This is part 2 in my cryptocurrency educational series.
⭐ Each part builds on the previous ones, so I suggest starting with:
Cryptocurrency 101 series (i.e., core principles and Bitcoin):
- Part 1: Why should I care? What’s in it for me? Why is crypto important (it’s about a lot more than just making money!)?
- Part 2: How crypto actually works, why Bitcoin is valuable (even if it’s just “made up!”), and what you should know about blockchains (the tech behind them and how they could influence the future of our world)
- Part 3: How the blockchain keeps running, where new Bitcoins come from (i.e., how mining works), and concerns about Bitcoin’s environmental impact
- Part 4: How crypto offers autonomy, why it can’t be stopped, and the value of decentralization
- Part 5: How to store and use cryptocurrency, some basic cryptography, how wallets work, identity management, and the future of democracy
- Part 6: Overview of the different types of wallets, which one is best for you, what to be careful of, and why a hardware wallet might be worth the investment
Cryptocurrency 102 series (i.e., intermediate principles, Ethereum, and other coins/tokens):
- Part 7: Ethereum (the #2 most popular cryptocurrency, and the one I’m most excited about), smart contracts, dapps, gas (and the high gas fee problem), Proof of Stake (PoS), and Ethereum 2.0
- Part 8: Coins vs. tokens, and some real Ethereum use cases—oracles and DEX’s
- Part 9: Intro to NFT’s (collectibles, research funding & historical significance, and music)
- Part 10: More categories of NFT’s (art, video games, virtual reality)
- Part 11: Wrapping up NFT’s (what you can actually do with them, upsides, downsides, risks)
- Part 12: DAO’s (organizations managed by algorithms, governance tokens, collective ownership, and the “network state”)
Cryptocurrency 103 series (i.e., advanced principles, investing):
- Part 13 (in progress): DeFi (decentralized finance): yield farming, liquidity staking, and more
- Part 14 (in progress): Investing (principles, leverage, indexes, risk/reward, and my favorite options for making money in crypto)
Part 2 Reading Time: 18 minutes
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What even is a currency? And, wait, isn’t Bitcoin just made up? Why is it valuable?
Let’s start with this: Why do you want money? At the foundational level, why is money useful?
Economists would say a currency does three things:
- You can use it to buy and sell things. This attribute is called a “medium of exchange” (it replaces the need to trade one good for another as in a barter system).
- You can trust that it will hold its value over time. This attribute is called a “store of value” (you can trust that if you put your currency in a vault for a year, it won’t be worthless when you come back to get it).
- You know that a lot of people (and companies) use it, so it will be commonly accepted out in the world. This attribute is called a “unit of account” (this gives things a common measure of value, meaning that the buyer and seller can agree on what price is reasonable for a good or service in a given currency).
And what shouldn’t a currency be?
Well, it wouldn’t work so well if people could easily make more of it (that creates inflation), and it wouldn’t make sense if it were hard to carry (e.g., giant heavy bars of gold).
So, a currency needs to be both rare and easily transportable. That’s why, long ago, things like seashells or gems were used as currencies.
Back to crypto.
To put it very simply, you might think of Bitcoin as a kind of digital gold that’s created and governed by software with very strict rules programmed in.
Bitcoin might only exist on computers, but it (roughly) meets all of the above definitions for a viable currency (there’s certainly some healthy debate in the community about the nuances of using Bitcoin as a medium of exchange, but let’s at least agree that—even if it’s not a perfect currency—it’s at least worth taking seriously).
Bitcoin is rare because there are only a limited number of coins that can ever be made—the creator programmed it that way, so it’s literally impossible to make more than a certain number—and Bitcoins are easily transportable because you can send them from computer to computer or smartphone to smartphone.
But isn’t Bitcoin just “made up?” Doesn’t it only have value because people say it does?
Well, yes, and that’s exactly the same as the ancient currency of seashells. They weren’t actually useful for anything on their own. They didn’t have inherent value.
They only became valuable because they were rare, easily transportable, and enough people believed in them.
So what about the belief piece?
Belief in Bitcoin has been dramatically increasing over the past two years. If it were only computer programmers telling everyone that Bitcoin is valuable, it wouldn’t be enough.
But, the more that high-profile, wealthy, powerful, well-established people and groups align with Bitcoin, the more credibility it gains. And that’s exactly what’s been happening:
- In 2020, PayPal and Square allowed users to easily buy Bitcoin right from their apps.
- In 2020, Fidelity Investments—one of the largest and most trusted wealth management companies in the world with nearly $5 trillion under management—started a Bitcoin fund for its wealthy investors.
- In April 2021, Fidelity’s head of digital assets said, “I think we’ve reached a tipping point… you’ve had the accumulated experience of now roughly 12 years of the bitcoin blockchain being operative since the genesis block in early 2009. And the pandemic, quite frankly, was a catalyst for institutional adoption, and specifically bitcoin and the narrative, or use-case, around digital gold.”
