salt

Things change. Buildings, held revered for reasons that actually defy logic when seriously contemplated, become entrenched. Tradition, history, and because mom shopped there, are all reasons touted. Things once valued highly, such as salt (yes, that is a link to the Encyclopedia of Money), become boring condiments or relegated to the dustbin of history. Essentially, what holds value now may not hold value in the future. And, as history has taught us with painful lesson after painful lesson, not everyone welcomes change. Such is the case now with nationalized money. Or, as you might know it, the dollar, the Deutschmark, the Euro, the Pound, the Loonie, the Rand, the Dinar, the Rial, the Yen, the Gourde, and so on. There are a lot of names for that stuff you keep in your wallet or under your mattress.

There is now this thing called “Cryptocurrency” and it is scaring the hell out of millions of people. Especially those with their livelihoods dependent on the stable trade of currencies between countries. But, to figure out what’s coming we first must know what’s here. And, as head slappingly obvious as it might seem to you now, you will find you probably don’t know what money is.

Let’s start simple; “Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.”

In other words, if where you’re at says this or that is money, it’s money. It has value and may be used instead of barter. You need not trade a chicken for a duck. You can just hand them whatever accepted representation is in your possession and say “Thanks for the duck.” It makes transactions easier.

In America we use dollars.

So how did we get here? Let’s head on over to the International Monetary Fund for a fun history.

No, really, it’s kind of fun. And silly if taken out of context.

… (M)oney is something that holds its value over time, can be easily translated into prices, and is widely accepted. Many different things have been used as money over the years—among them, cowry shells, barley, peppercorns, gold, and silver.

At first, the value of money was anchored by its alternative uses, and the fact that there were replacement costs. For example, you could eat barley or use peppercorns to flavor food. The value you place on such consumption provides a floor for the value. Anyone could grow more, but it does take time, so if the barley is eaten the supply of money declines. On the other hand, many people may want strawberries and be happy to trade for them, but they make poor money because they are perishable. They are difficult to save for use next month, let alone next year, and almost impossible to use in trade with people far away. There is also the problem of divisibility—not everything of value is easily divided, and standardizing each unit is also tricky; for example, the value of a basket of strawberries measured against different items is not easy to establish and keep constant. Not only do strawberries make for bad money, most things do.

But precious metals seemed to serve all three needs: a stable unit of account, a durable store of value, and a convenient medium of exchange. They are hard to obtain. There is a finite supply of them in the world. They stand up to time well. They are easily divisible into standardized coins and do not lose value when made into smaller units. In short, their durability, limited supply, high replacement cost, and portability made precious metals more attractive as money than other goods.

Until relatively recently, gold and silver were the main currency people used. Gold and silver are heavy, though, and over time, instead of carrying the actual metal around and exchanging it for goods, people found it more convenient to deposit precious metals at banks and buy and sell using a note that claimed ownership of the gold or silver deposits. Anyone who wanted to could go to the bank and get the precious metal that backs the note. Eventually, the paper claim on the precious metal was delinked from the metal. When that link was broken, fiat money was born. Fiat money is materially worthless, but has value simply because a nation collectively agrees to ascribe a value to it. In short, money works because people believe that it will. As the means of exchange evolved, so did its source—from individuals in barter, to some sort of collective acceptance when money was barley or shells, to governments in more recent times.

Even though using standardized coins or paper bills made it easier to determine prices of goods and services, the amount of money in the system also played an important role in setting prices. For example, a wheat farmer would have at least two reasons for holding money: to use in transactions (cash in advance) and as a buffer against future needs (precautionary saving). Suppose winter is coming and the farmer wants to add to his store of money in anticipation of future expenses. If the farmer has a hard time finding people with money who want to buy wheat, he may have to accept fewer coins or bills in exchange for the grain. The result is that the price of wheat goes down because the supply of money is too tight. One reason might be that there just isn’t enough gold to mint new money. When prices as a whole go down, it is called deflation. On the other hand, if there is more money in circulation but the same level of demand for goods, the value of the money will drop. This is inflation—when it takes more money to get the same amount of goods and services (see “What Is Inflation?” in the March 2010 issue of F&D). Keeping the demand for and supply of money balanced can be tricky.

