The virtual currency revolution began on October 31, 2008, when an anonymous figure (or figures) known only by the pseudonym Satoshi Nakamoto published a white paper for a peer-to-peer monetary system that would exist solely in a digital format. The name of the currency would be called Bitcoin, a composite of the words “byte” and “coin.” It would run on a brand-new technology that was actually created for the purpose of supporting Bitcoin: blockchain.
At first, Bitcoin received little attention, if any at all. It was little more than a side interest of the technophile community. It had no commercial value and was not even tied to the dollar as having any monetary value at all. It was more of an experiment with the new blockchain technology to see if it really was viable.
On January 3, 2009, the Genesis block was mined, releasing the first 50 bitcoins into circulation and officially launching the Bitcoin blockchain. On October 5, 2009, a website known as New Liberty Standard published an exchange rate for Bitcoin: 1,309.03 BTC per dollar, or about .08 cents each. This rate was not based on how purchasing power one Bitcoin had, but on how much electricity was required to mine (or produce, or create) each bitcoin.
A week later, New Liberty Standard used PayPal to buy 5,050 bitcoins, placing the value of each at about .01 cent each. This was the first time that bitcoins were engaged in exchange against the dollar. On May 22, 2010, a man on the Bitcoin forum named Laszlo Hanyecz offered 10,000 bitcoins to anyone who would order him a pizza. A user who went by jercos took him up on the offer and ordered 2 pizzas from Papa John’s for $25.
This was the first time that Bitcoin was used commercially to purchase a mainstream well. Still, the virtual currency was limited to the technophile community. Few, if any, people in the general public had heard of it.
Slowly, Bitcoin began to obtain value as an actual currency. In April 2011, journalist Jerry Brito published an article in Time Magazine about Bitcoin entitled, “Online Cash Bitcoin Could Challenge Government, Banks.” In it, he described how this new currency was gaining a foothold among users and could lead to a revolution in the way that finance is done. This was the first time that Bitcoin appeared in a mainstream publication, and it led to a surge of increase in Bitcoin. Its value began to soar.
Since then, it has received much more exposure and attention, leading to many people trading in their dollars for Bitcoins. In December 2011, it was featured in an episode of The Good Wife, generating even more interest. Today, millions of people around the world use Bitcoins, and other types of virtual currency have spawned as part of the movement. But what exactly is Bitcoin, and what is virtual currency?
Fiat Currency vs Virtual Currency
When people think about currency, they usually think about money. In particular, they think about fiat money. “Fiat” means “faith,” and fiat money is money that is backed by the faith of the government that issues it. A look at the history of money will help you understand why this concept is important in understanding what virtual currency is.
Currency, in its most basic definition, is simply a medium of exchange. Imagine that you are back in kindergarten. Your mom packed you chocolate pudding with your lunch, and your best friend’s mom packed him strawberry jello. Today, you are tired of chocolate pudding and would much rather have his jello, so you ask if you can trade. In other words, he has a good that you desire, and you have something that you are willing to exchange for it. The chocolate pudding is the currency, or medium of exchange, that you are offering in exchange for the jello.
Your friend has the option of accepting that particular exchange or declining it because it is not a currency that he feels is valuable enough. While most kindergarteners are certainly not capable of expressing such an exchange in economic terms, they implicitly understand the concept: You have something that we want, and we are willing to give you something that you want in exchange for it.
This concept of currency is much, much older than the elementary school cafeteria. In fact, some anthropologists have posited that the use of currency is what sets humans apart from other animals and marked the advent of human civilization.
Consider how cities first began to develop: People began to develop agriculture because they had learned to do things like plow fields and irrigate them. No longer did everyone need to be out foraging and hunting for food; instead, they could rely on a group of farmers to produce food for a larger group of people. With the extra time that had normally been devoted to finding food, people were able to begin developing crafts and trades.
Some people made pottery, some people built houses, and some people became what we would today recognize as government leaders. So, these people who were no longer growing food and instead procuring other goods that could improve others’ quality of life, how were they able to obtain food from the farmers? And what were the potters to do with all of the ceramics that they produced, or the carpenters with all of the things that they built?
