Cryptocurrencies Plain and Simple
The article that allows you to make sense of all the other crypo articles: Part 1of 2
Of all the hard conversations I’ve ever had to have with my mother, telling her I was involved with a cryptocurrency exchange start up was the one most likely to bore her to tears.
Naturally, there were questions. A lot of people in my life had questions. This is my attempt to explain some of the concepts behind this technology in an accessible way for the curious people in my life.
I can’t give financial advice. I’m not trying to convince you to start buying these things. I’m not endorsing any currency in particular. But I do think the technology itself is fascinating and you don’t have to buy coins to appreciate it.
This is a conversation in multiple parts:
Part 1: Cryptocurrencies Plain and Simple
Part 2: Blockchain Beyond Currencies
What is cryptocurrency?
There are over 1,500 different cryptocurrencies. You have probably heard of Bitcoin, which was developed 10 years ago to serve as a type of digital currency.
Some currency is minted in metal, some is printed on paper, and some is stored as data in a database. When you put money in your checking account, your transaction is stored in a database. At the simplest level, a database is a large amount of data that has been organized in some way. The storage and use of money you deposit in a US bank is highly regulated and usually insured up to $250,000 by the federal government. For the average person, this provides a high degree of trust that the bank’s database is a safe place to keep one’s money.
Cryptocurrency uses a very different kind of database called blockchain. Blockchain is considered by some to be the most secure type of database. However, the security of blockchain is accomplished by violating many of the normal safety protocols we have come to trust. Instead of relying on powerful institutions like banks or governments to protect and validate our information, blockchain functions as a “decentralized consensus-based database.”
What does all that mean? What’s a blockchain?
Blockchain is the technology behind cryptocurrencies. Just like no two dollar bills share the same serial number, each coin of a cryptocurrency is unique. Coins start their lives as a “block” of information, called the Genesis block. New transactions on that coin are grouped together into new blocks that are “chained” onto the previous blocks. Hence the name “blockchain.” In this way, blockchain gives us a complete digital record of the entire history of transactions on that one particular coin.
Again, let’s think about how your bank works. If your ledger says you deposited $100, but the bank records claim it was $50, how do you prove who is right? You could use a receipt but what if you lost it, or what if they claim it was forged? The bank owns the record, so all someone has to do is target one bank’s information system to fraudulently change the amount of your transaction.
With blockchain, the record is “decentralized,” meaning it exists in many locations, and no one person or institution controls all the copies. So if someone changes the bank’s ledger, the community will reject it when they see that the new version doesn’t match all the other copies. Someone would have to hack thousands of computers simultaneously to forge the ledger.
So you see, this is the opposite of how banks traditionally try to keep your information secure. With blockchain, the way to protect the integrity of the data is not to lock it away where only the bank can control it, but to make the database public and consensus-based. This system is designed to make it impossible to alter a record once it has been written to a blockchain. Any new information can only be added to what is already there.
People ask me, “What’s the big deal about cryptocurrency? Haven’t we been able to make digital currency before now?” One promise of blockchain technology is that the need for community verification will prevent the duplication of coin or creation of fake currency, which would be akin to counterfeiting money. We no longer have to trust governments, banks, or other traditional arbitrators to prevent this, because we have essential automated the process of validating money. With a permanent public ledger, transparency becomes the key to trust, which can feel counterintuitive, but that’s what makes it clever.
That’s the idea behind the initial design of blockchain. Later in this series, we can discuss some interesting variations people have tried, but for now, this gives us a good foundation for understanding the tech.
What is mining?
It’s not men in hardhats with pickaxes. Essentially, “data mining” means examining large volumes of data to try to find something valuable.
If I sell you a coin, miners go digging for the record of that coin and add our transaction to the blockchain. Finding and decrypting data on a blockchain requires math so complicated that only powerful computers can solve it. Mining computers ultimately race each other to see who can resolve the algorithms first. The first machine to get the answer is rewarded with a small amount of money. The other machines working on the problem also contributed to the consensus needed to validate the transaction, but the idea is that the rewards end up being distributed fairly enough over time to make it worth the effort for everyone. This money can come from very small exchange fees or new coin that is generated from the transaction to pay the miner. This is one way new coin is introduced into the market.
