Crypto Economy

How Blockchain, Cryptocurrency, and Token-Economy Are Disrupting the Financial World

Aries Wanlin Wang

• Publisher: Skyhorse
• Year: 2018
• Print ISBN: 9781510744820
• eBook ISBN: 9781510744837
• Topic: Business
• Subtopic: Entrepreneurship
• Index: Business

In late 2008, under the long shadow cast by the most severe economic crisis in generations, a revolutionary new form of currency was quietly being shaped. At the time no one could have predicted that an obscure form of electronic money would in less than a decade prove to be the most important financial innovation of the 21st century—a tool that would spark an entire new economic institution: crypto economy. That once-obscure money was known as Bitcoin, and today it is the highest valued digital coin. And though consumers continue to scramble to cash in on the trending currency, the technology behind Bitcoin known as Blockchain, which allows the currency to bought and sold without regulation by a government, remains a mystery to the public. In Crypto Economy, Aries Wanlin Wang provides the definitive blueprint for understanding how Bitcoin, Blockchain, and other digital technologies are disrupting traditional financial institutions and forever changing the world of commerce.

1.

HOW DOES SOMETHING LIKE BITCOIN HAPPEN?

In late 2008, under the long shadow cast by the most severe economic crisis in generations, a revolutionary new form of currency was quietly being shaped. Initially, there was no clue that an obscure form of electronic money would prove to be the most important financial innovation of the 21st century, a tool that would soon be widely adopted by people, economies, and companies all across the world. In October of that year, in a white paper issued by an anonymous person or group calling itself Satoshi Nakamoto—now known to the world as “the creator of Bitcoin”—the digital currency known as Bitcoin, and the technologies underpinning it, were laid out for the first time. There were few clues in this initial description that made anyone think Bitcoin had the power to upend and revolutionize the world’s financial system. Bitcoin’s success was far from assured.

In its early days, Bitcoin was mostly seen as an oddity—something that was only around to amuse experts in cryptography. Just ten years ago, the general public was still mostly unfamiliar with cryptocurrency. It was only for specialists and eccentrics. Today, of course, Bitcoin has become a household name. It has the highest market value of any cryptocurrency. Moreover, it has drawn an enormous amount of attention to blockchain, the technology on which it is built. (If you’ve ever been to a blockchain conference, you will truly feel the “electricity in the air” of the great expectations people now hold for the future of blockchain technology. Bitcoin has had its ups and downs, but this enthusiasm has not abated.) Blockchain was originally developed as a sort of “storage room” for Bitcoin—something that would record transactions and avoid the possibility of the currency being used inappropriately. The focus of this book will be the technical backbone of cryptocurrency and the crypto economies it makes possible. But before we get into the thick of it, we need to spend a moment on Bitcoin and its history, because Bitcoin was the driver of it all. It’s just that important.

The disaster of the subprime mortgage crisis in 2008 shook the public’s confidence in banks, governments, and other powerful institutions. Suddenly, everything was in doubt. Entities that had been seen as rock-solid and trustworthy for generations appeared to have abruptly let us down. They had been revealed as empty facades. The emperors had no clothes. Now, the world was looking for new solutions. And into this environment, Bitcoin arrived like a magic bullet, seemingly designed to solve the very issues that had caused the financial crisis in the first place. Bitcoin would decentralize power. There would be no external arbiter or regulator that might fail us. To the contrary, the people—the users of the cryptocurrency themselves—would truly hold the power.

But perhaps Bitcoin was not only successful because it arrived on the scene at just the right time. One must admit that it also has a sense of mystery about it, an allure that many found romantic and daring. Bitcoin was exclusive at first, like a club that people wanted to join. It was initially introduced to a very small group of people—experts in cryptography and “tech nerds” who were obsessed with the concept of individual liberty. (Some called these people “cypherpunks.”) Just as one sees in the trajectory of any exclusive brand, Bitcoin gradually made itself more available to the masses. Yet even as consumers scrambled to get in on the hip, new “Bitcoin rush,” many did not truly understand what the currency was, and the transformative power it held. But for us to discuss that here, we need to take a brief look at the history of money.

