The Age of Cryptocurrency: How Bitcoin and the Blockchain Are Challenging the Global Economic Order
by Paul Vigna & Michael J. Casey
The status quo
The current economy relies on banks and governments. Banks began by serving as middlemen in transactions, and keeping a centralized ledger of debts. Governments typically control the money supply in response to economic stimuli. In the modern economy, banks have evolved into a dangerous network of fee-taking gatekeepers upon which the entire economy relies. This became evident during the 2008 financial crisis. Governments have also contributed to various currency meltdowns throughout history.
A brave new approach
Bitcoin offers an entirely different infrastructure to facilitate transactions. Bitcoin’s ledger system, known as the blockchain, eliminates the need for governments, banks, and their associated fees by using a common algorithm and a network of computers. As a result, the billions of dollars collected by banks and other intermediaries could be instead returned to businesses and individuals to make the economy even stronger. This is one of the single greatest benefits of digital currencies. The bottom line is that digital currencies have the potential to make the economy more efficient by reducing the transaction fees, interest rates, and other costs associated with the current system banking system.
Bitcoin is just software
Bitcoin the technology is simply a protocol—a common language that computers use to communicate with one another. The protocol effectively serves as a platform–or operating system–upon which tools can be assembled. The system generates two things. The first is trustless proof of coin ownership and transaction validity without the need for external identification. The second is an automated ledger of every transaction ever performed on the platform (the blockchain). Computers running the bitcoin software (known as nodes) work to solve a random complex mathematical problem (known as a hashing algorithm) for each new new block of transactions on the network. The first node to solve this equation is rewarded in bitcoin. This is known as “mining.”
Why should we care?
History has shown us that technology does not wait for us to catch on. The technology of bitcoin and its byproducts have the potential to massively disrupt the current financial and governmental system of currency and exchange.
Bitcoin is not without risks. A major headline that traces its involvement in, for example, a terrorist attack, could significantly impact its public perception. Regulators could also impose fees and restrictions on its use. Finally, competition from newly issued digital currencies as well as other platform technologies pose a significant threat to the long-term viability of bitcoin.
Currency vs. money
For a currency to serve as a viable money source of money, it must be three things:
- a medium of exchange
- a unit of account
- a store of value
Bitcoin is currently used as a medium of exchange, but it is rarely used as a unit of account as many bitcoin vendors list prices in their local currency. Bitcoin is also a questionable store of value due to its extreme volatility relative to other more stable currencies. Perhaps the real question, however, is does bitcoin have unique economic utility that can make it more reliable as money.
The founder of bitcoin is Satoshi Nakamoto, a pseudonymous computer programmer (or group of programmers). In his white paper, Satoshi describes an individual coin as a “chain of digital signatures.” When a transaction is made, a user adds a hash sign and their unique digital signature at the end of a public key. Coins are transferred by signing a hash for the previous transaction, then adding the public signature of the new owner, and adding these to the end of the coin. A transfer can only take place if the current owner uses a “private key,” which is a string of code used to authenticate the transaction by adding it to a publicly available key attached to each coin.
Bitcoin was not the first crypto currency concept, but it did have two major innovations. The first was the universal ledger system, known as the blockchain. The second was the “proof of work” based mining system to keep it updated.
How bitcoin prevents fraud
Transactions are split into blocks, after which miner nodes can verify the transactions posted versus the historical ledger verifying that the bitcoin being exchanged belongs to the paying party. A “block” of freshly verified transactions are chained to predecessor blocks every 10 minutes to create a traceable record of transactions. As a result, it is not possible to double-spend bitcoin unless a party controls >50% of nodes in the bitcoin network, and is therefore able to manipulate the records on the blockchain.
How bitcoin mining works
Bitcoin uses a mining reward algorithm to adequately compensate miners for keeping the ledger and for the required computing power and electricity demands.
Bitcoin mining has morphed into a highly advanced industry, as major miners now employ data farms of supercomputers to process hashing algorithms for validating transactions. Mining pools also collaborate to share mining spoils among multiple individuals and companies in proportion to the hashing capability contributed to the network.
In order to make it harder for nodes to match the correct hash and thus win an allotment of bitcoin, a randomly generated set of code called a “nonce” is added to the string of characters in a hash. This adds an element of chance into a system that would otherwise be dominated by the fastest machine on the network.
A quantum currency
The supply of bitcoin is cut in half every four years. By 2140, there will be no newly minted coins. As the pay off for miners decreases, the system is set up for a transaction fee to take the place of block rewards.
The bitcoin value proposition
The developing world and other on banked communities present a huge opportunity for bitcoin as a technology. Many in these developing countries are used to complex financial arrangements, such as currency exchange is, that will likely make them more comfortable with a digital currency. Second, a greater portion of workers in developing countries are self-employed, which will make them more sensitive to transaction fees otherwise shielded from consumers. Finally, bitcoin presents a very compelling means by which to transfer money overseas, a process that currently requires fees ranging from 10 to 30% due to the current banking system.
The growth of digital currencies can leverage existing platform technologies, such as mobile devices, to make their reach more widespread, Even without the need for a bank account.
“Blockchain 2.0” is the set of innovations around bitcoin’s underlying technology that leverage distributed computing power and ledger keeping for a whole host of activities, ranging from financial and real estate contracts to micropayments for online content. One intriguing example of this is Mike Hearn’s “driverless taxi,” in which a driverless car is programmed to make a deliberately small profit by offering a ridesharing service. By operating off of bitcoin, the car could “own” itself, and be programmed to invest profits in new vehicles or drive to a new city where demand is higher. Communities, cities, or private benefactors might choose to collectively invest in these vehicles as a public service.
Regulations are a big threat to digital currencies, but in the long run, anything that can be decentralized will be decentralized (think Uber, Airbnb, etc.).
Other digital currency’s (known as “alt-coins”) such as Ethereum, Ripple, and Lite Coin are also being used, and have their own unique value propositions and advantages. Ethereum offers a Turing-complete platform by which to write and carry out “smart contracts,” while Ripple is a for-profit coin marketed toward international money transfers in fiat currencies.
The future of bitcoin
The future of bitcoin and other digital currencies is far from obvious. Current stalwarts like bitcoin could lose out to a marginally better solution that utilizes leverages the current banking infrastructure. It is also possible to imagine that the use of cryptocurrencies never grows beyond a core group of enthusiasts and investors to a wider audience that would create the network effects necessary for its utility and long-run usage.
One key difference between bitcoin and modern fiat currencies is inflation. While our society is used to inflationary currencies, where new issuances increase liquidity, bitcoin’s core tenet of an ever-decreasing new supply of coins makes it a deflationary currency.
Adoption of cryptocurrency may increase rapidly if a major company such as Walmart were to adopt this method to cut out financial middleman and save millions of dollars in fees.
The “Anti-Fragile” currency
If digital currency technology takes off in the future, it is not hard to imagine nation states creating their own digital versions of fiat currencies. This would have major political implications, as strong currencies like the dollar would likely become the dominant form of money in the global economy.
Even if bitcoin itself does not succeed as a currency, the underlying blockchain technology may become the background for a more modern financial system which would lead to the price of bitcoin (better thought of as equity in the bitcoin network) increasing substantially.
The future of cryptocurrency technology is, in effect, binary. If the technology fails, things continue as they are. If it succeeds, everything changes…