If you’re ready to invest better, Global Future Capital Stock Advisor can help. You don’t need a degree in Finance to grow your wealth. You just need a few minutes a month, and some great stock recommendations – and that’s what we’re here for.Read more
The history of cryptocurrencies dates back to the early 1980s, in which cryptographer David Chaum created an anonymous, cryptographic and electronic form of money. This was called ecash, and was later implemented through the Digicash framework, which allowed the digital currency to be untraceable by the issuing bank, the government, or any other third party.
Although further research preceded cryptocurrencies following these developments, they did not reach a point of prominence until the early 2000s.
Specifically, in 2008, the world witnessed a severe financial crisis: banks faltered, businesses collapsed, and hundreds of thousands of people were in severe financial predicaments; unable to pay off houses, loans, and other investments.
It was around this time that cryptocurrencies came to the fore.
Based on a phenomenon known as fractional reserve banking, banks are legally permitted to spend up to 90% of their client’s money at any given time. Put differently, banks are required to keep only 10% of their clients’ money on hand as financial reserve. The other 90% is spent on other investments (loans to new clients etc).
In the years leading up to 2008, banks around the world (especially in the United States) used up to 90% of their liquid capital to, amongst other things, bet on “high risk subprime mortgages”. These can be understood as housing mortgages that were taken out by borrowers who were from the onset not likely going to be able to repay them.
Because it was so easy to acquire a mortgage, the housing prices had become sharply inflated, and as such meant that the already ‘weak’ borrowers had even less of a chance of being able to repay the mortgage.
Eventually, the unsustainable cycle of mortgages and loans imploded. The mortgages were defaulted on (couldn’t be paid back), and the inflated value of the homes started to collapse. Consequently, banks were left holding on to a broad range of assets that amounted to far less than what had originally been lent out.
Remember that 10% rule mentioned in the beginning? Normally banks are able to survive with such a low liquidity percentage, but because they now had nothing close to the amount of money that customers had given them, they experienced what is known as a ‘liquidity crisis’. A ‘liquidity crisis’ can quite simply be understood as a shortage of available, on-hand cash and capital.
For example, Bear Sterns, a prominent bank at the time, had a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in assets, many of which were entirely illiquid and potentially worthless. Eventually, investor and lender confidence in the bank was diminished entirely, and they had no choice left but to call the Federal Reserve to begin the process of being ‘bailed out’ and rescued.
This pattern began to compound and multiply across other banks, investment firms and insurance companies, resulting in bankruptcy, general demise, and ultimately the ‘crash’ of the financial market in 2008.
Too big to fail
If we’re talking about how the financial system collapsed, it’s important to point out the scale at which banks have a grip on our financial markets.
In 2012, for example, Europe’s biggest bank- HSBC- was found guilty of facilitating money laundering of at least $881 million in proceeds from the sale of illegal drugs. Apart from that, they were also found guilty of moving money for Saudi banks tied to terrorist groups.
Following investigations by the U.S Justice Department, no HSBC executives were faced with charges for their actions. Rather, the bank was ordered to pay a fine of $1.9 Billion. Despite this seeming like a large amount of money, it only equated to five weeks worth of profit for the bank.
These kinds of stories illustrate a strong degree of power-imbalance within our current financial system.
The purpose of the above history is to provide context on the motivation for cryptocurrency. During the financial crash, banks and financial institutions around the world had to be “bailed out” by their governments, and therefore indirectly by taxpayers.
As a result, it started to become more and more clear that the modern financial system was not only untrustworthy and fragile, but perhaps even inherently flawed.
Thus, amongst other reasons that trace back to the research and interest in cryptographic technology, the desire for an alternative currency stemmed from a deep dissatisfaction for traditional banks and financial institutions.
Not only that, but cryptocurrencies also stemmed from a deep dissatisfaction with traditional Fiat currencies: the most predominant form of currency today.
Fiat currencies are currencies that were created by a national government, whose supply is completely controlled by a national government, and whose existence is predicated by citizens and institutions having faith in that government.
On October 31st 2008, a white paper was published that introduced Bitcointo the public. The primary premise of the paper highlights how the current model for electronic payments requires trust in a third party.
The paper then goes on to show that through cryptographic technology, that trust can be replaced with a mathematically sound solution.
Thus, the paper sketched a future payment system that doesn’t require the centrality of traditional banking and finance, nor one that requires collective trust in governments and traditional institutions.
Rather than going into the technical details of Bitcoin (we recommend reading the original whitepaper by ‘Satoshi Nakamoto’), understanding the coin is easiest when compared to gold.
