We’ve all seen the headlines about blockchain and cryptocurrencies by now, mostly the cryptocurrency ‘Bitcoin’. Some of you might not know what any of these terms mean, and some of you will just want to know what’s happening with cryptocurrencies generally right now. Well, crazy as I am, both will be explored in this blog.
Image from Verdict
Please skip to ‘So, what’s going on with cryptocurrencies and decentralised finance?’ if you know how coins work already. As always, we reference Bloomberg and the Financial Times but also, this time, a few guides published by Blockgeeks.
So, what is the Blockchain, what’s a cryptocurrency, and how exactly are cryptocurrencies ‘mined’?
Alright, let's get started – but know that I loathe you for asking me this. We'll crack on with the concept of a cryptocurrency. And let's go really baseline: cryptocurrencies rely on cryptography. Cryptography is a method of storing and transmitting data in a particular form, and that encrypted data can be read and processed only by those whom are intended. To encrypt a message, the plaintext – e.g. the word ‘Hello’ – is encrypted (turned into unreadable gibberish) by using an algorithm, and a key is created to reconvert the gibberish back into text also by algorithm. So, cryptocurrency is an internet-based medium of exchange (read ‘medium of exchange’ as ‘money’) that uses cryptography functions to conduct financial transactions. Thanks, blockgeek cryptocurrency guide. Sounds pretty secretive, huh! These Darkweb origins rumours are starting to make sense…
So, how do users know what’s happening with cryptocurrencies?
That’s where blockchain comes in, as the blockchain is a transparent record of cryptocurrency transactions that can be downloaded and stored on a computer. The blockchain works as a time-stamped series of data records, and those records are managed by a cluster of computers that are not owned by any single entity. Each one of these records, or ‘blocks’, of data is secured and bound to each other using cryptography. Importantly, these records cannot be changed, they aren’t controlled by any single entity and everyone can view the transactions.
And how is it transparent exactly?
Well, the way blockchain storage works is that one party initiates the transaction by creating a block, and that block is ‘verified’ when it is distributed to thousands, or even millions, of computers across the internet. That verified block is then added to a chain, and that chain is also stored across the net – this creates a unique record, with its own verified unique history. Falsifying a single record, therefore, requires falsifying the entire chain, across those millions of instances. That’s pretty impossible. This makes transacting through the blockchain pretty trustworthy. Thanks again blockgeeks Blockchain guide.
So, this is why there is such buzz over the ‘democratisation’ and ‘decentralisation’ of the cryptocurrency system. It’s trustworthy by the nature of its verification and traceability process, and it’s not managed by any central authority. Anyone can add a chain to the block, and anyone can start a transaction. So, rather than the Bank of England telling us the British pound is worth what we think it is, a chain’s unique verification history across millions of instances tells us that the particular chain is good. Phew!
OK, but what’s ‘mining’ then?
You dog! Alright, let’s take a look at understanding mining. This will be the last ‘explanation’ part of the blog, though. Cryptocurrency mining is essentially the process we just went through. It is where transactions between users are verified and added to the blockchain public ledger. Mining actually introduces new coins into the existing circulating supply, and is part of how cryptocurrencies operate as this peer-to-peer decentralised network. So, now we know what Bitcoin is and how it started – it’s the most popular and well-established example of a mineable cryptocurrency. We also know how other cryptocurrencies and coins are created. By the way, the algorithm that allows access to bitcoin for it to be mined is a ‘consensus algorithm’ called ‘Proof of Work’. Explanation from Binance academy, who go into a lot more detail about how mining is technically achieved through nodes and hashes. Really quickly, a miner is a ‘node’ and a ‘node’ is basically an individual computer’s identity; the node acts as a communication point that can transmit information about transactions and blocks within the network of computers, e.g. in the Bitcoin peer-to-peer protocol. This identity is all part of the trust and verification process, which removes the need for a central bank or authority to verify the transaction and prevent double-spending of the currency.
