Member Article

Cryptocurrency, for most of us at least, has been hidden behind a veil of incomprehensible idiom for most of its lifespan. However, it has the potential to revolutionise the way we pay, borrow and lend, maybe sooner rather than later.

Like quantum computing and artificial intelligence, we are told they’re set to change the world but few of us understand how that might actually work or what their impact might be.

Cryptocurrency is now regarded as an asset class (worthy of investment itself) and regularly hits the headlines. Cryptocurrency and digital currency have the potential to revolutionise the way we pay, borrow and lend.

What is Cryptocurrency?

‘Cryptography’ is simply using coded communication to protect information ensuring only the intended recipient can read or process it. Cryptocurrencies (like other currencies) are a medium of exchange for goods and services, that utilise a coded interface to record the transactions: cryptocurrencies are, in simple terms, currencies secured by cryptography. Bitcoin is the most recognisable cryptocurrency, and (arguably but not certainly) the first. Bitcoin is a cryptocurrency secured by what is known as Secure Hash Algorithm (SHA). In short, if you identify a unique “thing” (e.g. an asset or a number of Bitcoin) using a unique digital reference, and then there is only one small change in that reference, then the unique “thing” is no longer represented: it is something else entirely. In short, a ‘hash value’ serves as a cryptographic equivalent of the ”thing” – a digital fingerprint or unique identifier. It is this digital fingerprint which is recorded or transferred.

It’s a misnomer that cryptocurrency is inherently digital. It’s just the case that the most popular examples of cryptocurrencies are digital (e.g. Bitcoin and Ether). In the modern world, in order to be a viable form of currency, the medium must also be able to transfer quickly and the digital nature of these currencies assists with this.

What is Bitcoin?

Bitcoin is the best-known cryptocurrency. Its history and mechanics are technical - we’ve extracted three key components to explain how the currency works:

Blockchain

This is the technology that underpins the currency. Computers solve sophisticated algorithms (‘blocks’) to come to a consensus on the validity of a transaction (i.e. the digital fingerprint of an asset, transfer or cryptocurrency is confirmed). If they reach a consensus, the transactions are confirmed and added to the chain. The ‘blockchain’ is simply a ledger that contains all verified transactions. It is impossible to change transactions once they have been added, unless the majority of computers reach a consensus to do so. For this reason, so called “double-spend” is exceedingly difficult, fraudulently or otherwise.

We use the term “ledger” above. You may have come across the phrase distributed ledger technology (DLT). A blockchain is a type of DLT. The key behind the blockchain and DLT is the word “distributed”: it is a record which is written onto many ledgers at the same time, meaning that (at least in theory) one actor does not control the record and no actor may change the record. If the protocol for the DLT changes, i.e. the user base or developers decide to update the software governing the DLT, then the DLT divides (it forks). On one fork continues the original protocol (for future transactions or records for cryptocurrencies in circulation under the “old” protocol) and on the other is newly-mined cryptocurrency (and transactions relating to them). That is why you will see references to (for example) Bitcoin Lite, Bitcoin Cash, Bitcoin XT. These are completely different cryptocurrencies that derive from the original Bitcoin code.

Mining

The act of having a computer dedicated to verifying transactions (i.e. putting them on the immutable DLT) is known as ‘mining’. Computers compete to solve a difficult puzzle (to verify a transaction) and the winner (which adds the next block to the blockchain) is rewarded (often with the issue to them of new cryptocurrency, but see below regarding other DLTs). This incentivises verification of transactions and ensures a steady release of Bitcoin into the market. Only the winner will be rewarded, so mining can certainly be regarded as a gamble.

One of the challenges of DLTs which do not relate specifically to cryptocurrency transactions is determining the reward for verifying transactions. Some (such as Ethereum, which is the DLT on which the cryptocurrency Ether, and also many smart contracts or other tokens, sit) will issue miners new cryptocurrency, but it may as easily be Air Miles or a supermarket voucher.

Mining requires a serious amount of electricity and computational power to achieve success and the environmental impact of this usage has put off a number of potential users, including (at least temporarily) Tesla’s CEO, Elon Musk.

There is a finite supply of Bitcoin (as stipulated by its source code) – fewer than 3 million of a total 21 million remain to be mined. In this way, Bitcoin can be compared to other commodities, like gold, the value of which is dictated by its scarcity.

Decentralisation

We discussed “distribution” in the context of the DLT. Decentralisation is different (although related to the concept of having everyone but no one in charge). Government issued currency (‘fiat money’), which we are all familiar with, is controlled centrally by governments and central banks and its value is based on the economic strength of the issuing country. Interest rates and inflation can be controlled through manipulating the amount of money in circulation.

Bitcoin is decentralised. Its mining mechanism controls the amount in circulation with no involvement or control from a central third-party. Some see this as a benefit and a way to avoid the instability (and in some cases corruption) that banking institutions and governments can be susceptible to. Others argue that because such a high percentage of Bitcoin is owned by just a handful of people, that it isn’t free from control at all.

What is digital currency?

Digital currency is any money or money-like asset that is primarily managed, stored or exchanged on a digital computer system. This includes most cryptocurrencies but will also include tokens with some sort of intrinsic value (e.g. to be provided with a service or product or with an entitlement to a share of a capital or income-producing asset).

In reality, most developed nations are operating digital currencies already; we’re all familiar with online banking and money transfers and how else would those activities take place without the balances being transferred or registered “electronically”?

The end of cash?

As with many aspects of our lives, technology looks set to change the way we use money. However, according to Age UK, approximately 2.4 million over 65s, representing nearly 12 million people, still rely on cash to survive (and are still using chequebooks). They may not have access to the devices that would allow them to go cashless, even if they had the inclination. The charity also reports that Covid-19 represented a particular challenge for disabled people who broadly preferred to pay their friends, neighbours and volunteers in cash. In light of these challenges, cryptocurrency may be an exciting prospect for early adopters but is likely an anxiety-inducing thought for those who depend on traditional paper and coins (or even standard internet banking) and that will need to be borne in mind by those spearheading reform. At present, we appear some way off a cashless UK.

For more information on how we think cryptocurrency and digital currency might impact the banking & finance market, please see our follow-up article.