Let us begin by first explaining what we mean when we say Currency and what we mean when we say Money. Lots of people, myself included, use the terms interchangeably. Therefore, let us first make some clarification. Let’s first define currency: Currency is what you have in your pocket, the paper bill. Currency is tactile, you can touch it and feel it. It is used to represent money as a medium of exchange: you can take a few of those paper bills and exchange them for food at KFC or a TV at Best Buy. It is relatively durable, I am sure you have dried a few dollars after accidentally washing it while it was in a pants pocket. The bill doesn’t change whether it is in my pocket or your pocket, we are both equally limited in what we can buy with it. While the paper is made of the same material an accounting number $10, $20, $100 allows each piece of paper to represent some “value”. And this is the definition of money. It is the value that the bill represents. So when you check your statement online or pay via debit/credit card you are using money, but when you pay with a paper bill you are using currency.
So where does Money get its value? That depends; when gold and silver were used then we had a case where currency and money were one and the same. This has changed and money now gets it’s value from faith, belief and perception. In that way money is like a religion. Let us look at the history of money and it’s associated currency. Their ever changing properties will help show how our perception of what has value also changes.
Currency is believed to have developed at least at the same time of writing, even believed to have inspired the cuneiform in Mesopotamia, the first known writing system in the world. Before this currency didn’t exist but money did. However, money then was difficult to use as it belonged to the barter system. A smith would exchange some tools for grain, but how much grain exactly? And then there was the issue of moving this grain around. The people of Mesopotamia innovated this process. They created tokens. The earliest tokens discovered date back to 7000BCE, while cuneiform is believed to have been created in 3500BCE. Each token carried some accounting information. For example a token in the shape of a cone represented a small, unknown, amount of grain, while a spherical one with a line through it represented a measure of textile. This would evolve into envelopes containing the tokens with the cuneiform explaining what value exists in the envelope. This system was further evolved into a credit based system. Credit was the next major development towards currencies. Clay tablets from around 2500BCE have been found indicating a creditor and debtor. However, this system was still restrictive as it only indicated specific commodities that could be traded. And as civilization developed so did the number of commodities. Continuing a token system would have become extremely unwieldy. It is not known exactly how the first coinages were created but it is known that the first were based on metals. The people of ancient Mesopotamia eventually settled on silver. Tin, lead, copper and barley were also used, but these were denominations of silver; the cents to the dollar. Metals like silver, relatively rare commodities, could be easily manipulated into a shape and weight and was thus easy to transport. As trade expanded it was the metals that became dominant.
These developments weren’t limited to Mesopotamia. Egypt also used silver. Native Americans used obsidian and shells, early Chinese used shells and then bronze, silver and copper coins. The Aztecs used cocoa beans, they believed that cocoa was a gift from the gods, they are probably right. India used a combination of gold, silver and copper coins. The Greeks adopted gold and silver coins from Lydia around 700BCE and in turn introduced these currencies to Europe via the Roman empire. The use of coins dominated trade for thousands of years until the Chinese invented paper currency. For large transactions it was difficult to travel with large sums of copper coins, the official currency at the time. So traders would leave the coins in the safe keeping of some trusted person and get a promissory note issued to them. This note was then used in trade with the trusted person acting as a clearinghouse for the exchange of the coins. The government took notice of this and eventually refined the system. Printing paper currency instead of minting coins with the promise that each note was the equivalent of some amount of silver coins.
Travellers like Marco Polo brought these innovations to Europe. In the city states that made up what we call Italy trading had become incredibly important. The Italians used the idea of the Chinese paper money and innovated it to be outside the system of government. They created bills of exchange which was basically a note that you can take with you from city to city and exchange it for a quantity of gold. The institutions that kept the gold became the first banks. They further innovated by creating city bonds, insurance on trade and credit and debit to traders and individuals.
As this paper currency gained traction a curious thing happened. The banks realized that many people weren’t coming asking for gold or silver in return for their paper. So the banks began issuing more paper than they had gold, this innovation is now called leveraging. When the first central banks were created they realized that this leveraging allowed them to expand the economy in a myriad of ways the most important of which was managing the expansion of the economy through interest rate changes. It became obvious that what mattered was citizens’ trust in the paper currencies issued by various governments and not the gold or silver you could get back. After all outside of electronics, gold’s only intrinsic value is that it is pretty and people have agreed it is valuable. A similar belief system evolved around paper money it is valuable because it is a worldwide accepted medium to get some service or good. Think about it, when we speak of gold or silver we think of its value in terms of how much paper dollars we can get for that ounce of gold or silver, we hardly ever think of how much gold my dollars can buy, unless you are shopping for jewellery.
In much of the world paper currency has all but disappeared. In China, Korea and Japan paper currencies are hardly used. For the US dollar transactions, only 10% are done using paper currency. Payments are done using digital systems like credit cards and debit cards. To use these systems people have to have a relationship with a bank. Payments are electronically sent from a merchant through computer networks, usually the Internet, to payment processing systems that interact with your bank. In the case of a debit card a deduction to your savings or chequing account is debited and the merchant’s is credited. For a credit card system you are loaned the money to buy the item and have to pay it back in monthly instalments or all at once. Failure to do this incurs interest rate charges, just as a normal loan from a bank. These systems just use our current concept of currency but digitizes it eliminating the need for the end user to walk around with paper or coins.
So we see that a large number of the population in the world is quite comfortable with payments being done using digital money. In fact in China people hardly use cards for payments, they instead use their mobile or even face recognition systems to make payments. So a move to a completely digital form of money transactions is an obvious next step. Cryptocurrency is one of the technologies that can fulfill this economic need.
