Cryptocurrency is money native to the internet. Cryptocurrency is a system that is trustless and permissionless. A trustless and permissionless system is a system free from abuse and censorship. Cryptocurrency will change the way we interact with money and I will show you how to understand it.
This is the first post in a series I call Crypto For Nonmajors, meaning you do not need a foundation in computer science or economics to understand Cryptocurrency. If you want to understand crypto, why it has value, and how it will change how we use money Crypto For Nonmajors is for you! In this first post in our series, I cover what a cryptocurrency is, how it works, and how it moves us away from our legacy financial system. Let’s dive in!
What is cryptocurrency?
Cryptocurrencies are the application of how we as humans store the value created by our time and effort but without the centralized control that our current monetary system is built on. Anyone can create a currency but you need government approval to start a bank. Using a bank requires that you trust the third parties who control it, most cryptocurrencies do not require that you trust any third party. A bank has humans who run and lead it, a cryptocurrency is built around a distributed ledger of record that runs on computer code without humans running the system.
Permissionless. Trustless. Distributed. Those are the three core tenets of everything that I consider to be a true cryptocurrency. There are now and there will be in the future, other digital assets that call themselves cryptocurrencies or will be called cryptocurrencies by others but fail one or more of our litmus tests. We can consider these to be digital assets of one type or another but the core layer of crypto is built around the ethos of Permissionless, Trustless, and Distributed ledgers of record.
What is a distributed ledger?
A distributed ledger lies at the heart of cryptocurrency. Let’s take the original cryptocurrency, Bitcoin, for our example here. Every 10 minutes a set of computers around the globe who make up the Bitcoin network each receive a copy of all the transactions of Bitcoin between wallets around the world during that time. A wallet is an internet address that can receive, hold, and send Bitcoin and these computers record when one wallet sends some Bitcoin to another one. In order to hold an official copy of this distributed ledger each computer has to solve a difficult math problem, a cryptographic problem, to prove that it is available and connected to the network. Solving this problem comes at a computational cost and consumes resources, mainly electricity and the cost of internet service. This process is called mining and the providers of these specialized computers are called miners. When the network is running these mining computers are talking to each other to verify that their copy of the transaction report, the ledger, agrees with each other and they arrive at a consensus that yes these are in fact the legitimate transactions for the network during that time period. Every ten minutes another set of transactions are created and laid down over the top of all prior transactions, this is called a block. As each block is laid on top of one another it seals in the prior transactions making them effectively permanent. So a person in Indonesia and a person in Indiana who might not agree on anything else can each review the same distributed ledger and agree which wallets hold which amounts of Bitcoin. No human governs the process and anyone who spends the money for the hardware, power, and connectivity can become a miner on the network. This process of distributed computing documenting the same sets of transactions across the network block after block creates a continual chain of blocks of transaction data, thus the term blockchain.
How does computer code have value?
This question was one of my first as I was learning about the cryptocurrency space and why I didn’t understand Bitcoin until 2017. How could someone just create a currency out of thin air with nothing to back it up? If that would work, why wouldn’t everyone just do it and mint themselves millions of dollars? The very straightforward answer is scarcity. Scarcity is the idea that there is a limited amount of something and that there is value based on it’s scarcity. If you stand in a lawn and pick a single blade of grass it could be considered next to worthless because you are surrounded by grass that you could choose to pick at any time. If you attempted to trade that blade of grass to your friend for the sandwich they are eating they would laugh in your face. Why would they give up their meal for that blade of grass when they could just pick another one at their feet. The grass is abundant, the opposite of scarce.
Bitcoin solved this problem by creating scarcity via computation. The miners are spending resources, namely power, connectivity, and cost of equipment, to maintain the network. To compensate them for providing that service to the network they receive a block reward or payment in the cryptocurrency for each new block they mine for the network. That means that Bitcoin represents not just what humans think of it as a store of value but also that it represents the hard costs that miners spend to maintain the network. Scarcity through computation.
Why use cryptocurrency versus fiat currency?
Let’s think of the possibilities for how we could choose to store time as economic value. Barter is least efficient but most direct. I grow a tomato and will trade it to you for the egg from your chicken. We both devoted time to producing each of those goods and judge this to be a good trade so we each get what we want directly from each other. This works well with your neighbor and if you both want to consume the produce relatively soon but is more difficult if you wanted to trade your tomato for new business cards from a printer in the next state. So everything we as humans have built beyond barter transactions are intended to better preserve economic value and decrease the expenses of transferring it. Think about gold, gems, and rare seashells which have all been used by various groups throughout history. The scarcity of the item in nature gives it value and humans are willing to trade other goods and services for these items because they believe they will be valuable in the future and can be exchanged back into something we need. In the case of gold it never rusts or tarnishes, can be easily molded into standard shapes and sizes, and can even be stamped with the official seal of someone who guarantees it’s quality. A pretty robust tool for transferring value.
