It’s increasingly difficult to understand the financial side of bitcoin and other cryptocurrencies, but the “crypto” side is even more complicated.
While you don’t need to understand exactly how it works to become a Bitcoin billionaire or a digital currency loser, it’s well worth getting to grips with the basics to get a full picture of the potential and downsides of this innovation in digital currency — and understand its potential.
Why put the crypto in currencies?
You can have digital money without using cryptography, but that requires it to be centrally controlled. If a currency is decentralised — that is, not managed by a bank or government — it requires a control system to ensure each unit isn’t duplicated or faked.
“Cryptocurrencies are decentralised rather than centralised for digital currencies,” says investor and analyst Andy Pritchard from the 10x Growth Account. “This means instead of a group of people regulating the currency for other people to use (governments, banks, states), it’s the entire community that regulates the currency.”
There are other reasons to use cryptography: namely to protect anonymity while still offering transparency.
“Digital currencies require user identification whereas cryptocurrencies require no confidential information,” Pritchard notes. “However it must be noted that cryptocurrency wallet addresses are a public ledger therefore all transactions are transparent and publicly tracked. Digital currencies are not transparent so users cannot see each others wallets (and certainly do not know what is happening within centralised operation, any idea what goes on within the banking computers). Cryptocurrency wallets are fully transparent and all users can see each others wallets and transactions.”
What is cryptography?
To start, back to basics. Cryptography is a set of techniques for protecting data, originally developed to send secret messages. That includes the use of algorithms to mash information up into nonsense for safe transmission, and a cipher on the other end to unpick it back into understandable form — a process known as encryption and decryption using a key. It’s sort of like digitally scrambling and unscrambling eggs — the former is easy enough, the latter is a bit of a challenge.
Those of you paying attention will be aware that Bitcoin and other cryptocurrencies are not in fact secret messages. However, cryptography has since been developed for one-way functions, such as passwords, verifying information, and proving identity, all of which are handy tools for digital currencies.
“Cryptography can be defined as a method of storing and transmitting data in a particular form so that only those it is intended can read and process it,” says Pritchard. “Cryptography not only protects data from theft or alteration, but can also be used for user authentication — clearly a useful structure when linking it with something of value, namely a currency.”
There are two main main cryptographic ideas used in currencies such as Bitcoin. One key encryption idea used in cryptocurrencies is the digital signature. Public-key cryptography can be used to create a digital signature; the private key and data to be signed are mashed together, letting anyone with the public key check if the signature is correct and if the data has been altered.
The second key idea is hashing, which uses a mathematical formula such as an algorithm to take input data and change it into output data of a specific size. A very simplified example is adding five plus five to equal ten — if all you have is the number “10”, that doesn’t tell you much. If you know the formula — adding — that created it, it’s easier to guess (it could be two and eight, nine and one, and so on, but there’s only so many options.) A more complicated output string and hash function makes the input data difficult to guess.
How crypto is used
The two techniques of hashing and digital signatures are used in four ways across Bitcoin and other cryptocurrencies: to protect keys, for the proof of work in mining, to authorise transactions, and to verify transaction history as part of the blockchain.
That hash system is at the core of the mining system, which uses it as a proof of work — essentially, they guess at the hash and are rewarded with Bitcoin if they get it right. The guesswork chews through processing power, hence the proof of work.
Bitcoin and other cryptocurrencies use digital signatures to ensure transactions are coming from the right person and going to the correct recipient, with all the correct details about how many coins are being transferred at what cost. Digital signatures are used to ensure that data isn’t meddled with. Plus, it means users can’t send Bitcoin and then later claim they didn’t, as their “signature” is on the transaction.
At the heart of Bitcoin is the blockchain: this is the decentralised public ledger that shows a Bitcoin was sent from one address to another. The blockchain ledger is spread among all Bitcoin miners, who can’t change transaction details — such as saying they didn’t actually send 100 bitcoin to another individual for a payment — because then their version wouldn’t match with anyone else’s. Plus, each new block of transactions includes a hash created from the previous block in the chain; change a transaction, and the entire hash will be altered, making it obvious that someone has tried to meddle with the system.
The two ideas of hashing and digital signatures are combined for Bitcoin keys. Your Bitcoin address isn’t just a private key; it’s also been hashed, adding to the protection.
Need to know?
None of this is information is necessary to buy and sell Bitcoin et al — after all, plenty of us carry cash without understanding the finer points of our existing financial systems and pay with cards without understanding exactly how Visa’s processing works.
“In reality most users will have little or no understanding of the tech underlying cryptocurrencies in the same way that most people don’t know or understand how fiat currencies truly work,” Pritchard says. For example do most people understand how exchange rates between the pound and Euro is calculated? However it doesn’t stop anyone from going abroad.”
That means if all you’re using cryptocurrencies for is investing and profit, you really don’t need to know the finer points of encryption — you only need to understand how to use the exchanges and a digital wallet, which is complicated enough for first time users. “Cryptocurrencies work in exactly the same way as fiat currencies,” Pritchard says. “If a user wants to buy something using Bitcoin they simply pay for it from their wallet. However most activity in Bitcoin and other cryptocurrencies comes from buying and selling other cryptocurrencies. The same principle applies though in that most users won’t and don’t want to understand the underlying tech, they simply want to speculate on potential price movements.”
How secure are these systems?
Bitcoin uses one called Secure Hash Algorithm 256-bit — better known as SHA256, which was developed by the NSA. It’s generally considered to be nigh-on impossible to crack with existing technology.
Of course, there’s no such thing as perfect security, but cryptocurrency hackers would be wiser to target people rather than the systems. “If you sit in a restaurant and leave your open wallet on the table, there’s a good chance someone might steal your money. Cryptocurrency is exactly the same,” Pritchard says. “Most hacking or theft is a result of users making poor decisions on their security.”
That said, he argues the decentralised systems behind cryptocurrencies are more secure than your average bank branch — which is pretty secure. “If you set up the right security using the platforms that now exist, including removing cryptocurrencies offline via cold storage devices (like a USB stick but with additional security) then you have the highest level of security.”
Of course, any technological improvements that impact cryptography will hit cryptocurrencies. One that’s raised some concerns is quantum computing, a new breed of computer that could outperform traditional machines by an order of magnitude, leaving existing encryption at risk of being cracked. Such innovations remain in development, but if they do manage to crack encryption, cryptocurrencies are but one area that will be impacted.