Cryptocurrency 101: the synergies between Finance and Technology
Updated: Jan 1, 2021
Myra Leung explains how the technology behind cryptocurrency and explores why blockchain will play a big role in the future of finance.
With the rapid growth of FinTech in recent years, we are becoming more familiar with technical terms associated with this field. Although FinTech seems to be the popular buzzword these days, some of us might not know much beyond the fact that the term stands for ‘financial technologies’ and its relationship to Bitcoin: we may think that FinTech seems very distant from our daily life. To enable a better understanding of what FinTech means, this article aims to unravel FinTech and cryptocurrency jargon in a fun and easy way so that you might be able to speak like an expert next time when you come across this topic.
Fintech and Cryptocurrency
Although Bitcoin might be the first thing that pops into your mind when thinking about FinTech, Bitcoin is only a product in the cryptocurrency segment and the FinTech industry contains numerous segments. FinTech is a portmanteau of “financial technology”. It includes any kind of technology in the financial services industry and its major aim is to provide better financial operations for companies, business owners and customers. The scope of FinTech is huge and it can be categorised into many different ways. Below are some examples of different types of fintech which one may encounter.
Cryptocurrency is a type of FinTech that utilises blockchain technology. Cryptocurrency is a variation of digital currency: a currency that is only available in digital form. Unlike digital currency or any kind of currency, cryptocurrency does not have a centralised authority (e.g. banks and governments) to verify and record transactions. Instead, it uses cryptography to build a secure decentralised system — blockchain. In this system, no single individual or supervisory authority can control the actions occurring in the network and it is governed by the majority of the community. The security of cryptocurrency is one of the reasons why this currency is gaining more support. However, how does cryptocurrency ensure a high level of security without a third party authority?
The technology of cryptocurrency
Since cryptocurrency is a public ledger that uses cryptography and blockchain to record all the transactions, every user keeps a copy of the public ledger and can make changes to the ledger, meaning they can do transactions with the cryptocurrency. In 2009, “Satoshi Nakamoto”, a pseudonymous person, devised the first blockchain database and developed the first cryptocurrency, Bitcoin. He introduced a trustworthy decentralised, digital peer-to-peer payment network, where users can manage accounts and verify transactions without the help of banks.
In the past, a third party was always involved in digital transactions because unlike face-to-face cash payment, frauds and scams were more likely to take place. Typically, banks collect personal security information to enable transactions:
1. Your signature or password
Someone might have stolen your phone or credit card and want to make a payment using your balance. Hence, a signature or password that only the bank knows is needed to verify payments.
2. Your personal details
You might have spent more than your credit limit or intended to use your account for illegal purposes such as money laundering. Hence, banks have your details such as address, phone number and collateral to verify that you are a real person and have the ability to make your payment.
3. History of transactions
Someone may claim they didn’t receive the payment. Hence, banks keep a confidential record of transactions.
Without a trusted third-party authority using this information to monitor transactions, scams might happen easily and cause us to lose a huge amount of money. However, as a central information storage organisation, banks are often targeted and attacked by hackers. Customer information leakage causing potential financial problems has always been a concern. This is where cryptocurrency comes in, with the use of cryptography and blockchain. This technology ensures secure transactions without a centralised system and accessible to all users. The system follows a few main rules to operate securely:
1. Digital Signature: Cryptocurrency only verifies transactions if there is a digital signature.
Like all transactions, a cryptocurrency transaction is only valid if there is a signature. However, since it is digital, technically the “signature” would be a combination of 0s and 1s which can be copied easily. To resolve this issue, Nakamoto broke the digital signature into two parts: a private key that is secret and unique to each user, and a public key that is different for every transaction. Through combining the two, this digital signature ensures the transaction is done by the user yet changes every transaction, which is different from our normal hand-written signature.
Explanation: A digital signature is composed of two parts: Public key — the message of the transaction (e.g. “You are paying Bob £10”) and private key — which is unique to each user.
As a result the digital signature would be dependent on the message. The signature for each transaction would be different and no one can copy it for forgery purposes. The private key is kept secret and ensures that only you can produce the digital signature to draw money from your balance. This system protects you from other people using your balance.
Then, the digital signature is encrypted and broadcasted to the public where everyone can use the public key to decrypt it and check if that digital signature is “true”. If it is verified, it proves that you didn’t forge the message and your transaction would be added to the public ledger. This protects others from being scammed by your transaction message. This way, every transaction recorded on the ledger is safe.
2. No overspending is allowed. Hence, your details are not needed to be collected which users don’t need to worry about the leakage of personal information anymore.
3. Cryptocurrency stores transaction history in blocks and trusts the ledger with the most computational work
Since everyone around the globe can make transactions, simultaneous transactions are likely to happen. Without a central authority to manage and regulate these transactions, it becomes really hard to identify the sequence of transactions, hence a unified copy of ledger that everyone trusts is hard to be produced. It is important to have everyone to agree to work on the most updated ledger that is true. Therefore, cryptocurrency breaks down its huge ledger into “blocks” (a mini ledger). Through using blocks instead of “transactions” as the basic unit, spontaneous transactions problems are less likely to occur and building up a sequence of approved trusted transactions becomes easier.
Explanation: Each block contains a list of transactions. According to the content (prev. hash + “transactions”) of the blocks, a “proof of work” is calculated. Each “proof of work” requires a lot of computational work to calculate and they are placed at the bottom of a block. Then, the blocks are linked through putting the “proof of work” of the previous block in the beginning of the next block (displayed as “previous hash”). This forms a “chain of blocks” (blockchain) which is the huge public ledger, the cryptocurrency system.
Since the “proof of work” is based on the content of the block, if anyone changes the content in any block or takes out a block, the “proof of work” of all blocks would change correspondingly and require redo the calculations. It takes a lot of computational work (money to buy the equipment) and time to calculate a single “proof of work”. It requires a certain amount of time to add a block to the chain. Therefore a new “fake blockchain” that is as long as the present one is nearly impossible to build because a scammer, or even a huge group of scammers, would never be able to compete against the computational power of the whole community. Hence, the fake blockchain would always be shorter than the actual one. Therefore, all people need to do is to trust the longest blockchain to be the public ledger and work on that to continue building more blocks on that.
The finance of cryptocurrency
Because of the characteristics enabled by the technologies, there are a few advantages of using cryptocurrency that can benefit an average consumer. Firstly, the security and privacy of using cryptocurrency for payments is appealing. Recently, PayPal enabled payments using Bitcoin, showing the increasing usage of cryptocurrency. Secondly, the removal of third-party authority is actually providing new financial opportunities for 1.7B unbanked individuals around the world to access digital payment. Thirdly, as cryptocurrency is not issued by the government, there is a limit to the total supply of currency. This scarcity influences their value and it can be a good value storage. Lastly and most importantly, its decentralised secure nature that connects users and creators directly is a revolutionising concept to the finance industry. Hence, there is an increased usage of blockchain in all industries, because of its secure, direct and transparent nature. Cryptocurrency and blockchain may soon well be incorporated in our daily transactions.
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