For most of us, cryptocurrency is still an elusive concept. It remains shrouded by complicated technical jargon & a cult-like following of investors that endorse cryptocurrency as the future of the modern financial world. Meanwhile, there are swathes of financial experts on the opposite side, that denounce it as nothing but overhyped digital nonsense.
- So, what IS cryptocurrency?
- How does it work?
- Is it really the future of finance?
The following article is designed to be the ultimate guide to the basics of cryptocurrency: covering everything from its history, to how it functions, all the way through to a rigorous analysis of its potential upsides and downfalls.
This comprehensive guide will help you cut through the noise surrounding cryptocurrency and give you a detailed analysis of the most important elements, so that you can make better informed decisions about whether Bitcoin, Ethereum and blockchain technology in general has any merit.
If you run a quick google search asking for the definition of the term: “cryptocurrency”.
This is your result:
A digital currency in which transactions are verified and records are maintained by a decentralized system using cryptography, rather than by a centralized authority.
That’s not particularly helpful…
In Much Simpler Words:
- A cryptocurrency is a code-based digital asset that sits on top of a network of computers that are distributed throughout the world.
- This is called decentralization.
- This decentralized structure allows them to exist outside the control of governments and central authorities like banks. Decentralization ultimately means that cryptocurrencies do not originate from one location, nor is there a governing body that can makes decisions about who can access it.
- The complex coding systems that power cryptocurrency and make them incredibly secure are called blockchains.
- Blockchains record, verify and store all the transactions that occur on its system. They are also called distributed ledgers. A ledger is simply a record of transactions. And all regular bank records transactions when you buy and sell stuff, it’s just that a cryptocurrencies ledger is split up and stored throughout a complex network of computers.
- Unlike paper & digital money, which are the regular dollars that populate your wallet and the numbers on the screen of your bank account, cryptocurrency is almost impossible to counterfeit or forge because the underlying blockchains are amazingly difficult to hack or change (a lot more on this later.)
Now, if that still doesn’t make a whole bunch of sense. Don’t worry. In order to truly understand cryptocurrency, we need to start at the beginning.
The very beginning.
Bitcoin was created in 2008 by an unknown person or group using the pseudonym Satoshi Nakamoto and they remains completely unknown to this day. Bitcoin first came to the attention of a very small cryptography community when Nakamoto released a paper titled: Bitcoin: A Peer-to-Peer Electronic Cash System.
However, it was on the 3rd of January 2009, that Nakamoto mined the very first block of the chain of Bitcoin, officially rendering it a real useable piece of technology (more on “mining” & “blockchain” in a bit). The earliest adopters of Bitcoin were given small amounts of the cryptocurrency by Nakamoto in order to figure out the bugs and for them to try and use it in the physical world as a real currency.
The first commercial transaction with Bitcoin occurred when a programmer called Laszlo Hanyecz purchased two Papa John’s pizzas for ₿10,000 which if you were translate that amount into today’s Bitcoin price, would be worth around about US$560 million…
To put the level of growth that Bitcoin has seen in perspective: if you’d bought $10,000 worth of Bitcoin back in 2011 at its lowest price of 30 cents, you’d have scored yourself a tidy $2 Billion today.
Anyways, after these super-early “proof of concept” transactions ensured that Bitcoin could be treated as a legitimate financial asset, it was then pretty much just used to purchase dodgy stuff on the internet. This was because it was practically impossible to trace and authorities at the time had no idea what a cryptocurrency was or what to do with it.
In 2011 the infamous black-market website Silk Road began to exclusively accept Bitcoins for online purchases. If you didn’t hear about it back in the day, Silk Road was notorious for selling drugs, guns, and other shady stuff you couldn’t exactly get from your local corner store.
This early function of Bitcoin created a certain notoriety in the finance world, which was one of the primary obstacles to it gaining traction as a valid method of exchange. It was written off by the general public and the world of institutional finance as: “that thing you can buy drugs with on the internet”. Today, less than 1% of the total supply of Bitcoin can be tied to illicit activity online.
