Understanding cryptocurrency

You have probably heard about digital currency like Bitcoin in the recent years and read how it’s trading at an insanely high value when compared with standard currency. On 18thOctober 2017 (today), 1 bitcoin is trading at 3900 pounds, 5200 dollars, 4400 euros and a whopping 342000 Indian Rupees. To put this in perspective, a single bitcoin can purchase an 800cc hatchback car (Alto, Eon, i10) in India. Other cryptocurrencies are trading at very high values too.

What exactly is cryptocurrency? Why is it gaining popularity and how does it work? What exactly is mining? While the users of cryptocurrency try to explain the concept to the people who are not initiated, they fall short of easy examples and stick to their indecipherable jargon which can make the listener pull his/her hair out. In this post, I try to explain cryptocurrency to you in as lucid a language as possible.

What is cryptocurrency?

Let’s start with the jargon. Cryptocurrency is a ‘virtual, decentralised, encrypted currency that is not affiliated to any central authority’. Let’s unpack this mind-boggling statement and see the terms one by one.

Not affiliated to any central authority: The Reserve Bank of India controls Indian Rupees and the Federal Reserve controls US Dollar. Contrary to world’s real currencies where each currency is governed by a central authority, cryptocurrency has no central authority. No particular organisation controls cryptocurrency and an ever-growing worldwide system of computers keeps the system together. You could use your computer as a partipant in the system to keep the cryptocurrency working smoothly.

Virtual: There is no paper cash in cryptocurrency. The entire corpus is online and the only way to trade in cryptocurrency or use it is via online purchase / sale / transfer.

Decentralised: Since, cryptocurrency is not affiliated with any central authority or sub-authorities endorsed by a central authority, the flow and security of cryptocurrency is managed by a system of peers, equally responsible for the upkeep. A system of machines around the world participates to make sure that transactions are valid, identities of the vendor and customer are legitimate and that there is no theft or tampering. Decentralisation also makes the system resilient and fault-tolerant, since if a machine in the system goes down, other machines have the facilities in place to continue operations.

Encrypted: All values, transactions and person identities are stored in an encrypted format. No one can hack into the cryptocurrency system and tamper with the data or steal anything. Such security is made possible due to the ‘blockchain’ mechanism.

Blockchain

While explaining blockchain through jargon is extremely complicated, let us try to find a story which simplifies the concept.

Imagine a group of African pygmies who can write in an indigenous language called Ashanti. The pygmies control all the financial transactions happening in a village named Kahai. These pygmies were not chosen by any central authority. They have unanimously volunteered for the job. The pygmies understand English perfectly well, but you can’t speak or understand a word of Ashanti. And to make matters complicated, Ashanti script and numbers look totally different from English. As a resident of Kahai, every transaction you make needs to happen in the presence of an Ashanti pygmy. The pygmy duly notes down a transaction happening between you and others in the village. The pygmy writes the details of the transaction in Ashanti, so you won’t understand a word. However, all transactions make perfect sense to every pygmy in the group.

Here is a catch. To make things complicated, the pygmies divide the transactions into several notebooks. One pygmy is allowed to use only one notebook at a time. Transactions happening in a day are written in multiple notebooks. Let’s say 10 transactions happened today. The pygmies may use 3 notebooks. To start the day, each resident of Kahai has a balance of money against his/her account, duly recorded in the notebook. The pygmies may record 4 records in one notebook, 3 in the second and 3 in the third. After 4 transactions in the first notebook, all the amounts are totalled and a closing balance is written for each account involved. When the second notebook is taken out, the closing balances at the end of the first notebook are copied into the second notebook and that acts as the opening balance for this notebook.

Let’s say you want to launder money or cheat in some way. You don’t understand Ashanti, so there is nothing you can directly do. However, even if you manage to bribe one pygmy and get records fudged, two things will give you away. First, every notebook may have multiple photocopies made, so that differences can be caught. Even if a notebook does not have a copy, there will be differences between opening balances and closing balances and a thorough check will give something away. Most likely, the defaulting pygmy will be found out, cornered and made to divulge your sin.

Blockchains works in similar fashion. The transaction data is encrypted (Ashanti), so you can’t tamper with it. Records are divided into several blockchains (notebooks) and the computers (pygmies) who host these blockchains, constantly talk to each other to tally cryptocurrency wallet totals (accounts of the residents of Kahai), identities of persons and authenticity of transactions. Compromised blockchains can be isolated with relative ease.

What is mining?

The pygmy tribe is not closed. You can learn Ashanti and join the group of pygmies and help them out as trade inside Kahai grows and the pygmies are overworked. Recording transactions and tallying them across several notebooks is a lot of work, so each pygmy gets paid a fee to get the work done. After getting paid, you or other pygmies will update the balance in your account, so that the transaction is recorded and validated. This means that even if you do not participate in any trade inside Kahai, you are still getting paid and making money.

Mining works in similar fashion. On the one hand, there are several users who have cryptocurrency and are willing to pay and there are several merchants who accept cryptocurrency. Thus cryptocurrency exchanges hands and spreads in the system through trade. But on the other hand, if you were to set up your computer such that it offers its processing power to record transactions and validate them using algorithms specific to a cryptocurrency system, the system pays you a small amount for each computation done. This gets added to your cryptocurrency wallet. Running the algorithms takes a lot of computation power and will reflect on your electricity bill or on your cloud provider’s bill. The cryptocurrency system lauds your efforts and investment and pays you back. Remember, the crytpocurrency system is decentralised and depends on individuals offering their computers to be used for the efficient working of the system. The system is always overworked and they always welcome new entrants like you.

