To understand the power of blockchain systems, and the things they can do, it is important to distinguish between three things that are commonly muddled up, namely the bitcoin currency, the specific blockchain that underpins it and the idea of blockchains in general.
2. THE COMPLEX NATURE
To understand the Crypto system, it is necessary to
combine elements from the three disciplines of
economics, cryptography, and computer science
Crypto protocol can be altered if the network
participants, or at least a sufficient number of them,
agree on the suggested modification
Ethereum’s ideological dissent, which resulted in the
split to Ethereum and Ethereum Classic
Proof-of-work mining is expensive, as it uses a great
deal of energy
The price of Cryptocurrencies are highly volatile
In government-run fiat currency systems, the central
bank aims to adjust the money supply in response to
changes in aggregate demand for money in order to
stabilize the price level.
3. PURPOSE OF MONEY
Unit of Account: A way to compare the value of various goods and services
If you are shopping for a new computer, the price could be quoted in terms of cash, gold or corn. So, for instance,
your new computer might cost you 100 to 150 bushels of corn at today's prices, but you would find it most helpful
if the price were set in terms of money because it is a common measure of value across the economy
Medium of Exchange: Allows for non-barter transactions.
For instance, U.S. paper money carries this statement: "This note is legal tender for all debts, public and private."
This means that the U.S. government protects my right to pay with U.S. dollars
Store of Value: Allows value to be retained
If I work today and earn 25 dollars, I can hold on to the money before I spend it because it will hold its value until
tomorrow, next week, or even next year. In fact, holding money is a more effective way of storing value than
holding other items of value such as corn, which might rot.
Modern economies use fiat money-money that is neither a commodity nor
represented or "backed" by a commodity.
4. MONEY THROUGH TIME
The earliest known currencies were receipts for grain storage found in Mesopotamia.
Bronze age – Ingots (Pure material blocks, primarily metal) were used for trade
Iron Age - Coin was introduced
Description of currencies such as, Paper money, banknotes in the Far East, Silver Coin called Rupiya (178
grams) in India.
Some economies relied on goods as currency (Pound of Tobacco, Rice, Pelts, Wheat etc.)
Gold and silver have been the most common forms of money throughout history
Paper money became known in Europe through the accounts of travelers, such as Marco Polo and
William of Rubruck
European Banknotes (Originally issued by banks and replaced by the issuance of bank notes authorized
and controlled by national governments), National Currencies
Digitalization – Payment Cards , Digital Currency, and CRYPTOCURRENCIES
5. CHARACTERISTICS OF MONEY
Durability
Physically stable, does not rot, rust, or melt
Portability
Easy to transport and transfer ownership
Divisibility
Can be subdivided into smaller units of
money
Scarcity / Limited Supply
Limited Quantity available for use
Uniformity
Same size and shape and value; they are very
Uniform
Acceptability
One unit of money can be substituted for
another
Compare two examples of possible forms of money based on the above characteristics
• A cow. Cattle have been used as money at different points in history.
• A stack of INR 500 bills equal to the value of one cow.
• One Bitcoin
6. CASH AND EXISTING PAYMENT SYSTEMS
Cash is represented by a physical object, usually a coin or a note. When this object is handed to another
individual, its unit of value is also transferred, without the need for a third party to be involved
When using Physical Cash, Buyers and sellers have to be physically present at the same location in order
to trade, which in many situations makes its use impracticable.
An ideal payment system would be one in which monetary value could be transferred electronically via
cash data files. Such cash data files retain the advantages of physical cash but would be able to circulate
freely on electronic networks. If cash data files can be copied and the duplicates used as currency, they
cannot serve as a payment instrument. This problem is termed the “double spending problem.”
To counteract the problem of double spending, classical electronic payment systems are based on a
central authority that verifies the legitimacy of the payments and keeps track of the current state of
ownership. In such systems, a central authority (usually a bank) manages the accounts of buyers and
sellers.
Centralized payment systems solve the double spending problem, but they require trust. Agents must
trust that the central authority does not misuse the delegated power and that it maintains the books
correctly in any state of the world—that is, that the banker is not running away with the money.
