Partly due to Bitcoin’s astronomical price increase from $9.35 per coin in July 2012 to $13,860.14 per coin in December 2017, blockchain based cryptocurrencies have become popular buzzwords in the last decade or so. But aside from their reputation as a get-rich-quick scheme, few people understand any of their technicalities despite the many potential applications that cryptocurrencies will have in the near future. Moreover, even beyond their potential applications, cryptocurrencies are powered by a lot of very interesting Mathematics, Computer Science and Economics that are intriguing to explore from a purely intellectual perspective. Because of all this, I’ve decided to take some time to understand and demystify cryptocurrencies and the ingenious technology behind them.
As a result of the technical complexity associated with addressing everything from the origin of cryptocurrencies, to analyzing the algorithms behind them, to evaluating their effectiveness, I’ve chosen to do so in a series of more digestible posts rather than cramming everything into a single post. This first post will focus on understanding why cryptocurrencies even exist in a world where traditional currencies and banking systems already facilitate trillions of dollars of transactions and trade across thousands of miles on a daily basis. The answer to this question relies on understanding the traditional currency and banking system and the ways in which cryptocurrencies aim to address some of the traditional systems’ drawbacks and limitations.
The Traditional Currency and Banking System
So, what is currency or money anyway? Economists usually answer that question by explaining that money serves three key purposes. Firstly, money is a medium of exchange; it is a widely accepted token that you can use for all transactions. Secondly, money is a unit of account; wealth and economic value can be measured objectively with money. Thirdly, money is a store of value; it can be used to store wealth because it remains valuable for a long period of time.
However, although most modern currencies like the US Dollar, Chinese Yuan or Sri Lankan Rupee all serve these three purposes, they are all categorized as “fiat currencies” because the currency/money itself does not have any intrinsic value. Ultimately one US Dollar, Chinese Yuan or Sri Lankan Rupee is just a piece of paper or a few bits on a computer that isn’t worth anything. If you’re stranded in a remote jungle or on the moon, a $100 bill is just a useless piece of paper. Why and how then do fiat currencies like the US Dollar or Sri Lankan Rupee that have no objective economic value serve the three purposes of money and represent monetary value? How come you can use that same $100 bill to buy food from a grocery store, or a ride to the city on Uber or any number of goods or services that take your fancy?
It all comes down to what historian Yuval Noah Harari calls an intersubjective reality. You think the piece of paper or bits on a computer that represent $100 has value because you know that other people think it has value. A butcher will give you some meat for your $100 bill because she knows that the government demands some of it as taxes and that other people will give her groceries, knives and other items she needs for that $100. Although the money doesn’t have any objective value, because enough people subjectively believe that it does have value the money becomes objectively valuable. The development of this intersubjective reality that led to the widespread use of fiat currency like the US Dollar has been revolutionary because it facilitated exponential economic growth and continues to be the bedrock upon which the modern economy functions.
Yet every major currency from the Roman denarii used in the first century AD to the US dollar used today have relied on a centralized authority to coordinate its use. When it comes to physical currency, the central bank issues all banknotes and coins and verifies their authenticity. Without a central bank, the intersubjective reality in which physical money is valuable could break down because people will doubt whether that piece of paper really represents $100 worth of economic value. Likewise, digital currency and fund transfers are controlled and validated by a network of regulated financial institutions and commercial banks. When a $100 transaction is made for example, the two banks on the sending and receiving end verify the validity of the transaction based on account balances and identification. Thereafter, during a process called clearing the bits that represent those $100 of funds are moved from the payer to the payee. The two banks can take upto 10 days to verify the success of the payment and it can be reversed at any point during the process. Just like with physical money, without the two trusted banks that coordinate this process, the intersubjective reality in which those bits on a computer represent $100 worth of economic value could break down because everyone cannot be sure of their accuracy or integrity.
As you can see, the traditional currency and banking system is highly centralized because facilitating economic activity with either physical or digital currency relies on a trusted central authority, be it the central bank, a commercial bank, or some other financial institution. This level of centralization introduces quite a lot of challenges because centralization creates a single point of failure.
Centralization introduces Challenges
The centralized nature of the traditional currency and banking systems introduces challenges across three key dimensions – security, equity and effectiveness. Firstly, from a security perspective, the traditional systems are becoming increasing vulnerable as more and more transactions occur digitally. Because transactions rely on the verification processes that banks do, the entire system breaks down if someone gains unauthorized access to the bank either physically or digitally. Since most transactions take place digitally, even a single hacker can cause quite a lot of economic damage even if she compromises the security of a single bank.
Secondly from an equity perspective, the centralized nature of the traditional system concentrates a lot of power in the hands of the middle-men at banks and financial institutions, whose incentives aren’t always aligned with the public interest. As a result, the centralized traditional system often comes with regulations, fees and restrictions that minimize equity, financial inclusion, and innovation within the system. Centralization also leads to major compromises in terms of effectiveness. When the entire system relies on a single central authority, the process is usually slow. Moreover, as countries like Venezuela, and Zimbabwe have illustrated in the past, centralization can lead to massive, crippling hyperinflation out of malice or sheer incompetence because it gives national governments total leeway to print money and adjust interest rates (two big ways central banks can adjust the money supply of “normal” currencies like US Dollars and Chinese Yuan.)
Why do cryptocurrencies exist?
Although the intersubjective reality that the traditional currency and banking system has created has been revolutionary, it is significantly limited in terms of security, equity, and effectiveness due to its severe centralizations. Cryptocurrencies were first developed in order to solve these problems by moving away from centralization towards decentralization by taking central banks, financial institutions and middle men out of the picture so that a single party doesn’t control the entire system. But, as you can imagine, creating a fiat currency that acts as a medium of exchange, unit of account, and store of wealth is quite a challenge without a centralized bank or trusted authority. For example, if you don’t have a single entity in control, how do you create and verify transactions? How do you record transactions so that it can’t be changed in the future? How do you know that everyone has the necessary information about everyone else? Look forward to my next post, where I’ll explain exactly how cryptocurrencies deal with all these challenges using a data structure called the blockchain and some clever Computer Science, Mathematics and Cryptography.