Answering what, where, how and how much of this new form of money
Once humans started holding assets such as hunting tools, wild fruits and pieces of meat beyond their own requirement, they learnt that these could be exchanged for something they did not have. Thus started barter and the concept of comparative value of assets. Over time, it became robust and involved many goods of common, and uncommon, needs.
Humans also discovered some natural objects that were not directly of much use and were not common-place. These became a token of one’s influence and power, and thus attained a value far greater than their usefulness. Think of gemstones and sea shells.
Many more millennia ahead. Humans started making their own objects that carried much more value than their actual usefulness. Rulers issued their own clay seals, which were crafted in a way that made their replication difficult. Once metallurgy took birth, metals were used for making seals and coins. Then came precious metals and alloys. These eventually led to issuance of very sturdy coins and currency notes.
It would look utterly unimaginable to a stone-age human to think that a piece of paper could buy you goods and services, but we are so used to currency notes that we do not feel anything unusual about them. We take it for granted that the value of a note is what is printed on it.
The advent of accounts, and then the banking system, changed the way transactions took place. One could now carry out monetary transactions without actually exchanging currency. With the onset of computerisation, then online banking and then mobile banking, we have entered a stage when we can carry out financial transactions anytime and from any connected device.
There still are people who are not exposed to these forms of money, and it becomes difficult for them to come to terms with online and mobile money. Even those who have used traditional banking for ages are not comfortable with online record of their transactions; they insist on having their physical pass-book updated whenever a transaction takes place. When they make a fixed deposit, they insist on having the physical copy of the FDR. Many people, especially the elderly, can’t comprehend how a mobile phone can withdraw money from an account and pay it to a merchant.
For those of us not exposed to the new form of currency – cryptocurrency – there is a similar confusion. This new currency is supposed to be non-existent in physical form, and not even issued and guaranteed by a central bank. It also is not a record (like a bank account) that is maintained by a robust bank who you can trust. It is not even a number. It is all hawa-hawai! Yet, it is supposed to have value much like a coin, a rupee note, the bank balance. How?
If you don’t know about cryptocurrency, don’t feel bad; even in advanced countries, over half of the adult population has no good idea about cryptocurrency, and only one-eighth of them have actually dealt with it. But, mark my words: in a couple of years, you will be using it the way you use your mobile wallet and UPI today.
What is cryptocurrency
We shall try to understand the concept in a bit of detail in lower sections, but let us start with a definition so that we know what is included and what not when we use this term.
Cryptocurrency is a digital currency in which transactions are verified and records are maintained by a decentralized system using cryptography.
Mark these: This is a currency: a token that has value in terms of money. It is digital only; the glittering visuals of Bitcoin, etc that we see in the media and associate with cryptocurrency are nothing but an artistic visualisation. It is decentralized; there is no centralized authority (like RBI and banks) to issue the currency or keep and verify records of the currency and transactions. It uses cryptography or technologies for keeping the data secret.
A unit of a cryptocurrency is usually referred to as a coin. It is a piece of data that is structured in a unique way. But when you buy a coin, this data too does not travel from the seller to you. You just get a digital confirmation that you now have a coin.
There are more than 20,000 cryptocurrencies in circulation and many thousand arise every year. The prominent among them are Bitcoin, Ethereum, Tether, USD Coin, Binance Coin and Dogecoin.
Main technologies behind cryptocurrencies
There are a number of emerging digital assets: assets that are created and stored in digital formats. Take the example of a painting in digital form. If it has to be owned and sold, there should be a technology that ensures the uniqueness of the painting, and a way through which others could check the genuineness of that painting.
Cryptocurrency is also a form of digital asset. Since cryptocurrency is a highly dynamic form of digital assets that need to be fragmented, joined, added, deleted, transacted in real time, it needs many technologies working together.
Many encryption and authentication technologies are involved in the working of cryptocurrencies. A very strong mechanism needs to be in place for making the asset secure from unauthorised manipulations. This mechanism is called cryptography, and the term cryptocurrency is derived from it (crypto=secret).
In simple words, the data (the details about the buyer and seller, the value of transaction, transaction time, etc) is encrypted at the sender’s end using a key or password. The receiver must have a key to decrypt the data. For greater security, the key with the receiver is such that it is not known even to the sender. This extremely strong encryption takes care of one part of the game.
Another important requirement for security of a digital transaction system is identification of genuine users. In the case of cryptocurrency, this is handled by a network of computers (called nodes) dedicated to that currency. These computers are located in different parts of the globe and are updated instantly as any data is created or altered in the entire network of that currency. These nodes perform authentication before a user can deal with cryptocurrency.
For a digital currency to be viable, it must also ensure that nobody can manipulate a record. This is achieved by the most important technology in cryptocurrency universe, called blockchain.
As the name indicates, blockchain is a chain of blocks. Think of the transactions that used to be done manually in your bank account till a few years back. You deposited Rs. 100 in your account and the bank clerk added a line in your account in the ledger, making a credit entry for that amount. You withdrew Rs. 50 the next day, and the clerk made a debit entry after the previous entry, and reduced the balance by Rs. 50. In that situation, the clerk knew about all entries in your account, and he also could put 1 before 50, and make it 150, and pocket 100 rupees. Numerous frauds have been taking place in the banking system due to such vulnerability of accounts to manipulation, even after computerization.