7. VALUE = SCARCITY OR QUANTITY OR REPLACEMENT OR COST
BENEFIT OR JUST A BUBBLE
All currencies rely on scarcity.
Sometime the scarcity is enforced by a natural authority (i.e. limited amounts of copper or gold on Earth)
Sometimes, it is enforced by humans (i.e. Central Banks).
If there is an unlimited amount of money, none of it is valuable
Cryptocurrencies solves this problem with a novel approach, based on mathematics
A hash function generates a "signature" for the data. If the data changes, the hash changes. Hash functions are not
reversible. Bitcoin takes advantage of it by requiring miners to compute hashes for ledger blocks that fall below a certain
number (difficulty target). Miners do this by trying various "nonces" until they find one that generates a satisfying signature.
The difficulty target is adjusted to keep bitcoin from being mined too quickly, creating a satisfying level of artificial
scarcity.
A nonce is an abbreviation for "number only used once," which is a number added to a hashed—or encrypted—block in a
blockchain that, when rehashed, meets the difficulty level restrictions. The nonce is the number that blockchain miners are
solving for, in order to receive cryptocurrency.
Miners compete by trying to find “nonces” that generate a signature that falls below the current difficulty target. This is
computationally expensive, but financially lucrative as miners get rewarded in Bitcoin. This has led to the rise of mining
operations where electricity is cheap to power & cool server farms , as well as specialized mining equipment
Bitcoin can be thought of as algorithmic scarcity (given the supply of bitcoin is capped at 21 million).
8. VALUE = SCARCITY OR QUANTITY OR REPLACEMENT OR COST
BENEFIT OR JUST A BUBBLE
REPLACEMENT: Assumes the cryptocurrency as replacement to valuable and precious assets
Replacement for gold due to many similarities like a) no centralized supply, 2) Costly to mine, and 3) Universally same
Advantages over gold includes ease of transfer and storage, disadvantages is that no direct physical use
RELATIVE VALUE
The idea is that you fit a regression model to the price of the crypto versus other cryptos.
The model delivers a fitted price. If the fitted price is greater than the market price, then the crypto is relatively “under
valued”
The key word is relative. It is possible that both are over valued or both are undervalued
QUANTITY: Assumes the cryptocurrency to be an asset i.e., cryptoasset
It is claimed that “There is a fixed supply of tokens. As demand for the token increases, so must the price”. However, this is
problematic because it ignores the velocity.
The key equation is MV=PQ. Let PQ be Total Transaction Volume. So Average Network Value = (Total Transaction
Value)/Velocity. However, velocity is very high with cryptocurrencies. This high velocity means that the Average Network
Value should be small
9. VALUE = SCARCITY OR QUANTITY OR REPLACEMENT OR COST
BENEFIT OR JUST A BUBBLE
BUBBLE
A bubble is an asset that has value because people believe that it has value.
Large speculative demand for cryptocurrencies is typical of bubble behavior.
Bursting of a bubble does not necessarily take you to zero. Consider history of bubbles like the housing bubble, tech
bubble, …
COST BENEFIT EQUILIBRIUM
The idea is that people will not mine bitcoin unless it is profitable to do so. So the cost of the marginal miner is the floor
for coin price.
If price drops, then mining decreases as it is not worth buying a mining machine and paying the electrical cost
However, in contrast to gold, decreases in hash power simply cause the difficulty to decrease (it does not impact the
coinbase supply)
10. THE TECHNOLOGY - BLOCKCHAIN
Transactions are recorded in blocks
Each block contains the signature of the previous block, linking them together in a chain
As transactions get administered in a distributed, totally decentralized way, we see the rise of a new way
to store and exchange information, not unlike that of a new internet.
11. HOW ARE CRYPTOCURRENCIES CREATED
Cryptocurrencies are created through “mining”, a process of undertaking a series of mathematical
calculations that are registered through a series of autonomous internet nodules that together constitute
a blockchain
A blockchain is a digital ledger mechanism designed to insulate a validated cryptocurrency from hacking.
Blockchain validation is undertaken continuously by independent computing systems .
