Cryptocurrencies for Dummies

Bitcoin was born in 2008, the same year Lehman Brothers declared bankruptcy. On October 31 of that year, a user identified as Satoshi Nakamoto posted a message on the "Cryptography" mailing list that read: "I've been working on a new electronic cash system that is fully peer-to-peer, with no trusted third parties." It also contained a link to a document hosted on bitcoin.org known as the "white paper," which explained the system's operation point by point. In reality, nobody knows Nakamoto's true identity.

Bitcoin was the first digital currency to successfully transfer value between users without the need for a central authority to verify transactions. The idea, as simple as it sounds, gave rise to an unprecedented monetary revolution. On January 9, 2009, Nakamoto released version 0.1 of the Bitcoin client (now known as Bitcoin Core), an open-source software that connected multiple computers to each other, giving rise to the network that would support the cryptocurrency. The network's tasks were, in appearance, straightforward: allow transactions between users, maintain a list of all transactions, verify that the same coin isn't spent twice, and issue new monetary units.

That same day, at 00:54, the first block of bitcoin was mined and with it the first units were created. Three days later, on January 12, 2009, Hal Finney, one of the most prominent members of the "Cryptography" mailing list, received the first bitcoin transaction in history. On April 26, 2011, Nakamoto sent his last message and disappeared from public view. Three years later, on August 28, 2014, Finney died from an advanced case of amyotrophic lateral sclerosis. His body is preserved in a cryogenic state at the Alcor Life Extension Foundation laboratories.

Along with Nick Szabo, Finney is recognized as one of the pioneers of Bitcoin and one of the main suspects of being Satoshi Nakamoto or, at the very least, of having had close contact with the anonymous figure.

What is Bitcoin?

Bitcoin, besides being the name of the currency, is the network that supports it: a peer-to-peer (p2p) network, without intermediaries, that allows sending value from one part of the planet to another without asking anyone's permission, at a relatively low cost, in a semi-anonymous, fast, and completely irreversible way. These characteristics allow Bitcoin to be immune to censorship attempts by any nation, company, or authority.

Users can transfer bitcoins through the network to do almost anything that can be done with conventional currencies, such as buying and selling goods and services or sending money to another person, and some platforms even allow receiving or granting credit using bitcoins. Bitcoins can be bought, sold, and exchanged for other currencies at specialized exchanges. Unlike traditional currencies, Bitcoin is entirely virtual. There are no physical coins that represent it.

Network users possess a set of keys (known as private keys) that prove ownership of bitcoin. With these keys, transactions can be made to other network users. The keys are stored in digital wallets, which can be on a personal computer, a phone, or even specific hardware designed for that purpose. The private keys that enable transactions are the only prerequisite for sending bitcoins, thus placing total control of their funds in the hands of users.

What is mining?

Each unit of Bitcoin is created through a process called "mining." Certain nodes on the network, called miners, compete to find the solution to a mathematical problem while bitcoin transactions are being processed. Any participant in the Bitcoin network can become a miner, as long as they make their computer's processing power available to verify and record transactions.

Every ten minutes, on average, a Bitcoin miner competes to validate all the transactions from the last ten minutes and, if successful, receives a reward in the form of bitcoins. This function is known as "proof of work."

Currently, the reward consists of 6.25 bitcoins per mined block, and every 210,000 blocks, the reward is halved. In this way, Bitcoin will reach a unit limit close to 21 million. This limit is deduced from the issuance rate of new Bitcoin units, which is established in the network's software. Additionally, each unit of Bitcoin can be divided into 100 million parts, meaning we can split one bitcoin down to 0.00000001 of each unit. That smallest unit is called a satoshi.

The Bitcoin protocol includes algorithms that regulate the mining function on the network. The difficulty of solving the mathematical problem required to mine a block is automatically adjusted so that the validation time between one block and the next is ten minutes, regardless of how many miners are competing at that moment. The number of bitcoins in circulation takes the form of a predictable curve approaching 21 million by the year 2140. Since the issuance rate is decreasing, in the long term, Bitcoin is deflationary. It cannot be inflated by "printing" new money beyond the expected issuance rate.

