Blockchain and cryptocurrencies explained from scratch

This article is meant to help beginners understand the principles behind blockchain, and to help them form an opinion about where blockchain will be useful, and where it won’t.

What is Blockchain?

A blockchain is a shared immutable ledger that facilitates the process of tracking assets. Since a blockchain is a "distributed ledger", anyone can download it in its entirety, which will make them a "terminal" in the blockchain network. All transactions in the ledger are publicly available and there are complicated measures in place for updating the blockchain. Blockchains try to solve the intermediation problem, transparency problem, and trust problem.

Intermediation problem:?

Without blockchain, people would need intermediaries, like banks, to transfer money to each other. In this system, a bulk of transactions pass through a handful of powerful banks who are responsible for authenticating the payers/payees and maintaining the infrastructure. The infrastructure cost is borne by the payers/payees as transaction charges. When the payers/payee accounts are from two different banks, the two banks offset multiple payments due to be exchanged between them until one of them is owed a net amount. This is carried out through a central clearinghouse. When the transacting parties are in different countries, more intermediaries (SWIFT, Currency Converters), step in. An increase in the number of intermediaries increases the burden of accounting how much money each party owes the other and reconciling these entries. This burden translates into higher transaction costs and payment delays. A bank transfer to a different continent usually takes 5 days and 3-4% of the amount is lost as transaction fees. High-volume transactions with stock and other securities take days to settle (though transactions are booked in a fraction of a second). This is due to due diligence and reconciliation done by multiple intermediaries like brokers and transfer agents.??

Blockchain tries to solve this intermediation problem by having a single secure ledger where all stakeholders are participants. Transaction information is recorded once and available to all parties through the distributed network. This eliminates the delay and need for reconciliation between multiple siloed ledgers. If regulations require authorization from some intermediaries (IRS), the blockchain allows us to configure a consensus mechanism, where, for a transaction to be valid, all required parties must agree on its validity.

Transparency problem:?

The transactional systems we use day-to-day collect a lot of personalized information. Since this data is collected by independent entities, most of it is not used to make business decisions. For example, the RTO has data about a driver’s history of violations and his safety record. This data can be used by his insurance company to decide his premium. The insurance company can charge a higher premium for risky drivers or choose not to cover higher-risk drivers. This is beneficial for the safe drivers who were earlier subsidizing high-risk drivers by paying the standard premium. Such data exchange is currently limited due to a lack of a large-scale mechanism to expose data to only the relevant stakeholders in a secure and tamper-proof way. If the insurance company, RTO, and the bank transacted on a blockchain, the insurance company can look at the risk data of the driver before deciding to cover him and assigning the premium.???

Similarly. blockchain can help us keep track records of property rights, identities, and medical records without being at risk of someone tampering with those records.

The Karnataka government is doing a pilot using blockchain to store land-ownership records. The government plans to involve multiple stakeholders, like BDA, Survey Department, Urban Planning department, and Forest department as participants in the blockchain. Land ownership is established only when authenticated by all these participants. When the digitized land records are migrated to the blockchain, it will be easier to confirm not only the existing landowners but the historical ownership of each parcel of land. Hopefully, this should reduce the hassles faced by citizens who currently deal with multiple government departments to buy/transfer land.??

Trust Problem:?

We need central institutions to oversee our transactions to ensure the security of our transactions. A public network by definition can be accessed by anyone including bad actors who can steal/manipulate data. Regulators and auditors collect sample data from transactional systems to ensure process integrity.

A blockchain promotes trust through the immutable nature of its transactions. A transaction cannot be changed. It can only be reversed with another transaction and both transactions are recorded and visible. Data security and integrity are ensured by encrypting the data into fixed-value hashes and adding each data block to an immutable chain. All participants(terminals) enforce security by creating and verifying "blocks" of transaction data. The blockchain decides its main version based on what the majority of its users say is the truth. It follows the record of the longest blockchain present in most of its terminals since it requires the majority of the computational power to create the longest version of the chain.?If a terminal tampers with a record without authorization, all other terminals would cross-reference each other and easily pinpoint the terminal with the incorrect information. The network will automatically reject such an altered block. Less oversight is needed because the network is self-policed by network participants. Every terminal has the data that has been stored on the blockchain since its inception. Transaction details can be seen by only those participating in the transaction and by the auditors. Others can only see that some transaction has taken place. The shared ledger is the single source of truth, making it easy to audit.?

What makes a blockchain?

There are three important principles used to build a blockchain.

1. Cryptographic hash functions
2. Merkle Tree
3. Byzantine Fault Tolerance

Cryptographic Hash Functions:?

