Crypto doesn’t have to be cryptic. An explanation of how cryptocurrencies work, starting with the first principles of economics
What is money?
Money is such an integral part of every one of our lives that it’s easy to lose sight of what it actually is. To really understand the value of cryptocurrency, we have to ask a fundamental question – what is money?
Put simply, it’s a system that many societies have developed to represent value. It has two main purposes: value transfer, and value storage.
Imagine being an apple farmer in the dark ages. Apples are valuable, but you need things other than apples to live – warm clothes, for example. To solve this problem, people started bartering.
Bartering is the transfer of value through direct exchange of valuable goods. A cold apple-grower in need of warm clothes can find a hungry clothmaker in need of food, and the two can share the fruits of their labor for mutual gain.
The problem with barter systems
Bartering helped primitive societies to divide their labor. But it has serious drawbacks. These can be grouped under the term ‘non-coincidence of wants’. Put simply, bartering is pretty inefficient if the people around you don’t want what you produce at that moment in time.
To return to our apple farmer looking for warm clothes. He might have a bumper crop of apples. But what if the local clothmaker doesn’t want any apples?
The answer is to find some object that can be accepted across the whole of society as a universal language of value. The clothmaker may not want apples, but he definitely wants *something*. If society agrees upon an object that can be exchanged for *anything*, then the apple-grower can sell his apples in exchange for it, then buy clothes from the clothmaker with it, and then the clothmaker can go off and buy anything he wants.
This was how currency was born. And most societies over time started using precious metals like silver or gold as currency.
How money evolved
Gold was initially chosen as currency because it is scarce, hard to falsify, and doesn’t degrade over time like iron or copper does. However, there are obvious drawbacks to gold. It’s not easy to carry, if you have it on you, you’re a target for robbery, and you can’t send it over long distances with any ease.
Instead, people started depositing their gold with a novel institution called a bank. In return, a bank issued paper certificates, signifying gold ownership. Over time, people started using these paper slips to trade, rather than going to their bank, withdrawing their gold and using it to purchase goods. These paper slips effectively started working as gold-backed currencies.
As more time passed, governments started taking on the responsibility of storing gold and handing out paper currency in return.
Nowadays, money is not backed by gold anymore, but instead by nothing. People use it because it’s legally enforced by governments. Most governments took their currencies off the gold standard in the 1970s.
There is a term for this modern manifestation of money – fiat currency. Fiat currency basically refers to money as we all know it today. It comes from the Latin word for ‘by decree’ – because money holds value under this system purely by government decree. It’s no longer backed by apples, cloth, gold, or any other real-world good.
The problem with fiat currency
For fiat currency to work properly, everyone using it needs to have confidence in the currency’s ability to hold its value. For example, we need to have confidence that if we sell our apples, the money we receive will be able to buy other things, roughly equivalent to the value of the apples we sold.
This is usually guaranteed by the government, who will commit to continuing to use the currency, and to legally enforce its acceptability as value. They will also be responsible for the supply of money – ensuring that inflation and deflation don’t occur.
This is one of the most important roles played by any government. Without an honest, fair, impartial central authority managing the whole monetary system, then no-one can be sure that fiat currency is actually valuable.
The problem with this, of course, is that honest, fair, impartial governments are by no means guaranteed. Indeed, they’re pretty hard to come by! In fact, there’s not a fiat currency on earth that hasn’t been devalued at some point due to careless actions by the government in charge of it.
But, for most of history, if you wanted to use money (and you don’t really have a choice in that matter) you had to trust your government.
That is, until crypto came along.
What is cryptocurrency?
Everything changed for fiat currencies when an engineer named Satoshi Nakamoto asked: “What if we code our way out of government-enforced currencies?” Using some extremely smart technology called blockchain, he created the first cryptocurrency to answer that question. Its name is Bitcoin.
This was a monumental step in the history of money, and only time will tell its far-reaching consequences.
Cryptocurrency is a digital form of currency that exists purely in code, and is backed up by no government or central entity. They are stored as digital tokens in people’s ‘wallets’ – think of these simply as a digital storage mechanism.
We’ll go into the mechanics later, but at a high level, cryptocurrencies are currencies that work independently of any authority. They are a technology that automates the main purpose that governments served in backing up currencies – trust.
Why does crypto have value?
With typical money, value is preserved by the fact that it is backed by a government. Provided the government is trustworthy, and doesn’t print too much money, you could be sure that that currency will retain buying power.
Cryptocurrency is not backed up by any government, but instead by code and the blockchain. Crypto’s proponents argue that it doesn’t need to be backed by anything – ultimately, fiat isn’t either. Both are ultimately dependent on people believing that the currency holds value. But the blockchain is arguably more trustworthy than any institution.