So what changed? Quite a lot actually. You see money has become a bit of an abstract concept. Its value is based more on perception than reality. Were the world held to a common standard, such as gold, then the amount of that standard that you held, or had immediate access to, would be your worth. That doesn’t really apply to individuals as much as countries, or accepted institutions issuing money, but the core concept is the same.

Of course, you can see the problem. All you have to do to render that type of money worthless, or seriously devallue it, is to find more of whatever the standard is. It’s called “flooding the market” and it can lead to all sorts of heinous consequences. Mostly devaluing the money people hold until it’s worthless.

The inverse is also true. A finite amount of the standard can lead a government to print and distribute more currency in an attempt to bolster the economy, think 1930’s Germany or 1970’s Mexico, and, instead, lead to situations where wheelbarrows full of local currency would be needed for a loaf of bread.

So, stability becomes an issue that needs to be dealt with. And that, as noted above in the fun article from the International Monetary Fund (you did read it, didn’t you?) is how we got to fiat money.

To recap; Fiat money is materially worthless, but has value simply because a nation collectively agrees to ascribe a value to it. In short, money works because people believe that it will.

Gold, silver, and other precious metals, still provide the basis for all currencies, and their worth still fluctuates. But, by using fiat money, those fluctuations, in and of themselves, can’t wipe out a country or its economy.

Okay, so here we are. Now, for the record, you’re reading this on a digital device. Odds are you use digital money more than you think. Whether a credit card, a PayPal link, an app from your bank, or something else, you really don’t need any hard currencies in your wallet. Hell, you really don’t need a wallet at all if you live somewhere that digital identification is accepted (not anywhere yet, so relax).

That leads us to the development of cryptocurrencies. And this is where things get weird.

Brad Mills, senior tech engineer at Block Tech, took some time a couple of years ago to do a detailed breakdown of the whole affair. Please click his name if you want the deep dive. For now I’m just going to cover the gloss.

Few people know, but cryptocurrencies emerged as a side product of another invention. Satoshi Nakamoto, the unknown inventor of Bitcoin, the first and still most important cryptocurrency, never intended to invent a currency.

In his announcement of Bitcoin in late 2008, Satoshi said he developed “A Peer-to-Peer Electronic Cash System.“

His goal was to invent something; many people failed to create before digital cash.

Announcing the first release of Bitcoin, a new electronic cash system that uses a peer-to-peer network to prevent double-spending. It’s completely decentralized with no server or central authority.  – Satoshi Nakamoto, 09 January 2009, announcing Bitcoin on SourceForge.

The single most important part of Satoshi‘s invention was that he found a way to build a decentralized digital cash system. In the nineties, there have been many attempts to create digital money, but they all failed.

… after more than a decade of failed Trusted Third Party based systems (Digicash, etc), they see it as a lost cause. I hope they can make the distinction, that this is the first time I know of that we’re trying a non-trust based system. – Satoshi Nakamoto in an E-Mail to Dustin Trammell

After seeing all the centralized attempts fail, Satoshi tried to build a digital cash system without a central entity. Like a Peer-to-Peer network for file sharing.

This decision became the birth of cryptocurrency. They are the missing piece Satoshi found to realize digital cash. The reason why is a bit technical and complex, but if you get it, you‘ll know more about cryptocurrencies than most people do. So, let‘s try to make it as easy as possible:

To realize digital cash you need a payment network with accounts, balances, and transaction. That‘s easy to understand. One major problem every payment network has to solve is to prevent the so-called double spending: to prevent that one entity spends the same amount twice. Usually, this is done by a central server who keeps record about the balances.

In a decentralized network, you don‘t have this server. So you need every single entity of the network to do this job. Every peer in the network needs to have a list with all transactions to check if future transactions are valid or an attempt to double spend.

But how can these entities keep a consensus about this records?

If the peers of the network disagree about only one single, minor balance, everything is broken. They need an absolute consensus. Usually, you take, again, a central authority to declare the correct state of balances. But how can you achieve consensus without a central authority?

Nobody did know until Satoshi emerged out of nowhere. In fact, nobody believed it was even possible.

Satoshi proved it was. His major innovation was to achieve consensus without a central authority. Cryptocurrencies are a part of this solution – the part that made the solution thrilling, fascinating and helped it to roll over the world.

