Mr.Cai

TL; DR#

• This is a beginner-friendly article and a summary of my research on Bitcoin since I started studying it. It addresses the questions that arise when first encountering Bitcoin: Is Bitcoin a currency? Does Bitcoin have value? What supports its value? Why do many people have faith in it? Where does this faith come from? Is it purely belief or based on reality? If based on reality, what is that reality? If you are equally curious about these questions, then keep reading.
• The article explains the origin of currency starting from the inefficiency of barter, analyzing the basic properties of currency, using gold and stone money as examples, and illustrating that scarcity is the hardest property for commodity money to maintain in the long term. This is because, with technological advancement, the difficulty of producing a certain commodity continues to decrease, leading to overproduction of commodity money.
• A universal currency value model is established based on commodity money, which includes four layers: the expression layer, functional layer, attribute layer, and trust layer, where the trust layer is the source of currency value and the shortest board of the barrel.
• Based on the currency value model, substitute currency and fiat currency are created in the form of thought experiments, pointing out the most likely reasons for the collapse of fiat currency value: currency abolition and hyperinflation caused by political instability and economic recession.
• Using Bitcoin as an example, it describes a method to decentralize the core components of a centralized currency system (currency settlement system and currency issuance system), briefly explaining the basic principles of Bitcoin, and introducing why a public-private key system, hash functions, proof of work, and the longest valid chain principle are needed through examples.
• It analyzes possible ways that could cause Bitcoin's value to collapse, stating that the attribute that cryptocurrencies struggle to maintain long-term is not scarcity but anti-counterfeiting, specifically how to prevent others from forging transactions and tampering with transactions. Specific threats include the harm of quantum computers to the public-private key system and the impact of a 51% hash power attack on the consensus mechanism.
• Through the attributes of Bitcoin and real-world examples, it explains why censorship-resistant payments and absolute ownership of assets by individuals are the sources of Bitcoin's value. Losing these attributes would cause Bitcoin to lose its function as a store of value, leading to the conclusion of Bitcoin's value model.
• If interested, you can follow my Twitter: https://twitter.com/onecellinglamp

Currency Value Model#

Most investors believe that Bitcoin is a currency, a super currency superior to the US dollar and gold. So what supports their understanding? To answer this question, I asked myself the following questions during my research:

• How is currency created?
• Why does currency have value?
• What functions should currency have?
• What types of currency are there?
• Why do some countries' currencies collapse, such as the Zimbabwe dollar and the Turkish lira?
• Is there a universal model that can describe the value of different types of currency?
• Is Bitcoin a currency?
• Does Bitcoin have value? What supports its value?

I ultimately found the answer: Bitcoin fits the currency value model quite perfectly and addresses problems that other types of currency cannot solve or that currency issuers do not want you to solve.

Origin of Currency#

In today's society, we can earn currency (money) through work and then use that currency to buy the items we need, such as buying a bottle of cola for three dollars. This process is essentially an exchange of three dollars for a bottle of cola with the seller. But what about in a society where currency has not yet been created? How do we obtain the items we need through exchange?

The answer is barter.

Let's do a thought experiment. In primitive society, there is a farmer named A, who has a bumper harvest of potatoes this year. As winter approaches, he wants to exchange some potatoes with hunter E for a fur to survive the winter. Unfortunately, E hates potatoes and needs an axe to chop wood. A is a clever primitive person; he learns that B wants to exchange tomatoes for potatoes, C wants to exchange a hoe for tomatoes, and D happens to want to exchange an axe for a hoe. So, A first trades with B to get tomatoes, then trades the tomatoes with C to get a hoe, and finally uses the hoe to trade with D for the axe. In the end, he exchanges the axe with E for the coveted fur. The entire process is illustrated in the following diagram.

To obtain the fur, A may have run a long way to find B, C, and D, encountering some dangers along the way. Ultimately, he had to go through four exchanges to get the fur, which profoundly reflects the two words: inefficiency. This inefficiency manifests in three aspects:

1. The needs of both parties must align, otherwise multiple exchanges are necessary.
2. There is no method to measure value. How many potatoes can one tomato be exchanged for? How many axes can be exchanged for a set of furs? There is no recognized standard in the market, and both parties can only haggle, but the haggling process cannot determine the value of the items.
3. Some items are inconvenient to divide. If E wants to exchange a chair for A's potatoes, and both A and E believe a chair is worth 20 potatoes, but A currently only has 10 potatoes, E would not be foolish enough to cut the chair in half and give half to A. A also would not be foolish enough to exchange 10 potatoes for half a chair, as half a chair is just as useless as no chair at all.

Human history is a development history that makes life more efficient through scientific progress, engineering innovation, and institutional optimization. As long as there is demand, someone will eventually come up with a way to turn inefficiency into efficiency.

Analyzing the problem reveals that the primary reason for inefficiency is the misalignment of needs between the two parties—E wants an axe, while A only has potatoes, meaning A does not have what E wants.

What if A has what E wants, and this item is something that everyone in A's area wants, likes, and needs? Then A can not only directly exchange with E but can also exchange anything he wants with everyone in that area.

Assuming this universally desired item is called M. If A does not have M, he can exchange with someone who needs potatoes and has M to obtain M, and then use M to exchange with E for the fur. In this case, A only goes through two exchanges to get the fur; if A initially has M, he can directly exchange M with E for the fur, obtaining it in just one exchange. M acts as a medium of exchange.

With the emergence of this medium of exchange M, the four exchanges are reduced to two or even one. As human needs become more diverse, using M as a medium of exchange will become increasingly efficient.

At this point, M is money.

PS: Since currency appeared before the recorded history, any theory about the origin of currency is hypothetical. Besides the belief that the emergence of currency was to solve the inefficiencies of barter, some also believe that currency was created for the convenience of calculating how much others owe you, i.e., quantifying debt, and that it was created by governments to control economic activities.

Commodity Money#

You need money, and you want money; money is something everyone desires. Money initially consisted of tangible, visible items, hence called commodity money. Throughout history, many items have served as commodity money in different countries and regions, such as stones, trade beads, salt, copper, coral, gold, silver, etc.

Why did these items become money while others did not? In other words, what quality attributes do these items possess that make them money?