Blockchain takes care of that. In the digital world, a transaction is nothing but a set of new data. In the case of blockchain, whenever a transaction takes place anywhere in that system, its data enters a block – which is nothing but a set of transactions. After a certain time, the block is full. This block is then verified by dedicated nodes and is closed. After that, any transaction will be stored in a new block, and that block will come after the previous block, like the bogies in a train. You can think of cryptocurrency ledger as a set of blocks, in which blocks are being added one after the other. The beauty of this system is that once a block is closed, altering its data is nearly impossible. This fool-proof authentication and closing of blocks is achieved through a robust set of algorithms and cryptography.
A slight detour here: The blockchain and modern encryption technologies are not exclusive to cryptocurrencies. The way blocks are created and stored makes it nearly impossible for anybody to hack them; in simple words, the hacker will have to hack all the blocks before that hack, and even if he is able hack a block, the chain will break and his effort will go waste. Therefore, these technologies are being adopted by banks the world over for providing additional security to digital transactions, and also by big logistic firms. In fact, there is a possibility of their use in completely different areas, including elections, in the not-so-distant future.
How a cryptocurrency arises and is traded
For creation of a new cryptocurrency, someone writes a complex computer code that generates a series of records, data and policies that determine how the cryptocurrency would function.
After initial release, coins are added using the process called mining. People with powerful computers join them and contribute by validating transactions, etc. They do so through a sort of computational puzzles. In return, the nodes are rewarded with coins (and, therefore, such nodes are mining nodes or miners). That is a simplistic way of putting it, but in reality, it is much too complicated.
There is an in-built limit about how many coins can be mined. For example, only 21 million Bitcoins can exist, out of which about 19 million have been mined so far. About two decades will pass before the last of Bitcoin is mined.
A transaction in cryptocurrencies involves all the technologies mentioned above. Consider that you intend to buy a single coin of a cryptocurrency, say Bitcoin. You will open an account (called wallet) with a firm that deals in this cryptocurrency. You’d deposit the value of the coin, in Rupees, with the wallet firm. The seller will make an offer to sell. The system will immediately authenticate that the one who is offering to sell the coin actually holds it. This will happen in a very secure and anonymous way. At your end, the wallet firm will take the responsibility of authenticating you. Once the authentication is over, the seller will use his private key to release the coin, transaction will take place, and a private key will be generated for you. This key will also be delivered to you securely and anonymously. What you will get is just a key, which is as good as the coin.
This transaction of one Bitcoin will get entered in the block live at that time. In a few minutes, one of the mining nodes will authenticate the block (and will get a few Bitcoins as reward), and that will close the block. The block will be updated in all the nodes (recall, the definition termed it as decentralization). After that, nobody will be able to alter the record.
Some people have a notion that all dealings in cryptocurrencies are totally private and untraceable. Yes, the system works anonymously or pseudonymously (people mis-representing their identity). However, privacy is not guaranteed. Some currencies are of private nature, but not all. Further, since you deal with a firm, that firm knows your identity and how much money you have transacted (because that happens in the real world).
What makes cryptocurrencies popular and so much valuable?
When Bitcoin was created, it took years for it to be commercially traded and have reasonable value. Its value was initially a fraction of a dollar, and it rose to about $13 in four years. Then it caught the fancy of the people, and its value rose to over $65,000 dollars in another eight years before falling down to lower levels in the last two years.
What makes many cryptocurrencies so valuable today is beyond technology; it happens to be the mix of promotion, creation of public trust, exploitation of its secret nature by criminals, and exploitation of greed.
The one who creates a particular cryptocurrency does a lot of promotion. People get attracted towards it and want to own it. Others who see their own benefit in being part of the coin’s growth further promote the coin.
Since the number of coins of a particular cryptocurrency is limited, growing demand fast increases the value of the coin. Favourable forecasts are made about the future value of the coin, discounts and cashbacks are given, benefits are bundled with transactions made through the coin, exclusive deals are made with companies dealing with quick money transactions (e.g. online gaming). The coin becomes popular among consumers and speculators. Criminals start using it so as to secure their deals and money from authorities. People start having trust in the coin, and many start using it for wealth creation.
Cryptocurrencies have now evolved to the second level. Millions of transactions in cryptos take place in a day, much like national currencies. So, a number of exchanges have taken shape and thousands of dealers and agents have mushroomed all over the world. .
Out of the many thousand cryptocurrencies in circulation today, a handful have been utilising the latest technologies to become more secure and valuable while some others use unsafe technologies and some are involved in scams. Being secure and anonymous, cryptocurrencies are also helping criminals, especially with international operations. These are also the medium of choice for people hoarding their unaccounted money.
Many countries are thinking about enacting laws to control cryptocurrencies, but they are unsure and hesitant. On one hand, the fast evolution of technologies is making controls unviable and, on the other hand, a decentralized and secure system is inherently legitimate. In fact, central banks of some countries (including India) are in the process of issuing their own cryptocurrencies.
Should you use cryptocurrency for transactions and should you invest in it?
That is the other side of the coin.
You will agree that since this article is about the technology side of cryptocurrencies, their legal, financial and investment aspects are beyond this discussion. By the way, an article on these aspects is already available on Raag Delhi at this link: क्या आप भी क्रिप्टो करेंसी से कमाना चाहते हैं मोटा मुनाफा.
Manoj Pandey is a former civil servant. He does not like to call himself a rationalist, but insists on scrutiny of apparent myths as well as what are supposed to be immutable scientific facts. He maintains a personal blog, Th_ink
Disclaimer: The views expressed in this article are the personal opinion of the author and do not reflect the views of raagdelhi.com which does not assume any responsibility for the same.