Satoshi Nakamoto designed Bitcoin to decentralize money away from governments and central banks, and ultimately to be used as an alternative form of currency. However, as the rule of evolution dictates: as systems evolve, their functions change. And accordingly, the way people understand and use Bitcoin has changed over time as well.
Satoshi Nakamoto would have ideally imagined that by now, thousands of companies around the world would be utilising Bitcoin as a method of payment. However, the only major company on the planet that accepted Bitcoin: Tesla, recently went back on this decision citing environmental concerns.
This shows that there are still a host of problems centred around Bitcoin’s potential to be an accepted currency. So, if it’s not being used as a currency right now, how is it still growing in value to the tune of a 770% increase in 2020 alone?
Well, that’s because most investors would agree that Bitcoin offers some major innovations over traditional forms of investing. This has led a whole host of investors and financial institutions to approach Bitcoin as a “store of value” rather than a transactional currency like the US Dollar. Bitcoin, in its current form, is a lot more like gold. Digital gold.
This begs the question, why are so many people bothering with digital gold if there’s already physical gold?
Physical Vs Digital
To keep the stock market and the general economy functioning during widespread shutdowns caused by Covid-19, the U.S. government has printed over 3.9 trillion dollars. This represents a 26% increase in total money supply within a single year, the largest increase since 1928.
Printing new money is an incredibly effective way to stimulate the economy in times of fiscal decline. It keeps businesses going and temporarily prevents a major economic downturn by ensuring everyone has access to more dollars when they need them. However, while this is an alright temporary solution, there’s no such thing as a free lunch.
By increasing the amount of money available in the broader economy you simultaneously decrease the purchasing power of that money. This is called inflation. Because there’s so many extra dollars chasing the same assets this drives the prices of goods and services higher. You can expect to see high levels of inflation in the months and years following an enormous economic stimulus package like this one.
But what does any of this have to do with Bitcoin?
Well, when inflation increases, investors look to “safe haven” assets like gold to preserve the value of their money. This is because the value of gold is universally accepted by all countries and there’s an incredibly limited supply of it, so no one can make a lot more of it easily. Bitcoin cannot be created out of thin air either (unlike the U.S. dollar) and it has a production limitation of 21 million units meaning that it’s a finite resource, just like gold. Unfortunately for old school gold it has a bunch of problems that Bitcoin may be able to offer immediate and actionable solutions to.
Bitcoin: The Advantages Over Gold
- There’s no way to independently verify the entire supply of gold, whereas the entire supply of Bitcoin is immediately verifiable through the set of blockchain ledgers that it’s built on. Any financial institution can run a very check and find out what the total supply of Bitcoin is in a matter of seconds. This can’t be done with gold, as we don’t know how much is left in the ground or where every existing piece is at all times.
- It’s also quite hard to verify if gold is real. China’s largest jewellery company called Kingold Jewellery used 83 tonnes of fake gold to fraudulently secure a US$3 Billion contract that eventually forced the company to de-list from the Nasdaq and was done so at a loss to the tune of billions of dollars for investors. Fake gold has also made its way into the federal vaults of the United States and investment firms like J P Morgan. Bitcoin solves this problem by being instantly verifiable and being impossible to forge due to the near-unbreakable cryptographic code that it’s built on.
- Physical gold is also very difficult to transport, store and divide. You have to dig it out of the ground, refine it, smith it into bullions and then transport it to insanely expensive underground vaults via trucks that use real gasoline and require huge security operations to keep all of it secure. Bitcoin is easily divisible, instantly transmissible and can be stored safely by individual investors and giant investment firms alike.
Important Criticisms of Bitcoin
Power
Bitcoin uses lots of power. So much power in fact, that the sheer volume of fossil fuels being used in Bitcoin mining and transactions was reason enough for Elon Musk to discontinue its use for the renewables-focused Tesla. If the most crypto-positive businessman on planet earth can’t find a way to justify its use, it’s hard to imagine scenarios in the near future where anyone else will take it seriously.
