Alternative Investments Part II: Behind the Scenes of Cryptocurrency

Aside from refining their financial literacy and analytical skills, one of the most important duties for an investor is keeping track of the ever changing economic, cultural, and technological trends around the globe. As the world evolves, so too must investors’ strategies. Take, for instance, the invention of the World Wide Web in the late 1980s, which quickly led to massive amounts of capital poured into internet-based companies by investors who hoped to capitalize on the web: the way of the future.

Now, we find ourselves immersed in a digital world. Whether it’s direct messaging a friend, uploading a picture on social media, watching a favorite show, shopping for clothes, booking a flight home, or completing a homework assignment, we are tapping into the internet in one way or another. Those who bought into internet-based companies like Google, Apple, Uber, and Facebook (now Meta) in their early years are most certainly reaping the benefits.

So what’s next? It seems as though the global economy is rapidly shifting to e-commerce, and the recent COVID-19 pandemic has only quickened this transition. In fact, new data from IBM’s U.S. Retail Index suggests that the pandemic has accelerated the shift from physical stores to online shopping by approximately five years. Further, e-commerce sales are expected to top $1 Trillion for the first time in 2022. As more companies shift their focus to e-commerce, it leaves a window of opportunity for the implementation of cryptocurrencies as a viable payment method. Microsoft, AT&T, and Starbucks are some examples of the many companies attempting to boost sales by integrating cryptocurrencies into their e-commerce business models. It is therefore vital to explore cryptocurrencies in greater detail, specifically how they work, how they are valued, and how to get involved in the market.

So What Really is a Cryptocurrency and How does it Work?

Most individuals by now have probably heard of common cryptocurrencies such as Bitcoin and Ethereum. Cryptocurrencies can best be imagined as virtual tokens. They’re fully digital currencies that exist outside the control of any central government or authority. In other words, cryptocurrencies are decentralized. This is made possible because of complex cryptographic messages that ensure transactions are secure, hence the name cryptocurrency. 

There are many advantages of crypto, as it's commonly called. The primary benefit is that there’s no central authority or payment processor to regulate, control, or oversee transactions. Rather, payments are peer-to-peer, meaning people can send money directly to each other with no intermediary. Since there’s no intermediary, cryptocurrency transactions involve little to no processing fees. Lastly, transactions are quick, easy, and highly secure thanks to the advanced cryptography.

Let’s dive into the technical details of what’s really happening when we send and receive cryptocurrencies by evaluating the pioneer of all cryptocurrencies: Bitcoin. As mentioned before, Bitcoin is a decentralized digital currency that can be sent from user-to-user without an intermediary. This is all made possible by the blockchain. The blockchain is the shared public ledger on which the entire Bitcoin network relies; every computer (node) has an identical copy of the blockchain. All confirmed transactions (transfers of value between two Bitcoin wallets) are recorded in the blockchain. To protect the identities of the sender and the receiver, a unique identifier of alphanumeric characters known as the Bitcoin address is portrayed in the ledger rather than the individuals’ names. Additionally, both the sender and the receiver provide digital signatures to approve the transaction. But what’s stopping someone from copying these digital signatures to make illegitimate transactions? Well, in the real world, you use the same handwritten signature for every document. This is not the case with digital signatures.

Each Bitcoin wallet is associated with both a public and a private cryptographic key, called a Public/Private Key Pair. These keys are a series of bits (binary digits) that act similar to a password. The public key is viewable by the public and the private is, you guessed it, kept secret. The keys play an important role in creating a unique digital signature. Producing a signature depends on the specific transaction, or ledger message, as well as a user’s private key, as shown below:

Sign(Message, Private Key) = Signature

It’s important to note that if the message is changed just slightly, the digital signature changes entirely. The use of the private key in this function ensures that you, and only you, can produce that specific signature, and the function’s dependence on the message ensures that no one can copy and forge your signature on a different message. Paired with this function is another function that returns true or false:

Verify(Message, Signature, Public Key) = True or False

This function determines whether or not the signature is a result of the message and the private key that’s paired with the public key. The idea is that it would be completely infeasible to produce the valid signature without knowing the private key that corresponds to the public key. 

As can be seen, digital signatures are very complex and essentially provide a mathematical proof that the true owner of the wallet is making the transaction. Of course, all of this is happening behind the scenes. From the user’s perspective, sending Bitcoin is as easy as selecting an address and specifying the amount to be sent. Now that we’ve established how two parties “sign off” on a transaction, we can look into the heart of the issue when it comes to cryptocurrencies: decentralized consensus.

In the absence of a third party, there needs to be some method by which cryptocurrency networks can agree on the correct order of transactions. After all, you can’t spend money you don’t have, nor can you spend money that’s already been spent. The blockchain must be ordered unambiguously such that everyone has an identical copy. Timestamps seem like an easy solution, but any trusted source of time would fall under the category of a “trusted third party,” and that's a no-no for cryptos. What’s needed is a method that can verify one transaction occurred before the other.