Blockchain validation of cryptocurrency mining provides a way of currency quantity control independent
of any governmental central banking authority
A key to the appeal of a cryptocurrency is the perceived protection against counterfeiting. This is
particularly relevant in the context of cryptocurrency mining, which is the basis for expanding the existing
stock of the commodity.
Readily available online programs for bitcoin mining are available. One of the most popular is the CG
Miner Bitcoin Software program. All mining software engage in energy intensive hashing, which is a way
of executing a series of code to unlock a bitcoin blockchain to create a new block.
12. ACQUIRING CRYPTOCURRENCIES
Win a block
Miners
Receive a gift or be paid for goods or services
First bitcoin transaction – Laszio Hanyecz at Papa John’s pizza spent 10,000 BTC for
two pizzas (May 22, 2010).
Buy on an exchange ( Coinbase, Binance, Coindesk and so on)
Exchange often holds your keys and they pool all the keys – acting like a bank. In a usual crypto
trade, every transaction generates a new private key. If “off-chain”, then private keys are shifted
between owners in the exchanges’ database.
Largely unregulated.
Can be hacked
Worry of exchanges are a centralizing force similar to central banks
You can also obtain cryptocurrency through an Initial Coin Offering (ICO). New currency can also be obtained via a hard fork.
13. COMPETITIVE LANDSCAPE –CRYPTO MINING OF BITCOIN
Anyone can become a miner by downloading the
respective software and the most recent copy of
the Bitcoin Blockchain
Need highly specialized hardware and access to
cheap electricity can still make a profit from mining.
A miner obtains this fingerprint by computing the
block candidate’s hash value using the hash
function dSHA256
The hash value must be below a certain threshold
value—that is, it must display several zeroes at the
beginning of the fingerprint.
A miner who succeeds in creating a block candidate
with a hash value below the current threshold
value, he or she broadcasts the block candidate as
quickly as possible to the network All the other
network participants can then easily verify that the
fingerprint satisfies the threshold criterion by
computing it themselves
14. CRYPTO - ASSET OR COMMODITY OR CURRENCY OR COLLECTIBLE
Asset : Asset generates or is expected to generate cash flows in the future.
Commodity: A commodity derives its value from its use as raw material to meet a fundamental need,
whether it be energy, food or shelter. Value can be established looking at supply and demand.
Currency: A currency is a medium of exchange that you use to denominate cash flow. Currencies have no
cash flows and cannot be valued, but they can be priced against other currencies.
Cryptocurrency collectibles are digital media that can be authenticated as an original through blockchain
technology. Read NFT’s
Cryptocurrencies operate independently of any government monetary authority such as the Federal
Reserve, or Central Bank in any individual country.
So What is the value : For cryptocurrency, the disagreement is extreme. For example of Bitcoin : Many believe
the real value is zero. Others believe the future value is in millions
15. CRYPTOCURRENCY AS LEGAL TENDER
A successful currency ultimately must satisfy four criteria:
It serves as a medium of exchange – In El Salvador, bitcoin has been declared legal tender, though passing
through a dollar exchange rate. Some firms have declared acceptance of bitcoin as payment (e.g., Elon Musk and
Tesla), only later to restrict or withdraw endorsement. Bitcoin transactions as a means of payment constitute only
a fraction of daily transactions in both the U.S. and foreign economies.
It serves as a unit of account – Pricing goods and services in a cryptocurrency such as bitcoin depends on the
stability of its value relative to standard currency such as the dollar. Although bitcoin is the most popular
cryptocurrency, its acceptability as a unit of account has been severely constrained by its volatility
It serves as a standard of deferred payment – Given the role of time-dependent transactions in an economy, the
acceptability of a cryptocurrency is determined in part by the extent to which it can fulfil the requirement of
satisfaction of a future obligation. As long as the cryptocurrency undergoes price fluctuation, it becomes difficult
to rely on it as a means of settling future obligations, e.g., loans, mortgages, futures, and the like
It serves as a store of value – This appears to be the only function that cryptocurrencies may offer. Its appeal
resides in the domain of commodity investments such as gold, platinum, or other precious commodities in which
it serves as a hedge against inflation. As with gold, where inflationary spikes appear, investors turn to “safe”
investment such as precious commodities, of which cryptocurrencies now form part of the stable of such goods.
