Cryptocurrency 101

2 trillion dollars. That is the current market cap of the Cryptocurrency space. However, depending on the time and date you read this, that number could be higher or lower, such is the volatile nature of this new phenomenon. For context, $2 trillion dollars is close to the value of a company such as Microsoft, at $2.42 trillion. During the past year, names such as Bitcoin, Ethereum, Dogecoin have become more prevalent in society and conversations. You may know friends, family, colleagues who have begun to explore or invest in a number of these different names, and you may feel like you have missed the boat on this. What is Cryptocurrency, how does it work, and what problems does it look to solve in our society?

In 2008, a person or group under the pseudonym of Satoshi Nakamoto issued a white paper in the cryptography mailing list, the biggest cryptography forum dedicated to the art of writing and solving codes in the world. This was the white paper for the first cryptocurrency ever created, Bitcoin. In the proposal, Satoshi wanted to set the basis for cryptocurrency, a new form of currency that aimed to solve the problems of digital money. And no, cryptocurrencies are not the first kind of digital money. Every time you make a transaction on your online banking account or purchase anything with a credit or debit card, you are using digital money. The issue with banks is that they only hold around 10% of the physical assets of their money base, meaning that if everyone wanted to go to the bank to retrieve all of their money at once, your money would likely not be readily available to you. You would notice that digital money, as we know it, is essentially virtual and not much more than a number on a screen.

Satoshi aimed to solve problems such as this with Bitcoin, along with centralisation, inflation, and privacy:

Problem 1: Centralisation

Every time you make a transaction or purchase anything with your credit card, there must be someone who certifies that the transaction is valid. An entity that can certify that the sender has the money and that the receiver receives it. Banks and credit card companies are those certification institutions. Normally, under strict controls of central banks of the countries they work in. This is the established method, and this is the way our financial system has been running for decades. However, many detractors of this model feel that this kind of power should not be held by such a small number of players.

Solution: Decentralisation

Bitcoin uses a Peer to Peer system (P2P) ledger called Blockchain, where you can find every single transaction that has been made since the currency started. This chain of transaction information needs the entire chain history to make sense. This means that a new link in the chain can only be read when the whole chain is unaltered. Because of this, it is extremely difficult to alter past records. In the case of bitcoin, a block is generated every 10 minutes and it is the job of the people who possess the ledger and are running the transaction processing software to add blocks of information to the chain. These people are called “miners”, and they are the replacement for the bank or credit card infrastructure.

If one person can add a block to the chain, isn’t the system centralised? No, because anyone can be a miner and every miner in the network is competing against each other to be the one to add the block to the chain. To do so, they run millions of mathematical calculations with their hardware. When the solution to the calculation is found, it is proposed to the network. If 51% of the network approves the solution, the block is added to the chain. This exhaustive processing task is known as “proof of work” and it is the main security system in the blockchain. The problem of centralisation is solved using a decentralised scheme, as every miner in the network has a chance of validating a transaction.

Problem 2: Inflation

The value of currencies around the world is closely tied to the decisions that their respective countries make. For example, when a country decides to print more money, its value usually falls as it generates more supply than the current demand. This kind of decision is usually unilateral and impacts a huge amount of currency holders. However, this does not happen when there is a hard limit on the amount of a specific currency. Imagine if no more supply of this currency could ever be printed. This kind of action is something that we can see in gold, which is a limited resource, and Satoshi wanted to emulate this with Bitcoin. 

Solution: Limited Supply

We mentioned above that the miners are the ones validating transactions. Their compensation for doing this is with Bitcoin prizes or commission. The miner who adds a block to the blockchain gets paid a certain amount of the currency and this is the only way more cryptocurrency is created. When the miner adds a block, a fixed amount of cryptocurrency is created in the system with the sole intention of being the prize or payment for that miner. The new generated coins are then transferred to their digital wallet.

During Bitcoin’s inception, the prize was set around 50 Bitcoin for the miner who added the block. At the time it was worth nothing because Bitcoin did not have a price. However, today, that would be close to $2 million dollars. This prize is not fixed however, it decreases with time. For every 210,000 blocks, or every 4 years, the prize is halved. This means that it iterates from 50, to 25, to 12.5, to 6.25, which is today’s value. Since the price is halved every 4 years, and Bitcoin is only created as a prize, it sets a limit on the amount of bitcoin that will ever be created. The limit is 21 million Bitcoin. This mechanism gives bitcoin a function similar to that of gold as it becomes a limited asset.

Problem 3: Privacy

When you make a bank transaction or use a credit card you need to provide information in the form of a bank account or a credit card number, information that can all be traced back to you.

In this regard, there is no privacy in digital money. However, there is privacy, for example, in physical assets. You are rarely required to provide any personal information when you purchase with cash. Satoshi wanted Bitcoin to have similar levels of privacy to physical assets. 

Solution: Anonymity

Cryptocurrency uses wallets; an address or a set of numbers and letters that the Bitcoin network recognises as the holder of a certain number of coins. Cryptocurrency wallets are anonymous, interchangeable, and you can have as many as you want. Cryptocurrency wallets do not require any personal information and are designed to track the coins, not the people who hold them.

Undeniably, cryptocurrency helps address some important concerns with the traditional payments system. But it doesn’t come without some challenges of its own:

Problem 1: Ethics

One of the key questions surrounding cryptocurrencies is its worth. Cryptocurrencies are not backed up by any form of physical currency which raises issues and questions around its investability. The belief by those in the community is that it is the same with any other currency, and that usability, and trust over time will create demand. Many people believe in the core fundamentals of cryptocurrency and invest because of this. However, early adopters of cryptocurrencies were people who valued privacy as a key fundamental and exploited this through illegal activities where anonymity is key, such as money laundering. On top of this, those same individuals were driving forces behind generating demand and subsequently, raising the currency price. This raises ethical issues with its usability and foundations.

Problem 2: Carbon footprint

As mentioned earlier, “proof of work” is one of the key security measures of the blockchain and it requires a huge amount of computational power. Due to the widespread adoption of cryptocurrencies, “proof of work” has proven to be a problem. As of today, there are so many miners connected to the Bitcoin network that electricity consumption is beginning to take its toll on the environment. The electric consumption of the Bitcoin network is currently higher than that of countries such as Argentina and Switzerland, with a substantial proportion being carbon-based.

Problem 3: Centralised Decentralisation

Mining has become a very difficult task for miners to complete by themselves. For example, if you would like to mine a Bitcoin block using only your computer, it would take around 900 million days or approximately 2.5 Million years to complete. This is why miners started working together in groups known as “pools”. These pools hold thousands of miners with huge computational power, and when a block is mined by that pool, the prize is distributed between all miners in accordance with their contribution. Having said this, groups of miners can hold more than 30% of a network’s computational power. This is dangerously close to the dreaded 51% that could allow a pool to validate their own transactions. This means that 2 large pools in the cryptocurrency network could start working together to forge transactions. This has been seen already with some cryptocurrencies, and is known as a ‘51% attack’. Under these circumstances, the person who controls the pool’s computational power can add forged transactions to the network and become the sole ruler of the currency.

Questions around whether Cryptocurrency has the potential to change the financial system remain. The alternatives this type of currency offers to the current system certainly has its merits. However, perhaps a more poignant question will be whether it brings more harm than good to society as it grows and increases its footprint in the market.