A child’s guide to cryptos, crypto mining and blockchain – Part I

A committee has been appointed to suggest a regulatory mechanism for cryptos, permit crypto mining companies to operate in the country, and revolutionise all systems by introducing blockchain technology 

It is a good move by Namal to appoint this committee and seek expert views before he goes to the Cabinet on this matter. This is called ‘democratic economic policy governance’ which Sri Lanka lacks nowadays. Instead of political masters making decisions according to their whims and fancies, this permits them to consult others with knowledge on the issues in hand and make informed decisions. This is a deviation from the practices of the present Gotabaya Rajapaksa Administration, and we should welcome it

Aseni, whiz-kid in economics and a fan of technology, has been exhilarated by the Government’s pronouncement that Sri Lanka will go for a system of cryptocurrencies. She has learned that the youthful Minister Namal Rajapaksa has appointed a committee to examine the issue and make recommendations to the Cabinet. The committee is required to suggest a regulatory mechanism for cryptos, permit crypto mining companies to operate in the country, and revolutionise all systems by introducing blockchain technology. She loved it and wanted her grandpa, Sarath Mahatthaya, an ex-officer of the Ministry of Finance, to endorse her view. The following is the conversation between the two:

Aseni: Grandpa, it is a hot news that Sri Lanka will go for cryptos soon. A committee has been appointed to make suggestions. I am excited because this is something which Sri Lanka should have done long time ago. Aren’t you also excited?

Sarath: I saw the media reports on that. It is a good move by Namal to appoint this committee and seek expert views before he goes to the Cabinet on this matter. This is called ‘democratic economic policy governance’ which Sri Lanka lacks nowadays. Instead of political masters making decisions according to their whims and fancies, this permits them to consult others with knowledge on the issues in hand and make informed decisions. This is a deviation from the practices of the present Gotabaya Rajapaksa Administration, and we should welcome it.

Aseni: There you see! I also thought so. I can’t wait for this committee report.

Sarath: But there is a risk factor here. Too many people in the committee can make it unwieldy. The normal experience with large committees is that when you appoint otherwise busy people to committees they cannot effectively participate in the deliberations. As a result, the committee report is driven by one or two active people and there could be others who have simply penned their signature to it without even knowing what it is. The present committee should avoid this pitfall. 

Aseni: Surely, they may be knowing their mettle. Isn’t it true, Grandpa?

Sarath: Let’s hope for the better. 

Aseni: What are these cryptos? Can you enlighten me on that?

Sarath: The rupee notes and coins that you use are in physical form. You can touch them, see them, and physically move them. They are issued by sovereign governments and backed by the strength of the economies behind them. Therefore, they are called natural currencies. But cryptocurrencies are neither visible nor tangible. They are just imaginations that we have in our heads. Hence, they are not natural currencies but artificial currencies. They are also not backed by the strength of any economy. 

Take for example the US Dollar. It is backed by a $ 22 trillion large economy. Furthermore, the US authorities keep a gold balance to support it. At present, that gold balance amounting to about 8,110 metric tons, when valued at the current market price, covers about 23% of the dollars issued. If you take the Sri Lanka Rupee, it is backed by an economy of $ 80 billion. Sri Lanka’s gold reserves are just 6.5 metric tons and covers only 9% of the currency issued by the Central Bank. Cryptos do not have this feature.

Aseni: But Grandpa, though cryptos have this deficiency, I hear that the first crypto issued in the modern era was the Special Drawing Rights or SDRs issued by the International Monetary Fund. How could they do this without the backing of an economy or a gold reserve?

Sarath: Indeed, it was the IMF that ventured into cryptos in the modern era by issuing its artificial currency called SDRs. This was done in 1969 to present an alternative to US dollar which was the most accepted reserve currency at that time. But the dollar was under severe pain because the agreement it had made in 1944 with other countries under the IMF-World Bank arrangements that it would exchange dollars for gold at a fixed price of $ 35 per fine ounce was showing signs of difficulties. This scheme was known as the Gold Exchange Standard. The open market price of gold was rising, and the US Treasury could at any time either increase the fixed price or withdraw from the arrangement. 

