Originally published in The New Palgrave Dictionary of Economics
This article explains what cryptocurrency is and begins to answer the new questions that it raises. To understand why cryptocurrency has the characteristics it has, it is important to understand the problem that is being solved. For this reason, we start with the problems that have plagued digital cash in the past and the technical advance that makes cryptocurrency possible. Once this foundation is laid, we discuss the unique economic questions that the solution raises.
Cryptocurrency is the name given to a system that uses cryptography to allow the secure transfer and exchange of digital tokens in a distributed and decentralised manner. These tokens can be traded at market rates for fiat currencies. The first cryptocurrency was Bitcoin, which began trading in January 2009. Since then, many other cryptocurrencies have been created employing the same innovations that Bitcoin introduced, but changing some of the specific parameters of their governing algorithms. The two major innovations that Bitcoin introduced, and which made cryptocurrencies possible, were solutions to two long-standing problems in computer science: the double-spending problem and the Byzantine Generals Problem.
Until the invention of Bitcoin, it was impossible for two parties to transact electronically without employing a trusted third party intermediary. The reason was a conundrum known to computer scientists as the ‘double spending problem’, which has plagued attempts to create electronic cash since the dawn of the Internet.
To understand the problem, first consider how physical cash transactions work. The bearer of a physical currency note can hand it over to another person, who can then verify that he is the sole possessor of that note by simply looking at his hands. For example, if Alice hands Bob a $100 bill, Bob now has it and Alice does not. Bob can easily verify his possession of the $100 bill and, implicitly, that Alice no longer has it. Physical cash transfers are also final, in the sense that to reverse a transaction the new bearer must give back the currency note. In our example, Bob would have to hand the $100 bill back to Alice. Given all of these properties, cash makes it possible for different parties, including strangers, to transact without trusting each other.
Now, consider how electronic cash might work. Obviously, paper notes would be out of the picture. There would have to be some kind of digital representation of currency. Essentially, instead of a $100 bill, we might imagine a $100 computer file. When Alice wants to send $100 to Bob, she attaches a $100 file to a message and sends it to him. The problem, as anyone who has sent an email attachment knows, is that sending a file does not delete it from one’s computer. Alice will retain a perfect digital copy of the $100 she sends Bob, and this would allow her to spend the same $100 a second time, or indeed a third and fourth. Alice could promise to Bob that she will delete the file once he has a copy, but Bob has no way to verify this without trusting Alice.
Until recently, the only way to overcome the double spending problem was to employ a trusted third party intermediary. In our example, both Alice and Bob would have an account with a third party that they each trust, such as PayPal. Trusted intermediaries like PayPal keep a ledger of all account balances and transactions. When Alice wants to send $100 to Bob, she tells PayPal, which in turn deducts the amount from her account and adds it to Bob’s. The transaction reconciles to zero. Alice cannot spend the same $100, and Bob relies on PayPal, which he trusts, to verify this. At the end of the day, all transfers among all accounts reconcile to zero. Note, however, that unlike cash, transactions that involve a third party intermediary are not final, as we have defined it, because transactions can be reversed by the third party.
In 2008, Satoshi Nakamoto (a pseudonym) announced a way to solve the double spending problem without employing third parties (Nakamoto, 2008). His invention, Bitcoin, is essentially electronic cash. It allows for the first time the final transfer, not the mere copying, of digital assets in a way that can be verified by users without trusting other parties. This is accomplished through the clever use of public key cryptography, peer-to-peer networking and a proof-of-work system.
Like PayPal, the Bitcoin system employs a ledger, which is called the block chain. All transactions in the Bitcoin economy are recorded and reconciled in the block chain. However, unlike PayPal’s ledger, the block chain is not maintained by a central authority. Instead, the block chain is a public document that is distributed in a peer-to-peer fashion across thousands of nodes in the Bitcoin network. New transactions are checked against the block chain to ensure that the same bitcoins have not been previously spent, but the work of verifying new transactions is not done by any one trusted third party. Instead, the work is distributed among thousands of users who contribute their computing capacity to reconcile and maintain the block chain ledger. In essence, the whole peer-to-peer network takes the place of the one trusted third party.