Sumer is an ancient civilization that was founded in Mesopotamia around the year 3000 BC. Sumerians are generally understood to be the first people who used money as a medium to facilitate exchange. Before the Sumerians, humans mostly used a barter system to make exchanges—trading things for other physical things. There are many disadvantages to a barter system.

For example, say it’s winter, and you’d like some wood to heat your house. You raise sheep and cows. Your neighbor grows trees, and he would like to have some meat for his family. You and your neighbor have to work out a barter arrangement—say, one sheep for twenty wood blocks. You give him your sheep, and he gives you his blocks. Sure, it works, but it’s not as easy as using money.

The direct exchange of goods without a universally accepted medium brings all kinds of inefficiencies and issues. If you don’t have anything your neighbor wants, for example, then a trade cannot happen. As a way around these issues, we invented money and credit, which remain the foundations of our economy today. Today, if you want wood blocks, you can use credit or debt to borrow twenty wood blocks from your neighbor—which puts you in his debt but allows you to pay him in the future. You can also simply pay him for the wood blocks in cash, which he can then spend any way he likes. Either works if your neighbor trusts you and/or trusts the currency you give him. Credit and money enable trade and make it more efficient.

And now, after 3000 years of financial and technological evolution, the Internet has brought us to a digital version of ancient Sumer. Since the Internet was first invented in 1969, half a century has gone by. In the intervening time, the Internet has become an inextricable part of our lives. Many of us can live without our girlfriends or boyfriends, but not without access to the Internet! The Internet connects people wirelessly and instantly through emails, social media, online businesses, and more. The extent of the social and financial engagements we are forging through the Internet reveal just how much we rely on it in every aspect of our lives.

The benefits of the Internet are clear. But there are also downsides. Some of the biggest downsides that we really can’t ignore involve privacy and security. Namely, how can we protect our privacy and stay safe when all of our photos and personal information are all over the web?

For most of us, the answer has been to allow centralized, trusted authorities to verify and safely enable activities conducted online. In a way, it’s similar to how we’ve decided to let governments and banks oversee, manage, and control our economic transactions. Companies like Facebook, Google, Microsoft, and IBM have all—in different ways—become part of the apparatus we trust to provide safety online. The information we use is stored in central servers owned by powerful Internet companies. These companies provide services we value, and in return we trust them with our personal information. Yet once our information is in their hands, we have very little control over how they may use or exploit it. Think of how frequently we learn that a web company has been selling user information without permission. Think of how frequently websites change their terms of service, allowing customer data to be sold or used in other ways. Facebook’s recent scandal is an excellent example of the violations of privacy and abuses of power that many users feel are unfairly foisted on them month after month.

Yet no matter how one feels about the Internet, it’s undeniably the major force pushing us into the future. Much like banks, Internet-based giants have become too big to fail. Google dominates information exchange through the prevalence of its search engine. Dominant social media platforms such as Facebook control personal connections and public information exchange. E-commerce has also become a part of our lives, with Amazon and Alibaba the unshakable giants in the field.

Theft of personal information is one thing, but the potential for the theft of online financial information presents a whole new ball game. For many people across the world, the ritual of going to the bank in person has been replaced by completing our financial transactions online. As the hard times in retail evince, we also now buy and sell merchandise online with increasing frequency. And instead of picking up the phone and calling restaurants to place our orders, we now browse menus and make orders on the web. This increase in online financial activity demands better security and efficiency. Cryptocurrency was created for this. It provides better security and is easier to use. We don’t need to reveal our identities when we make purchases using cryptocurrencies. And that fact, vitally, means we can choose to remain anonymous.

CYPHERPUNKS, LIBERTARIANISM, AND DIGITAL MONEY

It took the public a while to migrate from digital money (transferring digital dollars online) to using cryptocurrency—that is, money created using cryptography. But that migration is now happening. Yet to truly understand a phenomenon like this, we need to ask why it is happening. Why did people want to create a currency separate from the fiat money controlled by the central governments and central banks?