But being a virtual currency doesn't mean there's no "materiality" behind it. Mining bitcoins requires the use of electrical energy. Under current conditions where competition is very widespread, bitcoin mining becomes profitable in regions that have some comparative advantage, such as very cheap electricity. The greater the computing power, the higher the probability of solving a block and, therefore, earning the reward. That's why "mining pools" were created to concentrate that firepower.

That is one of the reasons why Paraguay, for example, became one of the places where "mining bitcoins" is profitable. "In Paraguay it's still profitable to mine bitcoins because we have the lowest electricity cost in the region," says Luis Pomata, CEO and co-founder of Nano Mining Paraguay. "The normal cost is 5 cents per kWh and can even go as low as 3 cents per kWh. That's something you only see in Asian countries or in some parts of North America." He adds that the South American country also has "low technical labor costs and, lastly, you can buy or rent warehouses to use as data centers that meet the necessary requirements to house mining machines at a very affordable price."

How does it get its value?

One of the most frequently asked questions about Bitcoin is "how does it get its value" or "what backs it." To answer this, we need to take a brief historical detour. At the end of World War II, there arose a need to create an international trade system that would avoid the imbalances that had led to World War I, the crash of the 1930s, the rise of fascism, and ultimately, war and the Holocaust once again.

The United States, leading with the doctrine of liberal globalism, held the hypothesis that a world open to trade was a world of peace. Thus, at the Bretton Woods conferences, the US dollar became the guarantor of international trade and, therefore, of peace. Until then, the dollar had a fraction of gold guaranteeing its "value." Dollars were, in essence, convertible to a portion of gold. But in 1971, Richard Nixon decreed the United States' departure from the gold standard, and the American currency ceased to be convertible to the precious metal. From that point on, no global currency could be converted, via the dollar, to gold. This type of money is known as fiat or fiduciary money.

The "backing" of our currencies comes from the ability of states to enforce their use and declare all other currencies illegal. The radical shift from the gold standard to fiduciary money (which comes from the Latin fides, meaning faith) is still today, almost half a century later, a fact unknown to a large portion of the public. Our money has no backing other than the credibility of whoever issues it and the agreement between the parties who use it. Ultimately, the value of money is a social relationship and hence, therefore, its inescapably political character.

The value of Bitcoin, beyond its particular characteristics such as scarcity, security, resistance to censorship, immutability, and reliability, depends on the agreement of all users. In that sense, Bitcoin is also, in some way, a form of faith. The only difference from the money printed by the state or a bank (as may be the case in Hong Kong) is that the value is not tied to trust in a particular government, but rather to trust placed in a system of cryptographic proof.

This implies the destruction of the monopoly on money held by banks and states, and the empirical demonstration that a group of people who don't know each other, who have no contact with one another, and who don't even share the same interests or ideology can generate consensus through a sufficiently robust technology and properly aligned incentives.

Can a Bitcoin "oligarchy" emerge?

While Bitcoin is a decentralized network, the fear of centralization has always existed and is a problem with many nuances. In principle, one might suspect that the developers who update, write, and maintain Bitcoin's code could have special power over the rest of the community. But the truth is that each change may or may not be accepted by the community, since for it to be applied, each node must update the full version of the Bitcoin Core software. In that sense, a change that doesn't have sufficient network consensus can be rejected.

On the other hand, the greatest risk of concentration lies on the miners' side, since Bitcoin can maintain its autonomy as long as all nodes maintain cooperation. There is the possibility that the network could suffer a type of attack known as the "51% attack," in which someone who manages to concentrate more than half of the network's hashpower could rewrite the blockchain at will. The risk that a mining pool could achieve that amount of hash power is real, although if it did, it would be attacking, and therefore destroying value in, the very network in which it is invested. Therefore, it would be a kind of self-destruction.

