The idea of a digital currency: Creation and Value
When I got in contact with digital currencies, one of the first words mentioned was Bitcoin. Actually, I had heard Bitcoin years before, but had not yet realized neither its value nor its impact it was going to have. Nonetheless, alongside my first contact with Bitcoin, I also got to know that digital currencies are actually crypto currencies. The term crypto currency just emphasizes the cryptography a bit more. As I was starting to understand the basic terms, I quickly stumbled onto the questions, how a digital currency can have a value?! Or who is responsible for the value, similar to USD regulated by the FED or EUR by European Central Bank?
Value of a Digital Currency
All currencies on the planet Earth have something in common: Their value is created by their acceptance. If you could not use your EUR as a currency at the bakery next door, you would value EUR lower since you could not use it effectively for a lot. Maybe the bakery just accepted USD? If so, then I had to exchange my EUR into USD. This transaction would have though two effects: First, the EUR would loose value and second, the USD would gain value! Maybe I would not exchange at the stock market, but at my neighbor or at the travel exchange at the airport. Now, that would not have such an impact since I would only exchange a few EUR. But imagine, I would do that with 5 billion EUR! So, back to the start: The core of every currency is the acceptance of it. The more people accept it, the more value it has.
Digital currencies are basically just currencies not unlike EUR or USD. To have a value, they need to be of need for someone. Thence, for a high value of a currency, you need to have a high acceptance and be able to use it in a lot of situations. One case of digital currency is Bitcoin, which has already thousands of point of sales all over the world.
Printing of (Digital?) Currencies
Up to now, every currency has a central governing institution handling the printing of the money. For the EUR it is the European Central Bank and for the USD the Federal Reserve. The idea originates that one needs to keep track of how much of the currency is in the world and also be the final instance to determine currency fraud. Assume everyone is able to print money. Well, then everyone would be a millionaire, … or would it? Due to printing, the value is loosing in value. The benefit of a central institution is the security of the currency’s stability, since only one printer is running.
However, central institutions bring problems with them. They decide completely on their own and autonomously how much money is flooding the market. The more money they print, the less value it will have. Despite that, they could also just not print money and make the interest rate high and reduce the money in the market, since it is more expensive for banks to loan a credit. They will not easily lend credits and get it easily on to customers. Or who is willing to pay 10% for a credit?!
Decentralized Digital Currencies
Digital currencies completely invert the current principle. The main idea is to remove the central institution with their deficits, so that you are relying on a third autonomous party to decide on the value of your money. The idea has been around a while and along with the main problem: How to ensure that not everyone is printing money and that if you pay me, I will receive the money and you are not faking the transfer? 2009, the first software was presented where both problems were solved. It was the first implementation of a digital currency. Bitcoin Core was introduced. On the creation of Bitcoin, 50 Bitcoins were spread for an initial market liquidity and the solution of the creation was presented. When you confirm valid transactions of Bitcoin, you will receive a few Bitcoin as a reward, which was the main incentive to get people to verify transactions. The trick: The validation is done with a math puzzle which is extremely difficult to solve, but the solution is very easy validated. If you solve the puzzle, you simply present the network with the solution. Everyone can then quickly confirm the solution and agree on the validity of the transactions. Thus, we solve both problems: Transactions are proven to be correct by everyone using Bitcoin and additionally, you get a few Bitcoin for the solution. And this is the only possibility to get Bitcoin in the system!
So far, I have answered the two initial questions, how digital currencies are created and how they get their value. Definitely, this article just scratched the surface, but I hope this provides a first rough idea as to why Bitcoin has the value it currently has.
What were your first questions when you heard about digital currencies? Write a comment and let me know! 🙂