Diners Club is generally considered to have been the birth of the credit card. In 1974, Roland Moreno invented the IC card as a medium to store digital currency. In 1982, the United States created the electronic funds transfer system (EFTS), with Great Britain and Germany creating similar institutions shortly thereafter. Credit cards issued by banks were an instant hit, expanding exponentially as demand increased. This was the first digitizing of fiat money. It was important because it changed our perception of money in a way it hadn’t been in centuries. For the first time, most of us didn’t need to carry cash around. Everything could be done virtually.

Even though digital money is very different from—and exists in a different form from—fiat money, it still relies on the centralized oversight of powerful banks and governments. Not everybody likes this because of the inherent requirements and regulations. Namely, unlike cash, you can’t use your credit card anonymously. You’re charged a special rate to use your credit card in another country. Some cards are not accepted at all in certain countries. And middlemen—such as banks and finance companies—play major roles in the transactions. PayPal and Ali Pay likewise present themselves as “trusted third-party payment options,” yet their presence removes our ability to make many transactions discreetly or anonymously. International money transactions from one bank to another are also impossible without going on the public record.

To better capture customer and seller information, online middlemen have also attempted to introduce invasive technologies like Public Key that require both buyer and seller to go through complicated processes to verify their identities whenever they make a transaction. However, the birth of Bitcoin has largely derailed the adoption of these new systems.

The ability to make anonymous payments and transactions online has always had the support of certain communities, such as IT elites, cryptographers (the so-called cypherpunks), advocates of decentralization, and people on the libertarian side of the political spectrum. There is something of a communal identity involved—some shared worldview between these groups. They feel part of a fraternity influenced by thinkers like Friedrich August von Hayek. When barriers to free commerce like Public Key appeared on the horizon, cypherpunks and their kin aimed to create a new way of exchanging information (financial and otherwise) that would have little or no interference from the new regulators. They wanted to enhance privacy and protect personal freedom. They also wanted to actively subvert the government and its attempts at regulation.

All of these desires seemed to actualize themselves in Bitcoin.

Back in the 1980s, Timothy May proposed an idea for digital money that he called “Crypto Credits.” David Chaum was the first to apply cryptography to E-cash. Yet one of the major issues that E-cash faced was called “Double Spend.” This, more or less, is what it sounds like. Money is spent twice. Transactions are redeemed twice. It’s like taking a check to one bank and cashing it, and then being able to take it to another bank and cash it again. For example, say that the User A issues $1 in E-cash through an E-signature to User B. The risk is that User B will then duplicate User A’s E-signature to get two dollars instead of one.

An early solution calculated to solve the Double Spend problem was printing a unique serial number on each note issued. When the note was sent out from User A, User B would check the signature and make a phone call to User A, asking him or her for the serial number, and if the E-cash note had been used previously. If the note had not been cashed before, User B would accept the note. User A would then document that the note had been used.

Whew. Is it any wonder that a system like this did not catch on?

In today’s the digital world, servers complete all the work, including documenting every signature and serial number involved in financial transaction. Using serial numbers solved the Double Spend problem, but it did not allow individuals to transact anonymously, since each transaction (and corresponding personal information) could be tracked through the serial number.

To try and make each transaction anonymous, David Chaum then proposed a work-around known as “Blind Signature,” which basically solves two problems at once—anonymity and double spend. It allows the user to perform any monetary exchange that actual, physical money would allow (except perhaps physically flipping coins). How does Blind Signature work? It all takes place in an “envelope.” User A puts a note with a serial number into the “envelope,” which no one has access to except for User A. But then how does User B sign the note without his or her identity becoming known? The answer is to insert a carbon paper into the “envelope”—the signature will then appear on the note through the carbon paper. However, User B doesn’t know the serial number, and User A doesn’t know who signed the note.

The bottom line is that a transaction will take place with two parties not knowing each other’s identity.

