Financial Idiot 007 - Let's dig into Crypto! Part 1

This Blog Post was originally distributed by the Newsletter "Financial Idiot". You can find and subscribe to it here.
DISCLAIMER: I'm an idiot and this isn't financial advice! You can lose money when investing, and you should never invest money you don't own or you can't afford to lose. I'm not responsible for your decisions!

Oh wow, this is the seventh edition of this Newsletter, and nobody has tried to unsubscribe yet, so I must be doing something right. :) Anyway, this time, I want to change things up a little bit and would like to give an overview of how cryptocurrencies work and why they are not only speculative objects.

Of course, I have to start with Bitcoin, the first ever created cryptocurrency by a guy named Satoshi Nakamoto. Interestingly this name is used as a pseudonym. It is unknown who this person is, and many people tried to impersonate him. Instead of a face, you can draw a giant question mark (I would argue that even the gender is unknown). (Also, it could be multiple persons behind that nickname.)

The development of the first version of Bitcoin started already in 2007. On the 31st of October 2008, the "whitepaper" of bitcoin was published. On the 9th of January 2009, the first "Block" (the so-called Genesis Block that every Blockchain has and needs) of Bitcoin was posted, starting a new era in a completely new financial field and, in my opinion even more important, in cryptography and database terms.

For now, let's leave out the financial part and have a look at the database side of Bitcoin (well and every other Blockchain).

What is a Blockchain?
It is an extensive database of transactions. A transaction from Bob to Alice, or transactions to trigger a Smart Contract (more on that another time). Inside these transactions, a payload can be sent (for example, a simple message: "Hello everybody, I'm digging into blockchain technology, and I love it!") or some binary data (for example, an image).

What Blockchains differentiate from "traditional databases" (MySQL, PostgresSQL, ...) is that as soon as a record is "finalised" (included in a transaction and afterwards in a "Block") is final. There is no way ever to change that record.

But how is that done? Well, that is a step I don't fully understand myself (my math understanding is not good enough), but to keep it simple: with specified algorithms (hash functions), every "Block" is signed and anchored in the next Block. It is possible to check if a previous Block is valid and corresponds to the Block inside the Chain with the same algorithms. Since these Blocks always follow one after another, they build a Chain, thus the name Blockchain.

In the case of Bitcoin, the validity of the Blocks is guaranteed by the miners. The "Block Miners" compete against each other to find the next Block, as the new Block will "mint" (create) new Bitcoins, which then will be credited to the miner. And yes, this "wastes" a significant amount of energy, sometimes energy that isn't sourced ecologically (https://cointelegraph.com/news/this-earth-day-analysts-say-bitcoin-mining-is-naturally-gravitating-to-green-energy).

All cryptocurrencies that use algorithms that work that way are called PoW (Proof of Work; for a list, see: https://coinmarketcap.com/de/view/pow/) cryptocurrencies. But many intelligent people in the world did come up with an alternative method to secure a blockchain. There are a few different methods, but PoS (Proof of Stake) is the most common one. Cardano and Solana are using the PoS method (https://coinmarketcap.com/de/view/pos/).

It is essential to understand that PoS is not worse than PoW in terms of security and trust in cryptocurrencies (51% Attack). Both algorithms can be implemented with Bugs, always leaving a small risk similar to the risk of only having your money at one bank. If that bank goes bankrupt, your money is gone (yes, I know there is the "Einlagensicherung", but not all readers of this are Austrians :)).

We now know the technological advantage of the immutability of Blockchains. People ask a common question when talking about Blockchain in general: But how can that be used in "real world" applications? I think it is evident with the following example: In Austria, there is the debate of marking meat or vegetables where they come from to give the consumer a better overview of where the bought groceries are coming from.
Nothing is preventing the producer of beef from writing onto the selling package "made in Austria". However, the cow might come from Spain and is butchered in France before being delivered in temporary storage in Austria to mark it "made in Austria". Yes, there are regulations to prevent such mismanagement and spot checks, but how often are they conducted? This "simple" problem could be easily conquered with a blockchain:

Every cow gets a unique id (a wallet address) assigned that is clamped into the ear (or implanted with a simple NFC/RFID Chip (like in dogs)). Those unique ids are issued by the government or an authority created for food products. The farmer who raised the cow has a wallet themselves. Every cow's unique id gets cross-signed with the farmers (there are algorithms already used in Blockchain technology called "signing"; every transaction, for example, is signed to define whether it was sent from a specific wallet or not). The cows are then transferred to the butcher, where the same signing process happens again. Finally, the person buying the meat can scan the unique id of the cow on the label of the product and check online which farmer, which butcher (and maybe even which truck transported) "handled" the cow. It is a little bit more complicated since not all parts of a cow are sold as "one" batch. However, I'm ignoring this for this example (yes, there are ways to do that).

A similar thing could be done in the automotive industry, every part of a vehicle could be assigned a unique id, and every manufacturer can sign it.

The thing is, this whole setup wouldn't be enormously hard to create nor to maintain. If I remember correctly, there were even some crypto projects in the past wanting to solve the "supply chain trouble".

The next time somebody is telling you bitcoin is dead or will die soon, think of this example and smile, knowing cryptocurrencies and Blockchains are here to stay.

I hope I sparked your interest in cryptocurrencies now as we will dig into Smart Contracts in the Next Issue. Hopefully, I can find an excellent example for them. :)