Volume 1: What is a cryptocurrency?


The cryptocurrency world

A cryptocurrency is a form of electronic money which uses cryptography (or code solving) to secure its transfer.  Although cryptocurrencies only recently shot into the mainstream because of the dramatic increase in value of Bitcoin people have been trying to establish an effective cryptocurrency infrastructure since the 1990's.  Bitcoin, one of the best known cryptocurrencies, came into being in 2009 in the wake of the financial crisis.  At that time, a combination of improved technology, frustration with the establishment and a committed community of computer programmers resulted in Bitcoin being established as the first effective cryptocurrency.  One of the critical pieces of technology which enabled this was the creation of the blockchain.

At the time of writing, in mid-2018, according to investing.com, there are over 2,100 cryptocurrencies and the number is increasing daily.  That said, Bitcoin is by far the largest in terms of market capitalisation.  Other big players include Ethereum, Ripple, Bitcoin Cash and Litecoin.

Crucially, many of the thousands of cryptocurrencies out there are not competing with Bitcoin.  Bitcoin was created to facilitate the movement of money without the need for financial intermediaries.  It is trying to be an alternative to state issued currency.  But many other cryptocurrencies are not about transfer of value, they are tokens for various assets, rights and even information.  The number of cryptocurrencies that are actually trying to replicate Bitcoin are therefore relative low.

It is arguably not even the case that all cryptocurrencies necessarily need to use a blockchain.  The key is that they use some form of cryptographic security mechanism and that their transfer is facilitated by a decentralised ledger.  For much of this series, we will focus on Bitcoin to illustrate our analysis, but it is important to remember that there are thousands of cryptocurrencies out there and they are all different, but all potentially important.

Bitcoin – what is it and how are they transferred?

Bitcoin is currently the most popular cryptocurrency. There are currently around 17 million Bitcoin in existence. There will only ever be 21 million.  New Bitcoins are released through the process of mining and Bitcoins are transferred by entering records (known as "blocks") on the Bitcoin blockchain.

In order really to understand Bitcoin (and most other cryptocurrencies), it is important to remember that there is no physical "thing". When you own a Bitcoin, you have no record of ownership, except for an entry on the blockchain. There is no bank at which you hold an account and there is nowhere for you to go and withdraw your Bitcoin. The only way anyone (including you) knows that you have a Bitcoin is because the blockchain says that you do. The blockchain is like an online balance which everyone can see and no one can challenge.

Crucial to the operation of the Bitcoin blockchain is the concept of public-key cryptography. This is a system where there are two parts to a person's key.  A public part that can be disseminated to the world and a private key which only the owner knows. Through the use of public-key cryptography, the Bitcoin network ensures that only the owner of a Bitcoin can move it from A to B.  

  • The public key (much like an email address) is the address to which people can send Bitcoin. This can be (and necessarily is) shared worldwide. For security reasons it is common for people to use a different public key for each transaction involving a Bitcoin, but that isn't necessary. Once a Bitcoin is sent to a public address and verified (see below), the blockchain records that the particular Bitcoin belongs to that public key and, for the reasons covered below, that record is irrefutable. Although the records are public, they are also anonymous. Therefore, you can identify which Bitcoin belongs to which public key, but you cannot immediately know who the public key belongs to.
  • Everyone on the Bitcoin network also has a private key. In order to transfer that Bitcoin away from that address, the owner of it must use their private key (think of this like a password to your email account).  Without the private key, the Bitcoin cannot be moved.
Storage of private keys

If one loses their private key, it cannot be recovered. There is no "recover my private key" function. It is therefore common for people to store their Bitcoin's in "wallets". When people talk about storing their Bitcoin in a wallet, what they in fact mean is a place where their private keys are safely stored. The wallet could have a password which could be recovered and so this provides added security whilst an added layer of protection against losing your private key.

Wallets or storage can be "hot" (meaning they are connected to the internet) or "cold" meaning they are offline. A hot wallet is beneficial because the private key can be easily accessed and is unlikely to be lost. On the other hand, it is less secure because it is susceptible to hacks. Cold storage can be as primitive as a piece of paper with the private key written on it, or a USB which has a text file stored on it or a computer which is not connected to the internet. Cold storage is more secure because it cannot be hacked, but it can still be lost or stolen or suffer from corrupt/damaged hardware.

Verification

The thing that makes Bitcoin viable is the decentralised verification network which solves a fundamental problem with digital currencies. That is, the issue of "double spending". When A sends an email to B, they both, by design, have a copy of that email. The same cannot be allowed when it comes to transferring money. It cannot be allowed that A should transfer £10 to B and then also transfer the same £10 to C. The use of the blockchain as a decentralised ledger solves this issue. Each Bitcoin can only be spent once because once it is spent, that transaction is recorded on the blockchain for the world to see.