Using this technology, David Chaum started two companies. One, DigiCash, was created to provide digital payments online using E-cash. The other, Cyberbucks, was designed to provide support for banks.

E-cash was a very refreshing solution, but like a cool drink enjoyed too quickly, the refreshment it provided lasted only for a few moments! Despite its advantages, it was never able to get mainstream acceptance. Even though it was designed to help buyers and sellers facilitate transactions, few sellers saw a benefit in using it.

It’s a different story when it comes to Bitcoin—and we’ll discuss those differences later in this book. But regardless of the failure to commercialize its E-cash service, the concept of Blind Signature was a vital and important milestone in the history of digital currency.

David Chaum applied for patents for the technologies related to E-cash, including Blind Signature, a move that received some criticism as hindering the advancement of e-payments. However, this did not stop cypherpunks, who continued using Blind Signature to develop better payment solutions. Ten years after DigiCash went into bankruptcy, Satoshi revealed the birth of Bitcoin to the world. And most of the people on Satoshi’s email list were these very cypherpunks.

Let’s spend a little more time thinking about these cypherpunks, and what exactly they wanted to accomplish. Julian Assange might be a good example of a “distinguished cypherpunk,” but he’s not the only one. Cypherpunks share a passion for individual liberty. Assange was clearly passionate about making information available and accessible to the public. Cypherpunks feel the same way about cryptocurrency. They believe private financial transactions should be available to the public, decentralizing the existing banking system, avoiding inflation, and improving security. Cypherpunks also seek to avoid the calamities that have hit the world economy in recent years. The crisis of 2008 shook global confidence in the ability of governments and major financial institutions to effectively control the economy. To cypherpunks, Bitcoin presented a new hope by proposing a solution that would allow users to avoid the mistakes of the past entirely.

But despite the fondest wishes of the cypherpunk crowd back in 2008, Bitcoin and other cryptocurrencies have yet to be accepted as widely as fiat money. Yet, at the same time, Bitcoin has generated tremendous global awareness through its disruptive spirit and its astronomical increase in value. Because its benefits are so clear, and it is so appealing to so many people, many governments are actively trying to establish ways to work with it.

Next, I’d like us to consider cryptocurrency against regular currencies by looking at how currencies are issued.

THE EVOLUTION OF CRYPTOGRAPHY

For hundreds of years, central banks have been playing one of the most critical roles in the financial system by managing how much money is released into the market, and controlling when this release happens. This is true for fiat money, and also for traditional digital money. In order to be accepted as a legitimate currency, digital money needs to represent value and be able to carry value. As I mentioned earlier, digital money is merely another form of fiat money. It is, essentially, the same thing. It relies on a trusted third party to verify every transaction. Cryptocurrency, however, has no need for a third party. Another way to put this is that it cuts out the middleman. Cryptocurrencies are also different from fiat money in that they are backed up by cryptography. Cryptography has two critical functions, encryption and verification, which are accomplished through coding and decoding.

Cryptography as a science was widely applied during World War II. Fighting alongside the soldiers of the the allied armies were mathematicians and engineers who used cryptography to wage a silent war of information. As the Germans used their famous Enigma machine to transfer coded orders, allied cryptographers fought against time to decipher it.

Today, cryptography is widely applied in a variety of economic functions and ...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• Foreword by Kevin Barry, CEO of Myntum Limited
• Chapter 1: How Does Something like Bitcoin Happen?
• Chapter 2: Blockchain Evolving—From 1.0 to 2.0
• Chapter 3: Gold Rush—Today’s Mining Opportunity
• Chapter 4: Vocean—Decentralizing Financial Services
• Chapter 5: The Top of the Food Chain and the Birth of Crypto Exchanges
• Chapter 6: The Secondary Market: Low-Lying Land
• Chapter 7: Beyond Boundaries—Crypto Economics around the World
• Chapter 8: Getting Along with Regulators
• Chapter 9: Blockchain—Assets Protector
• Chapter 10: The Future of Blockchain
• Glossary of Terms