Chapter 2

What is a cryptocurrency?

Learn everything about cryptocurrencies: what they are, how they work, the different types of cryptoassets, and what is the revolutionary value they bring.

TL;DR

  • A cryptocurrency is a digital currency using cryptographic technologies to prevent double spending without the need for any intermediary. With a well thought out economic incentive system, all the actors of a cryptocurrency are encouraged to play by the rules rather than cheat the system.
  • While usually referred to as cryptocurrencies, the term cryptoassets is more suitable as not all of them are primarily designed for payment. Some are made to store value like Bitcoin, some are made to use an ecosystem like Ethereum, stablecoins like USDT, DAI or USDC are made to protect from the volatility of other cryptoassets, and some are indeed made to facilitate payments.
  • Why cryptoassets? Because of the following features they provide that fiat money doesn't, including:
    • Absolute digital scarcity
    • Hedge against the money printer
    • Asymmetric bet on the future
    • Fundamentally uncorrelated assets
    • Censorship and seizure resistance
    • Free entry & exist
    • Self-banking
    • Peaceful protest
    • Global interoperability and social scalability

In this article, we are coming back to where we left off in the historic overview of money covered in the previous chapter.

In the continuous evolution of money, Bitcoin is the latest iteration. But Bitcoin is not just any iteration, we can say that it is the beginning of a whole new chapter. With it, a new era has been ushered in: For the first time in history, we have real digital money.

What do you mean, “real” digital money?

Today's payment options like bank deposits, credit cards, e-cash or mobile banking apps are commonly referred to as being digital. Now that the world has been introduced to Bitcoin, this definition is not correct any longer. In fact, one should speak of electronic currencies and electronic payment when talking about these traditional tools.

Electronic vs digital money

As Bitcoin allows for value to be exchanged over the Internet, at first glance, it appears to be just one more electronic currency. However, a closer looks that it has many things in common with cash. A Bitcoin transaction is fundamentally different from an ordinary electronic money transfer.

Today's main currencies - US dollars, Euros or Swiss francs, operate almost exclusively on electronic money. An ever-greater amount of consumers pays for goods and services electronically (at least in industrialized countries) whether it be via credit card, online bank transfer or Google Pay, Apple Pay or PayPal. These financial transactions, of course, are extremely efficient and convenient.

But as stated in the previous chapter, there is one crucial thing to keep in mind: every electronic payment is recorded in a third party-controlled central database. All financial activities are monitored by an intermediary and can theoretically be censored, declined, or confiscated.

A solution for the double spend problem

This is the crucial difference between electronic currency and a cryptocurrency. The latter represent a true digital bearer instrument. This rather archaic term describes an asset that can be owned self-sovereignly, meaning that a person can take actual ownership of it. This is also true for cash (coins and banknotes), but not for the money you put on a bank account. When you do so, the money belongs to the bank, which then has a debt with you. But as you know, debts can be defaulted, which is the whole reason why we are working to build a full-reserve bank. But let's not digress.

Compared to bank deposits or mobile banking money, which are only account-based and reside on a central authority's ledger, a cryptocurrency is a token-based money that represents true equity and is no one else's debt or liability.

This was made possible with Bitcoin, which was a solution for the problem preventing true digital money to exist before that: the double spend problem.

Ever since the advent of digital technologies, there was no way of making sure digital units could not be spent twice (double-spent), unless a central authority would intervene to verify and enforce it. Without solving that double spend problem, truly digital money could not be possible as there would be no guarantee that units couldn't be copied at will, leading to run-away inflation of its supply.

With Bitcoin, its creator(s) Satoshi Nakamoto managed to bootstrap a virtual network in the style of an economic system governed by a well-balanced incentive structure. The system's units are truly digital, meaning that although they are abstract, they cannot be counterfeited or recreated at will.

This is revolutionary and its importance can be compared to the discovery of the printing press but with an opposite effect.

Fruitful catastrophe

How so? It was the printing press, paper money and finally electronic databases that led to the impressive story of capitalism unfolding. With the proliferation of new and different forms of money (substitutes), economic and materialistic riches have been accumulating like never before.

But scaling money and detaching it from a scarce, material reality like gold turned out to be both a blessing and a curse. The Faustian temptation humanity succumbed to has allowed for an ever-expanding credit expansion, which capitulated society to unimagined heights of wealth and riches.

Unprecedented waves of artificial volatility created by expanding and contracting credit cycles have led to recurring bubbles and financial crises during the past decades. These have made some of us realize that we may have overstrained the blessings given to us by the printing press and its successor technologies.

Bitcoin's irrefutable digital scarcity could well be the missing link modernity has been lacking. With the invention of Bitcoin, money remains abstract, digital, scalable and programmable, but it is set on the unshakable foundation of absolute, digital scarcity.

Bitcoin is a way to tame the breakthrough that the printing press unleashed, without undoing the very breakthrough.

Cryptocurrencies come in many forms

Bitcoin is the mother of a variety of other cryptocurrencies. Let it be said though: The term “cryptocurrency” is rather ambiguous and does not do justice to the many new forms and functions these new cryptographic technologies allow for. A much better word to generically describe this new phenomenon and its many representations is cryptoassets.

