Cryptocurrencies explained

The spread of cryptocurrencies, especially bitcoin, raises a number of questions. What exactly are they? How do they work? What does the jargon behind them mean? What are the consequences for states, and even for democracy?

Bitcoin was born in 2008, the same year Lehman Brothers declared bankruptcy. On October 31 of that year, a user identified as Satoshi Nakamoto posted a message on the “Cryptography” mailing list saying: “I have been working on a new electronic money system that is totally peer-to-peer, with no trusted third parties”. It also contained a link to a document hosted on the site known as a “white paper” explaining point by point how the system works. In reality, no one knows Nakamoto’s true identity.

Bitcoin was the first digital currency that managed to transfer value between users without the need for a central authority to verify transactions. The idea, as simple as it sounds, gave rise to an unprecedented monetary revolution. On January 9, 2009, Nakamoto released version 0.1 of the Bitcoin client (today known as Bitcoin Core), an open source software that connected several computers together, and this gave rise to the network that would support the cryptocurrency. The network’s tasks were, on the surface, simple: allow transactions between users, list all transactions, verify that the same coin is not spent twice, and issue new monetary units.

That same day, at 00:54, the first bitcoin block was mined and with it the first units were created. Three days later, on January 12, 2009, Hal Finney, one of the most prominent members of the “Cryptography” mailing list, received the first ever bitcoin transaction. On April 26, 2011, Nakamoto sent his last message and disappeared from public view. Three years later, on August 28, 2014, Finney died from advanced amyotrophic lateral sclerosis. His body is preserved in a cryogenic state at the Alcor Life Extension Foundation laboratories.

Along with Nick Szabo, Finney is recognized as one of the pioneers of bitcoin and one of the main suspects of being Satoshi Nakamoto or, at least, of having had close contact with the anonymous character.

What is bitcoin?

Bitcoin, besides being the name of the currency, is the network that supports it: a peer-to-peer (p2p) network, without intermediaries, that allows value to be sent from one part of the planet to another without asking anyone’s permission, at a relatively low cost, in a semi-anonymous, fast and totally irreversible way. These features allow Bitcoin to be immune to censorship attempts by any nation, company or authority.

Users can transfer bitcoins across the network to do almost anything that can be done with conventional currencies, such as buying and selling goods and services or sending money to another person, and some platforms even allow receiving or granting credit using bitcoins. Bitcoins can be bought, sold and exchanged for other currencies at specialized exchange houses. Unlike traditional currencies, Bitcoin is entirely virtual. There are no physical currencies to represent it.

Users of the network have a series of keys (known as private keys) that allow them to prove ownership of the bitcoin. With these keys, transactions can be made to other users of the network. The keys are stored in digital wallets, which can be on a personal computer, on the phone or even on specific hardware designed for this purpose. The private keys that allow transactions are the only prerequisite for sending bitcoins, thus leaving full control of their funds in the hands of the users.

What is mining?

Each Bitcoin unit is created in a process called “mining”. Certain nodes in the network, called miners, compete to find the solution to a mathematical problem while processing bitcoin transactions. Any participant in the Bitcoin network can become a miner, as long as they make the processing power of their computer available to verify and record transactions.

Every ten minutes, on average, a Bitcoin miner competes to validate all transactions for the last ten minutes and, if successful, gets a reward in the form of bitcoins. This function is known as “proof of work”.

Currently, the reward consists of 6.25 bitcoins per mined block, and every 210,000 blocks, the reward is halved. Bitcoin will thus reach a limit of around 21 million units. This limit is deduced from the very speed at which new Bitcoin units are issued, which is set in the network’s software. In addition, each Bitcoin unit can be divided into 100 million parts, i.e. we can fraction a bitcoin until we obtain 0.00000001 of each unit. This minimum unit is called satoshi.

The bitcoin protocol includes algorithms that regulate the mining function in the network. The difficulty of solving the mathematical problem that allows mining a block is automatically adjusted so that the validation time between one block and another is ten minutes, regardless of the number of miners competing at the time. The number of bitcoins in circulation takes the shape of a predictable curve approaching 21 million by the year 2140. Since the rate of issuance is decreasing, in the long run, bitcoin is deflationary. It cannot be inflated by “printing” new money beyond the expected issuance rate.

But just because it is a virtual currency does not mean there is no “materiality” behind it. Mining bitcoins requires the use of electrical power. With the current conditions where competition is widespread, bitcoin mining becomes profitable in regions that have some comparative advantage, such as very cheap electric power. The greater the computing power, the greater the probability of solving a block and, therefore, of obtaining the reward. That is why “mining pools” were created to concentrate that firepower.

That is one of the reasons why Paraguay, for example, became one of the places where “mining bitcoins” is profitable. “In Paraguay it is still profitable to mine bitcoins because we have the lowest cost of electricity in the region,” says Luis Pomata, CEO and co-founder of Nano Mining Paraguay. “The normal cost is 5 cents per KW/h and can even reach 3 cents per KW/h. This is something that is only seen in Asian countries or in some places in North America.” And he adds that the South American country also has “low technical labor costs and finally you can buy or rent warehouses/sheds to use them as data centers that meet the necessary requirements to house the mining machines at a very affordable price”.

How do you get your value?

One of the most frequently asked questions about Bitcoin is “how does it get its value” or “what backing does it have”. In order to answer this, we must take a little historical detour. At the end of World War II, the need arose to create an international trading system that would avoid the imbalances that had led to World War I, the crash of the 1930s, the rise of fascism and, finally, again to war and the Holocaust.

The United States, with the doctrine of liberal globalism at the forefront, maintained the hypothesis that a world open to trade was a world of peace. Thus, at the Bretton Woods conferences, the U.S. dollar became the guarantor of international trade and, therefore, of peace. Until then, the dollar had a fraction of gold that guaranteed its “value”. Dollars, in short, were convertible into a portion of gold. But in 1971 Richard Nixon decreed the United States’ exit from the gold standard and the U.S. currency was no longer convertible to the precious metal. Thus, no global currency could be convertible, via the dollar, to gold. This type of money is known as fiat money.

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