The answer is simple: They used currency in order to facilitate exchanges. Perhaps a potter needed so many bushels of wheat to feed his family, and a farmer needed large clay pots to store rainwater. They could agree on a certain medium of exchange so that both would be able to get what they needed. This exact same concept was portrayed in Harper Lee’s novel To Kill a Mockingbird. During the Great Depression, a poor family needed the legal services of Atticus Finch but was unable to pay him with money. Instead, they paid him with vegetables that they grew on their farm.
Why is this concept of exchange so essential to understanding virtual currency? Because currency does not only exist as cash that is printed by a government. Long before central governments minted their own coins, people were able to use the currency to make meaningful exchanges and thereby procure the goods that they needed.
As time went on and governments developed, they began to mint their own currency – coins, to become the established medium of exchange. This move was significant because it enabled governments to collect taxes. Collecting taxes based on how many vegetables a farmer grows in one year is a very cumbersome endeavor.
Officials would have to determine exactly how much he grew and take a percentage of that, in vegetables rather than money, to fund the government. But with a centralized monetary system in place, taxing citizens became quite easy. A monetary value could be applied to the farmer’s crops, and a portion of that taken as tax. In other words, the development of a centralized monetary system occurred so that governments could tax their people.
As civilizations grew, people began to trade with those outside of their own societies. Traders from ancient Egypt and ancient Greece traded with the Sumerians and Babylonians of Mesopotamia. Ancient Persians, in modern-day Iran, traded with the Chinese and those in modern-day Afghanistan. With multiple governments and therefore multiple monetary systems existing across vast geographical distances, determining how much a statue carved in Egypt would be worth in China was quite a challenge. And if an Egyptian merchant was traveling all the way to China to sell goods, he probably was not interested in getting paid in vegetables!
Imagine carrying tons and tons of vegetables all the way back from China to Egypt. There was a need for an international standard against which the value of goods could be determined. That international standard was gold. This is where the concept of the gold standard is derived: On an international scale in which many monetary systems are used, the way to determine the value of one currency against another is based on how much it is worth against an ounce of gold.
The practice of exchanging coins as currency carried on until the explorers of the Middle Ages set out to rediscover faraway lands. People who were wealthy would have to carry heavy bags full of coins just to be able to buy what they needed at the market. When Marco Polo visited China, he found that the Chinese people had devised a solution to this dilemma: banknotes. A central treasury held quantities of gold and other currencies, and in exchange, it issued bonds that were guaranteed to be worth a certain amount. The bonds themselves were practically worthless, only worth the value of the paper on which they were printed. However, whoever carried the bonds could take them to the bank that issued them and exchange them for coins.
When Marco Polo brought the idea of using banknotes back to Europe, the idea was laughable. However, in 1661 the Bank of Sweden began to issue banknotes in exchange for copper coins. Foreign imports of cheap copper had become so large that the value of copper coins against silver ones began to depreciate rapidly. In order to maintain the value of the copper coins, they had to get bigger and bigger. They soon became too heavy to carry around comfortably, so the bank accepted them on deposit and, in return, issued banknotes.
England became the first country in Europe to begin a permanent scheme of issuing banknotes. The Bank of England was established in 1694 to fund the ongoing war against France. In 1695, as part of the scheme to finance the war, the bank began issuing banknotes as a type of loan against the bank. Someone could deposit money, essentially making a loan to the bank, and be issued a banknote guaranteeing that the bank would repay the loan.
You may recognize the banknote system as one of cash. When you hold a certain denomination of cash, say, a twenty-dollar bill, that bill is worth virtually nothing on its own. However, the United States Treasury, the central bank that regulates the country’s money supply, guarantees its value. What the evolution of the cash system reveals is that it is actually a system of debt. People hold cash as a debt against their own government.
For almost 200 years, the value of cash was guaranteed against the gold standard. Banks were required to hold a certain amount of gold so that the value of the cash that they issued could be upheld. The value of the cash was connected directly to the value of gold. However, on August 15, 1971, President Richard Nixon abolished the gold standard. Banks were no longer required to keep a certain amount of gold in their vaults to guarantee the value of the dollar. As a result, the value of the dollar was no longer connected to gold. It did not have a fixed value but was rather worth what the government said it was worth.
