All of your friends and family have heard about it, some of them even own it, yet very few people seem to really understand how it works on a fundamental level. I’m talking about cryptocurrencies. This is my attempt at explaining the phenomenon to outsiders, starting with this first post on the relevance of cryptocurrencies. I want to stress that I don’t consider myself an expert, but someone who sees how often crypto is misrepresented based on (often) baseless prejudices. As someone who got into this technology at the start of the year, I see where the flaws in the communications are and I want to fix that for interested readers. I’m basically trying to write the guide I wish I would have had, purely educational!

(this post was first posted on my wordpress blog)

I discarded cryptocurrencies for a long time, and like most people, I just parroted whatever people said about cryptocurrencies: “ah Bitcoin, it’s a fad, it’ll go away soon”, or “It’s a ponzi scheme”, or another classic like “it’s not real money”. If you have said any of these without actually doing your research, the right answer to those statements is: you’re mostly wrong. Needless to say, and we need to be honest about this, there are parts of the crypto space that can be scams (I will do a blog post about this in the future).

But you’re right, it is not real money, if by that you mean fiat currency: dollars, euros and other money that can be physically printed. But that doesn’t matter: if something has value, and we – as a society – agree to use it and can trade it, it becomes money. This used to be the case for snail shells, then gold coins, then paper money and now digital money. If your problem with cryptocurrencies is that it is virtual and not tangible enough, ask yourself this question: have you ever seen that money on your debit or credit card? Sure, you might own a couple of thousand euros, and it’s right there on your laptop or phone, but in the end, you don’t physically own those numbers, do you? That’s a bit like showing everybody a Margot Robbie picture on your phone and claiming she is your girlfriend. Sure, buddy. My point is, crypto money is as digital as the money you currently have which you do trust and use (even though it’s virtual). There even are some benefits that cryptocurrencies have over the current fiat money, and I’ll get to that in a second.

Actrice Margot Robbie (source: horrornews.net)

Usually, at this point, most people start explaining the way Bitcoin (BTC) works, including words like mining, hashes, blockchains and others. This is because cryptocurrencies started off with cryptographers, mathematicians, and coders. Luckily, it’s getting more user-friendly by the day (which is why a Neanderthal like myself can understand it). And I will get to this jargon later, but I strongly believe this is a fundamentally horrible way of explaining it. I’d much rather start with the problems BTC is trying to solve, before telling you what it is. Otherwise it makes no sense. You need to know why a tool exists before you can understand how it works.

Which is why I’ll introduce two other concepts before finishing this post: inflation and decentralisation. These are important to understanding in what sense BTC might be superior to your savings account on the bank

Decentralisation

You could see decentralisation as the division of responsibility: spreading the power over more individuals instead of one centralised unity or authority. For instance, let’s go back to the days of imperialism, monarchy and nepotism. Back in ye old days, one king, monarch or emperor would hold control over its land. However, with time, we have decided that perhaps it is not a good idea to let one monarch decide the fate of everyone living on that land. After all, centuries of royal incest tended to make monarchs easily agitated, as evidenced by King Henry VIII’s appreciation of beheadings. As instead, we decided that everybody gets an equal vote to decide on political matters in a democratic republic, creating consensus. This was the decentralisation of power.

You can’t trust freedom when it’s not in your hands ~ the great poet W. Axl Rose

Some other examples of decentralisation are Wikipedia, AirBnb, Uber and Kickstarter. Wikipedia replaced encyclopaedias, like the famous Encyclopædia Britannica. This is a series of books in which our parents had to look up everything to verify facts. This is why it was so easy to bluff your way out of a conversation before Google was thing. Individual users can edit Wikipedia articles, rather than one publisher deciding over and controlling everything that gets published. Sure you could argue that Wikipedia still has some control over what is being published, but you get the point: I write a page, you edit, and we eventually create consensus.

Encyclopædia Britannica (source: en.wikipedia.org/wiki/Encyclopædia_Britannica)

Whereas you used to have to book a hotel, or a licensed B&B, Airbnb has essentially decentralised the accommodation economy: I can rent a bedroom from another individual on a website. A system of individuals peer-reviewing one another (I rate your bedroom, you rate me as a guest) creates consensus. Uber is another example: 10 years ago, you would have at most a handful of taxi companies controlling a big city. Right now, I can use Uber and pay for an individual’s services as a transporter, in a peer-to-peer transaction, like AirBnb, creating consensus through reviews. And where you used to have to go to banks for loans, Kickstarter provides an interesting alternative as a decentralised (crowd) funding initiative. Consensus of all the members, or funders in this case, is being created as they reach a target monetary goal. In some ridiculous cases, this can be the insane amount of over 10 000$ for an inflatable Lionel Richie head… Yes, that in fact was a legitimate Kickstarter campaign, I swear.

A blow-up Lionel Richie kickstarter campaign. Woman not included (source: kickstarter.com)

However, the best examples of decentralisation are without a doubt torrents. Some commonly used examples are BitTorrent, Limewire and Napster: digital files can be shared peer-to-peer directly between users. All you need is people that have the file willing to uploading it, while other users download that very same file.

