What is cryptocurrency?
A cryptocurrency (or crypto) is a form of digital cash that enables inpiduals to transmit value in a digital setting.
You may be wondering how this sort of system differs from PayPal or the digital banking app you have on your phone. They certainly appear to serve the same use cases on the surface – paying friends, making purchases from your favorite website – but under the hood, they couldn’t be more different.
What makes cryptocurrency unique?
Cryptocurrency is unique for many reasons. Its primary function, though, is to serve as an electronic cash system that isn’t owned by any one party.
A good cryptocurrency will be decentralized. There isn’t a central bank or subset of users that can change the rules without reaching consensus. The network participants (nodes) run software that connects them to other participants so that they can share information between themselves.
Centralized vs. decentralized networks.
On the left is what you’d expect something like a bank to use. Users must communicate via the central server. On the right, there is no hierarchy: nodes are interconnected and relay information between themselves.
The decentralization of cryptocurrency networks makes them highly resistant to shutdown or censorship. In contrast, to cripple a centralized network, you just need to disrupt the main server. If a bank had its database wiped and there were no backups, it would be very difficult to determine users’ balances.
In cryptocurrency, nodes keep a copy of the database. Everyone effectively acts as their own server. Inpidual nodes can go offline, but their peers will still be able to get information off of other nodes.
Cryptocurrencies are therefore functional 24 hours a day, 365 days a year. They allow for the transfer of value anywhere around the globe without the intervention of intermediaries. This is why we often refer to them as permissionless: anyone with an Internet connection can transmit funds.
Why is it called cryptocurrency?
The term “cryptocurrency” is a portmanteau of cryptography and currency. This is simply because cryptocurrency makes extensive use of cryptographic techniques to secure transactions between users.
What is public-key cryptography?
Public-key cryptography underpins cryptocurrency networks. It’s what users rely on to send and receive funds.
In a public-key cryptography scheme, you have a public key and a private key. A private key is essentially a massive number that would be impossible for anyone to guess. It’s often hard to wrap your head around just how big this number is.
For Bitcoin, guessing a private key is about as likely as correctly guessing the outcome of 256 coin tosses. With current computers, you wouldn’t even be able to crack someone’s key before the heat death of the universe.
Anyways, as the name might suggest, you need to keep your private key secret. But from this key, you can generate a public one. The public one can safely be handed out to anyone. It’s feasibly impossible for them to reverse-engineer the public key to get your private one.
You can also create digital signatures by signing data with your private key. It’s analogous to signing a document in the real world. The main difference is that anyone can say with certainty whether a signature is valid by comparing it with the matching public key. This way, the user doesn’t need to reveal their private key, but can still prove their ownership of it.
In cryptocurrencies, you can only spend your funds if you’ve got the corresponding private key. When you make a transaction, you’re announcing to the network that you want to move your currency. This is announced in a message (i.e., transaction), which is signed and added to the cryptocurrency’s database (the blockchain). As mentioned, you need your private key to create the digital signature. And since anyone can see the database, they can check that your transaction is valid by checking the signature.
Who invented cryptocurrency?
There have been a handful of attempts at digital cash schemes over the years, but the first of the cryptocurrencies was Bitcoin, which was released in 2009. It was created by a person or group of people using the pseudonym Satoshi Nakamoto. To this day, their true identity remains unknown.
Bitcoin spawned a huge number of subsequent cryptocurrencies – some aiming to compete, and others seeking to integrate features not available in Bitcoin. Nowadays, many blockchains do not just allow users to send and receive funds, but to run decentralized applications using smart contracts. Ethereum is perhaps the most popular example of such a blockchain.
What is the difference between cryptocurrencies and tokens?
At first glance, cryptocurrencies and tokens appear identical. Both are traded on exchanges and can be sent between blockchain addresses.
Cryptocurrencies are exclusively meant to serve as money, whether as a medium of exchange, store of value, or both. Each unit is functionally fungible, meaning that one coin is worth as much as another.
Bitcoin and other early cryptocurrencies were designed as currency, but later blockchains sought to do more. Ethereum, for instance, does not just provide currency functionality. It allows developers to run code (smart contracts) on a distributed network, and to create tokens for a variety of decentralized applications.
Tokens can be used like cryptocurrencies, but they’re more flexible. You can mint millions of identical ones, or a select few with unique properties. They can serve as anything from digital receipts representing a stake in a company to loyalty points.
On a smart-contract-capable protocol, the base currency (used to pay for transactions or applications) is separate from its tokens. In Ethereum, for instance, the native currency is ether (ETH), and it must be used to create and transfer tokens within the Ethereum network. These tokens are implemented according to standards like ERC-20 or ERC-721.