Let's try to deduce:

• Money is something everyone wants to possess, so it must be useful to some extent, whether consumed or providing aesthetic value, meaning commodity money should have utility.
• If you take a piece of commodity money to exchange for a fur, and through haggling, it is determined that the fur is worth half a piece of commodity money, but your commodity money is too hard to cut in half, then the transaction may not happen. Therefore, commodity money should have divisibility.
• If you need to find someone on the other side of the mountain, and you carry some commodity money for food and shelter, if the commodity money is very inconvenient to transport and carry (like using giant stones as money), that won't work either. Therefore, commodity money should be portable.
• When you use commodity money to exchange for someone else's items, others must be able to verify whether the money you gave is counterfeit. Therefore, commodity money should also have resistance to counterfeiting.
• Assuming gold is used as commodity money, then as long as it is the same weight of gold, whether in the form of bars, bracelets, or necklaces, they should all have the same value. Therefore, commodity money should have fungibility.
• Additionally, if a certain commodity money cannot be preserved long-term, is prone to rot, rust, or break, and the money earned this year rots next year, no one would want to use such a commodity, so commodity money should have durability.
• Finally, if mud cakes are used as commodity money, and today a chicken is worth one mud cake, tomorrow it might be worth one hundred mud cakes because the supply of mud is infinite, and everyone can produce mud cakes, the circulating mud cakes will increase, leading to the continuous devaluation of mud cakes relative to chickens. Eventually, no one would want to use mud cakes as commodity money, so commodity money should have scarcity.

These are the seven essential attributes that commodity money should possess: utility, divisibility, portability, resistance to counterfeiting, fungibility, durability, and scarcity.

Gold#

Now let's take gold as an example to illustrate the importance of these attributes to currency value.

Gold is very durable; there is a saying that "real gold is not afraid of fire." It does not rot or rust and can shine brightly even after being buried for a thousand years. Gold is very scarce, formed during supernova explosions. Supernova explosions generate immense energy, causing iron atomic nuclei to undergo nuclear fusion, forming gold. Therefore, gold is not only scarce on Earth but also a product from the early formation of the Earth, a gift from the solar formation stage. Approximately 3,000 tons of gold are newly produced each year, with an issuance rate of about 1.5%.

• source：616c92ea37a2ff12923190c8_NYDIG-Power-of-Bitcoins-Network-Effect.pdf

Gold has good resistance to counterfeiting; counterfeit gold can be identified through color, weight, and hardness identification. Real gold has a variety of colors and densities, so ancient people often judged the authenticity of gold by biting it; if bite marks are left, it indicates that it is real. Gold is also homogeneous; for example, as long as it is 10g of pure gold, regardless of whether it exists in the form of coins, bars, or ingots, they all have the same value. Gold also has strong utility, as it can be used for decoration and industry, such as making gold jewelry and smartphones.

However, gold's high value makes its divisibility worse; even a small piece of gold is very valuable, which is not conducive to small transactions. To compensate for this flaw, people used silver, which has better divisibility, as a medium for daily transactions, forming a bimetallic system. Gold is also inconvenient to carry, so in ancient times, there were often specialized security agencies—guard companies responsible for transporting gold.

Scarcity is the Hardest Attribute to Maintain Long-Term#

For currency, scarcity does not simply refer to being scarce; it refers to scarcity in the absence of significant shortcomings in the other six attributes. Once a commodity possesses the attributes of divisibility, portability, durability, homogeneity, resistance to counterfeiting, and utility, it will long maintain these attributes, as these are inherent properties of the commodity. However, scarcity is different; it is influenced by many external factors and is difficult to maintain long-term. If we compare the seven attributes of currency to the wooden planks that make up a barrel, scarcity is the shortest and most easily broken plank.

Salt was once used as currency (salt money) in Yunnan, China. Salt is a necessity in daily life, everyone has demand for it, it has good divisibility, is easy to counterfeit, and is homogeneous. However, salt is prone to moisture and is not durable. Most importantly, Yunnan has many mountainous areas, and the production of salt is low, making it a scarce commodity, thus qualifying salt as currency. Later, as society developed and transportation became more convenient, the supply of salt in Yunnan gradually became sufficient, and salt was no longer scarce, losing its qualification as currency.

Although gold has poor divisibility and is inconvenient to transport, it has always been scarce. From the above example, we can preliminarily see that to become currency, as long as scarcity can be guaranteed, other attributes can be somewhat inferior, as there will always be other ways to compensate for these flaws. For example, to address the shortcomings of gold as commodity money, silver with better divisibility was initially used as a supplement, and later representative money (Representative money) was further used to solve the problem—paper money issued by financial institutions pegged to gold, such as the US dollar before the collapse of the Bretton Woods system.

Thus, scarcity determines the value of commodity money. Value is reflected in the purchasing power of the currency you earn through work, which will not lose much over time and may even appreciate.

Currency That Failed Due to Loss of Scarcity: Rai Stone#

Scarcity determines the value of currency, but does today's scarcity guarantee tomorrow's scarcity? How is the scarcity of commodity money maintained? Munger once said to think in reverse; if you know where you will die, don't go there. This thought model can also be applied here: Instead of thinking about how to maintain the scarcity of commodity money, think about how to lose that scarcity.

There is a small island in the South Pacific called Yap, where the natives use large stones as currency. These stone coins are called "Rai Stone," shaped like disks with a hole in the middle, resembling ancient Chinese copper coins. The diameter of the stone coins ranges from a few inches to over ten feet (a few centimeters to several meters), with most having a diameter of over half a meter and weighing hundreds of pounds, with the largest weighing thousands of pounds.

• Image source: Rai of Yap - the stone money | Wondermondo

Becoming currency due to scarcity. The stone coins are made of limestone, which is scarce around Yap Island. To obtain this stone, islanders had to sail 250 miles (402 km) to a small island called Palau to mine it and transport it back using small wooden boats, which resulted in some casualties during transport. The stones mined in this way were extremely costly and very scarce. Additionally, Rai Stones shine in the sunlight and can be preserved for a long time, demonstrating good durability.

However, stone coins are heavy, making it inconvenient to exchange them for other goods. At this point, stone coins seem unsuitable for the function of a medium of exchange. But since Yap Island is small and has a low population, when islander A purchases goods from islander B, he does not physically carry the stone coins; instead, he announces to the entire island community that he is transferring the Rai Stone to B in exchange for goods, thus determining the ownership of the stone through word of mouth. Therefore, stone coins have the function of a medium of exchange.

Collapsing due to technology. In the 1800s, an Irishman named David O’Keefe arrived on the island. He understood the currency system on Yap Island and used more advanced navigation technology to easily transport stones from Palau to Yap Island, effectively becoming the central bank of the island, gaining the power to issue currency, and becoming the richest person on the island. The islanders worked for him, and he used cheap stone coins to buy more valuable goods from them.

