Cryptocurrency is the enigmatic craze sweeping the globe. But what exactly is a Cryptocurrency? The most well-known example is the “Bitcoin” where a single unit is worth about 11,280 US Dollars but where does this value come from? And how can I obtain a “Bitcoin?”
At a very high level, cryptocurrencies are digital currencies which use cryptography, or puzzles to generate and verify individual units; but there are three major keys to the success of Cryptocurrency that will be explored in this series: decentralization, and proof of work/stake.
What is decentralization?
Decentralization is the key to Cryptocurrency’s success but to understand a decentralized network, one must first have an understanding of a centralized network and its issues. To find an example of a centralized network, we have to look no further than the United States, where the entity is called the US Federal Reserve.
A central bank requires a huge amount of trust from its citizens to properly handle monetary policy. It must appropriately raise or lower inflation to encourage economic growth by changing money supply or wage and price controls but these actions have tremendous implications and introduce volatility in the cost of living and consumer goods; and as time has passed, people have become increasingly and reasonably cynical of these centralized networks.
The most notable recent example of the failure of centralization is the financial crisis of Zimbabwe where hyperinflation led prices to double in 24.7 hours in November 2008. This instance of economic mismanagement left people wondering how long centralized networks could be trusted and led Satoshi Nakamoto to create the first genuine decentralized monetary system which he called “Bitcoin”.
Bitcoin does not require government issuance or third-party confirmation for payments. In this decentralized network, there are no rulers and no rules. People are free to spend their money how they like with their trust placed in cryptography rather than in a government subject to corruption.
Interestingly enough, some economists believe that Zimbabweans will benefit from Nakamoto’s Bitcoin. The Cryptocurrency can be quickly and easily imported and this added value in 2017 pushed Bitcoin’s price in Zimbabwe ($13000) to be nearly twice the going rate in global markets ($7,500).
So how did Nakamoto reach decentralization?
Decentralization in cryptocurrencies is achieved through the use of peer-to-peer networks rather than centralized servers. In a peer-to-peer network, different computers or servers act as “nodes” in an interconnected system. Each peer has the same privileges and importance so they are all involved in the transfer and issuance of a cryptocurrency.
In such a network, there are many different nodes involved which keep track of parts of a single currency. This has a few benefits in that a single organization or server does not have the power to issue or regulate spending and it is more resistant to attacks as an adversary must target the entire network rather than a single server to steal cryptocurrency or bring it down.
How do transactions work?
So first we need to understand that a coin is simply a chain of digital signatures that show the chain of ownership. Owners of a single coin can complete a transaction by signing their coin over to the recipient of a coin. For example, if Person A wants to complete a transaction to Person B, Person A must sign their coin over to Person B using their private key (the key that only person A has). This signature can be verified using Person A’s public key (the key available to everyone) which is used to confirm that Person A is the individual who completed the transaction.
Yet, an issue that arises is that the is no way to check if Person A has already signed their coin over to Person C prior to their intended transaction to Person B. This issue is often referred to as “double-spending” and a common solution is to introduce a central authority that will check all transactions for double-spending. However, this is contrary to the nature of having a decentralized system because if a central authority is introduced, all money must pass through the “mint” and the system is no longer fully decentralized.
To prevent double-spending, Bitcoin uses a blockchain which a universal ledger (a book or other collection of financial accounts of a particular type) which is given to every node in the Bitcoin network. So when Person A signs their coin over to Person B, the transaction and a timestamp will enter a pool of unconfirmed transactions. Miners will work to verify the transaction and if it is deemed as valid, it will be added to the blockchain.
So what’s next?
The next post will explore proof of work and proof of stake concepts that are key to giving cryptocurrencies their value, so stay tuned and leave any questions or comments down below.