The different types of cryptocurrencies

The different types of cryptoassets

What kind of cryptoasset is Bitcoin?

A cryptoasset is first and foremost a cryptographic value that can be controlled self-sovereignly and resides on a public blockchain network. Even though Bitcoin can and is used as a currency, at its current stage Bitcoin is more sought after for its store of value function.

Experiencing what is called an ongoing monetization event, Bitcoin is trying to establish itself as a new world reserve asset. Because its price is subject to major volatility spikes as you probably know, its function as an everyday payment currency is not a defining feature for the moment. This might one day change, if Bitcoin's monetization phase is coming to an end and its price practically stabilizes thereafter.

Ethereum and utility tokens

Bitcoin's asset (written with a lowercase b) is a unit to use Bitcoin's network (written with an uppercase B). In the case of ether, the second largest cryptoasset as of today, its utility function to use a network is much more distinct.

Because Ethereum has much greater smart contract functionality, its expressivity is higher. As such, Ethereum is generally described as a smart contract platform with ether being the cryptoasset that is needed to use the ecosystem's smart contracts. There are many more such smart contract platforms with other cryptoassets as their native token.

Stablecoins

Stablecoins are another big category that is subsumed under the term cryptocurrency. These cryptoassets, like USDT, USDC or DAI, come much closer to what could be regarded as currencies as they are usually tied to fiat currencies and have been created to protect from the volatility of other cryptos. Yet again, there are cryptoassets like Bitcoin Cash that strive to make its public blockchain infrastructure function as a true currency, facilitating payments from the get-go.

Privacy coins

Privacy is another distinctive feature of some cryptoassets. While Bitcoin or Ethereum are pseudonymous (and not anonymous), so-called privacy coins are privacy-focused by default. Transactions happening within their network are anonymous as their ledger (public blockchain) is obfuscated using different cryptographic means. With Bitcoin, privacy features can be achieved off-chain as well, while with cryptoassets like Monero or Zcash anonymity is built into the public blockchain itself.

Asset tokens

Last but not least, asset tokens are cryptoassets that represent a right to something. For rights on tangible or intangible things coming from the traditional world, we know such asset tokens as security tokens: shares, bonds, precious metals, work of arts or real estate are prime examples of security tokens that can be brought on a blockchain. A token representing a real world thing can then be seen as that thing's digital twin.

Asset tokens representing rights that are not natively coming from the traditional world are typically called governance tokens, as they provide voting to participate in the decision-making process of a decentralized platform, such as Uniswap or Aave.

Finally, we can mention non-fungible tokens (NFTs) in this category, which are non-mutually interchangeable (i.e. each token is unique) tokens representing ownership of a real-world asset (art, collections) or of a digital asset (crypto art, collectibles, etc.).

Why cryptocurrencies?

To conclude this chapter, we want to elaborate on why cryptoassets are a positive addition to today's world of financial assets.

Because of Bitcoin's absolute digital scarcity, its purpose as a cryptoasset is to provide a great hedge against the present day's ever accelerating credit expansion and aggressive monetary policies. It is an inflation hedge par excellence.

Conspicuous about this inflation hedge are its features of censorship and seizure resistance. Because Bitcoin has developed into a financially potent and geographically decentralized network with thousands of network participants, it is very hard for an attacker to censor transactions, meaning that value can be sent at any time, from anywhere to anyone with certainty.

Since Bitcoin and other cryptocurrencies can also be owned self-sovereignly by possessing the relevant private keys, seizing assets is a difficult undertaking altogether.

Owning value without the need for institutions is revolutionary as these institutions cannot only control and deprive users of their assets, but they can deny access in the first place.

Because of a cryptoasset's permissionless nature, access as well as exit is possible at all times by anyone with no identification needed. These new cryptographic technologies are not about who you are but what you own, as a digital signature is all you need to control and move cryptoassets.

In a world where financial privacy is continuously undermined and offshore banking solutions are being fought with the utmost effort, a new alternative realm of cryptoassets allowing for more financial privacy and more financial self-control should be highly welcomed, as competition is generally a good thing that benefits users and consumers.

What is so enticing about crypto is the fact that it mainly comes in the form of a peaceful protest. Cryptoassets and their networks don't destroy. They offer a better, faster, more reliable, and honest system. Compared to traditional systems, they offer a better global interoperability and a higher social scalability by design.

But Bitcoin does not only represent an asymmetric bet against the current system. Cryptoassets are programmable money, which allows for innovation hitherto unseen.

When you short the bond market or holds gold as a hedge, you are really betting on the fallacy of mankind rather than its ingenuity. Bitcoin on the other hand is the only protective asset so far that gives your protection, while simultaneously giving you exposure to humanity's ingenuity.

With all these positive, constructive features of Bitcoin and cryptoassets, it is important to bear in mind the fact that the crypto ecosystem is not perfect by any stretch of the imagination.

All it offers is a true alternative: a monetary system that is based on a non-dilutive, non-politicized form of digital money. On top of this, it offers a new financial system with many amazing features that nobody would have thought possible just a few years ago.

In the next chapter, we will introduce you to what is a blockchain, the underlying technology behind cryptoassets and the new financial era that they are ushering in.

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