- In early 2021, Tesla invested $1.5 billion in Bitcoin and now allows you to buy their cars using Bitcoin.
- In 2021, well-known investors like Mark Cuban and Richard Branson have been publicly investing in cryptocurrency.
- In 2021, Visa is experimenting with allowing transactions to be paid off with cryptocurrency. I’ve even begun seeing their ads for credit cards offering rewards in Bitcoin. Earlier this week (May 2021), their CEO said, “this is space that we are leaning into in a very big way.”
- Update: On June 9, 2021, El Salvador became the first country to adopt Bitcoin as an official currency (legal tender), and citizens will even be allowed to pay their taxes in Bitcoin. Not only that, but to address environmental concerns, El Salvador wants to get into the Bitcoin mining game as well using 100% renewable energy from its volcanoes. (I’ll explain mining in a future post.)
Still not convinced?
100 years ago, people didn’t see diamonds as valuable.
Then, De Beers bought up all the supply and created an amazingly successful advertising campaign that convinced the public that diamonds should be associated with the rich and famous. Next, they convinced everyone that engagement rings should always be topped with diamonds. It worked, and all thanks to the power of belief.
Notice that an asset can be useful as a store of value even if it’s not a great medium of exchange.
Heavy gold bars might work fine as stores of value but be impractical as mediums of exchange. But, that fact doesn’t make them useless.
Some people originally imagined Bitcoin as a future medium of exchange. But the truth is that, over time, it’s evolved to be more of a store of value (more of an “asset” than a “currency”).
Because of its volatility and various technical issues (e.g., transaction processing speed, environmental impact from power consumption, etc.), Bitcoin itself is unlikely to ever be used for regular transactions like buying coffee. However, it’s still very likely useful as a store of value (similar to holding gold bars in a vault and waiting for them to go up in value over time).
In the meantime, other cryptocurrencies have been developed to be used as mediums of exchange (e.g., for buying that cup of coffee). It’s not clear yet which will end up working out the best (Litecoin, for example, is similar to Bitcoin, but its transactions are processed more quickly).
All this to say: Bitcoin is similar to a currency, but it’s more of an asset like gold.
So why do the prices of Bitcoin and other cryptocurrencies keep going up so much?
We’ll get into this more in a future post focusing on investing, but the short answer is this: supply and demand.
- If people believe Bitcoin (or whichever currency) has value (and that it will continue to have even more value), they’ll want to own it.
- As demand for that currency increases, the people who already own it are able to charge more to sell it.
- Therefore, with low supply and high demand, the price goes up.
In some cases—like with Dogecoin—the price is only going up because of either speculation (i.e., calculated risk-taking) or gambling (i.e., guessing that there’s a high probability the price will go up, even if you don’t understand why).
People who already own something like Dogecoin (e.g., Elon Musk) create hype so that the price will shoot up. Then, they can sell their holdings for a higher return.
In other cases—like, in my opinion, with the cryptocurrency Ethereum—it’s very reasonable that the price is rising so quickly. More and more people are understanding its value, and they can see it continuing to be even more valuable in the future. The price is rising so quickly because crypto has been risky and hard to understand; so, it’s taken a while for people to believe in it. Lately, though, the word has been spreading quickly, and big, institutional investors have been getting involved with large amounts of money, which rapidly pushes the price up (or down, if they’re trying to manipulate the market by spreading fear and uncertainty so they can get in at a better price point).
Ok, now we know what a currency is and why its price fluctuates. Let’s move on to the next important concept in crypto.
What’s a ledger?
A ledger is a record of transactions.
Imagine you run a business, and you want to keep track of everything people buy from you and what they paid. It’s important to keep a reliable ledger so you know how much money you’re making, where your money is being spent, etc.
But, paper ledgers can be lost or manipulated.
What if there were a better way?
Enter the blockchain.
A blockchain is a distributed ledger (i.e., a ledger that’s not just stored in one place).
Let’s say you only had one paper copy of your ledger, but your business burned down and you lost it. Say you restart your business in a new location. One day, a customer comes in to return something they say they bought from you a while ago. How do you know if they’re telling the truth?
Worse, what if one of your employees—or a hacker—has been secretly editing your ledger so they can steal expensive items by making it look like a customer purchased them?
A distributed ledger solves both those issues. The basic idea is this: Every single time a transaction is made with Bitcoin, it’s immediately checked and copied across the entire blockchain network.
That’s right, every single transaction for all time is recorded on the distributed ledger.
Say I try to buy a car with Bitcoin:
- The car owner and I each pull out our phones, and I attempt to send them the cost of the car.
- Whichever app I’m using to send my Bitcoin will first check with the blockchain (i.e., the Bitcoin network) to make sure I really have that amount of money available in my account.
- It won’t just check its own copy of the ledger within the app—it will check many other copies of that ledger that live on computers all across the world.