Just like learning the Ashanti language and the pygmies’s accounting system, you can install cryptocurrency mining software in your computer and leave the power and Internet connection on all the time. Whenever transactions take place in the world of cryptocurrency, your computer is called upon to record and validate the transactions using blockchain algorithms. In return, you are paid a tiny amount in your wallet. Depending on which cryptocurrency you are interested in, you need to install a specific software released by that specific community. Remember that Bitcoin’s software will not work with other cryptocurrencies.

How can I participate in the cryptocurrency mania

There are two ways in which you can participate in the cryptocurrency mania.

  • There are companies who trade real currency for cryptocurrency. You can take a bet and invest a portion of your investable real money into crytocurrency. The value of cryptocurrency is going up insanely and you can earn huge margins by trading, similar to the way you do in stock market. If you believe that cryptocurrency is the future, you can hold onto it and use your wallet to pay in cryptocurrency when the world starts accepting it on a wide scale.
  • You can install mining software in either your own computer or on a purchased machine on a cloud provider such as Amazon Web Service, Rackspace, Google Cloud Computing or Linode. These machines can then work as transaction recorders and verifiers, earning cryptocurrency for you. Please note that entry level machines DO NOT work. The machines need to be extremely powerful with humungous computing power such as 32 to 64 GB of RAM and 8 to 16 cores of processing units. Do not try to go cheap. It will never work. Your attempts to run the algorithms will crash, your operations won’t complete and you’ll not get paid. The cryptocurrency systems automatically detect non-performing machines and kick them out of the system.

Can I pay for goods and services in cryptocurrency?

Since the whole world isn’t ready for cryptocurreny, you have to actively seek vendors who accept cryptocurrency. Certain cryptocurrencies are more widely accepted than others. Bitcoin has the highest rate of acceptance among cryptocurrencies. Even big giants such as WordPress, Mint and Microsoft accept bitcoins.

That said, you will have to scour your area to find cryptocurrency accepting local vendors for your favourite goods and services. There isn’t an official list of vendors accepting cryptocurrency, so if you have cryptocurrency lying around, then you need to do the study on who accepts it. Countries like the United States, UK and Japan, countries in Scandinavia and some electronically advanced countries in northern Europe, such as Latvia and Estonia have been quick to adopt cryptocurrency for their businesses. The Internet backbone in these countries is main reason for their success.

In India, the RBI has played safe and not accepted cryptocurrency as an official currency. However they have not declared it illegal either. In June 2017, the Reserve Bank of India announced plan to start experimenting with their own mining machines and blockchains to see how cryptocurrency works and are expected to make an official stand on cryptocurrency by the end of the financial year. However the ground reality in India is different. Most of the retail businesses in the country, especially in the north, accept only Indian Rupees in cash and not even credit cards, cheques or fund transfer, let alone even consider cryptocurrency. With the exception of South Africa, cryptocurrency has yet to take off in Africa.

Can I exchange cryptocurrency for real currency?

No bank officially endorses or supports cryptocurrency. So approaching a bank is moot. Banks in the USA and UK are still toying with the idea, with the help of their central bank reserves. That said, there are private companies in technologically advanced companies which have taken a bet and opened quasi-banks. These quasi-banks allow you trade between the respective country’s currency and cryptocurrency, similar to Forex. These quasi-banks are heavily funded by venture capitalists who are also placing huge bets on cryptocurrency’s future. Some companies have taken a step further by installing Bitcoin ATMs. These dispense cash in local currency and deduct an equivalent amount from your Bitcoin wallet. There is an ATM card with a chip that represents your Bitcoin wallet account.

However be warned that these quasi-banks are not backed by any central bank reserve such as the Federal Reserve or the Reserve Bank of India. If a quasi-bank goes bust and your money is lost, it is a sunk investment and your capital is not bound to be protected legally. This can easily happen when too many people pull out their money and not many put money into the company. Eventually the venture capitalists will see less returns and pull out.

Your cryptocurrency wallet will remain, but no one will be at hand to exchange real money for it. You will have to wait for another company to take a bet. Trading in cryptocurrency is almost like trading in stock and that is why several governments, including Indian, are treating and taxing proceeds from cryptocurrency investment as capital gains.

What can I do next?

One of the following.

  • You can wait out the entire mania and start using cryptocurrency only when it becomes mainstream. You can relax for the moment and wait for a news article such as “Country X accepts cryptocurrency Y as official currency alongside currency Z”. By that time, currency Y’s value would have rocketed. So instead of exchanging for real money, you should try to build a business which accepts Y for payment and build your corpus.
  • Invest a small corpus of money (say $100 or ₹5000) today to build a cryptocurrency wallet and treat it similar to an investment. You should approach a company which can accept your real money and build a cryptocurrency wallet for you. This way of acquiring cryptocurrency is the easiest.
  • Build a mining platform where you lend your high-powered, high-memory computer to host a blockchain and facilitate and verify transactions and balances.

Will the world move to cryptocurrency eventually? Is cryptocurrency a bubble?

These questions are extremely hard to answer objectively. The world has to wait and watch. In principle, this question competes with the question, “Who is John Galt?”*

* A famous question from the legendary novel “Atlas Shrugged” by Ayn Rand. Among other things, this book also talks about a group of people using a currency different from the rest of the world!

Conclusion

Love it or hate it, but you cannot ignore it. The world of cryptocurrency is here and is increasing gradually. The world couldn’t predict the advancement of computers or mobile phones. The world couldn’t predict the crash of 2008. If evidence is anything to go by, the world is too sight-sighted with predictions. Only time will tell if cryptocurrency succeeds or not. In the meantime, I hope that you get inspired by this blog post, learn more about cryptocurrency in detail and keep yourself informed, so that you can be ready with whatever the future holds.


Originally published at www.tech101.in on October 19, 2017.