Predecessors of Bitcoin and Non-Blockchain Digital Currencies
In this article, we take a look at some of the early developments in digital money, some of which went on to make bitcoin possible. It is frequently a good idea to have an understanding of the past in order to have a better understanding of the present, in this case so we can see some of the problems that pre-bitcoin e-money faced that bitcoin attempts to solve. Money without a physical basis in reality is still a work in progress, but today we’ll help you understand why bitcoin is its best incarnation thus far.
Believe it or not, bitcoin was not actually the first form of digital currency. The idea of electronic money, or “e-money,” has been around a lot longer than you may think. As a matter of fact, its been around pretty much for as long as the idea of computer networks itself, even before the advent of the internet. It just so happens that none of them were very good. If they were any good, they were highly centralized and prone to all the problems faced by regular money (or worse, because they were seldom subjected to a regulatory body of oversight and therefore ripe for fraud, forgery, or other sorts of manipulation).
The two ideal components of any decent digital currency are:
- It is borderless and can be transferred anywhere, at any time, and
- Transactions are instantaneous and do not require a prolonged settlement time.
In a way, you can think of classic money transmitters like Western Union and bank wire transfers as engaging in a form of digital currency transference, as money appears to be sent via telecommunications networks from point to point (instead of actually being physically delivered by a courier of sorts). Ultimately, such companies simply employ the use of a regular ledger system which is balanced by the party of ownership, basically driven by a process of lending money to itself and charging fees to its customers along the way.
Before going much further, it is important to distinguish existing forms of money, mainly to help establish the differences between decentralized cryptocurrencies and other digital currencies. The Bank of International Settlements (BIS), sometimes referred to as “the central bank of central banks,” made headlines in June 2018 when they derided bitcoin in their annual report as “a poor substitute for the solid institutional backing of money.” In the same report, they did admit that blockchain technology was not without its benefits and perhaps could be employed successfully for the purposes of a currency if there were state or centralized controls guiding its development and function. The following is the BIS breakdown of all forms of money, as conceptualized in the Venn diagram below.
First, we have the overarching categories of “money”:
Universally accessible. Money made freely available to the public.
Electronic. Money that exists in digital form which may or may not be backed by physical money.
Central bank-issued. Includes all money created and approved by the central banks of federal governments.
Peer-to-peer. Money that is directly transferrable from one person or party to another.
Next, let’s review the most relevant subcategories of these groups:
Cash. Cash, being “physical money” – as in bills and coins – is interestingly the only subcategory to fall into every category except for Electronic. It is universally accessible, issued by a central bank (fiat currency), and can be transferred from person-to-person. For those reasons, cash is awesome.
Central bank digital currency. As mentioned above, this type of money is the digital form of fiat, which may or may not be backed by a given quantity of cash (dependent on rules imposed by federal governments on their banks). It is used by banks, credit cards, stock markets, money transfer services and for the vast majority of all monetary transactions, by total value transacted.
Virtual currency. Belonging only to the category of Electronic money, these will be the focus of our discussion. They are digital currencies that are not cryptocurrencies and not created by a central government. Since the blockchain revolution, they have largely fallen out of favor and very few new ones are still coming into existence. They are more-or-less what bitcoin has replaced, though some exist for niche functions and are unlikely to be removed entirely.
Cryptocurrency. Blockchain-based digital currencies (Bitcoin, Litecoin, Ethereum, Ripple, etc.) and the only subset of money to be contained in all categories except Central bank-issued. This includes both permissioned (private) and un-permissioned (public) blockchains.
Wholesale cryptocurrency. Think ICO-level cryptocurrency purchases, or purchases made by institutional or large-scale investors, in situations not readily accessible by the public.
Central bank-issued cryptocurrency (retail and wholesale). Largely theoretical and not yet employed on a widescale level, these are what the BIS envisions to be the ultimate forms of digital money: a state-backed cryptocurrency, combining the best elements of blockchain technology with the stabilizing hand of a central authority. Because their existence runs at odds with Satoshi Nakamoto’s vision of cryptocurrency being decentralized and free of government control, these types of money remain highly unpopular with the bitcoin-literate public, and their use case scenarios are virtually non-existent.
So, what were some of the primordial, pre-bitcoin versions of electronic money? Let’s review them now.
The distinction of being the first digital currency belongs to Ecash, originally developed by computer scientist and cryptographer David Chaum, in 1983. While the currency is actually a legally-tendered version of the dollar, it is still regarded as being electronic money, and the first one at that. In a paper titled Blind Signatures For Untraceable Payments, Chaum outlined the idea of how cryptography, or the art of securing information during its transmission, could be used not only for bank transfers, but used in such a way that the identity of the payer could remain anonymous from the payee, while retaining factors verifying its authenticity. His novel concept of cryptographically-secured blind signatures would go on to form the basis of future versions of electronic money; variants of which are used today in relatively successful cryptocurrencies like Monero (XMR).