The word Cryptocurrency is really a misnomer. It is not a currency, but it can become money. By definition money has the following properties:
Well we see that cryptocurrency has the potential to become money. However, it still has the stability issue. But what exactly is a cryptocurrency? To explain this we will look at the two main technologies that create a cryptocurrency. The Blockchain and the Mining. These are also the technologies that give cryptocurrencies their intrinsic value.
Blockchain is a type of data structure that can be used to create a database. It consists of a sequential chain of records that are not changeable. While it would be incorrect to say that a blockchain is 100% incorruptible the energy (power, wealth and time) required to corrupt a blockchain is very high. As the name suggest a blockchain is a set of blocks that are chained together. A block contains the data and each block is chained to a previous block. The sequence of these blocks indicate a timeline of activity. The link that connects each block to another is the hash value of the previous block.
What is a hash value? A hash function converts a set of data to another set of data that is called it’s hash value, and can have some defined properties. For example the CRC-32 hash function converts an input like “Luke I am your father” to “f12bd78b”. The property of CRC-32 is that no matter the length of the input the output will be 8 characters in length. Other hash functions can have additional functionalities like cryptography that encodes the data. These hash functions are not limited to text data but can be used on all kinds of data. It is these hash functions with the cryptography properties that are the crypto in cryptocurrencies.
So far we see that the block contains two sets of data, the record of interest and the hash value of the block that came before it. This is what gives the cryptocurrencies their “non changeable” properties. For example if a chain has 10 blocks. All the blocks, except block 1, will have the hash value of it’s predecessor. Now if someone manipulates block 4 by even changing a single character the hash value will be something completely different. So block 5 will not recognize block 4 as being part of the chain and this will signal that an attempt at tampering has occurred. Let’s look at CRC-32 again; “Luke I am your father” gives the hash value “f12bd78b”; while “Like I am your father” gives “c2db4145”. CRC-32 is not considered secure and is not used in creating hash values in cryptocurrencies but even here we see that one character change created a completely different hash value. Additionally each block will also have an index value indicating it’s position in the chain, example 4 for the 4th block etc. The hash values created for each block can also be used as a method of referencing a block. The index/height for Bitcoin is currently 706,801. A new block is created about once every 10 minutes.
Let us go into a little bit of detail of what data the blockchain of a cryptocurrency contain. We will be specific to Bitcoin. But other cryptocurrencies will have similar information with caveats here and there. But for simplicity’s sake we will just look at the first cryptocurrency. A Bitcoin block is made up of two main sets of data:
This is basically a system of accounting, a ledger. This is the money in cryptocurrencies. Now we will look at the second technology used by cryptocurrencies, the mining of bitcoins.
Mining is the process used to create a blocks for cryptocurrencies. First let’s realize that a blockchain does not require mining to work. If you want to create your own database system using a blockchain data structure on a centralized system, then this can be done without the need for mining. However, cryptocurrencies work on decentralized systems. With a myriad of people/organizations (nodes) having access to the network in order to create new blocks and confirm transactions there must exist a method that allows all these nodes to create blocks and encode transactions into them without duplication. That is you don’t want two blocks to be created containing the same information.
To do this a mining algorithm is used. The very basic property of this algorithm is that it has to solve a difficult problem, a problem that requires a lot of energy and time to solve. However, the solution to the problem must be easy and cheap to verify by any other node on the network. Each time a new block is created the node that created that block (solved the problem) is rewarded with bitcoins. The node that creates the block is also rewarded with the transaction fees. When the bitcoin first started the reward was equivalent to 50BTC, it is halved after the creation of 210,000 blocks (approximately every 4 years). Currently the reward for creating a block is 6.25BTC, at current time of writing is worth USD402,740. It will be halved again in about 920 days. The transaction fees for the node that created the block 706,801 was 0.07260719BTC or USD4,498.
Now let us briefly look at how mining is done. There are two main parameters used for mining. The first is called the difficulty, this provides the value for which the node has to find a solution. The second is the nonce, this is a value that leads to a solution. Bitcoin uses SHA256 algorithm to do the hashing. This is a cryptography algorithm that the nodes will try to solve. However, the criteria for solving is simpler than finding an exact match; instead the mining process has to find a hashed value that is equal to or less than the value the difficulty specifies. The only way to do this is to hash random values and hope to find a hashed value that matches the criteria. This is what the nonce value does. As time passes and more bitcoins are mined the difficulty increases.
The following is the process that occurs during mining:
A new block is produced on average every 10 minutes.
This in brief is a description of Bitcoin with much of the technical detail not included, however, most cryptocurrencies operate in a similar fashion.
Will cryptocurrencies replace the US or Canadian dollar? Will it replace the Chines Yuan or Japanese Yen? This is up for debate. However, I believe that if the volatility we see in cryptocurrencies continues the chances of any cryptocurrency replacing national money is remote.
Many countries have begun exploring their own digital currencies. This is basically replacing cash with digital money that basically follows the same economic principles as their paper currency equivalent. These are called Central Bank Digital Currencies. China is looking at the Digital Yuan with the possibility of blockchain being the underlying technology. Additionally England, Canada, the Eastern Caribbean, the US and others are also developing their own version. If these countries can launch their digital currencies before cryptocurrencies become stable then it is more likely than not that cryptocurrencies will only take up a niche in the economy and not displace our current monetary systems.