What is Cryptocurrency, Simply Explained
Cryptocurrency, also known as digital or virtual currency, has become a popular form of investment and transaction. However, not all cryptocurrencies are the same.
At its core, cryptocurrency is a decentralized digital form of currency enabled to process financial transactions on the internet. Bitcoin was the first decentralized cryptocurrency launched in 2008 by Satoshi Nakamoto through the publication of a white paper called “Bitcoin: A Peer to Peer Electronic Cash System”.
In the crypto world, Bitcoin stands out as the leader of cryptocurrency and is widely recognized and highly regarded in this space as being robust and sound money.
For the last 14 years, Bitcoin and other digital currencies like Ethereum 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).
At the start of 2023, the top ten cryptocurrencies by market capitalization include: Bitcoin, Ethereum, Binance Coin, Tether, Cardano, Polkadot, Dogecoin, XRP, Uniswap, and Solana. Market capitalization is the total value of the cryptocurrency asset when taking all the supply in circulation multiplied by the price.
These rankings of largest cryptocurrency coins fluctuate quickly in the dynamic world of cryptocurrencies and are likely to change throughout the year due to their speculative nature. Bitcoin and Ethereum are the two top competing cryptocurrencies in market capitalisation over the last decade as they have seen their total value grow year on year.
Cryptocurrency uses a unique, anonymous, and verifiable approach to making transactions peer-to-peer without using a third party involved, and is not controlled by a central authority.
Imagine you have a family member who is abroad and needs money over a weekend when banks are closed. By using crypto you can send money to your family member without the need of a bank. This is what it means to transact peer-to-peer: there is no third party involved.
It does this through the use of a decentralized open and public ledger, called the blockchain.
A blockchain can be simply defined as a decentralized, digital ledger that records monetary transactions across a network of computers in a secure and transparent manner.
Cryptocurrencies will continue to be accepted in society because they address the key characteristics of money:
– Durability of cryptocurrencies is supported by their decentralized and digital nature, which eliminates the risk of physical damage.
– Divisibility allows for the creation of smaller units of the currency to facilitate transactions. Crypto enables micro transactions to be made.
– Portability of cryptocurrencies is greatly enhanced by their digital form, which enables them to be stored and transferred easily through the internet.
– Scarcity is ensured through the design of cryptocurrencies, with a limited supply of coins, preventing inflation.
– Acceptability of cryptocurrencies is increasing as more merchants and individuals recognize and begin to accept them as a form of payment.
How Does Cryptocurrency Work?
Cryptocurrencies, like Bitcoin and Ethereum store transactions on a public ledger known as a blockchain. A blockchain can be thought of as a digital ledger available online for anyone to see and review. You can think of it in a similar fashion to a bank statement sent by the bank outlining all transactions you made at the end of each month.
The difference is that only authorized personnel and the client of the bank can review the transactions on a personal bank statement. Unlike an open-sourced blockchain which allows anybody to review all transactions. This ensures trust as the blockchain is verified by the whole of the network and can not be corrupted.
Every ten minutes all the Bitcoin transactions made globally are stamped together and put into an individual block or timestamp.
This ten minute block is then cryptographically chained to the previous block and cannot be changed or altered at any point in the future after it has been chained to the blockchain.
Cryptocurrency is created through a process called mining, which involves the use of computing power to solve complex mathematical problems which once solved miners are rewarded with newly minted coins every ten minutes.
If you are not a miner you can purchase cryptocurrencies from brokers and store them safely on cryptographic wallets which can be defined as hot or cold wallets.
History of Cryptocurrencies
Digital cryptography has been studied for decades and Bitcoin is an improvement on many past attempts at “digital cash” experiments like Hashcash in 1997, which was created by Adam Back who is a developer that is also cited in the Bitcoin white paper.
Hashcash was a cryptographic hash-based proof-of-work algorithm, which is a concept adopted by Satoshi in his white paper.
Other cryptographers and pioneers in this space include personalities like David Chaum who was the first person to propose the idea for cryptocurrency in a paper published in 1983, outlining an early form of anonymous cryptographic electronic money.
Bitgold, which is often deemed a direct precursor to Bitcoin, was designed in 1998 by Nick Szabo, another cypherpunk and pioneer in the crypto space.
Over the last fourteen years, the crypto space has seen thousands of coins enter the market. Bitcoin and a few others such as Ethereum and Litecoin are withstanding the test of time.
Today the total market cap of the space has grown to $1 trillion USD, hitting highs of $3 trillion in the 2021 bull run. The total market cap has been forecasted by some analysts to touch the market cap of Gold at $8 trillion in mid-long term future and eventually hit $100 trillion once the space matures.
Types of Cryptocurrencies
The crypto space has different kinds of coins created for different purposes. Some of these include:
- Proof-of-work coins that can be used to buy things, store value, or act as a commodity similar to gold and silver. These coins include but are not limited to Bitcoin (BTC), Litecoin (LTC) and Bitcoin Cash (BCH).
- Stablecoins are designed to maintain a stable value and are often pegged to a fiat currency such as the US dollar or gold. Some of the most popular stablecoins today are Tether (USDT), USD Coin (USDC), and Binance USD (BUSD).
