What is Cryptocurrency?

A simple explanation of how Bitcoin works

A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology, a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

Cryptocurrency can be cheaper and more convenient than many existing services like Paypal or Transferwise, if you regularly send money overseas. Several million people are actively using it today for that purpose.

Cryptocurrencies are still relatively new, and the market for these digital currencies is very volatile. Since cryptocurrencies don't need banks or any other third party to regulate them; they tend to be uninsured and are hard to convert into a form of tangible currency (such as US dollars or euros.) In addition, since cryptocurrencies are technology-based intangible assets, they can be hacked like any other intangible technology asset.

As well as functioning as a new type of internet money, cryptocurrency is also a very popular form of investment, with eye-popping long-term appreciation. Newbies to cryptocurrency find this aspect very confusing. How can this new internet money, which cant even be touched, be so valuable？

How does cryptocurrency have value？

Like any currency, cryptocurrencies gain their value based on the scale of community involvement. Cryptocurrency gains value if the demand for it is higher than the supply. When a cryptocurrency is useful, people want to own more of it, driving up the demand. Any way To answer that question we need to take a short trip back in time and trace the evolution of money. By understanding why we started using money we can strip it back to its fundamental characteristics and discover a concept called sound money.

The behavior of sound money give us a template against which to measure the money we use right now, and the improvements cryptocurrency promises to deliver.

Into The Time Tunnel

Archaeologists have found evidence of collectible items going back 75,000 years, such as beads and pierced animal teeth. Their choice wasnt random; they were durable, not particularly abundant and clearly had special value (often used as jewellery) and we know they took a lot of effort to make at a time when life was short and energy at a premium.

These collectibles were passed on as a family heirloom or as part of important ceremonies as their durability and scarcity enabled them to act as a store of value and a precursor to money. When our ancestors stopped being nomadic, and developed specialist skills, they were able to exchange their surpluses. On a small scale, a village for example, they could keep a mental note of who owed what - a credit or trust based system - and what a fair exchange rate was - how much wheat in exchange for a cow.

This commendation system became useless as the number of items being exchanged increased, and the two sides of the exchanging werent local, so credit on trust wasn't practical; the solution was to find something suitable as a universal medium of exchange for goods and services; early collectibles were natural candidates and thus became the first money.

The advanced versions of money included coconuts, cattle, rice or salt (the Latin salarium being the root of the word salary), but it took Aristotle in 350 BC to articulate what makes something more suitable and useful, as money. His ideas still apply today forming the concept of sound money. At that point in history gold was regarded as the best store of value and medium of exchange. Lets explore why.

The characteristics of sound money

The main property of gold is that it is almost impossible to destroy (durable) but can be melted down into smaller units (divisible), which are relatively easy to transport (portable) and when divided, each unit has identical properties (fungible). It is also very easy to identify, which isn't surprising as it has intrinsic value due to its colour and shine.

Gold cannot be produced, you can only get more of it by digging it out of the ground, but because of the difficulties in mining it, the stock of gold tends to change at a very predictable rate - this gives it the important property of scarcity.

So sound money, effective as a medium of exchange or store of value, has these properties:

• Durable

• Divisibile

• Fungibile

• Portabile

• Recognisable

• Scarce

This gives us a nice yardstick to measure sound money candidates against, and should help address the question of whether cryptocurrency, as a potential new form of money, has value.

But What is essential about sound money is that it has a natural evolution. All civilisations independently employed forms of money - varying depending on geography and culture - and all of them, over time, voluntarily gravitated to better (sounder) mediums of exchange or stores of value.

Gold will continue to be the dominant form of money up until the Italian Renaissance (from around 1420) when the one weakness in gold - the difficulty of transporting large amounts - was addressed with the introduction of Paper Notes, redeemable at a bank for the gold it represented.

The Gold Standard

This was the beginning of what we call the “gold standard” - paper money, backed by gold. This continued until 1971, when US President Richard Nixon changed the rules, allowing governments to create money without any mechanism for converting it into an equivalent amount of gold.

The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold. With the gold standard, countries agreed to convert paper money into a fixed amount of gold. Of course we now know that this breaks one of our golden rules of sound money - scarcity. The new system instead requires us to simply trust our governments to decide how much money should be created and for what purpose. This is known as Fiat Money, which literally means - this is money because the government says its money.

In consideration of the past time we should have known that the combination of trust, government and money would end badly. What makes the scarcity matters is that creating more money (known as increasing the money supply) makes the money you might have saved worth less; this is called inflation. In countries that totally lose control of their money you get hyperinflation, when your money is worth nothing.

As the saying goes, trust comes in on a snail and rides off on a horse, so how do you get back to sound money and regain peoples trust？

How cryptocurrency can return us to sound money

To recover sound money we could return to the gold standard, but heavy metals aren‘t exactly ideal for a digital world; the answer comes from cryptocurrency. Cryptocurrency is mainly designed to include all the characteristics we’ve discovered about sound money; be convenient for the digital age but with no one point of failure.