For cryptocurrency to hold its value, it needs to have an indisputable amount in circulation, and indisputable transactions that prove who owns which coins. This amount needs to be written into the distributed ledger on a blockchain. Indeed, this is the primary function of a blockchain – to keep track of all the coins in circulation, and the transactions that move them from wallet to wallet.
The beauty of blockchain is that no individual or group controls that ledger – it’s distributed across a network of global computers. When the system is dictated by a blockchain, the possibility of a corrupt or incompetent government devaluing the currency is eliminated.
How do crypto transactions work?
Cryptocurrency coins don’t actually exist as physical objects. Instead, they exist as records of transactions in the blockchain. Therefore, the way you would send a coin to someone else is by adding a message in the ledger that you have transferred your coin to somebody else. This message has to be processed by someone. But rather than a government or bank serving as the trusted validator, the blockchain network does.
In order to demonstrate transparency to all participants of the network, and in contrast to traditional financial transactions, these messages, or records, are not privately concealed. As a result, anybody can see when a transaction has taken place. Moreover, they can see the network addresses of both the coin sender and the coin recipient. However, they will not necessarily be able to understand who each computer address belongs to. As a result, cryptocurrency transactions typically provide partial, but not complete, anonymity.
Types of cryptocurrencies
Cryptocurrencies, like Bitcoin or Ethereum, are designed to exist in isolation to real world currencies or commodities. In theory, this means that their value wouldn’t be affected by a crash in the US dollar, presenting them as a favorable option for investors attempting to diversify their assets.
Pegged cryptocurrencies, also known as Stablecoins, are designed to work in conjunction with real world currencies or commodities. This means that their value is directly tied to a real world currency.
At the moment, there are thousands of different cryptocurrencies across over dozens of blockchain networks. In this pathway, we’re going to cover the two biggest ones: Bitcoin and Ether.
Drawbacks of cryptocurrency
Perhaps the clearest downside of cryptocurrencies is that their value is ultimately based on the trust and belief that people have for them. Technically this is no different from every other currency on earth – but trusting a currency like gold that has been around for 1000+ years, or the US dollar that has been around for 200+ years, is quite different from Bitcoin that has been around for 10+ years.
Crypto’s novelty comes with another drawback: most vendors don’t currently accept it as payment. This detracts from its utility, since you need to convert crypto back into fiat to spend it.
Decentralization also creates problems with fraud and institutional risk. In the traditional financial system, most bank deposits are insured by the government. Since crypto is largely unregulated, you are not entitled to compensation if you are a victim of fraud in cryptocurrencies. Once the money’s gone, it’s gone forever.
Finally, cryptocurrencies are difficult to regulate. If a blockchain network is truly globally distributed, under what jurisdiction should it be regulated? The anonymity that crypto affords its users makes it useful for criminals or tax avoiders.
Because money is a core tenant of government power, crypto is a great threat to the modern state, for better or for worse.
All cryptocurrencies are stored in ‘wallets’ which use ‘public-private key’ encryption.
Your ‘public key’ is like your street address. Anyone who can send a package to that address. Your ‘private key’ is something you never share, like a key to unlock your mailbox and read your mail. This system allows incoming transfers from anywhere, while maintaining private access and control.
Because all transactions and wallets are publicly visible on the blockchain, anyone can see exactly how much currency is stored where, and how many transactions have occurred. However, the public key just looks like a string of numbers. There’s no way to tell whose wallet is whose, unless they’ve publicized that information.
For security reasons, many people store their keys on a physical device – this is called a ‘hardware wallet’. Hard wallets exist on your own hardware. You can connect them to the network to make transactions, or you can keep them offline. When they are offline, the blockchain still maintains a record of their crypto balances.
This is in contrast to a ‘soft wallet’ that stores the keys in a cloud-based service, which users can log into with a password from anywhere. The most famous of these soft wallets is called MetaMask.
Case study: Bitcoin - a history
The first and most famous cryptocurrency is Bitcoin. Bitcoin was first proposed under the pseudonym of Satoshi Nakamoto in a 2008 academic paper. To this day, no-one knows who Satoshi is, though his (or her, or their) net worth must run into the tens of billions.
Satoshi proposed Bitcoin – and the first blockchain – because existing centralized financial systems “suffered from the inherent weaknesses of the trust based model” and wanted to design something which instead was “an electronic payment system based on cryptographic proof instead of trust”. Fundamentally, Nakamoto argues that the existing financial system relies on the trusted third party to mediate disputes, which itself is expensive, when a better solution would be to eliminate the potential for disputes altogether.
