This is part 2 of an introductory series, written to explain some of the high level concepts within the world of cryptoassets and blockchain technology.
Money hasn’t had an upgrade in a while. Although it has taken many forms throughout history, we’ve settled into a world consisting of hundreds of government issued, or “fiat” currencies. Governments and banks control the creation of new currency and then distribute it throughout a network of national banks.
Each fiat currency is only as strong as the government that controls it. Those unfortunate enough to live under unstable governments are stuck with unstable fiat currencies - Venezuela, Argentina and Zimbabwe are prime examples. In this system, banks control how people access money. Billions of people don’t have access to banks and thus, are locked out of the global economy. In modern economies we rely heavily on a complex web of intermediaries to move money, which has created massive inefficiencies that often go unnoticed. This same system caused a financial meltdown in 2008.
This was assumed to be just the way currency worked until Satoshi Nakamoto unleashed Bitcoin on the internet in 2009. Suddenly, there was a blueprint for an entirely new type of currency. Currencies where governments are replaced by clever software programs and banks are replaced by global networks of anonymous computers run by volunteers. Currencies open to anyone with an internet connection that move at the speed of information.
Basics
Behind every cryptocurrency is a software protocol and network that allows people to transfer money over the internet. The software is shared across computers all over the world, creating a global network. Computers in the network validate new transactions using a special type of ledger called a blockchain - a record of every transaction that has ever occurred on the network.
Bitcoin was the world’s first cryptocurrency but others like Litecoin, Bitcoin Cash, Monero and Zcash have also reached meaningful levels of success. Each consists of their own software shared across their own global network that maintain separate blockchains.
The computers running the software in each cryptocurrency’s network are operated by volunteers, made up of individuals and institutions. Some build applications and businesses that others can use to access the network - digital wallets and exchanges. Others perform a vital task called “mining”, that updates the blockchain with new transactions. Miners get paid in newly minted cryptocurrency. Bitcoin miners update the Bitcoin blockchain and earn bitcoin. Litecoin miners update the Litecoin blockchain and earn litecoin, etc. The rewards that miners receive also acts as the way new cryptocurrency is released into circulation.
Where do cryptocurrencies come from?
Creating a new currency has usually required a government, backed by an army - Bitcoin changed that.
Satoshi Nakamoto made Bitcoin’s software open source - this means that anyone is free to download it and see exactly how it works. This provided software developers around the world with a blueprint for creating their own cryptocurrencies.
An engineer with an understanding of blockchain technology can simply download the Bitcoin software, make some adjustments and release a brand new cryptocurrency. If they can convince miners to run their new software and users to transact in their currency, a new cryptocurrency is born.
Cryptocurrencies like Litecoin and Bitcoin Cash are simply augmented versions of the Bitcoin software running on their own individual networks. These adjustments were made to address what their creators saw as shortcomings within the Bitcoin system.
Nakamoto designed Bitcoin’s software so that new transactions would be processed roughly every 10 minutes and that only 21 million bitcoins would ever be created. Litecoin’s developers adjusted the Bitcoin software to make a faster currency more suitable for small transactions - new Litecoin transactions are processed roughly every 2.5 minutes and there is a limited supply of 84 million Litecoin. Bitcoin Cash transactions are still processed about every 10 minutes, but developers increased the “block size”, allowing for larger batches of transactions.
Digital money
A common misconception is that cryptocurrencies are the first forms of purely digital money. People are often surprised to learn that only 11.6% of all US dollars exist in the form of paper cash and coins* - the rest is all digital.
Almost 90% of all US dollars consist of numbers in a database
The databases where almost 90% of our money lives are owned by banks all over the world. These banks, aided by middlemen like Visa/Mastercard are the trusted third parties that are needed to facilitate most of our financial interactions.
A modern transaction where Sean pays Rachel $100 amounts to Sean’s bank deducting $100 from his account and instructing Rachel’s bank to add $100 to hers. Numbers in the bank’s databases change but no physical cash actually changes hands.
