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Decrypting the Crypto

In this week's FinMail we simplify all that the people on the internet have to talk about. Cryptocurrencies!

The Story:

A few weeks back, Elon Musk tweeted that Tesla would start accepting Bitcoin as payments meaning purchasers can buy Tesla by paying Bitcoins in return. Visa too a few weeks ago announced that it will start accepting Bitcoin as settlements in payments. Paypal too has started allowing users to pay in Bitcoin, Ethereum & Litecoin. Companies like Microsoft, Wikipedia & Starbucks have shown their support by considering cryptocurrencies as a medium of exchange. With countries too opening their doors for Cryptocurrencies there is also a certain curiosity around it and thus we thought let's start simplifying it with our readers. Before we start, we want to provide a disclaimer that Cryptocurrency as a concept is wide and complicated and hence we have tried to cover as much as we can in a single issue while taking care that you don't get bored.

What is Cryptocurrency?

Let's understand Cryptocurrency with a simple example. Assume that Paytm has come up with a new feature in its app where you can earn Paytm Points by playing games in the app. These games are puzzle games, quiz or games that require logic and intelligence, with high difficulty which means not everyone would be able to solve them. The players who solve them will be rewarded with Paytm Points. Paytm has decided to continue this offer till it distributes 1,00,00,000 Paytm Points to the winners. These points can be used to purchase products on Paytm Mall or to pay for anything on the Paytm app. These points can also be redeemed for Paytm Cash or can be withdrawn to your bank account as well.

Because getting the Paytm Points would be difficult, there would be some kind of curiosity on how to get those points. And if the points meant some money, you would also like to pay for obtaining such points. And thus there comes a market where people would trade their points for money or vice versa. Note here once Paytm Points get issued to some user, Paytm has no right or control over what the user does with those points. Paytm's job ends with the creation of that game (computer program & algorithm).

Now let us tie the loose ends to help you understand.

Cryptocurrencies too function similarly, as a medium of exchange i.e. you are able to buy/sell something using Cryptocurrencies. The process of solving puzzles is called the mining of Cryptocurrencies which involves some really difficult codes that need to be solved within the specified time frame to get them as rewards. Let's say Bitcoins are limited in number, so there exists a certain demand for it whereas supply is limited and hence it carries a value that a miner asks for providing you Bitcoins. And hence Bitcoin is valued at crazy valuations.

Cryptocurrencies are much much more complex than what we understood but for us to understand them as a concept, it is sufficient. Let us summarise Cryptocurrency,

Cryptocurrency is a type of digital asset/currency which is used as a medium of exchange to transfer anything. Cryptocurrency is limited in numbers and thus carries a certain value. Unlike other currencies in the world, Cryptocurrency is not controlled or regulated by anyone which is our next point of discussion.

How did the first Cryptocurrency come into existence?

Imagine you go to your bank to withdraw your money and you come to know that the bank has ceased withdrawal transactions from every account because the businessman which had taken a huge loan from the bank has fled the country and the bank is in no condition to recover the loan and thus due to shortage of funds, the bank decided to cease all withdrawals for some days.

Throwback to the night when the PM announced that the notes of ₹500 and ₹1000 will cease to exist from midnight and will only be a paper with no worth from the time ahead.

The panic is the same in both situations. We have used these examples to help you understand the motive or the reason that fuels the popularity of cryptocurrencies. Satoshi Nakatomi, the person who found the world's first Cryptocurrency - Bitcoin mentions in his research report that there is a need for a purely peer-to-peer version that promotes the transfer of electronic cash without a need of a financial institution in between.

To simplify, take for instance the events of demonetization, the government said that ₹500 and ₹1000 notes will not have any value henceforth, and thus out of nowhere they became just a piece of paper just because a government said that it is not valid. So for you to be able to use that note (a piece of paper) you need a government or a financial institution that backs it. The note doesn't carry any trust but the institution which backs it is the reason people trust that note.

This is similar in the currencies around the world be it US's Dollar or Britain's Pound. They carry value because the government says so. The whole system works on trust and this is what a major layback in the current currency system marks Satoshi. The government can also keep on printing more and more currencies which can also trigger inflation and thus it is just really a trust system that fuels the current currencies. So Cryptocurrencies are based on the foundation that they will not be regulated by any government or financial institution and there will be only a limited number of Cryptocurrencies in the world so the value of it will purely depend on the demand and supply force just as the value of other limited resources, for example. crude oil, gold, metals, etc are derived by market forces. Now let's understand the soul of cryptocurrencies - Blockchain Technology.

What is Blockchain Technology?

As we discussed in the example of understanding Cryptocurrencies, there are puzzles that a person needs to solve to be able to mine/get Cryptocurrencies. Blockchain, in particular, is a technology on which Bitcoin is created. For someone who wants to mine a Bitcoin, they need to solve the puzzle of Blockchain which contains several complex codes, when solved, rewards the solver of the code with Bitcoins. But what particularly is this game of Blockchain?

Blockchain, as the name suggests, is a chain of blocks (too obvious) The blocks are like ledgers that contain various records of transactions between the Bitcoin holders. For example, if A and B hold 10 Bitcoins each then the ledger records the same and the copies of the ledger are also sent to both A and B which can be used to verify the ledger without any problems.

If A sends 2 Bitcoins to B then the ledger (block) records the transaction and the remaining balances with the parties. Then the system also sends updated information to both A & B. Consider this for 1000s of people who hold Bitcoins, the number of blocks would increase thus creating a chain of blocks. Now, let's say someone wants to scam these blocks and wants to change the records in the ledgers, he would have to change all the ledgers of the persons that hold them which would be technically impossible as blocks and blocks are generated in the chain as transactions happen. So it is very difficult for someone to hack the system and steal from people holding Cryptocurrencies and thus this is the technology that is earning praise which is a result is promoting Bitcoin. As everyone has the data about each transaction, the system is now decentralized as against a centralized system where one institution (bank) has all the data. And being very secure, it is called the Technology of the future in the FinTech sector as security matters the most in Financial Technology. So this is what basically Blockchain Technology means. This is a technology on which Bitcoin is created. There are other Cryptocurrencies as well created on different technologies but we are discussing just the Blockchain as Bitcoin is the mainstream of Cryptocurrencies.

Now that we have discussed the basics of Cryptocurrencies, there is much more to be explored about the same. We would like to conclude this issue with one basic question that many od us have. It is already a long issue so let us conclude with one such question and we will cover the rest in upcoming issues.

Why are Cryptocurrencies so volatile?

The foundation of the majority of Cryptocurrencies is that they are limited plus Cryptocurrencies as Asset is something new to people so there is not a lot of acceptance rate right now. So when a popular personality tweets about it or positive news comes in, people get curious about it and thus the demand suddenly rises, pushing up the prices and the limited supply of it adds to the price rise as well. In the same case, if some negative news comes in, people start selling and thus pushing down its price. Hence, it is so volatile as the concentration of Cryptocurrencies i.e. people holding Cryptocurrencies is so low.

So that is it for this week's FinMail, we will see you in the next one.


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