Money, Blockchain & Cryptocurrency
Aktualisiert: 3. Jan.
Georg Simmel, the German sociologist, in his book “Philosophie des Geldes” described money as “pure interaction,” and shows how money is a highly flexible form of exchange that can be divided in any number of ways which can be put to an infinity of purposes (Simmel, 1978).
In “The Wealth of Nations”, Adam Smith defines money by the roles it plays in society and outlines its three characteristics (Smith, 1776):
1) Unit of account - price of goods and debt is recorded
2) Medium of exchange - an item that buyers give to sellers when they want to purchase goods and services.
3) Store of value - an item that people can use to transfer purchasing power from the present to the future.
Bitcoin doesn’t completely adhere to Georg Simmel’s definition as it’s use as a form of exchange is limited. Additionally, whether Bitcoin has the above features of money, is what has divided academia, finance & economics practitioners, Bitcoin naysayers and aficionados alike.
The concept of Bitcoin is traced back to a paper titled, “Bitcoin: A Peer-to-Peer Electronic Cash System”. The paper was released by Satoshi Nakamoto on 31st October 2008, against the backdrop of the Lehman Brothers crisis and a looming global financial crisis. The paper underlines the “distributed consensus” problem. This is the question of how multiple, independently run computers can reliably agree on a set of common data in the presence of faults, i.e., where there is a risk that one or more computers are intentionally or unintentionally programmed to introduce false information (Nakamoto, 2008).
Mark Carney, former central bank governor of Bank of England, gave a speech at the Scottish Economics Conference on 2nd March 2018. He said that Bitcoin & other cryptocurrencies alike are poor store of values, and there exists extreme volatility in their values. They are inefficient media of exchange as prices aren’t quoted in Bitcoin. Given the former two deficiencies, they are virtually non-existent units of accounts (Carney, 2018).
Bitcoin is rather a crypto-asset, or some say a hedge against gold. Like gold, its supply is limited, and its intrinsic value lies on the economic consensus of the society. It operates free of any central control or the oversight of governments or banks. Instead, it relies on peer-to-peer software and cryptography.
Blockchain is based on distributed ledger technology (DLT). DLT is a way of sharing and recording transactions and data across multiple data stores which are called as “ledgers”. Each ledger has the exact same data records which is collectively maintained & controlled by distributed network of computer servers which are called “nodes”. Blockchain nodes communicate with each other. The more nodes a blockchain has, the more decentralized the network is. Blockchain employs an encryption method called as “cryptography”. It uses a set of specific mathematical algorithm to create and verify a continuously growing data structure. Data can only be added and cannot be removed from this data structure and forms a chain of “transaction blocks”, which functions as a distributed ledger. (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 1)
Blockchain is a technology which can exhibit different features and has fully open and permissionless, to permissions blockchain (Pascal Witzig, 2018):
Permissionless blockchain – A person can join or leave the network at will and no central entity’s approval is required to do so. Only a computer with relevant software is required to join the network and add transactions to the ledger. Identical copies of the ledger are distributed to all the nodes in the network and there isn’t any owner of the network and software (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 1). Majority of cryptocurrencies are based on permissionless blockchains (e.g., Bitcoin, Bitcoin Cash, Litecoin).
Permissionless blockchain – Nodes, which are transaction validators, must be pre-selected by a network administrator to join the network. The identity of network participants is thus verified. It also requires the network participants to entrust a central a central entity to select reliable network nodes (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 1). Neo and Ripple are cryptocurrencies based on permissionless blockchain.
A user on a blockchain network has set of two keys- a public & a private key. A private key is used to create a digital signature for a transaction. A public key, unlike private key, is known to everyone on the network. A public key serves the purpose of an address on the blockchain network and to validate the identity of the sender by verifying the digital signature (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, pp. 8-9).
How does a blockchain work?
Suppose A wants to send 10 Bitcoins to B. A will first digitally sign this transaction using her private key. A will address the transaction to B’s public key, which is B’s address on Bitcoin network. Next the transaction will be collated in a transaction block and will have to be verified by the nodes within Bitcoin network. A’s public key is used to verify its signature. The network will process the transaction and transfer 10 Bitcoins to B if A’s signature is valid.
A user’s cryptocurrencies along with public and private key are kept in a digital wallet and can be accessed from client software or a range of online and hardware tools. A wallet can be saved online (online storage is referred as “hot storage”) and/or offline (offline storage is called as “cold storage”) Inter alia: (European Central Bank, 2015, p. 8); (FATF, 2014, p. 8).
Source: (Jane Wild, Martin Arnold and Philip Stafford, 2015)
One of the key advantages of blockchain technology is that it allows to simplify execution of transactions that would normally require the intermediation of a third party (e.g., a bank, a custodian, a securities settlement system, broker-dealers, etc.) The essence of blockchain is to decentralize trust and enable decentralized authentication of transactions (Pascal Witzig, 2018, p. 5). In simple words, it allows to cut out the middleman.
