A Terminology Primer: Understanding the Language of Digital Assets
Whenever a new technology takes off, it almost inevitably requires learning a new language.
Think of how our vocabulary has expanded as the internet has evolved over the last several years. There was a time when “smart phone”, “mobile app” and “opt-in” felt foreign and unfamiliar. Today those words are as much a part of the modern lexicon as “live streaming” or the “Internet of Things (IoT).”
Which brings us to cryptography, a once obscure computer science that is now in the spotlight. The word crypto is derived from the Greek “kryptos”, which translates as “hidden, concealed, or secret”.
Simply put, cryptography is a method of writing code for storing and transmitting data in a form that can be read and processed only by those for whom it is intended. Cryptography has been commonly used for decades in securing government, military, and commercial communication and data centers.
More recently, cryptography has been instrumental in developing what are popularly referred to as “cryptocurrencies”, a new but maturing asset class that represents a significant leap forward for digital technology and for money itself. Thus far cryptography has been used predominately to secure access, creating a private pipe between sender and receiver, such as HTTPS websites. But this technology is far more powerful, and cryptocurrencies combine the technology in new ways.
The first cryptocurrency to capture public attention–bitcoin–was started by an individual or group using the pseudonym Satoshi Nakamoto.
Nakamoto’s 2008 white paper, “Bitcoin: A Peer-to-Peer Electronic Cash System” outlined the architecture for a peer-to-peer (P2P) network where participants would engage in computer “mining” operations, essentially requiring all the computers or nodes in the network to compete to solve a computationally intensive mathematical problem, with the first “winner” awarded in bitcoins for a successful solution. This process repeats over and over by design. The creation, support and maintenance of the network would establish direct interaction and verification, or proof-of-work, among the participants, essentially avoiding the need for transactions to pass through third parties, such as financial institutions, all in support of so-called “trust minimizing transactions.” Unlike traditional ledger-based assets, the technology also creates a market where the unit of account has a cost of production, similar to gold or other precious metals.”
“Trust minimizing” in this instance alludes to the novel framework that supports bitcoin and other digital currencies: the blockchain. A blockchain consists of a series of connected ledgers, upon which are recorded the specific details of every transaction executed on the system. One of the most notable features of the blockchain is its ability to permanently prevent duplication or alteration of any kind. Transaction details recorded on a block prevent a bitcoin, for example, from being copied or counterfeited. This is just one of several security layers provided by a blockchain system as a way to prevent double-spending (e.g. using the same digital token for more than one transaction simultaneously). The details added to the blocks are verified by all the computers in the network.
The blockchain functions essentially as a decentralized ledger, a key construct in a digital currency network such as Bitcoin. One of the primary factors behind the creation of Bitcoin, and other digital token networks, was a desire to develop a currency that could not be controlled by a central authority, e.g. a central bank or government. As an example, the U.S. dollar can have its value adjusted for inflation by the Federal Reserve at any time. Bitcoin, on the other hand, is an independent network without any centralized control. The network operates through a decentralized, global system made up of thousands of computers known as nodes (nearly 94,000 to date) which communicate, transmit, and verify bitcoin transactions and data to each other.
Public key cryptography is another important method that is used to ensure secure communication and use of a digital token such as bitcoin. In short, public keys are shared with others and allow encrypted messages or instructions to pass between parties. Conversely, a private key is used to privately compute the public key, and is used to decrypt or verify a message or instruction, such as spending bitcoin. A public key is shared with others with whom you wish to communicate. The private key or the code for which is only known by the owner, should never be shared.
Digital signatures and multiple signatures (Multi-Sig) use public key cryptography to verify messages, in a way that is far superior to handwritten signatures. In the digital environment, your signature proves that it is your signature, but also proves that you signed a specific document! Multiple signatures are commonly used when more than one person is responsible for creating and approving a transaction, sometimes referred to as a maker/checker procedure. This is a preferred institutional regimen to ensure that a transaction is properly authorized by requiring more than one signature before executing a transaction, migitating risks associated with a single person or device being able to send a transaction.
The bitcoin token was designed to serve as a global medium of exchange, and function as a “store of value.” The concept of “store of value” lies at the core of any cryptocurrency discussion. A unit of account must first be able to store value before it is useful transactionally. How digitally-produced currencies gain, hold, and lose value remains an open question. A major factor supporting bitcoin’s role as a possible store of value is the absolute limit that is placed on the number of bitcoins that will ever be produced. The network will only produce 21 million bitcoins between now and the year 2140, with the output managed by the Bitcoin network year by year. Another support for bitcoin’s use as a potential longer-term store of value relates to the cost of the energy required to create a bitcoin. The large and powerful computers on the Bitcoin network are specifically built to solve a complex mathematical computation and win bitcoin. The average electricity costs to run the network’s computers are often cited as one measure of the “value” of a bitcoin, just as the costs of mining gold, silver or diamonds are reflected in their values respectively.
In the brave new world of digital assets there are, as you can see, many brave new words. As this emerging asset class matures, even more lingo and newly-minted words will also emerge to describe the products, processes, and applications within the digital coin realm. Check back with us frequently for more discussion on the terms and concepts that will shape the evolution of these dynamic financial instruments.
This content was created by Fidelity Digital Assets. All rights reserved.
Digital assets are speculative and highly volatile, can become illiquid at any time, and are for investors with a high risk tolerance. Investors in digital assets could lose the entire value of their investment.
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