David increased the supply of currency on the island, making it no longer scarce. Over time, inflation occurred, and the purchasing power of the stone coins in the hands of the islanders decreased, leading to the collapse of the currency system based on stone coins, a degradation initiated by advanced technology.

Technological advancement is the greatest enemy of currency scarcity because advanced technology can create more goods that can serve as currency in a short time. Whether it is salt money or stone money, both lose their scarcity due to technological advancement, thus losing their qualification to serve as currency.

To mitigate the devaluation of stone coins, islanders took some measures to artificially create scarcity. They stipulated that older stones and those that resulted in more casualties during transport would be more valuable. This is because older stones were mined by islanders manually decades or even centuries ago, and they would look somewhat different from stones mined by machines. However, this regulation would reduce the circulation of stone coins in the market, causing deflation and affecting the homogeneity attribute of the stones.

Gold can serve as currency long-term because current technology cannot mine more gold, ensuring that the supply of gold increases very little and does not lose its scarcity. Gold is a gift from the formation of the sun, and its reserves are limited. When mining technology is backward, people can only obtain gold that is easier to mine. When mining technology progresses, since the easily mined areas of gold have been depleted, people can only mine gold in more difficult areas. This creates a natural difficulty mediation mechanism for mining.

Additionally, although gold can be synthesized through nuclear fusion and particle collisions, the cost is much higher than direct mining. Therefore, at the current level of technology and for the foreseeable future, humanity cannot synthesize gold at a reasonable cost, so gold will continue to maintain its scarcity.

How to Quantify Scarcity#

Gold and silver are scarce, and rare metals like iridium, bismuth, rhodium, and gallium are also scarce. How can we quantify and compare their respective scarcities?

First, for currency, it must be scarce but not too scarce. For example, the newly added production of the metal gallium in 2020 was 300 tons, but it was consumed in the industrial sector, such as for making gallium nitride for semiconductors. The supply is low, but the consumption is high, resulting in no surplus inventory available for circulation as currency in the market.

Although gold's annual new production is only about 3,000 tons, it is not consumed much in the industrial sector, so there is a large amount of gold stored in various places, such as bank vaults, home decorations, and personal jewelry. This gold retained in the market can fulfill the role of currency as a medium of exchange.

From the examples of gallium and gold, we can identify two key parameters: newly added quantity and inventory quantity. Whether a certain commodity can serve as currency can be represented by the ratio of inventory quantity to newly added quantity, known as the stock-to-flow ratio. The higher the stock-to-flow ratio, the lower the proportion of newly added quantity to total inventory, indicating that the commodity is scarce.

Gold's annual new production accounts for 1.5% of its inventory, so the stock-to-flow ratio is 100/1.5=67. Bitcoin's current ratio is 56, and it will increase to over 100 by 2025, making it scarcer than gold.

Image source: Daily Stock-to-Flow charts – Daily updated charts of Bitcoin's stock-to-flow vs price

Establishing a Currency Value Model#

Certain commodities have served as currency in history because they possess the seven attributes, although the excellence of these attributes may vary. A certain commodity may have better attributes than another commodity, such as salt having better divisibility than gold. However, these commodities share a common point: at a specific time and in a specific area, they are scarce.

Only after possessing the seven attributes can they fulfill the three essential functions of currency:

1. Medium of exchange: Solving the problems of barter, improving transaction efficiency, and reducing transaction costs.
2. Store of value: Ensuring the purchasing power of currency in the future, primarily influenced by the scarcity of the commodity.
3. Unit of account: A unit and standard for measuring value. With it, different goods and services can be priced in the same unit. For example, if you sell bok choy, you say it costs 6 per pound, and the buyer says they can only offer 5 per pound. If you don't specify what 6 and 5 refer to, you cannot negotiate and reach an agreement on the price. If you say 6 dimes per pound and they say 5 dimes per pound, you can then determine whether the deal can be made.

Goods that possess these three functions become currency, and once they become currency, they possess the characteristics of currency.

Whether a commodity can maintain the seven attributes long-term is the key to whether people are willing to use that commodity as currency. In other words, people are willing to use a certain commodity as currency because they believe it can maintain its excellent attributes, especially scarcity, in the future. For example, people trust gold, and this trust comes from the fact that gold possesses other attributes of currency, with scarcity manifested as a limited total amount, impossible to mine in large quantities, and unable to be artificially synthesized at a reasonable cost, resulting in a high stock-to-flow ratio.

As for what this commodity is, it is not important; as long as it has several outstanding attributes among the seven (scarcity must be one), and can maintain these attributes long-term, it meets the conditions to become currency.

By abstracting the above content, we can establish a value model for commodity money, which consists of four layers:

1. Expression layer: The specific form in which commodity money is expressed, such as gold, silver, stone money, or salt money.
2. Functional layer: The functions that commodity money should possess—medium of exchange, store of value, unit of account.
3. Attribute layer: The reason commodity money possesses these functions is due to these attributes—scarcity, divisibility, portability, durability, homogeneity, resistance to counterfeiting, and utility.
4. Trust layer: The source of people's belief that this commodity can maintain the seven attributes long-term, especially scarcity.

Among these, the trust layer is the source of value for a certain commodity to ultimately become currency, the foundation of a tall building. The scores of various attributes in the attribute layer determine the basis for one commodity money to be superior to another. The better the attributes, the better they can fulfill the functions of currency.

Taking gold as an example, its greatest difference from other currencies lies in its scarcity. The reason it can maintain scarcity long-term is that current technology cannot mine gold in large quantities and cannot synthesize gold at low costs. In other words, the belief in gold comes from the belief in science. If humanity masters more advanced mining technology, lower-cost synthesis technology, or the ability to travel between stars to bring back gold from other planets, then the value of gold would plummet like the stone coins on Yap Island, as it would no longer be scarce.

References#

• Barter - Wikipedia
• What is Money, Anyway?
• Money - Wikipedia
• Fungibility - Wikipedia
• History of money - Wikipedia
• Rai of Yap - the stone money | Wondermondo
• David O’Keefe: The King of Hard Currency | History| Smithsonian Magazine
• Trade beads - Wikipedia
• How difficult is it to synthesize gold? Why has no one synthesized gold?
• The strongest explosion in the universe—supernova explosion - Zhihu
• What are the uses of gold? You will know after reading!
• Representative money - Wikipedia
• Substitute currency - MBA 智库百科
• Bretton Woods System - Wikipedia, the free encyclopedia
• Gallium, a metal rarer than rare earths, accounts for 96% of global production in China. Why haven't we raised prices?
• Daily Stock-to-Flow charts – Daily updated charts of Bitcoin's stock-to-flow vs price
• Unit of account - Wikipedia

Creating Currency#

Creating Substitute Currency#

The currency used in current life, whether it is the US dollar, euro, yen, or renminbi, is vastly different from gold as commodity money. They solve the problems of gold as currency: inconvenience in transportation and poor divisibility.

