What is a cryptocurrency? | Just Reflections - Issue #24
This is part 2 of a series on cryptocurrencies. If this is your first time here, I highly advise that you start with part one:
In the last issue, we went through a brief history of money all the way to fiat money.
Today, we consider whether there's a way to keep all the advantages of fiat money without relying on the government as the central authority to make the monetary system work. The specific solution we'll be talking about is cryptocurrencies. I know that there are some complex technologies and mathematics driving cryptocurrencies, but we won't dive into that. We're looking at the theory that can be understood by all of us.
Great! Now that I've said things will be simple, let's look at the difficult definition and then we can break it down together.
A cryptocurrency is a decentralized ledger currency based on public-key cryptography
There are two key terms I've put in bold in that definition; "a decentralised ledger" and "public-key cryptography". These two qualities are used to solve the two major problems with switching to a decentralised currency; "Decentralisation" and "Authorization". The newsletter issue is only long enough to talk about one, so today we'll cover the first.
Why does money have value?
Back in the commodity money system, the money had value because the commodity itself inherently had value. But as we've learnt from fiat money, this is not strictly necessary for money to have value. What gives money its value is our belief that we can use it to pay for things later. This belief can come from any consensus that a thing will be accepted as payment.
This may sound strange to you, but it happens in our society all the time. An example that quickly comes to mind is art.
According to Wikipedia, the Mona Lisa is one of the most valuable paintings in the world. It holds the Guinness World Record for the highest known painting insurance valuation in history at US$100 million in 1962 (equivalent to $870 million in 2021). If you think about it, what is fundamentally valuable about the Mona Lisa? The materials it is made of are hardly worth anything. In fact, they need continuous special care because they are so old. Many of us don't understand why anyone would pay close to a billion dollars for an old painting.
The Mona Lisa has value for two reasons. One, it is rare. It is the only genuine Mona Lisa by Leonardo da Vinci, it's a one of one. If it got destroyed, there would never be another. This quality is called non-fungibility, — you may have heard it if you've ever researched NFTs. And two, people believe it has value. It has that price tag because whoever owns it believes that someone will be willing to pay that much for it in the future. If we woke up tomorrow in a world where no one cares about art, the Mona Lisa would become worthless because there would be no hope of getting any money for it. The same applies to baseball cards, Pokémon cards, stamp collections; all these things have been sold for millions of dollars because their niche enthusiasts believe them to be valuable.
The problem with centralised money
One feature of money that is not backed by a commodity is that the government can create, or mint, additional money. This increases the money supply and causes the money to be inflationary. This is not a bad thing when it is kept under control. It gives the government some control over the economy. For example, the newly minted money can be lent to entrepreneurs to stimulate the economy. If you'd like to learn more about how inflation is used to affect the economy check out this brilliant video by Ray Dalio:
The fiat money system requires complete dependence on and trust in the government. And because governments have been known to falter, the great power they wield over the monetary system is worrying. What would happen if there is political turmoil and the government collapses? How about if the government becomes corrupt and starts minting money for their own ends? What if the government makes poor decisions that negatively affect the monetary system? In any of these cases, the monetary system could collapse or be subject to manipulation because it has a single point of failure; the government.
If we truly want to protect ourselves, we need to maintain a functional monetary system without the need to trust the government or any other central authority.
What do we need to build a monetary system that doesn't rely on the government's authority? Let's call this new decentralised money "People Coin". Just like we did with commodity money, everyone would exchange their fiat money for an equivalent amount of People Coins.
People Coin is only possible if we can solve the problems that the government, as the central authority, is currently solving for us;
Decentralisation: The central authority accounts for all transactions and maintains a record of everyone's balance so that no one can spend money they don't have. How do we keep an accurate record of all People Coin transactions without a central authority?
Authorization: The central authority handles all the authorisation needs to ensure that only you can allow transactions on your account. How do People Coin users sign transactions before they are approved and how can we trust those signatures without a central authority keeping track of their validity and of who's who?
One function of central banks — acting as agents of the government — is to maintain a ledger of accounts.
A ledger is a book or other collection of financial accounts detailing the activity in those accounts.
Maintaining a ledger ensures that everyone's accounts are tracked. You always have a record of how much you have. You can't spend money you don't have and you can't spend the same money twice.
To achieve the highest amount of decentralisation, we need as many copies of the ledger as possible. Ideally, everyone could have a copy of the ledger. That way, no one needs to trust anyone else. If a malicious agent wants to change the ledger, there would be tons of ledgers they'd need to change, all in different hands. If there were only three copies of the ledger, someone could sabotage the currency by changing only three ledgers.
But how do we maintain a ledger that captures all the transactions and can still be trusted by everyone when everyone has their own copy? The way to solve this is for everyone to have an electronic copy of the ledger and all these ledgers constantly communicate with each other, making sure that their own list of transactions agrees with all the others. Each time there's a transaction, it is written directly onto one ledger. After that, it is broadcast to all the other electronic ledgers. If the transaction has the correct signature and the sending account has sufficient balance to make the transaction, the transaction is accepted and accounts are updated accordingly on all the ledgers. Once recorded, a transaction cannot be changed. This way, it is the responsibility of everyone who has a ledger to verify and record transactions.
The ledgers can be set up so that anyone can look up any account to see the balance and transactions associated with that account. This provides transparency to the system; if anyone thinks the ledgers are not working properly, they can check the transaction to confirm whether the modular arithmetic is being done correctly.
Minting additional money
When we were using commodity money, we could always farm or mine or produce more of the commodity to add to the money supply. Similarly, when we were using fiat money, the government could always mint more money to add to the money supply. Both these systems were inflationary. So if we want People Coin to be an inflationary currency as well, we need a way to make more People Coins.
Remember from last week's issue that gold was a good commodity to back the paper money because it is difficult to get new gold, but it is possible with some effort. We need this same characteristic for People Coin. Bearing in mind that if it can be minted too easily, it would suffer from rapid inflation, which is bad. We also don't want some people to stop doing other useful work just to mint money.
So, in People Coin, instead of the government having the power to choose who receives newly minted money, minting additional money will be tied to the work of maintaining the ledger, and whoever does that work gets the newly minted money for that group of transactions. This also acts as the incentive for people to want to get a copy of the ledger and become a maintainer. However, maintaining the transactions must require a significant amount of effort so that new coins aren't just being minted willy nilly.
And there we have it. This system of distributed interconnected ledgers allows for all the decentralisation functionality that we want People Coin to have. The ledgers make the transactions transparent, so anyone with a ledger can verify that the transactions being made are truly valid. And anyone can look at the transactions if they want.
The system also allows for the minting of additional People Coins, but the speed at which this occurs is limited by how difficult maintaining transactions is. Finally, since each ledger keeps a copy of all accounts and their balances, People Coin doesn't depend on any central authority. As long as one valid copy of the ledger still exists, People Coin could still operate (in principle). Thus, the only existential threat to our money is if every single ledger was destroyed.
This solves for decentralisation and is indeed how the backbone of many cryptocurrencies works. But I'm sure you can see some problems that still exist with People Coin. Like authorization, for example. If anyone can have a ledger and a transaction happens at any ledger and is then broadcast to the rest of the ledgers, what stops me from creating a transaction pretending to be someone else, sending their money to my account and then broadcasting that transaction to the network of ledgers? We'll look at the solution to that problem in the next issue.
What do you think of these ideas? Are there things you didn’t know before reading this? Did I get something wrong? Whatever your thoughts, please hit reply and let me know. I’d love to chat about it.
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I hope I’ve given you something to think about this week and I wish you ever-increasing curiosity.
Until next week.