What is Cryptocurrency?

Last Updated April 29, 2018

There is a gold rush happening, but it is not taking place in the riverbeds of northern California, rather, it is occurring digitally. Daily, digital miners utilize super computer networks in order to mine cryptographic coins by solving complex mathematical equations. Although the process is physically less arduous, it is an infinitely more complicated process than gold pan mining ever was. Over the last year, cryptocurrencies such as Bitcoin, Ethereum, Ripple and Tether have become an integral part of the public finance discourse.

Blockchain technology is the new hot topic, especially for young investors ‘in the know’ with rapid, modern, technological advancements. You have likely read stories, or heard people talking about the ever-fluctuating prices of these coins and the meteoric rise in value, especially for the coins mentioned above. Doubtless, someone has said to you, “Buy now, it’s only going up!”

Now, any investor worth his salt would be dubious about any get rich quick scheme, which on first glance, many might view cryptocurrency to be. It would be easy to point out how in 2017, Bitcoin which, on average, had traded anywhere from $200-$1000 per coin, exploded, shooting up in value until it peaked at approximately $18,000 per coin. In less than three weeks, that price dropped precipitously, nearly losing 50% of its value until it eventually evened out. That insane volatility practically shouts, “Buyer beware.”

Again, it is wise to question and be doubtful about a new technology, but just to be clear; cryptocurrency is not a Ponzi scheme and should not be viewed as a means of making money fast. Crypto is a game changing, digital currency that brings with it a variety of benefits to investors in this modern age. That said, in order to objectively weigh and measure the efficacy of crypto, one must first ask the rather obvious question: what is cryptocurrency?

Currency 101

In order to gain insight into the world of cryptocurrency it is important that you first have, at least, a semblance of an idea on how normal currencies work. Before there was any sort of standardized currency, humans existed in a form of goods and services barter community.

For example, in a small village, a farmer trades his vegetables with a hunter for some meat or pelts. Both of the things being traded represent the time and labor invested into gaining those objects; they were the currency with an inherent value. In the beginning, this voluntary exchange of goods and or services works relatively well in a small community. Problems arise, however, as more parties are added to the mix.

The village doctor faces a dilemma; he is tired of meat from the hunter and would prefer vegetables from the farmer, but the farmer does not need or want the doctor’s services. So, how does the doctor go about acquiring the vegetables? Well, he must find someone who not only wants his services, but is also willing to exchange something that the farmer would, in turn, bargain for. This matter becomes even more complicated if you need multiple services in order to create one good.

The waters are further muddied, in that services or goods are not worth identical amounts; some are inherently more or less valuable or time-consuming. So, the question arises, how do we create a system where everyone benefits and this exchange can be simplified?

The answer to this question was to create a currency of sorts, an IOU that allowed people to convert their goods or services into something that would keep a relatively flat and tradable value. This IOU could later be used in exchange for something else.

In this way, currencies act as a sort of economic buffer; they allow people to convert their efforts into something universally desired, which maintains its value, and can be converted back into goods or other services at a later point in time. So, now the doctor could go to the farmer and give him this IOU in exchange for his vegetables and then the farmer could either save the IOU for another time, or go out and use it for anything he so desired.

Cryptocurrency: The golden IOU

This new method of currency exchange made everyone’s life simpler. However, the creators of this system saw that there was huge potential for immoral people to take advantage of this IOU system. If all an IOU was, was simply a piece of paper, that paper could be very easily replicated.

So, rather than working, a person could create a fake IOU instead and still reap the rewards. Thus was born the earliest form of counterfeiting. In order to prevent this from occurring, IOUs needed some physical backing to protect their value. It had to be something that there was finite amount of and something that everyone valued. Every currency became linked to a real world resource that was either scarce or finite, with Gold being the most common example.

Consider gold: it is rare and it is naturally occurring. Because of this, the only way it is possible to come by gold is by one of two possibilities: the first, you mine it or find it in nature, the second, you get it from someone else who (at some point in time, they or someone else) also got it from nature. Another benefit of gold is that it is highly divisible and based on weight.

 

Remember, for our hunter, a bear pelt is likely worth more than a wolf pelt. So, how do you pay him for one or the other? Half an IOU? A quarter? Now, thanks to gold backing the IOU, there is a clear, measurable and viable value behind it. Whether that gold has been earned or found, it does not change its inherent properties, the value remains and it is extremely difficult to fake that.

Gold was a great solution to that counterfeiting problem, but as with everything in life, a gold exchange currency had its own host of complications and issues. For one, gold is heavy, difficult to transport, easy to lose and it makes you a target for thieves, marauders or anyone else who wants to get their hands on your property. Once it is in their hands, that gold is theirs; who is to say that they did not earn it or come by it by honest means? There are also massive issues with scaling limits since there is only so much gold in the world.