The solution that Bitcoin offers is to simply trust whichever ledger has the most computational work put into it. This may be starting to sound like a new language, but hang in there. Computational work is actually a pretty concept, but before we can get into it, it’s important to understand what a cryptographic hash function is. A cryptographic hash function is a special function that takes any arbitrary input and spits out a seemingly random output of fixed length, which is known as the hash. Bitcoin uses a cryptographic hash function called SHA-256 whose hash is 256 bits long. Cryptographic hash functions are essential to cryptocurrencies because they are infeasible to compute in the reverse direction. There is no better way to work out the input of a cryptographic hash function output other than to guess and check 2256 different numbers. This cryptographic functionality allows for a process known as mining.

When a computer mines, it fields transactions from the Bitcoin network, groups them into a block, uses the previous block’s hash as the header of the block, and attaches some arbitrary number (called a nonce) to the block. The entire block is then run through the cryptographic hash function and the output is evaluated. This process is repeated by all mining nodes across the network until eventually, by chance, one lucky computer will find a solution. A solution is any hash that falls below the specified target value that Bitcoin generates. The smaller the target value, the harder it is to find an input that produces a solution. The mining process is basically a computational lottery, and to incentivize miners, Bitcoin is offered as a reward for creating a new block. The currency is essentially created out of thin air, hence the term “mining”. You can even check out sites like Blockchain.com to see when the latest block was added to the chain and who mined it.

As more nodes join the mining process, the difficulty of finding a solution is automatically adjusted so that a block is created every ten minutes, on average. When a solution is found, it serves as a proof of work. Logically, work implies time, so finding a solution essentially proves to all other computers in the blockchain network that a fair amount of computational effort was expended. From here, the block is distributed across the Bitcoin network to be updated on every node on the network. These other nodes independently verify the block and express their acceptance by adding it to their copy of the blockchain. The solution hash becomes the header for the next block, and the entire mining process begins again. It’s very important that the next block contains the hash of all the data from the previous block because it links all blocks together in a way that makes it impossible to alter prior transactions.

It is possible for multiple versions of the blockchain to arise if two nodes find a solution at nearly the same time, a situation known as an accidental fork. However, as stated before, all we need to do is trust the blockchain with the most computational work invested into it. This means we defer to the longest blockchain. The network abandons the blocks that are not in the longest chain, which are known as orphan blocks. Unfortunately, miners are not compensated for creating orphan blocks. It’s a real shame. As for the transactions, no, they’re not lost. They are all still contained within the longer blockchain. Through this simple rule of deferring to the chain with the most computational work, all nodes have a method of achieving decentralized consensus on the timing of transactions. 

The system really is quite cool. Transactions are digitally agreed upon and then are broadcasted to miners who are incentivized to confirm the transactions. One knock on Bitcoin, though, is that mining expends tremendous amounts of energy, which is both expensive and harmful to the environment. Many large corporations, therefore, pool their resources together to create large mining farms using economies of scale.

Alternatively, newer cryptocurrencies have adopted proof of stake protocols, rather than proof of work, as the consensus mechanism for validating transactions before they are added to the blockchain. This method does not require complex computations and therefore eliminates the environmental concerns surrounding the proof of work method. Instead, proof of stake lets users “stake” their own coins as collateral for the chance to validate blocks. Then, the system randomly selects a validator to confirm the transaction, which must be agreed upon by other validators, before the block is confirmed and the initial validator is rewarded. Different cryptocurrencies use varying proof of stake mechanisms, but the goal is to reduce energy expenditures. It relies on randomization rather than competition to mine. Ethereum is currently working on implementing the Proof of Stake mechanism, which they describe as a validation sharing dynamic rather than a validation competition dynamic.

But hold on, Bitcoin is nothing more than a made-up digital currency by some random dude who operates behind the pseudonym Satoshi Nakamoto. Why does it have any value in the first place?

Why Do Cryptocurrencies Have Any Value?

To illustrate how cryptocurrencies like Bitcoin accumulate value, it may help to understand why anything has value. Take a fiat currency like the US Dollar, for example. It’s not even backed by gold anymore. It’s just a fancy piece of paper. It has no intrinsic value, yet we all perceive it as having value. The same goes for the tickets I may win at the arcade or the points I may earn for staying in Marriott hotels. The only reason these things have value is because I trust that they have value. I trust that I can redeem those tickets for candy or trade in those points for a free night’s stay. As for currencies, they are valued depending on the trust that others have in the central bank and the government itself. A stable government in a good economic position will have a highly valued currency because people trust the credibility of the issuer, and thus they trust that the currency will be accepted as a medium of exchange by others. On the other hand, a government that loses international trust will see its currency value plummet. 

