Currencies From The Crypt
How does cryptocurrency work?
Cryptocurrency was one of the biggest financial phenomena in recent years: it dominated the news in 2021 and 2022, and the astronomical values and staggering drops of some cryptos had everyone wondering what the big deal was. Now, a year late to the action, I wondered: what exactly is a cryptocurrency anyways, and how does it work?
While you were partying, I mastered the blockchain
Not really, but pretty much. To understand Bitcoin, you have to understand how banks work. I have about 9,000 pesos (roughly 30 dollars) in the bank - what does that mean? Well, the bank doesn’t really have like a pile of cash from which they earmarked a small chunk to say “this is Maia’s”. Instead, the money I have is a loan I made out to them, and which they have in what is basically a fancier version of an Excel spreadsheet. So when you have a dollar in the bank, you don’t actually have anyting except an entry in a database that says you have a dollar. The weird part is that there isn’t any dollar anywhere - the entry is the dollar. So banks are a business built around producing currency through records of transactions (and also making loans) - if I pay for dinner with a debit card, they just reduce the number in my cell of the spreadsheet, and increase the restaurant’s number.
But banks aren’t perfect intermediaries (just look at the 2022 Nobel Prize) - this whole system is built around thinking that your bank isn’t going to be incredibly stupid and then go bankrupt and take the ledgers that say you have savings down with it, and in 2008 it was clearer than ever that this wasn’t a sure thing. So a person named Satoshi Nakamoto (we actually don’t know anything about them because it’s an alias) decided to create their own system to produce currency that doesn’t need you to trust the Wolf of Wall Street. This system, called Bitcoin, basically produces a currency also called Bitcoin (the distinction is important, so to avoid confusion I’ll call the thing that produces the currency Bitcoin, and the currency it produces BTC) by having records of transactions between two anonymized addresses - so a random string of letters and numbers that represents me1 sends my BTC to a random string of letters and numbers that represents the restaurant.
The list of all the accounts and how much money they have is public and available to everyone, but access to each account is private and available only to the person who owns the account - so you can do transactions in BTC by writing a message with a special code to someone else, and while the message (which is always “nonsense list of numbers and letters sends nonsense list of numbers and letters such and such amount”) is public, the codes to open either end and actually get the money are private. So nobody has to trust anyone - you just have to be able to read and write the publicly recorded messages.
The way this is done is called the blockchain, and it’s pretty complicated, but in general it works very similar to a public library. In a library, each book has a list of people who’ve taken it out, and the dates they took it out and turned it back in. A similar list, but for transactions with Bitcoin, is called a block. The blocks are stacked in order, basically so people don’t try to spend BTC they don’t have anymore. They all have references to the block tbat comes before so they're in order and therefore it’s harder to change the blocks afterwards - it’s like if they stitched together those book lists, for all books. The BTC is created because the blockchain says it is, basically. This isn’t too different from a bank: banks have a list of the money you earn and the money you spent, and you have more or less of it because you sign off on them reducing that amount and increasing someone else’s, for instance by paying for dinner.
The main difference between a Bitcoin and a bank is that your bank has information about your money that is private but specifically about you - they have your name, age, gender, address, ID, etc; and attach the money to those. They very very rarely let anyone who doesn’t have your explicit permission look at the money associated to you. On the contrary, all blockchain transactions are public, but they’re anonymous - so they know that a random string of numbers and letters sent 0.5 BTC to another, but don’t know anything else about them. The lists of books are updated by everyone at the same time, so everyone can check any transaction - but not the stuff behind them.
But how can you prevent people from making up false transactions? By mining. Mining Bitcoin is basically running a very large, very fancy computer 24/7 so it does a lot of math2, and the math it does is also verified by other miners - and they get paid, in BTC, for doing all this. How this works is that when a miner tries to submit a block of transactions so they join the official list (aka a librarian saying who signed such and such books on a given period), all the other miners “vote”, and they don’t get paid unless everyone else signs off. But couldn’t they conspire to make fake transactions? Yes, but if they did the BTC would eventually become worthless3, so it’s in everyone’s best interest to be honest as miners, even if they don’t especially care about Bitcoin.
So besides being public and anonymous, Bitcoin is also descentralized (all the miners decide, not some central clearinghouse that looks at transactions) and built on self interest, not trust - people are supposed to profit off Bitcoin working, not supposed to trust that others won’t profit off it not working. In a way, they made everyone a shareholder of a currency, so they all do better if they act honestly and it’s valuable vs if they act dishonestly and it’s worthless.