What is a crypto wallet?
Essentially, a cryptocurrency wallet is something that holds your private keys. It can be a purpose-built device (a hardware wallet), an application on your PC or smartphone, or even a piece of paper.
Wallets are the interface that most users will rely on to interact with a cryptocurrency network. Different types will offer different kinds of functionality – evidently, a paper wallet cannot sign transactions or display current prices in fiat currency.
For convenience, software wallets are considered superior for day-to-day payments. For security, hardware wallets are virtually unmatched in their ability to keep private keys away from prying eyes. Cryptocurrency users tend to keep funds in both types of wallets.
How does crypto mining work?
The process referred to above is known as mining. If the miner finds a solution, the block they constructed would extend the chain. As a result, they would receive a reward denominated in the blockchain’s native currency.
The cryptographic puzzle miners must solve involves repeatedly hashing data to produce a number that falls below a particular value. Hashing with a one-way function means that given the output, it is virtually impossible to guess the input. But given the input, it is trivial to verify the output. In this way, any participant can verify that the miner has produced a ‘correct’ block, and rejects those that are invalid. In this case, the miner receives no reward and has wasted resources by trying to forge an invalid block.
This results in some interesting game theory that makes it costly for an actor to attempt to cheat, but profitable for them to act honestly. No malicious entity has the resources to indefinitely attack a strong network. Therefore, we expect those with resources to make a return on their investment by participating correctly.
Can cryptocurrencies scale?
As you can probably tell, distributed networks aren’t very efficient. Unfortunately, cryptocurrencies can only be secure and censorship-resistant if all nodes can sync a copy of the blockchain. The lower the requirements to keep pace, the easier it will be for people to join.
You can see why a blockchain that only adds a small block every ten minutes is preferable, in this regard, to one that adds a huge block every five minutes. The latter would require nodes to run high-powered computers to stay in sync, and push lower-powered ones to go offline. This would result in greater centralization, as there are fewer peers on the network.
But with smaller blocks, we can’t achieve many transactions per second (TPS). That also means that, in busy periods, transactions can take a while to be added to the blockchain. It’s inconvenient if you want to make a fast payment, but it’s the price that must be paid for decentralization.
We call this issue a scalability dilemma. A system that scales well is one that can easily adapt to increased throughput with minimal downsides. Blockchains do not scale well – as we’ve explained, simply upping the throughput with bigger blocks undermines the entire purpose of the distributed network.
To increase TPS in a way that doesn’t harm the network’s decentralization, off-chain scaling appears to be a viable approach. This encompasses a broad range of solutions – centralized and decentralized – that allow transactions to be made without logging them to the blockchain.
Who makes decisions for cryptocurrency software?
Cryptocurrency networks are opt-in. Nobody’s forcing you to run software that you don’t want to. In a good protocol, the code will be entirely open-sourced so that users can be sure of the system’s fairness and security.
Generally, cryptocurrencies enable anyone to participate in their development. New features or edits to the code are vetted by a community of developers before being agreed on and published. From there, users can review the code themselves and choose to run it or not.
Some updates will be backward-compatible, meaning that updated nodes will still communicate with older ones. Others will not be backward-compatible – older nodes will be “kicked off” the network unless they’re updated. Check out Hard Forks and Soft Forks for an explanation of this.
What should I learn before investing in cryptocurrencies?
Where do we even start? There are a plethora of ways to analyze the financial markets, and generally, most professional investors will use widely different strategies. On a high level, though, there are two main schools of thought to assess an investment: fundamental analysis (FA) and technical analysis (TA).
Fundamental analysis is a method to assess an asset’s valuation based mainly on economic and financial factors. Analysts who use this method look at both macroeconomic and microeconomic factors, industry conditions, or the business underlying the asset (if there’s one). In the case of cryptocurrencies, they may also look at public blockchain data, which are sometimes referred to as on-chain metrics.
This can involve looking at the number of transactions, addresses, the top holders, the network hash rate, and countless other pieces of information. The goal with this analysis is to come up with a valuation for the asset and compare it to its current valuation. In the end, this approach aims to determine whether the asset is currently undervalued or overvalued.
With all that said, it’s important to remember that cryptocurrencies are a new and flourishing asset class. Fundamental analysis has little room to shine when it comes to determining their valuation. Simply put, there’s no standardized framework for determining the valuation of cryptocurrencies, and most existing models can’t be trusted to a high degree. The success or failure of a cryptocurrency project may depend on many different factors, for which no current framework can account for.
Technical analysts take a different approach. Unlike fundamental analysts, technical analysts don’t try to determine the intrinsic value of an asset. Instead, they evaluate trading and investment opportunities based on historical trading activity. They do that by focusing on price movements, chart patterns, indicators, and various other charting tools to evaluate a market’s strength or weakness. In essence, technical analysts believe that the previous price movements of an asset can be valuable to try to predict its future price movements.