To be ready for any eventuality, IMF came up with this artificial currency idea. As expected, the US withdrew from the arrangement in August 1971, creating a vacuum in the global reserve currency market. But SDR did not have a country backing or gold backing. Hence, the US Dollar continued to serve as the world’s most demanded reserve currency though it was not the officially accepted position by the US Treasury. This was because it had been backed by the world’s largest economy and a very large gold reserve. Today, SDR is just another unimportant currency in the globe.

Aseni: I did not know about it. But how come bitcoin came into the scene in 2009 to replace the US Dollar?

Sarath: I would like to name bitcoin as a protest currency rather than a replacement currency. That was because after the global financial crisis of 2007-’08, everybody became frustrated with natural currencies. At the same time, banks which had caused the financial crisis had been charging high fees for providing fund transfer services. So, the market which had been angered by these developments wanted to punish the natural currencies which had failed it. The main currency that deserved this punishment was the US Dollar. That was how bitcoin was invented by an anonymous developer called Satoshi Nakamoto in 2009. It offered the stability of the currency and the convenience and safety of transactions. It was a tall order which bitcoin had promised to its users.

Aseni: Isn’t it a plus point for bitcoin? Delivery of the most appreciated requirements by people. Stability and convenience cum safety?

Sarath: In a way, yes. But the method it used to ensure stability compelled it to give it up soon. However, the technique it developed to deliver convenience and safety has caused a revolution in the technology field. 

Aseni: Wow! It is both good news and bad news. Tell me the bad news first, Grandpa.

Sarath: Bad news is the loss of stability which bitcoin promised to deliver. Natural currencies had failed to deliver stability because they had been issued in excessive amounts by the respective central banks. As a result, the value of those currencies had declined in the markets or inflation had set in. Hence, Nakamoto’s solution was to restrict the issue of bitcoin by incorporating the same into the algorithm that governed its issue. As a result, in every four-year time period, the number of bitcoin to be issued was compulsorily reduced by a half. For instance, if the system had been configured to produce 100 bitcoin this year, after two years, the number will be reduced to 50, after two more years to 25, and so forth. Therefore, there was a natural shortage of bitcoin relative to its demand. The result was the increase in the market price of bitcoin in terms of the US Dollar. 

As such, when bitcoin was first issued in 2009, it was worth only 10 US cents. But the demand pressures were so high that its value shot up to $ 20,000 by 2017. This is now $ 65,000 as at October 2021. What this means is that instead of a fall in the value, it is now rising generating what economists call a deflation in bitcoin. Its mirror image is US$ inflation reducing its value. Stability is avoiding both inflation and deflation. So, bitcoin has failed in delivering stability. 

What this means is that a currency, whether it is natural or crypto, should be issued in the correct amount, neither more nor less. The problem with bitcoin was that it was subject to a rigid restriction which could not be changed to meet the changing conditions. It did not have that flexibility. The natural currencies have that flexibility, but the issuers had misused that flexibility to satisfy their personal goals. This should be avoided through an effective governance system in central banks. 

That governance was built into the algorithm of issuing bitcoin in a rigid manner with no space for change. That was the weakness inherent with bitcoin. As a result, when the demand for bitcoin goes up, its value in terms of the US Dollar too rises. But when the demand falls, that value comes down. As a result, it has a rising trend over time, it is subject to vast fluctuation in value, creating an uncertain space for its users. Thus, when the price goes up, the holders stand to gain. But the very same holders burn their fingers when the prices fall. This is not a good sign that can be attributed to a good currency. 

Aseni: It did not occur to me that deflation is also a bad thing. Now I know that bitcoin is an unstable currency. What is the good news that you talked about?