The government now guarantees the value of the dollar without having any assets to back up that guarantee. Using cash that the government issues take a lot of faith! That’s why cash is now referred to as fiat currency. You have to have faith in the government in order to use it. If the government collapses, all of the cash buried under your mattress becomes completely worthless.
Today, the value of your money is determined completely by the government. If the government decides that it is in its own best interest to deflate the value of the dollar so that its own debt can be decreased, it will initiate policies that will actually cause the value of your own personal wealth to go down. If the government wants to raise the value of the dollar so that its tax revenue is worth more, it will initiate policies that will cause the value of your wealth to increase.
Bitcoin Enters. Bitcoin was created as a type of currency that could not be regulated by the government because it is not issued by the government. Rather than being issued by a central bank, it exists as a peer-to-peer network. Its value is not determined by government policies, like interest rates, but rather by the growing number of people who use it. It began a revolution in the way that people see their money.
As the name implies, virtual currencies exist entirely in a digital format. They are not issued as cash but rather are a series of complex computer codes. Despite the use of modern technology, they function much the same that currency did in its earlier days: they are a medium of exchange that two or more parties can agree upon.
Bitcoin and other virtual currencies are not worth something because a centralized government says that they are worth a particular amount. They are worth something because the individual parties who use them decide that they are worth something. In this sense, they are actually truer forms of currency than dollars or Euros or any other type of currency issued by a national government.
Now, will look at some features of virtual currency to help give you a better idea of what it is and how it is different from fiat currency.
Features of Virtual Currency
While virtual currency performs the same basic function as fiat currency, meaning that it can be used to buy and sell goods, it has some fundamental differences.
Virtual currency is decentralized. Most of today’s world is centralized. The clothes that you are wearing were probably produced by a multinational corporation that operates a sweatshop in a poor country, such as Bangladesh or Malaysia, that employs the people that made them.
Instead of being sold by the sweatshop so that the people who work in it can earn a living, they were probably shipped to a central warehouse owned by the company so that they could be distributed from there to retail stores across the United States. The store where you bought those clothes is probably just a hub of a larger franchise whose corporate offices are in a big city, like New York or Dallas. Long gone are the days of people sewing clothes and selling them directly for a profit.
The same paradigm exists for the food industry. Unless you buy your groceries at a local farmers’ market, they were probably produced on land owned by a multinational corporation, possibly in another country. Your bananas may have been grown on a Dole plantation in Ecuador before being shipped to a Dole warehouse in the United States, from which they were shipped to your grocery store. Those lands in Ecuador are not being used to meet the needs of the local people who live there but are rather exploited by multinational corporations so that food can be produced cheaply for people who are fortunate enough to live in wealthier countries.
Fiat currency is also centralized. It is issued by a central bank connected to a country’s government. For example, pounds are issued by the Bank of England, Jordanian dinars are issued by the Bank of Jordan, and dollars are issued by the United States Treasury. The governmental body that owns that bank is able to make policies that determine what the currency is worth. It can raise or lower interest rates, enact policies that promote imports over exports and vice-versa, and issue loans to citizens who wish to engage in particular ventures, to name just a few things. In other words, by enacting policies, the government is able to manipulate the value of the money that it issues.
Virtual currency works differently. It is like the farmers’ market, which produces local goods to sell directly to individuals without going through a third-party supplier. It operates on a peer-to-peer network, meaning that it is managed directly by the people who use it rather than by a governing body that circulates money for the primary purpose of collecting taxes.
Virtual currency is not issued by anyone central entity, so it cannot be regulated by any one central entity. Any policy changes have to come from a majority consensus of the individuals on the blockchain.