Any node within a blockchain network can propose addition of new information to the blockchain. The legitimacy of this new information is validated when nodes reach a form of agreement. Here a “consensus mechanism” comes into play. A consensus mechanism is a predefined specific cryptographic validation method that ensures a correct sequencing of transactions on the blockchain (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 6). Such sequencing is required to address the issue of “double-spending”- if transfers are not registered and controlled centrally the same payment instrument or asset can be transferred more than once (Houben, 2015).
The two best-known consensus mechanisms are:
Proof of Work (PoW)
In a PoW system, a network participant must solve a “cryptographic puzzle” to be allowed to add new “blocks” to the blockchain. This puzzle solving process is called “mining” (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 6). These puzzles are made up of all information previously recorded on a blockchain and a new set of transactions are to be added to the next “block” (Ernst & Young, 2018, p. 17). Since each puzzle becomes larger over time resulting in a complex calculation it results in consumption of significant amount of electricity as the PoW mechanism requires a vast amount of computing resources.
If a network participant has solved a puzzle, it proves that he has completed the work, and is rewarded by newly mined coin. This reward serves as an incentive to uphold the network (Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein, 2017, p. 8). Bitcoin, Bitcoin Cash, Litecoin are based on a PoW consensus mechanism.
Proof of Stake (PoS)
In a PoS system, a transaction validator (i.e., a network node) must prove ownership of certain amount of cryptocurrency to validate transactions. This act of validating transactions is called “forging”. A transaction validator will have to prove his “stake” i.e., his share of all coins in existence to be allowed to validate a transaction. Depending upon his ownership of coins, he will have a higher chance of being the one to validate a transaction. A fee is paid to the transaction validator for his validation services by the transacting parties. Ethereum switched to PoS in 2022 as it is more secure, less energy-intensive and better for implementing new scaling solutions compared to the previous PoW (Proof-of-stake (PoS), 2022).
Blockchain technology can be applied to variety of sectors such as healthcare, governance, trade, and commerce. In addition, it has numerous potential applications and could impact registration of shares, bonds and other assets (Committee on Payments and Market Infrastructures, 2015), pledging of collateral, transfer of property tiles and the operation of land registers (Abrams, 2022).
Abrams, E. (2022, August 17). How European countries are using blockchain to reform the land registration process. Retrieved from Emerging Europe: https://emerging-europe.com/voices/how-european-countries-are-using-blockchain-to-reform-the-land-registration-process/
Carney, M. (2018, March 2). The Future of Money - speech by Mark Carney. Retrieved from Bank of England: https://www.bankofengland.co.uk/speech/2018/mark-carney-speech-to-the-inaugural-scottish-economics-conference
Committee on Payments and Market Infrastructures. (2015, November). Digital Currencies. Retrieved from Bank for International Settlements: https://www.bis.org/cpmi/publ/d137.pdf
Ernst & Young. (2018, March). IFRS – Accounting for crypto-assets. Retrieved from https://eyfinancialservicesthoughtgallery.ie/wp-content/uploads/2018/03/EY-IFRS-Accounting-for-crypto-assets.pdf
European Central Bank. (2015, February). Virtual currency schemes – a further analysis. Retrieved from European Central Bank: https://www.ecb.europa.eu/pub/pdf/other/virtualcurrencyschemesen.pdf
FATF. (2014, June). Virtual Currencies – Key Definitions and Potential AML/CFT Risks. Retrieved from FATF: http://www.fatf-gafi.org/media/fatf/documents/reports/Virtual-currency-key-definitions-and-potential-aml-cft-risks.pdf
Houben, R. (2015). Bitcoin: there two sides to every coin. International Centre for Criminal Law Reform & Criminal Justice Policy, 26(5), 195.
Jane Wild, Martin Arnold and Philip Stafford. (2015, November 1). Technology: Banks seek the key to blockchain. Retrieved from Financial Times: https://www.ft.com/content/eb1f8256-7b4b-11e5-a1fe-567b37f80b64?segid=0100320#axzz3qK4rCVQP
Nakamoto, S. (2008, October 31). Bitcoin: A Peer-to-Peer Electronic Cash System. Retrieved from Bitcoin: https://bitcoin.org/bitcoin.pdf
Pascal Witzig, V. S. (2018). Cutting out the middleman: a case study of blockchain-induced reconfigurations in the Swiss Financial Services Industry. Retrieved from Working Paper 1, 2018/E, the Circulation of Wealth, Université de Neuchâtel: http://www.unine.ch/files/live/sites/maps/files/shared/documents/wp/WP-1_2018_Witzig%20and%20Salomon.pdf
Proof-of-stake (PoS). (2022, September 21). Retrieved from Ethereum.org: https://ethereum.org/en/developers/docs/consensus-mechanisms/pos/
Simmel, G. (1978). The Philosophy of Money (English Translation). London: Routledge and Kegan Paul Ltd.
Smith, A. (1776). The Wealth of the Nations.
Solvej Karla Krause, Harish Natarajan, Helen Luskin Gradstein. (2017, December 1). Distributed Ledger Technology (DLT) and blockchain (English). Retrieved from The World Bank: https://documents1.worldbank.org/curated/en/177911513714062215/pdf/122140-WP-PUBLIC-Distributed-Ledger-Technology-and-Blockchain-Fintech-Notes.pdf