- Proof-of-stake coins are cryptocurrencies that adopt a digital voting system where instead of miners using computers to solve complex math problems, a group of individuals are chosen to validate transactions based on the amount of digital coins they hold or “stake” in the network. The benefit of this concept is that there are large energy savings compared to the Proof-of-Work system. Ethereum (ETH), Cardano (ADA), and Solana (SOL) are three popular coins that use proof of stake.
- Defi coins are cryptocurrencies that were born as applications that use public blockchains and crypto assets to disrupt the traditional finance sector. Uniswap (UNI), Chainlink (LINK), and Aave (AAVE) are three popular coins that serve decentralized finance purposes.
- NFTs are non-fungible tokens that are unique digital assets that represent ownership or authenticity of a specific item or piece of content. NFTs are secured and backed by blockchain technology and cannot be duplicated. Each NFT is unique and cannot be tampered with. Ethereum, Algorand, and Tezos are some names competing in this space to produce NFTs.
Advantages of Cryptocurrencies
Cryptocurrency offers the alternative of better security using decentralization, faster and cheaper cross-border transactions, anonymity in transactions, and reduced dependence on traditional financial institutions.
It is an attempt at a modern monetary framework, which works in harmony with the internet, is open 24-7, and ensures freedom and empowerment through the use of true digital scarcity.
It eliminates the need for intermediaries which significantly lowers transaction costs.
Cryptocurrencies can pose as monetary lifeboats against resistance to the degradation of fiat versus inflation.
Ironically some consider Bitcoin as one of the hardest money known to man yet cannot even be touched or seen physically, due to its intangible nature.
This is a benefit because it allows its holder to migrate from country to country and all that individual needs to access the holdings is a seed. This cannot be done with cash or gold as an individual runs the risk to have their physical holdings confiscated when crossing borders.
Disadvantages of Cryptocurrencies
Cryptocurrency also has several disadvantages. These include a lack of widespread acceptance to date, high price volatility, the risk of hacking or loss of funds, regulatory uncertainty, and limited consumer protections.
In addition, its complex background and groundbreaking technology can be confusing for the average person. It has also been associated with illegal activities which could slow down a wider acceptance.
Finally, there is an age-old debate in the crypto space about the overuse of energy consumption concerns related to the process of mining the coins.
Cryptocurrency Mining
Mining is the application of high-performance computing systems using specialized application-specific integrated circuit (ASIC) chips.
Miners receive new bitcoins as a reward for processing transactions through the reward protocol. The reward is distributed at a rate of 6.25 bitcoins every 10 minutes in a random and fair manner among miners who contribute to securing the network.
Think of mining as an analogy to the process of finding physical gold. There is no guarantee that miners will discover gold, but those with the best resources have a higher likelihood of success. However, the outcome remains random.
Mining plays a critical role in securing the Bitcoin network and enables stakeholders to engage in transactions without intermediaries, even though the miners themselves are not intermediaries. Participants can freely join or leave the network at any time, thereby preserving their anonymity.
Crypto Regulation
Regulation has been debated over since cryptocurrency began a decade ago.
Today many crypto enthusiasts and institutional investors are working with regulators to bring in regulation to help mature the industry.
Regulatory uncertainty mainly surrounds crypto exchanges, stablecoins, security tokens, DEFI exchanges and yield products.
There are also questions about Over-the-counter (OTC) trading, margin loans, tax disclosures, and security disclosures still need to be answered, with the US who will likely set the global standard for regulation.
In America, the SEC and CFTC have unofficially classified Bitcoin as a commodity. This means that when regulation surfaces it will not be regulated as a security unlike other altcoins.
In Europe, The EU has voted against the banning of proof-of-work in 2022 which was deemed a positive move for crypto acceptance.
Crypto Security
Blockchain uses advanced security features like hashing, digital signatures, and public-key cryptography to secure transactions.
Despite this, blockchain is not completely secure and can have vulnerabilities that affect its security. Each investor should avoid speculating on risky projects and carry out due diligence.
Storing your wealth in Bitcoin and Ethereum is considered a safer option, while other cryptocurrencies pose a higher level of risk. It is important to do your due diligence before speculating on a cryptocurrency.
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 your cryptocurrency on a digital wallet, you are sovereign which means you own your own private key and access to your cryptocurrency. The private key provides you 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, it’s recommended to keep a smaller amount in a hot wallet, which is connected to the internet, and store the majority of your cryptocurrency in a cold wallet. Some popular cold wallet brands include Ledger and Trezor.
FAQ
What is cryptocurrency?
Cryptocurrency is a unique, anonymous, and verifiable approach to making transactions peer-to-peer without a third party involved.
What are the benefits of cryptocurrency?
Cryptocurrency offers financial privacy, lower transaction fees and is decentralized. This means that it is not controlled by any single authority or institution. It also offers the potential for more secure and transparent transactions due to the use of blockchain technology.
How is a cryptocurrency created?
There are different ways cryptocurrency can be created. When we refer to Bitcoin, new Bitcoin is created through the act of mining. Miners use this technology to account for the transactions on the network and order them into blocks for which they are rewarded every ten minutes. When a block is found new Bitcoin is mined out of the protocol which increases the money supply incrementally every ten minutes.
What are the risks of using cryptocurrencies?
If you hold cryptocurrency on an exchange you are at risk of the exchange running away with your crypto. It is important to get the crypto off the exchange and into your private wallet.
