Cryptosphere — Unraveling the Mystery Part 2: Cryptocurrency

With today’s rapidly changing business landscape, it is increasingly important to understand both the opportunities and the threats that developments in technology are bringing to businesses around the globe. One development that has been receiving growing attention since its inception is the use of cryptocurrencies (“crypto’s”). Finding and maintaining adequate financing can be one of the most challenging aspects of running a business, and many companies are looking to cryptocurrencies as an alternative form of financing. This is due, at least in part, to the fact that some enthusiasts believe cryptocurrencies are a quick and easy way to raise a lot of capital. However, as with any form of potential financing, cryptocurrencies need to be thoroughly understood before they are embraced and relied upon. This article will first provide some historical background and context for cryptos, then address the basic elements of a cryptocurrency, and finish by covering some of the most important elements to consider when deciding whether to participate in the use of a crypto currency, whether through the creation of your own crypto currency, or the acquisition of another.

Background and History

The following section is not intended to provide a complete history of cryptocurrencies but is meant to provide a snapshot of some of the most significant events in the cryptocurrency market, and developments in the cryptosphere¹.

In 2008, Satoshi Nakamoto published a white paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System.” To many, this was the birth of what we now call cryptocurrencies. Although Nakamoto may be the parent of cryptos as we know them today, many may be surprised to learn that attempts to establish cryptocurrencies have been going on since the 1980’s. David Chaum is lauded as one of the true fathers of cryptocurrencies for inventing the “blind signatures” which allowed for the encrypted and untraceable transfer of “coins” from one user to another. This formula led to the creation of DigiCash by Chaum, which may be the very first form of cryptocurrency actually developed and used. B-money and Bit Gold also pre-dated Bitcoin but failed as cryptocurrencies.

Since 2008, cryptocurrencies have seen a dramatic upswing in value and popularity. In 2009 the public began mining² bitcoins, and the software behind Bitcoin was released. In 2010, two pizzas were purchased for 10,000 Bitcoin, marking the first ever Bitcoin transaction (as well as what may be one of the most regretted transactions ever made by a Bitcoin owner—had the original owner of the coins held on to them until the date of this publication, they would be worth more than $104 million).

2011 saw the rise of competitor coins Namecoin, SwiftCoin, and Litecoin, which was the mark of what has become somewhat of a craze, as there are more than 1500 forms of cryptocurrency as of the date of this publication, as reported by coinmarketcap.com. 2011 also marked the first dramatic swing in Bitcoin’s price, when it fell from $1,000 down to $300.

In 2013, J.R. Willett launched the very first Initial Coin Offering (“ICO”), offering his currency, Mastercoin.

2014 marked one of the largest cryptocurrency thefts up to that point in history, when over 850,000 Bitcoin were stolen from their owners. The theft took place via a hack into Mt. Gox, the world’s largest cryptocurrency exchange at the time of the theft. The events were so catastrophic that Mt. Gox declared bankruptcy, and many questioned the future of Bitcoin and cryptocurrencies as a result. Many details of the theft are still unknown, but there are several ongoing investigations looking into the event. This theft was only the beginning of what has become a major concern for many current and prospective owners of cryptocurrencies. The issue of security has become a widely debated topic and will likely be the topic of conversation for years to come. For more information on the technology and security behind these currencies, refer to our article: Cryptosphere—Unraveling the Mystery Part 1: Blockchain: A Ledger for the Modern Era.

‍In what was described by some as the most ambitious crypto 2.0³ project up to that point, the Ethereum blockchain launched in 2015. Ethereum’s coin, Ether, had raised roughly $18 million in the previous year. 2015 also brought a significant change to the cryptosphere, as LedgerX became the first United States Commodity Futures Trading Commission licensed exchange and clearing house.

In 2016, Overstock, the online retail company, became the first publicly traded company to use blockchain based technology to issue shares of its stock over the internet. 2016 also marked the scaling of investment in blockchain technology, when giants like IBM, VISA, Microsoft, and Goldman Sachs all announced plans to dive deeper into Blockchain technology.