Since we have established the currency value model, we will create a new currency based on this model to solve the problems of gold as currency—namely, inconvenience in transportation and poor divisibility.

Additionally, let's consider a thought experiment. Suppose we live in a country called Cai, where people use gold as currency, but gold has poor divisibility and is inconvenient to transport, making it somewhat lacking as a medium of exchange. Therefore, I establish a pawnshop widely distributed across the country. You only need to pledge gold to me, and I will issue equivalent paper notes to you.

Since people can redeem equivalent gold from my pawnshop at any time and place with the notes in hand, the pawnshop accumulates deep trust in people's minds and has a significant influence in society. Thus, people default to viewing the notes issued by the pawnshop as equivalent to gold.

The face value of the notes can be any amount, and the notes themselves are easier to carry and transport than heavy gold. I have solved the problem of gold's poor divisibility. Consequently, people begin to use the notes to purchase goods and services, such as buying food, houses, paying salaries, etc. They also start to store their gold in the form of my issued notes because they believe these notes can be redeemed for gold.

Through this method, the notes fulfill the functions of a medium of exchange, store of value, and unit of account, thus forming a new type of currency. The value of this currency is backed by gold, representing the underlying currency of gold, so it is also called substitute currency (Representative Money).

The reason people are willing to accept substitute currency is that they believe it possesses purchasing power and trust that they can redeem it for an equivalent amount of gold from the issuer. In other words, the value of substitute currency depends on the credibility of the issuing currency party.

Is the issuing party of substitute currency credible? Will they issue notes worth 2 kg of gold when users collectively pledge 1 kg of gold, quietly spending the extra 1 kg, diluting others' purchasing power through over-issuance? Or will the issuer misappropriate the gold in the vault?

Thus, trust in substitute currency encompasses two levels:

1. Trust in the purchasing power of gold itself.
2. Trust that one can redeem an equivalent amount of gold from the pawnshop, and that the pawnshop will not over-issue substitute currency or misappropriate gold.

Substitute currency has been widely used in history, such as gold certificates in the United States and silver notes in China.

Creating Fiat Currency#

We continue this thought experiment.

Due to my great business achievement, which significantly improved the transaction efficiency of goods and services in society, I became the most suitable candidate to manage the country and transitioned from business to politics, becoming the president of Cai.

However, I now face a significant problem. Before becoming president, Cai had just undergone a continuous six-year war with other countries, and almost all the gold in the pawnshop was used by the previous government to purchase weapons and ammunition. Now that the war is over, people are demanding to redeem their gold, and the pawnshop faces a massive run on the bank.

I thought of a solution: relying on the power of the government, I would invent a new currency to completely replace gold.

I despise substitute currency being tied to gold; I want the currency to break free from gold. While currency must possess the three basic functions of a medium of exchange, store of value, and unit of account, the most fundamental function is as a medium of exchange, which is the original intention of humanity in inventing currency.

The first thing I do is issue a new paper note, a new currency that is not tied to gold. I know that people will not spontaneously use the new currency because the paper itself has no value, even if it is printed with colorful patterns.

So, the second thing I do is create demand for the new currency. Since I have military and political power, with access to the army, police, and tax personnel, I require all companies to pay salaries and bonuses in the new currency. The tax department only accepts the new currency, and using old currency for tax payments is not recognized, with penalties for non-compliance. Through these methods, I successfully created the initial demand for the new currency.

For the convenience of transactions, people will gradually use the new currency in their daily lives. They begin to use the new currency to purchase goods and services and must keep the new currency on hand, thus creating a sustained demand for the new currency.

Additionally, to enhance people's confidence in the new currency, I establish good social rules, vigorously develop education, strive to improve the economy, raise people's living standards, and avoid arbitrary over-issuance of currency to prevent devaluation, further strengthening society's demand for the new currency.

At this point, the new currency begins to circulate widely in society, and I issue a decree no longer recognizing gold as legal tender, removing gold's function as a medium of exchange and leaving it with only the function of storing value.

Although the initial demand for the new currency was not spontaneous, once the demand was established, it would create a network effect. If you do not use the new currency, you cannot buy the goods and services you want. Ultimately, the more people use the new currency, the more indispensable it becomes.

The initial demand for this currency was created through a decree, and the cost of producing this currency is far lower than its face value. To demonstrate the difference between this currency and commodity money, it is referred to as fiat currency. This is the currency we use in our daily lives, such as the US dollar, pound, and renminbi. Most people's understanding of currency is likely fiat currency, but it was only after the failure of the Bretton Woods system that fiat currency began to become the sole form of currency, a status that has lasted for just over 50 years.

The Source of Value of Fiat Currency and Its Collapse#

According to the currency value model, the value of gold as a commodity comes from people's belief that it can maintain its excellent attributes, especially scarcity—based on current technology, gold cannot be mined in large quantities or synthesized at reasonable costs. Similarly, the value of fiat currency also stems from trust.

What specifically do we trust? Trust includes two points:

1. Belief that the government will not collapse.
2. Belief that the government will not issue excessive fiat currency, leading to a drastic drop in purchasing power. When purchasing power plummets, you will have no motivation to continue holding this currency, thus losing the demand to use it.

The first point is easy to understand; the original demand for fiat currency is created through coercion. If there is a change in power, the currency of the previous regime will naturally be abolished, as the new rulers will implement their own fiat currency.

To explain the second point, I will again use the fictional country Cai as an example explanation.

Although I hold the political power of Cai, an external ethnic group named W controls the economic lifeline of the country. I am very dissatisfied with this and have been looking for opportunities to drive them away.

Later, I initiated land reforms, sending troops to confiscate the farms of the W people, abolishing the constitutional provisions that granted fixed seats to the W people, and stripping them of political power.

As a result, the farmers lost their motivation to produce, fled, or withdrew their investments. Other countries condemned and sanctioned us. Although I regained the land, I lacked funds, production materials, technology, and capacity, leading to a significant decline in agricultural output and skyrocketing prices, resulting in hyperinflation. Price increases spread from agriculture to other industries, causing a decline in the production of various goods and services, ultimately leading to a significant rise in prices across society.

