Disclaimer: I have tried keeping the article as introductory as possible, so I might have missed a few things. Please report back if you find any inaccuracies.

While there are some people out there who are bullish on cryptocurrencies because they think they’re going to get a huge return on investment in a very short period of time, there are many out there who believe that the entire industry is a scam, or more precisely a Ponzi scheme. These groups of people, together, form almost an exhaustive set of human beings. I certainly do hope that there are a few people out there who actually understand the economics of cryptocurrencies, but, they’re not really that vocal. So, I’ve decided that I’m finally going to break my silence and give people a lesson in basic common sense working of cryptocurrencies.

Technical aspects first

To have a look at the bigger picture and get acquainted with the technical aspects of cryptocurrencies, let’s take a simple example of a bitcoin-like cryptocurrency that operates with Proof-of-Work mining mechanism (there are others like Proof-of-stake, that don’t require any energy and are faster, but we won’t get into that) and has a blockchain based ledger. Do note here that there are altcoins out there, each with it’s own unique aspect, mining mechanisms and ledger data structures, in fact, some are even centralised and non mineable, but, we’ll just ignore those complications for now. If you aren’t really interested, to save time, you could simply skip over to the ‘the money game begins’ section by assuming that cryptocurrencies cannot be forged and the ledger cannot be altered. I’ve tried keeping things as simple as possible, just so that the general public gets an idea of what’s happening.

Blockchain

So, here’s what’s really happening under the hood. A blockchain is like a chain of blocks, albeit with special strictly defined properties that turn a simple block of chains to a blockchain. To begin with, here’s what a block in a blockchain would look like:

As shown, the whole box is actually just a block in the blockchains of a ledger. Every single block holds a set of transactions. These transactions are kept together in a data structure called ‘merkle tree’. It doesn’t look as simple as I’ve shown over here, but at least it gives you an idea. The smaller boxes are all individual transactions that are arranged and connected together in a compact structure called a merkle tree. It is indeed this block that the miners compete to, first construct, and then get it attached to the blockchain.

The role of encryption

Now, here’s what a blockchain looks like:

So, what’s really the role of encryption here? Here’s what happens. When you encrypt the contents inside the blocks, as in, ask the computer to encrypt the contents, it gives you an output, which is called a hash (some call it digest, but it’s really just a generic word). The hash is really, just an arbitrary, but unique string of characters, of a fixed length. The hash has a property that whenever the contents of the block are changed, you will get a different, unique hash. That hash is taken and dumped into the contents of the Merkel tree of the next block. We repeat the same encryption process over and over again on every block and keep dumping the hash into the contents of the next block. As you might have already guessed, this creates a cascading dependence of the proceeding blocks on the preceding ones. Let’s say that an attacker tries to change the contents (transactions) of block number 100 in the blockchain. What would happen as a result, is that the hash of block number 100 will change. Remember that the hash of block number hundred was a part of the contents of block number 101. This would mean that block number 101 is no longer a valid block. Since the hash of block number 101 was a part of contents of block 102, it means that the validity of block number 102 also depended on the validity of block number 101. This means that block number 102 will also not be valid anymore. By induction, the entire chain of blocks, from 101 onwards will become invalid. To really have a chance of actually getting your forged version of blockchain, i.e. a version where all the hashes from 101 onwards have been changed, you need to gain at least 51% of the total (hashing) power of the network.

Mining

The miners are actually creating a block, every few minutes (for bitcoin, it’s currently set to 10 minutes). Now, they need to get it attached to the blockchain. So how do they do it? They do it, by providing a proof of work. Apart from the contents of the block, there’s another random number, called the nonce, that is added to the whole mixture (of contents) before producing the hash. You don’t know what the nonce is going to be, because it’s random (although, you do have the final hash of the block). So you need to guess it. Let’s say, you start with the number 1. You take the number ‘1’ and the contents, mix it well, and get a hash. If this hash matches the original hash that the computer had previously output, then you’re good to go. If not, you try it with some other number, until the hash with your custom nonce value matches the hash that you previously had, with a random nonce. The mining entity, that first reports the nonce of it’s block correctly is the one that wins the competition and successfully gets the block attached. This process of finding nonce is what consumes the most of the power. The rest of the miners will simply verify that your guess (nonce) was correct. The verification process doesn’t require much power and is thus, not rewarded, but, nonetheless, is mandatory, as a network membership rule. The nonce is also stored for verification in the future, to maintain the integrity of the network.

Decentralisation

As the miners are expected to be present across the globe, and at several locations, you can be sure that there’s no single point of failure, as in, it cannot get hacked as easily as even the distributed servers under a centralised entity do. It takes a huge amount of money (which is practically not possible and keeps rising with the increasing market) to tamper with the network. Since there’s no single body controlling it (i.e. nobody owns them. The miners are collectively responsible for running the network), cryptocurrencies are decentralised. It’s not possible for any single entity to tamper the records, as against centralised providers, like banks, that can easily do it.

The money game begins

Mining rewards

As the network traffic (i.e. the number of transactions, waiting to get added to the blockchain) increases, the demand for miners picking up the transaction increases. The mining software is greedy. Most of the transactions that it picks up, to form it’s blocks are the ones that are willing to offer higher fees. So, as you might have guessed, as the network traffic increases, the fees increases and miners start earning more and more. In addition, currently, a few additional coins are also created, which are awarded to the successful miners. Do remember that there’s an upper cap on the total number of coins. Once the limit is reached, this wouldn’t be a part of the reward for successful miners.

