Introduction to cryptocurrencies. | Credit: Shutterstock
Key Takeaways
- Cryptocurrencies use cryptographic technology to secure transactions and control the creation of new units.
- Cryptocurrencies offer decentralized financial systems and operate independently of central banks.
- Financial inclusivity is a potential benefit of cryptocurrencies, which give users direct access to their money without the need for conventional middlemen.
- The value of cryptocurrencies can fluctuate, based on a variety of factors including market demand, regulations, and technological advancements.
- Taxation of cryptocurrencies is a significant concern that individuals and businesses must address to remain compliant with the law.
What Is A cryptocurrency
A cryptocurrency, also known as digital or virtual currency, employs cryptography for security purposes. Cryptocurrencies are intended to function as a means of exchange, enabling people to conduct safe, peer-to-peer (P2P) transactions online without the aid of middlemen like banks. Cryptocurrencies leverage blockchain technology, a decentralized and open public ledger that keeps track of all transactions.
However, not all virtual currencies are cryptocurrencies but all cryptocurrencies are digital currencies. This is a bit of a mouthful but in a nutshell virtual currencies encompass a wide range of online value representations that can take various forms such as airline miles, loyalty points, and in-game video game currencies.
Cryptocurrencies are a distinct subset of digital currencies that are decentralized and function on blockchain networks, with examples like Bitcoin (BTC), Ether (ETH), and Litecoin (LTC). Centralized virtual currencies also exist, such as:
- Ripple (XRP);
- Central Bank Digital Currencies (CBDCs) like the Sand Dollar , which isa digital currency issued by the Central Bank of The Bahamas.
Bitcoin: World’s First Cryptocurrency
Bitcoin is the first decentralized cryptocurrency introduced in 2008 by Satoshi Nakamoto (an individual or a group of people) through the publication of a white paper called “Bitcoin: A Peer to Peer Electronic Cash System”.
In the crypto world, BTC stands out as the leader of cryptocurrency and is widely recognized and highly regarded in this space as being a robust and sound medium of exchange. For the last 14 years, other digital currencies like ETH have emerged as alternatives to traditional government-issued fiat currencies. A fiat currency is a currency that is backed by a country and not a commodity like gold or silver, like the United States Dollar (USD).
BTC and ETH are the two top competing cryptocurrencies based on market capitalization over the last decade as their total value grew year on year. Now, let’s take an example to understand the importance of cryptocurrencies. Suppose you need money on a weekend when regular banks are closed for a family member who lives abroad.
You can securely send money to a family member without using the standard banking settlement method by using cryptocurrencies. Peer-to-peer transactions enable seamless transfer of funds without the use of a middleman or other external entity.
How Does A Cryptocurrency Work
Cryptocurrencies, like Bitcoin and Ether, store transactions on a distributed ledger known as a blockchain, which is maintained by a network of computers around the world. A blockchain can be thought of as a digital ledger available online for anyone to see and review.
The distinction between a bank and a blockchain lies in the accessibility of transaction data. In a bank, transaction records are only accessible to authorized personnel and individual clients through personal bank statements. However, with an open-source blockchain, anyone can review all transactions, ensuring trust as the entire network of participants verifies them, making it highly transparent and resistant to corruption.
Every ten odd minutes all the Bitcoin transactions made globally are stamped together and put into an individual block and recorded on the Bitcoin blockchain. This ten minute block is then cryptographically chained to the previous block and cannot be changed or altered at any point in the future. It does this by making use of the Secure Hash Algorithm 256 (SHA-256) which is a cryptographic algorithm playing a crucial role in ensuring the security and integrity of data in the Bitcoin blockchain.
Each transaction must be confirmed by consensus among the network participants to maintain the security and integrity of the blockchain. Powerful computers compete in a process known as mining to solve challenging mathematical puzzles and validate the veracity of transactions. proof-of-work (PoW) cryptocurrencies like Bitcoin are created via the mining process. Miners who contribute computing power and validate transactions are rewarded with a new unit of the cryptocurrency (i.e., BTC).
The generation of new units of a cryptocurrency is governed by the mining process, and the supply of any cryptocurrency can be constrained by a predetermined set of rules embedded in the protocol. For instance, there will only be 21 million Bitcoin available in circulation, and this scarcity has been an important feature of the Bitcoin blockchain since its beginning.
However, not all cryptocurrencies have a limited supply, meaning they aren’t all deflationary. Even Bitcoin is both inflationary and deflationary. It is inflationary because new coins are added to the supply through mining, and it’s deflationary because its purchasing power can increase over time as its supply reduces gradually, in the form of halving events every four years (approximately).
Alternative to mining, individuals can purchase cryptocurrencies from brokers and store them securely using cryptographic wallets, which can be categorized as hot wallets (online) or cold wallets (offline).