But obviously Bitcoin being relatively scarce, and being produced in this self-interested descentralized value doesn’t make it valuable. I could print Monopoly money in my house, and nobody would think it’s currency even if I printed really nice bills. The reason why people use money, as I’ve written before, is that they want to pay for things with it - forms of money have a network effect: if people think chunks of gold, or pieces of paper with faces on it, or giant rocks, or weird computer math puzzles are money, then they’ll use them as money, and they’ll become money. People don’t use bank money only because they trust the bank’s spreadsheets, it’s because everyone else is on bank spreadsheets. So Bitcoin’s value has to come from people using it, and not from like the process that creates it - lots of other cryptos work in basically the same way and are way less valuable.
Out of the ether
The other major cryptocurrency thing is Ethereum, which refers not to the currency (ETH) but rather to the system that creates it - that’s why I made a distinction. For Bitcoin, the two are the same thing, because Bitcoing the system for creating information only creates information about where BTC the currency goes.
Bitcoin is a computer that only does one thing: have a big spreadsheet that says who has how much BTC and where the BTC goes. Ethereum, on the other hand, lets people do more complicated things. You can write something called a smart contract, which is basically a computer program that says “if you do X, I’ll give you ETH” or “if you give me ETH, I’ll do Y”. They’re completely automated, so they work more like vending machines than like legal contracts. To prevent these contracts from getting too big and clogging up Ethereum, there’s a fee they have to pay (called “gas”) and a limit to how much gas you can use. So if your contract is “pay me 10,000 bucks and I’ll give you a picture of a monkey”, that’s not a problem; if you want to run some weird algorithm with 500,000 steps, you’ll have to go out of pocket. The gas money goes to whoever is mining Ethereum, which works a bit diffferently.
Instead of miners, Ethereum block curators are called validators, and what they do is simply they pony up some amount of ETH to become one. When that happens, they’re allowed to put stuff on the blockchain, and 6 other validators are chosen randomly to review this. If the new blocks are on the level, they get paid; if not, they get a fine taken out of their stake. The self interest runs similarly, but instead of needing a massive computer setup, you just need a lot of money and an internet connection.4 So Bitcoin has "proof of work", where you have to do work for the community to like be allowed to run the library cards; Ethereum has "proof of stake", where you just have to show that you care by (literally) investing in it. Either way the economics of either seem pretty solid; you have to incentivize both participation (people wanting to mine or validate at all) and incentive compatibility (people wanting to run the blockchain in a way that benefits everyone and not themselves). Making it profitable to be a "miner" incentivizes participation, but making it so you only get paid if the community thinks you're any good at it ensures incentive compatibility.
What’s the deal with the apes?
Something else you can do in Ethereum is create a thing called a token. The tokens come in two flavors. The first can be used to pay for things, and it’s pretty much a way for people too lazy to set up a cryptocurrency to have their own one - because they can be spent, they’re fungible tokens. The usefulness is mainly that you can create networks of transactions with their own private walled-off currency.
The more common type are the tokens that can’t be spent as money - they’re created like BTC or ETH, but instead of being identical to each other, they’re all different. So you’ll pay for a non fungible token (NFT) which is to a cryptocurrency what those weird coins where Lincoln is upside down are to regular coins. An NFT can also be used as a certificate of ownership - so if you buy a weird ugly picture of an ape from some guy online, what you’re actually buying is a quasi cryptocurrency that tells anyone who asks that you own it. You can buy an NFT of something you don’t even own - there were NFTs of the Mona Lisa, or the Brooklyn Bridge, and if you show up to the Louvre with your Ethereum account and ask to take the Gioconda home, they’ll laugh so hard you might even not go to prison for it.
You might think that this is an insanely stupid idea, but how does owning a car work? You pay for the car and you get the car, but you also get a piece of paper saying you own it. The difference here is much smaller than you think: if you lose or car, or it gets stolen, you can prove it’s yours by showing the piece of paper. And that piece of paper works by including you and your car as a “legally certified couple” in what’s basically a complicated spreadsheet the government runs. I know of someone who paid 30,000 dollars to buy a plot of land neither he nor the guy he brought it from have a deed over - that part of town has very loose property registrations, so you just need other people to vouch for you being the owner of a plot of land. One last example is a driver’s license: it’s just a piece of plastic with some numbers on it, but it somehow proves that you’re in the government’s spreadsheet of “people who are allowed to drive”, so you won’t go to prison if you’re found driving. The monkey NFTs aren’t dumb because it doesn’t make sense to pay for a certificate that you own something you don’t necessarily own, they’re dumb because people paid millions of dollars for an insanely ugly thing - the crypto equivalent of Damien Hirst.
