Why would you spend your hard earned money on something with no obvious value? Gold for example can be seen and held, fiat currency that can be used in shops at your convenience? What is it that makes cryptocurrencies such as Bitcoin worth over R60 000 on South African exchanges? As a Fintech company, Singular Systems, asks why the world is placing their confidence in this technology.
In our previous article we eased into Ethereum, a cryptocurrency platform and explained how smart contracts work and how it has been used to solve common issues between parties while minimizing the trust issues people have when transacting. Ether is one of hundreds of different cryptocurrencies, each built on their own blockchains, but why does the blockchain technology enable cryptocurrencies to hold value?
Everything is worth what a person is willing to pay for it.
When one speaks of value, it is worth remembering that value is a subjective concept. Anything can hold value provided there is a group of people to believe in that value. For instance, gold first gained value, not because it had any specific use for society, rather for its perceived status as a precious metal due to its alluring and scarce qualities.
In the modern world we are subject to central points of failure in our systems as well as fraud and counterfeiting, blockchains aims to solve these issues. The underlying value of our current systems is trust and the belief that they will minimize if not eradicate these problems for the individual. Blockchain guarantees that there is no chance of the problems occurring. So why don’t more people trust in the crypto currency value? The obvious answer to that is that they don’t understand the blockchains and the technology that make them.
So where does the value lie in blockchain technology?
Value is a double-sided coin. Perception on the one side and utility on the other. The perception that gold has value is because throughout history, it has always been used as a store of value and was used to back global fiat currencies. Whereas the perception that Blockchain has value is based on the security, stability and reliability the technology enables. In the modern global economy utility is maximized through the speed and cost of transactions.
Traditionally, transactions are conducted through trusted third parties such as centralised banking institutions. To provide this service, these institutions charge a fee to process transactions, typically taking a few days to complete. Blockchain aims to maximize the efficiency of this process by eliminating the need for these institutions, allowing people to communicate directly with each other.
Blockchain technology provides security and stability through decentralization as well as transparency and accountability through the open ledger that uses cutting edge technology to ensure a faster and cheaper user experience for everyone. Until this technology was invented the nature of society dictated the need for these third parties.
OK, so I understand its value, what about the price? Gold vs. Blockchain
Despite first impressions, direct parallels can be drawn between gold mining and blockchains. For instance, to extract gold, it needs to be mined, the same can be said of the cryptocurrencies built on the Blockchain.
Gold is a physical commodity; it requires numerous hours spent on procuring the mineral from the earth. The process involves large capital investment – for the sake of simplicity let’s just say these costs are labour, fuel and machinery.
This is comparable to cryptocurrencies in that they too require large capital investment. Crypto mining requires massive amounts of processing power. To obtain this processing power, expensive mining hardware is needed as well as operational costs including electricity, internet and physical space for the mine.
An important concept to comprehend is proof of work (PoW). This is an economic measurement, used to understand the difficulty needed to produce a piece of data (a transaction in the blockchain). The PoW equivalent in gold mining is extracting the gold and refining it either for industrial or commercial use.
Blockchain mining requires a miner to first validate the transaction and second, link blocks to the existing blockchain. In order to validate the transaction, the miner must ensure that the sender has sufficient funds to pay the receiver, based on the current version of the open ledger stored on every node of the network. After validation, the miner can now publish this transaction to the public ledger. They do this by providing the transaction hash to the rest of the nodes on the network, which enables them to link that transaction to their ledgers. A blockchain network adjusts its difficulty levels every set number of blocks to ensure consistent block generation rate. The increase or decrease in difficulty is proportionate to block discovery time.
When a sufficient amount of these transactions are added to the blocks, the miners then search for the correct key to add another block to the chain. To add another block on the network, the miner must use a key (also known as a hash). In order to obtain this key, miners contribute their computational power, to the blockchain network, using algorithms to conduct a random search. The miner continuously guesses this key until they find a match; for this match, they are financially rewarded a fraction of the cryptocurrency. In comparison, gold miners must search through enormous amounts of earth to find the exact area of gold deposits and use specific tools to extract it and get paid a wage to do so.
In order to make a profit from these ventures, the price of the cryptocurrency or gold needs to outweigh the costs in obtaining them. Setting the price is still as simple as looking at the cost to extract though. Demand drives price – this is a very old concept which still remains true to cryptocurrency. This can also be explained through “The Greater Fool” theory, which states that it is not the intrinsic value that determines a price, but rather the irrational beliefs and expectations of those participating in a market. This leads the buyer to believe that “a greater fool” will be willing to pay a higher price at a later stage. The market price occurs at equilibrium where the demand and supply price meets. This is potentially where sceptics say “AH HA!”.
Does this technology have a future in society?
Ultimately, what is provided to us by the blockchain and where the true value lies is a system that enables complete transparency as well as anonymity in the processing of transactions. The transparency comes from the distributed open ledger. Every blockchain network has a complete record of all transactions that have taken place on that specific blockchain, all individually validated by every node on that network. The anonymity comes from the fact that the only trace of your identity or record of the transactions you make on the blockchain is nothing more than a series of addresses and a hashes.
Blockchain is so much more than just a medium of exchange, its benefits open up a world of possibilities for all sectors of society; the timestamped digital record that blockchains produce are immutable. There are massive implications for an industry such as the medical profession in which medical records will never get lost or for logistics where records and tracking are the backbone of the industry. As life becomes more digital the need to protect your cyber identity becomes essential; imagine what answers the blockchain’s anonymity could provide.
Tim van Rooyen