What is Cryptocurrency?

September 15, 2017

What is Cryptocurrency?

Cryptocurrency has become a hot topic over the course of the past few years, with some hailing it as the future of money. However, many of us don’t really understand what it is or how it works. Let’s break down where it came from, why it’s useful, and where the trends seem to be headed.

Digital money has been around longer than you might think, taking a variety of forms. In fact, even the money in your bank account is a type of digital currency. Banks don’t just have stacks of cash sitting around equal to the number we see on our computer screen. It’s just an approximation of value that we trust will be honored when we need to make a withdrawal. Non-bank entities like PayPal also deal digital currency, and a step closer to the modern cryptocurrency we see today. Created as a tool to facilitate private transactions, it’s based entirely on theoretical cash and at no point receives or deals with physical money. But bank accounts and PayPal aren’t really what we’re talking about here, are they?

For decades, people have toyed with the idea of a real, digital, and encrypted form of money, but none of them gained much traction until the fabled bitcoin. The idea was first brought to bear in 1983, in an essay written by a man named David Chaum while he studied at the University of California Berkeley. The paper introduced the idea of something called “ecash” — anonymous electronic money. Ecash software stored a user’s money digitally, and banks certified transactions via blind signatures, which prevent the banks from seeing the specifics of each exchange such as the amount of money transferred between parties, just that the exchange happened at all.

 


Blind Signature Concept | Image source: Source Forge

In 1990, while working in the Netherlands, Chaum made his vision a reality by founding Digicash, which sent the first electronic cash payment over a computer network four years later. Unfortunately, the company ran afoul of the Dutch government and was forced to sell its currency only to banks, which eventually led to its untimely demise. The company filed for bankruptcy in 1998, with Chaum stating that his business had tried to gain momentum at a time when not enough consumers had an interest in cryptocurrency.

Although his business failed, his studies and the resulting publicity did spark the rise of other digital money ideas. For example, legend has it that in the late ‘80s, Dutch petrol station owners experiencing a string of robberies decided to give their drivers “smartcards” that they used instead of cash to pay for fuel. The stations stopped holding physical currency and (unsurprisingly) stopped being targets.

While this is a rather primitive example of the digital currencies we see today, the same principles and benefits were on display even then, 30 years ago. Privacy, efficiency, and convenience are the cornerstones of any cryptocurrency, and though the inner workings have become decidedly more sophisticated since then, they perform the same essential function. It’s just on a larger scale with improved security.


What is Cryptocurrency and How Does it Work?

Cryptocurrency is a lot like an online bank account, in that it’s essentially a ledger that tallies purchasing power. However, it differs in that it isn’t simply a digital representation of national money. Because it’s not based on dollars, pounds, rubles, or any traditional currency, it’s not controlled by any centralized institution. This makes cryptocurrency entirely peer-to-peer, and the money is only given value by the amount of people that buy into the system and agree that it has that value. Interestingly, this is something cryptocurrency has in common with today’s money (or fiat currency) which is no longer backed by the gold standard.

 

 

We’ll use bitcoin as the example here because it’s the most widely accepted cryptocurrency to date. The bitcoin concept was published in a 2008 white paper by a relatively mysterious individual named Satoshi Nakamoto; it was essentially a spiritual extension of Chaum’s vision.

The core concept starts with the avoidance of “trusted” third parties’ involvement in transactions; bitcoin actually seeks to eliminate the need for active third parties entirely. Where typically we rely on banks and bureaucracy to resolve financial disputes, cryptocurrency users rely instead on mathematical encryption that ensures that no disputes exist to begin with.

Each account owner has a unique, encrypted account number and password, and possesses a digital ledger that contains a record of every bitcoin transaction since its inception. Every time a new transaction happens, it is referenced against the ledgers of everyone in the network to determine its validity.

Every time they make a transaction, they use their password to create one of Chaum’s blind signatures. The signature takes the form of a complex mathematical equation that is then verified by other users on the network, without revealing the actual details of the transaction like amount of currency traded. Once verified, the transaction is sent through, and all ledgers are updated containing the information.

A crucial problem with cryptocurrency bitcoin addressed is an issue with multiple-transaction fraud. Before bitcoin, it was possible for someone to send the same transaction twice and put fraudulent timestamps on them. This could lead to multiple people thinking they were paid when in reality the sender just spent the same money twice. This solution is called the blockchain.

