Bitcoin and cryptocurrencies - Hype or hope about technology
- Bild-Infos
- Download
In this article we will discuss further about Bitcoin and cryptocurrencies
Bitcoin and cryptocurrencies - Hype or hope about technology
To better answer this, we first have to understand what cryptocurrencies are and how they work. Therefore let us look into the technical as well as commercial aspects of cryptocurrencies. Let us start with the technical aspects in orderto answerour question of hype or hope.
A Cryptocurrency is a currency consisting of digital coins that are managed on a blockchain. As the name implies, a blockchain consists of blocks, that are created in a fixed interval, building a chain. Each block contains a set number of transactions. For each transaction that you run on this blockchain, you have to pay gas fees. Those are the prices you pay for the costs of processing your transaction and saving it on the blockchain.
One argument for blockchain transactions often is the distributed ledger technology. It is argued that trust into institutions is replaced by trust into the distributed ledger technology. Cryptocurrencies are therefore often described as decentralized. But a misconception is the difference between decentralized and distributed.
A decentralized system means the control and power is distributed between different instances, but there is still a hierarchy between nodes. Distributed system means every node on the blockchain is equal, so there is no hierarchy at all. Often people talk about decentralized systems while they mean distributed systems. In general Cryptocurrencies can be divided into two categories. The first are stable coins. Those are coins linked to a currency or a bundle of currencies with a fixed exchange rate to these currencies or a pool or basket of assets/goods. They can be created at any time to keep up with market changes. Furthermore, these coins are backed up by collaterals.
Those collaterals might be fiat money, gold/silver, other cryptos, etc. This makes them a great means of exchange. As for the second category, those are the volatile coins. Their exchange rate to normal currencies can fluctuate. This is the more prominent group of coins, including Bitcoin and Ethereum. But how are they created and are there any differences?
The first thing that comes to mind is “mining”. And for the most currencies that is true, but the mining can differ depending on the underlying consensus algorithm. Obviously, here the issue is somehow someone has to decide which transactions are saved in the next block and which are not. There is only limited space and there may be more transactions waiting than there is space in a block. That’s what the different algorithms are for. The most well-known are probably Proof of Work and Proof of Stake, but also Proof of Space and other possible algorithms can be used for that.
Bitcoin as the most popular cryptocurrency uses Proof of Work while Ethereum switched from Proof of Work to Proof of Stake. Proof of Work means each miner will get rewarded for the work done. In the case of Bitcoin that means each miner chooses transactions from the pool of transactions waiting to be saved on the blockchain. Then the miner will calculate the hash of his block plus the hash of the previous block plus a number.
You can imagine that as solving a mathematical puzzle to determine the place of the transaction in a library. This will create a very unique number that would change should one of the transactions or the hash of the previous block be changed. Because the hash of the previous block is also changed if a transaction in that block is changed it builds a chain, protecting previous blocks from being changed later. Now a winner from all the miners has to be chosen.
For example, this is done by deciding on the number of zeros the hash has to start with and a miner with a fitting result can then publish his result to be verified by the other nodes in the blockchain. The block of transactions the miner assembled is then written onto the blockchain and the miner is rewarded with coins. This can be a very expensive process with high power consumption though.
Proof of Stake on the other hand decides the person to choose the next block based on that person’s number of coins and maybe other factors depending on the coin. The more coins you possess, the higher your chance to be selected as the so called “Validator”. That makes this process more efficient, but a miner needs to have a minimum amount of Ethereum to even be able to participate in the validation.
Now let us look into our hype or hope question from a technological angel.
Cryptocurrencies are facing a trilemma. They can only choose two of the three goals: Security, Decentralization and Scalability. Bitcoin for example has a low transaction volume with a lot of miners and validators. Bitcoin creates one block of 3000-4000 transactions every 10 minutes.
This means bitcoin cannot handle more than 4000 transactions every ten minutes on average, otherwise more and more transactions would pile up waiting to be written onto the blockchain. Because it has multiple miners and a lot of validators it is a slow process but decentralized and secure. It also solves the double spending problem by preventing the same coins to be used in two different transactions by only processing up to one of them.