A hash function is a cryptographic algorithm that takes a piece of data as input and generates a string of numbers and letters that verify the data's validity. It does not reveal the information itself. Most blockchains use secure hashing algorithms like SHA-256.

The message is first converted to binary. The next steps involve padding, rotation, mutation, and multiplication with prime values. Please visit this link for a detailed explanation.

Some important points we need to remember about hash functions are

1. Hash functions return a fixed-length output irrespective of the input length.
2. A hash function is one-way. The inverse of the function, which will take the hashed output and return the input, is not possible to build. The only way to find the input is by brute force (guessing with all possible inputs) or using a rainbow table. These two hacking methods become infeasible for sufficiently large inputs due to prohibitively high compute power(brute-force) or memory(rainbow table) required.?
3. The hash function is deterministic (the same input always results in the same hash). Also, no two inputs can generate the same hash.
4. A small change to the message hashes the value so extensively that the output appears uncorrelated to the new hash value (avalanche effect). This is to ensure the one-way nature of the hash function.

Merkle Tree

Merkle tree is a binary tree with each leaf node containing the hashed value of the transaction.?It was patented in 1979. The Merkle tree uses the hash function to create a unique identifier for each piece of content.?

The hashed output will be of fixed length 256 bits. When shown as hexadecimal, each hash will have a fixed length of 64 characters. (4 bits of binary make 1 hexadecimal character). Merkle trees are used in storage technologies like the GIT file system, Cassandra Database, and Amazon DynamoDB. In Merkle trees, the leaf nodes store hashes of chunks of data. The parent nodes will be computed as below.

To form a Merkle tree of 4 transactions, the transactions will be hashed and arranged in pairs. The hash values of consecutive pairs will be concatenated, and their hash will be found to give the parent node value.?

For example, Hash 1 will be the hash of (" g543ab454d54gaab51b05aeb2246c024e99 35c290af5"+ "7e886f7c55d4e993581b05aeb2246c024e99eb2246c") and Hash 2 will be hash of "3e4fb05aeb2246c02d4e9935c290ade505aab51b05"+"9f9d8e9c98a90e98deb22 46c02a11df03e1187e886f". By the nature of hash function, the output hash will have 64 characters irrespective of the length of the input. Hash 1 and Hash 2 will be concatenated and put through the hash function to give the Root Hash. The root hash represents the value of transactions carried out until now.

By design, the parent nodes will be updated to the hash of the concatenated values of the child nodes. This makes any change to past transactions easily noticeable. If any value concerning Transaction 4 is updated, the corresponding hash value of Transaction 4 will change. This changes the value of Hash 2 since the value of Hash 2 depends on its child nodes. Since Hash 2 is affected, the root hash will also change. This design makes a change in any leaf node bubble up to the root node. If there are an odd number of transactions, the hash of the last transaction will be added as both the left and right leaf nodes of the last branch.

These connected nodes are grouped into blocks of size around 1 MB each, which are chained to each other in the described Merkle tree.?Since 1 MB contains 8 million bits of data and each hash occupies 256 bits, each block contains 8 million/256= 31250 nodes. All blockchains consist of a single chain of discrete blocks, arranged chronologically.?The bits are linearly stored. The tree diagram just represents the computation process.

When a new transaction is added to the chain, the hashed value of the transaction will be stored in a new node. This new hash value will be concatenated with the existing root node and hashed to give the new root value. The historical hash values are preserved and cannot be tampered with without changing the root hash. In this way, every node is immutably linked to the previous node, and every block is chained to every other block.?

Byzantine Fault tolerance:

Byzantine Fault tolerance is an integral property of a blockchain and ensures the validity of all transactions. This concept was initially developed to identify faulty components in distributed electrical networks.

Byzantine Fault Tolerance (BFT) is the feature of a distributed network to reach consensus (agreement on the same value) even when some of the nodes in the network fail to respond or respond with incorrect information. The network chooses the value provided by a majority of nodes as the right value. This reduces the influence of faulty nodes by employing collective decision-making.

In this article, I have used the word "node" to mean a node of a Merkle tree. I will use the word "terminal" to refer to a copy of the blockchain maintained by one of the participants.?

The entire chain of blocks is replicated on all the network terminals (computers, laptops, or servers). Terminals form the infrastructure of a blockchain. All terminals are connected to each other, and they constantly exchange the latest blockchain data to stay up to date. They store, spread, and preserve the blockchain data so it exists on all terminals. After enough exchanges on the network, each blockchain terminal will contain a full copy of the transaction history. This peer-to-peer exchange eliminates the need to store all transactions centrally. This prevents a central database from being a single point of failure. The only way data from a blockchain can be lost is if all the terminals get disconnected. Even in this unlikely event, the latest version of the blockchain can be recovered when one of the terminals comes back online.??