I only brought this up because there’s something called the metaverse, which isn’t really a cryptocurrency thing but is also very stupid and somewhat related. The metaverse is an online thing created by Facebook (now called Meta) where you basically pay for certificates that you own several online things. So you can buy a house or clothes, for example, and pay real money for it. Now obviously there’s an infinite amount of stuff online, so you could have infinitely many houses on the metaverse and having them be free (like in The Sims, which is a non-genocide affiliated offline metaverse), but you could also have them work like NFTs and make them a way to show off - “look, Kim Kardashian is my metaverse neighbor”.
The interesting thing that crypto people did, and also that the metaverse is trying to do (as soon as they figure out how to give people legs) is to figure out a way to make numbers in a computer real - if I send you a text saying “I pay you 10 Maiacoin for being a good friend” that’s nonsense, but if I send you that message through the blockchan it’s real because the blockchain works by making random numbers really scarce. Everyone who owns The Sims has the house next to the Goths, but only the people who pay for it can have the metaverse house next to the Kardashians.
Point being, an NFT (or a metaverse receipt) isn’t too different from a deed to a house, an ID, or just a receipt, except the things you pay for are all online and often stupid and useless. But why do people pay for it.
A Fonzie scheme?
So Bitcoin is a very complicated system to process transactions, except instead of processing transactions in actual money it processes them in this random made up fantasy money, and everyone decided that was cool and now it’s worth a trillion dollars. The value comes from expecting that other people will want it and want to use it, but ultimately that’s just for using it as currency. So that means that something stupidly arbitrary can become very valuable just because everyone decides it is, like random internet money, stock for a defunct video game thrift store, or tulips.
This explains why some people might want to hold crypto even when they don’t ever expect to use it at a restaurant: if the price generally goes up, but it goes up for random stupid reasons that don’t reflect things from the actual economy, then buying it becomes a good bet. Crypto as an asset should work a bit like gold, where people have it because it goes up and down more or less randomly, except it’s not associated with like 600 years of human rights violations in the third world and instead is associated with climate change, which might be a bit better. But in reality it didn’t, and crypto in general bled hundreds of billions when interest rates went up, so it wasn’t very good at that, and might just have worked as a Ponzi scheme - the only way to make crypto projects profitable is to make more people give them money.
But the crypto economy being wholly separate from the real economy is bad for it being even remotely useful. If you go to the restaurant and tell them “12cbQLTFMXRnSzktFkuoG3eHoMeFtpTu3S give me a burger” they’d not only give you jack, they’d also send you to a psych ward and/or check for signs of a stroke. So if you want to turn your crypto into like, actually usable currency, you need what’s known as an exchange: basically a company that lets you make an account and trade regular money for crypto, and viceversa. But here’s the problem: exchanges work like banks. Because you can do illegal things with crypto (since it’s anonymous), they won’t let just anyone make an account, and will force you to give them information. And they have a spreadsheet connecting your data to your crypto addresses, which they don’t let anyone see. So they’re basically just banks, and like banks, they check that you won’t do anything illegal or they’ll call the cops on you. And their finances work just like a bank, so they borrow your money from you and promise you it’ll come out as crypto, or viceversa.
Broadly, the difference between crypto and a bank is that if you have problems, the bank helps you and crypto doesn’t. If you get ripped off, you can call the bank and get them to give you your money back, but you can’t undo a transaction that’s in a block in the blockchain without an insane amount of money and effort. The most common thing that people complain about in banks is that they can’t log into their accounts because they forgot their passwords - but if you lose your key to crypto, you lose it, like this guy who has hundreds of millions in BTC lying around but can’t use them. An exchange helps you get past this because they’re like banks, so they have customer service and can detect fraud, but that also means you can’t buy heroin or donate to Hezbollah without them telling the authorities, or at least blacklisting you.