Alright, that’s really it for now! Let’s look at how cryptocurrencies work in the economy.
So, what’s going on with cryptocurrencies, and are they the future of decentralised finance?
Over the US election, Bitcoin rallied. On Wednesday, it went up 3.8% at one point – its highest level since January 2018. Bloomberg reported on Wednesday that Bitcoin, and other coins like Dash and Litecoin, perform well in periods of volatility and uncertainty. Crypto performed better than gold and stocks this year, according to ProChain Capital. So, while uncertainty like the U.S. election goes on, it’s suggested that institutional (professional) investors may become more familiar with cryptocurrency. For this to happen, Bitcoin will have to keep trading on an upward trend for a sustained period. Be aware that the Bloomberg headline 5 days before this positive report read: “Bitcoin Falls the Most in a Month Following Red-Hot Rally” and it was a 3.1% slump. Bloomberg said the sentiment behind this was that: the riskiness of Bitcoin meant it was less attractive in a volatile environment. So, really, who knows. Although, some news here on alleged black-markets: links to darker transactions that have damaged Bitcoin sentiment in the past have had less of a price impact this time around. So, that’s… something. With reference to Bloomberg.
So, let’s take a look at the Financial Times for a little help on what’s going on with the crypto trend. Reports have suggested that the private sector is unlikely to lead the crypto uptake. China recently, through its central bank, trialled a digital yuan with millions of transactions taking place. This is the opposite of a decentralised crypto revolution.
Wait, so, what about cryptocurrency’s role in decentralised finance?
Firstly, a brief explanation of what that is. Decentralised finance is the concept of financing without central banks or central authority – basically, peer-to-peer financing. There are decentralised finance apps, called DeFi apps, that seek to let people lend and borrow without intermediaries. So, on thematic 'justice', the gist is that it would be satisfying if this peer-to-peer currency could be part of peer-to-peer lending.
There is a buzz around the cryptocurrency Bitcoin at the moment because of a new ‘wrapping’ process around it. Wrapping is where Bitcoin is deposited with a custodian, such as BitGo Inc, who then keeps the Bitcoin in a central depository and uses the deposited coins to invest in decentralised finance apps. This process, ‘wrapping’, creates WBTC a.k.a. Wrapped Bitcoin. This means that there’s something else to do with Bitcoins other than sell, as this process can transform the coins into collateral. However, cybersecurity is a huge risk here, as this wrapping process removes some of the blockchain transparency. Remember how fundamental transparency and trust were when we talked about it earlier? A lot of trust goes into a depository’s cyber security, then, because otherwise the cryptocoins could lose value.
A really timely note here comes from a recent FT article on trust. The article explained how organised and intentional reams of fake reviews have gone unregulated on ‘trusted’ sites like Amazon and Facebook. This can be extrapolated into issues with the use of ‘wrapping’ crypto, namely issues of security, in decentralised finance like we just talked about. To believe as an investor that your crypto custodian has appropriate security, and that your investment won’t be hacked into ‘monopoly money’, takes a lot of trust.
A quick little note from me on social chains: when you get chain mail, where do you go for protection? To your email provider or to your friends list? I suppose, on a little logic leap, are we going to take crypto peer-to-peer, or keep our trust in institutions? Just because it is a social chain, doesn't necessitate decentralisation. It really is no surprise that China, with its rich fin-tech and decentralised banking history (see: AliPay), took the first step with crypto here; it could be that China does have the right idea, at least for them.
Finally, a little more on trust from the FT. PwC recently released a report on the positive future of cryptocurrencies, and the FT reported rather satirically on PWC’s seemingly unjustified optimism. I’m not even going to go into it because it’s such a great read that I couldn’t do it justice. Really. I’m putting this at the end so you go and read that FT article now. Here it is linked again.
So, at least you know how coins work and how they are being used at the moment with DeFi, or at least why crypto is trying to go that way. We shall end, then, in light of those articles on under-research and trust with the truly age-old internet adage, as follows:
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