Cryptocurrencies and How They Work
Blockchain Technology
While the term blockchain can at first sight sound nebulous, it is in fact a straightforward approach to storing what is effectively a list of records. The technology was developed in the 1990s and was initially devised to timestamp digital information in a tamper-proof way. Once developed, applications for the technology outgrew its initially intended use and gave rise to cryptocurrencies. In this article, we will outline the concepts underpinning blockchain technology as well as the benefits it affords.
How blockchain works
The fundamental unit at the heart of blockchain technology is, unsurprisingly, the block. As shown on Figure 1: Structure of a block, a block is simply a collection of three pieces of information: 1. The hash of the block; 2. The hash of the preceding block; 3. Some form of data. A hash is simply an alphanumeric combination of characters that acts as a cryptographic key. These encrypted hashes are unique and can be compared to a block’s “fingerprint”: it cannot be changed and no two are alike. The data contained in the block can vary depending on the application, but in the case of Bitcoin for example, it mainly includes the Bitcoin address of a sender, the Bitcoin address of a recipient, and an amount of Bitcoin being transacted. The only exception to the three-feature structure outlined in Figure 1: Structure of a block, is the genesis block, or the first block in a chain: given it cannot point to a preceding block, it simply contains data and its own hash. Once created, none of the three features of the block can be altered. Furthermore, by having each block contain the hash of the block that precedes, blocks can be sequenced in a permanent and unalterable order, hence forming an immutable chain, called the blockchain. A copy of this chain is provided to all users — known as nodes — in a network that choses to use the blockchain, effectively emerging as a distributed ledger — a ledger for which each user has an identical real-time copy.
The process of creating new blocks is called mining. Before any node adds a block to the chain — or records to this distributed ledger — all other nodes must agree that the proposed block conforms to the criteria of the chain. In other words, blocks can only be created by consensus of nodes. The process of validating conformity of a block is essentially done by solving a cryptographic problem, which is called the “proof-of-work” paradigm. This can be thought of as banks settling a financial transaction purely algorithmically through external parties. To ensure that the nodes (known as miners) are incentivised to solve these cryptographic problems (which requires computing power and electricity), the particular node (or miner) that ends up solving one of these problems are given a small reward. In the case of Bitcoin, miners are rewarded with new Bitcoins. While the amount of computing power and electricity required to mine blocks might seem minimal, consider that validating a single Bitcoin transaction requires approximately ~868 KWh of electricity, or the equivalent of the power consumption of an average US household for 29 days¹. On an annual basis,~112TWh of electricity is spent to validate Bitcoin transactions, which is comparable to the annual power consumption of Netherlands, as shown on Figure 2: Overview of Bitcoin Electricity Consumption. However, in addition to the large amounts of energy it requires, proof-of-work also poses other challenges: miners have been known to concentrate their computing power into mining pools, effectively centralising the mining process, and presenting a risk to the entire network given their ability to concentrate their power of consensus. Indeed, a powerful enough group of like-minded miners can effectively dictate what consensus should be.
An alternative approach to achieving consensus for validating transactions that has later emerged to address the issues associated to proof-of-work is known as proof-of-stake. Instead of having nodes spend substantial amounts of energy to solve cryptographic problems, proof-of-stake relies on having nodes — which under this approach are known as validators or, more commonly, stakers — be randomly selected to validate the creation of a block. This can be thought of as someone putting up a specific collateral confirming the execution of a transaction of a third party and getting rewarded if that transaction really happened. To become a staker, a node must commit a certain amount of capital into the network, known as their stake. The higher the stake, the higher the chances of being selected to validate a transaction. Each time the staker approves a transaction, he or she is also awarded a small fee. If stakers are found to have approved invalid transactions, they stand to lose part of the stake they committed to the network. By having fees be worth less than the stake, the network can ensure that stakers can be penalised for having approved incorrect transaction. Once a node decides to stop being a staker, their stake and earned fees are released after a certain time has elapsed, ensuring that fees for any transactions that have recently been approved can be clawed back should they be found to be invalid.