The difference between a bank spreadsheet and a crypto spreadsheet is that people think that everyone will have information in their bank’s spreadsheet, even if it’s a different bank than your own, so doing transactions is easy. Banks have no reason to let other banks interact with their spreadsheets, but they do this because it’s better for business - just like gmail lets you talk to yahoo and hotmail accounts. But crypto is more like a social media site than email - BTC blocks don’t talk to ETH blocks (or any of the weird smaller ones) so you can’t even get your money off one network. There’s something called a bridge, which is a kind of computer program that can turn one crypto into another, except it’s super risky because someone could just hack it and steal all the money inside it.
You could also do a cryptocurrency that, instead of tracking who has some random made up thing, tracks who has US dollars. This is useful because it’s less prone to lose all its value, so it’s called a stablecoin - and they’ve been anything but. Either they have a lot of assets worth the amount they hold, or they move it around on an algorithm, or they make up a second cryptocurrency that’s made up and tie the two together and one of them to the US dollar. Of course, the last one only works if that currency has any value of its own, or if they have enough assets to defend parity, and they usually don’t, so a bunch of stablecoins have ended up crashing and burning.
For the wages of sin is death?
Crypto finance is really complicated (read this because I’m no good at finance) but ultimately you can see that BTC dropping by 20,000 dollars this year is proof they did something very very wrong. What did they do?
The first way to understand this is as a financial crisis. Crypto is a thing because Satoshi hated banks, since banks did really stupid things and might have all died out and taken everyone’s money (which, remember, is a debt the bank has with you) to their graves. What the banks did was finding good oportunities (massive groups of people’s mortgages), borrow a lot of money cheaply, and spend a lot in those. But people stopped paying their mortages because the economy got worse, so the banks started being in trouble, and they had to get bailouts because them going under would have been insanely bad (the 2022 Nobel Prize was 50% on this). Crypto wasn’t supposed to have this kind of thing, but a lot of people participating in the environment did it anyways. Then a bunch of coins started going down for weird idiosyncratic reasons, the people trying to profit in that way lost oodles of money, and they had to sell off their other assets, which were often crypto, so they all went down for the ride - something called contagion that happens to real world economies a lot.
The second is as a currency crisis (I’ve already argued this). Half the “crypto currency” word is currency, so it plays a role. People demand currencies to pay for things, or to save; the global economy got worse, so they needed actual money over fantasy internet money, making mainstream cryptos lose some steam. At the same time, a bunch of currencies that were pegged to the US dollar started having trouble keeping the peg, so traders saw an opportunity to force a “devaluation” and make enormous profits. The problem is that the cryptocurrencies backed by “fake” ones had what amounts to hyperinflation, because the currencies they used to defend the peg lost the value, so the “economy” collapsed. And when currencies in one group struggle, others start struggling too - Mexico had had currency/financial issues in 1994, then the Asian tigers in 95, then Russia in 98, then Brazil in 99, and finally Argentina imploding in 2001.
The main difference between the crypto implosion and something like the 2008 financial crisis, or a major currency crisis, is that not much happened to the real economy - big banks didn’t have a lot of crypto because regulators didn’t let them, and because they didn’t buy a lot of them anyways, so the regular bank issues didn’t appear. And because crypto isn’t actual day-to-day currency, speculative attacks didn’t mean that suddenly people had to face 70% inflation or everyone hoarded currency because of uncertainty - it was just weird people who loved pictures of apes.
Conclusion
The conclusion here is that repeating the stupid mistakes bankers and central bankers make in the real world won’t yield any different results just because the currency comes from lists of library books and not from bank spreadsheets.
Sources
Previous posts on why people use currency, bank runs and their consequences (aka the 2022 Nobel Prize), and the stablecoin collapse
Matt Levine, “The Crypto Story”, Bloomberg Businessweek, 2022
Basically what they do is they turn your information into hexadecimal (the numbers 0 through 9, plus the letters A through F) and that’s called a “hash”, which is like a username except the point is that nobody knows it, because it’s hard to turn a hash into whatever information it contains without knowing the information beforehand.
This so mining Bitcoin is very costly, so people are not super likely to try to forge votes on their new block proposals by making up tons of new identities and voting on the blocks.
Bitcoin’s biggest legacy might be making Kant’s categorical imperative a falsifiable statement - do the miners act according to the maxim that they can at the same time will it become a universal one, or not?
There’s also “pools” where you can put up a smaller amount of ETH so someone else validates on your behalf, and then all the people in the pool get a share of the profits from validating - it’s like the 18th century Netherlands up there.