Naturally scarce objects like gold run into limitations though, if you want to buy a whole kingdom the wagonload of gold is heavy and difficult to transport. What if we simply put the gold into a secure central location and signed a contract guaranteed by someone we pay to hold the gold for us. I can leave my gold in the fortress of someone I trust, ride to the kingdom I want to buy, and sign something with my official seal that allows them to pick up the gold later on. Enter the trusted third party, banks, and deposit notes.
It is far easier to have the Medici, the town bank, or the national bank hold your gold for you and simply issue a receipt to show others how much you have. You can then sign over that receipt to someone else and allow them to go pick up the gold whenever they wish. This is the original certificate of deposit and how many societies organized their banking early on. The central theme is a trusted third party who bears reputational risk if they do not guard your deposit and give it back when a valid claim is made.
Now enter the central bank and loss of the gold standard. What if we no longer had to back up those deposits by actual scarce assets? What if we could simply have the full faith and credit of the nation state backing up the notes they create. Saves a ton of time and expense overseeing vast deposits of gold in vaults. It also solves the pesky problem of what to do if you want to buy more things with your currency than you currently have the gold to pay for. You simply add a bit more to the supply of notes outstanding. Nobody minds too much because the nation state can always levy taxes and fees to raise more money and back up the notes. But what if you continued to do that year after year and kept increasing the amount bit by bit. Doubt starts to creep in that the notes people have are as valuable as they once were, abundance over scarcity. Now we aren’t holding a blade of grass in the middle of the lawn yet but it is an erosion of value bit by bit over time.
This is the central problem of fiat currencies, there is no inherent scarcity in the production of that currency. Only the promise of a trusted central authority that your money is good because they back it up. As a store of value and medium of exchange, cryptocurrency solves the issue of central bank currency devaluation. Not with gold in a vault but with scarcity of the currency built into the set of rules written into the code.
What about trusted third parties?
Cryptocurrencies, as we have defined them to be trustless and permissionless, remove the potential for problems created by systems built around a trusted third party to facilitate transactions. While we have gone from the Medici to the Federal Reserve, Chase, and JP Morgan what these all have at their center is a trusted third party. Someone that we collectively agree is trustworthy to put in the middle of our transactions. We have the alphabet soup of FDIC, SIPC, SEC, CFTC, FINCEN, and others who watch over and regulate the various transactions that occur at public and private institutions. These are intended to maintain faith in the validity and fairness of the financial system. If an individual bank fails, insurance guarantees your deposit up to a certain amount. Fraud is greatly reduced. Markets are free and competitive. These narratives hold our system together but we have collectively made the tradeoff that in order to have a system that feels more stable we give up control to a third party.
Every transaction is monitored and controlled by a number of trusted third parties. Want to send money to someone else? Your bank has to review and approve the wire or ACH transfer. In the positive sense they are looking for money laundering, tax evasion, and market manipulation. Things we would all agree should be prevented. But the pursuit of these aims slows down the functioning of the system and creates the conditions for corporate and government censorship. Try sending a third party wire transfer to another individual and refusing to specify the purpose for the transaction. The bank knows that transfer fits the criteria for potential money laundering as defined by FINCEN and will refuse the transfer. Ask too many times and they may freeze your account for review. If you have too many transactions that do not fit neatly in the box they want, you may find yourself booted from the bank with a government regulator asking you additional questions. Even at a more benign level, try submitting an ACH transfer from your bank to another on the Friday before a market holiday. If you are lucky it should process the following Tuesday and perhaps settle by the following Friday.
With cryptocurrency as we have defined it, trustless and permissionless, there is no trusted third party at the center. If you want to send 10 BTC from one address to another, simply use your private keys to move the coin from your wallet to the next. If you want to loan your aunt 5 ETH (Ether) to purchase a car, send her the ETH and enforce the agreement however you choose. Trusted third parties create the opportunity for fraud, abuse, and censorship regardless of how much you trust the third party. People and institutions change over time and we should all be wary of systems that create the potential for future problems.
Summary
Cryptocurrencies are intended to solve a variety of unique challenges we face in storing and transferring monetary value. They represent an evolution away from the legacy financial system that is built around fiat currencies and trusted third parties. Cryptocurrency places the individual at the center of the system, a system built on code and distributed ledgers, rather than on the platform of government and private banks. Bitcoin relies on computational proof-of-work (PoW) to validate the blockchain and the network. In Crypto For Nonmajors #2, I discuss Proof of Stake (PoS) as a method to validate a network and what Etherium is.
Disclosure: All thoughts are my own, nothing is investment advice. Always seek counsel from a qualified professional for any tax, investing, or legal advice.