If you do not fully understand the concept of cryptocurrencies, you are in the majority. Non-tech savvy persons play a major role in the cryptocurrency market. This write-up aims to provide clarity about the underlying technology that drives most cryptocurrencies; it may not succeed.
So, let us dive in.
WHAT ARE CRYPTOCURRENCIES?
According to Cointelegraph, a cryptocurrency is a digital or virtual currency designed to serve as a medium of exchange. This definition masks the broader story behind the ongoing metamorphosis of cryptocurrencies. Better questions lead to better answers, so the question one would ask is why anyone would need a virtual currency.
Satoshi Nakamoto (it is unknown whether Satoshi is a developer or group of developers) explained why, in his 2008 paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. He explained that e-commerce relies exclusively on financial institutions to process electronic payments. For these commercial transactions, financial institutions act as trusted third parties (financial intermediaries) between buyers and sellers. Expectedly, these institutions wield a lot of power and charge large fees for these services. Nonetheless, these intermediation services do not provide a guarantee against fraud and other monetary crimes.
Satoshi Nakamoto set out to create a currency which would be decentralised i.e. cut out the central counterparties (financial intermediaries) while being resistant to fraud. Consequently, Satoshi created the blockchain technology on which he built the very first decentralized cryptocurrency; he called it Bitcoin. The blockchain on which Bitcoin is built, promises more value than the currency. From banking and secure communications to healthcare and ride-sharing, blockchain can have a huge impact on our future. To understand how blockchain could change the world, we need to understand how it works.
WHAT IS THE BLOCKCHAIN?
Hyperledger defines blockchain as a peer-to-peer distributed ledger forged by consensus, which may be combined with a system for smart contracts and other assistive technologies. A distributed ledger is usually referred to as a blockchain. Essentially a blockchain distributes a database of transactions to all participants in a network. There is no central administrator and the data is also decentralised. It has three important features which are:
The blockchain database is shared among untrusted participants and it is identical on all nodes in the network. All participants have the same information, and the information can only be changed upon consensus from participants.
The blockchain database cannot be altered and an attempt to alter the history of transactions is easily detected.
All changes are performed by transactions that are signed by known identities.
These features work together, along with agreed-upon consensus mechanisms, to provide trust among all participants in a blockchain network. Consensus is just an agreement among the network peers.
If the above explanation of blockchain hurts your brain, then the below definition is for you. And if the above definition made sense then please skip the next paragraph.
In simple terms, a blockchain is just an ever-growing list of transactions that are arranged in blocks, verified and permanently recorded.
Our daily lives are replete with situations involving intermediaries – How do you verify that the driver picking you up at 2 a.m is really from Uber or Taxify? What about when you meet someone on a dating website? How can you confirm their real identity? The point is, our lives become more difficult without trust. For our convenience and sanity, we trust banks to keep our money and execute our transfer instructions, fund managers to invest our money and Google to safely store our personal information and communication.
In all of this, we assume that our interactions with these established institutions, our information and assets are secure. But history has proven otherwise. For example, on July 29, 2017, Equifax one of the largest credit bureaus in the United States, discovered that personal information (including Social Security Numbers, birth dates, addresses, and in some cases drivers’ license numbers) of 143,000,000 consumers and credit card details of 209,000 consumers had been exposed. Blockchain technology can prevent situations like this. The use of blockchain technology is steadily rising. Below are a few instances of its use:
Allegations of multiple voting or incorrect counting are a regular blight on the validity of elections. Palo Alto, California based non-profit Democracy Earth has built an app based on blockchain technology called Sovereign with the goal of eliminating electoral corruption and fraud. According to Cointelegraph, the Brazilian government is currently developing a mobile app powered by Ethereum to give citizens the ability to register their details online and submit a petition or sign one.
Blockchain provides a faster and more efficient means of exchange for money. Today interbank wire transfers take about three working days and a $40 charge. Using a blockchain, the time can be reduced to minutes, payment can be done anytime and with a lower charge of around $1–$3. Ripple a cryptocurrency built on the blockchain technology has carved out a niche for itself in this space. Ripple is a California based company that uses their Ripplenet network to settle cross-border payments in 3 seconds.
The company currently boasts of clients like Standard Chartered, Santander, Unicredit and UBS using their network to settle international payments. CNBC, on October 10, 2017 reported that Ripple has over 100 clients.
■ IRREVERSIBLE TRANSACTIONS
Merchants understand, when accepting credit card payments or bank payments, that the sender can reverse or “charge back” the payment. There is nothing worse than sending products to a customer, only to receive a message that the payment has been reversed. Bitcoin is the only payment method that is 100% irreversible and cannot be charged back.
■ SHARING SOLAR POWER
A start-up, LO3 Energy, in partnership with Siemens, is testing the use of the blockchain technology’s capability through a microgrid called Brooklyn Microgrid. Consumers with solar panels can sell environmental credits to other residents who would not otherwise have access to solar power, and this is done in a decentralised way, no middleman is involved.
