Cryptocurrency, a Primer

By Whitman Knapp

Despite being a vast, all-consuming, front-page headline subject, crypto is still little understood. What started out as just one “coin,” the bitcoin, has now exploded with over 7,000 different coins in existence with a “value” of over $2.3 trillion. Coins such as Ether, XRP and Tether have now flooded the landscape. Further, the crypto world has now generated new layers of activity such as DeFi and NFTs. This paper is prepared in the hope of helping classmates who are trying to get their heads around this fascinating but extraordinarily complicated subject.

Because of the vastness and complexity of the subject, the place to start is at the beginning – in 2008.  In November of that year, a white paper was circulated to an email list of bank payment enthusiasts who were trying to figure out how to move money on the internet as seamlessly as information was then being moved.  The author(s) of the white paper was/were Satoshi Nakamoto and it was entitled “Bitcoin: A Peer-to-Peer Electronic Cash System.” In one of the best, long-running mysteries, the “real world” identity of Satoshi Nakamoto is still unknown.  As the title of the white paper implied, the bitcoin was a design to move electronic cash from one party to another without an intermediary – nothing more, nothing less – similar to moving information from one person to another via email. Person-to-person electronic cash movement had not been possible until Satoshi’s paper, due to the “double spend problem.” Sending cash electronically from one party to another did not prohibit the sender from sending the same payment to multiple recipients electronically.

To solve this longstanding problem, Satoshi used an elegant cryptographically-designed software program employing powerful cryptography created by scientists at Bletchley Park in England during WW II, and the development of the blockchain which came out of the Bell Labs in the 1990s. The program did not require any central authority (a bank) nor government body (the Fed) to avoid the double spend problem as is required by the existing payment systems. It also provided a degree of anonymity to users of the system. With no central authority and anonymity, the bitcoin gained immense popularity with the tech community, which was stinging from the collapse of the banking/financial system in 2008. If you could have a payment system which did not depend on central government or the reviled banking system, this was the wave of the future.

The bitcoin had an additional feature which attracted the attention of the financial world, investors in particular. This feature of the bitcoin software program was that bitcoins were to be produced in fixed tranches, in fixed time periods with a cap on the total number of bitcoins ever to be produced – 21 million – by the final year of production in 2040.  This feature was seen as making the bitcoin as an inflation-proof hedge, as good as gold. Despite the fact that the bitcoin was nothing more than a series of digits in a software program on a digital distributed ledger known as a blockchain, it became equated with gold.

While there are undeniably attractive features to the new electronic cash (no double spend, anonymity, inflation-proof), there was a big problem, too: Satoshi’s ingenious cryptographically designed software program, which enabled the bitcoin, was hugely complex to operate. With time, the realization came that the program is also massively energy intensive. To produce bitcoins in the number and frequency set out in the program designed in Satoshi’s white paper, and to store the underlying payment transactions in a cryptographically unalterable entry on the blockchain, computers were required to solve mathematical problems of increasing complexity, which could only be managed by increasingly powerful computing. In its earliest days, individuals, even members of Y’62, could set up “mining” programs on their computers and try to earn bitcoin by solving the algorithmic problems presented. Today, huge “mining farms” consuming vast amounts of energy are required to create new bitcoin.

The volume of bitcoin transaction in the early years was modest. The operational issues outlined above were just the beginning of issues holding back bitcoin adoption. The anonymity feature of the bitcoin drew in darker elements of society. As pornography was the key driver in developing the use of the internet, the drug trade latched on to the anonymity of the bitcoin and became its major early adopter.  Again, the anonymity feature attracted money laundering operators. Net/net what had been high-minded early features of the bitcoin, getting rid of the reviled banks and removing untrustworthy governments, quickly gave way to less salubrious element of society, and cast a cloud over bitcoin. Given this difficult start, how did we get to where we are today, with crypto a major subject occupying so much ink and attention?

The growth starts, I believe, with the adoption the word “crypto” for just about anything and everything which takes place in this space. As indicated earlier, the bitcoin joins two essential elements, cryptography and the blockchain.  Cryptography is well understood as the science of keeping information confidential (https://en.wikipedia.org/wiki/Cryptography). Blockchain is less well understood but is essentially a series of individual ledgers – just like the ledger for your bank account or a ledger for my bank account  – which are linked together by cryptography (https://en.wikipedia.org/wiki/Blockchain)  creating a computer-based distributed ledger system allowing information, in this case, digitalized currency – one version being the bitcoin – to move securely  from one ledger to another.

The growth was put on steroids by two additional factors. One is a massive number of incredibly bright young people drawn to this field.  I have had the great fun of attending “crypto” conferences since their inception (ca 2012), and watching the numbers of bright young people exponentially multiply, all trying to figure out how to use this technology in the public, mostly financial realm. One of the most satisfying elements of this trend was that these young techies were not doing it for their own enrichment. They were working on “open source” programs for the benefit of the community.

The second factor has been the growth of hyper liquidity in the financial markets over the past several years, and the “smart money” capturing the work being done by these bring young people for their own enrichment.  Massive amounts of money is pouring into crypto and the obvious result is that the value of crypto has been skyrocketing.

With these basics identified, this is the place to end an introduction.  The topic of crypto has metastasized across the financial, social, and political worlds, with each domain needing separate areas of exploration and understanding. It is quite remarkable that a single 2008 white paper by a yet-unknown author(s) could have sparked such a vast global dialogue.

 
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