To enable people to afford daily necessities, I had to raise workers' wages by printing money, but this method did not genuinely create value; instead, it further pushed up prices, resulting in hyperinflation.

Yesterday, a chicken was worth 20 yuan; today it is worth 200 yuan, and tomorrow it might be worth 1,000 yuan. The extreme fluctuations in prices cause the value of Cai's fiat currency to fluctuate wildly and unpredictably. People would not want to use such currency, leading to a loss of demand and its collapse.

The above example illustrates that fiat currency collapses due to excessive over-issuance leading to hyperinflation, and hyperinflation is likely caused by political and economic turmoil. The currency value model is illustrated in the diagram below.

References#

• Network effect - Wikipedia
• Meituan fined 3.4 billion! Alibaba fined 18.2 billion! How did the Internet monopoly giants come into being? - YouTube
• Bilateral market - MBA 智库百科
• Hyperinflation - Wikipedia, the free encyclopedia
• Land reform, famine, hyperinflation, and how Zimbabwe gradually moved towards a coup - Hong Kong Stock Channel - Financial 界

Bitcoin#

Flaws of the Fiat Currency System#

The value of both substitute currency and fiat currency stems from trust. Substitute currency requires trust in the currency issuer; if one cannot redeem the pledged precious metal, such as gold, from the issuer, then the substitute currency will lose its value. Fiat currency requires trust in the government that issues the currency; if there is a change in power or political and economic collapse, then fiat currency will also lose its value.

Commodity money, led by gold, requires trust that gold's attributes can be maintained long-term, which is determined by natural laws and the development of human science and technology. This trust is far stronger than trust in any institution or regime. However, gold itself has poor divisibility and is inconvenient to transport, making it less than perfect as a medium of exchange.

While substitute currency and fiat currency solve some problems of commodity money to a certain extent, they also bring new issues.

First: Currency is prone to over-issuance, causing inflation. Since the issuance of currency is the responsibility of a single institution, at certain times, such as during wartime, when the government cannot efficiently obtain resources directly through taxation, it has sufficient motivation to issue currency directly, indirectly collecting seigniorage from the people. For example, during an economic crisis, the government issues currency to acquire near-bankrupt large companies, causing the currency in people's hands to devalue. Both the United States and the United Kingdom have done this.

Second: It cannot resist censorship and may even actively serve censorship. The currency issuer can freeze and confiscate your property, restricting your ability to use the currency for transfers and transactions. In simple terms, it seems that your money is yours, but ultimately, the money belongs to them because you do not truly control your money. You might think that as long as you do not engage in illegal activities, you will be fine, but it is not that simple. The United States has frozen Russian assets; is that reasonable? The Russian government has frozen the accounts of democratic activists; is that reasonable? There are countless examples; essentially, this currency system cannot guarantee the basic right to private property from infringement.

Both of these issues stem from the centralization of the currency system. The currency system includes the currency settlement system and currency issuance. If controlled by a few institutions, and the power of these institutions is unchecked, then unchecked power is the root of evil.

The Path to Decentralization#

Can the currency system be decentralized? Yes.

The currency system of gold is decentralized. The mining of gold can be seen as the issuance of currency; everyone could mine gold, and it was not monopolized by any institution, so the issuance of gold is decentralized. People could directly use gold to pay wages and purchase goods without restrictions from other institutions, so the payment system of gold is also decentralized.

However, the gold currency system has the same flaws as fiat currency. Gold is a tangible, shiny object; although you can store gold yourself, it is not secure and can still be confiscated. If you want to carry a large amount of gold while traveling, such as going abroad, customs may seize it.

Can a currency system be designed that is both decentralized and secure? Yes, we will now design a system starting from Bitcoin.

The currency system consists of two parts: the currency settlement system and the currency issuance system.

The currency settlement system is used to record your transaction history. For example, if today Zhang San buys half a watermelon from Li Si for 40 yuan, a record will be made in the ledger stating "Zhang San transfers 40 yuan to Li Si." Tomorrow, if Li Si asks Wang Wu to clean his house for 50 yuan, another record will be made stating "Li Si transfers 50 yuan to Wang Wu."

The currency issuance system is used to record when new currency is issued, which increases the overall money supply in society. For example, the Federal Reserve can issue dollars and then lend them to the US government, which uses the borrowed dollars to inject into society, thus increasing the overall money supply.

In the fiat currency system, both the settlement and issuance of currency are determined by a few institutions, and power is centralized, which is often referred to as centralization. What we need to do now is design a system that allows anyone to participate in currency settlement and issuance, decentralizing the originally centralized power.

Decentralization of the Currency Settlement System#

Public Ledger#

"When everyone is watching, it is hard to lie." — Ian Grigg

To establish a decentralized currency settlement system where everyone is qualified to settle currency, the first step is to create a public ledger, so that everyone can record transaction information in the ledger.

However, using a public ledger where everyone has the right to record transactions presents the following problems:

1. How to prevent others from forging transactions? Anyone can record transactions in the ledger; how do we prevent Zhang San from recording a transaction that did not actually occur: "Li Si transfers 100 yuan to Zhang San"?
2. How to prevent someone from initiating a transfer without enough money? How do we prevent Zhang San from writing "Zhang San transfers 100 yuan to Wang Wu" when he does not have 100 yuan?
3. How to prevent existing transaction records in the ledger from being tampered with? For example, if there was a previous transaction stating "Zhang San transfers 100 yuan to Wang Wu," and later Zhang San alters it to "Zhang San transfers 200 yuan to Wang Wu."

Next, we will address these problems one by one.

Problem 1: How to Prevent Others from Forging Transactions?#

We often sign contracts to prove our acknowledgment of the contract's content, such as a rental agreement. Is it feasible to sign each transaction to prove that it was indeed initiated by us? It is feasible, but not entirely sufficient.

In the digital realm, signatures are electronic. For example, if Li Si initiates a transaction and leaves his electronic signature, since the ledger is public, anyone can copy this electronic signature. If someone uses a copied signature of Li Si to initiate a transaction without his knowledge, this still constitutes transaction forgery.

How can we solve this problem?

We can make the signature non-reproducible and ensure that the signature changes with the transaction content.

First, the user randomly generates a string of 256 bits consisting of 0s and 1s as a private key (secret key, sk), and then the private key generates a public key (public key, pk) through elliptic curve multiplication.