What are cryptocurrencies really?

If you take away all the noise around cryptocurrencies and reduce it to a simple definition, you find it to be just limited entries in a database no one can change without fulfilling specific conditions. This may seem ordinary, but, believe it or not: this is exactly how you can define a currency.

Take the money on your bank account: What is it more than entries in a database that can only be changed under specific conditions? You can even take physical coins and notes: What are they else than limited entries in a public physical database that can only be changed if you match the condition than you physically own the coins and notes? Money is all about a verified entry in some kind of database of accounts, balances, and transactions.

How miners create coins and confirm transactions

Let‘s have a look at the mechanism ruling the databases of cryptocurrencies. A cryptocurrency like Bitcoin consists of a network of peers. Every peer has a record of the complete history of all transactions and thus of the balance of every account.

A transaction is a file that says, “Bob gives X Bitcoin to Alice“ and is signed by Bob‘s private key. It‘s basic public key cryptography, nothing special at all. After signed, a transaction is broadcasted in the network, sent from one peer to every other peer. This is basic p2p-technology. Nothing special at all, again.

The transaction is known almost immediately by the whole network. But only after a specific amount of time it gets confirmed.

Confirmation is a critical concept in cryptocurrencies. You could say that cryptocurrencies are all about confirmation.

As long as a transaction is unconfirmed, it is pending and can be forged. When a transaction is confirmed, it is set in stone. It is no longer forgeable, it can‘t be reversed, it is part of an immutable record of historical transactions: of the so-called blockchain.

Only miners can confirm transactions. This is their job in a cryptocurrency-network. They take transactions, stamp them as legit and spread them in the network. After a transaction is confirmed by a miner, every node has to add it to its database. It has become part of the blockchain.

I’m going to skip over the details of how it all works and, instead, share the simple realities of cryptocurrencies. These are the parts that effect, and scare, the nice people who control economies.

1.) Irreversible: After confirmation, a transaction can‘t be reversed. By nobody. And nobody means nobody. Not you, not your bank, not the president of the United States, not Satoshi, not your miner. Nobody. If you send money, you send it. Period. No one can help you, if you sent your funds to a scammer or if a hacker stole them from your computer. There is no safety net.

2.) Pseudonymous: Neither transactions nor accounts are connected to real-world identities. You receive Bitcoins on so-called addresses, which are randomly seeming chains of around 30 characters. While it is usually possible to analyze the transaction flow, it is not necessarily possible to connect the real world identity of users with those addresses.

3.) Fast and global: Transaction are propagated nearly instantly in the network and are confirmed in a couple of minutes. Since they happen in a global network of computers they are completely indifferent of your physical location. It doesn‘t matter if I send Bitcoin to my neighbour or to someone on the other side of the world.

4.) Secure: Cryptocurrency funds are locked in a public key cryptography system. Only the owner of the private key can send cryptocurrency. Strong cryptography and the magic of big numbers makes it impossible to break this scheme. A Bitcoin address is more secure than Fort Knox.

5.) Permissionless: You don‘t have to ask anybody to use cryptocurrency. It‘s just a software that everybody can download for free. After you installed it, you can receive and send Bitcoins or other cryptocurrencies. No one can prevent you. There is no gatekeeper.

This gets more in depth but I’ll give you the basics. When you enter money into the system it doesn’t matter it’s original currency. When you do work and are granted a coin for your efforts (called mining), your money is yours. No matter what though, the transaction can’t be traced.

That’s as of today.

If quantum computing becomes real then all bets are off.

But that’s a worry for later.

Right now cryptocurrencies are beginning to be accepted as traditional currencies at banks, places of commerce, and online for transactions. There are many scams related to it, just as there are with gift cards, but that’s not a good reason for people to avoid them. The per-coin value will stabilize as time goes on. Right now it’s inflated for the same basic reason that Ferraris cost more than Kias. There aren’t enough to meet the total demand. And, for now – just like with Ferraris, that will remain the status quo until there are enough users to justify the restructuring.

Like any good frontier mining cryptocurrencies requires a reasonable investment in software (under $500 USD), and a hell of a lot of work. But it is there, it’s not going anywhere, and you may as well get used to it.