Bitcoin broke records in late 2017 when its value passed the $7,000 mark, with market capitalization sitting at over $116 billion. And while bitcoin is the most well-known cryptocurrency on the market, it is still only one of many options available in a $188.5 billion market. Hundreds of cryptocurrencies have sprung up since Bitcoin’s debut, with most based on the same basic principles. The currencies can range in value from just pennies to thousands of dollars.
Despite their popularity and value, cryptocurrencies are still somewhat limited to the tech community and younger people willing to adopt new technology for making payments. Many outside of these spheres are have either never hear of cryptocurrency or, even if they have, don’t understand how they work.
Never fear; understanding this new option in buy and selling can be simple. This article will walk through the basics of cryptocurrencies and how they work, both as a method of payment and as their own economy with speculation and market changes.
How did it begin?
The first cryptocurrency, Bitcoin, was created in 2009 by the pseudonymous Satoshi Nakamoto. Satoshi Nakamoto is the name used by the person or people who created Bitcoin, but it is unknown who the real creator was (though there have been claimants to the throne). However, Satoshi’s was not the first venture into digital money; several companies had established digital cash systems in the decades leading up to the creation of Bitcoin; Satoshi’s was simply the first to survive.
A basic problem that all systems must solve to be successful is the prevention of double spending. The early digital cash models used a trusted third party to prevent double spending, and each one failed. Satoshi’s system was the first to do away with a trust-based model. Instead, he created a system in which there is no central authority, replacing it with blockchain technology.
The blockchain is a ledger or database that is completely transparent and open to all users. All parties on the peer-to-peer network have copies of the ledger and can verify transactions. The open system of verification requires a consensus between everyone on the network for a transaction to go through. The peer-to-peer consensus system ensures that there is not a single point of failure or one party that can cause it to break down. Satoshi was the first to see the potential of a peer-to-peer consensus to eliminate double spending, allowing bitcoin to survive and thrive.
The cryptocurrency system can be compared to a basic in-person transaction between two people. If one party has a dollar and gives it to another party, they no longer have the dollar and cannot give it away a second time. However, if a party gives another party a check for $1, both parties must rely on a third party—the bank—to give the second party the actual money. The bank is also entrusted with making sure the first party does not write a check for the same dollar and give it to a fourth party. When money is spent from a bank account, a central server keeps track of the account balance to ensure the money is only spent once.
The peer-to-peer cryptocurrency transactions are the same as putting a dollar bill in someone’s hand. Once a bitcoin has been given away, it cannot be sent to a second party. The peers on the network can be compared to a group watching a transaction take place in person and verifying that the same check is only written to one party, not two.
When dealing with digital money, double spending is a serious problem. It can be easy for a person to digitally create additional copies of the digital cash and give the same dollar to several different parties. As a result, any successful system must come up with a way to prevent this double spending.
The bitcoin system created a public ledger of transactions that cannot be altered once they have been placed on the ledger. When somebody sends a transaction, it is verified by the network and added to the ledger. Everybody has access to every transaction on the ledger and can verify that a payment has only been made one time, which prevents double payments.
What are cryptocurrencies?
Investopedia defines cryptocurrency as “a digital or virtual currency that uses cryptography for security . . . not issued by any central authority, rendering it theoretically immune to government interference or manipulation.”
Cryptocurrency is essentially limited entries in a database. These entries cannot be changed without meeting specific requirements. Cryptocurrencies are supported by blockchain technology, which is the public database. When a payment is made, an entry is made on the database. The peer-to-peer network must verify the transaction before the payment can be added to the database.
All the peers on the network have access to the transactions, history, and account balances, and are able to verify each transaction. When the transaction has been verified, it is mixed with other transactions to form a block, which is then added to the blockchain. Once the transaction is on the blockchain, it cannot be altered, and the payment is complete. Although the process seems long and complicated, it takes only minutes for a transaction to be completed.
Transactions must be confirmed to be completed. Until it has been confirmed, a transaction remains pending. In the bitcoin system and many others, transactions are confirmed by miners, who are rewarded with bitcoins. Miners are used to verify transactions and also to create new coins. In the bitcoin system, the only way new coins can be created is when a miner adds a transaction to the blockchain. The process takes a certain amount of time, so the number of bitcoins that can be created at any one time is limited.
What is a cryptocurrency miner?
Miners can be anybody on the network, actively verifying transactions and adding them to the network. The nodes in the network must then add the transaction to the database, making it a part of the blockchain. Although anybody can be a miner, the miner must complete certain requirements in order to prevent fraud. Miners must solve a puzzle, which takes significant computational power. Therefore, a miner needs to have the appropriate computer hardware to complete the task, which is a significant investment.
