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Cryptocurrency and blockchain explained

 

What is cryptocurrency?

 

There has been significant media attention focused on cryptocurrency in recent months. In January 2018, the Australian Financial Review published an editorial on the link between cryptocurrency and interest rates.[footnote 1] South Korea has announced plans to regulate cryptocurrencies.[footnote 2] Estimates differ, but at the time of writing recent data puts the total market capitalisation of cryptocurrencies around the world at USD 507 billion (close to half of Australia's GDP in 2016).[footnote 3] It is an issue that is gaining attention not only in the media, but also at the level of policy.

One of the key issues at the centre of all this attention is the question of the 'real value' of cryptocurrencies. This is another way of asking: what is cryptocurrency? In the simplest terms, cryptocurrency is a digital token which represents value. The first cryptocurrency, Bitcoin, was assigned value which represented currency. This occurred for a range of factors, including: its underlying cryptographic technology, the way it could facilitate anonymous trades and the fact that it is purely digital (factors which are explained below). Since Bitcoin launched in 2009, many other cryptocurrencies have emerged, all of which represent and are assigned different units of value.

In the sense that cryptocurrency is a digital token, it is similar to our fiat money[footnote 4] system in that the actual units traded have no intrinsic worth—when we trade cash for goods and services, cash represents trust in a financial system of ascribing value which can then be traded or exchanged. Cryptocurrencies differ, however, in that fiat money is backed by governments while cryptocurrencies are not. The 'value' therefore derives from what buyers and sellers in the market are willing to pay for the cryptocurrencies, rather than the value deriving from a centralised governmental regulator.

Cryptocurrencies have different values as buyers and sellers in the marketplace buy and sell them for different prices. Some people are entering these new markets in the shared belief that cryptocurrencies will retain value in the future, allowing them to be on-sold at a profit. Other traders may enter the market hoping to use cryptocurrencies to exchange for goods and services. Inherent in the hopefulness of this activity is the idea that 'investment' in many cryptocurrencies is more akin to pure speculation.[footnote 5] There are exceptions, however: a Melbourne man recently announced he would accept part payment in Bitcoin for a house valued at AUD 2.5 million.[footnote 6]

Observers have argued that cryptocurrency is a 'bubble', referring in particular to Bitcoin. To the extent that cryptocurrencies are speculative, these views are founded. They are also founded in the sense that Bitcoin is more accurately a token, as opposed to a 'currency'. To become a currency would require Bitcoin to be accepted as legal tender for public and private debts.[footnote 7] It would also require a mechanism which would allow for value to remain stable, so that prices for goods and services could be stable.[footnote 8] Some industries are already taking some of these steps. In a world-first in 2015, 'titcoin' was recognised as a formally accepted unit of exchange by a major industry trade organisation (in this case, the Adult Entertainment Industry).[footnote 9]

Despite these exceptions, most cryptocurrencies in their current forms are inherently speculative. But if cryptocurrency is generally so speculative, why have people invested hundreds of billions of dollars into these markets? As above, part of the answer is most likely to do with the underlying technology, known as blockchain.

What is blockchain?

Blockchain is an open-sourced computer protocol which allows for users to transact, peer-to-peer. It decentralised, public and digital, effectively making it a 'transaction-recording database' stored on many different computers at once.[footnote 10] The technology confirms the legitimacy of trades in real time, using cryptography (hence cryptocurrency), which authorises trades based on building 'blocks'.

Blocks are built by 'mining', a process in which computers are tasked with solving complex and random cryptography. As more miners attempt to build blocks, the faster the blocks are built and the blockchain becomes more secure. This is because to undo or alter a block, more miners would have to be allocated to that task than the task of building new blocks. In other words, in order to defraud the blockchain, more computing power must be allocated to defrauding the blockchain the total amount of computing power working on the blockchain. This would be an enormous feat: in 2014, a study found that electricity consumption of the Bitcoin blockchain was roughly equivalent to that of Ireland.[footnote 11]

Blockchains can be conceptualised as 'distributed ledgers' of trades. Each blockchain is a different ledger which has the potential to record any trade of information. The ledger is highly secure in that: it is stored on many different devices in many locations, reducing the risk of corrupting the database; it is based on complex cryptography, reducing the risk of fraud, and; it has the potential to verify trades instantaneously, leading to huge increases in efficiency in managing and storing information.

