The History of Crypto

“The concentration of wealth is natural and inevitable, and is periodically alleviated by violent or peaceable partial redistribution. In this view all economic history is the slow heartbeat of the social organism, a vast systole and diastole of concentrating wealth and compulsive recirculation.”

– Will and Ariel Durant, The Lessons of History

The introduction of bitcoin as a technology is a limited innovation, it presents a quirky and limited solution to a classic problem in computer science. However, for most of the general public, the perception of cryptocurrency is often at the more basic level of:

Bitcoin has something to do with computers / is very expensive / is the future of something / sometimes goes up.

The technology behind cryptocurrency is the product of many people and the fusion of different advances from the last twenty years. Nevertheless, its history is described by a single overarching truth:

Cryptocurrencies were intended as a peer-to-peer medium of payment but have since morphed into a product whose purpose is almost exclusively as a speculative investment.

The Cypherpunk Era

Despite its most ardent acolytes’ claim, bitcoin was not an artifact of divine revelation. Like most technologies, it does not exist in a vacuum and was the product of a long sequence of trends going back to the early days of the internet. Bitcoin was not even the first digital currency and was preceded by multiple attempts along the same idea dating back to the early 1980s. The provenance of bitcoin is best understood through the lens of understanding the various internet subcultures that gave rise to the political ideologies and component technologies behind it.

The first hints of this idea go back to David Chaum’s cryptography paper Blind Signatures for Untraceable Payments which outlines a theoretical basis for a system of making an electronic payment system using digital signature algorithms. (Chaum 1984) The paper presents this idea as a mathematical formulation and does not provide an implementation. Later in 1989, Chaum started a company that attempted to bring these ideas into production in the financial services sector. The company sold three years later, and its technology was eventually folded into an open-source project called GNU Taler.

At the same time, the Cold War was coming to an end, and the United States Department of Commerce and the State Department were increasingly concerned with the geopolitical implications of allowing exports of strong encryption standards. This led Phil Zimmerman, the inventor of a common encryption standard known as PGP, to challenge the United States munition controls on encryption in what would be known as the first Crypto Wars. The legal precedent, in this case, had massive implications for the early development of internet browsers and internet technology which were starting to rely on strong encryption standards to enable secure communication and eventually e-commerce. This trend created an underground movement on the early internet known as cypherpunks, who were technological activists who advocated for the unrestricted use of cryptography and privacy-enhancing technologies as a vehicle for social and political change.

The first digital currency was launched in 2006 in the United States by a company named eGold. The company allowed early internet users to purchase fractional ownership amounts in offshore physical gold holdings and used this centralized register to make instantaneous transfers to other eGold customers. Businesses like MoneyGram and Western Union had been operating e-money services for many years, however, eGold differed in that it was not denominated or backed by a national currency. This service operated under what the law defines as a money transmitter business that facilitated payments between third parties by creating a central register that records credits and debits. The business quickly rose to prominence during the early internet eGold, and was soon prosecuted by the United States federal government under the Patriot Act as it was found to violate existing money transmitter laws. In 2007 the enterprise was shut down, and the federal government seized its assets. (Popper 2015)

The story continues with a company called Liberty Reserve S.A. that operated out of Costa Rica from 2006 to 2013 and offered an offshore anonymous money transmission service. The service allowed users to deposit money into a virtual dollar account via wire transfer or credit. Customers could then transfer these funds to other Liberty Reserve account holders without validation of the identities of the account holders or any legal restrictions. The FBI raided the offices of Liberty Reserve S.A., and the company was shut down in 2013 for violating the United States money laundering laws.

In the 21st century, most money is digital, represented as numerical values in databases holding balance sheets for bank deposits. The auditing and accounting of money is a regulated part of obtaining banking licenses, and this process of digitization of products and digital straight-through processing began in the 1980s. To most consumers today, this is transparent, although it was first, in the early 2000s that, consumers became aware of the digitization of their money in the form of increasing online banking. These now-common services gave customers a real-time view of their balances and transactions and increasingly allowed consumers to issue and receive payments. However, in the early days of e-commerce, there was still apprehension around receiving and making payments over the internet with credit cards. To fill this gap, PayPal emerged as a service to support online money transfers, which allowed consumers and businesses to transact with a single entity that would process and transmit payments between buyers and sellers without the need for direct bank-to-bank transfers. This was a particularly well-timed business that capitalized on the rise of online shopping services such as eBay and Amazon.

