Have you ever thought –“If all things around us are getting digitized, why hasn’t money been digitized so far?”
This might sound sort of easy on paper, but in reality, it may cause a lot of problems. People can copy this money as a document file, create torrents and create as many copies as they want, eventually making the system inefficient and inflationary.
Now what if I tell you that there already exists a mechanism mechani via which digitization of money is possible at scale, while money still holding its underlying intrinsic value. The system here I'm referring to is
“BLOCKCHAIN TECHNOLOGY”
In today’s blog, we are going to decomplexify and explain how and why cryptocurrencies are valued so much and the working behind this highly-hyped asset class. Understand Why are these so valuable and how do they actually work?
EVOLUTION OF CURRENCY
In order to understand the revolution of cryptocurrencies, let us first understand the fundamental features of money and its evolution over the years.
Historically, currency has been a medium of exchange of value. Now, the value exchanged was once in the form of grains, livestock etc. Eventually leading to metal coins and finally the paper currency that we know today!
Over the centuries, the reason why currency has been in use as a mode of exchange by the people, is because everyone collectively agree upon the fact that commodity exchanged is valuable and has some value with it. Without this collective belief in the currency, paper notes are merely pieces of paper for people.
Although, it might seem that the current system of currencies is the most efficient system we’ve found, concurrently, this system has few key drawbacks attached to it.
The system of currencies we currently are using, primarily-is centralized, that basically implies that an authority namely, government of various nations or even banks predominantly, control the exchange of money.
Theoretically or even in reality (in some cases-Turkey, Pakistan, Venezuela), the governments have printed huge amounts of notes, way out of the proportion, eventually devaluing these currency excessively.
From the example of Turkey and Venezuela, the concept of trusting some authority is questionable, don’t you think? The government along with banks dominantly and run the current money system and god forbid, the entire currency system could even collapse due to their mistakes (2008 Financial Crisis, Turkish Economic Crisis).
Another fundamental problem with our system of money is its inflationary nature, nontransparent functioning (banks) and even a few issues related to security of the money deposited with them.
These are the fundamental problems which blockchain technology and decentralization solves. Blockchain technology is the new revolution in terms of technology, which will reconstruct the financial and economic structure.
Source: - Ecofinlysis
Working of Cryptocurrency
Cryptocurrency works on the technology or algorithm of blockchain. From the word itself we can derive two words- block and chain.
Blockchain refers to a decentralized ledger of all the transactions that take place across a peer-to-peer (p2p) network. Each block in the blockchain represents a p2p transactions taking place between different entities. This implies that blockchain is chain of different blocks, in other words, the thread of different transactions.
A block stores different information about transactions between people, such as who is sending money to whom, what amount of money is being transferred between them.
These blocks are circulated between various miners so as to verify whether a block added to a particular blockchain is valid or notice whether the transaction is valid or not. The reason being a person can enter whatsoever amount to be transferred, even though he might not have the balance of such money.(decentralize)
But, for any person or miner to validate and verify these transactions, they are obliged to know the balance a person has, thus requires information about all the previous transactions. So, they require records of previous transactions, i.e. thread of all transactions
THUS, CREATING A BLOCKCHAIN.
Suppose 3 people have 10 DIR (Digital Indian Rupee) each. Each block would contain the information regarding the people involved in the transactions and information regarding the balance of each of the entity involved.
The first block in a blockchain is known as Genesis Block, which has only 2 compartments. Apart from that block, there are generally 4 compartments to a block which are as follows:-
§ First Compartment contains the information about the entities involved in the transaction, the amount of money transferred, balance of each of the entity. Basically all the information regarding the transactions.
§ Second Compartment contains of Hash/Reference Number. Every block has a unique hash number and no two blocks can have the same number. This is like the fingerprint of the block. This is calculated on the basic of the information in the 1st, 3rd and 4th compartment. This is based on hash function, where the input can’t be calculated from the output.
§ Third compartment contains the hash number of previous block.
§ Fourth compartment contains the work number, which a person who mines cryptocurrency gets by solving the hash functions. Each block has unique work number, which determines the hash number of the block.
Now, a person can edit the information in the block to create more money for himself but this isn’t possible, thanks to cryptography and blockchain. We don’t just need decentralization, but we also need to make cryptocurrency easily accountable too.
For a person to edit the block, we need to ensure it would require lot of energy and work to do so. Due to which a person would be hesitant to change the blocks due to energy required to do so. This gives rise to concept of Proof of Work.
The Work Number in the fourth compartment determines the hash number. So for person to change the hash no to a particular one, they are required to randomly calculate the work number by solving complex mathematical puzzles to get the desired hash number. This requires a lot of computation power which requires huge amount of electricity. This known as process is known as mining.
The miner who mines the bitcoin gets some coins, and this is how new coins are introduced in the system. But this will make it an inflationary currency. But it has a mechanism which makes them dis-inflationary.
Bitcoin has the rule that the amount of coins introduced in the system by mining would half every 4 years.
In 2009--> 50 BTC, 2012--> BTC, 2016-->12.5 BTC, 2020--> 6.25 BTC and so on.
By 2140, mining a new block would earn a person 0 BTC. Thus, total number of bitcoin is finite to 21 million making it deflationary and digitally scarce. This is the main reason why people are hedging onto cryptocurrency.
By now, the end of this article, you might have understood as to why cryptocurrencies are hitting valuations of thousands of dollars. This is just introduction and quite a simplified version to understand the blockchain technology. A separate article would be made to understand the blockchain algorithm in depth with advanced explanation. Hope you liked this.
~ Shravan Lad
Founder
©2022 by Ecofinlysis.