A cryptocurrency is a digital or virtual currency that is designed to make online transactions extremely secure. This currency is secured by mathematical algorithms and not people (like in a bank).
About a month ago, I was catching up with an old buddy at a coffee shop. In midst of our conversation, the word ‘Bitcoin’ entered the fray. This was at the time when one was likely to read the word ‘cryptocurrency’ more often than news about a celebrity scandal. It was very difficult to ignore. My friend started bragging about how he was a proud owner of half a bitcoin and was looking at investment avenues. This was when I realized that the only thing I knew about Bitcoins was that it was retailing at $13000 apiece and this figure was only getting steeper. I had no understanding about cryptocurrency or bitcoin, which was when I realized, ‘Half knowledge is dangerous, but no knowledge is worthless!’.
I decided to dig deeper into the whole concept of cryptocurrency. This process turned out to be quite interesting as I delved into that unchartered territory.
What is a cryptocurrency?
The simple definition goes like this: A cryptocurrency is a digital or virtual currency that is designed to make online transactions extremely secure. This currency is secured by mathematical algorithms and not people (like in a bank). A feature that makes a cryptocurrency unique is its organic nature, meaning that it is not issued by any central authority or government. This renders it theoretically immune to government interference. The most popular and the first-ever cryptocurrency to be created was Bitcoin, which was launched in 2009.
The concept of cryptocurrency can be explained simply by using an everyday entity as an example. Let us consider the entity to be a football. Suppose I have one football with me and I give it to a friend. The transaction took place physically and directly from one person to another. There was no third person (as a witness) involved in this transaction. Now I am left with zero and my friend has one football. I have no control over that particular football anymore.
Now let us convert this football into a digital form, that is, in terms of binaries and codes. Again I send this digital football to my friend. Now there is no way of knowing whether I sent my football to the friend in its original form. I might have made multiple copies of this ball and sent it to multiple people.
This is where the term ‘ledger’ comes into the picture. A ledger is simply a database that keeps a track of accounts and all the transaction activity taking place to and from those accounts. It is basically a directory that keeps a record of the amount transferred and received into the accounts. Now, in the case of my digital football, the ledger takes care of duplication and it will prevent me from cheating my friend.
In a physical bank, there is only one centralized ledger, to which only the bank has access. In the case of a cryptocurrency, each and every customer has a ledger with him/her. They can keep track of all the dealings that have occurred right from the very first bitcoin transaction. Bitcoin happens to have an open-source protocol (kind of like Wikipedia or Android app development), where anyone who is smart enough can monitor these transactions and digital dealings to make sure that the final number gets tallied perfectly.
Remember how I explained the physical trading of a football earlier? With the public ledger and an open-source protocol into place, this digital football now acts as a physical entity and its dealing takes place just like a regular football. There is no third party involved to facilitate this transaction.
How does a transaction work?
From now on, I will use Bitcoin as a reference for explaining the whole process of the creation and transaction of cryptocurrencies.
Bitcoin uses peer-to-peer technology (sharing or exchanging of information without the involvement of any centralized government body) to facilitate instant payment and transaction.
Bitcoins are created by a group of people known as ‘miners’. Miners are individuals or companies who own the governing computing power and are assigned with the task of releasing new Bitcoins into the network when a request is made by a user.
The individuals who are assigned with the task of mining are motivated by rewards for releasing new bitcoins into the system. The rewards are usually in the form of a percentage of every bitcoin that they successfully mine. These set of miners can be compared to a decentralized authority (having no affiliation to any government body). A transaction is considered to be valid only if it is verified by these miners.
How do miners create coins and confirm transactions?
We already know that every individual in the Bitcoin network has access to the records of transaction history of all users. This public record is in the form of a database and is referred to as a ‘blockchain’.
Let us consider a transaction taking place between Tom and John. Tom sends n bitcoins to John. This transaction is signed by Tom’s private key, which is masked by cryptography. Once it is signed, the transaction is broadcasted in the network and almost everyone in the network is now aware of this trade. It is yet to be confirmed though. A dealing in cryptocurrency is only valid if it is confirmed. This is where the miners come in the picture. Miners will validate the transaction between Tom and John and spread it into the blockchain. This transaction now becomes a part of the database.
But this isn’t the only job of the miners. The mining process involves complex mathematical puzzle solving. These puzzles are created from pending transactions in the network. The miners get on with the task of solving these puzzles and the first one to solve it announces it on the network. The other miners simultaneously validate the transaction linked to the puzzle. After a majority of the miners accept the transaction, it gets added on to the blockchain and new bitcoins are created. Once this task is completed, the miners are rewarded in bitcoins, which also acts as an incentive.
Now the question arises as to how long miners can keep adding new bitcoins to the network.
The founder Satoshi Nakamoto has capped the production limit to 21 million. Satoshi has based the creation of bitcoins on the lines of natural resources, such as gold or silver. After the cap of 21 million, we will essentially run out of its mining potential. This is true until the creators decide to increase that number.
What makes Bitcoins secure and not so secure at the same time?
Every Bitcoin created has an association to a specific key or address, which makes each Bitcoin unique. This public key cryptography method encrypts and decrypts messages for verifying each transaction. Bitcoins are sent to each person’s public key and they are stored in the owner’s private key. If an intruder, e.g., a computer hacker, gains access to someone’s private key, he can then send Bitcoins to his own public address using the private key, stealing the Bitcoins. These stolen Bitcoins are untraceable and cannot be recovered. It is therefore essential to keep the private key encrypted and safe from intruders. In the end, it depends on how careful one is with his/her Bitcoins.
Why is the price of Bitcoins getting steeper by the hour?
The price of Bitcoins rose a whooping 400% by mid-2017. It started out at about $1000 and reached $5000 by August. The highest figure at one point was about $19500. Why is there such a sudden inflation in the price of this cryptocurrency?
It all boils down to the factors listed below:
- A certain group of crypto enthusiasts are spreading the belief that storing Bitcoins has long-term benefits. People who bought bitcoins before the massive inflation are hoarding the currency and are unwilling to sell it at any price. This creates demand for mining more and more coins, which further inflates the already high rate.
- Increasing media coverage has put the whole fad of cryptocurrency into the limelight and has therefore coaxed people into buying Bitcoins for themselves. This increases the demand even more.
- Many important investors have placed their belief in the concept of cryptocurrency and have even hoarded some coins for themselves. Bitcoin might soon experience a huge injection of cash. It’s only a matter of time.
When all is said and done, the whole concept of cryptocurrency is quite complex and dangerous. No one can predict whether it will experience sudden inflation or massive deflation. The future prospects of crypto is also very unpredictable. In an age of credit cards, debit cards and online bank accounts, the prospect of digital currency doesn’t sound all that absurd. The use of digital money is very convenient, cheap and efficient. However, Bitcoin seems to be too complicated and unsafe for the common man to use it in his everyday proceedings. Furthermore, there isn’t much demand for decentralized currency from average consumers. People will still prefer banks, as liability can be issued against someone, which cannot be done for cryptocurrency. Two words that perfectly describe cryptocurrency would be ‘volatile’ and ‘unpredictable’, so keep that in mind before you jump on the Bitcoin bandwagon.
- Chapman University
- Princeton University
- The Economist
- Faculty of Business Administration, University of Iceland