An Introduction To Cryptocurrencies

As we discussed in the previous lesson on money, physical currencies are riddled with inefficiencies and drawbacks. These drawbacks have only become worse with the transition to fiat money from gold backed economies.

• Central banks decide how much money to print while other banks are free to lend money to whomever they deem fit.
• Further, banks follow a practice called fractional reserve lending – which enables them to lend much more money than the value of their reserves.
• This results in periodic market cycles where unsustainable economic growth fuelled by debt ends up in recession.

This is often due to irresponsible and sometimes, outright reckless lending by banks, following a period of economic growth.

• The money lent fails to bring about adequate economic growth.
• And once the debt turns due for payment, the economy shrinks. The amount of money in circulation comes down.
• The economy then shrinks – with a loss of jobs as people spend less, in what becomes a self perpetuating cycle.
• Some debtors default on payments and banks become wary of lending while people try to withdraw money en masse from their bank accounts.
• The economy comes crumbling down in a flash, thanks to the unholy nexus between banks and corrupt corporate heavyweights.

The latest global recession which happened in 2008, as would be expected, infuriated people whose lives were ruined for no fault of theirs. That the central bank propped up failing banks with massive sums of money, at almost zero interest rates only served to further incense the public.

Out of this chaos and carnage was born Bitcoin. A cryptocurrency, an answer to the sham that is fiat money. Satoshi Nakamoto, a pseudonymous entity, came up with the concept of a radically new form of digital currency completely free from government control while being extremely resistant to attacks.

Bitcoin by no means is the first attempt at a currency free from government control and oversight.

• From the 1980s, libertarian innovators have come up with multiple novelties as digicash and e-gold only to see them fizzle out as governments moved to stomp out contenders to fiat money.
• The difference between earlier attempts and Bitcoin is that Bitcoin is totally decentralised, making censorship almost impossible.
• Bitcoin is not a new technology in itself. Rather, it is an amalgamation of disparate cryptographic technologies.

Here are the underlying mechanisms which Bitcoin and many other cryptocurrencies follow.

1. Peer to peer transfers

Bitcoin exists in code. Every Bitcoin holder keeps their Bitcoins in a wallet which comes with a public key and a private key.

• As the names indicate, a private key is only known to you while people can see your public key when you transfer Bitcoins to someone else.
• In every transaction, the sender locks up their Bitcoin (computer code) with the recipient’s public key and sends it over the Bitcoin network. Everyone can see who the Bitcoin is being sent to, as the recipient’s public key makes it apparent.
• Only the recipient can now unlock this transferred Bitcoin with their private key and spend it. Without knowing the recipient’s private key, no one can spend the Bitcoin. Thus, private keys effectively give one control over locked up Bitcoins.
• To make sure that the transfer originated from a person who had the private keys and thus, control over the Bitcoins (to prevent fraudulent transactions), the sender is required to sign the transaction.
• Signing helps with confirmation that sender has access to the private keys, without directly looking at the private keys. Here, a sender signs a code digitally with their private key.
• Following this, their public key can be used to verify ownership of the private key.
• Thus, the transactions are fool proof. Only the receiver can use the Bitcoins while everyone can confirm the legitimacy of the transaction.

Note that both the sender and receiver are only identified by their public keys and wallet addresses. Their real identity is not divulged unless the transfer takes place through an exchange or other intermediary where Know Your Customer (KYC) details have to be given out. In person transactions are obviously not anonymous.

2. Immutable record of transactions

Every transaction is recorded in a public ledger called the blockchain which can be maintained by anyone. Before the transactions are included, the records are rendered tamper proof by a process called hashing. During hashing, the transaction information is converted into a 32 bit length code called a hash.

• Once a hash has been made out of a transaction record, it’s virtually impossible to falsify the transaction or alter the information without changing the hash. This makes the record totally secure against fraud.
• The hashing process consumes a lot of processing power as the Bitcoin protocol requires hashes to start with a string of zeros and the thirty two bit hashes are generated at random. The processors generate hashes to match the transaction’s hash, until one with the required number of starting zeros is generated. This is called mining and the people engaged in mining are called miners.
• Originally used as an anti-spamming tool in email networks, this process is basically proof of work done by miners, and is used to secure the blockchain. But why would miners do this? What’s their incentive?
• As reward for this work, miners are rewarded new Bitcoins generated by the Bitcoin network. Rewards halve every four years, such that only twenty one million Bitcoins can be possibly mined.

A processor must generate proportionately more hashes to find a suitable one with increase in the required number of starting zeros. This mining difficulty varies depending on the processing power used to mine Bitcoins. If more processing power is used to mine Bitcoins, mining becomes harder and vice versa. The difficulty is adjusted every two weeks. This ensures that transactions are verified at a constant rate irrespective of processing power and that miners don’t mine all the Bitcoins at once. A new block of hashes representing transactions are added to the ledger called the blockchain roughly every ten minutes.

No central bank or any other authority is in charge of how value is created or spent as rules for generation of new Bitcoins are set by the Bitcoin protocol and miners get rewarded based on the same set of rules.

3. A decentralised ledger

What truly differentiates most cryptocurrencies from earlier non-state digital currencies is their decentralised nature.

• This ledger which holds all the transaction records in the form of hashes can be stored by anyone in any storage device. Such storage devices are called nodes. All the transactions are linked to the preceding ones creating a chain of transactions called the blockchain. The nodes accept blocks from miners, test their validity and add them to the blockchain.

Nodes also communicate with each other ensuring that they have the same record. If there are discrepancies between two nodes, the longest record of transactions is  to be accepted as legitimate by both the nodes. Thus, Bitcoin is very much resistant to censorship and manipulation of records with thousands of nodes set up worldwide.

Other Bitcoin variants, such as Bitcoin cash and Bitcoin gold, which originated from the original Bitcoin code follow the Bitcoin protocol with some tweaks. There are over a thousand cryptocurrencies now, mostly based on the same underlying principles of decentralised and secure value exchange. Noteworthy out of these is Ethereum, a blockchain which allows developers to build applications upon it such as land ownership records and Monero, a completely anonymous cryptocurrency based on a different protocol called Cryptonote.

Many more cryptocurrencies exist, each with its own value proposition but none have attained as much acclaim as Bitcoin or the other big cryptocurrencies. Since Bitcoin has the largest base of users among cryptocurrencies and a market capitalisation which exceeds that of other cryptocurrencies by an unassailable margin, it is unlikely that Bitcoin would be dethroned as the number one cryptocurrency anytime soon.

Bitcoin is now being increasingly viewed as digital gold, a store of value, secure and immune to manipulation. Though volatile at present because of the low trading volumes and state opposition, with the entry of mainstream traders and investors, volatility is expected to come down significantly making Bitcoin a reliable asset and store of value.