In addition to the above, work on using the blockchain technology in the financial markets is ongoing. Recently the Australian Stock Exchange announced that it would begin the replacement of its current post-trade (settlement and clearing system) with a new system built on blockchain technology.
Today, the most popular application of blockchain is in cryptocurrencies. As explained above cryptocurrencies are designed to be used as a medium of exchange. There has been a lot of debate regarding this usage. So, do cryptocurrencies act as a better means of exchange than existing fiat currency?
To answer this, we would need to understand what the characteristics of a good currency are. A currency serves three main purposes:
■ UNIT OF ACCOUNT: A key role for a currency is to operate as a unit of account, allowing you to value not just assets and liabilities, but also goods and services. To be effective as a unit of account, a currency must be fungible, divisible and measurable.
■ MEDIUM OF EXCHANGE: Currencies exist to make transactions possible, and this is best accomplished if the currency in question is easily accessible and transportable and is accepted by buyers and sellers as legal tender. So, it will be easier for me to carry a flash-drive holding a lot of digital coins than a truckload of gold.
■ STORE OF VALUE: When you hold or save currency, you expect that the currency will not lose its buying power and will not be reduced significantly.
Cryptocurrencies function as a unit of account because they are divisible, fungible and countable. On the other hand, they really perform poorly as a medium of exchange, because relatively very few sellers accept cryptocurrencies. We will consider the reasons for this. As a store of value, cryptocurrencies have historically shown price appreciation but with great volatility. Thus, bitcoin has been referred to as digital gold because the value has been on the rise with more mainstream adoption. Nonetheless, people want to store their assets in something that will hold its price and the stomach-churning swings in cryptocurrency prices make this undesirable. No rational person would convert all his assets to cryptocurrencies.
Most currencies in use today do not satisfy the above criteria but they are still widely adopted and accepted. Why is the adoption of cryptocurrencies lagging? A few reasons are obvious:
Cryptocurrencies have seen and continue to see wild swings in prices. This is good for a traded asset but not a good one in a currency. A service provider who prices his or her goods and services in cryptocurrencies will constantly have to reset the price leaving consumers with uncertainty on how much the value in their wallets will buy a few hours or days from now. This uncertainty makes it even hard for people to spend their digital assets. Why spend it now when it will be worth more tomorrow?
■ PROOF OF STAKE ALGORITHM
There are two major algorithms that drive the workings of cryptocurrencies, Proof of Work (POW) and Proof of Stake (POS). Because of the inherent problems in POW (high electricity consumption) most cryptocurrencies are adopting the POS. The problem with this is, by its nature, a POS cryptocurrency is required to be held and maintained in its wallet so that the holder can gain rewards. Thus, instead of utilising the cryptocurrency, adopters hold large quantities hoping to gain more rewards. This limits the incentive to use such cryptocurrencies for transactionary purposes.
■ COMPETING CRYPTOCURRENCIES
The cryptocurrency game is still in its early days and the competing players each claim to have found the “silver bullet” for eventual acceptance. As technologies and tastes evolve, many cryptocurrencies will fail and only the more fundamental ones with value will remain. It is possible that until this happens, investors will hold up, for fear of backing the wrong horse in the race.
Blockchain is an emerging technology that has the potential to change and improve commerce as we know it. It is relatively new, many experiments will fail, but the possibilities for innovation are endless and the world in the future, may be vastly different from the world today.
For cryptocurrencies’ to be accepted in mainstream financial services, some form of regulation must be put in place. So far, governments have exhibited mixed reactions with varying degrees of impact. The Japanese government is the most supportive of development in the cryptocurrency space. They are the only government that has approved a few cryptocurrency exchanges through the Financial Services Agency – an integrated financial regulator responsible for overseeing the banking, securities and exchange and insurance sectors in order to ensure the stability of the financial system of Japan.
China has been the most hostile country; it banned Initial Coin Offerings (ICOs) and swiftly followed that with a ban on cryptocurrency trading for Mainland Chinese Citizens in 2017. Nevertheless, no government has applied blockchain to solve real-world problems like the Chinese government. We Highlighting all the numerous blockchain projects supported by the Chinese government cannot be captured in this article.
Another government worthy of mention is the United States of America (USA). It has trodden carefully in this space while taking steps to understand the pros and cons of the technology. They have largely stated through various Senate committee hearings (where blockchain experts, the SEC and the Commodity Futures Trading Commission (CFTC) have given testimonies) that they do not want to stifle innovation in the blockchain industry with regulation. Clearly, the government wants to understand the technology and put in place regulations to protect investors. How this plays out will go a long way in the direction the cryptocurrency space takes. It is safe to say that the Chinese and USA government will play a major role in the adoption or otherwise of cryptocurrencies and blockchain technology.
Please note that this piece is neither an investment advice nor a validation of cryptocurrency as an investment option. The Securities and Exchange Commission (SEC) of Nigeria and the Central Bank of Nigeria have emphasised the inherent risk of investing in cryptocurrencies and warned potential investors to steer clear.