🦾Economics behind cryptocurrency

For thousand years, physical tokens have been being used as means of payment (e.g. shells, gold coins, bank notes). In such setting, a direct exchange of sellers’ goods and buyers’ tokens allows them to achieve an immediate and final settlement. (See Panel (a)). This option is unavailable, however, when the two parties are not present in the same location (e.g. e-commerce), necessitating the usage of digital tokens.

In a digital currency system, the means of payment is simply a string of bits. It becomes challenging to prevent the buyer from re-using the same bit string over and over again. This is called the double-spending problem. This problem can be solved easily when there is a trusted third party (e.g. PayPal) who manages a centralized ledger and transfers balances by crediting and debiting buyers and sellers’ accounts. (See Panel (b))

In many settings, it is infeasible to find (e.g., lack of trust) or undesirable to use (e.g., the single point-of-failure problem) a trusted third party. In particular, cryptocurrencies such as Bitcoin are used as a digital means of payment in a distributed network in the absence of a trusted third party. (Panel (c)).