Virtual currency is trustless. Financial institutions, like banks, provide a valuable service. They keep your money safe, loan money, and provide a means for it to grow. For example, they issue loans so that people can buy a car or a home, or start-up their own small business. They collect interest on these loans, part of which is used to pay interest on people who have a savings account at the bank. However, they aren’t able to provide these services for free. They have to pay for their buildings, maintenance, upkeep, city taxes, employee salaries, cybersecurity, and other expenses. In order to cover those expenses and still make a profit, they charge fees.
Have you ever over-drafted your bank account? If so, you were probably charged a fee anywhere from $25 to $40 or even higher. You may have felt as if the bank was penalizing you for not having any money by charging you more money! High overdraft fees are one of the most profitable means by which banks are able to make money. They also make money from charging interest on loans; sometimes, the interest rate can be as high as 18%. A lot of your money goes to fund the bank!
Banks essentially act as middlemen, even more so now in our digital age. A middleman is basically a trusted third party that facilitates the movement of a good or service. For example, if you use your debit card to pay for something, the bank acts as a middleman to process the transaction. If you take out a loan to buy a new home or finish your education, the bank acts as a middleman to fund that loan and facilitate the repayment.
In order to use the bank, you have to trust that it is engaging in ethical practices and is managing its money wisely because its money is actually your money. But how do you know that someone high up the corporate ladder is not engaging in some corrupt practices that could end up costing you your life savings? You can’t.
For example, before Enron fell, it was engaging in highly unethical accounting practices that made the company appear that it had money that it actually didn’t have. People who had no idea what was going on behind closed doors lost large amounts of money. In order to use the bank as a middleman to facilitate your financial transactions, you have to trust it. As you can see, middlemen are expensive.
The virtual currency operates without a middleman. There is no trusted third party that is required to hold the funds and process a transaction. Instead, everything exists in an entirely digital form on a ledger that is visible to anyone who wishes to see it. Everything is entirely transparent, so if there is any problem at all, everyone on the network will know right away. They don’t have to trust a central entity to process their transactions because they are privy to all of the information involved in the transactions.
The result is that ethical practices are ensured all across the board, and the fees that are collected to process transactions are extremely small.
Virtual currency is anonymous. If you wish to open a new bank account or apply for a credit card, you will be required to provide quite a bit of personal information, such as your name, date of birth, social security number, average income, number of dependents, or education level. The bank or credit card company not only wants to guarantee that you will not default on any payments but must provide the government with certain information about account holders. In the event that, say, a government body wants to contact you, all it has to do is go to the bank with a warrant and will have immediate access to all of your personal information.
Many hacks and security breaches that have occurred to major companies involved the theft of the personal information of customers. For example, when Target and TJMaxx were hacked, the personal information of clients who held credit cards through those stores was exposed. Imagine if all of the information that your credit card company has on you fell into the wrong hands!
Virtual currency, on the other hand, is anonymous. You do not necessarily have to provide identifying information in order to use it. Some wallets and exchanges will require you to provide some level of identification, but the blockchain itself on which the virtual currency operates does not require any personal information. All that you need is a username and an email address.
The virtual currency operates on a peer-to-peer network. Virtual currency operates on a technology called a blockchain. Blockchain, for right now, is run through a system of nodes. A node is a computer that is connected to the network and has the entire program, including all of the transaction history of every user, downloaded. While this setup may sound like a complete violation of privacy, all of the information is encrypted. Personal information is not needed to join the blockchain, so the transactions that you make are not traceable to you.
However, the fact that everyone can see the transactions means that no one person or entity is able to manipulate the program or corrupt the data in any way. Instead of a central entity processing the transactions that occur on the network, such as MasterCard authorizing a purchase, everyone on the network has to authorize the purchase.
The peer-to-peer feature of virtual currencies goes beyond having thousands of computers involved in the process of verifying transactions. Consider the most basic law of economics: supply and demand. Put simply, the law of supply and demand means that the value of a particular good or service is determined by how much of it is in supply and how much of it people want.
For example, imagine that your local grocery store just got inundated with 10,000 pounds of sweet potatoes. That is a very big supply! The store has to sell off those sweet potatoes as quickly as possible before they go bad. Because the supply is so high, the store has to lower the price so that people who may usually buy one or two pounds of sweet potatoes will buy much more than that. It is lowering the price to increase the demand so that more people will want to buy sweet potatoes.