While blockchains by no means represent a perfect approach to storage of data, it does provide some key benefits, which will be discussed below.
Distributed nature
While a traditional data storage system typically relies on a centralised model where information is accessed using a client-server model, the blockchain paradigm operates under a fully distributed model, as shown in Figure 3: Overview of Data Storage Paradigms. This not only ensures multiple copies of the blockchain are available. Furthermore, there is no single authority that has more rights (there are for instance no “admin rights”), which ensures that all members on the network are created equal.
That said, it is also important to distinguish between public and private blockchains: while public blockchains are permissionless and allow all nodes to add blocks to the chain, private blockchains can restrict this capability to select users. Private blockchains may also be referred to as permissioned blockchains.
Immutability
Many data systems operate under a Create, Read, Update or Delete (referred to as “CRUD”) system. Following on from the point of decentralisation point above, this not only furthers the notion of hierarchy that exists in certain systems, but also creates the possibility for data to be changed. Indeed, using the Update, or the Delete functions, data can be altered or removed after it has been created. In contrast, blockchain systems operate under an append- only paradigm, implying that data can only be added to the chain. As a result, blockchains are immutable and offer the property of immutability.
Security
Through the cryptographic encoding of the hash, blockchains offer a degree of security that many traditional databases do not. Furthermore, by requiring other nodes to vet transactions through consensus algorithms prior to their approval, blockchains provide an additional layer of security. This degree of security in fact increases with the scale of the network: the more nodes on the network, the more nodes there are to validate the true copy of the blockchain. Indeed, if a party should ever want to maliciously alter data in a given block, this party would have to control the majority of nodes on a network so as to replace that specific block with its fraudulent copy in order to create sufficient discord amongst nodes as to which version of the block is genuine. These events — known as “51% attacks” owing to their requirement to control a simple majority of nodes on a network — become harder to execute the larger the network.
Types of Cryptocurrencies
While conceptually all cryptocurrencies are founded on the same general idea, they vary not only in terms of the blockchain project that issues them, but also in the protocols they use to function. In computer science, a protocol refers to the set of standards that are used to govern how data is exchanged between several parties. For instance, readers may recall running into TCP/IP or HTTP protocols when setting up a new mailbox on their computer: those acronyms simply refer to different internet protocols, each of which outlines how data should be divided into smaller packets and routed to parties across the web.
Similarly, blockchain protocols serve to define how a blockchain network will be governed, for example outlining how consensus is reached or how a given hash algorithm works. As with any rulebook, protocols may vary in their complexity and their flexibility.
Tokens
Before exploring cryptocurrency types, it is useful to outline what a token is. A token simply refers to any digital representation of an asset. As shown in Figure 4: Types of Tokens, we can distinguish between 3 main families of tokens. It is useful to note that some tokens can fall under one or more of these groups given the applications they serve.
While cryptocurrencies are often distinguished from tokens, these coins are in fact just a specific type of token — they are transactional tokens. However, coins can also have properties from other token classes, but at least all have transactional token properties.
Bitcoin
Likely the most popular of the coins, Bitcoin, was launched in 2008 by the still-elusive Satoshi Nakamoto. While it was initially used to trade amongst murky parties (the Silk Road marketplace being a prime example), this cryptocurrency gradually gained momentum and eventually made into the mainstream. As shown in Figure 5: Cryptocurrencies by market cap, Bitcoin by far tops any other cryptocurrency by market cap.
Bitcoin was launched as a permissionless peer-to-peer protocol that uses a proof-of-work consensus algorithm. Given its peer-to-peer nature — and therefore its independence from any third party or traditional financial institution, like a bank — bitcoin has gained in popularity as a tradeable currency. This independence from the traditional financial system, and its seemingly decoupled value, have led to it often being (disputedly) referred to as an “uncorrelated asset”, with some going as far as calling it digital gold. Over time, Bitcoin has in fact emerged as its own investable asset class.
However, due its popularity as a crypto asset, its low liquidity (as outlined earlier, bitcoin can only be generated through the process of mining), and the vagaries of speculative investing, Bitcoin has been known to be quite volatile. This volatility has caused many crypto-sceptics to discount the asset as a viable store of value (and therefore a viable currency) in the long term.