Cryptocurrency saw an incredible rise in popularity during 2017. Most cryptocurrencies saw massive price movements, but none were more publicized than Bitcoin’s. Bitcoin began the year with a rough start when it plummeted to a low value of $786 but finished the year strong with a high value of $19,498 on December 18. The year was full of cryptocurrency excitement with changes occurring all over the world:

Japan made Bitcoin a legal currency in April.
Australia’s government eliminated the Goods and Services Tax (GST) previously placed on digital currencies, stating that the government was “allowing digital currencies to be treated just like money for GST purposes.[1]”
China banned ICOs in September.
The US Securities and Exchange Commission (SEC) came out with multiple statements regarding cryptocurrency regulation. One statement was regarding the treatment of certain ICOs as securities; another was regarding the way celebrities are allowed to endorse cryptocurrencies and their ICOs.

In 2018, the cryptosphere remained a regular topic of conversation on many news outlets. Bitcoin experienced what some refer to as a bubble being burst, when the coin’s price dropped to $6,982.87 on February 6, a 59.17% decline from its 2018 high of $17,101.45 on January 7. Countries all over the world amped up the regulatory conversation surrounding cryptocurrencies; South Korea banned anonymous cryptocurrency trading accounts, France’s Minister of the Economy announced the creation of a working group tasked with regulating cryptocurrencies, and Russia’s Financial Ministry drafted a law titled “Federal Law on Digital Financial Assets,” focused on the regulation of tokens, ICOs, and all things cryptocurrency.

What Is a Cryptocurrency?

Government backed currencies like the US Dollar, the Russian Rubble, and the Japanese Yen are what most people think of when they talk about currency. These currencies are fiat currencies, meaning that the only thing backing them is the word of the government, rather than a commodity like gold or silver. Because a government has control of its currency, it has the ability to affect the value of that currency by printing additional funds. In some cases, this can lead to dramatic economic consequences, like what was seen in Zimbabwe in recent years where hyperinflation took over and led to the rapid devaluation of the Zimbabwean Dollar. It was this governmental control over currencies that originally prompted Satoshi Nakamoto to create Bitcoin. After the financial crisis of 2008, Nakamoto created Bitcoin to be used as currency that would not be able to be influenced by government economic policy, thereby making it a safer, more reliable, and inflation resistant form of currency, in the mind of Nakamoto. It is important to note that a government’s ability to influence a currency’s value and supply is a widely debated subject; while Nakamoto felt that the influence the government has over state sponsored currencies is a bad thing, many argue that it is this very influence that helped curb the financial effects of the September 11, 2001 terrorist attacks, as well as the effects of the 2008 financial crisis.

Like Bitcoin, most cryptocurrencies typically are not backed by any government, but are referred to as being decentralized. These currencies have no physical presence, but are earned, maintained, used, and traded electronically. They are created by individuals or groups for a variety of different uses and are generally categorized as one of three types of coin: bitcoins, altcoins and tokens. We will address the separation of these three categories later in the article. At the very basic level, a cryptocurrency is an electronic store of value, protected by sophisticated encryption technology, used for the exchange of data or other resources, and recorded and accounted for on a blockchain system.

Why Crypto?

All cryptocurrencies make use of cryptography to ensure the security of the coin and any transactions in which they are utilized. As you might guess, it is from the use of cryptography that cryptocurrency derives its name. On a very simplified level, the cryptography used by most cryptocoins can be explained using the following diagram:

Image by Munkhzaya Ganbold (Own work), via Wikimedia Commons

As illustrated in the image above, the data or message that is being transferred from sender to receiver is encrypted using a public version of the recipient’s key and is then decrypted using the private version of the key, which is available only to the receiver. The use of these private and public keys is paramount to the design and success of cryptocurrencies. This method provides both parties of the transaction with security and a certain level of anonymity and ensures that only the desired recipient will be able to access the data—or in the case of a Bitcoin transaction, the coin—that has been transferred.

Bitcoins vs Altcoins vs Tokens

As was mentioned above, cryptocurrencies are generally broken up into three different categories: bitcoins, altcoins and tokens. In this section we will explain the differences between these categories, why each category exists, and the uses of each type of coin. The following diagram breaks some of the most popular and successful cryptocurrencies into two of the categories being discussed:

Image Source: https://masterthecrypto.com/differences-between-cryptocurrency-coins-and-tokens/

Altcoins – For a cryptocurrency to be referred to as an altcoin, it must meet a couple simple criteria: 1) it is not Bitcoin and 2) it operates on its own blockchain, separate from Bitcoin, or any other cryptocurrency.