As a result, countries started to centralize gold reserves and issue a currency that was backed by gold, but was not gold itself. So, from gold, we moved back into IOUs. These IOUs were different though, in that they were backed by sovereign nations who held a great deal of power and respect amongst other nations. These nations also dedicated time and money into guaranteeing these IOUs and preventing counterfeiting in any form.

Today, the U.S. dollar is no longer an IOU for physical gold, instead it has become a currency or resource in and of itself. The government mints it, backs it, protects it and creates the scarcity by limiting circulation. Even though it is just a piece of paper, the trust we place in it is what gives the dollar its value.

The birth of Bitcoin

In October of 2008 an unknown coder published a paper under the name of Satoshi Nakamota. It was called, “Bitcoin: A Peer-to-Peer Electronic Cash System.” In this paper, Nakamota writes about his plan to create a way to communicate intrinsic value, but in a decentralized manner. Basically, his goal was to create a settlement system of sorts over a distributed ledger. Digital currency was only one part of such a value system. He had paved a way to something much bigger than simply cryptographic currency.

This system would function without a central banking system or single administrator, the network would be P2P (peer to peer) and financial transactions would occur directly between users without anyone interceding on their behalf. It eliminated the middleman, the third party and potential oversight.

His vision and all that it promised caught on in the digital world. It took hold and those with the computational power began mining the coin, storing them in digital wallets and trading them as a currency. Its early valuation circa 2010 was 10¢/BTC. By mid 2011, a coin was worth $70 and by 2014 it hit $1,000/BTC. As of January, 2018, there are 16,833,537 BTC in circulation with an appraised market value of $191,301,364,529. It is estimated that there are between 2.9 -5.8 million unique users utilizing a crypto wallet, and the vast majority of them use Bitcoin.

Digital gold

Cryptocurrencies, at their essence, are a digital form of currency; a decentralized system supported by mathematics, open source code, cryptography and the most formidable and secure computational network on the planet. They are a virtual accounting system that records and stores each and every transaction that takes place all the way back to the genesis, the alpha coin.

These transactions are bundled into blocks and then are given a secure cryptographic signature. At their core, they are all viable currencies, and what differentiates them are rather small operational changes in order to distinguish them in the marketplace.

One of the most attractive aspects about cryptocurrency is the inherent safety to the coin. Recall that a major issue with previous currencies was counterfeiting. When it comes to anything digital, this is an obvious concern, seeing as it is very easy to make a copy of a file, even without realizing it. This ease of duplication makes it difficult to create any sort of digital currency because of how easy it would be to fake it, rather than make it.

In order to protect the value of the cryptocurrency, cryptos have created a means by which people can exchange their exertion into a digital token system, which produces secure tokens that cannot be duplicated. It is a digital version of gold, silver or other precious gems; a finite resource that was mined.

Like these precious metals, cryptos can only be had in one of two ways: first, you digitally “mined it” yourself, or you got it from someone who mined it. Because of this, cryptos can be trusted to hold value and since they are decentralized, no one can artificially affect the market or simply create more of it.

Digital 49ers

To mine cryptocurrency coins you need an insane amount of computational power at your disposal.

Naturally, one would assume that the goal of mining was to create new coins, but that is realistically a tertiary goal. Remember, Satoshi’s focus of BTC was this decentralized P2P ledger. So, the primary focus of mining is to make sure that all members have a clear view of the Bitcoin data landscape. Since it is P2P, there is no centralized database logging BTC ownership, rather it is passed along the digital network. As you might imagine this could lead to some problems. According to Google Software engineer Ken Schirriff,

The main problem with a distributed transaction log is how to avoid inconsistencies that could allow someone to spend the same Bitcoins twice. The solution in Bitcoin is to mine the outstanding transactions into a block of transactions approximately every 10 minutes, which makes them official. Conflicting or invalid transactions aren’t allowed into a block, so the double spend problem is avoided. Although mining transactions into blocks avoid double-spending, it raises new problems: What stops people from randomly mining blocks? How do you decide who gets to mine a block? How does the network agree on which blocks are valid? Solving those problems is the key innovation of Bitcoin: mining is made very, very difficult, a technique called proof-of-work. It takes an insanely huge amount of computational effort to mine a block, but it is easy for peers on the network to verify that a block has been successfully mined.

 

Each mined block references the previous block, forming an unbroken chain back to the first Bitcoin block. This blockchain ensures that everyone agrees on the transaction record. It also ensures that nobody can tamper with blocks in the chain since re-mining all the following blocks would be computationally infeasible. As long as nobody has more than half the computational resources, mining remains competitive and nobody can control the blockchain.