Altcoins
Altcoins, whether correctly classified or not, comprise the vast category of all coins that followed Bitcoin (and may in many cases even resemble Bitcoin). While there are literally thousands of types of altcoins, notable ones include Ethereum, Polkadot, Ripple, and Cardano. Dogecoin — a cryptocurrency of staggering recent fame — also falls under the altcoin umbrella. Dogecoin was initially launched by two software engineers in 2013 with the aim of creating a peer-to-peer cryptocurrency with a strong online following. In the spirit of fun, they themed the coin on the popular Doge meme that was circulating on the internet at the time, using the image of the Japanese Shiba Inu dog breed as the coin’s emblem. While this project had started with a measure of humour, the coin achieved a phenomenal rise after Tesla CEO, Elon Musk, tweeted his support for the coin. In mid-April 2021, Dogecoin reached a market cap in excess of US$ 52M, illustrating both the strength and speed of the followings some altcoins can garner. In a phenomenon some have compared to the GameStop retail-driven stock market rally, Dogecoin often gets referred to as a “meme coin”.
While the advent of Bitcoin has certainly been an important milestone, as the first iteration in the world of cryptocurrencies, there are a number of limitations that it entailed. For instance, because of certain technology and protocol constraints, Bitcoin’s use case has primarily been narrowed to storage of value and collateral. Newer iterations have been able to bring innovations to the world of cryptocurrencies, growing in sophistication and applications with a new range of capabilities. Before delving into the specifics of these capabilities, it is useful to explore the blockchain technology stack shown on Figure 6: Overview of the Blockchain Stack, to give more detail on how these capabilities emerge based on the technology. To make this technology more graspable and less abstract, we have provided an analogy to the Mobile stack.
As we can see on the Figure 6, the blockchain stack is comprised of multiple layers, each fulfilling a specific function and adding an additional dimension of sophistication for the system as a whole.
• Infrastructure Layer: The most basic layer is comprised of the hardware artefacts that support the blockchain network and allow it to exist. These hardware artefacts include all the computers, servers, and data centres that comprise the nodes, as well as the internet connections that allow all these nodes to remain in contact.
- Networks (known as“Layer 0”): Once the infrastructure is in place, and the nodes are setup to communicate with one another from a hardware standpoint, the next objective is to ensure each one of these nodes can engage with one another. In practice, the network layer is what enables fundamental operations on the network such as node discovery, device authentication, block propagation and synchronisation across all nodes.
- • Protocols (known as “layer 1”): This layer outlines the “rules” of how the parties will operate the blockchain itself. An example of such rules includes how the consensus algorithm will operate (i.e. how nodes will come to agreement) or even how miners will be rewarded for solving cryptographic puzzles.
- Services (known as “layer 2”): This layer opens up a new level of sophistication for the technology. Indeed, the service layers refers to an additional set of tools that can be setup onto the blockchain to enable new “features”. This is the layer in technology that enables “digital asset” properties to emerge. A host of other features, such as data storage or communication, also become possible in this layer. In more concrete terms, this is the layer that enables the storage of cryptoassets on Coinbase, for example.
- Applications (known as “layer 3”): Another level of sophistication is enabled by the third layer, known as the application layer. This layer is what allows end users interact with the blockchain and deploy the services contained in Layer 2 towards a specific end. These ends can take endless forms, ranging from games (e.g., CryptoKitties) or even compliance solutions (e.g., KYC-Chain). Applications on this layer are commonly referred to as “dApps” and can be compared to mobile phone apps in our mobile analogy.