Some companies spend millions of dollars running large farms of servers devoted to mining for cryptocurrencies. There are also individual people who devote one or two personal servers to mining in exchange for a modest amount of supplemental income.
If it’s public, can’t people see how much money I have and what I spend it on?
No. Because the database is public, people don’t add their names or identifying information to the record. Instead, they use a “public key” and a “private key.” Think of the public key as a post office box. In this metaphor, people send cryptocurrency to your public key like sending mail to your mailbox. The private key is like the actual key on your keyring that unlocks your mailbox. Since your name is not on the mailbox, if you lose that private key, you can’t ever access what’s inside. Furthermore, because blockchain is such a secure type of database, bad actors are less likely to try to hack the blockchain and more likely to try to steal your keys. Therefore, how you safeguard your private keys is really important.
How do you keep your private keys?
A wallet is a collection of private keys. Here are some examples of types of wallets:
A paper wallet is literally a piece of paper with your private keys written on it. On the plus side, paper cannot be hacked. However, paper is easy to lose and vulnerable to fire, water, fading, theft, etc.
Your own memory can be your wallet, but if you forget, die, or become incapacitated, no one can access your coin.
A cold wallet is a device that is not online, like a USB drive. Keeping it offline protects it from being hacked, but like paper, it could be damaged, stolen, or lost.
Digital wallets are offered by crypto exchanges and other services. Some key concepts to consider are:
- Two Factor Authentication — This means you need more than just your name and password to get access. Maybe they text a code to your phone or send you an email to verify that it’s really you. If this feature is optional, please use it.
- Multi-signature — When you access your safe deposit box, you need 2 keys: yours and the bank’s. Imagine your vault had 3 locks: one for the bank, one for you, and one for your spouse. Either you set the vault to only open when all 3 keys are entered, or if you trust your spouse, you can set it to open with 2 of the 3 keys.
If you’re considering investing in cryptocurrency, you will need to do your own research and decide what you are comfortable with, but at least now you know the basics.
Why do cryptocurrencies have value?
Cryptocurrencies are valuable for the same reason any currency is valuable: because people are willing to trade them for things that are valuable. Either use them to buy things, trade them for other currency, or save them in hopes of being able to afford things in the future. If people believe in them and use them, then they are a valuable currency. If people become unwilling to trade with them or lose faith in the backers of the system, then they lose value.
So what backs cryptocurrencies? The internet is full of impassioned debates about what should back a system of money. I leave that discussion to the experts. However, as an introduction to the issue, I’ll give you some examples. These are not mutually exclusive. And again, I am not endorsing any of these in particular.
- Utility — Remember having to buy special tokens in order to ride the rides at the fair? Some companies make you buy a certain cryptocurrency in order to use their services. This is popular in gaming, where cryptocurrencies make it easy for users who don’t know each other to sell and purchase items within the game. There are virtual reality games where people buy plots of real estate and other luxury items that only exist inside that game.
- Commodity backing — The most famous type of commodity backing is gold backing. If you are a believer in gold-backed currencies, there are cryptocurrencies for you. For example, Royal Mint Gold is a gold-backed cryptocurrency from the UK’s Royal Mint.
- Scarcity — Another feature people love about gold backing is that it limits the amount of money that can be printed, because there is only so much gold in the world. Some cryptocurrencies invoke the economic mechanism of scarcity by limiting the number of coins that can be created. These are called “deflationary” currencies. Bitcoin, for example, is fixed at 21 million. This limit is built into the math required by the blockchain, so it cannot be changed.
- Fiat backing — Governments try to keep the value of fiat money stable and healthy. If you are investing in coin, you want to profit from its volatility by buying low and selling high. However, if you’re buying it in order to purchase something right away (like real estate in a virtual reality game), then you want the value to remain stable so you can evaluate a fair price. Some cryptocurrencies keep fiat money on reserve for every coin issued with the intention of stabilizing the currency. Tether is an example of a cryptocurrency that purports to be backed by the US dollar, although critics have questioned them over lack of transparency. Saga is a coin connected to a fiat reserve that is being built by academics who, collectively, boast impressive resumes, including one Nobel Prize in Economics.