Sarath: Satoshi Nakamoto had developed a new technology called blockchain to manage bitcoin operations. This is like the operating system that you have for computers or mobile phones. Every transaction relating to bitcoin is called a block. These blocks are then connected to each other like a chain, giving an unbroken trail of transactions. That is why it is called the blockchain. These blocks are transparent – visible to everyone – but at the same time secured from manipulation. Since there are millions of individual computers that are connected to bitcoin transactions, economically, it does not pay hackers to hack the system. That is because the cost of the efforts that they have to make is much more than the gain. Hence, there is no incentive like other computer systems for hackers to hack it.

A good example is some hackers based in China or the Philippines had hacked the computer system of the Bangladesh Bank – the central bank in that country – and tried to steal a mega amount of a billion dollars from its reserves. Fortunately, it was foiled when they had stolen some $ 200 million. But what it means is if the costs are low, hackers have incentive to hack systems and steal money. In the case of blockchain, costs are enormous because they have to hack millions of standalone computers to steal the money. So, no incentive for undertaking that type of a costly enterprise.

Aseni: But how is the security ensured in transactions?

Sarath: The signature relating to a blockchain transaction is a digital key. You need two such keys to establish your identity and activate a transaction. This is similar to banks asking for two signatures for a cheque issued by a company. If the signatures are identical, the bank will pay the money. Sometimes, if there is a slight difference in a signature, the bank refuses to pay though it had been signed by a genuine customer creating a lot of inconvenience and embarrassment to bank customers. Besides, with modern technology, signatures can be forged, and monies could be illegally withdrawn from bank accounts. This problem is not present in blockchain technology. 

Aseni: Why isn’t it present in blockchain technology? Can’t you forge the digital key?

Sarath: I can explain this by taking a bank as an example. You know there are banks, there are accounts with unique numbers in those banks storing your money, there is a system of establishing your identity either through your signature or a PIN assigned to you, and people to whom monies should be paid from those accounts. The same procedure is there in the case of bitcoin too. The entity equivalent to the bank is called a bitcoin wallet in which your bitcoin is stored. Then, to identify it in public, there is a public key which is like your bank account number. It is known to others. Then, there is a unique identity establishing system called the private key which is a secret and known only to you. The people to whom monies are payable called addresses. These addresses are like the instructions that you give to your bank in a cheque ‘Pay or Pay to the Order of’. Hence, bitcoin and blockchain are a banking system created in cyberspace. You cannot see it, but things happen quite perfectly.

The operation starts with the acquisition of a wallet. Bitcoin you have acquired is in the wallet. You operate it through a private key which is generated by the system for you. The number of such private keys that can be generated is equal to number 2 raised to power 256 in binary format in computer systems. That is made up of a number having 78 digits. Can you read that number? You can say that it is little bigger than a tredecillion which is the number 10 raised to power 78. So, this combination is difficult to be predicted accurately. Some people say that it would take about a little more than 65 quadrillion years even for the most powerful computer to correctly guess it. Therefore, it is impossible to forge them with the technology available at present.

You will now realise that is this private key that does the trick. That number is selected at random, and as I just mentioned, because of the sheer largeness of the combinations that can be formed, nobody can predict it in advance. You can compare this to the One-Time-Passcode or OTP that is sent by a bank to your mobile phone or the email address when you want to do a transaction with the bank on the internet. That number is not repeated, and it is applicable only to the transaction in hand. The blockchain authorisation is also a similar process. Therefore, it has the highest degree of security and convenience to the user. This is one of the wonderful services which the blockchain technology has offered to the global community. Besides functioning as the operating system of cryptos, it has many other applications too.

Aseni: Great! What are those other applications it offers?

Sarath: Let’s discuss it next week.

(To be continued)

(The writer, a former Deputy Governor of the Central Bank of Sri Lanka, can be reached at [email protected])