Contemporaneous to the e-money digital transformation was the digital file-sharing scene, which in 1993 grew out of early file-sharing systems on Usenet and found its way into the mainstream with the development of Napster. Napster was a global peer-to-peer file-sharing network that allowed users to share the newly invented MP3 files with other users without paying for the original recordings of the music. This service was eventually shut down for copyright infringement but spawned an entire generation of new open-source protocols such as Gnutella, Freenet, and BearShare. The most successful of these, BitTorrent, proved more challenging to shut down because of the lack of a single entity to target. The BitTorrent protocol was based on a data structure known as a Merkle tree which allowed large files to split up into individual pieces, transmitted over a network, and reconstructed in parts while maintaining the integrity of the entire data file. This core data structure would be instrumental in advancing peer-to-peer networks to share hashes of incomplete data while maintaining integrity through cryptography.

On the 31st of October, 2008, a person or group of people under the pseudonym Satoshi Nakamoto published (Nakamoto 2008) the Bitcoin Whitepaper, outlining a new system on a cryptography mailing list. The nine-page essay outlines what is described as a peer-to-peer electronic cash that could operate independently of central authorities.

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. We propose a solution to the double-spending problem using a peer-to-peer network.

– Nakomoto, Bitcoin Whitepaper

Computer science had previously grappled with what was known as the double-spend problem since the first networked computers and databases were invented. In short, this problem is concerned with ensuring that a digital representation of value is not copied and consumed by multiple sources that require it. The digital banking and credit card industries had dealt with a similar set of problems in which digital ledgers recording payments would need to be reconciled or communicated to multiple parties to ensure that digital representations of units of value were kept in sync with deposits. The existing solution to this problem had always been centralized trust authorities which held a legal obligation to maintain authoritative digital records and would handle discrepancies by introducing time delays for compliance checks and manual mechanisms to handle disputes and inconsistencies.

The mechanism described in the bitcoin whitepaper proposed a novel solution for the double-spend problem, which did not require a central trust authority. Instead, it relied on a computer program known as a consensus algorithm and clever use of a digital signature scheme to maintain a consistent record of a ledger database across multiple computers without needing an authoritative central source of trust. A digital signature is a technique in cryptography where a user uses a set of cryptographic keys (a public and a private key) to sign a piece of data to verify the integrity and origin of the data. The public key can be shared with the world and authenticated by associating it with another identity. The private key is kept secret and is used to generate digital signatures, which only the user who possesses the private key would be able to generate. This technique was extensively studied and widely used in existing internet infrastructure such as SSL, which protects not only online banking and other secure services but also the majority of websites.

A consensus algorithm is a kind of computer program in which multiple computers use a set of steps to write a shared set of data (such as a database) so that all users can access a consistent view of the data from any computer. Consensus algorithms are part of the branch distributed systems field in computer science. This field concerns itself with different approaches to building consensus algorithms, techniques of sequencing read and writes to shared data stores. All consensus algorithms are constrained by a fundamental result known as the CAP theorem, which states that any algorithm may have at most two out of three properties: Consistency, Availability, and Partition Tolerance.

• Consistency - Readers of data from the service see the same data at any given point of time

• Availability - All readers can retrieve the data you stored in a system even if a subset of the service goes down.

• Partition Tolerance - No set of failures less than total network failure result in the system responding to queries incorrectly.

The bitcoin network chooses the availability and partition tolerance properties of this triplet.

Moreover, the bitcoin algorithm took a particularly interesting approach to consensus by attempting to create a censorship-resistant network where no participant is privileged. The consensus process was eventually consistent and tied the addition of new transactions to the solution of a computational problem in which computers that participated in the consensus algorithm would need to spend a given amount of computational work to attempt to confirm the writes. This approach, known as proof of work created what is known as a random sortition operation in which a network participant would be selected randomly and probabilistically based on how much computational power (called hashrate) was performed to attempt consensus.