Other possible candidates for being "bitcoin oligarchs" are those users who mined or bought many bitcoins when they were worth almost nothing. These users are known in the jargon as whales, and for a long time, the movement of their funds caused great tensions in bitcoin's price. As the network grows in users, the power of whales diminishes, but they remain a factor that must be taken into account. Despite the possibility that a person or group of people could "seize control" of Bitcoin, it's important to understand that the network's greatest asset is consensus, and anything that threatens Bitcoin's consensus will affect its price. Therefore, all actors have a very strong incentive not to take measures that could destroy the network's trust.

What sets it apart from other cryptocurrencies? Is there competition among them?

As the first cryptocurrency, bitcoin has a singular prominence. It has been around the longest, is the most well-known, and has survived the most challenging moments. Additionally, it has several elements that encourage its growth, among them the price peak at $20,000, which could be surpassed. There are thousands of new cryptocurrencies, but few truly contribute something unique and significant to the space.

Ethereum, for example, is currently the most popular platform among developers interested in blockchain, since it is not just a cryptocurrency but a decentralized computer with the ability to execute immutable computer programs known as "smart contracts." More than competition, the emergence of projects different from bitcoin, with other scopes and goals, strengthens the space, provides alternatives, and allows for solutions that perhaps cannot be executed as easily in Bitcoin's software.

What consequences could it have for states?

At a minimum, states will have to learn to deal with these technologies and understand that their citizens will start using them in their daily lives. At a maximum, the state would lose control of its monetary system. This perspective, fueled by some libertarian utopias, is highly exaggerated, because too many things would have to go right in the cryptocurrency ecosystem (and states would have to do nothing) for that situation to become real.

Already today, the measures required of crypto exchanges (also known as exchanges or brokers), such as KYC (know your customer) and AML (anti money laundering), function as a good tool for regulating trade between state money and crypto assets. The conversion from fiat to crypto is the bottleneck where the state can intervene and obtain some type of benefit. A ban, on the other hand, pushes users to operate entirely in the black market and in cash. With the emergence of the digital renminbi, also known as the "crypto yuan," China is leading the way among states seeking to create their own cryptocurrency to compete with, or cushion, the impact of this technology. Currently, 65% of bitcoin mining comes from China.

Why can't it be used for everyday transactions?

This depends a lot on the technology and the price. While in its early days bitcoin was used as a means of payment, there were some issues that made it quite inconvenient. The issue is that only one block is validated every ten minutes, and the block size limit allows only three transactions per second, which limits the system's capacity and makes it inefficient if we think about purchases or sales at places like coffee shops, grocery stores, produce stands, etc. Nobody is going to stand there waiting for their transaction to be validated. Additionally, there's the problem of transaction fees.

While for a transaction of, say, two bitcoins the cost is negligible, for small transactions (remember that one bitcoin can be divided into up to 100 million units) the fee could exceed the value of the transaction. In that sense, there are several proposals to solve this and turn bitcoin back into a means of payment. The most interesting, which uses Bitcoin's own blockchain, is called the lightning network, a protocol that operates on a second layer of the blockchain and allows the creation of payment channels in which thousands of payments can be made in seconds at no cost. The only payment would be made when the channel is closed and would be equivalent to a normal network fee.

Are cryptocurrencies a kind of radical tax haven?

When we think of tax havens, we refer to a geographical location with a legal-administrative structure that allows companies, families, organizations, or individuals to keep their capital out of reach of the government of the country where that money was generated. Panama, Malta, small islands, sometimes paradisiacal, and even US states like Delaware or New Mexico can fall into this category. In fact, the expression in English is tax haven and not "paradise."

In this sense, cryptocurrencies function similarly. One can store their purchasing power outside the control of states, although this has some somewhat stronger implications. First, the money kept in a tax haven is fiduciary money; on the other hand, those who access this type of jurisdiction have a legal and economic structure of certain magnitude to achieve it. While states claim to be against them, the largest tax havens on the planet are jurisdictions of the European Union, the United States, and the United Kingdom. Which doesn't fail to draw attention. In the case of cryptocurrencies, they are open to any citizen, whether or not they have a legal structure, whether or not they are part of the wealthy who typically move their money to tax havens. And on the other hand, the purchasing power stored in cryptocurrencies is not in state-printed money and never was. In that sense, it's very similar to buying gold: gold is scarce, its quantity is not controlled by the state, it cannot be issued at will, it withstands the passage of time, etc.

