• Tanish Bafna

Cryptocurrencies 101


Much like cryptocurrency prices, the world has moved along a hockey-stick curve of being mystified by the evolution of a completely digitised financial system. Although any such correlation between profit and fame is fairly obvious, what is strange is that the number of individuals who understand the new market’s mechanism, doesn’t match the total players eagerly waiting to trade away their secure liquid dollars. This imbalance is a bit open to interpretation causing the argument to stretch out in opposite directions. Since 2017 — post the Bitcoin spike — a pattern of herd behaviour has been observed in cryptocurrency markets, backed by surveys reporting a stunning ratio of people trading to those who actually understand the inner workings. A 2019 finding showed that 19% of global consumers have in some sense purchased cryptocurrencies, but only 10% of the total population are familiar with how these transactions play out. Contrastingly, many who can mathematically follow the trading processes don’t believe cryptocurrency to be a substitute to conventional systems of payment or at its barest minimum: a foolproof practice even in isolation.



A Model Analysis


So, are cryptocurrencies purely hard to comprehend or not worth the hassle due to their inadaptability? Well, neither. Agreed that the idea behind it is quite genius, but not necessarily complicated. Even if a potential cryptocurrency user neglects the math-heavy part of hash functions, network optimization, and peer to peer architecture, they will be well versed with more than a significant amount of operations that take place under the hood. Drawing from a CS philosophy, let’s just consider all mathematical nuances to be a black box built by someone else. We don’t know what’s inside it and we definitely don’t know how it works. All we are trained to do is give some input and feel confident of whatever gets thrown out. Now let us lay out a scaled-down model of an actual crypto market and then navigate through any difficulties or concerns that could potentially arise.


Imagine there’s a group of friends who regularly exchange money amongst themselves as a payment system for favors. (Essentially, an assumption which can later be restructured and applied to the whole world for more complicated transactions). And to keep track of all these dealings they decide to maintain a ledger that chronologically stores data in a simple ‘To and By’ pattern — To X By Y: 500 Rs. However, with no central authority, how do you decide who maintains and possesses the book?


Bitcoin (2008) came up with a very clever solution which depended on building a peer to peer network for storing past transaction data. It simply suggested that instead of one person holding on to one ledger, what if everyone had their own copy with full edit access? Under this system, whenever a transaction takes place the payee has to broadcast the message to all members of the friend circle so that every book in the model remains up to date. The obvious security concern here is how do you know someone is broadcasting an honest and real transaction? In the absence of a central authority, it could be nearly impossible for a real-time audit or verification. Enter Public-Key Cryptography.



The 'Crypto' Part of Cryptocurrencies


This will be our first black box; so let’s just abstract away from the how and why of such a cryptographic system. The what however is very intuitive and simple. Every friend is given two randomly generated keys — a public key (PK) and a private key (SK). The box takes in a transaction message and an SK to return a secure output, which when put inside another box along with the PK can authenticate that it has come from the payee itself. The second box doesn’t decode to check validity but rather verifies that the message has been encrypted using an SK generated along with the respective PK.


This is analogous to you signing a cheque and me trusting it because there is no way you could have gotten access to the payee’s checkbook without being the payee. To reiterate, this ensures that no one else could have broadcasted a transaction wherein you paid them X bucks. This brings us to our second issue — if I’m the receiver, how am I to trust that the cheque won’t just bounce?



A Faith Mechanism


In the decentralized system, maintaining a faith mechanism involves setting limits for every individual and making sure they don’t spend more than they have. Each time a user makes a payment, every ledger holder scans all previous transactions of the payee and ensures that they don't go over their limit. This is also how new friends/users are introduced into the cryptocurrency market! Players are written into the books by making a ‘To (New Player) By Ledger’ entry for the amount of cryptocurrency they bought, which now becomes their spending limit. Let’s visualize it:



If the fourth transaction took place, the new player’s limit would be negative. Every bookkeeper will come to this conclusion by doing a simple (+)(-) calculation and thus immediately discard it. An important caveat, which is also a sort of a segue into understanding the trending term ‘blockchain’, is that records are not maintained in a tabular format as represented. The structure of data storage is much more complex and optimal. Transactions are grouped — about 500 for Bitcoin — and dumped in a block. New incoming blocks keep getting placed after previous ones and linked together by attaching the previous block’s address (hash) to the new one. Hence, a chain.



