Sample 2 Crypto

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Sample 2 Crypto

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mivizyko

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1 Introduction

The market of cryptocurrencies is one of the most volatile and unpredictable markets there is.
The ups and downs of these digital currencies sometimes seem sporadic and random. One
simple explanation for this is the fact that most cryptocurrencies lack an obvious underlying
asset from which to derive an intrinsic value from. This means that cryptocurrencies are seen as
very speculative investments which is shown by the massive volatility of the market, a feature
exacerbated by the huge influx of new cryptocurrencies adding to an already great amount of
currencies in circulation.
Many investors and analysts have tried to price cryptocurrencies fairly and to draw up
investment strategies which predicts the market movements. The heavy correlation between the
individual currencies and the somewhat lacking correlation between cryptocurrencies and the
equity market, have made the cryptocurrency market extraordinary difficult to comprehend.

Bitcoin and Blockchain

During the aftermath of the 2007-2008 financial crisis, an anonymous developer (or group of
de-velopers) under the pseudonym Satoshi Nakamoto created Bitcoin, the world's first purely
peer-to-peer digital payments system functioning completely without any central party
(Nakamoto 2008,
1). Bitcoin became the first of the cryptocurrencies and has an uninterrupted record of being the
highest priced cryptocurrency since the first bitcoin was minted in 2009 (Coingecko 2022). The
idea of Bitcoin was that it would function similarly to physical currency or gold, but digitally, i.e.
that transactions can be made directly between two parties, and if participants wish:
anonymously and untraceable. Another important feature is that transactions made using bitcoin
are permanent and irreversible.
Various ideas of how currencies would work in a digital landscape has been thrown around
since at least the 1990s. The way fiat currency (unbacked currency issued by governments)
works is that financial institutions such as banks keep centralized ledgers of all transactions they
process and so keeps track of the amount of money belonging to each account in the system. In
order to remove the third party of the transaction, the centralized ledger has to become
distributed. When the ledger is distributed, multiple parties have their own version of the
transaction history recorded on the ledger and when a new transaction is made, every party
updates their ledger.
By far the biggest challenge with ledgers in general is that they can easily be tampered with.
Banks prevent this by using very secure systems that are difficult to access by intruders, which
keep the ledger and bank accounts secure from manipulation. For a distributed ledger to work in
the pre-digital era, every single party that own a copy of the ledger has to be completely honest
and never make any transactional mistakes and somehow find a way to broadcast each update
to every ledger-holder. At the dawn of the information age and with the rise of the internet, some
of these problems could be solved. The internet allows updates to be sent out to each party so
that they may update their ledger almost instantly. Cryptography allows incredibly secure
transactions between anonymous people and as long as users keeps their passwords or private
keys safe, no one can touch their funds. This means that distributed ledgers can be updated
instantly and user's
money can be kept secure with virtually unbreakable cryptography. It also means that no money
can be created out of thin air since no more money than the amount available to every user can
be spent and this is verified by everyone owning a copy of the ledger. Cryptography can also be
used to keep the transaction history of the ledger unchangeable.
Despite advances in communication and cryptography, two major problems persisted which
prevented peer-to-peer digital currencies from coming into existence. The first was the issue of
broadcasting information on a network when there is difficulty knowing which actors are honest
and what information is correct and has not been tampered with. The network needs to be able
to form consensus, in our case on which version of the ledger is the correct one despite there
being some faulty or malicious actors in it. This problem is often referred to as the Byzantine
general's problem (Reischuk 1985, 1)!. The problem can be solved when a majority of the
network's participants arc honest and there is a way to reach consensus among them.
The second challenge was the double-spending problem, an accounting issue resulting from the
fact that it is difficult for decentralized networks of parties to form consensus without a third or
central party (Hoepman 2007, 152-153). For a peer-to-peer digital currency to function there
must be some way for the parties involved to agree on which transactions are valid and which
are not.Since there are many parties in the network owning a copy of the transaction history,
money cannot be created out of nothing in a way not allowed by the network protocol, the
money has to come from somewhere and be accounted for. But this type of verification does not
prevent a party from spending the money they already posses twice or more. A dishonest actor
may spend some money at one place, then immediately spend it somewhere else, thereby
reaping a double reward for the same money and the network cannot keep up with which of the
broadcast transactions are valid.
There must be some way to form consensus on which transactions are accepted by the network
despite the latency in the flow of information and the distrust among participants, without
involving a central authority with extraordinary power over the network.
Nakamoto (2008) invented blockchain as a solution to the double-spending problem. Blockchain
works by having transactions recorded on "blocks" which are chained together using a
cryptographic hash function which makes it impossible to change the transaction history without
ruining the entire blockchain. Users owning the entire transaction history/blockchain are called
nodes and they are responsible for validating new blocks. To process transactions, Nakamoto
(2008) proposed using proof-of-work to reach consensus on new blocks. Proof-of-work lets
participants in the network use their computing power to mine, which is the process of using
one's CPUs, graphic cards or other means of computation to generate random values until a
value that is accepted by the Bitcoin protocol is found. The miner who manages to find a fitting
value will add a new block with transactions to the blockchain and is rewarded in Bitcoin. The
nodes will consider the longest blockchain as the correct one and miners will begin mining for a
new block on this newer version.
As long as the honest miners control more than 50% of the networks computing power, double
spending is prevented and the network is considered to have solved the Byzantine general's
problem since all honest actors are able to agree on which transactions are valid despite not
necessarily
trusting each other and despite the latency regarding information about new blocks. More
miners and nodes equals a higher level of security for the network.