Imagine that a chipocalypse occurs and every store in the country runs almost completely out of chips. The supply is now very low, but a lot of people want chips. Because there are so few in circulation and so many people want them, the price will increase. Also, people will be eventually willing to pay more for them.
Something’s monetary value is determined by the law of supply and demand. However, the value of the dollar is not. Why? Because the government enacts policies to regulate its value, policies that artificially increase or decrease what it is worth. The keyword here is artificial because its value is only upheld by the government and not by the most basic economic principle. Virtual currency works differently.
The peer-to-peer nature of it means that its value is determined only through the law of supply and demand. The reason that the value of virtual currencies such as Bitcoin has been skyrocketing is that so many people demand it. There are only so many Bitcoins in circulation, and with more and more people wanting to buy bits of the cryptocurrency, its value naturally increases in the most basic economic sense.
The peer-to-peer nature of virtual currency means not only that thousands of computers are required to process transactions rather than one central entity, but also that its value is congruent with basic economic principles.
Virtual currency cannot be manipulated in any way. When one central entity is responsible for large sums of other people’s money, the people involved have to trust that that organization is not going to engage in practices that will cause them to lose money. However, the fact is that that entity can manipulate the money that it holds, even if it chooses not to do so. For example, imagine that you are investing through a Wall Street company that owns shares of a particular fund. The company will probably engage in practices that will increase the value of the shares that it holds, even if they do not necessarily mean that the value of your own investment will grow.
Consider also how the United States government is able to manipulate the value of the dollar. It can decide to decrease the amount of money in circulation by raising interest rates, and all of a sudden, you are no longer able to afford to buy the home that you were just about to close on.
Virtual currencies cannot be manipulated. This concept will become clearer as you learn more about how blockchain works. For now, keep in mind that every single transaction is visible to every single person on the network. If any type of foul play was going on behind the scenes, every single person on the network would know immediately.
Virtual currency is not printed but rather mined. One responsibility of central banks is to mint or print money. Huge sheets of metal are passed through machines that press out coins. Special paper blends are printed with the images and watermarks necessary to assure people that the bills were genuinely printed by the central treasury.
If the virtual currency doesn’t exist in cash form, how is it created? Couldn’t anybody go in and write a code to give themselves infinite amounts of virtual currency, just as if that person had a money-printing machine and was able to print endless supplies of cash? Yes and no. Yes, anybody can create a virtual currency, but the fact that a virtual currency was created doesn’t mean that it has any value. If nobody is using it (in other words, if no one demands it), then no matter how much is in supply, it is worthless.
Virtual currency is generated through a process called mining. A brief idea of mining is that transactions made using virtual currency are grouped together into blocks. In order for a block of transactions to be verified, the network generates a complex algorithm that has to be solved. The block and the algorithm are broadcast to the entire network, and mining computers get to work trying to solve the algorithm. Once it is solved, the block is verified, and a certain amount of new “coins” are produced, usually given as a reward to the person who successfully mined them.
Virtual currencies are global. If you are a US citizen and want to travel to Europe, then at some point, you will have to exchange your dollars for Euros. You will probably lose money in the process, as the company that facilitates the exchange (the third party or middleman) has to generate revenue to cover its own expenses. If you are on eBay and want to buy something from a merchant in China, you will probably have to pay a currency exchange fee, in addition to any other fees, in order to make the purchase. This is because national currencies are limited to the geographical area in which the state that procures them operates. Dollars are only good in the United States. You can’t spend them anywhere else. Euros are only good in the European Union. Pounds are only good in the United Kingdom.
Virtual currencies are not limited by geography. One ether, one bitcoin, one dogecoin, or any other virtual currency will have the same value anywhere in the world. If you travel to another country and find merchants who accept payments in the virtual currency that you hold, you won’t have to exchange to any other currency.
Blockchain
What enables the profound differences between virtual currency and fiat currency? The answer is simple: the blockchain technology that is used to support the virtual currency.
The traditional client/server model.
