Crypto here, crypto there. Countless “introductory” webinars and article reads later, you still don’t quite grasp how this whole thing works. Rest assured, you’re far from being the only one.
Cryptocurrency is notorious for its high learning curve, so don’t beat yourself up if you can’t seem to understand. This article will offer a concise description of how cryptocurrency works, and why it is superior to fiat currencies as a form of money.
In essence, cryptocurrencies are programmable money living on a decentralized network (the blockchain) — a shared public ledger.
User independence on their funds is achieved through encryption/decryption processes via public keys (your public key or crypto address, like your bank account number) and private keys (your private key or seed phrase, like your bank account password). This is referred to as public key cryptography.
Complex math powers public key cryptography, specifically designed to allow users to encrypt pieces of data with a public key. However, decryption can only be done with a private key. Conversely, you can encrypt a piece of data with your private key, but it can only be decrypted with your public key.
Furthermore, it is also designed in such a way that although the public key is generated from its private key, you can never work backwards to derive the private key from its public key — again, this is enforced via mathematical algorithms.
To put things into perspective, as an analogy, if you receive a package from Amazon, you want to make sure that: a) Indeed Amazon has sent the package and not some bio-terrorist (signing) b) While in transit, nobody else knows what is inside the package (confidentiality) c) The package is not tampered with while in transit (tamper-proofing).
Similarly, a network transaction also involves a sender, the ‘in-transit’ or network pipe, and a receiver. Public key cryptography comes in to solve the problem of signing, confidentiality, and tamper-proofing of network transactions, all in one neat package.
Bear with me, let’s see how cryptocurrencies aka “data” are sent in practice:
The sender encrypts the data that the sender wants to send to the receiver with the sender’s private key to create the signature “sender-private-encrypted-data”. This is then combined with the data once again to form “data + sender-private-encrypted-data”.
The sender will again encrypt the above with the receiver’s public key to form “receiver-public-encrypted-data”. This is broadcasted on the blockchain network — no intruder can decipher this message as only the receiver’s private key can decrypt it.
The receiver would for the first time decrypt the above with the receiver’s private key, from “receiver-public-encrypted-data” to “data + sender-private-encrypted-data”. Since only the receiver can see “data”, confidentiality is achieved.
The receiver would for the second time decrypt only the “sender-private-encrypted-data” using the sender’s public key, resulting in “data”. Being able to decrypt it with the sender’s public key ensures that signing is achieved, and the fact that decrypting it with both the receiver’s private key and the sender’s public key results in the same “data” means that tamper-proofing is achieved as well.
Once a transaction has been authorized (or “signed”), it will be made eligible for inclusion into the blockchain (or the shared public ledger). Only when the transaction has been successfully included, then the balance change will be reflected on both your address and the receiver’s address.
With that said, we need to decide on a mechanism that decides who gets to write this transaction into the blockchain in the first place. Enter what we call “consensus mechanism”. Although there are various models of consensus, the two most prevalent ones are proof-of-work and proof-of-stake.
In proof-of-work, people (referred to as miner nodes) compete to solve a complex mathematical problem, and the first miner to get to the solution gets to group a bunch of pending transactions into a “block”, and then include it into the blockchain — obtaining cryptocurrencies as compensation for each successful block inclusion. Therefore, the more powerful a miner’s mining rig, the better the chance they will have of being the first one to solve the math problem, and hence the likelier that they will be able to “mine” the next block.
In proof-of-stake, the probability of a node mining the next block will be equivalent to the percentage of their staked tokens relative to the total tokens staked in the network. For example, if you staked 1 $ETH, and the total staked in the network is 100 $ETH, then you will have a 1% chance of mining the next block. Similar to proof-of-work, the miner will be rewarded with cryptocurrencies as compensation for each successful block inclusion.
Once a block has been mined, all transactions included inside this block can’t be reversed or tampered with — the block will be stacked on top of the previous block, such that the series of stacked blocks (hence the term “blockchain”) presents a chronological view of transactions. These “stacks” are engineered in such a way that each node on the network will be able to verify that the latest block is indeed stacked (or “chained”) by the “winning” miner — facilitated via a hash-based data structure called the Merkle Tree.
Now that we know how cryptocurrencies actually work under the hood, the remaining parts of this article will elaborate on why cryptocurrencies are by far the superior form of money in comparison to our existing fiat money system.
In a nutshell, the current financial system is just a network of silo-ed bank ledgers, with each country’s central bank at the top coordinating everything: from interbank transfers to the reduction or expansion of its currency’s money supply.
To illustrate, when you transfer $1 to a friend, the money doesn’t actually “move” per se. Instead, the bank will just adjust your’s and your friend’s balances accordingly on its internal ledger, debiting $1 from your account and crediting $1 to your friend’s account. If your friend uses a different bank, both banks simply account for this movement internally until the central bank adjusts for this interbank money movement on its ledger.