The blockchain works by putting transactions together into groups called blocks. The blocks are encrypted with more complex equations called cryptographic hashes. The only way to solve these equations is for powerful computers to try random inputs over and over again until they happen upon the correct answer. When a computer finds the answer, the associated block is added to the top of the chain, and the transaction is verified. The speed of this process depends largely upon the power of the computer, or network of computers, that is working on the problem, but the average is about ten minutes.

While the ten minute transaction time may seem lengthy, it’s substantially faster in comparison with many banks and online payment systems, which often use holds that take a day or more for security purposes. The time is even longer if you attempt to do business over weekends and holidays.


How Is Cryptocurrency Created?

While that’s a basic rundown of how cryptocurrency functions, the question remains: where do these non-physical units of currency come from? Since they aren’t fabricated from any material or commodity, they come right out of thin air.

Most cryptocurrencies have a set amount that will be released into circulation during their lifetime, making them — unlike the dollar — an appreciative currency. Once that limit is reached and there is a finite amount available, some units are invariably lost and the total number decreases, driving up the value of the remaining units. In this way, cryptocurrency behaves much like gold.

Because of this, the act of producing new cryptocurrency is called mining. When users with powerful computers verify blocks of transactions, they are rewarded with new currency each time they successfully add one of those blocks to the chain. This is the essential mechanism that drives the whole security aspect of cryptocurrency. It incentivizes people to use their resources (in this case, processing power) to facilitate secure and efficient transactions by rewarding them with additional money. It’s a beautifully convenient way to distribute currency, while also maintaining the integrity of the system without the need for a third party guaranteeing the safety of each transaction. Instead, these verifications are performed by both parties mediated by an unbiased network of computers whose entries are countersigned by countless others.

You may also wonder what will happen when the stream of new cryptocurrency runs out. In the case of bitcoin, of which there will only ever be 21 million, the reward system will shift. The users that owned computer systems that were previously “mining” will instead receive currency from transaction fees paid by those that send money. At this point, the value of each unit will increase as the number of units available slowly decreases. Ideally, this will make transaction verification an appreciating investment and still profitable for those that continue to perform the service.


Bitcoin Alternatives and the Future of Cryptocurrency

The success of bitcoin has understandably inspired people to create their own cryptocurrencies. It’s hard to resist — that is, if you’ve got the technical know-how or the money to pay a business to start one for you. However, maintaining the code and getting people to mine your currency tends to prove quite difficult. There are currently estimates of up to 900 different cryptocurrencies available, and most of them fail rather quickly.

This is often due to many of them not being built as genuine, innovative competitors to bitcoin. Some end up used in a pump-and-dump scheme; the creator of the currency attempts to gain publicity, which inflates the price per unit, and then sells everything, sending the price plummeting.

 

altcoin

Examples of “altcoin” currencies | Image source: Crypto-Currencies

 

Despite this, there are a few real contenders that have carved themselves respectable niches within the cryptocurrency market. Litecoin, one of the first bitcoin “forks,” is functionally the same as bitcoin, but boasts higher transactional capacity and faster confirmation times. Dogecoin initially began as a joke stemming from an Internet meme and was used on Reddit as a reward for a quality post or comment. Dogecoin became so popular it even made a NASCAR appearance. It does boast some advantages, like an average transaction time of one minute and no ultimate limit on how many may be produced. The lack of that limit makes it an inflationary currency, unlike bitcoin and most other prominent cryptocurrencies.

One especially interesting cryptocurrency that’s been gaining lots of momentum lately is ethereum. Since 2015, its value is climbing steadily. What’s unique about ethereum is that it supports “smart contracts,” computer programs that execute terms of contracts when certain conditions are met. The applications of smart contracts are immensely varied and have the potential to create completely autonomous corporations, or, as an example, form a decentralized database of ownership rights for musicians, transmitting royalties instantly whenever their song is played.

Indeed, it seems that the future of cryptocurrency isn’t necessarily in developing a “better bitcoin.” Bitcoin is already extremely good at what it does (facilitating peer-to-peer online cash transactions) and new cryptocurrencies that will be truly resilient aren’t ones directly trying to replace bitcoin. They’re using the example set by bitcoin and building off of that in ways that perform a particular function or improve a specific type of transaction. Litecoin is fast, dogecoin is fun and easier to tip people on the Internet with, and ethereum facilitates smart contracts with endless application.

It seems certain that cryptocurrency is here to stay. As more enterprising individuals create new ideas and innovate on old ones, we’re likely going to see rapid expansion of digital currency in coming years. The real uncertainty lies in what forms they will take and what purpose they will serve. Will governments officially recognize them? Will they become the standard method of payment in our daily lives? We’ve but to wait and see.

 




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