Most computer networks rely on what is called the client/server model. In this model, the main server holds all of the information for that network. Client computers connect to that network by logging in to the main server.
For example, say that you want to do some online shopping through a company that uses the client/server model. When you log in to your account, you are actually logging in to the main server with the information associated with your account. All of the information stored on your account, your shopping preferences, your credit card information, everything, is stored on that main server.
Companies spend billions of dollars every year to guarantee the safety of their servers. Cybersecurity is serious business nowadays, as hackers are continually coming up with new ways to break into main servers so that they can access the information stored within. With just one centralized server holding all of a company’s information, if someone can break into that one computer, he or she has access to all of the information stored in it.
The failure of the traditional client/server model is seen in the fact that main servers are constantly getting hacked, and companies are losing a lot of money every year because of it. Despite all of the innovations in cybersecurity, companies are only able to stay half a step ahead of hackers. Clearly, a new, decentralized model is needed.
When Satoshi Nakamoto published the white paper on Bitcoin, he was not only introducing a peer-to-peer virtual currency. He was introducing a new technology called blockchain that would prove to be far superior to the traditional client/server model.
How blockchain operates?
A blockchain is essentially a public ledger. A ledger is a list of transactions that have occurred on an account. For example, your bank account statement and credit card statement are both ledgers. If you keep track of your income and expenses, you are actually keeping a ledger. While most ledgers are private, a blockchain ledger is publicly available to anyone. Believe it or not, that feature is actually what protects the privacy of the people on the blockchain. Because Bitcoin was the first blockchain, we will use Bitcoin as an example of how blockchain operates.
Transactions that are made using Bitcoin are grouped together in something called a block. When the block is ready for verification, it is broadcast to the entire network. The values of all of the data contained within that block are translated into something called a hash; if one single shred of information inside the block is changed, the entire hash will change. The hash presents as a complex algorithm for the computers on the network to solve before the transactions in that block can be verified.
Once the hash is solved and the block is verified, it becomes connected to the block before it in a chain. When the next block of transactions is presented for verification, the hash value from the preceding block is included in the data that is used to generate the hash for the new block. When that hash is solved and that block becomes a part of the blockchain, its hash value is used to create the hash for the next block, and so on and so forth.
Because there is no way to retroactively change any information in any of the blocks without disrupting the entire chain, none of the data can be manipulated in any way. Because there is no central computer involved in processing, the only way for a hacker to access the network is for every single user to be in collusion. Since all of the information is publicly available, the entire network will be alerted if there is any discrepancy or cause for alarm. Blockchain is completely immutable and impervious to hackers. There is no need to purchase expensive cybersecurity software because security is a built-in feature.
Nodes
Because there is no central server, in order for blockchain to successfully operate, there needs to be a critical number of computer nodes. A node is a computer connected to the network that has the entire blockchain downloaded to it. Every new block is broadcast to all of the node computers. For optimal functioning, thousands of nodes need to be spread across vast geographical distances.
Private and public keys
A private key is like the password to your account on the blockchain. If you are storing dogecoins, it is like the password for you to be able to access your dogecoins. It is also like a digital signature that is used to authorize any transaction that you send. If anyone has access to your private key, he or she can drain off your entire account in seconds. Therefore, it is of the utmost importance that you do not let anybody ever know what your private key is.
Your public key is what people use to send you virtual currency. While your public key is accessible to anybody, your private key should absolutely be kept private.
Mining and proof-of-work
As previously mentioned, mining is the process whereby new tokens of virtual currency are created. It is also a crucial part of the blockchain’s security because it prevents any of the information from being retroactively changed. When a block is presented for verification, miners get to work solving the hash problem presented. Because computers are very, very efficient at solving complex algorithms, something called proof-of-work is required to ensure that new virtual tokens are not created too quickly and that enough time lapses to prevent a problem called double-spending (double spending occurs when someone uses the same virtual currency token twice).
All of these pieces work together to create a technology that is impenetrable to hackers, completely decentralized, and incapable of being hacked. You could say that blockchain embodies the philosophy behind virtual currency: decentralization.