What Bitcoin allows, to give an example, is obtaining the same characteristics of a store of value like gold but with some advantages: it's easier to transport, it doesn't require physical interaction with anyone, and it's resistant to any type of state "censorship." In that sense, Bitcoin represents the possibility of completely exiting the economic scheme controlled by the state, politics, and banks. It is a total "outside" of the banking and state system. And it can be accessed from a computer or phone that fits in your pocket.

Ultimately, it is much more than a tax haven, because it even exists outside the power relationships between banks and states. It is, in some way, a total democratization of banking, since the need for an intermediary to transfer value to any part of the world is completely eliminated. One could say it is a radical form of money controlled by its users.

What consequences could it have for democracy due to the complexity of its use?

The main challenge that bitcoin and any cryptocurrency represents, as we mentioned above, is the threat to the monopoly on money issuance that states currently hold. As became clear in the 2008 crisis and now with the pandemic, Wall Street, banks, and other financial institutions are too big to fail. The collapse of the banking system would also be the fall of the governments in power and a turning point for any democracy.

Those of us who lived through the 2001 crisis in Argentina could see this firsthand. Sustaining the current banking system means increasing the circulation of money, through printing, credit, bonds, etc. The only way ordinary people have to protect themselves against these increases in the money supply is by buying gold, cryptocurrencies, or other types of assets. In this sense, for the first time in years, ordinary people have a tool to protect themselves from bad economic policy decisions on one hand, and to challenge the financial status quo on the other. In the case of failed economies like Venezuela, for example, bitcoin functioned almost as an oasis for those who could access the cryptocurrency through transfers from abroad.

In this sense, Bitcoin could be considered a radical version of the independent central banks system, in line with what Milton Friedman proposed, where the amount of money is completely separated from political needs. It remains to be seen whether a system with these characteristics allows the economies of peripheral countries to grow. In principle, there would be nothing structural preventing democratic governments from existing without total or partial control of their monetary policy.

Regarding the issue of usability, today Bitcoin is still in a fairly early stage. If we consider the transition that the internet underwent from being just a system for programmers at US universities to becoming the largest global communication platform in just 40 years, we can grasp the magnitude of the process that cryptocurrencies must go through. Today, any child who can't read can pick up a phone and open YouTube without a problem. Although parents attribute this to a special intelligence in their children, in reality it was the interface designer who achieved this. What I mean is that as a technology evolves, so does its interface, which becomes increasingly simple. You don't need to know how the internet works to use it, or know the bit transfer rate to watch a movie on Netflix, or understand the details of the TCP/IP protocol to send an email. This is precisely because of the evolution in what is now called "user interface" and "user experience" (UX/UI).

What Bitcoin really needs to become even more "democratic" is to eliminate, as much as possible, the level of knowledge required to operate on the platform. Nowadays, while there are very simple bitcoin wallets for smartphones, the process of converting bitcoins to fiat currencies and vice versa remains quite friction-filled.

But this problem will likely be eliminated over time, and the importance of cryptocurrencies will stand out even more when most of the world's money becomes digital. When nearly the entire population replaces cash with digital money (fiduciary, state-issued, and centralized), the adoption of bitcoins will be much simpler and, moreover, many will prefer to hold anonymous digital money.

The now widely popular QR code payments, which require almost zero understanding of the technology behind them from any user, were born with Bitcoin wallets. Anyone can send and receive bitcoins from any phone using QR codes. In that sense, what remains to be polished is the friction involved in acquiring new units. Something that, little by little, is starting to happen on a global scale. In October 2020, digital payments company PayPal announced it would soon integrate Bitcoin into its wallet. The Cash App (a kind of American Mercado Pago owned by Jack Dorsey, CEO of Twitter) has allowed bitcoin trading since late 2018.

This article was originally published in Nueva Sociedad (November 2020). It is reproduced here with the author's permission.