“Alt” in altcoin is short for alternative, because these coins are all alternatives to Bitcoin. Despite Bitcoin not being the first cryptocurrency to ever be developed and used, its widespread popularity and the way it catalyzed the crypto revolution has earned it the position of the original coin. Thus, all other coins are referred to as alternatives.

Altcoins all operate on their own unique blockchain. This is where many people really start to get confused. Those that are new to the blockchain and the cryptosphere may not have realized up until this moment that there is not one “Blockchain,” but many, many instances of the use of blockchain technology to facilitate the accounting for and protection of a cryptocurrency. When Bitcoin was created, Nakamoto also created the blockchain system that came with it. This system was made publicly available as an open-source protocol, and since its release, it has been used many times as a template for the creation of additional blockchain systems. The code from Nakamoto’s original blockchain has been altered by the creator of each new cryptocurrency, making it useable for each of their unique circumstances.

Alternatively, some cryptocurrency founders have opted to create their own blockchain, completely independent of the Bitcoin system. These blockchain systems operate using unique code that is generally not open-source. Because these blockchain systems are made from scratch, they are referred to as native blockchain. One of the main reasons for creating a native blockchain is to program into the system the ability to do complex activities beyond transacting cryptocurrencies. Many of these activities will be explained later in this article. In cases like this, the broad spectrum of value derived from cryptocurrencies becomes clear. Within native blockchain systems such as Ethereum, cryptocoins are referred to as programmable money, because in additional to fulfilling the function of currency, they are acting as the fuel to a blockchain that creates smart contracts, where money can be programmed to come and go without a human hand guiding it.

No matter which cryptocurrency you use, one thing remains constant; they transact on their own blockchain.

Tokens – Conversely, a new blockchain does not have to be built for a token, as a token can operate on a preexisting blockchain. Where a coin is meant to be used as a store of value and a form of currency, a token is meant to be used as a tool, operating internally within a specified system.

To help explain the difference between a token and a coin we will create two hypothetical companies: Company A and Company B.

Company A thinks it has perfected blockchain technology with a new form of encryption, and it wants to use this technology to create the most secure form of transactions in the world. To do this, Company A creates a new blockchain system and with it a currency to exchange. We will call this currency PerfectCoin. PerfectCoin can be purchased on an exchange, or it can be earned by mining the coin. Company B is based in a college town and is tired of housing contracts that are not properly enforced. Company B has become aware of the PerfectCoin blockchain and recognizes its value as the most secure form of blockchain technology on the market, and wants to take advantage of the technology. Company B creates a company that will work to fix the broken housing contract system currently in place by using smart contracts that neither party controls. Company B creates a token called FairToken that will be used as currency to enter into housing contracts. Fortunately, PerfectCoin’s blockchain is open-source, so Company B is able to release its token on the PerfectCoin blockchain, making use of its established system without needing to build a blockchain of its own. FairToken can be purchased via Company B’s ICO, or it can be earned through mining. The key difference between these two fictional scenarios, is the use of the coin. PerfectCoin is a form of currency, meant to be used for all kinds of transactions, and will likely be tradeable on many exchanges. FairToken on the other hand only has value within the system it was created for. A party to a housing contract with Company B enters into a contract by means of FairToken, but the token has no value outside of this contract. In very simple terms, one can think of a token like the coins used to play games at many arcades. In order to participate in the games at the arcade, you must have the correct tokens, but when you leave the arcade, the tokens cannot be used to purchase goods or services anywhere else.

