cryptocurrency
.jpeg)
Technical overview
Cryptocurrency is the name given to a system that uses cryptography to allow the
secure transfer and exchange of digital tokens in a distributed and decentralised
manner. These tokens can be traded at market rates for fiat currencies. The first
cryptocurrency was Bitcoin, which began trading in January 2009. Since then,
many other cryptocurrencies have been created employing the same innovations
that Bitcoin introduced, but changing some of the specific parameters of their
governing algorithms. The two major innovations that Bitcoin introduced, and
which made cryptocurrencies possible, were solutions to two long-standing
problems in computer science: the double-spending problem and the Byzantine
Generals Problem.
Double spending
Until the invention of Bitcoin, it was impossible for two parties to transact
electronically without employing a trusted third party intermediary. The reason was a
conundrum known to computer scientists as the ‘double spending problem’, which
has plagued attempts to create electronic cash since the dawn of the Internet.
To understand the problem, first consider how physical cash transactions work.
The bearer of a physical currency note can hand it over to another person, who can
then verify that he is the sole possessor of that note by simply looking at his hands.
For example, if Alice hands Bob a $100 bill, Bob now has it and Alice does not.
Bob can easily verify his possession of the $100 bill and, implicitly, that Alice no
longer has it. Physical cash transfers are also final, in the sense that to reverse a
transaction the new bearer must give back the currency note. In our example, Bob
would have to hand the $100 bill back to Alice. Given all of these properties, cash
makes it possible for different parties, including strangers, to transact without trusting
each other.
Now, consider how electronic cash might work. Obviously, paper notes would
be out of the picture. There would have to be some kind of digital representation of
currency. Essentially, instead of a $100 bill, we might imagine a $100 computer file.
When Alice wants to send $100 to Bob, she attaches a $100 file to a message and
sends it to him. The problem, as anyone who has sent an email attachment knows, is
that sending a file does not delete it from one’s computer. Alice will retain a perfect
digital copy of the $100 she sends Bob, and this would allow her to spend the same
$100 a second time, or indeed a third and fourth. Alice could promise to Bob that
she will delete the file once he has a copy, but Bob has no way to verify this without
trusting Alice.
Until recently, the only way to overcome the double spending problem was to
employ a trusted third party intermediary. In our example, both Alice and Bob would
have an account with a third party that they each trust, such as PayPal. Trusted
intermediaries like PayPal keep a ledger of all account balances and transactions.
When Alice wants to send $100 to Bob, she tells PayPal, which in turn deducts the
amount from her account and adds it to Bob’s. The transaction reconciles to zero.
Alice cannot spend the same $100, and Bob relies on PayPal, which he trusts, to
verify this. At the end of the day, all transfers among all accounts reconcile to zero.
Note, however, that unlike cash, transactions that involve a third party intermediary
are not final, as we have defined it, because transactions can be reversed by the third
party.
In 2008, Satoshi Nakamoto (a pseudonym) announced a way to solve the double
spending problem without employing third parties (Nakamoto, 2008). His invention,
Bitcoin, is essentially electronic cash. It allows for the first time the final transfer, not
the mere copying, of digital assets in a way that can be verified by users without
trusting other parties. This is accomplished through the clever use of public key
cryptography, peer-to-peer networking and a proof-of-work system.
Like PayPal, the Bitcoin system employs a ledger, which is called the block
chain. All transactions in the Bitcoin economy are recorded and reconciled in the
block chain. However, unlike PayPal’s ledger, the block chain is not maintained by a
central authority. Instead, the block chain is a public document that is distributed in a
peer-to-peer fashion across thousands of nodes in the Bitcoin network. New
transactions are checked against the block chain to ensure that the same bitcoins have not been previously spent, but the work of verifying new transactions is not
done by any one trusted third party. Instead, the work is distributed among thousands
of users who contribute their computing capacity to reconcile and maintain the block
chain ledger. In essence, the whole peer-to-peer network takes the place of the one
trusted third party.
The economics of cryptocurrency
Governance
Cryptocurrencies do not have central banks to regulate the money supply or oversee
financial institutions, but no one should neglect the importance of cryptocurrency
governance institutions. We focus our discussion on two separate but interrelated
ways that cryptocurrencies can be said to be governed.
Algorithmic governance
Rules for what are considered valid cryptocurrency transactions are embedded in the
peer-to-peer software that cryptocurrency miners and users run. One valid kind of
transaction is the creation of new coins out of thin air. Not everyone can execute this
kind of transaction – miners compete for the right to execute one of these
transactions per block (on Bitcoin, every ten minutes or so). When a miner discovers
a valid hash for a block, they can claim the new coins.
A transaction in which a miner claims new coins, like any other transaction, has
to conform to the expectations of the network. The network will reject a block that
contains a transaction in which a miner awards themselves too many new coins. The
growth of coins is limited by a pre-determined amount per block.
On Bitcoin, the pre-determined amount is not scheduled to be constant over
time, but rather is set to halve every 210,000 blocks, or about every four years, as described above. The total supply of bitcoins will asymptotically approach, but never
exceed, 21 million. It will reach 20 million in 2025 and stop growing altogether in
2140.