Along with being a digital token, Bitcoin refers to one ledger of over a thousand blockchains or ledgers. Bitcoin therefore describes a system of exchange. Because Bitcoin is a cryptocurrency, it also describes the monetary value which is ascribed to those exchanges. This is not always the case: while all blockchains use tokens to represent trades or information, not all tokens are used to represent currency (see below).

Returning to the blockchain, traders can be either anonymous or named, depending on the way that each particular blockchain is set up.[footnote 12] The cryptography used to confirm the validity of trades means it is difficult to succeed in making fraudulent trades. This allows for users to trade even when they do not trust each other; when they do not know one another's identities, or; when they do not have the time to themselves verify the legitimacy of trades.

This is significant in that blockchains can be set up so that trades are completed only when certain conditions are fulfilled. These particular blockchains enable 'smart contracts', which can be used in situations such as a life insurance policy which is managed by a blockchain to pay the beneficiary only when a doctor submits a digitally signed death certificate to the blockchain.[footnote 13] In that instance, the token used would not represent currency, but would represent the completion of the trade of information and the storage of that information on the ledger of transactions, the insurer's blockchain.

In the cryptocurrency context, the peer-to-peer nature of the technology has a libertarian application in that the blockchain removes the need for an intermediary which authorises and regulates individual trades, like a bank. When used as a currency, blockchain also removes the need for a centralised authority which authorises and regulates the value of the unit of trade, like the Federal Reserves used to regulate fiat currency. In a currency context, this offers the potential for greater efficiency and freedom for people to trade as they wish. However, third parties such as banks are leading research into the ways in which some services will still be required to be performed by third parties to make transactions.[footnote 14]

Figure 1 illustrates the way in which blockchain could be used to record a transaction of money:

Other businesses already utilise blockchain in data management. For example, Nestlé, IBM and Walmart have implemented blockchain in order to manage supply chains with increased efficiency and to detect and mitigate against food contamination.[footnote 15] Another group in the USA is using blockchain to help low-income people to pay bail at court.[footnote 16] An Australian start-up, backed by the United Nations, has announced plans to use blockchain to improve democratic processes like voting.[footnote 17] Other applications are in 'responsible' journalism, which will use blockchain to create a decentralised community of writers, fact-checkers and funders to create unbiased, 100 per cent verified stories.[footnote 18] Blockchain is also being used in a new pilot program which aims to combat illegal fishing of tuna.[footnote 19] Commonwealth Bank of Australia has been using a blockchain to store government bonds for over a year.[footnote 20] These new applications are using blockchain due to its transparency and traceability.[footnote 21] In a 2015 report, the World Economic Forum predicted that ten per cent of the world's data will be stored using blockchain technology by 2027.[footnote 22]

Public entities are also turning to the technology. The Canadian Government has recently announced a pilot which will use blockchain to increase transparency in recording government grants.[footnote 23] In 2016, a Swedish business partnered with the Swedish Land Registry to trial a pilot which seeks to put land ownership and sales onto a blockchain.[footnote 24] The same company is investigating the potential for applying a blockchain to government activity in Andhra Pradesh, India, to reduce fraud and data management errors.[footnote 25]

It is difficult to estimate the market capitalisation of cryptocurrencies in Australian 'exchanges', or cryptocurrency markets. It remains to be seen as to whether any cryptocurrencies will become recognised by governments as legal tender. The 'value' of blockchain technology is easier to approach in that the technology has real applications, some of which have been listed above. The software is interesting in that it has the potential to disrupt information management and data security systems as we know them. The applications of the technology are many and varied.



References

(2018) 'Bitcoin fuelled by cheap money boom', Australian Financial Review, 17 January.

Bail Bloc (2018) 'Bail Bloc is a cryptocurrency scheme against bail', The New Inquiry.

Browne, R. (2017) 'IBM partners with Nestle, Unilever and other food giants to trace food contamination with blockchain', CNBC, 4 October.

ChromaWay (2017) 'Cases: Future house sales'.

Civil (2017) 'What if the news were run by the people?'.

Coinmarketcap (2018) 'Cryptocurrency Market Capitalizations', 31 January, coinmarketcap website.

Cranston, M. (2017), 'First Victorian home ready to accept bitcoin as $2.5m sale payment', Australian Financial Review, 28 November.

De, N. (2018) 'Canadian Research Body Pilots Ethereum in Transparency Push', Coindesk, 22 January.

Decentralised News Network (2017) 'News by the people, for the people.'

Eyers, J. (2017) 'Commonwealth Bank puts government bonds on a blockchain', Australian Financial Review, 24 January.