When initiating a transfer, the user needs to sign the transaction using the private key. This requires a signing function $Sign(Message, sk) = \text{Signature}$. Since only the user knows the private key, only they can sign their transaction, and others cannot forge the signature, thus preventing transaction forgery.

In the signing function, $Message$ represents the transaction content, such as "Zhang San transfers 100 yuan to Li Si," and $sk$ represents the private key. The output of the signing function $\text{Signature}$ is also a 256-bit binary number.

In addition to needing a signing function to generate the digital signature, a verification function $Verify = (Message, Signature, pk) = T/F$ is also needed to verify whether the digital signature belongs to the private key owner. During verification, the transaction content, signature, and public key (pk) are input into the verification function. If the signature belongs to the private key owner, the output of the verification function is T (True), indicating successful verification; otherwise, it outputs F (False), indicating verification failure. Note that the public key is public knowledge, and everyone knows it.

It is important to note that the private key can generate the public key, but the private key cannot be derived from the public key.

How secure is such a signature? Can others guess the signature? It is nearly impossible.

Since the signature is a 256-bit binary number, there are $2^{256}$ possible outcomes, which can be expressed as a number in base 10, approximately $10^{77}$, while the total number of atoms in the universe is about $10^{80}$. This is a super astronomical number; if the private key is unknown, there is no possibility of guessing the signature with current technology. To understand how large $2^{256}$ is more intuitively, you can refer to this video.

Does having a digital signature suffice to prevent transaction forgery? Not yet.

If Li Si transferred 100 yuan to Zhang San and personally signed it, Zhang San could copy this transaction and its corresponding signature, thus forging a transaction again. The solution is simple: add a unique ID to each transaction to prevent someone from directly copying transaction information.

Ultimately, the public ledger obtained through the above methods is illustrated in the following diagram:

In summary, digital signature technology solves the problem of others forging transactions on the public ledger.

Problem 2: How to Prevent Someone from Initiating a Transfer Without Enough Money?#

Now that we have a public ledger that records everyone's transaction history, how can we ensure that users do not initiate transfers when they do not have enough money?

We can verify how much money a user has. For example, if a mysterious person X initially transferred 100 yuan to Zhang San, Li Si, Wang Wu, and Song Liu, and then Zhang San transferred 60 yuan and 40 yuan to Li Si and Wang Wu respectively, Zhang San would have no money left. If he attempts to transfer 20 yuan to Song Liu, everyone can check the transaction records and see that he does not have enough money, thus deeming the transaction illegal.

Therefore, in a decentralized currency system using a public ledger as the settlement system, the amount of money a person has essentially equals the transaction records in the ledger.

However, this method of calculating balances has a problem. The public ledger only records transactions and does not directly record balances. Balances need to be indirectly obtained by calculating transaction records. When the ledger records an enormous number of transactions, if every time we need to calculate how much money each person has from scratch, it would mean recalculating all transaction records, which is very resource-intensive and time-consuming, slowing down transaction confirmations and affecting the currency's function as a medium of exchange.

To solve this problem, when transferring money to others, the user can also transfer any remaining money back to themselves. For example, if Zhang San has 100 yuan and transfers 60 yuan to Li Si, he can then transfer 40 yuan back to himself. This 40 yuan is essentially the change, which is also called Unspent Transaction Output (UTXO). This method can significantly reduce the time and resources needed to calculate balances.

Now let's illustrate how using the UTXO method is much more efficient than calculating balances by going through all transaction records from start to finish.

Assuming that the mysterious person X initially transferred 100 yuan to Zhang San, Li Si, and Wang Wu, and the following transactions occurred:

• Zhang San transfers 10 yuan to Li Si.
• Li Si transfers 20 yuan to Zhang San.
• Li Si transfers 10 yuan to Wang Wu.
• Zhang San transfers 30 yuan to Wang Wu.
• Zhang San transfers 40 yuan to Li Si.

If we do not use the UTXO method to calculate balances, the above transactions would look like this:

The number of calculations needed to determine the balances of Zhang San, Li Si, and Wang Wu is as follows:

• Zhang San
  • Zhang San's balance: 100 - 10 + 20 - 30 - 40 = 40
  • Calculation times: 4 times
• Li Si
  • Li Si's balance: 100 + 10 - 20 - 10 + 40 = 120
  • Calculation times: 4 times
• Wang Wu
  • Wang Wu's balance: 100 + 10 + 30 = 140
  • Calculation times: 2 times

If we use UTXO, the above transactions would look like this:

The number of calculations needed to determine the balances of Zhang San, Li Si, and Wang Wu is as follows:

• Zhang San
  • Zhang San's balance: 40
  • Calculation method: Directly read from transaction 8 (UTXO)
  • Calculation times: 0 times
• Li Si
  • Li Si's balance: 80 + 40 = 120
  • Calculation method: Use the most recent UTXO value for Li Si (80) and add the amounts transferred to Li Si by others (40).
  • Calculation times: 1 time
• Wang Wu
  • Wang Wu's balance: 100 + 10 + 30 = 140
  • Calculation method: Since Wang Wu has not transferred money to others and has no UTXO, he needs to calculate from start to finish.
  • Calculation times: 2 times

The comparison shows that the UTXO method is more efficient, especially when there are many transfer transactions, the advantages become even more pronounced. The UTXO acts like a periodic summary; every time you make a transfer to someone, you record your balance, and all previous transactions do not need to be involved in subsequent calculations.

Thus, the balance calculation method is: balance = most recent UTXO itself $\pm$ the amount transferred to oneself after this UTXO.

Problem 3: How to Prevent Others from Tampering with the Ledger?#

Proof of Work: Consensus Mechanism

For a public ledger, we first solve the problem of others forging transactions through digital signature technology, then address the issue of others initiating transfers without sufficient funds through transaction record tracing and the UTXO method. However, there are still two problems remaining:

• Who maintains the public ledger?
• How to prevent the ledger managers from tampering with transaction records?

Since the ledger is public, it cannot be maintained by a few individuals or institutions; otherwise, what if they collude to tamper with transaction records? Since transaction records determine how much money you have, tampering with transaction records is equivalent to stealing your assets.

Therefore, this public ledger should be owned by everyone, and anyone who wants to participate in bookkeeping can have a copy, with the content of the ledger maintained collectively by everyone.

If Zhang San initiates a transaction stating "Zhang San transfers 10 yuan to Li Si," the content of this transaction will be sent to all individuals responsible for bookkeeping in the network, and they will record the transaction in their respective ledgers.

