Cryptocurrency 101 - What are cryptocurrencies?
Blockchain & cryptocurrencies

Cryptocurrency 101 – What Are Cryptocurrencies?

In this post I would like to talk about cryptocurrencies. But before I share my personal long-term market outlook and the high growth potential that I see, I would like to talk about the basics. There are many good posts and articles already shared on the web, so I will not go too much into the details and will just provide a broader overview about it. If you are interested in learning more about cryptocurrencies you will find plenty of content in the web.

What is a cryptocurrency?

A cryptocurrency is a digital asset that is secured by cryptography, distributed via a decentralized network based on blockchain technology. This means that the currency is not issued and regulated by a central authority, but by a network of thousands of computers and servers worldwide, which together validate the transactions in the network. Due to that, it is highly secure and nearly impossible to hack or counterfeit. Moreover, it is immune against governmental interferences and manipulation (theoretically).

Cryptocurrencies are stored in so called cryptocurrency wallets and can be transferred worldwide 24 hours a day via the blockchain network. These transactions take place directly between one person and the other (peer-to-peer), without the need of any middleman and at low costs (in dependence on the cryptocurrency you use). The best-known cryptocurrency is Bitcoin.

How does a blockchain work?

A blockchain is the record keeping technology behind a cryptocurrency, and can be interpreted as a distributed ledger, in which all related transactions are stored and validated in form of a public database. It is literally just a chain of blocks strung together and referencing to each other, while each block stores digital information of a variety of transactions, e.g. like transaction date and time, transaction amount and its participants using a digital signature. To distinguish the different blocks and transactions from each other, each block stores a specific and unique code called “hash”.

When new transactions are issued on the network and need to be validated by the network, a new block is generated storing these new transactions. This new block now needs to be added to the blockchain for confirmation, otherwise the transactions are not valid. To do so, the new block will be tied to the most recent block, that was already validated and confirmed on the blockchain. Therefore, the hash of the most recent block will be stored in the new block together with its own unique and identifying hash. Let’ take a look at an example:

  • Jennifer transferred 50€ in Bitcoin to Peter. Jennifer’s public key is 111, Peter’s public key is 222. The transaction took place on November 6th, 2020 at 2:00 pm and was confirmed by block with hash #100. Previous block was #99.
  • Peter now sends 100€ in Bitcoin to Michael. Michael’s public key is 333. The transaction takes place on November 6th, 2020 at 2:30 pm and is now confirmed by block with hash #101. The hash of the recent block #100 is also stored in the new block with hash #101.

In reality the block hashes are way more complex than shown in my example and are basically the key to confirm and validate a new block in the blockchain. Miners (or network validators) compete with each other to find the correct hash for a block, using mathematical equations. The one that finds the correct hash first will be rewarded with a specific amount of mining rewards, in terms of Bitcoin currently 6.25 Bitcoin for each block. This concept of validating a blockchain is known as proof-of-work and arouses the interest of miners to participate in the validation of the blockchain. Besides that, there are also other methods to validate a blockchain, e.g. proof-of-stake. Network validators stake an amount of their cryptocurrency holdings into the network in this case and therefore receive a so called staking reward.

In the meantime, blockchains have further developed from single-chain blockchains, which means that only one chain is validated on the network, to multi-chain blockchains, were multiple chains are validated in form of a grid in parallel. This approach helps to increase transaction through-put and transaction speed.

What about security?

In general, a blockchain is highly secure due to the technology-related reasons mentioned above. It is nearly impossible to change or manipulate a confirmed block and thus a transaction in a blockchain, because in this case millions of computers worldwide, that already validated the blockchain, need to be manipulated at the same time. However, it is not impossible that particularly less popular blockchains, in which only a few miners are involved to validate the blockchain, are manipulated by so-called 51% attacks.

More concerning are price manipulations obviously taking place in the markets, that are not related to the blockchain technology itself and thus cannot be avoided. These manipulations are based on the principles of supply and demand and are caused by trading high amounts of money to influence the direction of the price movement of a digital asset.

