A tiny tutorial on cryptocurrencies

TechRepublic's Tonya Hall spoke to StrongHold Labs CEO Alexander Lipton, and he explains that "cryptocurrency is a way to exist now, an agreement between willing parties" who calculate the cryptocurrency of each participant. "As long as you can do it in a consistent, logical way, any group of people can create their own cryptocurrency."

Watch the video interview above or read the full transcript below.

Tonya Hall: Are cryptocurrencies the Dutch tulips of the 21st century? Hi, I'm Tonya Hall of ZDNet, and joining me is Alexander Lipton, he is the CEO of Stronghold Labs, connections science fellow at MIT, and his article, "Beyond Bitcoin," was recently published in Scientific American. Welcome Alexander.

Alexander Lipton: Thank you for having me.

Tonya Hall: What do you do at Stronghold Labs?

Alexander Lipton: Well, Stronghold Labs is a startup where we are building novel infrastructure for banks in the 21st century, most usable to the current environment.

Tonya Hall: You're, I would say an expert on not just digital currency, cryptocurrency, but just the banking system of the world in general, not just here in the United States, but abroad, and the evolution that needs to happen in banking, you've written quite a bit about. Let's start with: what is cryptocurrency?

Alexander Lipton: A cryptocurrency is a way to exist now, it's an agreement between willing parties of how to calculate the amount of cryptocurrency each particular participant in the system actually has. So as long as you can do it in a consistent, logical way, any group of people can create their own cryptocurrency, if they wish to, right. So that's what it is.

So it's not backed by any government, it's not backed by any currencies, it exists solely as long as there is an agreement between participants of who owns what.

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Tonya Hall: We've heard commonly of Bitcoin, that seems to be the most referred to of cryptocurrencies, what are the other cryptocurrencies?

Alexander Lipton: Well, there are actually plenty. You can observe, they're kind of in excess of 1,000 cryptocurrencies which appeared, and some of them already disappeared, since Bitcoin was first introduced around 2009. And for example, there is Ether, which is kind of, backs Eterium, blockchain. There is Ripple, which is behind the Ripple blockchain, and there are many, many others. The Light Coin for example, which is a variation of classical Bitcoin. There is Bitcoin cash, etc, etc. so there are many and some would argue way too many cryptocurrencies in existence.

Tonya Hall: Well, then what are the pros-and-cons of Bitcoin or some other type of cryptocurrency? I mean, is there a type of crypto that we should be following or should be more interested in?

Alexander Lipton: Well, in my opinion, Bitcoin is an important and impressive technical accomplishment, but from a pure financial standpoint, it doesn't really meet the requirements and stated objectives, right. So it's neither decentralized, nor transaction cost free, and it's extremely volatile as far as its price is concerned. It's not really suitable for transactional purposes, and so I would say what we really would like to look at are electronic currencies, which are oriented towards facilitating legitimate commerce on the internet.

These currencies are such, not yet there, but they're concerted efforts by many people to do something along these lines. One of those is a utility settlement coin, which is being developed by a company called Clear Matics in London, which I'm a senior scientific advisor, and that currency is linked directly to the Fiat currency.

There is a digital-trade coin, which my colleagues at MIT and myself are trying to build, and was backed by assets. And what we should be looking for currencies, which basically can be used in order to meet all the requirements which people normally expect from money in particular to be a store of value, a unit of account, and a means of transaction. So exiting cryptocurrencies are not quite there yet.

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Tonya Hall: What do we need to do, or what needs to be done, to make cryptocurrency you know, legitimate for real-world finance?

Alexander Lipton: In my mind, several obstacles have to be overcome. One is they have to be made much less volatile than they currently are, and think about it. Basically, if you bought Bitcoin for $1,000, you're very happy about it when it went to $20,000, but if you bought it for $20,000, you're much less happy when it's now at $11,000. It all happened in a very short period of time, and hence, if you are a merchant and try to accept payments in Bitcoin, you open yourself to incredible fluctuation of value.

You know, and risk of ruin. So that's one aspect, so the other aspect is that we need to sort out issues related to anti money laundering laws of the land, and this is quite important. I would say stability is very important, and price stability, and then you know, anti money laundering.

Tonya Hall: What type of transactions or exchange is the best for cryptocurrency right now?

Alexander Lipton: Well that is a little hard for me to say, because all of those exchanges have their pros-and-cons, and without naming any particular exchange, I would say, that the one which has the best protections against cyber fraud, and cyber attacks is probably better. Having said that, you have to understand that the moment you start to create distributed currency on exchange, the advantages of this currency being distributed actually disappear, right.

So, it's theoretically possible to have your own public key and hold your own Bitcoins and so on, so forth, but that's basically then you open for people who have very clear understanding of coding and things of that nature, while the majority of people who speculate in this currency simply open an account with an exchange, and from that perspective, all this decentralization is lost.

Tonya Hall: You mentioned stability of crypto, or rather the instability of cryptocurrency. On what kind of platform should crypto be backed in order to maintain stability. Should it be something like gold?

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Alexander Lipton: Well that is a possibility, definitely. So, basically, my understanding of the situation is as follows. So, see, Bitcoin, to use as an example right. Bitcoin has zero value, and as such it can have any price, you know. Since we really cannot value it, it can fluctuate in price very actively. For instance if you have a car, and say it's a Ford, and you say it's worth $20,000, and then you know, you cannot say that it's worth $200,000, because then you will buy a Chevrolet for $20,000, etc, etc.

With Bitcoin, there is no mechanism of that nature, and hence prices solely function of supply and demand, and speculative activity of the people who are engaged in this trade, and so, by itself it cannot be standardized as such, besides, think about it. As I was mentioning in the beginning, you know, cryptocurrencies sort of functions of a social construct. Which is enforced by cryptographic means, and hence, you know, in Bitcoin, what happens is that I sent you a Bitcoin, you send a Bitcoin to somebody else, etc, etc, etc.