A Brief History Of Cryptocurrencies
The concept of digital currency can be traced back to the “digital cash” experiments like Hashcash in 1997, which was created by Adam Back,a British cryptographer and cypherpunk . Additionally, cryptographer David Chaum created an anonymous electronic cash system called eCash. However, it wasn’t until the late 2000s that the first modern cryptocurrency, Bitcoin, was created.
Bitgold, which is often deemed a direct precursor to Bitcoin, was designed in 1998 by Nick Szabo, another cypherpunk pioneer in the cryptography space.
It can now be noticed that the groundbreaking white paper released in 2008 by the pseudonymous Satoshi Nakamoto laid the foundation for Bitcoin and introduced the innovative blockchain technology, which would become the backbone of not only Bitcoin but also numerous other cryptocurrencies that followed. However, the white paper was merely an upgrade on systems that had already tried to replace fiat currency years before.
Over the last fourteen years, the crypto space has now seen thousands of coins enter the market. Bitcoin and a few others such as ETH and LTC are withstanding the test of time.
Types Of Cryptocurrencies
The crypto space has different kinds of coins created for different purposes. Some of these include:
Bitcoin
Bitcoin is a peer-to-peer network-based decentralized digital currency that enables safe and direct transactions without the use of middlemen like banks. It uses blockchain technology to record and verify transactions, and high value, restricted supply, and rising demand contributed to its popularity among investors.
Altcoins
Alternative cryptocurrencies that were developed after Bitcoin are called altcoins. Some examples include
- Proof-of-work coins like Litecoin (LTC) and Bitcoin Cash (BCH), can be used for transactions, as a store of value, and can be bought, sold, and traded on various cryptocurrency exchanges
- Proof-of-stake (PoS) coins such as Ether , Cardano (ADA), and Solana (SOL), use a staking consensus mechanism for transaction validation, leading to significant energy savings compared to PoW systems.
- Privacy coins like Monero (XMR) and Zcash (ZEC) prioritize anonymity and privacy in transactions.
Stablecoins
Cryptocurrencies designed to maintain a stable value, often pegged to a fiat currency like the USD are called stablecoins. Popular stablecoins include Tether (USDT), USD Coin (USDC), and Binance USD (BUSD). However, it is possible that a stablecoin’s value diverges or disconnects from its intended pegged value, possibly due to mismanagement of reserve assets or market forces.
Utility tokens
Digital tokens that serve a specific purpose within a blockchain ecosystem, such as providing access to a platform or service are called utility tokens. Examples include Uniswap (UNI) and Chainlink (LINK), which respectively offer efficient decentralized trading for users on its platform without a third party intermediary and provide secure and accurate real-world data for the operation of DeFi application smart contracts to make use of.
Security Tokens
Digital assets that represent ownership in a real-world asset, such as stocks or real estate, and are subject to regulatory oversight. These tokens can provide investors with rights like dividends or voting power.
NFTs (Non-Fungible Tokens)
Unique digital assets that represent ownership or authenticity of a specific item or piece of content. NFTs are secured by blockchain technology and cannot be duplicated or tampered with. Ethereum, Algorand, Cardano, and Tezos are some platforms that support the creation and trade of NFTs.
Advantages Of Cryptocurrencies
There are various reasons why cryptocurrencies are a viable alternative to the current traditional financial system in place. Some of the advantages on offer include:
- Better security: Decentralized nature of cryptocurrencies eliminates the need for a central authority, which could be a potential point of failure or attack. Additionally, the cryptographic infrastructure inbuilt into the blockchain technology provides data that holds integrity and transparency which are features that make it more secure.
- Preserving privacy and reducing dependency: Anonymity in transactions and reduced dependence on traditional financial institutions due to a peer-to-peer system where no third party can block a transfer. This is not the case using a centralized system such as the traditional banking system.
- Innovative monetary framework: It is an attempt at a modern monetary framework, which works in harmony with the internet and is open 24-7.
- Middlemen not necessary: It eliminates the need for intermediaries which significantly lowers transaction costs.
- Resilient towards inflation: Cryptocurrencies may be posed as monetary lifeboats against resistance to the degradation of fiat versus inflation.
- Hard money: Ironically Bitcoin has been debated to be one of the hardest money as it cannot be debased, touched or seen physically due to its intangible nature. This means holders can migrate from country to country without the risk of their coins being seized. This cannot be done with cash or gold as an individual runs the risk to have their physical holdings confiscated when crossing borders.
- Cryptographically secure: Blockchain uses advanced security features like hashing, digital signatures, and public-key cryptography to secure transactions.
