Bitcoin, Ethereum, Litecoin, Monero. It seems that every month a new crypto-currency is in the news, but what are they, and why have they grabbed our collective attention?
In order to understand crypto-currencies, we need to understand how our existing fiat currencies work. Fiat currency is issued by the central bank of a nation and declared legal tender by its government. It allows central banks to manipulate the value of a currency, to kick-start an ailing economy or slow down an overheating one. Just as importantly it lets governments track transactions of substantial value to ensure nothing illegal takes place and tax is paid. One challenge of fiat currencies however is the fact that a population’s liquid wealth is at the mercy of policy makers who if they get things wrong, could wipe out the value of people’s savings. What happened in Zimbabwe is an extreme example.
In the wake of the 2008 financial crisis, central banks around the world started printing new money to give their economies a kick start and everyone’s existing hard earned savings were diluted. Much like watered down wine, you needed more of the stuff to get the same effect (this is what technically causes inflation).
With the culprits that triggered the crisis getting away with a slap on the wrist and the ordinary person getting kicked in the teeth with diluted savings and footing the bail-out bill, many who understood the injustice were rightfully angry about what had taken place.
One of those (presumably) angry individuals went by the alias of Satoshi Nakamoto (nobody knows who Satoshi is). In the aftermath of the crisis, Satoshi created a new digital currency, designed to completely dis-intermediate central banks, retail banks, investment banks, governments and pretty much any organisation that would traditionally claim to have authoritative influence over a currency. Satoshi called their new currency “Bitcoin”.
Bitcoin was not only a symbol of defiance against a financial system that favoured the powerful, it was the first implementation of an architecture that made decentralised transactions practical and practically unhackable. That architecture was Blockchain, the most revolutionary change to recording value since double-entry bookkeeping.
Blockchain works by regularly taking a sequence of pending transactions, making sure they can take place, wrapping them up in a “block”, executing them and appending them to the end of a chain of existing blocks that represent past transactions. This is akin to the settling / clearing process found in traditional monetary systems. For Bitcoin, this happens every ten minutes (newer crypto-currencies typically have shorter intervals). And, because a blockchain contains all historical transactions, it knows what the ledger would have looked like at any moment in time. It is an encrypted, immutable version of the truth both past and present and to ensure it cannot be compromised is replicated and stored in the computers and mobiles of its users making it peer-to-peer. This last part is key to its organic resilience. A hacker may be able to hack one instance of the blockchain but would need to hack more than half of of the live instances within minutes before the blockchain caught the anomaly and flagged the hacked instance as corrupt.
Bitcoin, much like many “firsts” has its challenges. It’s transactional throughput is limited, the electricity required to mine it (do the proof of work that helps validate transactions) is unfeasibly high and its underground history and quasi-anonymous transactions status have given it a mixed legacy. Bitcoin may not be a practical crypto-currency in the long term, but that’s not to say Etherium, Litecoin, Ripple or even Monero won’t take the crown from Bitcoin and reign as the currency of choice. The idea of a global, trustworthy currency that’s difficult to manipulate and that settles in minutes if not in near real-time is highly appealing for obvious reasons but two questions remain unanswered; will Governments use draconian measures to shut them down before they have a chance to become ubiquitous and if allowed to flourish; which currency will build enough critical mass to be the de facto currency of choice?