Cryptocurrency 101 (Part 2)

Photo Credit: Diari La Veu – http://diarilaveu.com Flickr via Compfight cc

Click here to read Part 1.

Last week, I said that a key concept in cryptocurrency is the idea of a trustless transaction. Let me now expand on that idea.

A lot of things we do with our money involves trusting an entity other than the one with whom we are transacting. That means if Jose wants to buy a watch from Maria, he has to trust another person or entity other than Maria, and likewise for Maria.

Let’s go with the clearest example first. Jose sees a watch on the internet and wants to buy it. He sees that the merchant is Maria and after doing some background research, he decides that Maria is trustworthy and is not a scammer. So he transacts and buys the watch using his credit card. Aside from trusting Maria, he is also TRUSTING:

  1. The owner of the website to handle his transactions securely. But this can also be checked visually by looking at the address and making sure the transaction is sent over a secure layer (https instead of http).
  2. The owner of the website not to use his credit card information maliciously. Since Jose has entered all the pertinent details of his card, the website owner can theoretically store this information and use it for ill intentions.
  3. The credit card issuer to settle the payment for him, and then bill him correctly afterwards.

These are some reasons why people are still uncomfortable with online transactions using credit cards, although that number is growing smaller.

But from Maria’s point-of-view, there is also some trust involved. She is also trusting the credit card company to pay her.

But what about if Jose uses physical cash to transact? If he goes to Maria’s store and buys the watch and hands over his money, does he still need to trust a third party? Well, yes, he is effectively trusting the Philippine government which is backing up the value of the pieces of paper he is handing over to Maria, and Maria is also trusting the government for the same thing — that the pieces of paper she is receiving has value. If Maria received that money now and 5 minutes later, she hears on the news that the government has just declared bankruptcy, that money will be worthless.

Now what if Jose simply keeps his money in the bank? There is still trust involved. Jose trusts that his money is “safe” in the bank and that when the time comes when he needs to withdraw it, the money will be readily available. But what happens when there is bank run or when the bank declares bankruptcy? Jose will be unable to recover his money beyond the maximum amount he can claim via insurance.

This issue of trust could be felt quite recently when a local bank had some problems with its systems that caused some depositors to have negative balances, double transactions, and other such errors. This caused some people to lose their trust in that bank and transfer to another bank — but what they don’t realize is that the very same thing could also happen to whatever bank they run to. Human error, carelessness and negligence is unfortunately universal.

What I hope you see here is that the power of our money system today still derives from central authorities from banks to central banks to governments. These central authorities are prone to security failures such as hacking, or even simple mistakes in programming, or manipulation by those in power within that authority.

Cryptocurrencies, by their very nature and programming, try to move away from the idea of a central authority to being truly decentralized. That does not mean that there are no rules, but that the rules, once set, will be virtually impossible to hack or to manipulate, even by the program authors themselves.

To understand that, we have to understand a key architecture of cryptocurrency called the blockchain, which I will explain next week.

Originally published in Sunstar Davao.

Email me at andy@freethinking.me. View previous articles at www.freethinking.me.

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