Since technical analysis can be applied to essentially any market with historical data, it’s widely used by cryptocurrency traders.
So which one should you learn? Well, why not both? Most market analysis tools work best when used in combination with other tools. In either case, it’s absolutely vital to understand financial risk and risk management, and never to invest more than you can afford to lose.
Where to buy cryptocurrencies
There are various ways to buy cryptocurrencies. The first thing you’ll need to do, though, is convert your fiat currency into cryptocurrency. Then, you can choose to either HODL, trade it with other cryptocurrencies, or lend it and earn interest. Let’s take a look at the different types of cryptocurrency exchanges.
Centralized exchanges (CEX)
You might find the concept of a centralized exchange a bit confusing since cryptocurrencies are often referred to as decentralized. In short, centralized exchanges are online platforms that facilitate trades by connecting buyers and sellers.
The way this works is that users deposit their fiat money or cryptocurrency to the exchange and trade within its internal systems. If you’re familiar with how cryptocurrency wallets work, you’ll know that, in this case, your cryptocurrency is custodied by the exchange. But it should be fairly easy for you to withdraw your funds and keep them in your own wallet, if you want to.
Some might prefer keeping their funds on the exchange, either because they trade regularly or for convenience. However, if the exchange is hacked, user funds might be at risk.
Decentralized exchanges (DEX)
Decentralized exchanges are different. When you’re using a DEX, there are no custodians involved. In fact, a more accurate way of referring to this type of exchange would be non-custodial exchange.
Here’s what happens when you trade on a DEX. Instead of depositing your funds to the exchange’s wallet, you’re trading directly from your own wallet. When a trade is executed, the funds are transferred directly on the blockchain using the magic of smart contracts.
Since there’s no entity acting as a custodian, some consider this a safer choice than CEXs. Another upside might be that most DEXs don’t require you to provide any personal information other than a blockchain wallet address. At the same time, taking custody of your own funds requires some amount of technical expertise, and you’re entirely at your own responsibility.
A peer-to-peer (P2P) exchange is also a place that connects buyers and sellers, but it’s different from both a CEX and a DEX. In this case, the exchange itself does nothing more than connect buyers and sellers, and they can settle the transaction in whatever way they agree on. So, the deposit and settlement method can be decided by buyers and sellers for each inpidual transaction.
Is cryptocurrency legal?
Very few countries place an outright ban on buying, selling, and storing cryptocurrency. In the vast majority of the world, Bitcoin and other virtual currencies are perfectly legal. But before getting started with them, you should check if your jurisdiction permits it.
It’s important to remember that each country has a different approach to regulating cryptocurrency activities. Make sure that you’re not in violation of any rules surrounding taxation or compliance.
Is crypto dead?
The media have pronounced cryptocurrency dead hundreds of times in the last decade. And yet, it continues to work just as it did in 2009. That’s not to say it isn’t volatile – the price fluctuates wildly. To those solely trying to turn a profit, bear markets can be disheartening.
However, it would be a mistake to describe cryptocurrency as “dead.” It continues to attract new users, and the technology and infrastructure are only growing more sophisticated.
The core innovations of Bitcoin and Ethereum will undoubtedly play an important part in reshaping our existing monetary systems to be more suitable for the current age. Immutability, censorship-resistance, trustlessness, or near-instant transactions using a public monetary system could completely revamp the mechanics of economic activity on the Internet.
Is cryptocurrency safe?
There’s a degree of risk taken on with cryptocurrency. If you forget the password to access your bank account, you can just have it reset through customer support. But, if you forget or lose the private keys that give you access to your crypto, there’s no one that can help you. Using a reputable exchange can be a more forgiving option – it requires trust, but you aren’t at risk of losing your private keys.
Public-key cryptography has not yet been broken. With good security measures, you’re probably more likely to have any of your other online accounts hacked than you are to have your funds stolen. Best practices include being aware of common scams (social engineering, phishing, etc.), keeping your private keys offline at all times, and backing them up in a secure location.
Is cryptocurrency anonymous?
Your name isn’t connected to your cryptocurrency addresses – they look like random strings of numbers and letters on the blockchain. Be careful when assuming that this makes you anonymous, though. You’re pseudonymous – you still have a sort of on-chain identity, it just isn’t the one you use in real life.
There are certain methods that may allow people to tie IP addresses to your activities. On this front, things like dusting attacks and other analysis techniques can be used to deanonymize you. Remember that blockchains are essentially massive public databases. If you’re concerned about your privacy, you should try to make it as difficult as possible for others to link your transactions to your name. Cryptocurrencies like Bitcoin aren’t private by default, but methods like coin mixing and CoinJoins can make analysis heuristics unreliable.
