Throughout history, technology has pushed the human race forward in unimaginable ways. Armed with the faculty of intelligence and the ability to make tools, humans were able to excel beyond any other mammal. Some like machine guns or anthrax gas enabled the darker sides of the human race to commit horrible acts of violence. Others like the light bulb, and penicillin saved lives. Still others like the internet democratized the world by giving anybody access to voice their opinions, raise capital, and have the power to make a living from the world. In the world of 2022, there is another technology that enables the next thing that needs democratizing – access to one’s wealth. This technology is cryptocurrency. In a previous post, we explored the ‘currency’ part of the what is cryptocurrency question. Now it is time for us to look at the other part: The technology that enables cryptocurrency.
To understand how cryptocurrencies work, we must know how it can be like a digital currency. According to Wikipedia, a digital currency is defined as any currency, money, or money-like asset that is managed, stored or exchanged on digital computer systems. So how might a digital currency be better than paper money?
Imagine I want to buy a car that costs 50,000 dollars. Without a digital currency, I would have to go to the bank and bring 500 $100 bills in a bag to the auto dealer. I run the risk of hurting my back from the weight of the money and getting robbed. With digital currency, I show up to the car dealer with my iPhone. When I reach a good price with the dealer, I just simply wave my phone storing my digital visa credit card and buy the car instantaneously. Beyond this digital currencies enable buying or selling on an online marketplace or a video game and transferring money online.
The following are the 5 characteristics of a digital currency:
1) Record of all transactions/ownership: Any currency system requires a complete record of transactions and a list of who owns what
2) Issuance of currency units: The system at hand needs to make possible the issuance of new currency units
3) Enabling of Transactions: The currency needs to make possible transactions, the transfer of ownership of value between different users
4) Guarantee of Value: A centralized organization issues and manages the digital currency, ensuring that its value will not fail
5) Lack of physical form: Money is digital, meaning it can be transferred instantaneously at the speed of light at any time to any one anywhere.
But how are cryptocurrencies like digital currencies but also different?
Cryptocurrencies are able to replicate the 5 characteristics above, but on top of that they do it in a DECENTRALIZED manner. Decentralized means that the cryptocurrency is maintained by 1) pure technology and 2) by a group of random people
Wait a sec…did I hear that right?
Imagine there is a list of transaction records that is digital, accessible to anyone, and is somehow not stored in a single location. This distributed, digital, public ledger is what we refer to as a Blockchain. Through this distributed ledger, a cryptocurrency satisfies the first characteristic of a digital currency. The transactional data is stored in batches (or blocks) in a chain-like form, hence the name blockchain. Each contain the following: a special code called a Hash tying the block to its previous block, valid transaction data, and a timestamp. Why is the blockchain structured this way? How is it better from data structures before?
Traditionally, data is structured in the form of large encrypted data tables (like excel sheets). Once a hacker breaks into these huge databases, they have access to ALL of the data in those tables. If I am a bank or an ecommerce store, the last thing I would want is for others to have the ability to access my data and manipulate it. The most important thing in any business is trust and if somebody is able to fraudulently claim that they are owed money or buy something with someone else’s money by making up transactions, the trust is forfeit and the business has to close.
Blockchain has a robust way of preventing this. First, the transactional data is not centralized in one location but distributed among the different blocks. The special code in each previous block changes every single time a new block is added to the chain and the new code from the block is created (more about this a bit later). So if the hacker somehow broke into a block and tried to manipulate a transaction (let’s say he bought a watch for $200 but wanted to change it to $0), this would change all of the hashes across the whole blockchain. A single change to any data on the blockchain is thus immediately detectable, and all the previous blocks would have to be checked and approved again. All of these point to blockchain enabling a decentralized version of digital currency:
1. Blockchains are secure in that it is difficult to change records on them, thus guaranteeing value associated with the recorded transactions
2. The hash codes used by a blockchain are all computerized codes thus digital.
But how about enabling new transactions and producing/retiring currency units? Does a blockchain enable these things?
We have discussed how a blockchain is a secure digital ledger, but how are its blocks created in the first place?
Every time a transaction takes place, it needs to be checked for fraud. Unlike a bank, there is no centralized entity in charge of validating transactions on a decentralized blockchain. So how do a group of people agree that a transaction is valid? There are many ways “distributed consensus” is reached, but the 2 most famous ones are called “Proof of Work” and “Proof of Stake”. Removing all the technical details, proof of work involves a bunch of users that use their computers to try to randomly guess the special hash code of a block. Whoever comes up with the closest guess is rewarded cryptocurrency, which is new cryptocurrency introduced into circulation. The proof of stake system involves users owning a lot of the cryptocurrency to volunteer and validate the transactions on the blockchain and getting rewards in return.
Through these decentralized means, new blocks are created, transactions are processed, and new cryptocurrency is minted and introduced into circulation. Bitcoin and Ethereum are the most well-known cryptocurrency that follows the proof-of-work mechanism. It has been widely publicized that Ethereum will be transitioning to a Proof of Stake consensus mechanism soon. We will be delving deeper into the different types of consensus mechanisms in a future post.
For now, we know that cryptocurrencies are able to do what digital currencies do with the help from a group of random users with computers over the internet. For more information on distributed consensus, check out this below.
We now have a better idea of how blockchain technology and distributed consensus can enable cryptocurrencies to be like money. However, just because something functions like money does not mean that people will regard it and use it as such. As with any technology, cryptocurrency also follows the technology adoption cycle where even if technologies gain early adopters, they may still fail to acquire enough mainstream users and ultimately fail. An example of this was Google’s failed social network service, Google+.
The adoption of cryptocurrency is another league of ball game because it is a technology directly associated with the use of money. In other words, there needs to be a cryptocurrency service adopted by a lot of users who will continuously pay cryptocurrency to use it. The key to enabling crypto “services” lies in another paradigm called ‘Smart Contracts’ which we will discuss in a subsequent post. In future posts, we will look at cases in the crypto space and outside of the crypto space where service adoption + commerce have been successful. We will also look at examples where the adoption is more of a fascade for fraud.
Enter your email and hit the subscribe button to join the Crypto In Play weekly newsletter
for a review and insights on cryptocurrency and life.
© 2022 Crypto In Play All Rights Reserved