By now you’ve probably heard of Bitcoin. If you are young and internet savvy, or you keep up to date with the tech world, there’s a good chance you at least know what it is, even if you don’t understand how it works or why it’s important. But the rest of you may be completely clueless, as I was until recently.
Well, it’s time that you learn about Bitcoin, because Bitcoin (or something like it) will dramatically change the world and the way that we live.In fact, it already is. Stick around and I will tell you why.
Pay close attention, because I’m about to introduce you to some words and phrases that you never thought you’d need to know. But you do need to know them.
What are cryptocurrencies?
Bitcoin is something called a cryptocurrency. Cryptocurrencies are virtual currencies. This does not mean that they are not real. They are just as real as any other currency. But they exist purely in the digital world. You will never be able to hold a Bitcoin in your hand.
Traditional currencies that you are familiar with, such as the American dollar and the Euro, are called fiat currencies, or fiat money. Unlike commodity money such as gold and silver, they have no value beyond that given to them by government regulations. Fiat money was first used by China in 1000 AD, and became dominant throughout the world in the 20th century.
Fiat currencies are controlled by central banks. A central bank controls the value of a fiat currency by regulating quantity, which they can do through several methods. The most obvious is by printing more money. This is something they usually don’t like to do because it devalues the currency.
They can also change the amount of money that banking institutions have to keep in reserve. Most economies use a fractional-reserve banking system. The lower the reserve requirement, the more money banks can loan out. If the reserve requirement is 10%, a bank can loan out $100 million for every $10 million it has in storage. Drop this to 5% and the bank can loan out an additional $100 million without increasing its stores. As you might imagine, dropping this reserve % too low is dangerous, as there is a risk that the banks won’t have enough money to cover withdrawals.
If a bank is having a difficult time, it can happen that many customers get scared of losing their money and try to withdraw at the same time. The bank may not have enough money to cover everyone’s withdrawals. Then even more people will get scared and try to withdraw. This is called a bank run. If it happens to multiple banks at once, as it can during severe economic crises like the Great Depression, it’s called a bank panic.
The central bank can also change the federal funds rate (the interest rate they charge when they lend money to other banks), buy or sell government bonds, or do something called quantitative easing, where they create money and use it to buy back bonds from other banks, thereby increasing bank reserves, which in turn allows the banks to loan out more money. To learn more about how central banks work, click here.
Cryptocurrencies are not controlled by central banks. In fact, no banks are necessary at all. They are decentralized. Transactions occur directly from person to person, person to business, or business to business. There is no mediator or third party needed. And there is no need to keep your cryptocurrency in a bank account because there is no risk that anyone can steal it by traditional means (it can be stolen by hackers, but a bank won’t help with that. More on that topic later).
This may already give you a clue as to one way in which cryptocurrencies can change the world. Removing the need for central banks, or indeed any banks, is revolutionary.
How cryptocurrencies work
The term ‘crypto’ comes from the fact that cryptocurrencies use cryptographic techniques for security. When you own cryptocurrency, it is stored in a digital ‘wallet’ and you get a very long password called a key. Without the key, no one can access your cryptocurrency, including you.
Every cryptocurrency transaction is recorded forever on a public ledger called the ‘blockchain’. The identity of the sender and receiver are encrypted, so although anyone can access the ledger, no one can see who sent or received the cryptocurrency. It is this blockchain technology, more than cryptocurrency itself, which is the true world-changer.
The blockchain is the key to everything, so it’s important to understand how it works and why it is such a game changer.
Blockchain technology solves a very significant problem related to transactions between one party and another: the problem of trust.
Traditionally, financial transactions (e.g. an online VISA purchase) involve some amount of trust. Trust that the amount of money being offered, bet or spent actually exists in the account of the one promising. Trust that they will follow through and actually make payment. Trust that the bank will execute the transaction properly instead of blocking it or freezing the account(s) of those involved. Trust that no in-between person or institution will run off with the money. Trust that the sender will not cancel the transaction.
Sometimes this trust is broken and fraud is committed or mistakes are made in the process by the bank.
The blockchain solves this problem. There is no middle man. No transaction can take place unless the money exists in the account of the sender, and when it does take place, it happens quickly and irreversibly, and the records are publicly available for anyone to check (the downside of all this is that if you make a mistake, e.g. send money to the wrong account, there may be no way to get your money back).
