View my more recent article on this topic here: Cryptoeconomics: A Panoramic Analysis
Going beyond the "security" bubble of Central Banks
Currency Backing Hoax
The biggest hoax in the world is the security provided by central banks. In the present days most central banks do not hold gold as security against the currency in circulation. Golds are held by central banks in nominal amounts only for trading purposes. In such case gold reserve of the country lies in direct ownership of the government of the country rather than with the central bank.
Around 70% of the worldwide currency in circulation is not backed by gold/precious metals. It is only backed by government promise.
USA has the largest gold holdings all around the world, it might be useful to derive insights on currency backing from its holding and also comparing it with India and Nepal. The data are from Annual Reports of the respective central banks from the year end 2019.
| Heading | USA (USD) | India (INR) | NPR (NPR) |
| Currency Liability | 1,671,437,000,000 | 26,355,750,000,000 | 494,389,500,000 |
| Gold backing Currency Liability | – | 792,040,000,000 | – |
| Gov Treasury backing Currency Liability | 1,671,437,000,000 | – | – |
| Foreign Currency backing Currency Liability | – | 25,563,710,000,000 | 494,389,500,000 |
| Gold with Gov | 460,891,210,769 | 2,795,009,982,692 | 43,516,652,308 |
| Gold backing Foreign Currency (Approx) | – | 5,112,742,000,000 | 98,877,900,000 |
| Total Gold backing Currency Liability | 28% | 33% | 29% |
Central bank's currency backing is a broken skeleton
Under conventional gold standard currency, currencies derived their value from the gold/precious metals backing the currency. Under gold standard every currency was exchangeable with gold if produced to central bank because currency in circulation is essentially is the promissory note issued by central banks.
After the gold standard of the currencies around the world was dropped the currencies in circulation simply became a quality printed paper with a government assigned value. It no longer was a promissory note. In Nepal every note contains this term under the name of Nepal Rastra Bank signed by the Governor of the Bank “नेपाल सरकारको जमानत प्राप्त यसको रुपैयाँ भुक्तान माग्न आएमा नेपाल राष्ट्र बैंकबाट रुपैयाँ ५ तुरुन्त पाइने छ”.
What a load of horselaugh. This means if you go and ask to central bank to reimburse you the value of Rs. 5 by presenting Rs. 5, the central bank will give you Rs. 5.
Government backed currencies are the largest scam in the whole world. It is a bubble of security. It will burst once the trust system fails. When this trust system fails all currencies around the world will revert to their real value which is very lower that the prevailing values. But everything going as usual, will this trust system ever fail? In which case might this system of fiat currency fail?
1. In case where the countries around the world will involve in gold selling/buying spree that causes huge fluctuations and failures in exchange rates.
2. In case where a country in strong economy issue excess currency backed by the their government treasuries that causes global unsustainable inflation.
3. In case where governments or investors decided to switch away from the U.S. dollar as reserve currency, the flood of short positions could significantly hurt anyone with assets denominated in dollars.
4. In case where USA enters into domestic recession without impacting the countries around the world.
5. If import activities of the USA, China, Japan, Germany and other strong nations declines.
Where does a cryptocurrency derive its value from?
So, onto the main question, where does a cryptocurrency derive its value from?
A similar question could be asked to a fiat currency. Where does a fiat currency derive its value from? We know that governments and central banks around the world have the capacity to back only 30% of the total currency in circulation. How does the 70% of the currency derive its value from? It a trust based system. It a trust that an individual places on the economy that the economy doesn’t collapse just tomorrow and that he will be able to earn more in future to sustain the future inflations.
Cryptocurrency is a currency with no backing of any assets but derives its value based on the trust that is built from the blockchain technology.
What is a blockchain? vis-à-vis Cryptocurrency
What is a block?
Blockchain is an open, censorship resistant method, for managing records by the public. Blockchains are incredibly popular nowadays. But what is a blockchain? How do they work, what problems do they solve and how can they be used? Like the name indicates, a blockchain is a chain of blocks that contains information. This technique was originally described in 1991 by a group of researchers and was originally intended to timestamp digital documents so that it’s not possible to backdate them or to tamper with them. Almost like a notary. However it went by mostly unused until it was adapted by Satoshi Nakamoto in 2009 to create the digital cryptocurrency Bitcoin
A blockchain is a distributed ledger that is completely open to anyone. They have an interesting property: once some data has been recorded inside a blockchain, it becomes very difficult to change it. So how does that work? Well, let’s take a closer look at a block.
- Each block contains some data, the hash of the block and the hash of the previous block. The data that is stored inside a block depends on the type of blockchain. The Bitcoin blockchain for example stores the details about a transaction in here, such as the sender, receiver and amount of coins.
- A block also has a hash. Hash identifies a block and all of its contents and it’s always unique. Once a block is created, it’s hash is being calculated. Changing something inside the block will cause the hash to change. So in other words: hashes are very useful when you want to detect changes to blocks. If the fingerprint of a block changes, it no longer is the same block.