Instead of a central authority, cryptocurrency monetary systems instead rely entirely on maths - more specifically, on a branch of maths called cryptography. This is where the “crypto” part of the name comes from, and what makes the idea of cryptocurrency so revolutionary. The first and most important cryptocurrency is Bitcoin.

Bitcoin, Ultimate Sound Money

First let's make a clear difference before we dive in to the Bitcoin rat race. Bitcoin (with capital B) refers to its money system - whereas bitcoin (lowercase b) refers to its units - the money itself. It was the first cryptocurrency to find a successful solution that ticks all the boxes of sound money with none of the risks of a single controlling authority.

Lets explore how it achieves those two things.

Achieving Trust

So far the most absolute aspect of Bitcoin is that it requires exactly zero trust in a central authority - which as weve learned, has led to ludicrous national debts driven up by catastrophic financial crises (2008), and the impact of the Covid Pandemic (2020). Bitcoin simplify the trust issue by taking control of the monetary system out of one pair of hands - the central authorities' - and into many hands of a wide network of dispersed users, none of whom have ultimate control. This is what the term decentralised means.

Surely, Bitcoin did have a creator, (we‘ll learn more about them in the next lesson) but the greatest gift they gave was to remain anonymous and relinquish any control, understanding that Bitcoin could only succeed as trusted sound money, controlled by the many, not the few. All these users locally run some software that maintains the Bitcoin network, creating an ongoing consensus of every user’s balance of bitcoin. All Bitcoin transactions are final and cant be arbitrarily reversed unless all users agree, so as the network grows, it becomes more secure.

These users (also known as Nodes) are incentivised to support the network and maintain its accuracy.

The use of cryptography secures transactions against fraud and theft, while allowing anyone to mathematically verify the correctness of all transactions in the system. It is possible for you to bribe maths. No matter how much you try to sweet-talk, massage, or threaten an equation, you won‘t change its result. So in retrospect, it really shouldn’t be so surprising that maths - combined with computing - was the answer to the problem of trust in the money system.

The design of Bitcoin makes it impossible to freeze, seize, spend someone elses coins, or to spend the same bitcoin twice. If you try to double-spend your coins, only one of the transactions will go through - any others will fail. Therefore when you want to send 0.5 bitcoin to your friend, you can use a smartphone app, a bit like your personal banking, and the network is incentivised to agree that your balance has 0.5 deducted and your friend, 0.5 bitcoin added.

In contrast to national currencies, Bitcoin is a global money system, recognising no borders. It can be exchanged nearly instantly, at any time. There are no “Bitcoin banking hours” and no KYC. Transactions can be carried out any time. But what about the principles of sound money, I hear you ask？ Well Bitcoin has those covered too

• Scarce - There will only ever be 21 million bitcoin in circulation, and new ones are mined (the process by which new coins are created) at a predictable pace. This means that there wont ever be a sudden tsunami of new bitcoin flooding the market generating inflation

• Durable - With so many users maintaining the network it would take an unimaginable catastrophe to knock them all out at once.

• Portable - It is just data after all so you can use your phone, a USB device, or even just a QR code on a piece of paper.

• Divisible - Bitcoin has its own special denomination to eight decimal places. Tick.

• Fungible - The beauty of a decentralised system is that no one can make special exemptions, every Bitcoin is created equal.

Two for one - Internet money & investment

When the Bitcoin system launched, its currency, bitcoin, was pretty much valueless. It wasnt valuable until 2010, when someone paid 10,000 BTC for a couple of pizzas, that bitcoin began to give signs that it could be used as money. As of April 2021, that would amount to US$ 600,000,000 - easily the most expensive dinner in History. Clearly belief in the Bitcoin system has grown dramatically as people go on the journey you are now taking, learning about sound money.

But by that time is anyone using it as money？ Yes, there are over 1 million active Bitcoin addresses (users) particularly those suffering from the hyperinflation mentioned earlier, which constantly reduces the purchasing power of their existing money and those looking for a strong store of value. (We explain how to measure Bitcoin adoption in a later article). Hopefully you‘ve now understood in basic terms what cryptocurrency is, and how it tries to achieve the function of sound money. As the first cryptocurrency, Bitcoin’s design has opened up a new phase in our journey to find the best sound money, and this is just the start.

Later In the next coming lesson, you will be exposed to know how Bitcoin is evolving and as more people understand it, new improvements and refinements are made. The final frontier for bitcoin is volatility. Even though its price and popularity are increasing, it is still susceptible to big swings in value because in truth Bitcoin is still in its infancy, so congratulations, you are early to the party.

But one thing that could makes us to believe that cryptocurrency will become more stable over time, and prove to be the ultimate form of sound money, is when many people own and use it.