How blockchain technology works
The blockchain is so called because it is literally a chain of transaction ‘blocks’. A blockchain can be centralized, but the blockchains used by Bitcoin and many other cryptocurrencies are decentralized. This means they are stored on a large number of computers distributed throughout the world. Taking Bitcoin as an example, every person that owns Bitcoin has a wallet with two keys, one public and one private. When a new transaction is executed, the user sending Bitcoin uses his private key to access his wallet and tell the network to send Bitcoin to another wallet.
A string of text describing his transaction, along with his public key, are then sent out to the network. The transaction is received by computers, or ‘nodes’ on the network, and combined with other transactions to form a ‘block’. But in order for this block to be added to the chain, a complex mathematical problem must first be solved.
This is done by Bitcoin ‘miners’, independent users or companies who use powerful computers dedicated to solving the math problems. They all compete across the network to solve the problems and are rewarded for their efforts by the production of new Bitcoins. Every time a mathematical problem is solved, a new block of transactions is added to the chain, and some Bitcoin is created and given to the miners. This incentive ensures that there will always be miners to keep the network running, and that there will always be new Bitcoin created to replace what is lost when, for example, people lose access to their Bitcoins by losing their passwords.
This process of solving mathematical problems to add blocks to the chain is called proof of work (some cryptocurrencies use other types of ‘proof’ which are arguably better, but that is beyond the scope of this article). It is very important for a trustless system to have some kind of proof method for adding transactions, because this is what prevents fraud.
Once a block has been added to the chain, it is considered valid because of the work that went into adding it. If there is any conflict, the block which took the most work to generate is considered the correct one. Therefore, since each block is verified by competition through the network, replacing a transaction with a fraudulent one would require more computing power than exists throughout the entire network of miners.
The mining process also ensures that the chain is built correctly. Because the blockchain is on a distributed network, it would be a common problem that new transactions would be added in different orders on different nodes, thus resulting in disagreements between computers about the exact structure of the blockchain. The mathematical problems are so difficult to solve that they will not be solved at the exact same time by different nodes. Thus each block will be added in an agreed-upon order.
This is considered a trustless system because there are no humans or institutions involved, making decisions. Everything happens by mathematical algorithm. Of course, it can be argued that there is still trust involved, as one needs to trust the algorithm or the system. But the longer it operates and the more transactions are successfully executed, the easier this will be.
Because there are thousands or millions of computers holding copies of the blockchain, it is protected from attack by extreme redundancy. The ledger itself cannot be altered or hacked. As I alluded to earlier, though, it is possible for hackers to steal Bitcoins. For example, they can put malware on your computer that changes the account number that you are sending the Bitcoin to. Or they can hack into your computer and find your password. They may also hack into the exchange (a place where Bitcoin is bought and sold in exchange for other currencies) where you are holding your Bitcoins.
If you store your Bitcoins on your own hardware that is disconnected from the internet, you are mostly protected from hacking. But if you lose the hardware, your Bitcoins are also gone. For most of us, safely transacting with cryptocurrencies will require learning more about digital security.
So let’s talk about how these technologies will change the world.
The rise of cryptocurrencies
If you’ve been paying attention to the news, you’ve probably heard something about the recent meteoric rise in value of Bitcoin and other cryptocurrencies. When Bitcoins were first introduced, each coin was worth less than a penny. There is a now famous story of a man who spent 2000 Bitcoins to buy a pizza. Today each Bitcoin is worth many thousands of dollars.
Anyone who has been holding Bitcoins since the early days of the currency is likely a millionaire by now (that was a very expensive pizza). But Bitcoin is not the only coin to experience such a spectacular rise in value. Many people have gone from poor to rich in an extremely short time by investing in cryptocurrencies. Some of these coins have risen thousands of percent within months or even weeks.
There have always been such occurrences in the stock market here and there, but the speed and extent of this is more extreme even than the dot-com bubble. This has led many people to believe cryptocurrencies are a giant bubble waiting to burst. They may be right. But there are two things to keep in mind.
1) The bursting of the dot-com bubble made a lot of people poor overnight and destroyed a lot of companies, but it was not the end of dot-com companies. It merely got rid of the losers and allowed the winners to rise to the top and dominate the market. Look at Google and Microsoft today.
2) Cryptocurrencies will replace fiat currencies over time. This means that all of the value currently associated with fiat currencies is going to end up in cryptocurrencies. So far the total value of cryptocurrencies is only a tiny fraction of fiat currencies. That means that while there may be a bubble pop in the short term, in the long term cryptocurrencies are going to rise far, far more than they already have.