Hold your horses, this gets even more complicated for international transfers — involving what we refer to as Nostro and Vostro accounts.
As a byproduct of how our current financial system is structured, besides being highly inefficient by itself, it gives financial intermediaries a bird’s eye view on transactions, in which they can intervene at will.
Donating money to a political opponent of the current government? Blocked, whereabouts tracked, then jailed. Moving money out of the country? Restricted, whereabouts tracked, then questioned. While this might seem exaggerated for those living in functional democracies, just ask the citizens of China or Vietnam — they would beg to differ.
You could even go as far as to say that banks are ultimately the ones controlling “your” money. What you are holding is simply a receipt that says that your money is with the associated bank, backed by ‘good faith’ that the receipt will be honored at all times.
While highly unlikely, if your bank goes belly-up, your money will be at risk (in the United States, the FDIC will only insure up to $250k per individual per bank). Again, although this might seem exaggerated, just ask Saudi Arabia women on whether they can open a bank account without involving a male guardian, or Venezuela citizens whether they think saving money in a bank is a good idea.
In addition, due to the silo-ed nature of the current financial system, opacity in financial markets is inevitable. For example, an asset can be securitized by a bank, sold to the bank’s investors, gets further repackaged by these same investors, and then resold again to other entities. Extrapolate this instance with every representable asset on the financial system, and what you get is a messy convoluted spiderweb of financial products with untraceable “source” assets.
In fact, this is exactly what happened during the 2008 Global Financial Crisis, culminating in the bankruptcy of Lehman Brothers (at the time the fourth largest investment bank in the US) and the bailouts of other firms deemed to be “too big to fail” (the likes of Bear Stearns and AIG). This would not have happened in the first place if everything is out in the open for the public to scrutinize — allowing anyone to transparently evaluate the tangible value of these repackaged securities for themselves over being forced to blindly trust the security underwriter’s word for it.
Cryptocurrencies allow you to no longer subject yourselves to a bank’s internal ledger for money movements. Anyone is able to initiate a transaction, and no one is able to do anything to prevent your transaction from going through — unless you pay absurdly low amounts of gas fees (miners won’t bother including your transaction into their block, as they feel they are not compensated enough for it).
Gone are the days when we had to adhere to a bank’s working hours, wait 10 minutes (or even a few days) for a transaction to be confirmed, or pay $50 in fees per transaction — blockchain networks like Solana or Avalanche operate 24/7, confirm within a few seconds, and charge mere cents in fees.
Without needing to involve banks, intermediary banks, and central banks for international money transfers, sending money via cryptocurrencies to a friend residing on the other side of the world would be as if you’re sending money to your neighbor living just a few blocks down the road!
Moreover, instead of being forced to trust the ‘good faith’ of banks to store our money, cryptocurrencies provide anyone with the option to store money on a decentralized network that is impossible to shut down (unless the whole internet goes off, which if it does, we would have bigger problems to worry about). As far as saving money goes, options are no longer restricted to the currency of the country you reside in or are a citizen of.
Donating to an opposition political party? Go ahead. Handling $1m as a 12-year-old business owner? Why not. Opening a bank account without a male guardian as a woman in Saudi Arabia? Who needs one when you can save in cryptocurrencies!
This might seem trivial for people living in countries with stable currencies, but for those living under oppressive (like Saudi Arabia or Afghanistan for women) or corrupt regimes with highly inflationary currencies (such as Argentina or Venezuela), cryptocurrencies present the only lifeline for them to store wealth and escape the continuously eroding purchasing power of their local fiat currencies.
To top it off, blockchain networks enable anyone to have equal access to transaction records, compared to our current financial system where only select financial institutions are provided with this privilege — significantly reducing information asymmetry.
Recall the example of an asset being securitized and repackaged repeatedly. If every transaction is done on the blockchain, then no matter the number of ‘iterations’ that a securitized asset has been subjected to, we can always trace it back to the “source” asset with confidence, knowing that any transaction recorded on the blockchain will be immutable — no entity is able to reverse or tamper with an already confirmed block.
Cryptocurrency is an amalgamation of various technological components elegantly intertwined with one another: public key cryptography, consensus mechanism, and the Merkle Tree data structure, just to name a few.
A new frontier of a similar magnitude to the internet in the 1990s, the advent of cryptocurrencies made it possible for us to reimagine the entire stack of our financial system — away from the inefficient, centralized, and opaque nature of fiat money.
Money is the lifeblood of the economy. Cryptocurrency might just be the messiah that we are all waiting for: a superior form of money on a better financial system to propel our economy of the future to the next level.
Also published here.