It is important to note that at the time of publication, there are two main types of tokens: Utility tokens and Security tokens. Security tokens are generally accepted to be tokens that have characteristics of equity, such as dividend payments and ownership. Utility tokens on the other hand are viewed as a representation of the right to take part in a system or project. The main purpose for this separation is to avoid the regulation that comes with the classification of a security. The current way of thinking is that if a token can be called a utility token rather than a security token, it will not need to be registered with the SEC and will be under far less scrutiny than a security token would be. As of the date of publication, the SEC is openly investigating dozens of ICO’s for the violation of SEC security regulations, and there is a great deal of speculation regarding the future of tokens designated as utilities. SEC Chairman Jay Clayton helped spur these speculations when he stated in December 2017 that “merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security.” Clayton went on to explain that tokens “that incorporate features and marketing efforts that emphasize the potential for profits based on the entrepreneurial or managerial efforts of others continue to contain the hallmarks of a security under U.S. law.” This is, in essence, the Howey Test, which is a set of criteria created during the SEC v Howey Co. case in 1946. Supreme Court Justice Murphy stated regarding the case and the subsequent Howey test, that what must be considered is whether “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” He further stated that “if that test be satisfied, it is immaterial whether the enterprise is speculative or non-speculative, or whether there is a sale of property with or without intrinsic value.” Stated simply, this means that any investment, speculative or otherwise, that will create a profit because of the work of someone else qualifies as a security. Chairman Clayton was reiterating this fact when he stated that it doesn’t matter what you call a token, so long as the efforts of someone else is what will create profits for the token holders. If tokens do indeed fall under U.S. security laws, completing an ICO will become a regulated event, just as IPOs and other funding events are. Furthermore, there will likely be a significant number of companies that will be found to be in violation of SEC regulations and will face penalties or other legal actions.

For more information on ICO’s, check out our article on the topic: Cryptosphere—Unraveling the Mystery Part 3: Initial Coin Offerings.

‍How Cryptocurrencies Are Used

While many view blockchain technology to be in its infancy, there have already been many use cases for the technology that have emerged since the popularization of the system in 2009. Each one of these use cases represents a new way that the currencies are used.

Below, we’ve listed 8 of the most common ways cryptocurrencies are used, each with several examples of real companies that are using the technology as described.

‍Note: The following companies have not been vetted by our staff, and we are in no way promoting them or providing investment advice by including a particular company in the list below.

An alternative form of currency: These coins are intended to provide users with another form of currency free from governmental control, useable across borders without the need for foreign transaction fees.
1. Bitcoin
2. Litecoin
3. Zcash
4. Ripple
Wealth management tool: These coins are intended to provide opportunities for investors to further diversify their portfolios and to share in the wealth generation accompanying the rise of cryptocurrency popularity.
1. SwissBorg
2. Elpis
3. AxionV
4. Fluon
Eliminate voter fraud: These companies intend to create a digital identity for every voter that cannot be manipulated or falsified, thereby eliminating, or decreasing at the very least, voter fraud. The use of a token or coin in these instances will create a transaction that is verifiable and immutable.
1. Democracy Earth
2. Open Vote Network
3. Horizon State
4. Follow My Vote
Cutting down on corruption in charitable organizations: These companies are using cryptocurrency to track the supply of donations to reduce the improper use of funds and resources within charitable organizations.
1. World Food Programme
2. BitGive
3. Aidcoin
Banking the unbanked: These companies are striving to create tools to provide liquidity to individuals in areas that previously have not enjoyed the benefits provided by modern banks.
1. BitPesa
2. OmiseGo
3. WeTrust
4. Humaniq
Improving cloud storage: These companies are providing an alternative form of life storage to individuals and companies through peer-to-peer networks and highly sophisticated data encryption and decentralization.
1. Storj
2. MaidSAFE
3. Sia
4. FileCoin
Opening users to supercomputing: These companies are making use of the secure peer-to-peer networks created by blockchain technology to combine the computing power of many smaller systems to accomplish tasks previously only possible with a supercomputer.
1. Golem
2. Project Provenance
3. Skuchain
4. Wave

Conclusion

Cryptocurrencies present a complicated area of discussion for financial markets, the SEC, and the public. Though certain coins may come and go, it is unlikely that cryptocurrencies as a whole will go away any time soon. On the contrary, they are likely to become a more significant part of our lives each year. Thus, it is important to become educated in cryptocurrencies, the blockchain, and all things in the cryptosphere. This article has explained some of the basic history behind cryptocurrencies, has provided a basic understanding of the technology behind these currencies, and has established some of the primary features of cryptocurrencies that need to be understood to communicate effectively within the cryptosphere.

Resources Consulted

Footnotes

The ecosystem of cryptography. It is the plane in which all things related to cryptocurrency, blockchain, and cryptography exists.
The process by which individuals acquire new coins in a blockchain.
Crypto 2.0 is the second generation of blockchain technology that bitcoin made popular. It is an improved protocol of the original system, not only providing fixes to some of the original system’s challenges (long transaction times and ease of use for illegal activities), but also providing for many use cases beyond the transfer and tracking of digital currencies.