Defining cryptocurrency

When it comes to cryptocurrency, misleading words are often the source of fundamental misunderstandings that can have expensive consequences.

In this article, we will take a look at some words that create the false impression that cryptocurrencies are technically efficient and that buying yet-to-be-created crypto-coins is similar to buying shares on the stock exchange. The first four misleading words relate to how cryptocurrencies work.

Transactions made using cryptocurrency such as bitcoin are recorded on a system called 'blockchain', which is said to be 'distributed' over a network of computers.

In the technical terminology of computing this is true, but ordinary interpretation of those words creates a false impression. Those words suggest that there is one data pot that somehow records all the transactions and that it is distributed across many computers. It sounds like each computer has just part of the ledger, but together they hold the whole thing.

That’s not what happens with cryptocurrencies, which use another form of distributed data storage where a copy of the whole ledger is held on each computer.

This means that if a cryptocurrency network uses hundreds, or even thousands, of computers to hold the blockchain (and some do), then there will be hundreds, or even thousands, of complete copies of it.

Each computer has to be sent details of every transaction and has to update its copy of the data store. That means using hundreds, or even thousands, of times more computer power and storage space than is really needed to store the transaction records.

When you see 'distributed blockchain', think 'duplicated blockchains'. This will help.

Another key aspect of how cryptocurrencies work is the so-called consensus algorithm. The word ‘consensus’ suggests people talking among themselves and reaching agreement. It sounds co-operative, perhaps even cosy.

In reality, these mechanisms usually work by ruthless competition. Every few minutes, a competition is held to see which computer can be the first to find a solution to a computationally difficult arithmetic problem.

Computers race each other to be first and the winner gets a payoff, as well as the task of creating a new block that can then be added to the ends of blockchains duplicated across the network.

As with most commercial competitions, the resources expended by the losers are just wasted but, in this case, the waste is more profound. The computers doing the racing are said to be ‘mining’, which makes it sound like valuable things will be discovered. In reality, the arithmetic competition does not discover or create anything valuable. It only decides who creates the next block and gets the reward, and discourages certain types of fraud by making it too expensive to bother. The winning result is useless and thrown away.

Occasionally, two computers will solve the arithmetic problem at almost the same time and both, thinking they have won, will create a new block. The duplicate blockchains then become inconsistent, with some adding one of the new blocks and others adding the other new block. Again, ruthless competition decides on the winner as the computers across the network are programmed to prefer the blockchain version that is longer. As more blocks are added a winner will emerge.

In addition to making a certain type of fraud too expensive, this computation work aims to prove that real computers with real computer power exist out there on the network, not just computers pretending to be lots of computers by setting up multiple IP addresses on the internet. Within the cryptographic design of cryptocurrencies, this is an important objective and an expensive technique.

When you see ‘miners in the consensus algorithm’, think ‘competitors in the blockchain competition’ and remember that a lot of computational effort is expended on just this task.

The word consensus also suggests rather more careful consideration of the details of transactions than actually occurs. The checks done on the transactions added to the next block are only those needed for a technically valid block where cryptocoins have not been spent more than once. Other aspects of transactions, like whether they are legal, or correctly record the intention and actions of the people involved, are not checked, still less discussed and agreed.

These design features seem so inefficient that it is difficult to believe that leading cryptocurrencies use them. Surely, the combination of duplicated effort and wasteful competition would make cryptocurrencies hugely inefficient compared to systems that operate in the more conventional way? Yes, they do.

In March 2018, Bank of England governor Mark Carney delivered a speech on the future of money, discussing cryptocurrencies. During the speech, Carney mentioned that the fees paid by Bitcoin users to get their transactions processed faster had reached £40 per transaction, though at the time of his speech the costs were back down to £2. In comparison, the cost per transaction to retailers of cash was 1.5p; the cost for cards 8p; and for online payments, 19p. Also, the processing speed was vastly better. These costs include the internal control and other services provided by conventional payment methods that are completely missing with bitcoin, so the cost of cards for example is only two orders of magnitude better than bitcoin.

Carney’s figures on electricity consumption provided a comparison that is more focused on the computing efficiency. He said that the electricity consumption of bitcoin miners was estimated to be roughly double the electricity consumption of Scotland. In comparison, the global Visa credit card network uses less than 0.5% of this while processing 9,000 times more transactions. This translates into Bitcoin needing at least 1,800,000 times more electricity per transaction than Visa card payments.

This inefficiency is one of the reasons that, according to Carney, Bitcoin is not really succeeding as a payment system. Instead, it is a cryptoasset to be traded speculatively.

In future we may see new forms of blockchain system that distribute the data in the more obvious sense of sharing it out, perhaps providing a guaranteed minimum level of redundancy for resilience and security purposes. The costly arithmetical competition that is mining has alternative methods already in use and is trying to gain the confidence of blockchain experts.

Companies aiming to launch yet another cryptocurrency, especially in the past two years, have often raised money using what has been called an initial coin offering (ICO). The deal offered is usually that people provide the company with money now in return for electronic tokens, which will later be exchangeable for cryptocoins, once all the programming has been done and the computers set up ready to support the cryptocurrency.

An ICO sounds very similar to initial public offering (IPO), and I strongly suspect this was initially a deliberate attempt to mislead. An IPO is, of course, the first issue of shares onto a recognised stock exchange by a company and nothing like an ICO.

Despite the similar sounding name, expert bankers, lawyers and accountants do not necessarily organise an ICO. It is not a specially regulated process like an IPO. There are no minimum requirements for the contents of a prospectus and auditors do not have to be involved to check the information provided.

The company will have a website and probably a white paper, which may include some technical detail along with more sales material, but this is nothing like a prospectus; inconvenient facts can be left out and nobody has to check the words are true.

An ICO does not necessarily give the people providing the money any ownership of the company as shares would. They have no voting rights either. If a company fails then its shareholders are last in line for a share of any remaining assets, but at least they are in the line. Holders of tokens are not even in the line if the company that promised to create and launch a cryptocurrency just takes their money and then fails (escrow arrangements may be offered to allay this concern).

Also, while an IPO is an investment in a company that will create wealth by doing useful things for customers and getting paid in return, an ICO involves buying virtual assets that will not create wealth. Speculators can only hope that the tokens or coins will, at some point, be saleable to other speculators at a higher price than originally paid to acquire them.

Cryptocurrency promoters sometimes reinforce the false impression created by the phrase 'initial coin offering' by talking about market capitalisation. Their website might also feature material on the risk investment, again underlining the superficial resemblance to properly regulated investment in companies. When you see ‘ICO’ think ‘request for money’.

The exact proportion of ICOs that have been scams or failures is unknown, but a report by Satis Group claimed that only 15% of ICOs in 2017 led to coins trading on the exchange. Instead, 78% were scams, about 4% failed and the remaining 3% had gone dead. In the US, the Securities and Exchange Commission increased its focus on ICOs, launching cases against fraudsters, producing guidance for investors and creating a fantastically realistic fake ICO website of its own to educate investors.

These are the main ways the language of cryptocurrencies have helped to promote misconceptions, leaving people vulnerable to losing money on poor technologies and scams. We may yet see cryptocurrencies that are efficient, offer better control to users, have stable exchange rates and intelligently controlled money supplies. Until then it is important to probe for the truth behind the white papers and breathless promotional material about the revolutionary technology and unprecedented money-making opportunities.

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• Defining cryptocurrency
  Business & Management Magazine, Issue 272, March 2019

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