- The third element inside each block is the hash of the previous block. This effectively creates a chain of blocks and it’s this technique that makes a blockchain so secure. Each block has a hash and the hash of the previous block. So block number 3 points to block number 2 and number 2 points to number 1. Now the first block is a bit special, it cannot point to previous blocks because it’s the first one. We call this the genesis block.
How to maintain data in a block?
Decentralization reduces the risk for corruption, fraud and manipulation. Blockchain technology is a new and innovative way to implement decentralization. In a nutshell, Blockchain technology is a solution for the problem of centralization. It’s a system for keeping records by everybody, without any need for a central authority – a decentralized way of maintaining a ledger that is practically impossible to falsify.
What are the essential elements of blockchain?
Another way to ask this question would be – how do I create a system that allows the creation, verification and updating of records by everybody? Well, there are four elements a blockchain needs to actually have a life of its own.
The first thing required to support a blockchain is a peer-to-peer network
A network of computers, also known as nodes, that are equally privileged. It’s open to anyone and everyone. This is basically what we already have today with the Internet. We need this network so that we will be able to communicate and share with each other remotely.
The second ingredient is cryptography
Cryptography is the art of secure communication in a hostile environment. It allows me to verify messages and prove the authenticity of my own messages, even when malicious players are around. We need cryptography because of the first element. Remember, I said anyone can participate in this network – including bad actors. It’s great that I can communicate, but I also need to make sure my communication comes through unaltered.
The third element is a consensus algorithm
You can switch the technical word “algorithm” with the word “rule”. This means we need to agree about rules on how we add a new page, also known as a block, to our records. There are many types of consensus rules, in Bitcoin’s case we use a consensus algorithm known as Proof of Work. This algorithm states that in order for someone to earn the right to add a new page to our ledger they need to find a solution to a math problem, which requires computational power to solve. Computers around the network run calculations to solve the math problem and in doing so, consume a lot of energy. In other words they do a lot of work. That’s why when one of them finds the number that solves the problem and displays it to the network, they’re basically displaying a “proof of work”. Think of it as the node’s way of saying: “Hey, I spent quite a bit of energy here in solving this problem first, so I’m entitled to write the next page”. As I mentioned before, there are other consensus algorithms that don’t require so much energy, this is just the algorithm type that the Bitcoin blockchain employs. There are pros and cons to different algorithms, but in order to run a decentralized ledger you’ll need to choose one, otherwise it will be really hard to reach a consensus with so many people in the network.
Some explanation is needed here.
The fourth element is punishment and reward
This element is actually derived from game theory and it makes sure that it will be in people’s best interest to always follow the rules. So far, we’ve set up a network that has a way to communicate securely, and follows a set of rules for reaching consensus. Now we’ll glue these elements together by giving a reward to people that help us maintain our records and add new pages. This reward is a token, or coin, that is awarded each time a consensus has been reached and a new block is added to our chain. On the other hand, bad actors who try to trick or manipulate the system will end up losing the money they spent on computational power or their coins can be taken away from them. In the end, the important thing to remember is that the punishment and reward system works on psychological behaviour. It turns the rules of the system from something you need to follow into something you’ll want to follow, since it will be in your best interest to do so.
The fifth element, that can’t really be synthesized... market adoption.
I mean, we can have a group of five people sharing a ledger with a consensus algorithm but it doesn’t really make it decentralized, since not enough people are a part of the system. Moreover, if there’s no adoption, there’s not really any value to our coin and the fourth element of punishment and reward isn’t very effective. Only once you achieve critical mass in the number of users, does a blockchain become truly decentralized and therefore immutable. And at that point, the coin of that blockchain usually begins to appreciate in value. It’s hard to say what triggers mass scale market adoption. In Bitcoin’s case things actually started through use on the dark web, where people used Bitcoin to pay for drugs and other illegal stuff. But since then, more people have begun to research Bitcoin and blockchain, and have seen the benefits they offer; either in practice, or as an investment. So there you have it, the five elements of a truly open, public, decentralized blockchain. Up until today there are only a handful of blockchains that have over 1,000 truly independent participants, and as such can be considered as decentralized – Bitcoin, Ethereum and Monero to name a few.
Necessity of Blockchain Technology?
Blockchain technology is very good at decentralizing, but it’s also very inefficient, slow and energy consuming. For example, Bitcoin’s network takes 10 minutes on average to confirm a transaction. Not the ideal waiting time for buying a cup of coffee.
The only reason to choose Blockchain technology as your solution is if your problem is actually centralization. If you don’t need to decentralize something, you probably don’t need to use blockchain technology and are better off with some centralized solution. In fact it will probably work better.
Video Summary for Blockchain Technology
Here are some excellent summary of blockchain technology from Simply Explained and 99Bitcoins.
How to mine cryptocurrency?
Here are some excellent summary of how to mine cryptocurrency from We Do Tech and 99Bitcoins.