- Legal tender — A government can declare a currency to be legal tender, meaning it cannot be refused as a form of payment within that government’s jurisdiction. The Marshall Islands announced earlier this year that it will launch the world’s first legal tender cryptocurrency, called the Sovereign.
Each cryptocurrency will present potential users with a case for why they are worth the investment, what innovative features they offer, or what problems they are solving. We will discuss some of the technological and real-world applications being explored in Part 2 of this series.
What can you buy with them?
You can pay with cryptocurrency wherever people are willing to accept them as payment. Currently, you can use Bitcoin to book a hotel on Expedia. PayPal also accepts Bitcoin as payment and has announced that it is looking into adding other types of cryptocurrencies. Overstock is an online store that accepts a variety of cryptocurrencies. There are crypto debit cards that allow you to pay in restaurants or shops like you would with any other card. Some merchants are employing QR codes that you scan with your phone in order to deposit cryptocurrency into their virtual wallets. Last year saw a upsurge in the number of Japanese retailers who accept them after Japan passed The Virtual Currency Act, which did not require merchants to accept cryptocurrencies, but it did formally recognize them as a legitimate payment method.
Are they just for buying things?
People use different cryptocurrencies for a number of things. They can be a medium of exchange. They can be a way to invest your wealth in hopes of future gains. They can also build community or inspire loyalty.
For example, Dogecoin started as a parody of an endearing internet meme featuring a good-natured Shiba Inu, named Doge. It was kind of a joke that ultimately developed into a subculture of loyal users, who call themselves “shibes” after the breed of dog. It began with people casually passing Dogecoin around as tips on social media. They weren’t worth much, just a fraction of a penny, but they were a way of saying “great job” or “I appreciate this.” Perhaps due to the coin being used primarily as a gift rather than a payment, the community that formed around Dogecoin tended to favor people who enjoy giving. Shibes continue to have a reputation for generosity, providing crowdfunding for a variety of charitable causes including socks for homeless people in LA, clean drinking water in Kenya, and medical equipment for hospitals in the Ghana. This year, the “joke” currency reached a $2 billion market cap.
Burger King is also jumping on the crypto train, launching its own “Whoppercoin,” which it is currently only available in Russia. These are less like a currency and more like tokens used to reward brand loyalty. You are probably familiar with stores that give you “points” for every dollar you spend and let you redeem those points to make in-store purchases. Frequent flyer miles are another example. These kinds of loyalty rewards were around before cryptocurrencies, but with the new technology, companies are rethinking how these systems could work.
For example, will customers be more invested in collecting reward points if they are on a blockchain? Maybe. You might not care very much about that punchcard for your 10th free sub, but if the deli can add a small coin to your digital wallet that can easily be traded around for all kinds of things at other stores, then it might mean more to you. There are platforms that allow multiple businesses to create their own blockchain store tokens, which users can then swap for other redeemable tokens at other stores.
In addition to giving the customer flexibility, some companies are finding a blockchain database is less cumbersome for them to manage. Unless you’re in that industry, you’ve probably never thought about the costs, people, and tech involved in tracking and redeeming the world’s frequent flyer miles. The airline might prefer to let that function go to a public ledger with the customer in charge of keeping up with their own keys.
Are they money or assets?
They were originally designed to work as a medium of exchange, like money. However, a lot of people buy them because they want them to increase in value, not because they want to make payments with them. This might lead people to treat cryptocurrencies like stocks, but it is important to understand that buying cryptocurrency does not mean you do not own a piece of the company.
In the US, the IRS considers them to be property. The Securities and Exchange Commission (SEC) sees them as securities. In April, a federal judge upheld that they are commodities to be regulated by the Commodity Futures Trading Commission (CFTC). A lot of governments, businesses, and individuals have their own takes. I would say the classification is subject to change as market regulations develop. Depending on when you’re reading this, my information may already be outdated.
I hope this has been informative. In Part 2 of this series, we will explore some applications of blockchain beyond cryptocurrencies. Now that you understand the basics, we can talk about how this new technology is shaping many aspects of our world, not just the realm of finance.