- So, even if I managed to hack the app on my phone and told it I had a billion dollars in Bitcoin, the blockchain wouldn’t be convinced because all the other computers would have an immutable record of the true history of all my transactions.
- Once it’s confirmed that I have enough money for the car, the money is sent to the car owner, and the new transaction is sent out to all the other computers on the network. In fact, literally every computer supporting the Bitcoin blockchain network will be notified that the money has changed hands from me to the car owner.
- By “every computer supporting the network,” I mean computer servers that people and organizations run 24/7 to keep the Bitcoin network running. Computers in that network are called “nodes,” and what they do is called “validating” and “mining.” More on this later.
What’s a cryptocurrency, then?
A cryptocurrency (like Bitcoin) is a digital currency where all transactions are stored in a decentralized way (i.e., public records are copied to many locations rather than being only in the hands of a central bank, government, etc.). Cryptocurrencies typically use blockchain technology or some other kind of security technology based on cryptography.
Cryptography (i.e., the “crypto” in “cryptocurrency”) refers to a series of techniques for ensuring secure communication, just like the secret codes and ciphers that were used during World War 2. It’s based on very complex math that’s incredibly secure.
Bitcoin is based on an encryption protocol called SHA-256. This cryptography is so advanced that it would take 0.65 billion billion years (yes, billion billion) for a supercomputer to crack it.
But what about quantum computers? Amazingly enough, SHA-256 is designed such that even quantum computers would have a hard time defeating it. They would either be no better than traditional computers at cracking the code or, at best, they’d be double as effective (i.e., they’d take 0.325 billion billion years).
Who knows what the future holds for tech advancement. But for now—and for as far as theoretical physicists can see as of now—crypto seems incredibly secure.
Where does all this lead?
Before we wrap up, I want to invite you to extrapolate forward.
As I explained, the Bitcoin blockchain is used to track financial transactions. And it does so in a way that’s incredibly secure and nearly impossible for anyone to change or censor in the future.
But what if the blockchain could be used for more than just financial transactions?
I’ll get into this a lot more when we discuss Ethereum in a future post, but here’s a preview for now:
As our world grows increasingly connected, people are more and more concerned about supporting companies that have an ethical reputation. A lot of people would much rather buy from a company that treats their workers fairly, keeps a green footprint, and can promise that their goods are ethically made (i.e., that the people they buy from down their supply chain have the same values).
What if we didn’t just have to take their word for it?
Imagine a future where all records are kept in the blockchain—not just a company’s sales transactions, but their entire supply chain.
If you’re someone who cares about fair trade and ethical sourcing, you could look back at their public, unforgeable records and confirm that all their promised ethical sourcing was legitimate every step of the way.
Remember the examples from Part 1 around how Bitcoin is being used in countries like Nigeria and Sudan.
Those were real, tangible examples of people using blockchain technology to dramatically improve their lives. To circumvent their governments’ oppressive laws and norms. To connect with like-minded people in other parts of the world and form partnerships and businesses.
Imagine where we could go from here: A future world without borders.
Now add in all the other technologies that have been racing forward:
- Increasingly-sophisticated smartphones
- Fast broadband Internet (and satellite connections to get online from anywhere in the world)
- The normalization in the corporate world of working remotely from anywhere (and thus highly-distributed teams)
- A brand new crypto-based financial system with easy payments and easy loans to buy property or start a business
- Nearly photo-realistic virtual reality (plus continually-improving video conferencing tech)
- And some other crypto-based functionality like “smart contracts” (similar to automated legal contracts) that I’ll get into in a future post
What does the future look like?
Imagine organizations and structures in the cloud (i.e., the Internet) that are similar to countries. People connected not by geographic location but by shared values and ideals. Guaranteed free speech, privacy, and the protection of private property from seizure by corrupt governments.
(P.S. If you’re thinking of the common claim that Bitcoin is mostly used to hide illegal activities, here’s a former CIA director saying he was surprised to discover that there’s “probably less illicit activity in the Bitcoin ecosystem than there is in the traditional banking system.”)
Don’t worry if it’s not at all clear to you yet how blockchain tech could form the foundation of future cloud-based “countries.” It’s a big leap to make, but I wanted to paint a picture for you early on of the potential scope of change we’re talking about here. And as you continue reading this series, hopefully more pieces will fall into place for you—especially once we begin exploring the cryptocurrency Ethereum in Part 7.
Finally, if this kind of exploration of a more utopian future is exciting to you, here’s a very interesting article by the brilliant former CTO of Coinbase (and partner at venture capital firm Andreessen Horowitz), Balaji Srinivasan, on futuristic “network states.” And here’s another one by him on how, as the United States is declining as the dominant world power, something new based on crypto could replace it.
At this point, you might be wondering how all this tech actually works in practice. What keeps the Bitcoin network running? Who’s paying for all this? Find out in Part 3: How the blockchain keeps running, where new Bitcoins come from (i.e., how mining works), and concerns about Bitcoin’s environmental impact.