One cannot open a newspaper or website today without encountering a story about bitcoin or other cryptocurrencies. Advocates claim that cryptocurrencies represent a fundamental shift in the way we will use money in the future and that government-sponsored currencies such as the dollar and euro are intrinsically flawed. Critics see nothing but tulip bubbles and Ponzi schemes. Passionate cases are made on both sides of the argument. The truth, as is usually the case, lies somewhere in between.
In the commentary that follows, we attempt to sort through the hyperbole to better understand the opportunities and risks that cryptocurrencies pose by exploring not only bitcoin, but also the underlying blockchain technology on which cryptocurrencies rely. As usual, we start with a glance back at history.
A Brief History of Money
Why does the dollar bill in your pocket have value? Its intrinsic value is practically zero: It is nothing more than a piece of paper with images, letters and numbers on it. Your dollar bill – or money in general – derives value solely from a common agreement, a collective story that we tell each other about value. The collective story has evolved over time, starting in prehistory with things that genuinely had commodity value, such as livestock or salt (from which we derive the word salary). As humankind tired of walking around with cows and bags of salt, money evolved into things that had representative value, such as cowrie shells, metal coins or pieces of paper. Intrinsic value was lost, but these artifacts were durable enough to be traded from hand to hand.
For most of the 19th and 20th centuries, major economies retained a modicum of intrinsic value by offering to exchange representative money for a certain amount of precious metal, usually gold. As gold standards came to an end in the modern era, money today is simply called into existence (fiat) by central banks and backed by nothing more than the issuing entity’s ability to manage an economy and levy taxes. All traditional currencies today are fiat currencies.
Money moved at the speed of humans for most of history, as payment required coins, bills or checks to literally change hands. In the digital era, the speed of money has accelerated: We bank online, check our investment accounts on our phones and pay bills through vendor websites linked to our bank accounts or credit cards. This is an improvement over putting checks in the mail but still requires centralized institutions such as banks to validate money flows and ensure that we aren’t spending the same digital money twice.
This “double-spend” problem is inherent in the internet. Sending a file to another person via email is an act of duplication: A copy of the data is sent, and a copy is retained by the sender. That’s problematic when it comes to money. It’s critical when someone executes a digital transfer of money that the money doesn’t remain in her account as well as that of the recipient. This requires one or more intermediaries to ensure that payments wind up in the right place and that the funds are deducted from the sender’s account. This creates friction, delay and cost and allows other entities (banks, money transfer firms, etc.) to know the details of transactions.
Programmable money, or cryptocurrency, represents an attempt to address these issues and evolve money once again. Today’s widespread use of digital fiat money is unquestionably an improvement from the analog world, and cryptocurrencies are intended to disintermediate centralized authority from digital payment systems in order to establish a genuine decentralized peer-to-peer transaction network without the friction, cost and oversight of middlemen.
The Creation of Bitcoin
Bitcoin was created in the wake of the 2008 financial crisis, a period in which financial institutions around the world teetered, the stability of monetary systems was called into question, and global central banks adopted policy roles far beyond their original charters. In the midst of the crisis – on Halloween in 2008 – a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” was posted to a cryptography listserv. The purported author was Satoshi Nakamoto, a name that has never been positively linked to any known individual. Nakamoto – whoever he, she or they are – proposed a framework for a genuine peer-to-peer network that would establish trust without the presence of a central authority, solve the double-spend problem and disintermediate institutions as well as government entities such as central banks. The opening paragraphs of the nine-page paper propose that:
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. … What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.
The tech community was intrigued by the notion that cryptography might replace institutions, and the libertarian community liked the idea of economic transactions without third-party oversight. Furthermore, for people concerned that central banks were debasing sound money in the pursuit of political goals, a currency free from government influence held great appeal. Unsurprisingly, some of bitcoin’s earliest advocates hailed from countries plagued with rampant inflation and confiscatory government policies. Finally, bitcoin offered an opportunity to lower transaction costs and time by disintermediating institutions whose very economic models were based on transaction fees.
Instead of relying on a central trusted authority, such as a bank, to validate holdings and transactions, bitcoin and other cryptocurrencies distribute information widely across distributed ledger technology and use advanced cryptography to assure the legitimacy and security of financial information. Anyone with sufficient computing power may join the bitcoin network and participate in the validation effort. Successful validations are rewarded with newly created bitcoins. This distributed ledger technology is called blockchain.
How Does Blockchain Work?
Information is traditionally stored in a central location. Your bank has a record of balances and financial transactions, your doctor’s office holds your medical records, and various government entities hold a wide range of personal information such as Social Security numbers and tax returns. The beauty of centralized storage is that you know where to go to find the information you need. The downside is that the bad guys know this as well. In a world in which information is largely digital, central repositories can be (and often are) hacked, and it often takes days, weeks or months to realize it. Credit card numbers are stolen, identity theft is made possible, and celebrities run the risk of embarrassing photographs showing up on the internet. Central points of control can lead to central points of failure.
A blockchain, on the other hand, can spread this same information – appropriately encrypted – across a decentralized network of computers, without the need for an authoritative intermediary such as a bank or government. A blockchain is a type of distributed ledger technology, and, indeed, the two terms are often used interchangeably, although technically a blockchain is but one type of a distributed ledger approach to managing data.
Information contained within a blockchain requires a private key for someone to access it. These private keys are randomly generated numbers, with a nearly infinite number of possible combinations, making them difficult to the point of impossible to crack. A blockchain furthermore employs cryptographic security to ensure that information cannot be added, deleted or changed without a rigorous, costly and time-consuming application of an algorithm that confirms the new data, while linking it to all the previous data in the chain. A majority of the network participants must agree to a change, so a breach in one or even multiple points on the network doesn’t compromise the data.
On what basis do network participants agree to changes? Here is where rather advanced cryptography enters the picture.
New information (financial transactions, medical test results, etc.) is accumulated into blocks over a period of time, with the specific data encrypted so that only the holder of the correct private key can see the underlying information. Now it gets tricky. Network participants apply an algorithm, also known as a cryptographic hash function, to the block of encrypted data in order to create a unique identifier for the entire block. Bitcoin uses the SHA-256 cryptographic hash algorithm, created by the National Security Agency, but there are many others.
A hash function turns the block of data into an output (called a hash value) that appears to the naked eye to be a random string of numbers and letters, but always of a fixed length. The first feature of a hash function is that the same input must always result in the same output (hash) value. Since all network participants are working with the same input value, or block, to start, the output (hash) value will also be the same. Next, participants add to the block an arbitrary piece of input data (called a “nonce” in cryptography) so that the hash values created by different network participants differ, even when applied to the same block of data.
A second feature of a hash function is that the slightest change in the input data results in a completely different hash value. As the block data doesn’t change, the hash value only changes as a result of alterations to the random, or nonce, inputs.
See the nearby example for an illustration of this. Using the SHA-256 algorithm, the string “To be, or not to be” creates a completely different hash value when we change just the punctuation at the end of the phrase. Because the same input always translates to the same hash, you can try this at home. Google “SHA-256 encoder” and have fun!