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Why Cryptocurrencies?

August 22, 2017

The transfer of "things" in the physical world is easy. I have a chocolate bar. I give that chocolate bar to Dave. One simple action and Dave has full control over the chocolate bar. No need for outside assistance, no need for witnesses, no need for secret handshakes.

 

In the digital world, the transfer of things work very differently. When I send Dave an email, my computer sends a copy of that email through the internet. When I hand over a USB drive of photos, I'm handing over a copy of these photos. There's no guarantee that I haven't sent the data to anyone else. There's no guarantee of authenticity.

 

This is certainly not a problem (and may in fact be desired) when sending spreadsheets, movies and cat pictures. However, this model is absolutely useless when trying to electronically send something of value: Money. We actually have a name for this long standing puzzle: the "double spending problem".

 

The ledger

 

How then did the internet world handle electronic money? It borrows the core idea from the world of accounting - the ledger.

 

Having a record of transactions and account balances solves the problem of double spending. The ledger - and all copies of it - serves as the record of transactions and account balances. The double spending problem is now solved.

 

But wait! Which copy of the ledger is correct?

 

The traditional ledger model of electronic transactions relies on trusted third parties - banks, credit card processors, remittance providers, paypal - to maintain the "correct" ledger and to keep the ledger safe.  These trusted third parties do this by building systems layered behind layers of security, and limiting outside access to the system to prevent unauthorised editing. Users pay them a fee for this service, and are subject to opening hours, transfer limits, and processing times. These ledgers are also merely a representation of money, which means we are also trusting our banks to act as proper custodians of our money.

 

Enter Cryptocurrencies

 

Electronic money took a momentous step forward with the birth of the Blockchain and with it the first cryptocurrency: Bitcoin.

 

The Blockchain borrows ideas from ledgers and cryptography. Public key cryptography - which uses "public keys" that are widely known and "private keys" known only to the owner - is used to represent ownership and control of electronic tokens. Transactions recording the transfer of control of these tokens to a public key can be initiated by the owner of the private key.

 

Computers running specialised software and hardware then enter into a race to assemble these transactions into "block" using a set of rules that are computationally difficult to create but easy to verify. The winner of this race gets issued a number of tokens as a "block reward" that is used as a mathematically secure method of creating the cryptocurrency's monetary policy. Bitcoin, for example, has set within its code a diminishing inflation rate, topping out at 2.1 quadrillion (2.1 thousand trillion) discrete monetary units.

 

These blocks are then disseminated widely to users. These users can verify that the transactions are valid and that the block was created correctly, and then linking it with all other blocks that came before it as a correct and unbroken record of all transactions - the "chain".

 

The blockchain creates purely electronic tokens that are  durable, portable, uniform, scarce, divisible and fungible. All the necessary qualities of money. For the first time in history we have money that exists in a purely electronic format without the need for a trusted third party. Exactly like cash, without the paper.

 

 

 

Cryptocurrency is real money. It is used as money by millions around the world, and is accepted by hundreds of thousands of stores. Cryptocurrency has been officially recognised by governments as money, and even accepted by a Swiss canton as a means of paying city fees.

 

Cryptocurrency is sound money. The cryptographic functions ensure that transactions are statistically impossible to reverse. The validation process ensures that all transactions are valid. Monetary policy is governed by the laws of mathematics, securing the predictability and limit of supply.

 

Programmable Money

 

The most exciting aspect of cryptocurrencies is that it is programmable money. The code behind the blockchain is open source and transparent. Security is built on cryptographic keys and not access control. This model allows developers to build apps linked to the blockchain, programming how and when money can be transmitted. It is possible to build a cryptocurrency transaction that is only processed the moment a package tracking system shows a package as "delivered". It is possible to program a monetary gift to only be spendable on the recipient's 18th birthday, and only on food and university fees. It is possible to program a cryptocurrency balance to be transferred to a next of kin if the cryptocurrency wallet has been left inactive - bypassing courts, estate lawyers, and feuding siblings. Companies can issue shares linked directly to a blockchain token - bypassing the need for stock exchanges and share registries.

 

It is definitely exciting to read headlines saying that Bitcoin has reached another all time high, and for now Bitcoin might still remain a speculative investment vehicle and the plaything of technophiles. However, make no mistake - the creation of blockchain technology has the potential to be the most important and disruptive financial technology breakthrough in our lifetime.

 

 

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