By using functionalities across these layers in different ways, Altcoins can offer new capabilities for users. One illustration of this can be shown through the issue of transaction processing speeds. As explained earlier, approval of transactions on a network can be quite taxing, requiring miners to devote substantial energy and time to process transactions. There have been instances where networks have been overwhelmed by the quantum of transactions flowing through them, leading to unusually long transaction processing times and high processing costs. The crypto bull run of 2017 was one such instance where the Ethereum network was clogged, partly as the result of the popularity of the CryptoKitties game. To address this issue there are primarily two solutions available: either the network can be expanded, allowing more nodes to process transactions, or the load imposed by each transaction can be reduced. Technically, this can be accomplished by processing the data workload on off-the-chain state channels (e.g., Celer), using sidechains and plasma chains (e.g., Matic/Polygon, Omise), or using zero-knowledge rollups (e.g., Starkware). By using the service layer to enable processing of communications off-the-chain, the load on the chain can be reduced and processing speeds can be enhanced. By using this approach — known as “Layer 2 Scaling” — Ethereum can drastically increase transaction processing times and reduce its “gas fees” or the cost of processing a transaction. Figure 7 above shows the range of Layer 1 and 2 Ethereum scaling solutions and projects in use. Newer protocols such Polkadot are already addressing the scalability issues at the protocol (Layer 1) level.
Stablecoins
Stablecoins — a specific group of altcoins — were conceived with the intent to overcome the volatility that has been exhibited by other types of cryptocurrency, such as Bitcoin or Ethereum. Stablecoins have overcome this challenge by
(i) tying the value of their cryptocurrency to an external asset, such as a fiat currency (i.e., ones we use every day, such as US dollars) or real assets (e.g., precious metals), or (ii) an algorithmically stabilising the price to a target level. This linkage between real world assets and the cryptocurrency is created by having the issuer of the stablecoin allocate a certain amount of real-world assets as collateral against the amount of stablecoin issued. The conveyed idea is that a holder of that particular stablecoin could theoretically redeem the cryptocurrency for a portion of the real-world assets that are being held by the issuer of the cryptocurrency, much in the same way as the gold standard previously guaranteed a certain portion of gold to holders of a particular currency. As mentioned at the beginning of this section, we established that protocols may vary in their complexity and sophistication. As a result, we now see new varieties of stablecoins each illustrating different levels of complexity in terms of how their linkages to real-world collateral is built.
Furthermore, while stablecoins are, by definition, backed against a real-world asset in principle, it is worth noting the rise of a new class of stablecoins, known as “algorithmic stablecoins”. These non-collateralised coins use algorithms to ensure the price of the coins remains stable: if demand for the coins rises, an algorithm drives the creation of more coins and, conversely, the opposite happens when demand slumps. This means that while other collateralised stablecoins would suffer from a crash in their underlying asset — say a USD crash — algorithmic stablecoins would remain stable. In fact, given the overall drive towards decentralisation of finance, this particular flavour of stablecoins is gaining interest. Figure 8: Overview of Stablecoin families provides a more comprehensive overview of the types of stablecoins in use.
Non-Fungible Tokens (NFTs)
NFTs create digital scarcity, using tokens to mark the unique provenance of the underlying asset (be it physical or digital). The tokens’ non-fungibility refers to the fact that they cannot be replicated or replaced. Non-fungibility is actually a characteristic that qualifies most of the things we have, such as a house, a work of art, or a piece of furniture: no two are exactly the same (though they might be extremely similar). Fungible tokens are in fact the exceptions: money, or a share in a company are fungible tokens. They hold exactly the same value and are exact replicas of one another.
NFTs therefore describe unique digital assets that cannot be replicated. While this idea of dematerialised assets might be perplexing at first, NBA Top Shots serves as a useful example: basketball fans can now purchase a video highlight that is licensed by the NBA and trade it with other fans. As these NFTs are built on blockchain technology, they cannot be replicated and therefore have inherent scarcity. A common response that comes up when describing NBA Top Shots is that could you instead simply rip the video highlight in question for free on YouTube. In the case of NBA Top Shots, this would be analogous to printing a picture of a Van Gogh and hanging it in your living room — it might look the same, but it would not have the same value as the original and anyone can replicate it. The Top Shot highlights, just like the Van Gogh, are a unique digital asset that is serialised and licensed by the NBA. Much like a digital version of sports cards, NBA Top Shot moments can be bought and traded by fans as they seek to build out collections. While this idea might seem gimmicky, the most expensive card on sale at the time of writing — a highlight of a dunk by Memphis Grizzlies rookie, Ja Morant — trades for US$ 240,000.