Miners: The Paid Volunteers


So the steps till now have been - broadcast every payment, listen for other transactions, verify signatures, check spending limits, and then create a chain of blocks. Understandably, this is getting too cumbersome for every individual user to do. The one advantage of having a regulatory agency like a central bank was that it saved normal users from all kinds of logistical hassle. Additionally, these bodies also had a reconciliation system in place that continuously checked for frauds or mistakes. But for cryptocurrencies, which ledger should be followed if they all could end up having different balances and lose chronological sync due to some hack or miscommunication?


Both roadblocks were taken up by the anonymous founder of Bitcoin, who decided to delegate certain steps to volunteers inside the market. These ‘miners’ performed all steps for a fee paid to them by the Ledger. They would transmit finished blocks into the market and as per our old bookkeeping system, every player would continue to keep a copy of this ledger-like blockchain.


Moreover, another security layer was added in the process and is perceived as the real beauty of the crypto-system since it made it impossible for any miner to swindle cryptocurrency —

“as long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they'll generate the longest chain and outpace attackers”

- Bitcoin (2008)


The black box translation would be that to be a fraudulent miner, you need to control over 51% of computing power among all miners in the entire world. And even if you do manage to achieve this, it doesn't provide you with a guarantee of a successful financial hack. It just makes it probabilistically favourable for you to pull it off.



Current State of Affairs


According to our model, we ended up with a strongly protected network of decentralised finances, which at the very least can operate seamlessly in isolation. Considering the early stage we are at, this is somewhat neat. However, bureaucratic agencies around the world have a slightly different take on this. Many of them haven't been able to wrap their heads around the idea of allowing another financial system to coexist with their own economies. The US and EU are trying to regulate and impose sanctions on crypto markets while Asian countries including India, are planning to completely ban its trade.


Despite this, Bitcoin is at an all-time high today (December 2020) with a figure north of 22,700 USD, while Ethereum and XRP (other cryptocurrencies with significant market cap) continue to show positive trends as well. Nations like Russia and many others perceive this as an opportunity for integration rather than a parallel black economy threat. The Putin administration has therefore been working with Ethereum — which allows for much more dynamic system development on top of its blockchain service — to build applications for government usage.


Thus, the battle between whether cryptocurrencies are a bubble yet to burst or the greatest invention since the Internet, is still raging on. For now, however, the latter seems to be winning by more than a decent margin.



 

References:


Nakamoto, Satoshi. Bitcoin: A Peer-to-Peer Electronic Cash System. 2008. https://bitcoin.org/bitcoin.pdf


Kapersky. Uncharted Territory: Why Consumers Are Still Wary about Adopting Cryptocurrency. 2019, www.kaspersky.com/blog/cryptocurrency-report-2019/.


Haig, Samuel. “Bitcoin Block Size, Explained.” Cointelegraph, 24 July 2019, www.cointelegraph.com/explained/bitcoin-block-size-explained


Perez, Elena. “How the US and Europe Are Regulating Crypto in 2020.” Cointelegraph, 12 July 2020, www.cointelegraph.com/news/how-the-us-and-europe-are-regulating-crypto-in-2020


Bloomberg Quint. India Plans to Introduce Law to Ban Cryptocurrency Trading. Sept. 2020, www.bloombergquint.com/global-economics/india-plans-to-introduce-law-to-ban-trading-in-cryptocurrency

Cryptocurrency Market Capitalizations | CoinMarketCap, 2020, www.coinmarketcap.com


Mavadiya, Madhvi. “Putin And Ethereum: A Match Made In Fintech.” Forbes, www.forbes.com/sites/madhvimavadiya/2017/08/29/putin-ethereum-fintech/?sh=4c82faee6b5c


3Blue1Brown. “But How Does Bitcoin Actually Work?” YouTube, 7 July 2017, www.youtube.com/watch?v=bBC-nXj3Ng4


VICE News on HBO. Inside The Cryptocurrency Revolution. www.video.vice.com/en_us/video/inside-the-cryptocurrency-revolution/5e0f6ad0dc45817cb5357bb1


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