Cryptocurrency has in a relatively short amount of time evolved into what Investopedia describes as “a speculative investment for individuals seeking alpha from alternative assets and a possible hedge against global uncertainties and weaknesses in fiat currencies”. In this 3-part series of articles we will attempt to demystify the space, and help you understand who the players are, and more importantly, how they work, so that you can make informed decisions!
Cryptocurrencies and the blockchain: a primer
When we choose pay someone in cash, we can largely do so without external third parties helping us: governments might back their currencies as legal tender and print the physical bills, but they don’t help us pass cash from one person to another.
However, when we transfer money digitally, it is nearly impossible to do so without an intermediary. Governments, banks and other financial institutions facilitate the transactions for us. Centralized mediators like banks thus control transactions, track them and are responsible for the maintenance and security of their systems and our accounts. Use of these systems requires that we trust them: we trust that when we Paynow or Paylah our friends after dinner, the correct amount of money gets deducted from our bank accounts and gets deposited into theirs.
Cryptocurrencies are a means to facilitate digital peer to peer transactions independent from third parties. From Satoshi’s Nakamoto’s 2008 paper on bitcoin: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network.”
The technology underlying bitcoin and all other cryptocurrencies is the blockchain: a “network [of nodes which] timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work.” In simpler terms, blockchain technology allows for a decentralized ledger to exist: it is a means for many individuals to collectively update a ledger of transactions as well as verify the ledger’s accuracy. This is the basis for peer-to-peer transactions without a centralized database.
Some of the key traits of a blockchain are:
1. Consistency: new data cannot conflict with data that is already in the database. (Caveats)
2.Immutability: the database is append-only; old data cannot be re-written. Nobody can rewrite past transactions.
3. Canonical: everyone agrees on what the state of things on the database are
4. Decentralised: all the above occurs without a central authority. In other words, there is no single point of failure.
That’s effectively what blockchain technology does. It is technologically supported by breakthroughs in computer science, including asymmetric cryptography, and solved a big problem facing electronic currencies: the double spending problem.
The blockchain as a solution to the double spending problem
Assuming I’m not an expert at counterfeiting, if I were to spend $5 buying Bak Chor Mee, it would be impossible for me to spend that exact same $5 again. This is not as straightforward in the digital world: I might be able to send a friend a cute video a corgi and five minutes later send another friend the exact same video. This isn’t problematic with most forms of digital media, but it is deeply problematic for digital currencies.
This is because electronic coins are by definition chains of digital signatures. I’d transfer a coin to someone by signing a string of numbers which includes information about the previous transaction and the public ID of the person I’m giving these to ‘onto’ the coin, thereby making it his. (This public ID is a public key – the string of numbers which allows you to receive coins, like your bank account no.) The person I’m paying it to can look at this signed string of numbers to verify the chain of ownership. A bitcoin is thus effectively an encrypted list that sounds like “Joshua gave this to Ted who gave this to Jocelyn”. The problem coins faced before blockchain is that because the coins are digital, Jocelyn couldn’t verify that Ted didn’t make a copy of the coin and also send it to 5 other people.
One usual solution might be for the coin to return to a central authority after every transaction, who makes sure that double spending does not occur by minting a new coin, with everyone trusting that coins fresh from the mint have not been spent before. With the blockchain, the chain of ownership is instead publicly announced: everyone who uses the currency ‘knows’ that Ted gave Jocelyn, and only Jocelyn, the coin.
This is another way of understanding the decentralized nature of the blockchain: each node, or individual user, independently verifies every single incoming transaction for validity. If proven valid, the node forwards the information to its peers. And the computer science and incentive system is set up such that everyone wants to find out the truth and share the truth, which is determined by 51% of the computing power of the network, so no individual can change the ledger and commit fraud: eventually it gets registered across everyone in the network that Ted gave Jocelyn a coin.
Stay tuned for our next article, where we talk about the hedge funds entering the crypto space and employing quantitative strategies!
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