It may be clear now how fragile our current economic system is, and how we are sort of powerless when it comes to how our assets will be valued in the future. Centralization inherently creates a single point of failure. But when it comes to cryptocurrencies, you don’t have to trust anyone. You just have to trust the coin. If enough people believe that Bitcoin has value, it has value.

So how did Bitcoin garner so much trust? The Bitcoin network came into existence when creator Satoshi Nakamoto mined the first ever block, known as the genesis block, for 50 Bitcoin in 2009. A few days later, Nakamoto made the first transaction by sending 10 Bitcoin to programmer Hal Finney. And with that, the blockchain began to grow. Initially, the low computational difficulty to mine Bitcoin allowed many miners to get into the game. The early Bitcoin community was fun and inclusive. It was not uncommon for individuals to introduce their friends to the network by sending them hundreds of Bitcoin. After all, Bitcoin was a novelty and its value was very ambiguous at the time. In 2010, the first commercial transaction occurred when Laszlo Hanyecz purchased two Papa John’s pizzas for 10,000 Bitcoins. As more and more people became familiar with the system and learned to trust it, Bitcoin gained more credibility as a safe, efficient, decentralized medium of exchange. 

Just as with any cryptocurrency on the market today, supply and demand determined Bitcoin’s value. As more and more speculative investors foresaw the bright future of Bitcoin, they poured their own capital into the digital currency. Demand continued to grow, and supply was not nearly as fast to follow. That’s because Nakamoto programmed the network to cut the Bitcoin reward for mining a block in half after each set of 210,000 blocks was mined. A reward that started at 50 Bitcoin is now down to just 6.5 Bitcoin. This diminishing supply means that Bitcoin is limited to a total quantity of 21 million, which experts expect us to hit some time near 2040. Bitcoin is only becoming more scarce, and at the same time, demand is only increasing as more investors try to get a slice of the profit pie. As a result, the price of Bitcoin has skyrocketed to an astounding present-day value of over $40,000, reaching a high of $68,000 in November of 2020. It’s safe to say that people have trust in the currency. Oh, and in case you were wondering, the 10,000 Bitcoin used to pay for those pizzas is now worth over $400 million.

How to Get Involved in the Cryptocurrency Market

So what does this mean for speculative investors like us? Since there’s no central body that we can point to, it can be tough to gauge whether or not a cryptocurrency will increase or decrease in value. ”. Valuation is hard, but there are few general ideas to keep in mind:

Cryptocurrencies gain their value based on the scale of community involvement. 

If the cryptocurrency monetary system is working well, providing fast and secure transactions with low fees,  we can expect more community involvement. As a result, demand will increase and so will the cryptocurrency’s value. Conversely, a network prone to hacks or slower transactions will have the opposite effect. 

Businesses will influence demand for cryptocurrencies as they adjust to incorporate them.

More and more businesses are starting to accept cryptocurrencies as a means of payment. For example, Microsoft now lets customers add funds to their Microsoft account using Bitcoin, while Overstock recently partnered with Coinbase to allow Bitcoin payments for online orders. Home Depot, Wikipedia, KFC, and Twitch are some other notable companies that have integrated cryptocurrencies into their business models. We can anticipate other businesses will follow to capitalize on users who prefer cryptocurrencies as their payment method. As a cryptocurrency’s utility increases, so does its value. 

Social media and the news will influence demand for cryptocurrency. 

National headlines certainly played a large part in jumpstarting Bitcoin’s early fame, and consequent successes. However, plenty of niche sources exist to “value” cryptocurrencies. Smaller, lesser known cryptocurrencies are often discussed on Reddit. And of course, there is everyone’s favorite combination of Twitter, Elon Musk, and cryptocurrency. In spite of the widespread media attention, we can anticipate regulations or national bans on cryptocurrency, which will undoubtedly exert a more permanent influence on their value.

Cryptocurrencies can be used to hedge against inflation. 

Cryptocurrencies can serve as a store of value: a place to put your money when fiat currencies lose real world value. However, the idea of cryptocurrency as an “inflation hedge” has been scrutinized as of late. Bank of America released a statement saying, “the argument for holding Bitcoin is not diversification, declining volatility, or inflation protection, but rather sheer price appreciation.” The price stability of a cryptocurrency, which reflects supply and demand stability, should be evaluated before using a crypto as a hedge to inflation. 


What Does the Future of Cryptocurrency Look like?

Cryptocurrency is young and exciting, but it doesn’t come without risk. For all the stories of individuals striking it rich, there are ten times as many instances of people losing it all. The fact that there is so little history behind cryptocurrency only increases the speculative nature of cryptocurrency as an investment. Nevertheless, the future of crypto looks bright and I am excited to see its progression over the next several years. With that, I wish you good luck and happy trading.

The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.


Sources and Further Reading:


Christian Siaton