There is no counter flow of anything, which is in the system itself. Hence, you really don't know how to solve the delivery versus payment problem, which is all important for finance. Hence, as you say, anchoring this cryptocurrency in real assets, if it is technically possible, is very attractive, and that's what we're trying to do with trade coin and other people as well.

So as long as you can solve this issue, you will get something which is significantly more stable than what we have right now. Having said that, it will never become completely stable, because the price of gold is not stable, as with the price of the dollar. But that does not prevent it in theory to be used as a medium of exchange, because as long as fluctuations are slow compared to the time scales involved in actual trading, it's acceptable.

Tonya Hall: You talk about the digital or the transformation of our banking system, specifically maybe the central banks. What role do the central banks play today and where should potentially they be headed?

Alexander Lipton: It's a very interesting question. Right now, so first of all, I want to emphasize that there is a conventional wisdom that central banks actually create currency, and Fiat currency. This is actually not true, at least you know as far as I can see. So basically, currency in the system is predominantly generated by commercial banks, as part of the lending operations. Every time a bank lends money, it creates new money when money is repaid, it's actually destroyed but the interest stays in the system for good.

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So basically, that monetary creation is actually delegated by the states through private banks. However there is another side of the bargain, in order to be able to create money out of thin air, as commercial banks do, they have to agree to be heavily regulated by the state, and by central banks. And that's what they basically do, they regulate the activities of private commercial banking system through several powerful mechanisms, some are you know, interest they charge through their own money, which they lent to banks and so on, so fort.

So basically, the role of central banks right now is to regulate commercial banks. In principle, if they wanted to play kind of truly revolutionary role, and change the way financial system operates, they could do something along the lines of issuing central bank digital currency, that's a very interesting possibility, even though the ... Replacing not only physical cash, but some other assets with this type of currency. So right now, the actual amount of physical cash is not particularly large, it's maybe in the United States about $1 trillion worth of paper money and everything else is maybe another $20 trillion or so.

But in principle, central banks can issue digital currency, and then basically move the whole banking industry into direction of becoming much more narrow. So banks would actually only hold assets in central bank cash equal to the liabilities of formal deposits, and then lending would be performed by other institutions. So that is theoretically possible, but I think it's politically extremely challenging, and it's not also clear that it is really badly needed, because right now the system operates reasonably well, even though it was not so during the global financial crisis, system was quite challenged on many fronts.

I would think that co existence of narrow banks, and the conventional fractional reserve banks would be very nice outcome, and central banks should be pushing in this direction in my mind. It's pretty much like having gasoline cars, and electric cars co existing. I think it's theoretical to say all cars have to be electric, but you should be able to have your chance to put your money in a narrow bank if you feel like. Which is not existing right now.

Tonya Hall: Well it sounds like we're not really ready for a complete digital transformation. In fact, my question to you might be even, what kind of implication on individual freedom would there be if we went to eliminating cash completely?

Alexander Lipton: Exactly, this is a very deep and interesting question, and the answers can be given at several levels, so certainly, individual freedom kind of would be indeed, you know, kind of at risk if indeed all the transactions would be meticulously recorded, etc, etc. Well right now, cash gives people a modicum of anonymity. And so the question to answer is, you know, you have to structure this digital cash in a way which would potentially emulate some of the features of physical cash.

So the switch point between efficiency of electronic currency and preservation of individual freedoms has not been found yet. It is a complicated philosophical slash legal slash technical question, and you know, people are thinking about it, myself included, but there is no definite answer, final answer is not that easy.

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Tonya Hall: Well then, what might be more immediate is what kind of maybe big developments do you expect in the way of cryptocurrency in the coming months?

Alexander Lipton: Well, it's hard for me to say, but I think maybe this market would become more rational in my mind, we're in the grip of money of sorts, and I think that stabilization of this market at a certain level, which is kind of alottable to you know, to people, would actually not be such a bad idea.

So in essence, if you think about it, basically, Tulip money jumps to mind, but in the following sense. I want to emphasize that Tulip money not only had immediate bad consequences for the parties involved, even though it seems like these concepts were severely limited because the actual cash never changed hands in the Netherlands during this. But the interesting thing is that the actual skills of growing Tulips grew enormously during this time, and until this day, the Netherlands was the biggest and the most profitable producers of Tulips in the world.

So if you ever go to the Skipho airport, right next to it there's a huge auction where they sell every day, Tulips, and the so called Dutch auction where the price goes from top to bottom. And it's a fantastic spectacle. As I said you know, even though there were massive excesses, and some people lost money, but as I said, not that money, the actual consequences long term were quiet beneficial. So I hope that this money study of a system, money stage of this development of cryptocurrencies will be behind us soon enough, and then we will start to reap benefits as a society and as people.

Tonya Hall: Thank you so much Alexander for your time. I could talk to you about this topic forever, because there's so much to say and I'm really excited to see where we're taking this in the future. If somebody wants more advice from you or to find out what you're doing, how can they go about following you?

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Alexander Lipton: Well as you mentioned, you know, we published with some colleagues from MIT, popular article in Scientific America, which is obviously readily available, and I published a few more in some small sort of specialized journals. But also, you can follow my activity on LinkedIn, that's the only social media I have any kind of profile at all. All right?

Tonya Hall: Absolutely, and thank you again. And you can follow me and more of my interviews here on ZDNet or TechRepublic, or find me on Twitter it @TonyaHallRadio, or find me on Facebook by searching for the Tonya Hall Show. Until next time.

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