His solution was Bitcoin. Interestingly, it was developed and launched in 2008-2009, the years of the Great Recession, where trust in government financial competency was at an all time low.
Case study: Bitcoin - how it works
In his whitepaper, Nakamoto explained the principles of Bitcoin. Whenever a transaction happens, it is broadcasted to a network of computers called ‘nodes’. The nodes will then independently validate the transaction based on whether its transaction history matches up to the existing transaction histories in the chain. Basically, the nodes check whether you actually have sufficient funds.
If it appears valid based on the network’s rules, called a ‘consensus mechanism,’ they are added to their own localized version of the chain and broadcast back out to the network as the latest version.
The Bitcoin blockchain uses the SHA256 encryption algorithm. The SHA256 algorithm was developed by the US government and then released under a royalty free patent in 2008. This encryption method turns data of any length into a relatively short but uniquely identifiable output, meaning you can verify things easily.
Case study: Bitcoin - benefits and drawbacks
One of the big benefits of Bitcoin when compared to other cryptocurrencies is how widely it is used. Out of the total amount of money stored in cryptocurrencies, around 40% of that is in Bitcoin. This means that it is even easier to find someone to conduct a transaction with in Bitcoin than with other cryptocurrencies. Moreover, because Bitcoin has been around for so long, there is a degree of confidence that it has held up thus far as ‘unhackable.’ Finally, because Bitcoin is coded as having a finite supply, it is immune to inflation.
However, a huge drawback of Bitcoin was that it wasn’t designed with smart contracts in mind. Smart contracts allow for blockchains to go much further, in replacing not just money but many of the institutions essential to money – like banks and lending services. Newer blockchains are mostly built to accommodate smart contracts.
Moreover, even though Bitcoin is the most widely accepted cryptocurrency in the world today, with companies like Microsoft, Subway and Gucci accepting it as payment, it is still not universal enough yet for someone to survive entirely on it without using conventional payment currencies.
Case study: Ethereum - a history
Ethereum is a newer blockchain with its own cryptocurrency called Ether. It was first proposed in 2013 by Vitalik Buterin in order to create programmable money. He says that he wanted to build “a blockchain with a built-in Turing-complete programming language”. That means that you can run “if this, then that” statements with your money, rather than just sending simple transactions. Effectively, it means that you can build applications on the Ethereum blockchain as well, not just currency.
While the Bitcoin blockchain was mostly designed around a single digital currency, Buterin wanted to build a blockchain that had more functions through decentralized applications, which are known as dApps.
However, Ethereum recognized that the dApps of the future would require more flexibility, scalability, and features than were technically possible in 2013, so rather than release a ‘final’ version of Ethereum that would soon be outdated and slow, a decentralized network of contributors called the Ethereum Foundation continue to improve the network.
This allows Ethereum to take advantage of technological developments over time. When different groups of users disagree about this, it leads to what is known as a ‘hard fork’, where two different protocols exist.
Case study: Ethereum - benefits and drawbacks
A huge benefit of Ethereum was that it was designed with smart features in mind. This means that the full potential of countless decentralized applications built on smart contracts can be unlocked. This allows for the implementation of countless potential use cases including automatic transactions (if this, then that). Any time that conditions are met, payments can be triggered, automating things like sales commissions, tax payments, or salaries.
Moreover, the application infrastructure in Ethereum is more developed than in other blockchain networks. According to CNN, 94 of the top 100 rated dApps are based around the Ethereum network. This means it’s at the core of interactive decentralized finance.
Case study comparison: Ethereum vs Bitcoin
Fundamentally, the key difference between Bitcoin and Ethereum is that while Bitcoin was designed purely to function as a cryptocurrency, Ethereum is an entire ecosystem for regulating interacting transactions.
Because Bitcoin is older and higher-profile, more people accept it as payment. Ethereum is still largely only available for transfer through apps that work on its network. This means that currently, Bitcoin has more practical uses in the real world. While most people don’t use Bitcoin to shop at Gucci, the possibility of doing so allows it to hold its value better. Moreover, its wider acceptance in the digital network means that you can use it for in-game purchases and cosmetics at many of the world’s top video games.
However, an advantage of Ethereum over Bitcoin comes because Ethereum continues to improve its codebase, while Bitcoin operates identically to the day it was created. As further advancements in cryptography arise, Ethereum will continue to improve speed, efficiency and security. Although secure, Bitcoin’s lack of additional utility and functionality limit the use cases for which it can be used. Others argue that in its simplicity lies Bitcoins strength. Only time will tell.