Why Cryptocurrencies Matter
Blockchain, segwit, hard fork, soft fork, HODL, FUD, hashing, proof of work, proof of stake, ICOs, smart contracts. The world of cryptocurrencies is seeing a massive increase in interest, but can be extremely overwhelming with technical jargon. I will try to explain the significance of cryptocurrencies, more specifically, blockchains, to the average person. To really understand blockchains, we need to understand the motivation behind it and it’s implications. I will skip over technical details to focus on the problems blockchains try to solve. Similar to how the world wide web has had a huge impact in our lives without the average person understanding the TCP/IP protocol that made it possible, we don’t have to understand the technical details of cryptography and blockchains to reap the benefits of it.
A Short History Lesson
In order to understand blockchains, we need to understand the historical and political context and the problem the original blockchain, Bitcoin, aimed to address.
The Value of Fiat
Most people take the value of money for granted. Take a second to think about why the dollars in our pockets have value. (I’ll be talking about the USD in this article because I’m American, but this applies to any fiat currency around the world). Fiat money is currency that a government declares as legal tender but not backed by a physical commodity. Simplistically, it’s value is derived from the supply of the currency in circulation and the demand for the goods it can purchase.
This all sounds fine until we learn about central banks. Central banks, like the Federal Reserve in the US, are granted special privileges by their government to directly manipulate the supply of money using. In theory, this is meant to stabilize the economy, but in practice we have seen it prop up the biggest bubbles in history!
More importantly, the Federal Reserve can monetize government debt by printing money and buying government bonds. This allowed government spending and debt to grow rapidly to the tune of $20T (that’s not even including unfunded liabilities like Social Security and Medicare)! Each child today is born with about $60k in liabilities it owes to Uncle Sam, for benefits it hasn’t received.
An increase in the amount of currency in circulation causes prices of goods to go up, known as inflation. Inflation particularly hurts savers as the value of their savings erodes. The cost of living also goes up squeezing people to demand higher wages, further pushing the prices of what they produce to go up. People blame greedy capitalists as the problem, but really the root is inflation, another form of taxing citizens if it’s used to monetize government debt.
This created a lot of frustration to have to trust a central authority that freely erodes the people’s purchasing power in order to let their government spend go into deeper debt while putting its citizens on the hook to pay the bill. More and more cash is pumped into the economy while government spending and debt continues to grow. It’s gotten to the point where we now live in a world where negative interest rates exist. How does paying for someone to borrow your money make any sense?
Worst of all, there doesn’t seem to be an end to this any time soon. The only way for the US government to pay its current lenders is to take on more debt with new lenders. In other words, it pays its current debt with more new debt. This is a classic ponzi scheme.
A New Gold Standard
Before we had fiat money, the US was on the gold standard. This meant that each paper note represented an amount of gold that can be redeemed. This kept the size of government and its spending in check since they didn’t have an accomplice to simply print money and monetize their debt and the supply of the currency had to be limited. Once the US got off the gold standard, the supply of fiat currency skyrocketed and continues to grow at an alarming rate.
The Housing Crash
In 2008, we witnessed one of the biggest bubbles in history pop. A bubble that was inflated with artificially low interest rates, easy access to loans, and government guaranteed housing loans. The proposed solution of quantitative easing (big words that simply mean pump cash into the economy) and bailouts meant that we needed to use inflation to “help” us get out of the depression. Government and money market manipulation that caused the crash was also now the “solution” to the crash.
In order to support all the quantitative easing and bailouts, massive amounts of debt and money printing took place. That means the people were on the hook again. Big banks were able to profit while the people paid for it through inflation.
The anger and frustration from the bailouts and quantitative easing helped catapult the idea of Bitcoin as an alternative to fiat. Similar to how church and state is separated, bitcoin aims to separate money from state.
To be a valid alternative to fiat, Bitcoin had to have several key properties. It had to be decentralized and trustless.
A decentralized system would mean that there isn’t a centralized vulnerability. This makes it hard for governments to get involved and regulate Bitcoin itself (although they are regulating exchanges, which are still not decentralized).
Additionally, the supply of Bitcoin cannot be manipulated. Since it is spread among millions of nodes, in order to make a change like that, a majority of the nodes would have to be corrupted. This means that inflation can not be introduced due to a decision by a central authority. In fact, Bitcoin is deflationary in nature if we assume the economy continues to grow while the supply of Bitcoins remains capped.
Bitcoin would also be nearly impossible to shut down. Since it is spread onto millions of machines, all of them would have to be shut down to really take down Bitcoin.
Typically we would need a third party to facilitate transactions and to protect against bad behavior. However, Bitcoin was designed such that if everyone acts in their own self interest, the system would still work. In other words, the economics of it is designed such it assumes everyone will act in their own self interest.
The game theory behind rewarding miners is a virtuous cycle. In short, mining valid blocks create trust in the system, which cause the price of the rewards to go up. If a bad actor were to corrupt the network with malicious data, the value of Bitcoin would drop, reducing the reward for fraud. Bitcoin is self regulating.
Blockchains are the innovation that allowed for Bitcoin to have a decentralized and trustless ledger of transactions. Without getting into the technical details, it can be thought of as a database that is decentralized with incentives baked in to keep it running without corruption.
This decentralized and trustless database allows us to freely transact and save in a currency that can’t be regulated or manipulated.
Bitcoin is mainly focused on a decentralized global currency to reduce the power of central banks. The innovation of a blockchain is the technology that allowed for this. However, people started to see the value of the blockchain technology beyond just money.
Ethereum is the most popular platform where people can store and execute code known as smart contracts on the blockchain. This means that we get the benefits of a decentralized and trustless system applied to anything we can imagine!
We are just at the very early days of this and the implications are huge. Think of anything with a third party used for validation or to create trust. Those can all be automated. For example, an escrow is typically used to hold the assets of two parties and is released once certain events occur. On a blockchain, the events would simply trigger a smart contract to execute and transfer the assets.
Even broader applications of being decentralized has many benefits. For example, when we use services such as Facebook or Google, there is an implicit trust in what they do with our data and that they won’t give us biased search results or feeds. I’m not claiming there is corruption happening in these companies, but the incentives for corruption in addition to humans having biases exist. By decentralizing these services, we get closer to true freedom with no censorship or manipulation.
An ICO, or initial coin offering, is a play on the word IPO, or initial public offering. Be careful though, you are typically not buying equity in a company when you participate in an ICO. You are buying tokens which are tied to an asset as defined by the company. The value of a token is derived from the supply and demand of how useful the token is. Again, it is typically not an equity share.
I’ll save the discussion for what I suggest to look for when investing, but please be careful. In my opinion, this feels like a bubble with uninformed people flocking into ICOs hoping to get lucky. To be clear, I don’t think bubbles are bad per se. In a free market, bubbles allocate massive amounts of capital to uncertain and risky ventures to help bootstrap an industry (like the dot-com bubble). However, make sure you understand the risk!
A token is typically programmed onto the Ethereum blockchain as a smart contract. You participate in an ICO by buying tokens from a company as a way for the company to raise funds in exchange for tokens.
This has several advantages such as democratizing the raising of capital and the securitization of digital assets with tokens. For example, you can tie tokens to the amount of claps an article gets which could potentially reward writers of great content.
I gave a very high level overview how a decentralized and trustless database known as the blockchain can have profound implications on the future of software and transactions. However, I obviously glossed over details and many topics such as privacy and how blockchains are facing a scaling problem along with their proposed solutions. I hope I have given you enough of a foundation to understand the motives and benefits of blockchains to go out and learn more about how this innovation can transform our lives!
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