In 1989, Chaum founded DigiCash, a company which employed the use of Ecash as a digital payments solution. Through a novel form of downloadable software, users could send money back and forth to other users by making withdrawals and deposits from and to their respective bank accounts. Transactions were secured by Chaum’s patented blind signature cryptography and used an early system of public and private keys for bank verification, laying some of the groundwork to be used later by bitcoin.
Unfortunately, the number of banks that agreed to implement the Ecash transaction system never grew beyond 1, and by 1999 DigiCash had filed for bankruptcy. In an interview the same year, Chaum stated his belief that the primary reason why his project never really got off the ground was that e-commerce hadn’t really yet been integrated with the internet throughout the 1990s, as only in the latter half of the decade did major online retailers (like eBay and Amazon) even come into existence. Regardless, Chaum’s foolproof invention of transacting money online through blind signatures is instrumental to the foundations of cryptocurrency as we know it today.
Launched in 1996, e-gold was the first example of an independently digitized commodity that was transferable peer-to-peer. Three short years later, it was being hailed as “the only electronic currency that has achieved critical mass on the web.” Though e-gold started off being backed by gold coins kept in a safe deposit box under the control of the company’s founders, it eventually grew to being backed by 3.5 metric tons of actual gold (approx. $77 million) and had over one million user accounts at its peak, with over $2 billion in annual transaction volume. E-gold was one step closer to acting as an employable digital currency than Ecash: it was ubiquitous (traded on independent exchanges), pseudonymous (almost anonymous), enabled microtransactions (the minimum transaction was one ten thousandth – or 0.0001 units – of a gram of gold), and perhaps most importantly, accepted by a wide variety of merchants, including online casinos, metals trading and auction sites, as well as political and non-profit organizations.
One thing that e-gold was sorely lacking was security measures. Similar to bitcoin, e-gold used an immutable ledger system that maintained the origins and recipients of each transaction, albeit a centralized ledger system whose contents were only available to employees of the company itself. In this way, it was secure, and its system was never actually hacked. However, criminal elements were quick to capitalize on e-gold’s semi-anonymous nature and its users were frequently the subject of phishing attempts and hacks on their own computers. Fraud artists began to use e-gold to conduct large scale Ponzi schemes, engaging in identity theft, check and wire fraud for the purpose of opening up e-gold accounts with other peoples’ money. Standards for credit card applications were also relatively lax at the time, which could then be used to fund e-gold accounts, with the applicants never intending on repaying any of their debt. Simply put, at the turn of the century, the banking industry was simply not up-to-snuff in an increasingly digital landscape. E-gold’s strengthening association with fraud and criminal activity was beginning to affect its popularity.
The last bullet for e-gold came after the passage of the USA Patriot Act: a set of somewhat draconian laws meant to curb the influence of terrorism on America, written in the wake of the 9/11 terror attacks. Soon after, the US Justice Department proceeded to use statutes in the Patriot Act to stretch the definition of “money transmitter” to include any electronic system that allowed for the transfer of value from one person to another — not simply fiat currency. E-gold was soon prosecuted under the Patriot Act for not having a now-required money transmitter license, even though they had a history of previous cooperation with federal authorities. In June 2011, e-gold made the announcement that it was court ordered to dissolve all of its holdings and deliver the value of the holdings in dollars to a claims administrator, who would then be responsible for settling e-gold holder claims. After a long, drawn out period of court proceedings, claim filings and distributions, the e-gold website closed down in 2015.
Like Ecash, e-gold was also critical to the development of bitcoin because it introduced the idea of digital transference of property ownership rights via peer-to-peer software, in a process that would eventually be known as a “smart contract.” Though it may now be closed for good, a Canadian re-interpretation of the company known as BitGold sprang up in 2014 and is currently doing quite well for itself, operating in over 160 markets and boasting over half a million active users. (It is worth taking the time to note that this BitGold is different from the bit gold idea developed by cryptographer Nick Szabo, which is commonly regarded as a direct precursor to bitcoin in that the completion of cryptographic puzzles is required for its transfer. Szabo’s work is considered to be fundamental to the principles of bitcoin that he is frequently mistaken to be Satoshi Nakamoto by researchers and the media.)
When people think of digital currencies, they normally don’t think about money systems used in video games. Usually it is non-transferable from player-to-player and cannot be moved or redeemed for anything outside of the game. With the advent of the internet and the massive multiplayer online role playing game (MMORPG) all this began to change. In these games, players traverse “virtual worlds,” frequently with other players connected through the game’s network, to complete quests, missions, or stories, usually for the purpose of “leveling up” or increasing their character’s abilities. Virtual worlds allow users to create or obtain virtual goods (such as clothing, buildings, furniture, vehicles, and weapons), which have additional utility outside of gameplay, as they can be sold to other users who lack the time or skills to obtain them for themselves, often for a substantial profit. As a result, such games end up creating virtual economies, sometimes supported by virtual goods exchanges hosted outside of the game itself, the most vibrant of which is centered around World of Warcraft (WoW).
