A deep dive into the technologies (and abstractions) that shattered our traditional understanding of currency.
By Ben Fitzgerald
Cryptocurrency is a kind of modern alchemy. Your uncle’s ranting about it, your little cousin’s trading it, and all the economists railing against it seem to be just as confused as you. Whole societies seem to be minting themselves fortunes… or going bankrupt in the process.
Maybe weaving of cash from code is like making gold from iron: too good to be true. After all, people can’t just get rich latching themselves onto a print-your-own-money scheme. Can’t they?
Like all alchemies, cryptocurrency has its believers and its skeptics. I won’t argue for either side. Instead, I’ll walk you through the mathematical marvel that enables what feels like a currency pulled from thin air. Cryptocurrency exists without individual coins, without central regulation, without a central database — many of the components we see as intrinsic part of currency systems. Join me as we unpiece this model… and rethink our own views of currency along the way.
What is cryptocurrency?
A traditional currency tracks a user’s balance physically and is regulated by a central agency. Cryptocurrency tracks a user’s balance digitally and regulates itself with cryptography — “the computerized encoding and decoding of information.” Cryptocurrencies like Bitcoin are decentralized because they are minted and regulated by individual nodes, the individual computers composing a cryptocurrency’s network.
Sounds fishy? Many experts agree! The value of a single Bitcoin has plummeted from around $65,000 in April 2021 to around $26,000 in September 2023. In other words, people who poured their livelihoods into Bitcoin only two years ago have seen their assets depreciate by over 50%. Multi-million dollar crypto “heists,” most notably from the trading firm Mt Gox, and cryptocurrency’s involvement in illegal activities like the infamous Silk Road have all framed it as a dangerous investment. These factors led Nobel prize-winning economist Nouriel Robini to dub the cryptocurrency trend “the mother of all bubbles.”
But Bitcoin functions as a viable currency for many people. Since Bitcoin creator Satoshi Nakamoto mined the “Genesis Block” of Bitcoin in 2008, Bitcoin’s money supply has soared to $518.6 billion, surpassing the money supply of the Russian Ruble. Citizens of countries with tumultuous currencies have often seen Bitcoin as a better alternative: for example, crypto use in China skyrocketed when the Chinese government artificially devalued in the Yuan in 2016. Furthermore, cryptocurrency remains a haven for those distrustful of government interference in currency.
Currencies without coins
Now that we know the basics, let’s pop the hood.
Every crypto transaction, every minting of new cryptocurrency, and every exchange of cryptocurrency for physical currency is recorded in a currency’s blockchain ledger. These entries are digitally signed using an encryption created with a user’s private key. To put it in layperson’s terms: each user’s crypto-currency balance is tracked in a shared record whose entries are impossible to plagiarize.
This facilitates one of cryptocurrency’s most fascinating mechanics: the abstraction, or “illusion,” of individual coins. When Wendy sends Peanut ten Bitcoin, no coded tokens are changing hands. Instead, Wendy’s computer adds a more complex translation of “Wendy gives Peanut ten Bitcoin” to the blockchain ledger. When Peanut buys a new chew toy, he receives the chew toy without exchanging separate units of currency, but records in the ledger, “Peanut gives chew toy vendor x Bitcoin.” And, when Peanut exchanges his cryptocurrency for physical currency, he is sent traditional currency without exchanging a physical commodity, but records, “Peanut sends Mt Gox 10 Bitcoin.”
Cryptocurrency functions as a system for recording users’ balances in a non-fungible way. In that sense, it is very similar to physical currency. Whereas a system of physical currency records debts and balances by exchanging physical tokens, cryptocurrency records debts and balances by aggregating ledger entries. As one explanation puts it, “the ledger is the currency.”
Records without record keepers
In a centralized network, one central server maintains a copy of a currency’s blockchain ledger. In a decentralized network, each user maintains an (ideally) identical copy of the blockchain ledger, taking power away from a central agency. A fraudulent actor can only manipulate a decentralized network by modifying over 50% of its users’ ledgers (for reasons we’ll clarify later), rather than simply accessing a centralized server.
The processes of updating a ledger and mining new cryptocurrency are actually intertwined. Since crypto-currencies are decentralized, a user’s node broadcasts its transactions to the other nodes in its cryptocurrency network. These computers then compete for the privilege of coining a valid block to house this ledger. A computer does this by taking the hash function of [the combination of] the new ledger and a corresponding hash code.
Validating a block is a technical process, which most casual cryptocurrency users can ignore. Suffice it to say that a “hash function” returns a number corresponding to any computational object. These numbers don’t follow an order. The only way to determine a hash function’s output, when given a blockchain ledger and a hash code, is simple: trying random numbers. Eventually, the output will meet the conditions for a desired value, or proof of work — which is almost always a number starting with x amount of zeros. Another user can use this “proof of work” to confirm that a block was verified correctly without having to verify it themselves.
The key takeaway is that computing power, rather than programming skill or market knowledge, is the sole determinant of successful cryptocurrency mining. Certain parameters, such as the number of crypto tokens in a block and the rate at which blocks are rewarded, provide fixed value to the currency by regulating supply and demand. But the final result remains the same. The user achieves a valid, up-to-date ledger that includes the newest transaction. And to acknowledge their contribution to the network, the ledger includes a block reward for is creator — a certain amount of “new” cryptocurrency gifted to the miner.
With this system, cryptocurrency is recorded, verified, and mined — all in one, fell swoop.
Data without databases
Okay, technically, blockchain is a database. However, a conventional database aggregates data into a single computational object. Blockchain distributes data among many computational objects.
Each aforementioned block contains an updated version of the blockchain ledger and two other components. The first is the hash code that we identified when validating the block. This hash code functions as the block’s unique identifier. The second, final component is the hash code of the previous block. This functions as a pointer to preceding blocks, allows users to view old versions of the blockchain ledger.
Why use blockchain? Issues such as blockchain security are targets for a much, much longer article. A simple reason is that blockchain saves processing and system memory. If blocks of cryptocurrency data were stored in a traditional database, they would all have to be loaded simultaneously and require a more robust metadata structure. Blockchain, on the other hand, requires no data and functions as a linked list between blocks, allowing each iteration of the blockchain ledger to be loaded in and viewed independently.
In other words, by using hash codes to validate, identify, and link blocks, blockchain serves as a more elegant base for cryptocurrency data. In doing so, it precludes aggregation of information into a centralized computational location — something computer scientists have previously considered a necessity.
Whether you’re scoffing at it or paying your tuition with it, cryptocurrency is a fascinating deconstruction of the institutions we think necessary for currency. Currencies without coins, mining without minting, regulation of prices without central oversight… Some might claim that removing these central beams returns currency to a more natural state. Divisions of resources can again be negotiated without an intermediary, just as some claim they always were.
I’ll leave these questions to the anthropology majors. But the technical analysis, I’ll leave with you! The next time that one family member brings up Bitcoin, throw around words like hash function and blockchain ledger. Soon, they’ll be the ones trying to change the topic.