A brief history of cryptocurrencies.
In this chapter, I’d like to set the scene and give you some context. Before we get to the what and the how, I think it’s important to know the why – so we’re going to take a quick look at the landscape before cryptocurrencies.
Why do we need cryptocurrencies?
Bitcoin, the world’s first cryptocurrency was launched in 2008 by Satoshi Nakamoto, a talented computer programmer who used a real sounding pseudonym to guard his privacy.
Nakamoto wrote a white-paper outlining his reasons for creating Bitcoin and published it online. In a nutshell, Nakamoto believed that the current system of owning and transferring money was inefficient, expensive and carried with it a high risk.
“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network.”
In an ideal world, a transaction between two people would only involve two people – the sender and the receiver. Here’s a good example of this kind of transaction: If you purchase goods from a retailer and you pay them cash – the retailer keeps 100% of the money and does not pay a transaction fee. Cash, however, is risky – it can be lost, it can be stolen, it can also be damaged in a fire, flood or accident, which obviously Bitcoin cannot.
There are other ways to pay: cheque, credit card, bank transfer, direct debit etc. Each of these involves a trusted third party – the third party is usually a bank, lender or payment processor.
If we go back to our earlier example, when we use a credit card or cheque to buy goods, the retailer pays a transaction fee to the third party – meaning they receive less money for the same goods.
Nowadays, many of our purchases are made online and sometimes overseas – in these instances, cash becomes unviable and we have to find alternative means of payment.
You may be familiar with PayPal. Sending money through PayPal is free for the sender, however, the receiver often pays a small flat fee plus a percentage of the total transaction – if you pay someone in another country, currency conversion fees also apply. If you’ve ever sent money by Western Union, you’ll know that fees can be as much as 10%. International credit card fees are often high, and you will also have to pay conversion fees.
In other words, involving a third party in the transaction can introduce high fees. Bank transfers and cheque payments can often take days, sometimes weeks when making international payments. This is a highly inefficient system.
If you cast your mind back to 2008, you may remember the world was in the middle of a financial crisis. I won’t go into too much detail here, but many people lost their trust in the banking system. In some countries, the government had to borrow heavily and ‘cut back’ on essential services such as police, schools and hospitals. In others, citizens who had money saved in their accounts had it confiscated – all to bail out the banks.
Ultimately, money is built on trust. When you have money, you trust it holds value which you can exchange for goods and services. In most circumstances, we trust a financial institution to look after our money and ensure it is available when we need it. When we pay for a product or service, we trust we will receive what we pay for. For many people, the trust was broken.
Nakamoto created Bitcoin to address all these issues. Essentially, Bitcoin was designed as a process to make secure payments between a sender and a receiver without involving a third party.
In creating Bitcoin, Nakamoto had created a way of paying people anywhere in the world quickly, cheaply and securely – some see Bitcoin as the next best thing to cash.
What made cryptocurrencies possible, and how did it all come together?
Every new, ground-breaking technology seems to come from nowhere – it appears to have been conjured out of the mind of a genius and sent into the world to change it forever. Once a new technology changes our way of life it becomes almost impossible to live without, and we begin to take it for granted.
The reality of discovery is rarely as simple as a single Eureka moment. What seems obvious in hindsight is often a long process which grows with each iteration. Ideas build upon ideas, somebody discovers a connection between two unrelated ideas and something new is created. Isaac Newton recognised this when he said “If I have seen further, it is by standing on the shoulders of giants”. Philosophers and scientists had already discovered many of the principles behind his theory of gravity, Newton happened to be the one who connected the dots.
Take computers for example. Think of everything that had to be in place before even the simplest computer could be assembled. Without electricity, transistors, microchips, mathematics and a whole spectrum of other scientific discoveries computers couldn’t have been created.
Once a discovery is made, others begin to understand the implications, they look at it from all angles and see how it can be applied. This is exactly how Satoshi Nakamoto created Bitcoin, the first cryptocurrency.
Long before Bitcoin, various computer scientists had thought of ways to create a secure digital currency. Anonymity has always been one of their key concerns: without any form of protection, every purchase you make can be linked to you. In most Western countries this isn’t thought of as a problem (at present), however owning certain things in some countries is against the law and can even lead to imprisonment or worse. Even in Western countries, there is a small risk that a government or third party can view your transactions and make assumptions about your intentions. What if your government was overthrown by a dictatorship? Your privacy would then become a huge concern to you.
In 1983, David Chaum came up with an idea for Ecash, an electronic cash system which would allow anonymous payments to take place using cryptography to secure transactions. In 1990, David Chaum put his Ecash system to use when he started a company called DigiCash. It gained some traction before it was bought out by a credit card issuer then dissolved in 1998.
Hashcash was created originally as a method to combat spam email. One of the reasons spam is so prolific is that it is relatively cheap to send email in bulk. Hashcash aimed to solve this issue by requiring the sender to perform a complex calculation to create a ‘stamp’ which is added to the header of the email, the concept being called “proof of work”. The sender’s computer must do the work necessary to create the stamp, then proving it has done so by adding it to the email header. The software on the receiver’s computer tests whether the stamp is valid and filters it appropriately. The stamp itself took around a second to create using a normal desktop computer at the time. For spammers, one second per email becomes very costly when sending millions of emails per day.
In 1998, a new system for distributed electronic cash was thought up by a computer scientist called Wei Dai. He published his solution online and called it b-money. Nick Szabo followed this up by creating Bit Gold, a decentralised digital currency which used proof of work to verify transactions. Neither system was implemented, but Bit Gold is thought to be a precursor to Bitcoin.
In 1999, Napster was released and changed the music industry forever. You may not think this has any relevance to online payments and cryptocurrencies, but this is a good example of how ideas from different areas can be combined with others. Before Napster, anybody wanting to share music with others had to email it directly, copy it to a CD or upload it to a server on the internet. If you think of a server like the hub of a wheel, each spoke would be connected to a computer (or client) downloading files. This is known as a centralised system. In a centralised system, everybody relies on access to the hub – if it develops a fault, is shut down or hacked, the system fails. Peer-to-peer networking does not rely on a central server.
With Napster, each user on the network listed the music files they wanted to share. To download music, you would perform a search, and if at least one computer (or node) on the network had the song you were looking for, the software would connect you to the node and download it. If any single node leaves the network, for example when a computer is switched off, some particular files may not be available but the network continues to work. Napster brought peer-to-peer networking into the mainstream.
In 2008, Satoshi Nakamoto published his Bitcoin white paper. In it he describes a peer-to-peer system where transactions take place between two people without a third party, they are verified before being recorded on a public distributed ledger (a blockchain). Unlike Wei Dai and Szabo, Nakamoto turned his theory into a viable working system and launched it. Incidentally, Wei Dai and Nick Szabo have been thought to be the real Satoshi Nakamoto, but both have denied this.