A layman’s attempt to make sense of cryptocurrencies

I understand that there a 4 factors of economic production in the capitalist system (land, labor, capital and entrepreneurship). If I am a diamond miner, I get rewarded wages for mining the diamond and as an entrepreneur I sell the diamond for a profit based on the market value of the diamond. While the diamond which is a finite resource is useless, it holds economic value as a jewel. Extending this line of reasoning to cryptocurrencies I told myself that the miner is probably getting rewarded for his/her labor (using a machine to mine virtual coins). But what is the value of these virtual coins? Is it a currency made up of hashed strings of text that serve no other purpose? I mean, can’t we use all that computer processing power to identify larger prime numbers or crunch satellite data and reward miners for that instead? I spent a few days going back to the fundamentals of block-chain to try and make a bit more sense of this.

A block-chain is a distributed ledger where instead of one central trusted authority facilitating and keeping a record of all transactions, we the public contribute to maintaining a public record of each transaction. Every record is time-stamped and encrypted with a reference to the previous record on the ledger, which means nobody can alter a previous record (as all parties using that crytocurrency also have a copy of it, and the encryption is difficult to alter -> this makes it immutable).

Now onto the mining side, I understand that anyone can dedicate an energy intensive PC to mine units of a finite number of cryptocurrency like Bitcoin. Miners also serve the role of maintaining the distributed ledger (a KEY point for which they can be rewarded units of cryptocurrency, cash or precious metals), but at some point when all units of currency are mined they can then be afforded higher transaction fees to incentivise their maintenance of the ledger. Mining is what adds blocks to the block-chain, an important component of the system that guarantees that nobody can spend the same coin twice. In other words, it’s like a friend and I starting a company with our personal resources and we each have a 50/50 share in it. One day the company offers a solution of value to the world (in this case a trustworthy distributed ledger) and our share certificates can be traded for real-world cash. Or, an investor who believes in the company can buy our company shares with real-world cash before we even launch our product.

Higher levels of encryption (needed in a public ecosystem) require more energy, and energy is costly for cryptocurrencies that work on the Proof of Work based cryptocurrency system (like Bitcoin). There are other cryptocurrencies based on other systems (like the Proof of Stake system which Ethereum may move to) where coins are pre-mined and forgers (not miners) earn higher transaction fees to maintain a less energy resource intensive system. How much energy are we talking about? 1 Bitcoin transaction requires the same amount of energy as powering 1.57 American households for a full day. In June 2015 the Bitcoin network was consuming enough energy to power 173,000 American homes and today that figure has grown to +-1.4m households, which some people are saying is unsustainable.

So, miners and forgers dedicating system and energy resources to maintain the blockchain underlying the cryptocurrencies are rewarded like the merchants or intermediaries that party’s in a P2P relationship would normally engage with (at a cost) to facilitate a secure transaction.

The cryptocurrency itself holds economic value for being based on this distributed, trustworthy channel. However, there is definitely room to introduce further efficiency to drive down the running costs.

Zaid Mahomedy is certified Enterprise Architect and Mixed Reality Entrepreneur with over a decade of experience in IT consulting, Enterprise & Solution Architecture; Digital Content Creation and Influencing. Zaid is available to consult to businesses on how they can adopt disruptive technologies to transform themselves in order to thrive in the Digital Age. 

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