However, this method of bookkeeping still requires solving the problem of how to ensure that the contents of the ledgers in Zhang San, Li Si, Wang Wu, and Zhao Liu's hands remain consistent. Each person has a ledger, and if the contents of the ledgers are inconsistent, it will be impossible to determine how much money a person has based on the ledger. For example, in Zhang San's ledger, you may have 80 yuan, but in Li Si's ledger, you might have 100 yuan, because someone transferred 20 yuan to you, and this transaction is only recorded in Li Si's ledger and not in Zhang San's ledger.

In addition, if multiple transactions are received simultaneously, how to decide which transactions to accept and which to reject? How to ensure that the order of transactions recorded by others is the same?

These issues all point to the same thing: how to reach consensus on the contents of the ledgers in everyone's hands? That is, what is the consensus mechanism?

Since it is difficult to control how each person chooses which transactions to accept and the order in which to record transactions, we can select one person at a time to record certain transactions, for example, Zhang San, and then Zhang San will send the transactions he recorded to others, who only need to record the transactions that Zhang San has already recorded.

But how do we choose that person who is qualified to record transactions?

Choosing someone to do something is something we often encounter in daily life. For example, we often vote to elect class representatives, with the person receiving the most votes winning, or we vote to decide what to have for dinner, where to travel, or even who becomes a government official.

But I want to discuss another selection method: selection. The education system selects students through examinations, where students earn scores by answering questions, and the scores determine who is qualified to attend prestigious high schools, undergraduate programs, and graduate schools, with the highest scorer being called the top student.

Inspired by this and with slight modifications, we can design a system where the system presents a question each time, and all those who want to participate in bookkeeping must solve it. Whoever solves it the fastest qualifies to record transactions in the public ledger.

What characteristics should the question possess?

We can think in reverse: what would a bad selection exam look like? For example, if the questions are not fair and do not consider the students' knowledge backgrounds, that would be unfair. Similarly, the questions used to select who records transactions must also be fair. The following content will explain how to ensure the questions are fair.

Since this is a selection exam, the questions should not be too easy; otherwise, the purpose of selection cannot be achieved. Similarly, the questions used to select who records transactions should not be too easy to answer.

Since this is a selection exam, once the students answer the questions, the grading teacher must have a standard answer; otherwise, how can they judge the correctness of the results? Why give the grading teacher a standard answer instead of having them solve the questions again while grading? To improve grading efficiency. Similarly, among those willing to record transactions, if someone quickly finds the answer, others must easily verify whether the answer is correct.

Thus, the questions should meet the following three criteria:

1. Fairness
2. Difficulty in finding the answer
3. Ease of verifying the answer

What kind of question meets these criteria?

Hash Function

Fortunately, there is a type of function that meets the requirements—hash functions. A hash function (H) has some interesting properties:

1. Any information or file ($x$) can be used as input to the function, and given the input, the output can be easily calculated.
2. A slight change in the input will lead to a dramatic change in the output.
3. Resistance to hash collisions: The probability of obtaining the same output from different inputs is almost zero. That is, if $x \neq y$, then $H(x) \neq H(y)$.
4. One-wayness: Given input $x$, the output $H(x)$ can be calculated, but given output $H(x)$, it is impossible to directly derive $x$. That is, $x \rightarrow H(x)$, but $H(x) \nrightarrow x$.

You can verify the second property of hash functions with a simple example. Using the SHA256 hash function, the input Money's model produces the output:

When the input is slightly changed to Noney's model, the output changes dramatically:

With just one letter changed (M→N), the output undergoes a dramatic transformation.

The one-wayness and resistance to hash collisions of hash functions mean that if the output of the function is known, the only way to find the possible input is through brute-force calculation of every possible input.

Using the SHA256 function as an example, its output is a string of 256 bits consisting of 0s and 1s. Since each position has two possibilities (0 and 1), the output has $2^{256}$ possible outcomes, which is an astronomical number, and literally an astronomical number, as the total number of atoms in the universe is about $10^{80}$, while $2^{256} \approx 10^{77}$. Thus, given the output, there is no other way to find the possible input except through brute-force calculation.

With this powerful tool of hash functions, we can design specific questions for selecting recorders. Let’s define the question as follows:

Please find a string of numbers, place it after a transaction record, and then use this string of numbers and the transaction record as input to the SHA256 function, ensuring that the output result has the first n digits as 0. Whoever finds this string of numbers first will be selected as the person to record transactions.

Now, let's review why hash functions are suitable as questions for selecting recorders:

1. The solution can only be found through brute-force calculation, indicating that the question is very fair, as calculating the output of a hash function has no barriers; you do not need specialized equipment and can even use a webpage (SHA256 online calculator).
2. The question is difficult, as you may need to try many times to find a number that makes the output have the first n digits as 0.
3. Also, because calculating the output of a hash function has no barriers, it is easy to verify the correctness of the answer. This perfectly meets the three criteria for the question.

However, there are some points to note:

The question is not set to find a string of numbers that makes the output equal to a specific value, but rather that the output has the first n digits as 0. This is because, based on the one-wayness of hash functions, it is impossible to find such a string.

Candidates will select some valid transactions from all the transactions they receive and package them into a list, which is called a block. The criteria for judging whether a transaction is valid are to check whether the transaction's signature is correct and whether the person initiating the transaction has enough money, both of which have been emphasized earlier.

The questions are constantly changing because transactions can be initiated at any time, and transactions can vary greatly based on the initiator, transfer amount, and initiation time. Since transactions are an important part of the input to the hash function, the questions are also constantly changing.

Since this method of selecting recorders requires candidates to expend a large amount of computational power, finding that string of numbers proves that they have done enough work, so this string is also referred to as proof of work (Proof of Work, PoW).

Blockchain

If Zhang San is fortunate enough to become the qualified person to record transactions, he will send the previously packaged transaction list to other participants in the network. They will verify whether the transactions in the list are valid and whether the previously mentioned string of numbers is correct. If the verification passes, the others will connect this list to the ledger they have. Since the transaction list is called a block, and blocks are linked together to form a ledger, this ledger is vividly referred to as a blockchain.

So how are blocks connected to each other?

Chains are linked together, and links are established between links; for paper ledgers, the pages are glued together, establishing a visible and tangible connection. You, as a child, carry the DNA of your parents, and your children also carry your DNA, establishing a connection between you and your parents and children. This connection is invisible and intangible but actually exists.