Because there is no central authority, and because it takes computational work—and thus an expense—to record transactions an incentive mechanism is required to reward those who sustain the network integrity. Therefore the bitcoin architecture created a computational game mechanic in which the computers in this network (called miners) competed to perform consensus actions and successfully confirming a block of transactions gave a fixed reward to the first “player” to commit a set of transactions. The rules of the game were defined by the shared software that all participants ran, which defined the network protocol. The critical ideas encoded in the protocol are the predetermined release schedule, fixed supply, and support for those protocol changes that have support off a majority of participants.

One of the core algorithms used in most blockchains is a hash function. A hash function is a classic cryptography algorithm in which data is repeatedly scrambled in a process that is difficult to reverse and produces a unique fingerprint of the data unique to the given input. The output of this function is an inordinately large number which is often encoded in the hexadecimal (base-16 number system).

Hello World
d2a84f4b8b650937ec8f73cd8be2c74add5a911ba64df27458ed8229da804a26

Minor changes to the input of a hash function alter the output. For instance, if the Hello World statement instead has a lowercase “w” the output changes drastically:

Hello world
1894a19c85ba153acbf743ac4e43fc004c891604b26f8c69e1e83ea2afc7c48f

The hash function’s output follows some well-studied statistical distributions, and the probability of an output prefixed by a fixed number of zeros can be predicted to occur within a certain amount of hashes. This process allows the difficulty mechanism of obtaining a particular output to be scaled and gives rise to the adjustable puzzle that miners are forced to solve to perform block confirmation. This mechanism allows the difficulty of bitcoin mining to be artificially adjusted proportionally to the rewards.

This consensus algorithm’s underlying data kept in sync a specific constructed data structure known as a blockchain. The blockchain is a ledger data structure that holds an authoritative record of all proposed spend activities of a digital numerical unit of value. A bitcoin is thereby a decimal value whose spend activities were enforced by the consensus algorithms and could be transmitted to other accounts, recorded on the blockchain, and mapped to addresses corresponding to public cryptographic keys. This design created a distributed digital ledger that recorded debits which could be continuously updated over time as the bitcoins were created and spent.

The censorship resistance of this algorithm was the critical improvement over existing eCash systems which previously had a single legal point of failure, in that the central register or central node would have to be stored in a single server that could be targeted by governments and law enforcement. In this trustless peer-to-peer (P2P) model—the same mechanism that powered Napster and BitTorrent—all computers participated in the network, and removing any one node would not degrade the availability of the whole network. Just as previous P2P networks had routed around intellectual property laws, bitcoin routed around money transmitter laws.

On January 3rd, 2009, the first block in the bitcoin blockchain, also known as the genesis block, was created. It contained a simple message in The Times concerning the bank bailouts during the subprime mortgage crisis:

The Times
03/Jan/2009
Chancellor on brink of second bailout for banks

The early history of bitcoin saw the technology primarily used as Nakamoto intended, namely as an anonymous global digital payment network. Early-adopter technologists used Bitcoin as an anonymous way to pay for goods and services and as a tip system for authors of online content. One of the first notable exchanges was two pizzas in exchange for 10,000 bitcoins ($40 at the time) on March 22nd, 2010. The first evidence of a price bubble followed in June 2011, when the exchange value for one bitcoin moved from $30 down to $2 in December 2011 after a prominent bitcoin exchange website hack. In 2013 the technology began to receive mainstream attention from the press, and this era represents the philosophical transition of the technology from use as a hypothetical digital currency into an asset for investment. The rapid price movement was at the time uncorrelated with traditional assets and proved an attractive investment for a class of traders looking for new speculative opportunities. After this point, the single defining feature of bitcoin no longer became its utility for anonymous payments but for its price action as a speculative investment.