The point here is that we currently do not have decentralisation in our financial system. What if you could let more than 7 billion people together control the price of a common currency, rather than the banks? Because what if you at some point decide you don’t trust your government, the only authority of your money. What if the government determines that you can’t withdraw any money from the bank for whatever reason: perhaps because you are a jew in nazi Germany or a member of the bourgeoisie during Stalin’s communism.

Or what if everybody desires to withdraw money from their bank during an economic depression (a so-called bank run). These are examples where you cannot access your money due to a centralised power. A bank run is problematic when banks do not have enough cash in their reserves to provide for their clients. For instance, if a bank has 100 clients, all of whom have 5 000€ worth of saving in this bank, then the bank would have a capitalisation of 500 000€, right? Quick maths.

The problem is that banks often don’t have this money in a vault, because they simply don’t have to, according to the central banks. These central banks are the European Central Bank (ECB) in Europe, the Bank of England in the UK and the Federal Reserve (Fed) in the US. These banks are not your typical AXA, CitiBank, Deutsche Bank or ING, but they are central banks with special authorities: they design economic policies to regulate the economies and are expected to control the aforementioned private banks. Currently, the ECB only requires private banks to have only 1% of their capitalisation as cash (so: 5 000€ in our hypothetical example from above). So if all clients in my previous hypothetical concept come to get their money, only 1 person would actually be able to get his cash, leaving the bank empty. So far for the problem of centralisation: a centralised authority can be an incredibly limiting factor.

Inflation

In the UK, per the Bank of England, this aforementioned reserve ratio (or minimum reserve requirement), is 0%. In the US, this was held at 3%, but has – due to the pandemic – been lowered to 0%. You can see why this is problematic: you’re creating money that is not actually there.

This brings us to inflation, the second theme or concept. When you’re creating money that did not exist before, you’re creating inflation which causes prices to rise. This is what happens when you lower the reserve ratio, as I mentioned above: the bank can hand out more loans to anyone without having to have the cash to back it up. In essence, they’re giving money to people they don’t actually have, stimulating the economy. That is the idea behind inflation.

The same happens when the central banks “print” money (called quantitative easing), as was done during pandemic times. And we didn’t print just a bit, but A LOT: 25% of all the cash money that has ever existed has been created in 2020. Let that sink in. They don’t actually print money, but what the central banks do is that they buy bonds from the governments. A governmental bond, for those who are not aware, is like a stock, but not issued by a private business but instead by a government and they are generally less risky and usually also less lucrative. The central bank then prints some money, but mostly buys a massive amount of bonds from governments. This then provides the individual governments with the necessary amount of money to allocate as they wish.

Think of it as the following metaphor: there is severe congestion on the train network (too many people on too few trains, people are fainting in the summer as you’re all together squeezed into each other’s smelly sweat). So, the government buys about 20 extra trains for the national train service which they can allocate to whatever trajectory they see fit. They can spread out the extra trains over all the trajectories, or they can assign 4 times 5 trains to the big trajectories (think Brussels-Antwerp, for instance) because that’s where most of the congestion exists. This would solve a big part of the congestion, but does not relieve congestion in the smaller trajectories. However, because there are more trains to take care of and more personnel to train (pun intended) and pay, every train ticket in Belgium gets more expensive.

For clarification: the government is the central bank, the train service is a national government, and the trains are the bucks, the Benjamins, the pesos, the gravy, the moolah, the greenbacks, that fuel our economy.

Let’s back away from the train metaphor: if there was at first 1 billion euros in the economy for a fixed amount of 1 million bananas and 2 million apples, and quantitative easing injects 500 million euros in the economy, instead now there is 1.5 billion euros in the same economy (1.5x). This means there’s now 500 million extra euros to spend on the same amount of bananas and apples (and erasers, car tyres etc.), which will now increase in price. So in short, the currency itself devaluates (loses value against any other valuable object). The result is: everything becomes more expensive for everyone, yet not everyone receives that freshly-printed money, do they?

The decline of fiat currency purchasing power (source: whatismoney.info).

And that’s how traditional, fiat currencies work. Many cryptocurrencies such as BTC are anti-inflationary: there will always be a fixed amount available which can’t be increased, i.e. there is no way of tampering with the supply (once it’s reached a threshold). This is not to say that inflation is bad in all cases and that fiat currencies will disappear and bow to the great king that is BTC, but it is a niche which BTC fills very elegantly. I will do a post in the future about where I think BTC is headed and whether or not it will dominate the future economy.

And so, to recap, this is what BTC is trying to do: decentralise our finance, without some of the issues that fiat currencies come with (not to mention the horrific shitshow that was 2007-2008).

So now that you know what BTC wants to do, I’ll explain how it attempts at doing that in my next post. In my next post, I will lay out the differences between bitcoin, blockchain and cryptocurrencies in a comprehensible way, as well as explain BTCs mechanisms.

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