Mining can be done with any CPU on a desktop computer. However, the technology for mining has advanced and become much faster over time. While CPUs were once the standard hardware for mining, they gave way to graphics processing units (GPUs) and application-specific integrated circuits, or ASIC. While each of these hardware options will work for mining, the latest ASIC is needed to be successful because it is faster and more efficient. Each cryptocurrency requires different computing power, so some can be mined using just CPUs. But while a person could use a CPU to mine bitcoin, they would not earn enough bitcoin to make it worth the time and effort; the process would simply take too long.
There is no central authority to assign miners, so miners are kept in check by predesigned rules:. Bitcoin miners are required to find a hash to connect the new block to the blockchain. The hash is the product of a cryptographic function and based on an algorithm. This is known as Proof-of-Work. Bitcoins are only created when miners solve this puzzle, which limits the number of coins that can be created in a set amount of time. The first miner to complete the puzzle and add the block to the blockchain is rewarded with bitcoin.
Miners are also usually rewarded with the transaction fees. Mining is similar for each of the platforms that used mined coins—like Bitcoin, Ethereum, Litecoin, and others—but the rewards vary for each kind of coin.
What properties set cryptocurrencies apart?
Cryptocurrencies are unique because of some key properties. While traditional money has similarities to cryptocurrencies, a key difference is that money is secured by people or trust. Customers must trust banks to take care of their money and not devalue the currency. Cryptocurrencies, however, are secured by math, which makes them much less susceptible to fraud.
The basic properties of cryptocurrency transactions are that they are irreversible, pseudonymous, fast and global, secure, and permissionless. Cryptocurrencies also have a controlled, limited supply and are not based on debt like traditional currencies are.
Irreversible—Cryptocurrency transactions are irreversible: once the transaction has been completed and added to the blockchain, it cannot be removed or altered by anybody. No one on the peer-to-peer network has any more authority over transactions than another person, so there is no ultimate central power to reverse a transaction. This is beneficial because it solves the double-spending problem. However, it also means there is no way to reimburse funds that could be lost to a scammer. If a credit card is stolen, a person can often report it to their bank, and they may not be responsible for fraudulent charges. If someone sends bitcoins to a scammer or loses their private key and has their account wiped out, the funds are gone forever.
Pseudonymous—Cryptocurrencies are not attached to a real identity. Bitcoins are received on an “address,” a string of about 30 characters. However, “pseudonymous” does not mean “anonymous”: transactions are not completely untraceable. A user’s transactions are all available on the public ledger using the same address. However, those transactions cannot necessarily be linked to a person’s true identity.
Fast and Global—Transactions are completed in just a few minutes on the peer-to-peer network. When a transaction is requested, it is seen by the network immediately, and the verification by miners takes a few minutes. The peer-to-peer network is also stretched worldwide, so transactions can be between people in different countries without any restrictions. There is no currency conversion that needs to take place in order to pay a person in another country. Cryptocurrencies can be used as a safeguard against inflation in individual countries. A person living in Greece may be affected by inflation of their country’s currency, but that inflation will not affect any cryptocurrency they possess.
It is also just as fast to send Bitcoin to a person across the world as it is to send it to someone a mile away. The speed of the transaction depends on the kind of cryptocurrency being used (For example, Ethereum is faster than Bitcoin), but transactions on the various platforms are all generally very fast.
Secure—Cryptocurrencies are incredibly safe because they are secured by math. They are protected using a public key cryptography system, which ensures that coins can only be sent by somebody with a private key. The key is a string of completely random numbers, so it is extremely difficult to steal without gaining control of the private key. As long as the private key is only in the possession of its owner, it is unlikely the key itself could ever be hacked.
The private key makes cryptocurrencies quite secure, but they are only secure if the owner does not lose the key. The key can be lost if a person’s computer is hacked or if they accidentally give it away in a phishing scheme. The key can be printed or stored on a thumb drive, but these methods are also vulnerable to physically losing the key.
Permissionless—Anybody can use cryptocurrencies. They are open source and the software can be downloaded and used by anybody at no cost. There is no cryptocurrency authority to give permission to users. Once the software is downloaded, it can be used to send currency to anybody. Users do not have to provide identifying information or financial history to use cryptocurrencies. This also extends to the creation of a cryptocurrency. Most cryptocurrencies are open source, so anybody can create a new currency. While some cryptocurrencies are more successful and worth more, there are hundreds of different kinds on the market.
Limited, Controlled Supply—Traditional currency like dollars do not have a limited supply. Money can be printed and controlled by a central authority (e.g., governments), which can also increase the monetary supply without printing physical bills by buying and selling securities. This can cause inflation and deflation in the value of the money.