To reach a consensus, each terminal will have to communicate with every other terminal. Whenever a new transaction gets broadcasted to the network, terminals have the option to include that transaction in their copy of their ledger or to ignore it. When the majority of network actors decide on a single state, a consensus is achieved. If a malicious terminal alters its own copy of the blockchain, it will no longer align with everyone else's copy. When the terminals cross-reference their copies against each other, they would see this one copy stand out and the bad terminal's version of the chain would be cast away as illegitimate. The blockchain will have integrity as long as more than 51% of the nodes are benevolent.

The cost of Byzantine Fault Tolerance

Verifying the values of all the nodes in all the terminals involves a high processing overhead. Blockchains use a distributed mechanism to verify each transaction by involving terminals. Participant terminals contribute to blockchain maintenance by calculating and updating all the node hash values after every transaction. As the blockchain is stored, maintained, and updated in a distributed manner, there is no need for a central overseeing authority.?

The terminals make the blockchain fault-tolerant. The trade-off is that the terminals must be incentivized to identify and disregard invalid transactions and authenticate valid ones. This is to compensate the terminal users for the storage, electricity, computational power, and communication bandwidth they invest in maintaining the blockchain. In cryptocurrencies networks like the Bitcoin blockchain, terminals who validate blocks of data are rewarded with proportional cryptocurrency, in a process called "mining".?

Managing resource allocation

The Bitcoin network gamifies the mining process to manage the allocation of the scarce cryptocurrency. Terminals need to expend effort solving an arbitrary mathematical puzzle to prevent anybody from gaming the system. The puzzle is described by the below diagram.

The blockchain network affixes the block with a block header containing the block version number and a timestamp.?Then, the root node is hashed with a random string of numbers called the "nonce" to give the target hash value. The terminals don't have visibility onto the nonce value. The terminal that finds the nonce first will be awarded cryptocurrency. Since the hashing function is not invertible, the only way for the terminals to find the nonce is by trying out all possible nonce values (brute force). The nonce difficulty is adjusted so that a new block is added to the blockchain approximately every 10 minutes. The software makes the process artificially time-consuming, so terminals won’t be able to spoof transactions.

The terminals compete to find the nonce first and be awarded cryptocurrency. In the process, they verify the legitimacy of the blockchain transactions. The amount of cryptocurrency is limited since cryptocurrency enters circulation only when a terminal is rewarded for finding the nonce. For example, the 18.7 million Bitcoins in circulation have been created by miners. In the Bitcoin blockchain, in addition to finding the nonce, the terminal should have verified 1 MB worth of transactions in the Bitcoin blockchain (1 block worth of data), to be awarded Bitcoin. The difficulty level is adjusted for every 2016 blocks, that is every (2016*10/(24*60))=14 days, with the goal of keeping mining rates constant. When more miner terminals are on the network, the blockchain generates difficult nonces. When computational power is taken off the network, the difficulty adjusts downward to make mining easier. One of the terminals finds the nonce and validates a block every 10 minutes, but which terminal it will be is anyone's guess. Terminals are located in all time zones so transactions can happen around the clock.??

In the Bitcoin blockchain, the reward is cut in half every 210,000 blocks mined, or, about every four years. So lesser and lesser new Bitcoin enters circulation. Right now, each new block adds 6.25 bitcoins into circulation. The Bitcoin blockchain will provide rewards until the year 2140. Post-2140, no new Bitcoins will be created, and miners will be incentivized by transaction fees. The hope is that healthy competition will keep fees low.

Specialized terminal hardware

From 2008, when blockchains were started, until 2010, all blockchain terminals were run by independent users across the globe. They contributed to blockchain maintenance with their desktop computers. In 2010, some miners realized that graphics cards commonly used for video games were faster at solving cryptographic nonce puzzles, and began to deploy such specialized hardware. In 2011, bitcoin miners started using computers designed specifically for cryptocurrency mining, using Application-Specific Integrated Circuits (ASIC).

Private blockchain:?

Private Blockchains are configured within enterprises to help them transact internally or with other known enterprises. Cloud infrastructure providers like AWS and Oracle help configure private blockchains. An enterprise can also configure its own distributed ledger according to Blockchain principles on-premises or on the cloud. Since blockchain is more of a framework than a technology, it can be implemented from scratch using C++, Python, or JavaScript.??

Why are private blockchains not catching up??