But with miners gathering their resources together into pools and reducing the decentralization this may well become a problem as soon as a pool has 51% of the nodes. This poses the question if such a cryptocurrency or cryptocurrencies at all are viable alternatives to our current payment system which is secure and scalable but centralized. Bitcoin is not scalable enough to handle all international currency transactions, and Ethereum might not be safe enough (we all remember the DAO vulnerability in 2016). There are centralized privately owned blockchains that issue coins, which are scalable and secure, but they are centralized, then we are in the old centralized system again- with more transparency, but this additional transparency is for the owner of the blockchain only and not necessarily for you. So that crypocurrencies will be able to handle the international payment flow looks like an unfounded hope from todays perspective.
Another prominent issue is anonymity. Anonymity is often mentioned as a pro for crypto currencies which is somewhat right but basically false. Its basically impossible for any normal person to find out who owns how many coins, but for someone with insane amounts of resources, it is actually possible leading to Bitcoin and the absolute vast majority of crypto coins being more pseudo anonym than anonym. It is not us saying that but one of the biggest bitcoin buying platforms
In the end, it all boils down to the use cases. IT company Gartner estimated the cryptocurrencies to have left the “Through of Disillusionment” and is already halfway through the “Slope of Enlightenment”. And Smart contracts are already a very plausible use case nowadays. Though there might be more to come.
To sum it up, Crypto Currencies don’t hold much value right now besides speculation with the highly volatile crypto currencies, but there are real use cases, that further develop and create further quality of life improvements and innovation.
Other deciding factors on the way, Bitcoin might get attributed its value due to the creation process and to the fact that is is limited, however by creating ETFs or other products on it, the question is whether the argument of limitation is entirely true. In any case it is true only when you hold real Bitcoins.
And this leads us to the next question: Who is the custodian of that Bitcoin (or any other cryptocurrency). If you hold it on the platform it is in “hot storage” internet enabled and online, when you have it on your stick offline it is in cold storage. In cold storage you are the custodian, a function that normally a bank or wealth manager holds for you.
Cryptocurrencies exist only in digital form. Finally you will have a code enshrining the rights. There are no physical coins or notes to hold in your hand.
On of the main points why a permissionless blockchain is able to create crypto tokens that serve as a Cryptocurrency on the blockchain instead of using institutions and central bank created fiat money is the fact, that cryptocurrencies like Bitcoin are able to solve the double spending problem.
The Double Spend Problem describes the difficulty of ensuring digital money is not easily duplicated. In the traditional banking system trusted third parties such as banks prevent double spends by privately verifying each transaction. In contrast to the traditional system with trusted third parties like banks and notary pubics, the system is decentralized or distributed and every Bitcoin member is part of the verification process. The Bitcoin Network prevents double spends by creating a mathematical puzzle for each transaction (to find the next block) and this math puzzle has to be verified by every member of the Bitcoin community. This process is called proof of work and is quite energy intense.
Therefore some parties in other crypto currencies – like Ethereum - have moved to proof of stack, which we will explain in one of our next article. This way trust into a third party is replaced with trust in technology. For Bitcoin every member has to calculate the same result for the mathematical puzzle.
The market has developed further from crypto currencies to crypto assets, which can be described as electronic securities or in jargon security tokens. Finally – if liquidity is high enough to establish a real market price like for a security on a stock exchange – an investor should be indifferent whether he or she holds a security token or a share in her portfolio (lets leave the custody issue for a moment as there are professional custodians like banks who now offer custody services).
So every company today can decide about their go to market strategy be it in form of and Initial Public Offering of shares (IPO) or in form of an security token offering (STO). It is expected that over the next 10-20 years there will be a confluence of STOs and traditional shares which even could trade on the same market. The US regulator Security Change Commission SEC is currently segregating business at crypto exchanges.
Let us assume we are “Through of Disillusionment” and halfway through the “Slope of Enlightenment” as Gartner is putting it.
There is much more to say about Crypto Currencies and Crypto Assets and the pros and cons of crypto currencies and crypto assets. This article is written to shed some light into some myths existing about crypto. Finally we believe there is hope in particular when looking into Crypto Assets and block chain and cryptography as technologies. There are also rigorous protocols and protocol verification models currently established and there is appetite in crypto assets at least from institutional investors
Whether decentralized or distributed crypto-currencies are here to stay as an additional payment methodology – we believe so – but without exaggerating their payment potential and without going into the hype mode. As Gartner has put it: There is enlightenment on the way. Perhaps bitcoin and other cryptocurrencies are now beyond the crypto bubble, which behavioral economists have seen coming.
Let us have a fresh and enlightened look into the question whether crypto assets are fro you and also discuss pros and cons of cryptocurrencies and crypto assets in our forthcoming articles.
Karen Wendt
President of SwissFinTechLadies