Disadvantages Of Cryptocurrencies
With any groundbreaking technological advancement comes issues that need to be considered or disadvantages behind its use case. These might include:
- Lack of acceptance worldwide: Cryptocurrencies face a lack of widespread acceptance to date due to its high price volatility, risk of hacking or loss of funds, regulatory uncertainty, and limited consumer protections.
- Complex in nature: A complex background and groundbreaking technology that supports cryptocurrencies can be confusing for a non-technical person to understand. As a result, people might view Bitcoin and cryptocurrencies as scams or ponzi schemes.
- Association with illegal use: It has been associated with illegal activities such as money laundering, terrorism and fraudulent behavior. The Silk Road was the first website that used Bitcoin to facilitate the buying and selling of illegal drugs and other illegal activities.
- Many scammers in the space: The cryptocurrency industry breeds a lot of scams that have stolen funds from exchanges and investors. It is important to carry out due diligence on any coin you intend to speculate on or invest in to avoid losing your money to bad actors.
- Energy intensive: Bitcoins PoW consensus mechanism uses a high amount of energy in order to secure the network and mine new coins.
Cryptocurrency Wallets
Once cryptocurrency is purchased on an exchange it is recommended that you withdraw the crypto asset from that exchange and deposit it onto a digital wallet. A wallet can come in different formats.
- A hot wallet is a wallet that is always connected to the internet. This can be found in an app on your mobile phone.
- A cold wallet is a physical USB looking type device that remains offline. Keeping your cryptocurrency offline or in a cold wallet, such as a Ledger Nano device, helps to protect it from hacking.
By holding cryptocurrency on a digital wallet, one becomes sovereign which means the individual will own his own private key and access to his cryptocurrency. The private key provides one access to a secure digital wallet which is protected by a seed phrase consisting of 12 to 24 words.
If the cold wallet is lost, the seed phrase can be used to recover the cryptocurrency on another device. For added security, keep a smaller amount in a hot wallet, which is connected to the internet, and store the majority of the cryptocurrency in a cold wallet. Some popular cold wallet brands include Ledger and Trezor.
Crypto Regulation And The Future Of Cryptocurrencies
Regulation has been debated over since cryptocurrency began a decade ago. As cryptocurrencies have gained popularity and increased adoption, numerous governments have enacted legislation to safeguard investors, stop money laundering, and guarantee the stability of financial systems. Today, many cryptocurrency enthusiasts and institutional investors are collaborating with regulators to introduce regulations that will help the industry mature.
The regulatory environment for cryptocurrencies is still developing and might differ greatly between nations. For instance, in the United States, the regulatory landscape is complicated and fragmented, with various authorities in charge of different aspects of cryptocurrency regulation.
The Securities and Exchange Commission (SEC) controls cryptocurrency securities offerings, while the Commodities Futures Trading Commission (CFTC) is in charge of overseeing derivatives and futures trading. The CFTC has informally classified Bitcoin as a commodity, indicating that when regulations emerge, it will not be treated as a security like other altcoins.
In Europe, the EU has voted against the banning of PoW in 2022, and in April 2023, the Parliament endorsed the Markets in Crypto-Assets (MiCA) legislation to trace crypto asset transfers, applying anti-money laundering and counter-terrorism finance measures to crypto assets, intending to increase transparency, protect consumers, and reduce anonymity in crypto transfers.
Furthermore, there are ongoing concerns surrounding the taxation of cryptocurrencies that require attention. In order to avoid facing legal or financial repercussions, it is crucial for people and companies dealing in cryptocurrencies to stay up-to-date on the latest legislations and adhere to them.
As cryptocurrencies continue to acquire popularity among various stakeholders, the future of digital currencies seems promising. That said, cryptocurrencies are likely to play a big role in revolutionizing banking, enabling decentralized applications, and disrupting numerous industries around the world as a result of technological breakthroughs, growing acceptance, and legal developments.
FAQs:
What is the difference between cryptocurrencies and tokens?
Cryptocurrencies, like Bitcoin or Litecoin, operate on their own independent blockchain networks, whereas tokens are built on existing blockchain platforms, such as Ethereum, and represent assets or utilities within a specific ecosystem.
How do cryptocurrencies work?
Blockchain, a decentralized ledger technology, powers cryptocurrencies. Transactions are verified by network users and recorded on a public ledger to ensure transparency and security.
What is proof-of-work?
Proof-of-work is a consensus mechanism used in blockchain networks where participants solve computational puzzles to validate and add new blocks to the blockchain.
Are cryptocurrencies legal?
Different nations have different laws governing cryptocurrency. While some governments have adopted them to some extent, others have put restrictions or rules in place. Before engaging in cryptocurrency activities, it is crucial to review and adhere to local laws and regulations.
Can cryptocurrencies be exchanged for traditional currency?
Yes, through peer-to-peer transactions or cryptocurrency exchanges, cryptocurrencies can be converted into conventional or fiat currencies.
