Still Don’t Understand Cryptocurrency? Start Here.
Part Two: Money for People with Trust Issues
In part one of this series, I explained why trust is so critical to any workable system of money. We trust money because we trust the institutions behind that money. And among the world’s currencies, the U.S. dollar is the most trusted because of its unusually strong institutions.
That trust took a hit during the great financial crisis of 2008, which came after years of gradual erosion of trust in institutions broadly. The crisis was a turning point for many people, who had become fed up with the financial system’s imperfections.
With the government bailing out the very banks and other financial firms at the heart of the financial crisis, and leaving homebuyers on the hook for underwater home mortgages, it appeared the government was working against its citizens.
Bitcoin, which launched early the following year, in early 2009, was expressly designed to solve this problem of trust in the financial system.
Let me explain how it works by comparing a simple transaction—buying a book at the local bookstore—using traditional money and using crypto.
A Transaction Using Traditional Money
With traditional money, you might pay for your book by swiping your credit card in a card reader. The reader sends an electronic request to the bookstore’s payment processor and to the bank that issued your credit card.
The credit card issuing bank makes sure the card is valid, that it’s allowed to spend money, and that there is enough credit or funds to complete the transaction. If the answers are yes, the bank authorizes the sale. It also assigns that amount to that transaction and reserves it, so that money can’t be spent twice.
You have your book, and the bookstore has a promise from the system that it will be paid. That night, the banks and card network settle—the bank transfers the money to the bookstore, and transaction fees are subtracted.
You and the bookstore owner trust that your bank and the card network will correctly keep the official record, approve correctly, prevent double-spending, and make the bookstore whole.
Image created wih ChatGPT
A Transaction Using Cryptocurrency
In a transaction using crypto, you might pay for the book by opening a wallet app and entering or scanning the bookstore’s address and the sale amount. This creates a transaction message with a tamper-proof digital signature that proves the payment was authorized by the sender. The network (or your exchange, if you’re using one) then checks whether the funds are actually available and unspent, and—if that’s true—records the payment.
This message is sent to a network of computers that check your message: Is the signature stamp authentic? Do you really have the sale amount available? Now, one risk of any digital currency is that it’s possible for the system to be tricked into accepting two or more payments using the same funds (called “double spending”). For example, you pay the bookstore and Amazon with the identical funds for one book from each vendor. You get your books, but the network rejects the second transaction—that money was spent in the first transaction—and that rejected vendor is out of its money.
So this network of computers also asks a third question: Have you already spent these funds somewhere else? If the computer network determines that you really do own enough of the cryptocurrency to cover the sale and it hasn’t been spent elsewhere, your transaction is considered valid.
There’s just one more step: the computer network must add your transaction to the shared public record. This allows other members of the network to “agree” that the transaction has happened.
This is accomplished through a competition to solve a code-based or “cryptographic” puzzle that’s embedded in the cryptocurrency transaction. This is where the “crypto” in cryptocurrency comes from. The first member of the network to solve the puzzle gets to add the transaction (along with a batch of others) to the shared record. The winner is paid in Bitcoin.
A Very Different Kind of Money
That was a lot, so let me recap how radically different the crypto transaction is from the traditional transaction:
Instead of trusting in banks and other financial institutions, cryptocurrency transactors rely on a public network of many individual computers to compete in solving mathematical proofs—and to identify invalid transactions. (There’s a big incentive to the solvers: rewards and fees, often in that network’s crypto coin.)
Transactions aren’t recorded on thousands of individual private ledgers at different financial institutions. Instead, they are kept on a shared record available to anyone in the computer network.
On the public record, all transactions are pseudonymous—no names are shared. In the world of crypto, “ownership” is defined by whoever the record indicates is the latest rightful owner.
Because there are so many participants in the network and because this is all done in public, it’s extremely difficult for someone to double-spend their crypto, or to fraudulently rewrite this public record once it’s widely accepted by the network.
Some cryptocurrencies such as Bitcoin have rules limiting the issuance of new coins. Changes to those rules require broad agreement. This protects currency owners against the risk that their currency becomes devalued.
Crypto doesn’t necessarily get rid of intermediaries or fees. In practice, those who make cryptocurrency transactions often pay network fees, using exchanges that look a lot like financial institutions.
Nevertheless, crypto seems to do exactly what “a leading figure in the Bitcoin movement” (and possibly the creator of Bitcoin) proposed almost 10 years before Bitcoin was launched: to create
“an electronic cash system ‘entirely disconnected’ from modern banking that would have [five] key attributes: It would preserve the privacy of both payer and payee; it would be distributed across a network of computers to make it hard to shut down; it would have some built-in scarcity to prevent excessive inflation; and it wouldn’t require trust in any individual or bank, [and would provide] a publicly verifiable protocol.”
So that’s a very simple explanation of what cryptocurrency is—a fairly new and revolutionary answer to the problems of traditional money. But the original question remains: is crypto really money? And why would we want to invest in it?
I’ll take up those questions in the final part of this series.