Let’s say you are the ruler of Banana Bread Land (BBL). As ruler, your subjects demand you create money for their day to day needs. What kind of money would you create?
As ruler, you decree, “No coins or paper money!” Everything has to be digital.
How much money should we create, asks the Treasurer? Money will be created by performing useful work, you say. In exchange for the useful work, money will be created. Because there is no money currently, it will take very little effort to get the first units of money. As the amount of money increases, we will increase the amount of work necessary to get money. This will ensure everyone who wants money will get some.
What’s the maximum limit we can create, says the Treasurer cautiously? Because my favorite number is 13, and there are a million people in Banana Bread Land, the maximum amount of money we can create is 13 million units of BBL money, known as muffins, says the ruler.
And, what dear ruler, are we going to do to ensure there are no counterfeits of our money? Each time money changes hands, we will have three of the wisest persons in town, verify that the money and the transaction is legitimate. As the amount of money expands, we will have more wise people check each transaction and record it in a public register.
The Treasurer is feeling a bit better. She asks, Dear ruler, the previous ruler cheated the people of Banana Bread Land. How can we ensure the good people of this land believe your promises? You appreciate the Treasurer’s courage, and declare, to make sure the people are not cheated, the government will set up an independent commission, separate from the government, of trusted business owners, who will create each unit of money and verify the useful work.
Therefore, the Banana Bread Land muffin, has four key characteristics.
- It is purely digital, no coins or cash exist.
- The maximum amount of currency is 13 million muffins. Money will be easy to come by at first, and harder to get as more is in circulation.
- Each transaction will be checked by 3 wise people for fraud and counterfeiting. As the supply of money expands, so will the number of wise people checking for fraud. Since each transaction is publicly noted down, anyone can verify the history of the money. The longer the history, the harder it is to cheat.
- Because you are a legit nice ruler, the money will not be controlled by the government, but an independent group of trusted business owners. These business owners will create money when a useful amount of work is presented to them.
The above is the cryptocurrency known as Bitcoin in a nutshell, with no muffins (boo!). Here are the differences.
- I would guess 99% or more of Bitcoin is digital. Very few circulating pieces of Bitcoin physically exist. At $40,000 to $60,000 a Bitcoin, it doesn’t make much sense. Too easy to steal, too easy to lose.
- The maximum number of units of Bitcoin is capped at 21 million units.
- Instead of 3 wise people checking for fraud, many Bitcoin miners running dedicated, heavy duty computing power check the transaction. If it is legitimate, the record is noted down in a growing public ledger, called the blockchain. This is called Proof of Work. The energy needs and work needed to verify the Bitcoin network of public transactions is immense, which leads to its security.
- Bitcoin grew out of its libertarian roots, as money that was outside the control of central banks and governments. It was started in the middle of the 2007 to 2009 financial crisis. The open source Bitcoin program controls how much Bitcoin is produced for the miners for the work they perform validating a transaction as true. The amount of work is related to solving math equations related to cryptography, the science of encryption, hence the name cryptocurrencies. When a puzzle is solved, each Bitcoin miner is paid for the amount of work they contributed towards solving the problem.
This is my casual understanding of Bitcoin, having done a bit of reading on the subject. Unlike Banana Bread Land, there is nothing stopping everyone from creating their own currency. Hundreds of cryptocurrencies exist, with different features. More are created every day. Bitcoin is the largest cryptocurrency by price and market value.
There is one other main way to verify transactions on a blockchain. It is called Proof of Stake. Instead of solving complex math problems, you have investors with cryptocurrency pool their currency together. The bigger your stake, the better the chances of you verifying the transaction and getting paid. If you try to cheat the network, your entire stake might be lost, thereby incentivizing you to act in a decent manner. It takes a lot less energy than Proof of Work, about 1% as much. The risk is if you own 51% of the entire currency and try to cheat the network. Safeguards can be put in place to reduce that risk. The cryptocurrency Ethereum is taking steps to move from Proof of Work to Proof of Stake. Ethereum is the second largest cryptocurrency by price and market value.
Cryptocurrencies are really not that great as a currency. The amount of transactions taking place is limited when compared to the world financial system. Sometimes these transactions can be slow, sometimes they can be expensive, and sometimes both. It’s probably more accurate to call them cryptoassets trying to be a widely used currency. As an asset class, they compete with cash, stocks, bonds, gold, commodities, and real estate for attention. Because of the lack of interference from central banks, crypto markets are some of the freest markets in the world. They trade worldwide, 24 hours a day, without artificial breaks.
There are many more features of cryptocurrencies. I hope this gave you a small idea of how they work.
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