An Introduction to Cryptocurrency
How do you describe money that you can’t touch?
Uh, your Visa card, Ruhani, duh
How do you explain money that you can’t touch and that isn’t controlled by the bank?
Uh, a hidden stash of credit cards under your bed, duh
How about money that you can’t touch, that isn’t controlled by any one power and can be worth whatever you decide?
…blasphemy
What Are Cryptocurrencies?
- Not credit or debit cards
- Not cash
- Not backed by anyone power or bank
Sooo what are they?
I’m glad you asked.
Cryptocurrencies are decentralized digital currencies. This means what I said before, that they aren’t backed by any bank or government institution. They do, however, abide by a set of rules. These rules allow it to exist outside of the traditional financial system and instead within a computer network.
I’ll explain how in a minute.
I’m sure many of you reading this will recognize the above as Bitcoin. When I first heard of it, I was under the impression that it was a currency, not unlike monopoly money, that is used in some false reality of a video game.
Boy, was I wrong.
This is not the case. Bitcoin was the first, very real, decentralized digital currency to exist. It was introduced in 2009, and along with it, came the blockchain.
woah woah woah — what’s the blockchain?
I’ll get back to explaining how this currency exists within a computer network now. The blockchain is a massive digital ledger (for those of you who aren’t accountant terminology aware — a ledger is a collection of financial accounts used to track transactions) on which each transaction on the network is recorded.
How does the Blockchain work?
It is a permission-less system. No one need permission to participate in the ledger and no one is in charge of the system.
The blockchain has radically challenged the status quo in using cryptography to create a database that is both open and decentralized. It created a record that is now verified by a community rather than one governing power.
A huge benefit is that anyone with an internet connection will have access to this currency. The future of global economy in it’s entirety will shift towards one that includes trust of this magnitude.
Even in the traditional banking system, this new power will make it much harder for public authorities to enforce financial regulations that are unjust because this oyster of new possibilities exists thanks to this digital ledger.
But Ruhani, if no one is in charge of this massive global system of money, then how is it protected against fraud?
This job is taken care of by the miners.
A miner is someone who verifies the transactions occurring on the blockchain. They record these exchanges on the blockchain and this earns them Bitcoin as a reward. Fact: every Bitcoin in existence was originally produced to reward a miner.
For every 210,000 blocks, the number of coins generated when a new block is created decreases by half. The final Bitcoin will be mined in 2140 (this will be the 21 millionth). The idea around this is to retain a limited supply to sustain the value of Bitcoin.
The transaction information contains the time, date, participants and amount involved. Everyone on the blockchain has access to a shared single source of truth.
To protect against cheating the system, we need another system. The blockchain stores information across a network of personal computers. This is where it gets more technical with how exactly the blockchain is decentralized and distributed.
The peer-to-peer network layout makes it extremely difficult for anyone person to attempt to take down the blockchain or corrupt it. The digital ledger uses cryptography — a type of math — to guarantee blocks cannot be changed by anyone else or counterfeited.
The blockchain allows us to bypass intermediaries.
Traditionally, supply chains rely on intermediaries. The financial industry relies on intermediaries for transactions. With the blockchain, transparent transactions become a reality.
The process begins when someone requests a transaction. This request is broadcasted to the peer-to-peer network of the blockchain including the nodes (all those computers I mentioned before). The node network verifies the transaction and the user’s status via algorithms.
Once validated, the transaction is added to the others by creation of a new block of data for the ledger. The new block gets added to the existing blockchain.
Each block is connected to the one before and after it via its hash. This is extremely important because it allows its path to be traced easily. Once data has been recorded it is difficult to change because of this.
Each block containing data has its own hash. This is a digital fingerprint which helps to identify a specific block and its content. This hash is always unique. The Bitcoin blockchain uses SHA256 — a set of cryptographic hash functions.
Whenever a new block is added to the chain (see where the name comes from now 😉) it is encoded with the hash of the block before and its own.
The data kept inside the hash is dependent upon what type of blockchain it is in. For example, the hash within a block for Bitcoin has details about the transaction.
The reason that it becomes difficult to change anything is because changing a block will alter its hash. Because the block after it will contain the altered block’s hash, it will also have to be altered, and the one after that, and the one after that etc.
It causes following blocks to become invalid because they no longer will contain the correct hash of their predecessors.
This makes the blockchain secure. Only the first one cannot point to the hash of a previous block. The first block is called the genesis block.
However, this isn’t enough to prevent tampering because computers are able to very quickly calculate hashes and re-validate blocks. To get around this, the blockchain uses other security mechanisms as well.
What is Proof-of-Work?
It takes, on average, ten minutes to calculate the required proof of work required to add a new block to the chain. If a block is tampered with, the remaining proof of works for all the following blocks will have to be altered.
Proof-of-Work is a consensus algorithm. All this is, is a system used to confirm transactions and create new blocks for the chain. Miners compete to solve this algorithm and get rewarded; it is the cryptography they use to verify transactions.
To keep the network secure, the cryptographic algorithms become progressively more difficult. They require a lot of computational power to solve. The answer to these mathematical problems is what we talked about before, the hash.
This computational puzzle keeps the blockchain secure because it guarantees that a certain number of computer cycles will be used to solve it. This ensures that a certain amount of work has been done to solve the puzzle — it is a proof of work.
This mining difficulty actually directly affects the price of the Bitcoin too (I’ll talk more about buying and investing in crypto towards the end).
This is because a low mining difficulty indicates that the cryptocurrency is easy to mine. This in turn means that it is easier to supply more of the crypto which causes pressure for its price.
Another security mechanism goes back to one of the key aspects of blockchain — that it is distributed.