This idea of NFTs is a powerful phenomenon that is not only being replicated across a range of other sports, but also extends to other areas such as art, video, songs, and even Tweets where videos, audio, text, or pictures are similarly digitally codified in non-replicable ways. In fact, in March 2021, the contemporary artist named “Beeple” sold one of his digital works for US$ 69.3M, beating past digital art records. As these anecdotes illustrate, NFTs fundamentally offer the possibility to create unique and therefore scarce assets in the digital world. The reality is that NFTs will represent the scarcity and uniqueness of both digital (e.g., media) and non-digital assets (e.g., real estate) and will transform how IP is monetised for the long tail of creators by technically and legally enabling more flexible royalty streams.
Other Tokens
As explored in the section on Altcoins, different projects can use blockchain layers in various ways to generate more powerful features to the ones seen in Bitcoin. For instance, Ethereum combines transactional token properties with platform token properties through SmartContracts. Through SmartContracts — a decentralise app, or dapp — Ethereum enables the automatic triggering of a transaction between two parties. This specific feature is immensely powerful and opens up a range of opportunities for ETH: not only can it serve as a currency, but it can also be programmed to be transacted in specific ways.
Benefits of Programmable Assets vs. Traditional Instruments
Cryptocurrencies have certainly benefited from a certain degree of “hype” in recent times, but it is important to be clear on the concrete benefits that cryptocurrencies can provide beyond the traditional means of exchange or store of value. While we explored the broad benefits of blockchain as a technology earlier, in this next section we will detail how these benefits translate into the particular application of cryptocurrencies. Indeed, as detailed below, we will go into more depth as to why cryptocurrency can establish itself as yet a new iteration in how the world trades and protect assets. Beyond tokenising both financial and real assets, the blockchain and SmartContracts have potential to bring all legal contracts for any transaction natively online and automate them from end to end.
Disintermediation of the financial system
Today’s economies are heavily financialised, with growing complexity in financial products and the processes that exist to transfer value. The result has been the emergence of countless actors and intermediaries that need to exist to make the system function, each taking a bite of the proverbial apple, ultimately reducing the value captured by the parties actually looking to trade value.
A tangible example that illustrates this issue is witnessed in cross-border money transfers. Many will be familiar with the high costs entailed by having to send money from one country to another, ranging from (volatile) foreign exchange rates to a litany of transaction commissions. For new businesses in emerging economies, such as those in Africa, these costs of doing business can be a heavy burden. As a result, as shown in Figure 9: Bitcoin in Africa, we have seen some signs of a crypto boom in Africa, especially in countries like Nigeria and South Africa which have particularly volatile currencies. Indeed, businesses on the continent have for decades had to contend with the reality of being in countries with highly fluctuating exchange rates, already-high costs of doing business, low availability of dollars, and elevated bureaucracy, all of which have translated into higher economic costs for market participants. With the growing adoption of digital technologies and growing ubiquity of smartphones, it is however now possible for small businesses to trade with their buyers and suppliers in other geographies much more smoothly and efficiently. Instead of having Africa-based businesses pay their Asia-based suppliers through their banks — and incurring high (and unpredictable) costs in doing so — these businesses can perform their payments in seconds by using bitcoin and at a low cost. This example illustrates how cryptocurrencies, through their decentralised peer-to- peer paradigms are able to offer a cheaper and more efficient direct medium for market actors to interact.
Programmable (composeable) money and financial assets
Perhaps one of the most potent advantages cryptocurrencies can offer traditional fiat currencies is their“programmable” nature. Cryptocurrency projects are built on a stack that dictates the functions that a given cryptocurrency can fulfil and the rules that govern it. Being digital, the possibilities that are offered by these rules are as broad as the potential of digital technology itself. Indeed, computer algorithms can today be engineered to achieve any particular goal, be it winning a game of chess against a world champion, or trading stocks according to a particular pattern or strategy. Cryptocurrencies offer the possibility to harness that power and embed it into the currency itself. Indeed, thinking back to the blockchain stack described earlier, it is useful to highlight in detail the specific capabilities that this technology brings forward.
