The new buzzword of finance gurus who have taken over YouTube, cryptocurrency has created quite an impact over the past year. Bitcoin, a leading cryptocurrency, reached its all time high, and coins that started out as jokes, like Doge and Shiba Inu, rose to stardom. However, due to the fragile, unpredictable nature of cryptocurrency, with certain coin values being influenced by tweets, memes, and other pop-culture factors, investing in the current crypto market can only be viewed as an optimistic gamble. In this article, I aim to break down the basics of cryptocurrency, discuss some of the underlying technology that powers crypto, and highlight the properties of some of the leading crypto-based assets.
Let’s start by clearing up a misconception. Cryptocurrencies are not just digital dollars, and that definition oversimplifies an intricate relationship between pioneering innovations in software, cutting edge technology, and financial strategy. In reality, cryptocurrencies represent an innovation that is pressingly relevant to the future of the economy.
When our human ancestors began interacting with one another for the first time, humanity was at “Level 1” in financial transactions: the Barter System. During this time, money was not an established innovation. In order to attain a good or service, another good or service of equal value must be given.
Two apparent problems rose as the rate of financial transactions began to increase. First, the value of a good or service was largely subjective and very few civilizations actually had a metric to measure this value during the time of the Barter system. Second, the value of a good or service was driven by demand. Although this is still true in today’s economy, the lack of actual currency brought hidden implications to transactions during the Barter system, since goods and services acted as a form of currency. For example, let’s assume that a man was willing to trade his cat for a horse, an exchange that he saw as fair. However, the person with the horse had no desire for a cat. Therefore, there is no opportunity for this transaction to be completed, since the cat’s value is different to both people. Since the cat’s monetary worth was subjective, the “currency” that the trade was based on had no stable value. The problems caused by the subjective nature of the Barter system led to “Level 2” finance.
“Level 2” focuses on coins. Since these coins were made of precious material, everyone just accepted their value. Once coins were introduced to financial transactions, it didn’t matter if the person with the horse didn’t want the cat. The man could trade coins for the horse, and even if the owner of the horse had no use for coins, they still held intrinsic value, since they were made from precious material. “Level 2” finance led to the current names of currencies, like the British pound, for example. The reason currency in Great Britain is called the pound is because during “Level 2” financial transactions, a pound was literally 1 pound of silver.
The cumbersome nature of lugging around “pounds” of precious metal in the name of trade, coupled with increasing trust in centralized government, led to “Level 3”: paper money. During this stage of financial transactions, money didn’t have value because it was made of precious metal, but rather because it was widely believed that the paper held value. Therefore, due to widespread belief in the relatively stable value of paper money, it was capable of completing financial transactions.
But during the advent of the internet, widespread ownership of computers, and the idea of credit, more people than ever have been shopping online. And that is where we are currently, “Level 4” finance, where people don’t really see their money anymore. Money is no longer physical, but quantified by entries on a spreadsheet. For example, if I buy a ten-dollar item on Amazon, only 2 things happen from a financial perspective: 1) My bank adds an entry within my spreadsheet that states that I now have 10 dollars less, and 2) Amazon’s bank adds an entry within their spreadsheet that states that they have 10 dollars more.
Now this entire timeline of the history of financial transactions lands us at one point: “Level 5” finance, the most convenient era of exchange ever. Cryptocurrency. With cryptocurrency, there are no gold coins, paper notes, or unwanted cats; it’s just the transfer of digital assets. Much like “Level 4”, cryptocurrency keeps track of all transactions made, just like the bank in the previous stage of finance. However, instead of separate spreadsheets for each person/entity, cryptocurrency keeps track of all transactions in one 1 large spreadsheet, known as a ledger.
Now that we understand what crypto is from a general perspective, let’s talk about the underlying technology that cryptocurrency is based on. As stated before, all transactions using cryptocurrency are tracked in one communal ledger. The central software architecture that powers cryptocurrency is blockchain, a technology that is valuable both in and out of the crypto space. Under blockchain, a new ledger is created to record all the crypto transactions of each day. After around 10 minutes (for most cryptocurrencies), the existing ledger is turned into a block, added to the chain of previous 10 minute transaction tracking blocks, and a new block is started. All of these blocks chained together form the complete ledger that keeps track of the transactions.
Since all transactions within a time period are tracked in the block, if someone were to access the ledger and illegally add an entry that paid them money, it would be entirely possible for them to do so. This is where crypto mining comes into play. Miners all have copies of the existing block of transactions, which is automatically updated. All the miners use their computing power to crunch through transactions and ensure that all the copies of the current block are the same. If a malicious actor were to add a false record into a certain block, cryptocurrency mining would instantly invalidate the transaction, since the record didn’t update in every other copy of the block. This is what makes cryptocurrency so secure, its decentralized nature. Someone trying to exploit the system and add a false transaction would have to add the same transaction to millions of copies of the blocks.
Now what motivation do miners have to actually validate these transactions? Well, by successfully verifying transactions, crypto miners are dedicating their computing power to earn some cryptocurrency as compensation. The benefit of cryptocurrency is found within the blockchain. Assuming Amazon will accept cryptocurrency as a valid form of payment in future years, if I were to buy a 10 dollar item off Amazon, instead of updating the transactions within my spreadsheet and Amazon’s spreadsheet, a cryptocurrency would check the validity of this transaction with every other computer on the network, and then every copy of the current 10-minute block would be updated with this transaction at once. Therefore, with so many copies of the ledger, it is extremely easy to catch people who are trying to add unverified transactions. The most interesting part of this concept is the fact that people who aren’t miners can still view the blockchain as a whole. For example, this link will show you all of the Bitcoin transactions that are happening as you read this article.
The top cryptocurrency currently is Bitcoin (BTC), with a market cap of over $1.08 trillion. Started by someone using the pseudonym Satoshi Nakamoto, Bitcoin is widely regarded as the original cryptocurrency. Five years ago, you were able to purchase a Bitcoin for around $500. Now, a bitcoin is worth over $50,000! This massive growth is seen in other emerging cryptocurrencies, like Ethereum (with a market cap of over $557 billion), Binance Coin (market cap at $104 billion), and Tether (market cap over $73 billion).
The largest issue with cryptocurrency, within the United States, is regulation. The blame of crypto volatility could fall on the federal government, who has been very indecisive regarding how cryptocurrencies should be regulated. The reason cryptocurrency is appearing on the news recently is because of the regulations proposed by Biden’s Infrastructure Bill. The reason the U.S. is struggling to implement effective cryptocurrency legislation is authority overlap. The Securities and Exchanges Commission (SEC), Commodity Futures Trading Commision (CFTC), and the Financial Crimes Enforcement Network (FinCEN) all define crypto in different ways and plan to regulate it differently. Certain departments treat cryptocurrencies as property and want it to be taxed accordingly. Others treat cryptocurrencies as securities and want regulation appropriate to that definition enacted. The inconsistencies within regulating cryptocurrency within the United States highlight the many problems cryptocurrency poses for our modern society, since widespread implementation and regulation requires a deeper general understanding of the technology that runs cryptocurrency.
Where do we go from here?
While I wish I could say that this article covers everything you need to know about cryptocurrency, that is not necessarily true. We have gone over the basics of crypto, including blockchain, mining, current currencies, and regulation. However, if you want to delve further into the world of crypto, here are some potential topics to research:
- Non-Fungible Tokens
- Smart Contracts
- Rug Pull
- Proof of Work and Proof of Stake
- Cryptocurrency Wallets
- Coin vs. Token