A primer on cryptocurrencies
I’ve had enough friends lose money “investing” in cryptocurrencies that it’s past time we all sort those ideas out together
Bring me up to speed here
With words like ‘blockchain’ and ‘crypto’ it can be hard to tell which cryptocurrency concepts you already know and which are new inventions that you need to learn. To start with, let me split the concepts into layers. Each one builds on top of the previous one. Like if I were to explain an axe to you I’d first talk about metal and wood, then I’d talk about forging metal into a blade and wood into a handle, and then only later I’d talk about joining these two together and swinging them at stuff. An axe wouldn’t make much sense if you first didn’t know that metal is harder than wood.
Layer one: records
If I were to tell you to imagine a piece of paper with an agreement on it you might think of a legal contract. A grocery store receipt works just as well. Just any document that records something happened and multiple parties saw it happen and agree about the details. That’s the first building block of what we now call cryptocurrencies in the same way that wood or metal is a building block of an axe.
Now imagine these records are stored online all together and, importantly, they’re all public. Anybody can see all of the agreements all of the time. What’s in the record? It doesn’t matter. Just like a printed document it could be anything. In the case of Bitcoin they’re basically bank transfer statements. But they could be lists of people’s favorite colors. It’s just a document recording a fact.
Layer two: lots of people sharing these records together
These records are all stored together in the same place and everybody in the world who’s interested gets a copy of the whole set. Rather than have to keep track of billions of records they’re handily grouped together into ‘blocks’. Each time enough new records are written a new block is created to package them up. These blocks are chained together from earliest to most recent. That’s where we get the term ‘blockchain’.
You might be thinking that I’m dumbing this down. I’m not. I’m omitting the details of how the whole system is implemented but these are the core concepts. And if you’re thinking this sounds a lot like a traditional database or, frankly, a spreadsheet then your intuition is spot on. That’s basically what this is, though the way it gets modified is much more sophisticated.
Layer three: a process for creating new records
This is where modern technology and some novel concepts start to appear.
Imagine that you shared a spreadsheet with me where each row represented an event. Jennifer loans Gloria her lawnmower. Roshelle did some plumbing work for Jennifer, etc. Either you or I could just add a new row to it. You’d have to trust me to tell the truth about who did what. This wouldn’t work if you shared it with the whole world, you’d need some kind of way to prevent people from making up lies and writing them down.
A blockchain solves this in two ways. The first is that each record is ‘signed’ with a digital signature that proves the people involved were really involved. The second is that the record isn’t created by the people involved — some 3rd person is brought in to arbitrate.
So instead of a spreadsheet that we’re all writing to this is more like a community bulletin board where if I want to publish that I did plumbing work for you we’d need to get some random member of the community to come in and talk to us both to make sure we both agree it happened. They’d be the one to actually pin this new fact on the bulletin board, not either of us.
At this level we start to use the ‘crypto’ of ‘cryptocurrency’. Cryptography only does two things: It either hides data so that nobody can read it (like in a wartime encrypted message) or it verifies some data for you (like comparing the handwriting between two signatures). That’s it. When people right now mention the “crypto community” that term means “financial speculators.” It used to mean the mathematics community and I suspect it will mean that again shortly.
Cryptography is used to ‘sign’ each document so everybody knows for sure that the members involved were really involved. It’s just a way to prevent lying.
Layer four: money!
Once you have a global and verified way to read and write little agreements about facts you have the basics for recording financial transactions. And you can, if you want, use this chain of blocks of records as a bank ledger that anybody can read and use. This is what we’re calling a cryptocurrency.
In practice it’s the exact same as using a traditional bank. The difference is that you don’t have to trust the bank and you don’t have to tell anybody who you are (you get to be semi-anonymous). But the blockchain is purely a record of transactions — it doesn’t manufacture any money for you. You have to bring your own cash.
Layer five: speculation!
Imagine now that you could convince people to give you their United States dollars and in return you’ll agree to write a new records with them in this blockchain. You give them nothing else. Just an agreement that they definitely gave you some money. They give you cash, you both write down that it happened, and then… that’s it.
Now you have more money. And they have less.
This is the modern cryptocurrency movement. All the action is at layer five — trying to convince other people that they should put their actual money into the system. And “putting money into the system” means giving that money to people who were earlier participants in the system.
If all you knew about Bitcoin and Ethereum were from recent news headlines you’d think that cryptocurrencies had value. That they are a legitimate form of wealth and that you can semi-safely transfer your US dollars into and out of it. There’s a moment in each bubble where we think that. Real estate in 2007, dot-coms in 2001, and Beanie Babies in 1999.
A short list of the problems of Bitcoin
Now that we’re all up to speed let’s look at some of the unfortunate side effects of this whole cryptocurrency stuff.
Increased wealth inequality
The way you make money in Bitcoin is by convincing people who found out about it after you did to put in some of their money so you can take yours (and more) back out. The earlier you got involved the more money you’ll have. With each passing day it becomes less useful as a currency and more useful as a means for a few people to have outsized wealth.
Paul Krugman predicted this almost perfectly way back in 2011:
“So how’s it going? The dollar value of that cybercurrency has fluctuated sharply, but overall it has soared. So buying into Bitcoin has, at least so far, been a good investment.
But does that make the experiment a success? Um, no. What we want from a monetary system isn’t to make people holding money rich; we want it to facilitate transactions and make the economy as a whole rich. And that’s not at all what is happening in Bitcoin.”
In practice Bitcoin now functions exactly like a multi-level marketing system. And since Bitcoin started in a particular community (highly technical professionals with libertarian political views) the people who have made millions and even billions of dollars are a sampling of that already-privileged group. If there were a problem with overprivileged men having an outsized influence on the internet or finance then Bitcoin has now made that problem worse.
The last people to get access to cryptocurrencies are communities that have already been disenfranchised. Any group that relies on a public library for internet access, for example, is unlikely to have built farms of GPUs in 2012 to mine their own Bitcoin.
It amazes me, frankly, that my same friends who fight for social equality and would never sell a pyramid scheme to their neighbors are okay with speculating in Bitcoin.
Burning the Earth
Bitcoin requires such an enormous electrical supply that it’s contributing to global warming. This is a problem specific to Bitcoin but, as that’s where most of the hype is right now, it’s worth pointing out. Being both pro-Bitcoin and pro-all-of-us-surviving is a tricky ethical dance right now.
There’s no “there” there
There is no collateral behind these currencies. Nothing. Some folks would say the same about the US dollar but all American government employees are paid in dollars. I’m paid in US dollars. Our whole system runs on it. There is such inertia to the dollar that it’s extremely costly to get rid of.
Getting rid of Bitcoin would mean we’d have to… nothing. It would just go away. Most Americans wouldn’t notice.
Tulips are for smelling, not selling
I’m clearly pretty bearish on cryptocurrencies. I advise anybody who isn’t building a distributed asset store themselves to stay away entirely. Blockchains are a fun exploration of distributed agreements and may prove useful in the future but today they’re a way for a few folks to get mega-rich and for late-adopters to lose their shirts.
Follow me (Jack Danger) on Medium if you want all of: More posts like this, writings on the psychodynamics of relationships, slightly funny satirical posts, and the occasional romantic poetry. I dunno how to make Medium separate that stuff so you get it all. My deepest apologies.