The original author (or authors) of the technology withdrew from participation in the network and any communication; as other software developers and companies took up development. This new era marks a rapid expansion of a cottage industry of startups and early adopters who would build exchanges, mining equipment, and a marketing network to proselytize the virtues of this new technology. The culture around the extreme volatility of the asset created a series of memes within the subculture of HODL (a portmanteau of the term “holding,” standing for “hold on for dear life”), which encourages investors to hold the asset regardless of price movement. This investment philosophy became central to the cryptocurrency sector and was a statement of faith in the asset class. The implicit promise of bitcoin and any cryptocurrency in this era is that if of easy money for nothing and; the idea that if you invest early, you can get rich when the value “goes to the moon.” Effectively a digital form of the classic get-rich-quick scheme for the internet era. This marked the start of a new crypto era, the Grifter Era.

The Grifter Era

In addition to bitcoin, a series of similar technologies based on the same ideas emerged in the 2011-2013 era. The first movers were Litecoin, Namecoin, Peercoin, and a parody token known as Dogecoin based on an internet meme. These projects (called altcoins) were built on the bitcoin model but tweaked the implementation of the protocol to allow for different network behaviors and incorporated different economic models. As of August 2018, the number of launched cryptocurrency projects exceeded 1600. In 2015 a significant extension to the bitcoin model called the ethereum blockchain was launched with the aim to build a “world computer” in which programmable logic could be expressed on the blockchain instead of only simple asset transfers. This project would become the second-most traded token and would popularize the notion of smart contracts. In addition to fully visible transaction models of previous tokens, chains such as Monero and ZCash would incorporate privacy-enhancing features into the design, allowing participants to have blinded transactions that would obscure the endpoint details for illicit transactions with no public audit record.

Unlike in the original bitcoin paper, the idea of “one computer, one vote” was supplanted by the economic reality that large groups of computers could more efficiently compute the hashes required to confirm blocks and thus reap financial rewards from the network. Early entrepreneurs realized that they could gain an advantage over traditional server farms if they built faster and more specialized hardware to compute these hashes. These entrepreneurs began to build ASICs (Application Specific Integrated Circuit), custom hardware circuits that could do the computations required for the bitcoin network more efficiently than traditional CPUs offered by companies like Intel and AMD. This economic circumstance led to a technical arms race in which dedicated hardware became required to mine bitcoin, and larger groups would build clusters of computers that would pool the rewards acquired by mining together. These mining pools became a centralized and very lucrative business for early investors. An example is, the Chinese company BitMain, which began to centralize most of the computational resources, resulting in 70% of all bitcoin mining being concentrated in mainland China by 2019.

The underutilization of coal-fired power production and Chinese capital restrictions on renminbi outflows offered a unique opportunity for enterprising Chinese citizens to move capital outside of the mainland beyond government controls. In 2018 the Chinese government officially declared cryptocurrency mining an undesirable activity. The same year, Bloomberg reported $50 billion of capital flight from the Chinese state using the Tether cryptocurrency (Leising 2020).

In 2017 a new trend emerged when market participants realized that secondary tokens could be launched on top of the ethereum blockchain. This trend gave rise to a controversial new market for ICO (Initial Coin Offerings), offerings of digital tokens to fund project development. In September 2017, an ICO named Kik raised $100 million within several days. Over the next year, many other ventures would raise unconventionally high amounts of money for early-stage ventures. Between January and June 2018, over $7 billion was raised to fund ICO projects. Most of these projects failed within a very short period and exhausted their funds to pursue business models that would prove intractable and economically unviable. Many, moreover, turned out to be fraudulent or thinly veiled exit scams in which the entrepreneurs simply abscond with the crypto assets raised and never build the product claimed in the prospectus. These cases are being litigated to this day.

The Grifter Era period also saw the introduction of stablecoins such as Tether, aiming to be a stable cryptoasset with its price allegedly pegged to the US dollar and theoretically backed by a reserve of other assets. This is followed by a 2019 period of market volatility and market consolidation of cryptocurrencies, during which many unfounded ideas fell off and left a handful of 20 projects which would dominate trading volume and developer mindshare.

In 2021 China outright banned all domestic banks and payment companies from touching cryptoassets and banned all mining pools in the country. At the same time, the United States continued to be hit by an onslaught of cyberterrorism and ransomware attacks that began to attack core national infrastructure and the country’s energy grids.