- Oracles: One of the first capabilities to highlight is the ability to bridge the on-chain and off-chain worlds. Oracles — known as blockchain “middleware” — are the medium that allows information that is off-chain be incorporated into on-chain transactions. This ensures that external information, such as the price of a particular commodity for example, can be incorporated in an autonomous and real-time way. Through these Oracles, blockchains can transcend beyond their virtual context and effectively be used to operate in concert with the “real world”. This makes it possible for a host of data points, such as the price of a commodity or even flight status data (as explored in the next point), to be brought onto the blockchain in real-time. As shown, Figure 10: Comparison of Partners Using Oracle Technology, Chainlink (LINK) and Band (BAND) are by far the most prominent protocols in this regard. In fact, the founding thesis of Chainlink was to greatly enhance blockchain capabilities by “enabling access to real-world data, events, payments, and more without sacrificing the security and reliability guarantees inherent to blockchain technology”.
- SmartContracts: Another feature to highlight is the programmability, and therefore the versatility, of the technology. Much like smartphone apps have revolutionised how we use our phones and lead our lives, dApps enable the embedding of intelligence within cryptocurrencies towards an endless range of use cases. SmartContracts are a useful illustration of how revolutionary the ability to build intelligence into an asset really is. Suppose two parties have agreed to perform a transaction on a given date and at a given price. By building a SmartContract on the Ethereum blockchain, the two parties in question can effectively program the terms of the agreement, ensuring that it is executed in the way they have agreed, without any third-party intervention and without any tampering. The company Etherisc provides a useful illustration of how this concept works in practice. In 2017, the company started offering blockchain-based insurance for passengers wanting to protect themselves against flight delays. The product — unsurprisingly named Flight Delay — which was developed using Ethereum SmartContracts, allows passengers to receive an indemnity payment should their flights be cancelled or delayed. As mentioned above, flight status data can be synced into the contract in real-time through the oracles. While the product is conceptually simple, it illustrates the depth of the capability of Ethereum SmartContracts: in this particular instance, the technology is used to price risk, act as a transaction mechanism, and administer the contract, without third party involvement.
- Automated Market Makers: Automated Market Makers (“AMM”) represent yet another example of how the programmable nature of cryptocurrencies can be leveraged in practical financial applications. Typical exchanges work by having order books that are used to record all “buy” orders and all “sell” orders. External parties, known as market makers, are then involved to “make the market” by always being available to take the other side of a “buy” or a “sell” order, earning a margin on each trade by buying at a slight discount and selling at a slight premium. Without these market markers, exchanges would become illiquid and could not function, making them an essential third party between traders. In contrast, AMM are exchanges that are setup to automatically provide liquidity for certain crypto trading-pairs, for example ETH/BTC. Liquidity pools are set up, with a proportion of each asset from the pair invested in the pool. The trading price for the pair is determined by an algorithm that evaluates the quantity of each asset in the pool: in our example, the more ETH there is relative to BTC, the lower the price of ETH becomes, and vice versa. Trades are executed via SmartContracts, eliminating the need to have an external market maker. AMMs are also permissionless, thereby ultimately increasing the size of the market that they create. Indeed, by not having any hurdles to entry, more participants can enter the market. For any market, liquidity is fundamentally a key challenge to overcome, but through AMMs we can appreciate how the creation of the relevant blockchain application can address the liquidity challenge for crypto assets. The first AMM to be created was Bancor, which went live in 2017, though more popular ones — such as Uniswap, Sushiswap, and Balancer — have since emerged.
Through the examples mentioned above, we can appreciate how Layer 2 and Layer 3 programmable capabilities can be combined — in conjunction with the decentralised nature of Blockchains — to revolutionise the world of Financial Services. In addition, these capabilities are also “composable” in nature meaning that the components mentioned above, such as SmartContracts, can interact amongst themselves. These capabilities can therefore be leveraged in modular and additive ways to develop a host of financial products and services, without a centralised authority managing the apparatus. Instead, end-users interacting directly with one another through decentralised and automated systems to meet their needs with higher efficiency and lower cost.