A small subset of cryptocurrencies (known as privacy coins) are able to obfuscate the source, destination and amount of funds in transactions, using methods like Confidential Transactions. They have stronger privacy by default but are not totally resistant to deanonymization.
Is cryptocurrency valuable?
In financial systems, value is a shared belief. Just like with anything valuable, the value isn’t inherent to cryptocurrency itself – it’s assigned by people. In other words, something has value if people believe it does. This is true regardless if the object of value is a precious metal, a piece of paper, or some bits in a database.
With all that said, some consider cryptocurrencies and Bitcoin, something akin to a scarce digital commodity. Due to its predictable issuance rate and monetary policy, some argue that Bitcoin may act as a store of value in the future, similar to gold. Since Bitcoin has existed only for a little more than a decade, it’s yet to be seen whether it will stand the test of time in this regard.
Are all digital currencies cryptocurrencies?
No. You might have heard that many nation-states and central banks are working on creating their own versions of digital currency. However, these are just that – digital currencies. As a matter of fact, they’re often collectively referred to as central bank digital currencies (CBDCs). These are essentially digital versions of fiat money, and they don’t enjoy most of the benefits of cryptocurrencies. They are issued and declared legal tender by a central government and typically don’t use a distributed ledger, such as a blockchain, to keep a record of transactions.
You might also have heard about Facebook Libra, another type of digital currency. On the plus side, it’s planned to be built on an open-source blockchain system. However, it wouldn’t be permissionless such as Bitcoin or Ethereum, meaning that participants would need more than a simple Internet connection to use it. What’s more, the project and the activity on it would be run and managed by an association made up of a few selected members.
So, despite CBDCs and other forms of digital money making use of blockchain or cryptography, they’re quite different from cryptocurrencies such as Bitcoin.
What is the market capitalization of a cryptocurrency?
When you’re looking at the price of a cryptocurrency, you only see part of the picture. An equally important metric is how many inpidual units of that cryptocurrency exist out there, i.e., the supply.
More specifically, to assess the valuation of a cryptocurrency network, you need to know how many inpidual units exist right now. This is called the circulating supply. Different cryptocurrencies may adopt different issuance schedules, so it’s important to understand how the issuance works with each network.
The market capitalization (or market cap) is the price of an inpidual unit multiplied by the circulating supply.
Market Capitalization = Circulating Supply*Price
As you might imagine, the market capitalization of a cryptocurrency network is a more accurate representation of the value in the network than the price of an inpidual unit. A network with a lower-priced coin but a higher circulating supply might have a higher total valuation (market cap) than one with a higher-priced coin but lower circulating supply. And the opposite could also be true in certain cases.
It’s worth noting, however, that the market capitalization does not represent how much money entered a particular market. For instance, it’s a common misconception among newcomers that the Bitcoin market cap represents the total amount of money invested in Bitcoin. But that doesn’t make sense because the market cap depends on the price and supply.
Why do I need to pay transaction fees?
If you send one bitcoin to another address, you’ll notice that the address receives slightly less than what you’ve sent. That’s because you pay a small fee to reward miners for adding your transaction to the blockchain.
Many cryptocurrencies use a similar mechanism to incentivize users to secure the network. In Proof of Work systems, transaction fees are usually bundled with freshly-minted coins (the block subsidy) to form the block reward.
You can adjust the fee depending on the urgency of your transaction. Rational miners will always seek to make as much revenue as possible, so they’ll prioritize transactions with higher fees. You can look at the current pending transactions to get an idea of the average fee, and set your own accordingly.
I lost my key. Can I get my funds back?
If you’re sure you lost your keys, chances are you will never get them back. The great benefit of cryptocurrencies is the removal of custodians and middlemen from managing financial transactions. The downside of that, however, is that the responsibility is now entirely in your hands. So you need to be extremely careful not to lose your private keys, as they’re what give you ownership of your funds.
What is the future of cryptocurrency?
What the future of cryptocurrency will look like depends entirely on who you ask. Some believe that Bitcoin will rise to replace gold in the digital age and disrupt the existing financial system. Others argue that cryptocurrencies will always be a secondary system, existing as a niche market. We also have the ones that believe Ethereum will become a distributed computer, serving as the backbone of a new Internet.
Skeptics predict the industry will eventually collapse, while enthusiasts are happy with cryptocurrencies remaining niche monetary systems. There are many possible outcomes – it’s simply too early to say with certainty what will happen even a year from now. But we can’t deny that there is a huge potential for growth.