There haven't been many successful private blockchain implementations. A reason could be that there is no need for a blockchain when known parties transact in a controlled environment.???

Blockchain is not a disruptive technology that can replace existing systems and instantly offer benefits like lower costs or increased speed or accuracy.?

One of blockchain's selling points was that it could enable unknown parties to transact securely without the involvement of intermediaries. This benefit doesn't make sense in a secure private network with known parties.?

Another one of blockchain's benefits was that it could decentralize processing by incentivizing independent terminals to maintain and verify the chain. This use case also falls flat for a private blockchain. There is no mechanism by which external participants can be incentivized to maintain a private blockchain. It is more efficient to use a secure traditional database to process and store data centrally than to invest in multiple self-validating terminals that needlessly hash and cross-reference each other.??

Alternatives to private blockchain

Blockchain can help eliminate time-consuming reconciliation efforts that accompany high-volume enterprise transactions. However, most enterprises underestimate the efforts needed to migrate transactional systems to the blockchain framework. It is far easier to standardize a process than to move it to the blockchain. Once the process is moved to standardized templates, proprietary software like Blackline can automatically reconcile the items from General Ledger and vendor invoices using configurable matching rules. Not all accounting efforts are nails to be set right by the blockchain hammer.?

Enterprises may adopt blockchain for their audit and control capabilities alone. These capabilities come from the shared immutable nature of the blockchain that makes it a single source of truth. A blockchain, however, is an unnecessarily convoluted way to achieve this end. Existing transactional systems like SAP already aggregate transactional data and provide sampling mechanisms for auditing. The transactional systems can also be made immutable to prevent internal manipulation. The database can be configured to have only "insert" access. "update" and "delete" access can be disabled. AWS QLDB is an immutable database specifically built for this purpose.?

There is not much value to be added by a blockchain to an enterprise where there is no intermediation, transparency, or trust problem. Maintaining a blockchain requires massive amounts of energy and computing resources. Many companies, after burning their fingers with failed POCs, have realized that implementing a private blockchain is like moving from transistors to vacuum tubes.??

Threat from mining farms:?

In 2013, an Iceland-based company called Genesis Mining started an industrial-scale cryptocurrency mining farm with specialized hardware. Industrial farms like these will reduce the incentive for the independent terminals to compete in the verification game. This is because an individual terminal's chances of finding the nonce are minuscule when competing with industrial farms. If a handful of mining companies form an oligopoly, they would collectively control over 51% of the terminals in the blockchain and would be able to spoof transactions with the consent of all their terminals. All the Genesis Mining terminals are managed centrally using an internal software called Hexa. This software can control terminals, forming a powerful intermediary. If the software is allowed to modify transactions, the integrity of the blockchain will be under question. Operating with large-scale centralized terminals defeats the purpose behind the blockchain, which is not to trust centralized intermediaries. Cryptocurrency mining farms might make the blockchain as useless as a private blockchain.

Many Chinese cryptocurrency mining farms have mushroomed after 2015. If the number of independent terminals falls too low, the blockchain will be prone to Sybil attacks. A mining farm with a large number of terminals can replicate a blockchain with the same fake transaction across all their terminals and make them validate each other. The farms may not do this since they have a reputation to keep and since it is in their interest to preserve blockchain integrity. But still, a bulk of validating terminals being controlled by a single entity is like a fox guarding the henhouse.?

Scalability:

The Byzantine consensus model works efficiently only when the number of terminals in the distributed network is manageably small. The communication overhead increases exponentially with every extra node in the network since messages must be sent from every terminal to every other terminal at each step to arrive at a consensus.

If n is the number of nodes and k is the number of ranks of terminals, n^k is the number of messages needed at each stage to make the network fault-tolerant. The Bitcoin blockchain, the largest blockchain in operation, has 10000 operational terminals. This is 2 out of every million internet users. (an estimated 5 billion people use the internet). When the number of terminals increases, the high processing, and communication overhead along with high response time might make the blockchain unusable. The world's largest bank in terms of deposits, JPMorgan, has 51 million retail customers. No blockchain will be able to operate at this scale.

Anonymity problem:?

The blockchain framework ensures the validation of transactions but does not verify the identities of the transacting parties. In public blockchains, anyone or anything can participate in the network with no identification. This is dangerous since it provides an avenue for criminals to launder money, manipulate the market, or finance illegal activities. In 2020, 98% of all ransomware payments were made in Bitcoin.?

