Science & Technology

The cryptocurrency primer

While cryptocurrencies have been around for a while, they now seem to be at a flashpoint.

MFR Graphics

MFR Graphics

This month as we focus on the prospects of a 'Digital Maldives' MFR will feature a series of articles on cryptocurrencies; this week the paper concentrates on outlining a basic understanding of the cryptocurrency ecosystem.

Cryptocurrencies or “cryptos”, are digital currencies which, much like regular currencies, are designed to work as a medium of exchange. However, unlike hard currencies, cryptocurrency ownership is ledgered in computerised databases using strong encryption, or cryptography, to secure transactions, to manage the creation of the digital currency and to verify transfers of ownership.

Satoshi Nakamoto and Bitcoin

Developed over 12 years ago, Bitcoin (₿ — BTC or XBT) was the first in a now ever growing roster of cryptocurrencies. First proposed in a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System,” published by the developer and inventor under the pseudonym Satoshi Nakamoto, it was soon after developed as a practical application of a cryptocurrency.

This first cryptocurrency can draw a parallel to gold mining. Hypothetically, when a new material is discovered that is both rare and unorthodox, an initial value may be assigned to it. Accumulating more Bitcoin would take efforts akin to actual mining of rare materials and discovering new sources of the material — this electronic equivalent is known as Bitcoin mining. When markets, consumers and service providers, start using this new material as an alternative means of exchange, the material, in this case Bitcoin, becomes a currency. In time, when it created a system of exchange that stood apart from the central financial system, many flocked to Bitcoin creating both greater incentive and hype. Knowing that there is a finite amount of this currency out there — ensured by the Bitcoin mining process — also increases the urgency for the rush to join in.

Initial demand

A unique line of code, that cannot be replicated, ensures the rarity of every unit of cryptocurrency. In the beginning, a certain number of Bitcoins were sold in exchange — there was little demand for it except through sheer enthusiasm and the promise of profit, and so prices were low. However, like a physical and finite material, there is a cap on the number of coins available, and in the case of Bitcoin, there is a maximum capacity of 21 million. While this may sound huge, the finiteness has now recreated a “gold-rush.”

Mining

To generate more coins a computer system goes through a series of complex calculations to ‘earn’ coins. In order to ensure authenticity as well as value, a shared system of computer servers holds a digital ledger that keeps track of the ownership of each individual Bitcoin. This ledger is called a blockchain, and when someone exchanges Bitcoins for a service or an item, the change of ownership is recorded on this ledger across all systems — there is no one centralised ledger that can be manipulated. This allows authentication and safety of ownership; nobody can steal Bitcoins from one person or a central ‘bank’.

Basic system requirements

A cryptocurrency, according to Jan Lansky,  must meet six conditions:

  1. The system should be maintained through distributed consensus (blockchain).
  2. The system should maintain an overview of cryptocurrency units and their ownership.
  3. The system should define whether new cryptocurrency units can be created — if new cryptocurrency units can be created, the system should also define the circumstances of their origin and how to determine the ownership of these new units.
  4. Ownership should exclusively be proved cryptographically.
  5. The system should allow ownership of the cryptographic units to be transferred — a transaction statement can only be issued by an entity proving the current ownership of these units.
  6. If two different instructions for changing the ownership of the same cryptographic units are simultaneously entered, the system will only perform, at most, one of them.

Maturing as a currency

Being established beyond the controls of the traditional financial systems of governments gives this new type of exchange more of a “free market” standing. Existing currencies in the market can be exchanged at rates that reflect their demand and supply. A shared system of verification ensures the authenticity of Bitcoin and prevents exploitation, and manipulation, of the market and the users. Bitcoin, and by extension other cryptocurrencies, can be seen as globally accepted when users begin making cross border transactions — as has been the case — allowing for real world movement of goods across exchange rates and tariff systems.

More from MFR