16. THE PIONEER - BITCOIN
The name or pseudonym "Satoshi Nakamoto" is listed as the author of the Bitcoin whitepaper 2008 . This
person/persons also created a message board called bitcointalk in 2009, leaving several messages
Bitcoin is a virtual monetary unit and therefore has no physical representation
A Bitcoin unit is divisible and can be divided into 100 million “Satoshis,” the smallest fraction of a Bitcoin
The Bitcoin Blockchain is a data file that carries the records of all past Bitcoin transactions, including the
creation of new Bitcoin units
The average time between Bitcoin blocks is 10 minutes. The first block, block #0, was created in 2009.
Everyone can download and read the Bitcoin Blockchain, it is a public record, a ledger that contains
Bitcoin ownership information for any point in time
The notion of “public record of ownership” also has to be qualified because the owners of Bitcoin units
usually remain anonymous through the use of pseudonyms.
17. BITCOIN AND OTHERS
The total number of bitcoins in circulation as of 2020 has
been estimated at 18,748,468.75. The estimated limit value
is 21 million bitcoins
Example of a Bitcoin Blockchain in 2010 :
Litecoin, Ethereum, Ripple, Stellar, NEO, Cardano, Doge,
SHIBA Inu
The number of cryptocurrencies in circulation as of 2020
has been estimated at 50 million blockchain users.
17,000 Cryptocurrencies in existence and counting
18. LET’S THINK THEORY & BUSINESS
Most Bitcoin users believe that Bitcoin’s limited supply will result in deflation. That is, they are convinced
that its value will forever increase
Bitcoin units have no intrinsic value. Because of this, the present price of the currency is determined solely by
expectations about its future price. A buyer is willing to buy a Bitcoin unit only if he or she assumes that the unit
will sell for at least the same price later on
State monopoly currencies, such as the U.S. dollar, the euro, and the Swiss franc, have no intrinsic value either . The
history of state monopoly currencies is a history of wild price swings and failures
The price of Bitcoin, therefore, reacts highly elastically to changes in the expectations of market participants and is
reflected in extreme price volatility
From monetary theory, we know that currencies with no intrinsic value have many equilibrium prices. If all market
participants expect that Bitcoin will have no value in the future, then no one is willing to pay anything for it today
The path for the money supply is predetermined by the Bitcoin protocol written in 2008 and early 2009. However,
in principle all aspects of the Bitcoin protocol can be amended, including the money supply
even though in theory it is possible to increase the Bitcoin supply, in practice, such a change is very unlikely
because a large part of the Bitcoin community would strongly oppose such an attempt
19. THE TAKEAWAY
Bitcoin creators’ intention was to develop a decentralized cash-like electronic payment system.
Fundamental challenge of how to establish and transfer digital property rights of a monetary unit without
a central authority
Solution was Bitcoin Blockchain - This novel technology allows us to store and transfer a monetary unit
without the need for a central authority, similar to cash
Price volatility and scaling issues frequently raise concerns about the suitability of Bitcoin as a payment
instrument
Bitcoin and alternative blockchain-based tokens should not be neglected
Blockchain technology provides an infrastructure that enables numerous applications - colored coins,
smart contracts, NFT’s etc
Cryptos may become new asset class that can mature into a valuable portfolio diversification instrument
The technology behind cryptos may bring change to the world of finance and to many other sectors
20. REFERENCES
Berentsen and Schär (2018). A Short Introduction to the World of
Cryptocurrencies. Federal Reserve Bank of St. Louis Review, First
Quarter 2018, 100(1), pp. 1-16.
Eyal, I. (2017). Blockchain technology: Transforming libertarian
cryptocurrency dreams to finance and banking realities.
Computer, 50(9), 38-49.
Liu, Y., Tsyvinski, A., & Wu, X. (2019). Common risk factors in
cryptocurrency (No. w25882). National Bureau of Economic
Research.
Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash
System.” 2008; https://bitcoin.org/bitcoin.pdf.
Tapscott, A., & Tapscott, D. (2017). How blockchain is changing
finance. Harvard Business Review, 1(9), 2-5.