Integration Problem

Blockchains do not communicate with one another and there is no mechanism to integrate two blockchains other than the inefficient method of chaining them together. Siloed blockchains don't add value. The rosy promises of blockchain will not come to fruition unless everyone operates on the same blockchain, which is costly and impractical

Funding problem

As we saw earlier, blockchains are maintained by independent terminals and terminals from mining farms, which are incentivized by the cryptocurrency they "mine". If the cryptocurrency related to the blockchain crashes, the terminals would stop maintaining the chain since they won't have an incentive to contribute their efforts.?

Cryptocurrencies:?

Cryptocurrencies are increasing in value due to restricted supply and high demand. The high demand is because those who buy, or mine cryptocurrencies think cryptocurrencies are the future of money. They are led by influencers like Twitter CEO Jack Dorsey.?

I will explain why I think cryptocurrencies can never enter mainstream usage and will remain a niche at best.?

Low penetration:?

Let’s take the example of India, the country with the second-highest number of smartphone users after China. The largest Indian bank, SBI has 410 million active retail accounts. The largest Indian crypto-exchange, CoinDCX, claims to have 4 million users but the number of active users is not known. A bulk of them may have signed up for the Rs 100 worth of free Bitcoin given to all new users.?

UPI, the Indian mobile gateway supported by all banks, accounts for 150 million transactions per day, as does the international payment network VISA. The percentage of non-fiat crypto payments is close to zero. Indian traders use exchanges like CoinDCX to trade in cryptos but cannot use cryptos to pay for goods/services due to cryptocurrencies not being recognized as legal tender.?

User acquisition problem:?

Cryptocurrency adoption is not expected to increase among general users as it offers no advantage in terms of convenience, cost, or response time.

There are two methods for a user to get into the crypto ecosystem.

1. Mining cryptocurrencies: Mining farms have made individual crypto-mining futile

2. Buying cryptocurrencies: It can take around 5 days to buy a cryptocurrency through net banking. 3% of the money is lost as transaction fees while buying through credit/debit card. This is not a good deal for the buyer since he would be moving money from a more widely accepted medium (banking or credit card) to a less accepted one.

Taking the Indian example again, there are 420 million mobile internet users in India. Over 100 million of them are monthly active UPI users. It is expected that a substantial number of these users will register with UPI by 2025, leaving little of this market for alternate options. It is very easy to enroll with UPI since it authenticates the user's existing bank account using his phone number.

966 million Indian users use mobile phones. Payment banks like Airtel payment bank, with their SMS-based payment systems, are trying to serve the target market of 446 million Indian users who use mobile phones but not internet-connected smartphones. There is no option for non-internet users to transact with cryptocurrencies.

Scalability Issues:??

As we saw earlier, Bitcoin, the most widely used cryptocurrency, adds a block every 10 minutes. Since every block has 31250 transactions, the maximum number of transactions possible in a day is 31250*(24*60)/10=4.5 million transactions. Currently, around 30000 Bitcoin transactions take place in a day, which is 0.002% of UPI or VISA. Even when the blockchain is used at full capacity, the number of Bitcoin transactions cannot be more than 3% of what UPI or VISA currently handle. A 150-fold increase in Bitcoin payments will make transaction costs skyrocket due to the exponential nature of the power function in the Byzantine algorithm, while UPI will continue to charge 50 paise per transaction, irrespective of transaction volume.?

Acceptability Problem:?

Less than 1% of large vendors accept non-fiat cryptocurrencies as payment. No local businesses recognize cryptocurrencies outside of El Salvador(a tiny Central American country with no currency of its own and whose $27 billion GDP accounts for 0.03% of world GDP).

Many governments, like China, Russia and Taiwan do not allow financial institutions to facilitate crypto transactions. The Indian government does not recognize cryptocurrencies as legal tender and is trying to crack down on their use for criminal activities. Japan allows only currency-backed cryptos and not non-Fiat currency.?

Even some of the few vendors who accepted cryptocurrencies, like Tesla, are now moving away from it citing environmental concerns. In May 2021, Elon Musk said that his company will no longer accept cryptocurrencies as payment since their customers did not want to buy eco-friendly products using an energy-intensive currency.?

Environmental issues:?

The Bitcoin blockchain consumes 133.68 terawatt-hours of electricity in a year. Bitcoin production is estimated to generate between 22 and 22.9 million metric tons of carbon dioxide emissions a year, or between the levels produced by Jordan and Sri Lanka, a 2019 study in scientific journal Joule found.

This will increase exponentially as the nodes and terminals increase. This is another reason for government and responsible citizens not to use this "dirty" currency.?