Cryptocurrency like Bitcoin, on the other hand, has a limited supply that is dictated by code. A schedule is written into the code of the cryptocurrency to determine its supply, and this amount can be calculated at any time. The code exists when the cryptocurrency is created and does not change, so the supply of the cryptocurrency will never change. While governments and central banks have tremendous control over the value of their currency, the value of cryptocurrencies is based on supply and demand. The value can go up and down with the market, but cannot be artificially altered by a central authority.
Not Based on Debt—Money in a bank account represents a debt the bank owes to the customers. The customer does not have the physical money in hand, but the bank is obligated to hand over the money when requested, whether to the customer or to an entity the customer is sending money to. Cryptocurrencies are different in that the number on the ledger does not represent a debt to be paid out. Instead, it only represents itself.
How do cryptocurrencies have their own economy?
The uses for cryptocurrency extend far beyond a method of payment. An entire economy is developing around cryptocurrency due to the impacts it can have. Cryptocurrency is valuable as a method of payment, a means of speculation, and a store of value. While there are a few well-known cryptocurrencies like Bitcoin and Ethereum, there are hundreds of kinds of cryptocurrencies. The different kinds can be traded much like stock on the stock market.
Dozens of exchanges exist for trading cryptocurrencies. On some of the bigger exchanges like Bitfinex, Bithumb, Coinone, and others, volumes of currencies equal to more than half a billion dollars are traded daily.
Companies have also begun raising money via an initial coin offering, or an ICO. With an ICO, a company offers investors a new cryptocurrency against an existing cryptocurrency like Bitcoin. ICOs are often compared to crowdfunding because they are frequently used to fund the development of a new cryptocurrency or other projects. The Ethereum platform and the use of smart contracts have helped the success of ICOs, with some companies raising tens of millions of dollars with an ICO.
Like the stock market, trading cryptocurrencies gives rise to volatility in the market. Some cryptocurrencies may see their value skyrocket, with investors getting huge returns. Other cryptocurrencies may plummet, with investors seeing enormous losses. Here is a look at some of the bigger cryptocurrencies in trading.
- Bitcoin is easily the most successful cryptocurrency on the market. When it debuted in 2009, it had a worth of less than one cent. In 2017, its value began increasing dramatically, hitting more than $7,000 per coin by November with a market cap of more than $118 billion.
- In a distant second place to Bitcoin, Ethereum is the second most successful cryptocurrency with a market cap of $28 billion. Ethereum’s use extends beyond currencies, with its platform supporting smart contracts and programs. Ethereum offers several different tokens and currencies, but its currency ether traded at nearly $300 in 2017.
- Bitcoin Cash was created in August 2017 after a hard fork of Bitcoin. It quickly jumped into third place in trading, hitting a market cap of $10 billion and trading at nearly $600.
- Of the top five cryptocurrencies by market cap, Ripple has one of the largest supplies of cryptocurrency with more than 38 billion XRP in circulation. Though its price per token was only about 20 cents in late 2017, its market cap of $8 billion brings it into fourth place.
- Litecoin is very similar to Bitcoin, but is about four times faster. It has been around since 2011 and has a market cap of more than $3 billion, putting it in fifth place. In late 2017, Litecoin had a value of $61.
Cryptocurrencies can be a store of value in the same way gold is. Gold can be held and put in a safe for 20 years and should be worth more money when it is sold. In the same way, the value of cryptocurrencies has gone up over time. If a person bought only one Bitcoin in 2009 for a cent, they could sell it today for thousands of dollars. The currencies can have day-to-day market volatility, but generally gain value over time.
What does the future hold for cryptocurrencies?
Cryptocurrencies have been around for nearly ten years, and the future appears bright for them. While many different cryptocurrencies will come and go through the years, the need for the technology will only grow. The digital currencies are no longer limited to use over the Internet with lesser-known companies. Big-name companies like Microsoft, Overstock.com, and Expedia all accept Bitcoin. Some brick-and-mortar establishments are even beginning to accept the technology as well. As the technology grows, real-life applications will increase as well. Some companies are beginning to create debit cards that can hold cryptocurrencies, which could help expand their use in everyday life.
Although cryptocurrencies are gaining popularity, not all of the uses have been above board. The relative anonymity these currencies provide has made them very attractive for illicit uses, such as drug smuggling and money laundering. In the summer of 2017, an alleged $4 billion money laundering scheme using Bitcoin was busted. With the growth of these popular currencies, crime will also increase, which will inevitably lead to more regulations. Illegal uses for the cryptocurrencies could make some people hesitant to adopt them.
Cryptocurrencies have the potential to change the way money is exchanged around the world. They have had a significant impact in the short time they have been in use, and as technology advances, the currencies could become more mainstream. As cryptocurrencies become easier to use and more widely accepted by retailers, they could signal a new era for currency.