De-dollarisation
Countries with powerful currencies can weaponise them to attain whatever ends they chose. This creates a situation where hierarchies between nations is amplified and causes countries with weaker currencies to submit to the will of more powerful nations. In stark contrast, by operating across borders and independently from sovereign states, cryptocurrencies are not tied to political ends. Cryptocurrencies can indeed emerge as pure currencies, functioning strictly as stores of value, units of account, and mediums of exchange, without any strings attached. Having a currency be independent of political agendas could perhaps be a step towards a fairer society, on a global level.
A number of countries have already shown appetite to this idea. At the 2019 Kuala Lumpur summit, a number of countries, such as Malaysia and other predominantly emerging countries, raised the idea of launching a new cryptocurrency that would reduce their dependency on the dollar. While these state-sponsored cryptocurrencies would simply displace the problem by having nations other than the US have greater economic and financial sovereignty, it does prove that cryptocurrencies are increasingly being looked at as a pathway to a rebalanced global economy. If we take this idea further and instead replace it with a non-state-affiliated cryptocurrency, such as Bitcoin or Ethereum, we can see a further global decoupling from dominant currencies.
A reliable store of Value
Fiat currencies are subject to a decrease in value resulting from the effects of inflation. Cryptocurrencies, such as Bitcoin, cannot simply be created out of thin air the way a central bank increases the money supply: new units of cryptocurrency must be mined. The resulting scarcity results in a situation where the value of a Bitcoin is tied to the demand for it and the rate at which it is created (which will be capped at a ceiling at 21M Bitcoins, to ensure excess supply is not generated). To ensure Bitcoins remain practical to trade with as their value increases, Bitcoins are highly divisible: they can be divided into lower sub-units, the lowest of which is called a Satoshi and is equivalent to 0.00000001 Bitcoins. As more and more people trade with Bitcoins, they can be divided into smaller units. As economies grow, the value of each Bitcoin and its subunits, would grow rather than fall as the supply is finite. This would enable savings to keep up with the growth of markets and economies, rather than lose value, as is the case with fiat currencies.
Digital Coordination Layer
If we think about the range of digital assets that we have seen emerge in recent years, be they skins in a digital game, tickets for a virtual event, or even domain names, we note that these assets only have value that can be realised in specific contexts. For instance, a specific skin in Fortnite is only usable in the game and does not really have value outside of the game for its owner. Furthermore, digital assets across different environments do not have a common representation either. For example, suppose two users wanted to trade World of Warcraft in-game gold for a virtual concert ticket on Zoom: they could have to agree what each is worth in some form of fiat currency, and then execute a trade on an external platform. Alternatively, each of the digital platforms they use — the game and the concert event platform — could be built using a common blockchain protocol that would ensure a far easier way for users to trade their digital assets. Instead of having to agree a fiat currency price, the items could be priced in digital currency terms and could be traded through a feature that is already pre-built into the native platforms. The digital currency would fulfil the three functions we think of for money in the real world: a store of value, a unit of account, and a medium of exchange, and would do so for all applications in the digital world. The revolution this represents is in effect equivalent to the first invention of money which allowed humans to move on from barter economies to financial economies.
Furthermore, with a fully-fledged digital currency in use, people can then centralise the value of all of their digital assets, creating a digital assets balance sheet that could be usable much in the same way a traditional balance sheet represents value in the non-digital world. We currently live in a world where there is a staggering quantum of digital value that is simply untradable and illiquid due to the absence of a common coordination layer. However, imagine a world where there was a way to represent and trade all of the digital assets that you have, be it a piece of digital art, to prizes won in a virtual game, to the event tickets mentioned above. All this value would not only be counted, but it would then become usable beyond its original context, giving rise to a purely digital economy. The same way a person can sell a car for money that can then be used to purchase books, a person might be able to sell a proprietary piece of code they wrote for an artefact in a sims game.
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