Security Issues:

Cryptocurrencies are not fraud-proof. Multi-level cyber-attacks are being developed to hack crypto exchanges. In 2014, Mt Gox, the exchange that then handled 70% of the Bitcoin trading volume, went bankrupt after $450 million worth of Bitcoin was stolen. In 2018, Bithumb, the sixth busiest crypto exchange in the world was hacked and 31.5 million USD worth of currency was stolen. Cryptocurrency thefts in the first four months of the year 2021 alone totaled $432 million, according to an analysis by Ciphertrace.?

Mining becomes a nuisance to cloud companies?

Cloud companies like AWS offer customers their servers on rent. Some malicious employees on customer rolls have illegally converted cloud servers into crypto-mining terminals. This unintended usage has increased the cost of running cloud operations. Cloud companies that offered free services for SaaS development have been forced to shut down their free tiers to prevent massive signups from such abusive users. In September 2020, 11 GitHub users were banned for running mining operations on company infrastructure. The cloud providers are forced to implement laborious controls and monitoring on compute time. The impacted cloud companies and users are pushing regulators to crack down on cryptocurrency miners.

The fundamental problem

Even if all the above issues are solved, there is a fundamental problem with non-fiat cryptocurrencies. To judge whether cryptocurrencies can be considered currencies, let us first look at why fiat currencies have value.?

Fiat currencies, whether in digital or physical form, are backed by governments. Fiat currencies have been in widespread use since the US government discontinued the gold standard in 1971. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government. Governments and Central Banks oversee the production of fiat currencies and control and supply to maintain a favourable exchange rate for their own currencies. Central Banks maintain enough currency in circulation and attempts to print too much of one currency are promptly punished by the devaluation of that currency in the Forex market. Currency supply changes are instantly noticed by the Forex markets in which $5.3 trillion dollars worth of currency is traded every day. Currency devaluation reduces exports as export goods become costlier. If central banks don't respond to Forex feedback, the currency will go through hyperinflation as it happened in Germany in 1923, China in 1949, and Yugoslavia in 1994. In a particularly notorious example, Zimbabwean president Mugabe, in the year 2000, printed Zimbabwean dollars to finance the suppression of his political opponents. Zimbabwe had printed so many notes that, by the year 2008, Zimbabwe had a 100 trillion dollar note that was worth a few cents in USD and a loaf of bread costed a third of the average Zimbabwean wage. I will explain the relevance of these examples in the upcoming paragraphs. We just need to remember that, in every country, banks are highly regulated by the Central Bank since it is in the country's interest to contain fluctuation of the national currency. Non-fiat cryptocurrencies are not overseen by any central authority, and neither is their usage regulated.??

A currency is valued favourably in the Forex market if it is widely accepted as payment for goods, as in the case of the US Dollar or Japanese Yen. The currencies that are priced well with respect to the US Dollar are either from countries that have greater purchasing power due to their export capability (as in the case of the Chinese Yuan) or from countries that have shown the ability to control inflation (as in the case of Swiss Franc). A currency will weaken against the US Dollar if it is from a country with lower economic growth or if the currency is not widely accepted (due to sanctions, etc). Since cryptocurrencies like Bitcoin are not traded in the Forex market and are accepted only by a minuscule portion of the world's traders, they cannot be treated as currency. Their highly volatile nature prevents them from becoming a reliable medium of exchange, as shown by the below internet meme.

If cryptos cannot be treated as currency, can they be valued as financial instruments???

Financial instruments are either equity-based, debt-based, or a combination of both. One thing common to all such instruments is that they are used by their issuers to raise capital. This capital is used to finance expansion or operations to create value. For example, the Airtel IPO, launched in 2002, helped Airtel finance the tower infrastructure they needed to build their seamless telecommunication network. Over time, this network has helped Airtel gain the 350 million paying subscribers they have today. Similarly, the corporate debt raised by KIA helped them develop the Seltos model, which sold over nine thousand units in India alone.?The Facebook IPO in 2012 helped them raise the 16 billion dollars they needed to add features and increase server capacity so that they could increase the number of their users from the 483 million they had that year. Facebook's current user base of 2.7 billion has helped them achieve 85 billion dollars in annual advertising revenue.?

If company revenues don't live up to investor expectations, the demand for the financial instrument will fall and the issuer will be penalized with a lower price for his instrument. In 2001, the energy company Enron's stock crashed after it was revealed that Enron had committed accounting fraud. Enron went bankrupt the same year.?