F. Filpo & M. Berne (2017) 'The bitcoin and blockchain: energy hogs', The Conversation, 17 May.

Gibbs, S. (2011) 'Bitcoin and Ethereum tumble after renewed fears of regulatory crackdown', The Guardian, 17 January.

Gilder, S. (2017) 'Early blockchain experiments point to jobs of the future', Commonwealth Bank of Australia, 29 November.

Horizon State (2018) 'Redesigning democracy for the 21st century', Horizon State.

Kshetri, N. (2017) 'Can blockchain technology help poor people around the world?', The Conversation, 1 May.

Lantmäteriet, ChromaWay & Kairos Future (2016) 'The Land Registry in the blockchain', July.

Mr Money Moustache (2017) 'So you're thinking about investing in bitcoin? Don't', The Guardian, 15 January.

National Australia Bank Group Economics (2017) 'State Economic Handbook: October 2017', October, NAB.

Titcoin (2018) 'Titcoin Digital Currency: The Official Crytocurrency [footnote sic] of the Adult Industry'.

Visser, C. & Q. Hanich (2017) 'How blockchain is strengthening tuna traceability to combat illegal fishing', The Conversation, 22 January.

World Economic Forum (2015) 'Deep Shift—Technology Tipping Points and Societal Impact', September.

 

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[footnote 1] (2018) 'Bitcoin fuelled by cheap money boom', Australian Financial Review, 17 January.

[footnote 2] S. Gibbs (2011) 'Bitcoin and Ethereum tumble after renewed fears of regulatory crackdown', The Guardian, 17 January.

[footnote 3] Coinmarketcap (2018) 'Cryptocurrency Market Capitalizations', 31 January, coinmarketcap website.

[footnote 4] Fiat money refers to a currency that is not backed by a physical commodity and thus does not have any intrinsic value. The value of the currency comes from the backing of a government and the stability of the economy it belongs to. Almost all paper and coin currencies in use today are fiat money.

[footnote 5] Mr Money Moustache (2017) 'So you're thinking about investing in bitcoin? Don't', The Guardian, 15 January.

[footnote 6] M. Cranston (2017) 'First Victorian home ready to accept bitcoin as $2.5m sale payment', Australian Financial Review, 28 November.

[footnote 7] Mr Money Moustache (2017) op. cit.

[footnote 8] Ibid.

[footnote 9] Titcoin (2018) 'Titcoin Digital Currency: The Official Crytocurrency [footnote sic] of the Adult Industry', Titcoin Development Group.

[footnote 10] N. Kshetri (2017) 'Can blockchain technology help poor people around the world?', The Conversation, 1 May.

[footnote 11] F. Filpo & M. Berne (2017) 'The bitcoin and blockchain: energy hogs', The Conversation, 17 May.

[footnote 12] For example, Monero offers 'anonymous' trading. See: Monero (2017) 'Monero: Private Digital Currency'.

[footnote 13] N. Kshetri (2017) op. cit.

[footnote 14] S. Gilder (2017) 'Early blockchain experiments point to jobs of the future', Commonwealth Bank of Australia, 29 November.

[footnote 15] R. Browne (2017) 'IBM partners with Nestle, Unilever and other food giants to trace food contamination with blockchain', CNBC, 4 October.

[footnote 16] Bail Bloc (2018) 'Bail Bloc is a cryptocurrency scheme against bail', The New Inquiry.

[footnote 17] Horizon State (2018) 'Redesigning democracy for the 21st century', Horizon State.

[footnote 18] Civil (2017) 'What if the news were run by the people?'; Decentralised News Network (2017) 'News by the people, for the people.'

[footnote 19] C. Visser & Q. Hanich (2017) 'How blockchain is strengthening tuna traceability to combat illegal fishing', The Conversation, 22 January.

[footnote 20] J. Eyers (2017) 'Commonwealth Bank puts government bonds on a blockchain', Australian Financial Review, 24 January.

[footnote 21] C. Visser & Q. Hanich (2017) op. cit.

[footnote 22] World Economic Forum (2015) 'Deep Shift—Technology Tipping Points and Societal Impact', September, p. 24.

[footnote 23] N. De (2018) 'Canadian Research Body Pilots Ethereum in Transparency Push', Coindesk, 22 January.

[footnote 24] ChromaWay (2017) 'Cases: Future house sales'; Lantmäteriet, ChromaWay & Kairos Future (2016) 'The Land Registry in the blockchain', July.

[footnote 25] 'ChromaWay (2017) op. cit.