Cryptocurrencies are digital monies (or, potential monies) that rely on cryptography to keep transactions secure and govern the supply over time. The most popular cryptocurrency to date is bitcoin. There are many others (usually referred to as AltCoins), including ripple, litecoin, and dogecoin. Following bitcoin, most cryptocurrencies are based on a publicly viewable ledger known as the blockchain. As such, we can take a closer look at the bitcoin protocol to see how cryptocurrencies work.
Transferring a balance of bitcoin amounts to debiting the sender’s account on the bitcoin ledger and crediting the receiver’s account. This takes place in two stages. First, a transaction is initialized when the sender uses his private key to authorize a transaction to the receiver’s public address. Second, the transaction—or more correctly, a block of transactions—is confirmed as legitimate and added to the blockchain. Who gets to decide if a transaction is legitimate? That’s the beauty of bitcoin. Transactions are pretty easy to verify as legitimate. One need only run a hash function and compare the computed hash value to the known and expected hash value. But, absent sufficient checks, we might worry that a malicious user will confirm an unauthorized transaction as legitimate. This is a problem because it could enable users to spend the same balance multiple times.
Bitcoin overcomes this problem by requiring those confirming the transaction to produce a hash value that is less than or equal to the target value for the block. The first user to produce a hash value that satisfies this criterion gets to update the ledger. Since satisfying the criterion reduces the ability to update the blockchain to a random probability equal to one’s relative computing power, no one user (or group of users) can continue to update the blockchain round after round without possessing a majority of computing power on the system. To be a bit more precise, there isn’t one blockchain. At any moment, there are many competing blockchains that users are proposing as legitimate. The bitcoin system recognizes the longest blockchain as valid. So, when updating the blockchain, users start with the longest one available and modify it with the most recent block of transactions.
With this in mind, we can think of what would happen if a dishonest user were, by chance, able to add an unauthorized transaction to the longest blockchain. The honest users on the system would recognize that the transaction is fraudulent and would apply their computing power to updating the legitimate blockchain. As long as they have more computing power than the dishonest user(s), they will eventually be able to produce a blockchain that is longer than the fraudulent one. Of course, would-be dishonest users know adding unauthorized transactions is a losing proposition in the long run so they are better served by applying their computing power honestly.
Why are they encouraged to do good? Users that contribute computing power to the system are rewarded with new bitcoin whenever they win the lottery that allows them to update the blockchain. This is the only way to generate new bitcoin. The reward, which was originally 50 bitcoins per confirmed block, is cut in half roughly every four years. Moreover, the target is adjusted such that one block is processed roughly every ten minutes. If computing power increases, such that the target is hit too frequently, the target is automatically adjusted downward making it less likely to be satisfied. If computing power decreases, such that the target is not hit frequently enough, the target is automatically adjusted upward making it easier to satisfy the criterion. In this way, the bitcoin system ensures that the supply of money grows in a steady, predictable manner.
There are a lot of questions surrounding bitcoin in particular and cryptocurrencies in general. Will cryptocurrencies be able to overcome switching costs and network effects to achieve widespread acceptance? Can bitcoin become a major currency? On what grounds might regulators attempt to dissuade would-be users? Can governments prevent bitcoin and other cryptocurrencies from succeeding? Will the blockchain technology be used to process digital transactions? I address these questions in the linked-to articles. I’ve also teamed up with the Institute for Human Studies to offer a free-to-access and fairly comprehensive online education program on the economics of bitcoin. Cryptocurrencies are a new and interesting technology, though. So many questions are sure to follow.