An extreme example is the failure of mortgage-backed securities that led to the financial crisis of 2007-08. In 2001, the US Fed slashed interest rates and financial capacity requirements for homebuyers. Taking advantage of this, mortgage divisions of US banks tried to exceed their loan targets by giving home loans to buyers without stable income sources (sub-prime mortgages). When the number of loans increased beyond the bank's ability to finance them, the banks raised money by issuing mortgage-backed securities. These securities raised money to finance housing loans with the expectation that the homeowners would pay back the investment along with interest. All large US banks issued security-financed home loans since projected returns on mortgages were greater than returns on other financial products. The dramatic rise in home loans led to the property market getting flooded with millions of new homes. With increased supply, property rates began to fall. Many homes lost their market value by around 32%. This caused a cascading effect as the sub-prime borrowers, with the already stressed financials, did not want to make good on loan payments. Most of them owed the banks much more money than their houses were worth. With increasing defaults in loan repayments, the prices of mortgage-backed securities began to crash. This crash caused a collective loss of 2 trillion dollars to the banks that held these securities. Lehman Brothers, the fourth-largest US investment bank at that time, went bankrupt.????

It may appear that the above examples are not relevant to the topic, cryptocurrencies. The point I was trying to make with these examples is that the value of a currency represents the confidence the markets have in the issuing country. Similarly, the value of a financial instrument represents the reliability of the issuing entity. When trust on a currency-issuing country/issuer of securities falters, the corresponding currency/financial instrument is devalued by the market. Therefore, the Forex Markets/Stock markets act as continuous feedback mechanisms to ensure that the market prices of currency and financial instruments are correlated with their actual value. In the case of cryptocurrencies, there is no such corrective mechanism to prevent the market from overvaluing them. Cryptocurrencies such as Bitcoin might be the only non-fiat financial instruments that don't have any corresponding value added in the real world. When the first Bitcoin was mined, it did not help its issuer create any assets that added real value. In fact, the Bitcoin creator hasn't been heard from since 2008. The value of a stock goes up when its issuing company grows in capacity and revenue. When the value of Bitcoin went up from $997 in January 2017 to $10000 eleven months later, this 10-fold value increase was not correlated to an increase in any real-world business or economic activity. This reveals that the increases in cryptocurrencies prices are purely demand-driven. In the case of mortgage-backed securities in 2008, when word got out in the market that a disproportionate number of borrowers defaulted on their loan payments, the demand for the mortgage-backed securities fell, as did their price. In the case of Enron, the stock was devalued from $90 to less than $1 within months after accounting fraud was revealed. Bitcoin is traded within an isolated network of a few million active crypto traders and does not offer the market a chance to give it a reality check.??

Techno-anarchists and misguided evangelists say the restricted supply of Bitcoin (not more than 21 million can be mined) justifies its increasing price. A commodities' value cannot be driven by its scarcity alone. It is Bitcoin's scarcity that has helped attract the buyers that have bloated its price. These buyers don't see any use for Bitcoin itself but are motivated by profit to be made by future price increases.?

When the CEO of JP Morgan, Jamie Dimon was asked about Bitcoin prices going up, he drew a parallel to another commodity that was priced not for its intrinsic value but for its scarcity and prestige. In the 1600s, the Dutch East India Company owned a global fleet of 200 ships and a private army of 10000 soldiers, which gave them a monopoly over the inter-continent textiles and spices trade. The Dutch East India Company is the largest company to ever have existed in recorded history, with an inflation-adjusted net worth of 7.9 trillion dollars. In this time period, tulips were introduced in Europe from Turkey. Tulips take 7 to 12 months to flower and bloom for only a week. It was a symbol of status for a Dutch aristocrat to have a tulip on his front porch. Noblemen were willing to pay a premium for tulip bulbs. In one of the earliest examples of futures trading, the Dutch set up a market where one could trade tulips all year round, even when they weren't in bloom. The prices of the tulip-based derivatives were pushed higher and higher by speculators who planned to turn around and sell them for a profit. They were motivated by the early tulip traders who had made a fortune. At the peak of Tulip-mania, a single tulip bulb was worth more than a craftsman's annual wage. The Dutch East India Company had heavily invested in the tulip trade, tempted by its unprecedented returns. In 1636, many buyers did not show up to the routine tulip-bulb auctions held in Amsterdam. This fall in demand caused tulip prices to slightly reduce. This made some more people sell their tulip-based securities and prices fell further. This cycle continued until it triggered a panic selling and tulip prices fell by 99% within a few weeks. Tulip-mania was the first recorded asset bubble in history and was one of the reasons for the fall of the Dutch East India Company. The important thing to remember about the tulip bubble is that the bubble did not burst due to an increase in the supply of tulips, but because buyers realized that tulips were worthless.?

How did Bitcoin bounce back from falls, unlike the tulips??