WoW was not the first MMORPG, but it is one of the most successful, having grossed over $10 billion in revenue for its creators, Blizzard Entertainment, since its launch in 2004. What sets WoW apart from its competitors, besides its engaging role play experience and relatively advanced graphics engine, is the fact that its in-game currency (known as WoW Gold) can be easily transferred from user-to-user via the game’s mailing system (kind of like an in-game version of email). In effect, this renders WoW gold similar to bitcoin, in that a software client connected to a network is used to transfer a digital form of money from peer-to-peer. And this was all developed and practiced a good 4 years before the launch of bitcoin. Currently, there are hundreds of websites dedicated to WoW gold and virtual goods trading, several active WoW gold exchanges and thanks to brilliant marketing maneuvers by Blizzard, a rather consistent demand for them. WoW gold cannot only be used to purchase monthly WoW memberships $7.99 to $15.99), but exchanged for currencies in other games, non-game related merchandise, and of course a dizzying array of fiat currencies, worldwide.
Acting as a peer-to-peer utility to transfer digital money is where WoW gold’s similarities with bitcoin end, however. WoW gold is centralized (its production rate is decided by Blizzard), its transactions are not cryptographically secured, and it does not employ the use of a blockchain to maintain its ledger. Within the first year of WoW’s launch, the USD price of WoW gold fell dramatically, from 60 cents per gold piece at the beginning of 2005 to 10 cents by the end of June. Natural in-game inflation, combined with a surmounting flood of professional gold farmers worldwide, has vastly increased the amount of WoW gold in circulation, and its current exchange rate is about 5,882 gold pieces per dollar. Simultaneously, the practice of gold farming is said to significantly decrease the quality of gameplay; so much so that companies that profit from it are sometimes sued by WoW players for that very reason. Therefore, while the inflation rate of WoW gold might remain lower than that of Venezuela’s hyperinflated bolivar, and its total market capitalization is higher than that of most altcoins, it is not very useful as a day-to-day currency, but then again, it was never meant to be. A few other MMORPGs with thriving virtual economies include:
- Dungeons & Dragons Online
- EVE Online
- Star Wars Galaxies
- Ultima Online
- Elder Scrolls
Second Life Linden Dollars
Our last example of a popular, pre-bitcoin digital currency comes from a different sort of game: Second Life. Unlike most games where the focus revolves around accomplishing tasks, getting gold, obtaining virtual items and increasing character abilities, Second Life is an open world simulation game, in which the end result is less clearly defined as the game focuses more on social interactions. Players create fantasy versions of themselves, often known as avatars, interact with one another in a virtual environment, and can create virtual goods using the game’s API.
Second Life was initially launched by Linden Labs in 2003, and by 2013 it had grown to a user base of over one million members. Its in-game currency, known as the Linden Dollar, or more commonly linden, can be used in the transfer of a variety of virtual goods, including avatar clothing, furniture, and household items, houses themselves, and even real estate. The Second Life virtual economy is so successful that at one point its total value surpassed half a billion dollars, accounting for 25% of the value of all virtual goods in any online multiplayer game. The sale of Second Life real estate is such a lucrative industry that it has made some of its virtual real estate agents millionaires, allowing thousands of players to make a living engaging in the sale of content hosted on its servers over the course of the game’s existence.
Though the popularity of Second Life has waned somewhat in recent years, it interestingly retains a connection to bitcoin, as lindens are tradeable through online exchanges for both bitcoin and dollars (as well as other fiat currencies like the euro). In this way it can act as a less-regulated intermediary between the two, allowing people to purchase or sell bitcoin using fiat currency by exchanging it to lindens first. Bitcoin/fiat lindens exchanges like VirWox support several cash out / cash in methods, like PayPal, Skrill, OKMoney and a wide variety of other money transmitter services. Because the exchange rate of lindens per dollar remains relatively consistent and non-inflationary compared to WoW gold (approximately 255 lindens per dollar), it is highly popular for this use, employed by people who perhaps cannot buy or sell bitcoin using traditional cryptocurrency exchanges. VirWox also supports trading of Open Metaverse Currency, a digital currency that is redeemable across a wide array of open world simulation games that share a certain degree of interconnectivity, in a multi-game network known as the metaverse.
Since bitcoin and the idea of the blockchain began to achieve some degree of traction with the mainstream in the last few years, there doesn’t seem to be any turning back to pre-blockchain ideas for the development of digital currencies. Many online game providers are beginning to experiment with using cryptocurrencies in their virtual worlds, and bitcoin seems to be the only decentralized currency to gain any amount of acceptance in the world of online merchants. By being digitized, secure, open source and decentralized, bitcoin’s novel architecture makes it a different type of money than any to come before it. Though it is not without its own limitations, its acceptance by the public far supersedes any of its closest competitors, including other cryptocurrencies. World governments may have a hand in restricting its usage or imposing controls upon it, but for now, bitcoin cannot be stamped out completely, and represents a digital revolution in finance that many ideas before it had only dreamed of achieving.