If we look at the “best” aspects of gold, these are arguably its non-reliance on any central authority (no single entity controls the value of gold), its capacity for being transferred globally, and the fact that it is fundamentally scarce.
In simple terms, Bitcoin can be understood as a form of value that, like gold, is inherently scarce and needs to be ‘mined’. By allowing code and number sequences to continuously run, specific mathematical equations are solved, resulting in Bitcoins eventually being ‘unlocked’.
In line with its limited supply, Bitcoin is designed in such a way that as its’ supply shrinks, it becomes harder and harder to mine.
Throughout the last year within the crypto and Blockchain space, the nature of ‘cryptocurrency’ has become increasingly complex. Some coins exist as utility tokens, and others as security tokens, with various definitions existing for both.
With the objective of providing a basic introduction to cryptocurrencies, let us proceed with understanding how cryptocurrencies work based on their ‘original’ purpose, namely that of facilitating digital transactions (we can dive into their other use cases in another article).
The idea of ‘facilitating digital transactions’ may still seem somewhat vague, so let’s be more precise: through cryptocurrencies, people are able to transfer value between each other in a direct manner, similar to a cash transaction.
Let’s clarify that with an example:
Imagine James, Mary, and John: three friends that spend a Friday night at the movie theatre. Mary pays for John’s movie ticket at the counter (in cash), and John wants to pay Mary back at the end of the night. This process could occur through a cash payment (John physically handing Mary the owed money).
Alternatively, if John doesn’t have any cash on him, he might decide to use his online banking app to pay Mary back ‘digitally’. For this, he would need to provide his bank with the amount he would like to transfer to Mary, as well as Mary’s bank details, where the money will be registered within a few days, hours or minutes (depending on which part of the world you are in).
The bank therefore plays a central role in the transaction, registering the money going out of John’s account, as well as the incoming payment in Mary’s account.
What makes this central role of banks so important?
This role by banks is crucially important because it prevents something known as a Double Spend Problem: Because digital money is like a file stored on your computer, it is easy for somebody to simply “counterfeit” it by copy and pasting the transaction, resulting in John making the payment to Mary twice.
Banks prevent this Double Spend Problem by keeping track of the money in everybody’s accounts, ensuring that nobody makes the same payment twice.
With cryptocurrencies, however, John is able to transfer the movie-ticket money to Mary without having to facilitate the transaction via a bank.
This is because cryptocurrency and its underlying infrastructure, is one of the first forms of technology able to solve the Double Spend Problem whilst having central third parties (such as banks) cut out of the equation.
In simple terms, cryptocurrencies like Bitcoin operate using distributed ledger technology. For the sake of simplicity, a ‘distributed ledger’ can be understood as nothing more than a ledger that is shared. In other words, it is still a system for managing transactions within a particular system.
Thus, a Blockchain ledger is sort of like a traditional accounting ledger that keeps track of balances and transactions between users within a system. The difference, however, is that Blockchain ledgers are generally public and decentralized.
In a decentralized (Blockchain) network, there is no central server (such as a bank) to validate and legitimise transactions between peers. Rather, every entity within the network is given the responsibility of doing this job.
In other words, every peer or user within a network has a list with all transactions to ensure that all transactions are valid and that double spending does not occur.
With this in mind, let’s briefly wrap up the story of James, Mary, and John:
If John decides to pay Mary back for the movie ticket in cryptocurrency (the particular coin is irrelevant, but let us pretend it’s called MovieCoin), then the following would occur:
The steps above, although highly simplified, form the underlying basis of every transaction with predominant cryptocurrencies such as Bitcoin, Ethereum, etc. By “transaction”, keep in mind that this includes every cryptocurrency trade.
After the above processes have taken place, the transaction between John and Mary is set in stone. It is not reversible, cannot be forged, and is part of an immutable record of historical transactions.
Let us go a little deeper into this, shall we?
Now that you hopefully understand the basics of cryptocurrency transactions, you might be wondering when these transactions occur. On the one hand, cryptocurrencies are used to buy and sell goods and services.
A more popular use case for them at the moment, however, is trading: using either Fiat or cryptocurrency to buy and sell more, different cryptocurrencies, benefitting from the price differentiations and appreciations between tokens and coins.
Although cryptocurrencies still find themselves in a phase of infancy and early development, they present immense potential. Specifically, cryptocurrencies have the potential to be used as safer, more private value storage mechanism. At the same time, they’re able to facilitate transactions in potentially more efficient and affordable ways.