One of the side-effects of this mining is that new coins are added to the system, with 25 new coins added for every block that is mined. A new block can theoretically be mined every 10 minutes, if you have the computational power. Because of this, there are huge incentives to begin mining the currency.

The mining aspect is simply cryptographically signing each block of transactions, for which you receive the coin. The concept is universal amongst cryptos, although different cryptocurrencies use different algorithms for the cryptographic signature of the transaction blocks. They also have disparities in recompense amounts, the amount of coins received with each blockchain and the frequency at which new blocks may be generated.

Mining ain’t easy

What may be overlooked by many is how difficult is it is to computationally solve a blockchain equation. As of now, the chance of a computer finding the correct answer is 1 in 10 quintillion (1019)… to put that in perspective the odds of perfectly guessing the NCAA basketball playoff bracket, which would earn you a $1 billion reward from Warren Buffett, is 1 in 9.2 quintillion. It is estimated that BTC miners currently work at 25,000,000,000,000,000 blocks hashed per second.

A personal mining computer might take weeks, if not months to solve a block by itself. The electrical power required to solve these equations is astronomical, so the utility bill will be enormous.

To make matters worse, miners go through dry spells where the equations simply are not being solved. For these reasons, mining is much too large an enterprise for most people to reasonably take on by themselves. So, the majority of miners will join or form an online, profit-sharing, mining community. In this way, they are able to pool their resources and work on blocks as a team, sharing fractions of BTC between the various miners.

The benefits of Cryptocurrencies

You may read this and still say, “So what? Why should I care? I’m not going to start digitally mining, I can barely turn on my computer!” or, “It is already too late to get into coins, they have already peaked.” Admittedly, these are reasonable opinions to hold. You should by no means sell all your earthly possessions and immediately invest everything in cryptos; just about anyone, including Nakamota, would call you a financial illiterate for doing so.

Investing all your wealth into one thing is a recipe for disaster, regardless of what that thing is. Ask any financial advisor, diversification is the name of the game, in that it minimizes risk and exposure to financial loss. If you have the means, it is wise to spread out your investments in stocks, land, businesses, cash and precious metals. So, if you view cryptocurrency as a form of precious metal, they are a more than viable investment. Below are some of the tangible benefits of cryptocurrencies:

  • A trustless digital cash system – As mentioned above, in regards to IOUs, there is an inherent amount of trust required in digital payment systems. There is an underlying risk between two parties in order to make these exchanges. For example, you must rely on a bank, Paypal, Venmo, or a credit card company to guarantee the transaction. Coins do not function on a digital payment system, rather they function in a digital cash system. These systems allow peer-to-peer cash exchanges, as if you were handing them physical cash on the spot. So, you do not need to trust the individual or a third party to guarantee the transaction since the coin is good regardless.

Since settlements are immediate and do not require a third party intermediary, contracts can be upheld in a fraction of the time they would be by more traditional means. If you want to buy real estate, that generally involves, brokers, bankers, lawyers, a notary and all the delays and fees that come part and parcel. Cryptos completely eliminate these extraneous parties and boil the process down to a simple exchange of cash.

  • Decentralization –There is a global network of computers accessing blockchain technology in order to manage and record transactions. Every interaction is peer-to-peer and free from outside influence.
  • Fraud Prevention – A person’s cryptocurrency is kept in a secure digital wallet, it cannot be counterfeited, nor can the transaction randomly reversed by the sender, like those that can occur with credit card charge-backs. You also need not worry about identity theft when using cryptocurrency since they use a “push” information mechanism; where the sender sends exactly what specific information to the merchant or buyer, where as with credit cards, a store or broker “pulls” from your line of credit. This can be an issue in that, when you give someone your credit card, you give them access to your entire line of credit, no matter the size of the transaction. That pull leaves your vulnerable to those who might take advantage.
  • Low, if not, no fees – For most cryptocurrency, there are generally no transaction fees since miners were already paid for their mining. Note, most users will have to use a third party digital wallet service that act like a credit card or PayPal account and there are varied fees for these services.

Conclusion

What is so incredible about blockchain technology and cryptocurrencies is that they are still in their infant stages. We have barely begun to even scratch the surface of what is now possible using these new technologies. Nakamota’s vision of the future was vast and we are in an extremely exciting time as these ideas and techs take root in our society.

Cryptocurrency is simply the dollars you hold in your hand but digitized. It is your own bank and wallet all wrapped up in a marketplace owned by the people. The technology, intuition, innovation, and intelligence involved with cryptocurrency positions the marketplace to possibly conquer all other forms of currency.

That’s what crypto gurus are betting on and from what we’ve seen, they might be right. When asking what is cryptocurrency in a philosophical sense, well, it’s the future. And it’s here. Right at our fingertips.

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