Academic journal article Federal Reserve Bank of St. Louis Review

A Short Introduction to the World of Cryptocurrencies

Academic journal article Federal Reserve Bank of St. Louis Review

A Short Introduction to the World of Cryptocurrencies

Article excerpt

1 INTRODUCTION

Bitcoin originated with the white paper that was published in 2008 under the pseudonym "Satoshi Nakamoto." It was published via a mailing list for cryptography and has a similar appearance to an academic paper. The creators' original motivation behind Bitcoin was to develop a cash-like payment system that permitted electronic transactions but that also included many of the advantageous characteristics of physical cash.

To understand the specific features of physical monetary units and the desire to develop digital cash, we will begin our analysis by considering a simple cash transaction.

1.1 Cosh

Cash is represented by a physical object, usually a coin or a note. When this object is handed to another individual, its unit of value is also transferred, without the need for a third party to be involved (Figure 1). No credit relationship arises between the buyer and the seller. This is why it is possible for the parties involved to remain anonymous.

The great advantage of physical cash is that whoever is in possession of the physical object is by default the owner of the unit of value. This ensures that the property rights to the units of value circulating in the economy are always clearly established, without a central authority needing to keep accounts. Furthermore, any agent can participate in a cash payment system; nobody can be excluded. There is a permissionless access to it. Cash, however, also has disad-vantages. Buyers and sellers have to be physically present at the same location in order to trade, which in many situations makes its use impracticable.

1.2 Digital Cash

An ideal payment system would be one in which monetary value could be transferred electronically via cash data files (Figure 2). Such cash data files retain the advantages of physical cash but would be able to circulate freely on electronic networks. (1) A data file of this type could be sent via email or social media channels.

A specific feature of electronic data is that it can be copied any number of times at negligible cost. This feature is highly undesirable for money. If cash data files can be copied and the duplicates used as currency, they cannot serve as a payment instrument. This problem is termed the "double spending problem."

1.3 Electronic Payment Systems

To counteract the problem of double spending, classical electronic payment systems are based on a central authority that verifies the legitimacy of the payments and keeps track of the current state of ownership. In such systems, a central authority (usually a bank) manages the accounts of buyers and sellers. The buyer initiates a payment by submitting an order. The central authority then ensures that the buyer has the necessary funds and adjusts the accounts accordingly (Figure 3).

Centralized payment systems solve the double spending problem, but they require trust. Agents must trust that the central authority does not misuse the delegated power and that it maintains the books correctly in any state of the world--that is, that the banker is not running away with the money. Furthermore, centralized systems are vulnerable to hacker attacks, technical failures, and malicious governments that can easily interfere and confiscate funds.

1.4 Stone Money of Yap

The key feature of the Bitcoin system is the absence of a centrally managed ledger. There is no central authority with an exclusive right to keep accounts. In order to understand how this is possible, we will first discuss a historical payment system that has certain similarities with the Bitcoin system.

On Yap Island, large millstone-like stones were used as a medium of exchange. (2) The stones were quarried almost 280 miles away on the island of Palau and brought to Yap by small boats. Every inhabitant could bring new stone money units into the system. The money creation costs, in the form of labor effort and equipment such as boats, protected the economy from inflation. …

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