Like I mentioned earlier, the blockchain uses a node network or a peer-to-peer network. This means that it is open to everyone to join and that everyone gets a copy of the blockchain. Each node will only ever add a new block to the chain if it has been verified by everyone.
This consensus prohibits anyone from tampering with the blockchain easily — in order to take charge, one would have to control over 50% of the peer-to-peer network or else the proposed fraudulent change wouldn’t be accepted by everyone else.
Wait, if there are thousands of people trying to keep the blockchain up to date, how do all the ledgers remain in sync?
As I mentioned earlier, each transaction is announced to the network. This announcement consists of your account #, the account # of the person you are sending/receiving to/from and the amount of money involved.
Cryptographic Keys
Another security mechanism used with Bitcoin is encrypted keys. These keys are collections of information used to guarantee the validity of the persons involved in a transaction.
When an account is made on the Bitcoin network, the wallet (where money is stored) is given two keys.
To verify a transaction on the network, you would use your private key to sign it. Then, others on the Bitcoin network use your public key to ensure that it checks out.
Digital Wallets
The money itself is stored in digital wallets. There are a few kinds.
- Hot Wallet: keeps your crypto in a device that is connected to the internet
- Cold Wallet: offline crypto storage
- Hardware Wallet: physical devices (like a USB) that store crypto
- Paper Wallet: offline cold storage that keeps printed out public and private key
Transactional Properties
When a transaction does occur on the blockchain, the properties of this exchange vary from the conditions placed on the exchange of regular currencies (aka Fiat currency i.e. the Euro).
- Irreversible: when a transaction does occur on the blockchain, the money sent or received is irretrievable.
- Pseudonymous: this means that transactions and accounts are not connected to a user’s real identity
- Global: transactions can occur internationally
- Timely: the exchanges are quick
- Secure: the cryptographic key system, proof-of-work system and hash system
Where do I find Bitcoins?
A few places.
Cryptocurrency Exchange: you may trade regular coins for Bitcoins here
Bitcoin ATM: trade Bitcoins for cash or other cryptocurrencies
LocalBitcoins: a website that locates a seller who will trade Bitcoins for cash
Storage: your cryptocurrencies are stored in a digital wallet
How much does it cost?
On the topic of actually acquiring Bitcoin, it is important to note that the ledger does not care about the value of a Bitcoin. You get to decide how much one unit is worth and even what it represents.
“…blasphemy” — I think not.
Each unit of the cryptocurrency is individually identifiable and programmable. For one person on the network, one unit might amount to one Euro. For someone else, it might be a certain number of shares in a company.
Using these programming rules, cash and money flow becomes automatized.
Okay — but, what’s the hype?
Why use cryptocurrency? Many people, (I’m looking at the skeptics) favor a system of money that is not controlled by an institution or government. Participating in a fiscal system that functions outside of traditional banking is, what some might call, a political statement or stand.
This entire new economy also provides investment opportunities (i.e. buying Bitcoin as it proliferates then selling before it hits bottom to earn a profit).
The anonymity behind cryptocurrency transactions is a huge deal for many…and it’s not just for the shady stuff. There are many instances in which anonymity is preferred — perhaps donations or funding.
It is important to note, however, that it isn’t all sunshine and rainbows — it is possible to ID blockchain users using external information. For reasons of security and privacy, many countries, including Canada, intend to create coordinated policies to regulate the use of blockchain.
Another massive bonus is how much this age facilitates trade. The blockchain is available to literally anyone with an internet connection. The trading is global and has private bookkeeping 🤯
We are also eliminating the middlemen with this approach. Bodies such as governments and banks all require fees in exchange for accounting or financial services. Bitcoin creates a network of computers that maintain a single source of truthful bookkeeping on the internet in a public setting.
The potential implications are massive — in an IOT (Internet of Things) future, machines will actively participate in economic traffic.
When you purchase Bitcoin, there are two types of exchanges that can take place. The first is Fiat to Crypto. This is when you exchange Fiat money for cryptocurrencies. The second is Crypto to Crypto. This is exchanging things like Ether for Bitcoin or vice versa.
On the topic of actually using Bitcoin, we must also talk about taxes. A user must pay taxes if money is earned with crypto, VAT exempt. However, if you hold on to your Bitcoins for over a year then you are exempt from taxes upon selling it.
Investing in Cryptocurrencies
When it comes time to invest in this technology, there are many facets to consider. I’m not going to pretend to be an expert on investing in crypto, but I can give some pointers of things to look for.
With cryptocurrencies, the market cap is the term used for the value of all the tokens of that currency available. One of the most effective ways to establish the value of crypto is to determine this.
Whitepapers are absolutely necessary to read. These are reports written by the currency’s issuing body that are meant to guide and inform its users about the issue the currency wants to solve and what their belief is.
Don’t get caught up in popularity of the coin — look into if it really is bringing utility into the digital currency economy. For example, Ethereum, a type of cryptocurrency, was the first to introduce a concept called “Smart Contracts.” Without getting into too much detail, these are cryptographic conditions used to facilitate transactions between parties. Here’s a really awesome summary of how it works:
A good idea is to practice purchasing and predicting crypto movements via a coin-buyer simulator.
Key Takeaways
There is still much to learn about cryptocurrencies. What types of currencies exist? How do the economics of the digital exchange work? How exactly does SHA256 work?
Cryptocurrencies have massive potential implications and are extremely interesting to learn about. Here is a compilation of some of the most important bits to remember:
- Cryptocurrencies are decentralized digital currency
- Blockchain is a decentralized and distributed public, digital ledger
- Transactions are verified on the blockchain via miners
- Security mechanisms like PoW and hash systems exist
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