The connection between blocks is similar; the header of each block contains the hash value of the previous block, which is calculated by using the previous block as input to the hash function. Thus, each block contains information about the previous block, just as children and parents share common information (DNA).

Blockchain Forks

Those responsible for recording transactions are usually referred to as nodes. All nodes form a network, which is the blockchain network. When a node obtains the right to record transactions, it will send the packaged transaction to nearby nodes. If two nodes (A and B) simultaneously find the answer to the question, that is, the string of numbers, they both obtain the right to record transactions. Due to network transmission limitations, some nodes may receive block $N_A$ from A, while others may receive block $N_B$ from B. This leads to the existence of two different ledgers in the blockchain network, a phenomenon known as a blockchain fork. Forks essentially indicate that the contents recorded in the blockchain have not yet reached consensus among all nodes.

Note: The diagram indicates the existence of two ledgers in the network, with the contents within the dashed box being the same, while the contents outside the dashed box represent the two blocks generated simultaneously, leading to the blockchain fork.

Although there are two different ledgers in the entire Bitcoin network, each miner only has one ledger: either ledger one or ledger two. Therefore, when node C obtains the right to record transactions and packages a new block $N+1$, it will attach this block to the ledger it holds. Assuming it holds ledger one, the blockchain in the entire network will look like the following diagram.

At this point, it appears that there are still two ledgers in the current network, and the nodes still have not reached consensus on the contents of the ledgers. So when node D packages block $N+2$, should it connect the new block to $N+1$ or $N_B$?

The Longest Valid Chain Principle

After a blockchain fork, how do we ensure that the contents of the ledgers in all nodes reach consensus?

Since bookkeeping is voluntary, and there is no super administrator telling them where to connect the new block, theoretically, nodes have the power to connect blocks anywhere, not just to $N+1$, but even to $N-1$.

However, if nodes do this, it will be challenging for all nodes to reach consensus on the contents of their ledgers. Without consensus, the currency's function as a medium of exchange cannot be realized, meaning it cannot fulfill its role as currency.

In real life, when there is a disagreement about something, a common method is "the minority obeys the majority." The blockchain operates similarly.

It can be stipulated that the chain containing the most blocks is the legitimate chain, while transactions recorded on other chains are not recognized. Since each block's production consumes a certain amount of work, the more blocks there are, the more work is consumed. Therefore, this stipulation is also known as the longest valid chain principle.

Under this rule, nodes will voluntarily connect new blocks to the longest chain, while the other chain is discarded, referred to as a "orphan chain." Returning to the previous question, miner D will connect block $N+2$ to block $N+1$.

Through the proof of work method, it is determined who has the right to record transactions in the blockchain and how blocks are linked. Ultimately, the contents of the blockchain reach consensus under these two mechanisms.

By establishing a public ledger, a public-private key system, and a proof of work consensus mechanism, we have created a decentralized currency settlement system. The decentralized currency system not only includes the decentralization of the settlement system but also the decentralization of currency issuance, which will be explained next.

Decentralization of Currency Issuance#

While we have designed a public, decentralized bookkeeping method that allows everyone to participate, what incentivizes nodes to maintain this ledger? Capital is profit-driven, and altruism does not widely exist in reality. So what motivates nodes to act? More specifically, why are nodes willing to expend significant computational power just to gain the right to record transactions? After obtaining the right to record transactions, why are they eager to send the block to surrounding nodes? Why do they obediently connect new blocks to the longest chain? These questions pertain to the main content of this section: currency issuance.

Because there is another stipulation: nodes that have the right to record transactions and connect blocks to the longest chain can receive rewards, known as block rewards. For the Bitcoin network, the block reward is a certain amount of Bitcoin; currently, a successful block creation yields 6.25 BTC, and the current price of one BTC is approximately $28,000.

Thus, nodes invest capital to purchase equipment, rent space, pay electricity bills, and cover maintenance costs. After obtaining the right to record transactions, they immediately send the block out to quickly receive the reward. Therefore, the process of nodes obtaining block rewards is akin to miners obtaining gold, and thus nodes are also vividly referred to as miners.

In addition to incentivizing nodes, block rewards have another brilliant function—currency issuance.

Block rewards come from the currency issued by the Bitcoin network, which is newly created currency that increases the overall money supply of the system. More importantly, the issuance of currency does not rely on any centralized institution, specifically, it does not rely on a central bank.

As mentioned earlier, the flaws of the fiat currency system are the centralization of the currency settlement system and the centralization of currency issuance, ultimately leading to currency being prone to over-issuance and devaluation and excessive censorship. In contrast, the Bitcoin system's currency settlement system is a public ledger maintained collectively by all nodes, which is decentralized; currency issuance occurs through block rewards generated by the protocol, which cannot be altered, and is also decentralized.

Ultimately, this achieves the decentralization of the currency system.

The Practicality of Bitcoin—The Cornerstone of Value#

Commodity money possesses certain utility; gold and silver can serve as raw materials for producing goods and can provide aesthetic value. From this perspective, Bitcoin indeed lacks practicality, as it is merely a record of transactions on the blockchain and cannot produce goods or be displayed at home.

However, Bitcoin possesses a function that other types of currency do not have: you can self-custody (Self-Custody) Bitcoin.

The Value of Self-Custody of Currency—Censorship-Resistant Payments#

You may wonder why self-custody is a unique feature of Bitcoin, as both ancient gold tickets and contemporary cash in US dollars are also self-custodied. The difference is that what you are holding is merely a debt certificate, an IOU, and not actual currency.

Whether during the gold standard or the current fiat currency era, you have never truly owned or controlled your own currency.

As previously mentioned, due to poor divisibility, even a small piece of gold is very valuable, making it inconvenient for daily purchases of goods and services. For large transactions, transporting gold is also inconvenient. Therefore, people store gold in financial institutions, which provide them with some notes as proof, guaranteeing that they can redeem the corresponding gold with these notes at some point in the future. Thus, these notes are essentially IOUs from the institution.

These notes can be redeemed for equivalent gold, and carrying notes is more convenient than transporting gold. Consequently, people transitioned from directly using gold for transactions to using notes backed by gold for transactions, solving the shortcomings of gold as a medium of exchange.

So, if you do not self-custody gold but instead hold notes, then you must trust the financial institution that issued these notes to allow you to redeem the gold. What if the institution goes bankrupt? Or what if the institution does not allow you to redeem it for some political reason?

Returning to fiat currency, it is essentially also a liability of the central bank, but if you take fiat currency to the central bank, you cannot redeem anything.