Scarcity creates value

Let’s have a look at marginal analysis here. You must already be knowing that people value goods unit by unit. Let’s have a look at an example. Let’s say that you’re locked up inside an empty room for a week and you have nothing along with you (except for clothes that you’re wearing). Now, if I offer you to choose between 10 dozen bananas and a brick of gold, given that you’ll be getting nothing else for 10 days, what would you choose? Choosing bananas would be the right choice here, because otherwise, you might die without food. So you see? Bananas are more valuable than a brick of gold right now. But let’s say that I give you 10 dozen bananas anyways, and then ask you to choose between another dozen of bananas and a brick of gold. What would you choose now? Probably a brick of gold. So you see? The marginal utility of gold has increased. On the margin, gold is more valuable than banana. The same goes for currency notes. The currency notes are a scarce resource. This is what gives them their value. As the federal reserve (or the central bank) prints more currency notes, it becomes less scarce and more abundant. Therefore, it’s value decreases. This process of printing more notes is called inflation. The government ensures that the design of currency notes is secure enough, so that any third party can not print notes as and when they require. That would leave the currency notes worthless, because of uncontrolled inflation. The same is true for Cryptocurrencies. Cryptocurrencies are also scarce goods. This is what gives them their value. In addition, they cannot be randomly created or destroyed, even by the federal reserve. Hence, they are non-inflationary as well. (If you’re thinking that you can simply copy and paste a bitcoin as many times as possible and multiply it, then that’s not the case. You can’t do it. That is, you cannot double spend.) The encryption protects it against any foreign intrusion, so they’re totally safe for use. To say that these coins are worthless, as many skeptics do, would be wrong.

The benefits of being non-inflationary

The federal reserve prints money as and when required. It does so, to create an artificial boom. It simply prints the money and buys debt (bonds) from middlemen (might be JP Morgan, I don’t know), who in turn bought it from the treasury (government). When the government borrows loan, it has to pay an interest on it. The government will naturally borrow money from the ones who provide it at a lower interest rate. The federal reserve does exactly that. Since the amount of loanable funds in the market has increased, because of inflation, lenders are willing to lend money at a lower rate of interest. This means that not only the government, but private entities can also take loans at a lower interest rate from the lenders. This means that they can invest more. This easy availability of money makes them reckless. They start investing carelessly, without thinking about whether or not there’s a demand for it. The stock prices go soaring, but ultimately, at some point, they do realise that there are simply not enough capital goods (and producer goods) as the amount of consumer goods waiting in line for production. So, the right thing to do, for the federal reserve is that they simply raise the interest rate and tell them that, “look, there isn’t enough capital goods out there. Only produce enough goods, that you have a market for. Don’t just keep borrowing.”. As a result, the investors in stock market start pulling out from the stocks that don’t have enough market, because they won’t be earning as much revenue and the market ultimately crashes. According to popular belief, even if the federal reserve keeps the bubble going, at some point, they will finally run out of capital and producer goods, that would be even more catastrophic. So, the bubble has to pop and the longer you wait, the harder it hits you back. Here’s where the real benefits of being non-inflationary comes up. Since you cannot create an artificial boom like the federal reserve did, lenders would be more cautious with their investments and take care of the actual market demand for what they’re investing in. The borrowers would be more cautious as well, because the interest rate is high. This significantly reduces the chances of bubble formation. Hence, cryptocurrencies are better than fiat because they’re immune from the artificial boom creation by the federal reserve. Companies can be sure that their stocks won’t fall in case the market panics. Remember, not every investment is a bad investment, but, when the bubble pops, almost all of them take a hit. As you might have already noticed, this gives cryptocurrencies a huge advantage against fiat currencies, in enabling free and open market. Traders would love to trade in cryptocurrencies, because, they wouldn’t need to worry about popping of bubbles while investing with cryptocurrencies elsewhere.
One thing to note here is that inflation in cryptocurrencies can happen due to hard forks. What this really means is that some members of the developer team disagree with the rest of the team and decide to have their own version of cryptocurrencies. What they do is, take the blockchain as it is, and convince a chunk of miners to update their software to their new version. This creates a diversion in the chain. Up until that point, whosoever had 1 unit of old currency, will also have 1 unit of new currency on their chain, and from that point onwards both the ledgers can be independently operated by the coin owners. This division of the mining power can lead to prices of both the coins to fall (because there are less people backing each of them, than what the old coin had, before the fork). This is a bad phenomenon, but it has only happened with Bitcoin (3 other hard forks existing) and Ethereum (1 other hard fork existing), among the popular ones.

Benefits against gold

Some of you might be thinking, “Aren’t cryptocurrencies exactly like gold in their behaviour?”. The answer is YES. You’re right. However, there are a few advantages. One would be that, gold is not so easily divisible. Once more and more people want to own some, you can’t really cut the coins in half and distribute them. Cryptocurrencies, on the other hand, are divisible upto very tiny fractions, that ensure enough liquidity, something that fiat acquires through the use of printing press. Another advantage is that, you don’t need to verify the validity of cryptocurrencies every time you receive them. The network does that for you. Gold, on the other hand, is quite difficult to verify. You need to carry an atomic balance and stuff like that, everywhere, to verify it’s purity.

Conclusion

I think that it’s safe to conclude that cryptocurrencies take almost all the benefits of fiat and gold and combines them into one. Not only that, it eliminates several of their disadvantages. Apart from this, they have several other utilities, like eliminating corruption with the help of a non-editable ledger and paving the way for future technologies, like Web 3.0 and Internet of Things. This would also help in rooting out funding to terrorism which was previously happening secretly through conventional payment systems, operated by companies like visa. It would also reduce the dependence on SWIFT and visa, who might want to take advantage of their powerful position or can be used to totally isolate a country in case of sanctions. Cryptocurrencies are the currencies of the future.