People get information instantly today, unlike in the 1600s, which makes it easy to cloud people’s judgment by bombarding them with biased information. The traders who bought Bitcoin for a few dollars in 2008 have an incentive to keep the hype going. Social media has helped sustain this hype by equating skepticism about cryptocurrency with technological backwardness. Buyers, driven by the fear of missing out, see slumps in Bitcoin value as opportunities to buy Bitcoin at a lower price. This is why Bitcoin prices recovered after some slumps, unlike the tulip bulbs, whose initial price fall triggered an avalanche.?

Can a blockchain with its peer-to-peer transaction mechanism eliminate intermediaries like banks??

Even with blockchain, we would require intermediaries to verify the identities of transacting parties and to vouch whether the transaction corresponds to the physical exchange of goods. Validating the chain alone does not confirm the current state of physical assets. The blockchain is not a replacement for databases or transaction-processing systems.?

By leveraging the money in their vaults as loans, banks act as a channel between those who have funds and those who need them. They also manage the efficient distribution of capital by diversifying and providing loans at tailored interest rates according to the borrower's default risk. Banks produce capital gains for investors by maintaining mutual funds. A blockchain does not replicate these bank functions since an encrypted ledger is only one of the components of the bank infrastructure.?

Banks have invested in the latest security technologies to facilitate digital transactions, through a centralized infrastructure that has evolved to minimize transaction costs. Transacting through a blockchain will always be costlier than through a bank since the blockchain framework is inefficient by nature as it requires recursive hashing and replication of processing efforts across all terminals.

Will banks accept non-fiat cryptocurrencies in the future??

Banks have been using encryption and digitized payments for almost half a century since the US government endorsed the IBM-developed Data-Encryption-Standard(DES) in 1973.?JP Morgan digitally moves 6 trillion dollars around the world every day. It is apparent that Jamie Dimon has no problem with the digital or crypto nature of Bitcoin. His problem is that, behind the inflated price and investor confidence in Bitcoin, there is no issuing entity that adds value in the real world.

I will explain why banks will never accept cryptocurrencies as a legitimate form of payment

• Banks hold other electronic assets like stocks and bonds, but unlike these securities, cryptocurrencies do not generate any future cash-flows for the owner.
• Cryptocurrencies are not guaranteed by any stable government.
• They cannot add value to any process as a raw material.
• Mining cryptocurrencies does contribute to blockchain maintenance. But as we saw before, the blockchain is worthless as an alternative payment system since banks do a much better job of handling transactions.?
• Cryptocurrencies from a particular blockchain are limited but since any number of blockchains can be created, cryptocurrencies are not a truly scarce?

The above points make the DCF value of cryptocurrencies 0 in the eyes of banks. Banks will not hold cryptocurrencies in the future since they don’t believe in holding worthless assets.?

Did participants of the blockchain ecosystem just glorify encryption the way the Dutch glorified a spring-blooming import crop? Let's wait and watch.?

References

1. https://blog.goodaudience.com/blockchain-for-beginners-what-is-blockchain-519db8c6677a
2. https://medium.com/loom-network/understanding-blockchain-fundamentals-part-1-byzantine-fault-tolerance-245f46fe8419
3. https://marknelson.us/posts/2007/07/23/byzantine.html
4. https://www.investopedia.com/terms/p/proof-work.asp
5. https://www.investopedia.com/terms/b/bitcoin-mining.asp
6. https://www.investopedia.com/news/how-bitcoin-works/
7. https://www.sciencedirect.com/science/article/pii/S2542435119302557
8. https://blog.goodaudience.com/blockchain-for-beginners-what-is-blockchain-519db8c6677a
9. https://www.investopedia.com/terms/b/blockchain.asp
10. https://marknelson.us/posts/2007/07/23/byzantine.html
11. https://www.investopedia.com/terms/p/proof-work.asp
12. https://www.investopedia.com/terms/t/target-hash.asp
13. https://www.investopedia.com/terms/n/nonce.asp
14. https://www.reuters.com/technology/how-big-is-bitcoins-carbon-footprint-2021-05-13/
15. https://medium.com/devopsinternationalbv/what-is-this-quantum-ledger-database-that-im-keep-hearing-about-a3c16c35c799
16. https://economictimes.indiatimes.com/news/economy/indicators/digital-payments-will-grow-to-71-7-of-all-transactions-by-2025-report/articleshow/81777553.cms?from=mdr
17. https://101blockchains.com/qldb-vs-hyperledger/
18. https://blogs.oracle.com/blockchain/post/oracle-blockchain-platform-receives-widespread-recognition-from-the-analyst-community
19. https://docs.aws.amazon.com/qldb/latest/developerguide/limits.html