The new wild west
Another difference between cryptocurrencies and the stock market is the lack of regulation. Registering an account to trade stocks is a process that generally requires some sort of verification of income and signing of documents, etc. And stock trading (at least on the major exchanges) is regulated by organizations like the SEC.
The trading of cryptocurrencies currently has no regulating body. Anyone can open an account, transfer money, and start trading within minutes. This makes it more risky, but it also means there are more opportunities. Banks and governments are not making the rules (yet). A 13-year-old can turn his 20 dollar allowance into 10,000 dollars trading in his bedroom. A janitor can become rich investing the few extra dollars of his paycheck each week. This is the wild west.
Cryptocurrencies are global currencies. A poor farmer in Uganda can earn, hold and use Bitcoin as well as a rich American lawyer. This offers unprecedented opportunities for the equalization of wealth across nations.
Imagine a collective trading network where people produce goods or art or information and receive payment in Bitcoin or some other global cryptocurrency. This currency has the same value everywhere. Artwork produced by the poor Ugandan farmer will have the same value as artwork produced by the rich American lawyer.
An example of the possibilities offered by cryptocurrencies is the social network called Steemit. Here tens of thousands of users post stories, blogs, videos, pictures, digital artwork, music, etc, and are paid in Steem Power, a cryptocurrency. The payment takes place by other users ‘upvoting’ their content. The more upvotes and the more Steem Power owned by those upvoting, the more the poster gets paid. Anyone from any country can participate. Money is not paid directly by those upvoting, but from the community pot. The whole system works because people invest in the currency, giving it value.
Of course, not everyone gets paid according to the quality, or even the popularity, of their contributions. If you produce high quality content but have no followers you won’t get paid. And having just a couple of followers rich in Steem Power will mean you get paid more than someone with a lot of comparatively poor followers.
Nonetheless, the potential is clear, as one’s location or status has little bearing on payment. They are paid because people find value in the content they produce, no matter where in the world they come from or what their background is or how rich or poor they might be.
Loss of government and institutional control
Cryptocurrencies could mean the end of government and institutional control over money. This is not something to be taken lightly. The effects will not be sudden. Governments will not fall like dominoes. Banks will not start shutting down, at least not right away. But they will slowly begin to lose control.
As cryptocurrencies rise, fiat currencies will drop. Banks are already starting to realize the problem and are starting to get on board with cryptocurrencies. This may aid or ensure their survival. But it is likely that they will still lose control. With the world’s monetary value moving to decentralized global currencies, banks don’t get to make the rules. Many of them are investing in a centralized cryptocurrency called Ripple, in an effort to maintain some control. It remains to be seen how that will turn out.
Banks won’t be able to control interest rates on loans, because people will form globalized networks and loan to each other. This will keep rates competitive and reasonable, and ensure that anyone has the chance to get or give a loan. Such communities already exist, but they will surely become more common as cryptocurrencies gain traction.
Without the need for centralized banks and with the value being transferred out of national currencies, governments will lose control of the money system. Without central banks, they won’t be able to control the value or quantity of currencies. Further, with transactions being anonymous, they will not have an easy way to control or keep track of the financial transactions of citizens.
This will be an aid to criminals, who can do their business anonymously. It will also make tax auditing far more difficult.
Governments may run into a number of financial troubles if fiat currencies disappear. Without control over the money system, they may not be able to control their own budgets.
Those governments which decide to outlaw cryptocurrencies in an attempt to maintain control may find that underground economies of unprecedented size operate throughout the country and are nearly impossible to shut down.
The whole monetary system is going to change. Governments. Banks. Individuals. Economies may rise or fall. The worldwide balance of money and power will change. Equality may increase, or riches and power might just shift around, as is often the case with revolutions. Nothing is certain. But there will be change.
If you knew nothing about cryptocurrencies and the blockchain before reading this article, you may find a lot of my claims to be unbelievable, just fantasy talk. So I encourage you to take some time to educate yourself. Do your research. Think about the implications. I’m not a cryptocurrency expert. I’m still struggling to understand all this myself. But it’s real, and those who refuse to acknowledge that fact will be left behind, just like those who refused to learn how to use the internet.
The insanely fast rise of cryptocurrencies is a good reason to exercise caution if investing in them. It is not a good reason to ignore or dismiss them. They, and especially the blockchain they are built upon, are here to stay.
Since the rise of the internet in the mid-90’s, our lives have changed to the point that most of us can barely imagine living without it. The blockchain has the potential to do the same. It’s not a fad. It’s not some obscure technology that you don’t need to know about. It’s a life-changing, world-changing revolution, and it’s not going away. The only question is: what are you going to do about it?