Bitcoin and other cryptocurrencies are simply a way for Sean to digitally pay Rachel that relies on a global autonomous network, rather than a bank.
Why are cryptocurrencies important?
So why would we need money that doesn’t rely on banks and governments?
Odds are, you’re reading this from a country where the traditional financial system works pretty well. You have a credit card linked to a bank account and probably spend little time thinking about the money you spend on a daily basis. This is a luxury that much of the world is not afforded.
Nearly 2 billion* people are ”unbanked”, meaning they lack access to basic financial services and are locked out of the global financial system. When you lack access to basic financial services, you cannot take out a loan to start a business and the safest place for your life’s savings is under a mattress. Even more are “under-banked,” meaning they are forced into using non-traditional financial services such as money transmitters that charge predatory fees. Cryptocurrencies are available to anyone with a smartphone and an internet connection. With smartphones becoming cheaper and access to the internet ubiquitous, cryptocurrencies are a powerful alternative for the unbanked and underbanked populations that the current system has left behind.
Living in a country where the government’s currency holds its value is also not the norm for many. Venezuela is a prime example, where irresponsible government policies have led to hyperinflation. Holding your life’s savings in a hyperinflating currency is the same thing as lighting a bunch of it on fire, as it has less and less buying power each day. Cryptocurrencies again provide a needed alternative to inflationary currencies issued by unstable governments, and are already creating new micro economies for Venezuelans and other people around the world.
Building a more efficient global economy
In addition to providing alternatives for the unbanked and those stuck using hyperinflating government currencies, cryptocurrencies can bring efficiencies to modern economies.
Sending an email from New York to London doesn’t take any longer than sending an email to your nextdoor neighbor. The fastest way to send your friend in London $100 from New York is to hop on a plane and hand it to them in person. This is because money sent internationally is processed by a litany of middlemen and takes 5 days to arrive. With cryptocurrencies and the Internet of Value, money moves like email and is unrestricted by borders.
In-person transactions are no simpler than international ones. While swiping your credit card to buy a cup of coffee may feel instant, behind the scenes is a complex messy process involving up to 7 different middlemen. These middlemen profit massively from their role by charging fees to the merchant, who don’t usually receive the funds until 3 days later. Merchants are forced to pass these costs along to consumers, inflating the costs of goods and services for everyone. Businesses are often forced to set $10 credit card minimums because smaller transactions are made unprofitable by all of the fees. Cryptocurrencies can cut out all of these expensive middlemen by allowing payments to immediately flow from consumer to merchant in a fraction of the time.
Where’s the value?
Cryptocurrencies are often difficult to understand at first because they’re so radically different from what we’re used to - currencies issued by governments and controlled by banks. After a closer inspection of the world that our current system has created, they start to make more sense. 2 billion people don’t need to be excluded from the financial system. Venezuelans don’t need to be stuck using worthless government currency. Money doesn’t have to be restricted by borders and seven different institutions don’t need to be involved in buying a cup of coffee.
While the potential for cryptocurrencies to tackle these issues is immense, we’ve got a ways to go before a meaningful impact is made. In their current state, volatility makes them difficult to use for every day transactions and blockchain networks can’t handle the scale of centralized systems like Visa and Mastercard. Cryptocurrencies are still early stage technology and rebuilding the global financial system is going to take time.
The promise and excitement surrounding cryptocurrencies has attracted some of the world’s smartest minds in both tech and finance. As resources continue to pour into these groundbreaking new technologies, they will continue to evolve and integrate themselves into our everyday lives. Once cryptocurrencies reach their true potential and value, we’ll look back on the days when banks and governments monopolized money and wonder how we ever got along in the first place.
Citations
*USD Currency supply calculation as of May 2017 - 1.63 Trillion / 14.02 Trillion = 11.6%
*Unbanked statistics - https://globalfindex.worldbank.org/