Everyone on the Bitcoin network can, if they wish, download a copy of the blockchain – a complete, verified history of every Bitcoin that has been transferred to every address. This is why the Bitcoin network works. Thousands (if not millions) of copies of the blockchain are held on computers around the world and all of those computers are constantly checking with each other that their versions marry up. If someone somewhere tries to give themselves a Bitcoin that is not theirs or tries to double spend, the network will reject the transaction because everyone else's copy of the blockchain will reveal it as incorrect.

In order for a transaction to be allowed (or "verified"), it needs to be included in a "block" which is added to the end of the existing blockchain. Think of the blockchain as a series of pieces which fit perfectly together. This is where the cryptography comes in. In order to add the block to the existing blockchain, one needs to find a block that fits. To find a block that fits, one has to solve a complex mathematical algorithm which requires an immense amount of computing power. Importantly, whilst it takes a lot of computer power to find a solution, it takes very little computing power to check that the answer is correct. Once someone finds the answer, it is broadcast across the entire network, checked, and then added onto the end of the blockchain and the process starts again.

Transactions are bunched into groups roughly every 10 minutes and put into blocks for verification using the process above. The people who are trying to solve the mathematical problem by expending that immense computer power are called "miners". Each 10 minutes, they compete with each other to solve the mathematical problem for the solution which will provide the next block. They compete because when they find the solution that fits, they not only verify all the transactions in the relevant block, they are, themselves, rewarded with Bitcoin for their efforts.  

This is how new Bitcoin are released onto the network. The verification method is known as a "proof of work". The Bitcoin is their reward. To put it differently, in order to earn Bitcoin and verify blocks on the Bitcoin blockchain, miners have to come up with a solution to a difficult mathematical puzzle which necessarily requires an enormous amount of computing power. The computing power needed requires expensive hardware and a significant amount of electricity. The fact that a miner has managed to solve the solution for a particular block is itself proof of the work they have put into the system.

How many Bitcoin are there?

We mentioned above that there are about 17,000,000 Bitcoin currently in circulation and that there will only ever be 21,000,000. This is because the amount of work needed to verify transactions and therefore gain Bitcoin is constantly fluctuating – the system automatically updates to make the cryptography easier or more difficult depending on the amount of computing power on the Bitcoin network.  

The result is that no matter how many or how few people there are on the network, there will always be a new block added every 10 minutes. Further, every 210,000 blocks (approximately every 4 years) the amount of Bitcoin that a miner receives as a reward is halved. For the first 4 years, miners received 50 Bitcoin for each block. The reward is currently 12.5 Bitcoin for each block and the next halving is scheduled for 2020.

As time goes on, therefore, as the Bitcoin network grows and more computing power is introduced, not only will it require more effort to mine Bitcoin, but fewer coins will be released by way of reward. Current predictions are that the final Bitcoin will be mined in 2140 and based on the above, it will take a great amount of effort for very few Bitcoin to obtain it. The very small amount of Bitcoin may, however, by 2140, be very valuable.

This halving schedule or "decreasing supply algorithm" was chosen because it approximates the mining of gold and therefore mimics the real life release of commodities onto the market – hence the term "miner". The result is that Bitcoin is a deflationary currency whereas most fiat currencies are inflationary. To put this another way - one has to spend more pounds sterling now to buy a newspaper than one did in 1950, whereas conversely, one will have to spend fewer Bitcoin in 50 years to buy a newspaper than one would now. It is for that reason that the final very small amount of Bitcoin mined in 2140 may be worth more than 1000 Bitcoin today.

What will the future look like?

In this series we will explain why, despite the revolutionary nature of Bitcoin, there are still a range of legal issues to grapple with. The underlying technology in the form of the blockchain may also be the real hero of the story, but even that is still in its infancy. In some quarters, blockchains are being implemented without necessity – essentially for the sake of it and to stay with the times. In other quarters industries have yet to grapple with how revolutionary the blockchain could be. 

Focusing on cryptocurrencies for a second, Bitcoin and other currencies will clearly play an integral role in the future. That said, it is important to appreciate that they still present a number of unique challenges. They are not currently regulated and, as we will discuss later in the series, may not even currently be catered for under English law. Coin exchanges have brought some accountability to the system as a forum for regulation to bite, but they are coming under increasing scrutiny even though they are only a small piece of the puzzle. There are also regular news stories of coin exchanges being hacked and significant sums lost which undermines confidence in the system. 

Notwithstanding this, Bitcoin and cryptocurrencies more generally are here to stay. They can, afterall, operate without any offices, employees or premises and allow cross-border secure transfers. It is entirely self-sufficient and arguably cannot in any event be stopped. What is important is that anyone handling or investing in a cryptocurreny does so with their eyes wide open appreciating what they are dealing with (which although it looks like normal every day currency is in fact very different).

Key contacts

James Herring

James Herring

Partner, Finance Disputes
London

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Sivan Daniels

Sivan Daniels

Managing Associate, Finance Disputes & Commercial Litigation
London

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