In many people’s eyes Bitcoin and cryptocurrencies came out of nowhere, from the dark shadows of the Internet. The truth is that the idea of digital currencies dates a few decades back before the Bitcoin White Paper was actually released in 2008.
One of the most crucial pre-conditions for the development of digital currencies was the invention of asymmetric encryption in the late 1970s by the legendary cryptographers: Martin Hellman, Whitfield Diffie and Ralph Merkle.1 Soon enough, their concept was elaborated on by another legendary trio from this field: Ron Rivest, Adi Shamir and Leonard Adleman (hence the name for the RSA encryption algorithm).2
In the early 1980s, a young computer scientist named David Chaum published multiple papers related to various cryptographic protocols and elements that later served as the source of inspiration for a plethora of digital currency projects.3 Chaum would later become known as the “father of online privacy”. It took almost a decade to turn the ideas from his papers into real products. In 1990, he founded DigiCash, an electronic cash company based in Amsterdam. The company created the first digital currency, eCash. Even though eCash utilised traditional banking infrastructure, it allowed for completely anonymous transactions using so called “blind signatures”, a cryptographic technique devised by Chaum. DigiCash managed to partner with multiple banks across the US and Europe, and at one point was offered very a lucrative sum for acquisition by Microsoft. But eventually, the company went bankrupt shortly before the dawn of the new millennium.
In the meantime, the e-money space became significantly more robust during the 1990s. The World Wide Web took the world by storm. Netscape’s popularity was booming and its IPO sparked a huge amount of interest not only among the VCs, but also many corporations that entered the arena as well. DigiCash soon had to compete with CyberCash as one of its most prominent competitors. Visa commenced their “Electronic Purses” initiative that was competing with Mondex, a smart card electronic cash system acquired eventually by MasterCard. New payment systems appeared all over the world – NetCash, NetCheque and Microsoft Money were just some of the more famous ones. In 1998, Paypal started to spread in the US mainly because of the userbase of the eBay community. At around the same time, WebMoney launched in Russia.
However, it wasn’t just virtual dollars, euros and other fiat currencies that people desired to transact within the digital realm. Gold-backed digital currencies started to appear in 1996 in the form of E-Gold. During the peak of its popularity, E-Gold served over five million customers. But the fact that the service allowed certain levels of anonymity resulted in the outbreak of money laundering activities which, unsurprisingly, resulted in its shutdown by law enforcement agencies.
To many in the digital currency space, it became clear that some level of decentralisation would be necessary for a digital currency to succeed. In 1997, another well-known cryptographer and coder, Adam Back, came up with the concept of Hashcash.4 While Hashcash was not designed as e-money per se, it introduced the notion of a digital token that represents computational power, and thus the concept of Proof-of-Work. The system was designed as an anti-spam measure where such a token, created by costly computations, would be embedded into the email’s header, thus signalling its validity to the receiving server. The problem with the tokens in Hashcash was that it was not possible to use (or spend) them multiple times.
At around the same time, two other important concepts emerged – B-money and Bitgold.5,6 Both of the respective authors, Wei Dai and Nick Szabo devised their proposals as P2P networks such that there would be no one central server in charge of the system. Both concepts also utilised pseudonymous identity systems based on public key cryptography. Dai’s B-money was similar to Bitcoin in terms of the way that money creation was designed to work. Dai proposed a system where monetary unit creation was strictly proportional to the costs of computing, even though he was aware of the drawbacks associated with such a setup. Even though both systems utilised some form of Proof-of-Work, they were still vulnerable to the double-spending problem. That is, in the absence of a central authority, it was rather difficult for a P2P network to resist attackers who cheated the system by spending the same monetary unit at the same time at two different places (recipients). Perhaps this was also the reason why the concepts did not turn into working prototypes.
In 2004, another legendary persona from the cryptocurrency chronicles, Hal Finney, who would later be known as the first recipient of a bitcoin transaction, proposed a system which would efficiently improve the issues with B-money and Bitgold, as well as Hashcash. The system was called RPOW – Reusable Proofs of Work.7 As the name suggests, PoW tokens in his system could be spent and used multiple times. The double-spending problem was alleviated as the system had a central server. The centralised nature of the RPOW’s architecture was mitigated using a special type of processor that allowed for trusted computing - where all participants in the system could verify that software being run on the server had not been tampered with. Yet, even though the system could not be cheated by the server’s owner, it could be eventually turned off.
Typically, any new network usually faces a chicken-and-egg problem. Network value increases as new users join, however users only have the incentive to join the network if they know that others are part of it. This part proved easier for digital currencies in gamified worlds (e.g. Second Life’s Linden dollars, or virtual gold in games like World of Warcraft). Nonetheless, such money suffered from the drawbacks of centralisation, since a single company exerted full power over the value of the money.
Perhaps the most recent, notable attempt for digital currency in the pre-Bitcoin era was Liberty Reserve. The company was established in 2006 in Costa Rica. Its customers could deposit only their internal currency which was also called Liberty Reserve. The currency could be acquired only through a network of intermediaries named “exchangers”. Exchangers usually consisted of unlicensed money transmission companies, often based in Asian or African countries. At one point, Liberty Reserve served more than a million customers, but its fate was very similar to the one of E-Gold. KYC-free accounts were reportedly used for criminal activities, and made up most of the service’s traffic. As such, the company’s founder, Arthur Budovsky, was eventually sentenced to prison in 2016.
The case of Liberty Reserve, as well as many others before, demonstrated the importance of decentralisation for digital currencies. Even though this fact was known to engineers, researchers and cryptographers for over a decade, it was extremely difficult to design a decentralised and censorship-resistant system that would be resistant not only to double-spending, but also all kinds of attacks. This was achieved for the first time in human history, with Bitcoin.
1 For more information on the early development of asymmetric encryption, see: https://ee.stanford.edu/~hellman/publications/24.pdf.
2 For more information on the earlier development of RSA encryption see: https://nakamotoinstitute.org/literature/rsa-paper/.
3 For more information on David Chaum’s untraceable payments, see: https://nakamotoinstitute.org/literature/blind-signatures/.
4 For more information on Hashcash, see: http://www.hashcash.org/papers/hashcash.pdf.
5 For more information on b-money, see: https://nakamotoinstitute.org/b-money/.
6 For more information on Bitgold, see: https://nakamotoinstitute.org/bit-gold/.
7 For more information on Reusable Proofs of Work, see: http://cryptome.org/rpow.htm.