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Amid the recent hype associated with the rise (and fall) of the price of bitcoin, few commentaries have addressed the overlap between the technological and economic characteristics of this and other cryptocurrencies. In this blog, we attempt to shed some light on the inner workings of bitcoin and its digital currency peers.
Most cryptocurrencies propose a peer-to-peer system in which “money” can be moved directly between individuals’ “wallets” without having to go through a banking intermediary, as occurs with online transactions paid using credit cards or other centralized systems in which individuals post a sum that is drawn down against to meet obligations (e.g., prepaid transport cards). While the analogy is alluring, the decentralized electronic reality is a little more complex. Let us try to see what “having” bitcoin (or another cryptocurrency) in your “wallet” actually means.
What is in a cryptowallet?
Cryptocurrencies require a fairly large set of data. For example, the bitcoin blockchain is currently over 145 gigabytes in size, recording the creation and allocation of new bitcoin to digital addresses and the transfer of bitcoin from one address to another. An address is the public key in a private-public key pair. Possession of the private key for an address allows the generation of transactions sending bitcoin from that address to another. Generating a valid sending transaction is not feasible without knowing the private key. The public and private keys are related in such a way that it is easy for anyone to verify the validity of a transaction with respect to the private key if they know only the related public key. This relationship is based on mathematical schemes (for public-key encryption) discovered no later than 1970 in Britain and hinted at even in the 19th century by the famous British economist William Stanley Jevons. The underlying mathematical assumptions (which holds, to the best of our knowledge) is that certain problems are much easier to solve in one direction that in the other. For example, given two large prime numbers it is in general easier to compute the product than to compute the two prime numbers if given only the product.
The possession of a certain amount of bitcoin comes down to controlling the private keys for addresses to which that amount (in total) has been allocated and from which it has not yet been spent. A “wallet” file or software stores the private key and (optionally) other information related to all transactions (public-private key pairs) associated with it. For security reasons, bitcoin wallet owners are encouraged to generate different public key addresses for each discrete transaction, to avoid the aggregation of large sums in publicly-observable locations. Wallet software programs report on the balance held in the wallet by checking the transactions in the blockchain associated with the addresses (public keys) stored by that wallet.
The integrity of the system is guaranteed by “mining”: solving difficult but basically useless mathematical problems and verifying the consistency of a block of new transactions to be added to the blockchain. Miners are essentially simply a number of computers running the same software and having a copy of the same blockchain. The first to be accepted by the rest of the bitcoin network to have “cracked the code” gets rewarded, the transactions are “closed,” and the blockchain record is updated with the block just mined on all computers on the network.
Miners are rewarded by a small amount of bitcoin generated by the system and optional transaction fees included with each proposed transaction. In bitcoin’s early days, the system-generated rewards were comparatively generous with respect to the amount of effort required to mine, but as more bitcoin have entered circulation and transaction volumes have grown, the system reward has decreased and the transaction fee paid by the transaction originator has become a larger proportion of the reward. Naturally, miners will favor transactions with high fees but with no entry barriers to mining, competitive forces drive toward an equilibrium transaction price. A recent small transaction of ours incurred a $11 transaction fee, for example.
What and where is the bitcoin network then?
The bitcoin system is therefore nothing more than a number of computers running the same software and having a copy of the same blockchain. The (open-source) software governs the mechanism for creating new currency and expanding the blockchain to record transactions. Agreement on what constitutes the current blockchain is really nothing other than a soft and fluffy knowledge of what one believes other nodes are doing and the firm conviction that other nodes will process further transactions in the prescribed way. A new node (software instance) discovers other nodes of the network by looking at a list of well-known nodes’ IP addresses that is included in the reference software or by looking in certain internet chat rooms. The bitcoin network could be immobilized by taking down these nodes as well as bitcoin.org, but since faithful copies of the blockchain itself are distributed all over the world, it is very likely that the network will be resurrected by a coalition that can agree on the last trusted version of the bitcoin blockchain.
Furthermore there is nothing stopping anyone from setting up a bitcoin copy on a putatively isolated network where the nodes will use the same software and decision mechanism but have no connection at all to the original bitcoin network. This can be seeded with the current blockchain or not — the new chain can start afresh. Likewise, when a dispute arises in real life over revision(s) of the software, bitcoin can and does “fork” — that is, a subset of the mining nodes go off on their own and expand the blockchain in a different way from that point on (e.g., the crypto-currency called Bitcoin Cash). Other cryptocurrencies operate in a broadly similar manner.
The current bitcoin network is quite large, and people have invested many billions of dollars in purchasing bitcoin, mining, and other associated activities such as establishing brokerages that price and undertake transactions between bitcoin and other fiat and cryptocurrencies. The first bitcoin software implementation was released in 2009, and the number of users (nodes) grew from one to two on the first day. It took more than a year for the value of bitcoin to reach (roughly) $0.01 and another year to go to dollar parity. Since then, there has been considerable price volatility, but the bitcoin earned by early adopters is now worth a fortune. Because of the dramatic increase in the value of bitcoin, the number of miners and the cost associated with maintaining the system (e.g., transaction costs that were initially low) have now increased dramatically. At several dollars per transaction, bitcoin is no longer a viable means of exchange for everyday transactions, such as paying for a meal at the airport.
What does this mean for the future of bitcoin and other cryptocurrencies?
As the transaction costs for bitcoin transfers increase, its appeal as a transacting currency decreases, and the appeal of using alternative less-costly cryptocurrencies increases. However, the more cryptocurrencies there are, the harder it is to establish a basis for comparison of prices or to move value between the currencies to settle transactions when buyers and sellers hold different currencies in their wallets. The role of brokers is crucial to the smooth functioning of cryptocurrency systems. Brokers can lower transaction costs by aggregating their clients’ transactions together in their own proprietary “wallet management” systems denominated in bitcoin derivative currencies and then recording only the change in balances on the bitcoin system. This arrangement mirrors the way in which banks emerged to deal with the high transaction costs of individuals paying each other with initially different bank currencies but eventually different fiat currencies.
It remains to be seen whether the institutions emerge over time to replicate some elements of the banking system that cryptocurrencies were developed to challenge. To the authors, this seems likely.
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