Introduction
Cryptocurrency is a digital currency that works via blockchain technology which is a network of computers each maintaining an independent copy of public distributed ledger of transactions without central oversight. This makes the information about the balance and transactions not reside on a single computer owned by a single organisation.
Common types of cryptocurrencies
- Payment coins – original version of cryptocurrency eg. Bitcoin
- Stablecoins – Cryptos meant to stay close to the value of fiat currencies like USD
- Meme coins – Coins driven by culture and has absolutely no logical rationale for their valuation eg. Dogecoin
Bitcoin was the first Payment cryptocurrency, it’s the biggest and the most well known. In this blog we will use Bitcoin to explain how cryptocurrencies get their value
Original objectives of Bitcoin
The 2 main purpose of Bitcoin at the time it was founded were the below
- A digital currency outside the control of governments and Banks. Why this was considered important:
- Cannot be manipulated through monetary control
- Cannot be printed unlimited (as it a max limit of 21M Bitcoins in circulation)
- Supports “any” transaction i.e. not sanction controllable (by restricting access to traditional financial system like banks)
- Not reliant on middle man i.e. regulated entities (financial institutions like banks, card companies etc.) which may gain monopoly or their database can be subject to data loss or hacking. This gives it the same advantage similar to doing a face to face transaction via cash.
2. Transactions are pseudonymous i.e. your address is visible but to get the address KYC is not necessarily required vs to get a back account KYC is always required.
The downside of no centralised storage is energy and storage wastage – the same ledger has to be on multiple servers + energy used to cryptographically decode the transactions for validating against the ledgers
How Blockchain and Bitcoin works
Bitcoins are created by “mining”. A Bitcoin miner solve a complex problem (called proof of work) first and hence adds a block to the block chain (mining) and get a predetermined number of bitcoin as reward for adding the block. The total number of Bitcoins that can be mined are finite and adding each progressive blocks gradually gets diminishing Bitcoins.
A “node” is any computer running the bitcoin software and hence keeping a ledger copy – every transaction is checked and validated by the nodes. Records of transactions are grouped together into blocks and blocks are linked to each other (through saving encrypted key (hash) of one block on the next block). This creates a “block chain” and this makes its almost impossible to tamper with the data on the block chain as altering one block means to alter all blocks after it. The only way to tamper is to tamper with >50% of all nodes at the same time.
Miners are special type of nodes. Non-mining (or general) nodes only need database and doesn’t need a very strong processing power. There is reward for running general nodes.
A Bitcoin user can be a node, a minor or can just use a Bitcoin account by buying bitcoin from an exchange.
To create a Bitcoin account, a user is first assigned a Private key by the bitcoin software. Private key is then used to generate public key in one way ie. you cannot get the private key using public key. Public key (which is the Bitcoin Account address) can be made public – it works like as bank account number and used to transfer bitcoins to each other.
A Bitcoin wallet holds the private key and holds bitcoin address & interacts with bitcoin network. The easiest way to get bitcoin today is to buy from exchange.
It’s best not to host the private key on the exchange or the wallet app. It’s best to keep a private copy of the private key (through a software or hardware wallet) but it’s subject to you loosing it.
Current use of Bitcoin
Bitcoin today is overwhelmingly used as an investment/ speculative/ store-of-value asset. Use as a legitimate or illegitimate payments are a small minority.
For people to use bitcoin as investment there has to be more demand to buy than to sell. There has to be an implicit trust that the value of bitcoin will not free fall. For fiat currencies the trust comes from trust in governments i.e. the govt will maintain the country such that there is steady growth in the country and inflation wont get out of hand. For the trust on bitcoin, it comes from generic trust in overall stable world.
Conclusion
The problem with the current usage of Bitcoin is that it can now never be used as payment currency which was one of its 2 original objectives.
It’s value today as investment is not because it can be used as a payment currency but because of its pseudonymous quality which means that although it may not be used for a lot of illegal/untraceable payments today, the potential of it being used in future for untraceable payments is extremely high. Hence, the 2nd objective of Bitcoin is what gives it the value today.
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