The biggest security issue in my opinion are cryptocurrency exchanges and online wallets. Private keys, verifying the ownership of a digital asset, are stored and processed by these exchanges. Thus, in case an exchange is hacked, and the private keys are stolen and distributed to the public, in the worst case all funds can be accessed and stolen by third parties. If you hold a bigger proportion of your net worth in cryptocurrencies, I recommend you to self-custody them using a hardware wallet. In this case you are the owner of your private keys, which also accompanies with higher responsibility to keep your keys private and secure.

What about privacy?

As mentioned above transactions are stored in form of a public database, which can be accessed by everyone. Thus, it is obvious that every transaction can be traced back in the blockchain basically back until its creation. If your public key can be linked to your personal data, which is the case if you have signed up to a public exchange and bought your digital assets there, theoretically all your funds and transactions can be traced back in the event of a data breach. But there are some cryptocurrencies available that provide a higher level of privacy using encryption methods.

Bitcoin – The mother of all cryptocurrencies

Bitcoin is the mother of all cryptocurrencies and was invented as a digital payment system in 2008 after the financial crisis in 2007 / 2008, from a person or group named Satoshi Nakamoto. The Bitcoin network started to operate in 2009 by mining the first 50 Bitcoin. It is still unknown until today who really invented Bitcoin and if Satoshi Nakamoto is his real name or just a pseudonym. Thus, you can imagine that there are a lot of rumors about the actual inventor of Bitcoin. Even Elon Musk was assumed to be the inventor of Bitcoin recently.

The central issue of our current financial system is that it fully relies on trust. Trust in central banks that fiat currency will not be depreciated by their monetary policy. Trust in banks and financial institutes that they hold our money responsibly in our bank and savings accounts. Trust in money itself as a reliable medium of exchange. Moreover, we must provide our personal information and identity to banks and trust them that they process our data responsibly, to be able to take part in this financial system.

The idea of Bitcoin breaks with our current financial system. It is a trustless cryptographic currency based on blockchain technology, that relies on a mathematical, cryptographic proof (proof-of-work) instead on any bank or financial institute as a middleman. It can be interpreted as a monetary revolution.

The evolution of cryptocurrencies

Initially, cryptocurrencies were invented as digital currency / digital payment solution and alternative to fiat currency. But since then a lot more use cases have evolved. In the following you will find my personal view about cryptocurrency evolution.

Crypto 1.0 – Digital money

As mentioned above Bitcoin was invented as digital payment system. But in the first years after the invention of Bitcoin many alternative cryptocurrencies were invented, e.g. using multi-chain blockchains to reduce transaction costs and increase transaction speed. Due to that, there are many other faster and cheaper alternatives that can be considered as better solutions for digital cash. Due to its low transaction speed and high transaction costs, Bitcoin is not recognized as a payment solution anymore, but rather as a digital store of value, respectively digital gold. But still the initial intention of cryptocurrencies was to invent a digital payment alternative or digital cash.

Crypto 2.0 – Internet of value

Especially in the last 3-5 years a lot of new crypto projects were invented to support the growth of the idea of the internet of value. Their use case is not to be operated as a payment solution, but to provide services and use cases to the real world besides that. To mention some of them there is for example the space of decentralized finance more in particular crypto-backed loans or insurance services provided based on blockchain technology. In addition, there are many use cases for blockchain technology in the field of internet of things, artificial intelligence, cloud computing, data storage, data processing or supply chain management.

Crypto 3.0 – Crypto interoperability

An important factor to accelerate mass adoption for blockchain technology and cryptocurrencies is to establish interoperability between different projects and blockchains in order to combine their use cases. Up to now, most projects have been developed to solve exactly one problem, but what if we are able to combine different projects to solve a broader general problem or several problems altogether. Some projects, that are concentrating on that approach are currently being developed. If you ask me, this will be a necessity to trigger mass adoption from companies and bigger corporations.

I hope that this article helps you to better understand the background and general idea of blockchain technology and how cryptocurrencies work. Of course, the technology is more complex and there are a lot more topics that need to be mentioned to fully understand this technology. The intention of this article is only to provide you a basic undertstanding.

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