets can be created which would be more difficult to steal, and would allow some process of restitution in the case of theft, similar to what banks provide today.

2) Bitcoins can be used as collateral for a unique model of debt-financing as follows:

Bob deposits 10 BTC today with Alice Bank via sidechains. This creates a loan that is a fractional value of the bitcoin he deposited.

Today those 10 BTC are worth around $2700, and once deposited with Alice bank, this will make a loan that is leveraged 1:10. Alice Bank will now give Bob a lump sum of $27,000 to be repaid in the future. In order for bob to recover his 10 BTC, he will need to make payment of $275 each month for 100 months. Bob is free to pay back the the loan + the fixed interest early if he chooses to do so. Once the total of $27,500 is fully repaid Bob will ‘unlock’ his bitcoin from the sidechain. Bob now has his 10 BTC back.

What makes this so revolutionary is that it solves the impossible trinity problem that all central banks face. This allows for a natural equalization of the USD value of bitcoin to occur through debt-financing via bitcoin, fixed in dollars. If the value of bitcoin substantially increases beyond the initial $270 that Bob’s bitcoin is financed at over the next 100 months, he will have all the more motive to repay quicker to get his bitcoin back. If bob defaults, Alice Bank will be able to keep the 10 BTC for itself.

By treating bitcoin as property, a sidechain bank could use a fixed amount of bitcoin as collateral just like a how a home is used as the collateral in banking today.

The Next Generation of Bitcoin

If bitcoin is to advance itself beyond the wild west of digital finance, while remaining true to its core tenets we will need sidechains. This will allow for a revolution that will be similar to the scale and scope of the one William the III ushered in when he created the BOE. This will help bitcoiners resolve some of the security issues that have plagued the coin-based bitcoin economy, but more importantly, it will help financialize the bitcoin economy. By using bitcoin as an assest for debt-financing in fiat values, bitcoin banks will be able to create loans for people, while still remaining free from the hands of the state–if they choose to do so.

As dangerous as this is to flirt with debt financing, I believe that sidechains offer a revolutionary way to financialize the bitcoin economy in a way that allows for those in the bitcoin economy to have their cake and eat it too.

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Next: Bitcoin is Political