So, until Bitcoin can rely solidly on renewable energy to power its mining and verification processes, it’s quite unlikely that any business will be willing to treat it as a legitimate form of payment. This also threatens the long term outlook of the asset, with an increased awareness of Bitcoin’s environmental impact, many investors are looking to other cryptocurrencies that provide more energy efficient and environmentally friendly alternatives
Volatility & “Bubble”-like Properties
Bitcoin is often viewed as a volatile asset that is completely separate from the regular stock market in the way that its price moves. However, if you see the graph below, you’ll find that Bitcoin has actually become increasingly correlated with the S&P 500 over time…
With this being said, Bitcoin and other cryptocurrencies are still treated as highly risk-laden assets because of how young they are as financial instruments. Because their value is so susceptible to “make or break” style news, like new announcements from governments and decisions made by major companies, they should be approached with a good deal of caution by regular investors.
If you do not have the propensity for a relatively high level of risk and are not alright with watching your portfolio move up and down in value by massive amounts on a weekly basis, then cryptocurrency may not be the best investment choice for you. Of course, if you think that the Bitcoin / broader cryptocurrency project is a good idea in the long term, then these day by day shifts won’t matter in the final analysis.
Bitcoin has also been attacked by investors and economists for being a “bubble” asset, meaning that it could pop at any moment. Because of Bitcoin’s 770% increase in 2020 alone, it leaves many investors fearful of an incredibly sharp crash in the near future, which occurred on May 12, 2021 where a combination of negative global announcements saw it shave 40% off of its total value within a week.
The Very-Recent China Problem
The brunt of this selling activity came from investors being concerned with China banning the use of Bitcoin back in 2019, and its subsequent announcement warning that any Chinese investor trading cryptocurrency will have 0 security or insurance on losses if they choose to do so. It’s fair to say that this scared a lot of investors and once people start “panic-selling” an asset, it can lose a lot of value very quickly.
So, is China’s recent stance a big problem for Bitcoin and cryptocurrency in general? From a quick glance, the answer is: not really.
Facebook, Amazon, Netflix, Google, Instagram, Snapchat, Twitter, Youtube, iTunes and Harrison Ford are all totally banned in China, and they seem to be doing just fine without the backing of direct Chinese capital. Obviously, there are flow on effects that come from these sorts of announcements, but we’ll address that later on in full in the Pros and Cons section…
Is Bitcoin a Good Investment in the Short Term?
All investment in new projects carries a heightened risk of having the rug pulled out at a moment’s notice. Ultimately the S&P 500 (the main U.S. stock market) and other large institutional stock markets around the world are far more stable day by day but are still vulnerable to enormous nosedives.
The vast increase in institutional money that is flowing into Bitcoin by the billion, shows that financial institutions around the world are beginning to recognise the upsides of the larger cryptocurrency project, or at least want to have some share in its potential success. This increases the security of the asset as more and more people begin to have a stake in its long-term success.
The only obvious ways that way the Bitcoin & general cryptocurrency “bubble” could be popped in a way that spells disaster for the asset, is if there was an extremely good reason for investors to flee the entire project: which would most likely be the revealing of a fundamental flaw in the way that blockchain technology operates. If someone were to prove that blockchain technology was vulnerable to attack by successfully hacking the Bitcoin blockchain then it would unravel the legitimacy of the entire cryptocurrency mission.
So, if a successful attack on a blockchain could render cryptocurrency useless, just how robust is blockchain technology? And is there cause for concern regarding its security?
To truly understand whether or not cryptocurrency is a valid long-term concept you have to understand the basics of blockchain. The blockchain technology that cryptocurrencies are built on, is the fundamental property that gives cryptocurrencies real value as assets. Whether or not a cryptocurrency has a sufficiently de-centralized, robust, and environmentally friendly blockchain will determine the future success of that cryptocurrency.
Blockchain isn’t one of these things that’s simple in reality but just obscured by overly technical crypto jargon, it’s a genuinely complicated concept to wrap your head around.
Regardless, here’s how blockchain works explained in the most straightforward way possible:
- Blockchain is a database shared across a network of computers.
- Users record their transactions on this database.
- Once a record has been added to that network it’s incredibly difficult to change.
- To guarantee that no one has come in and changed any of the entries in the database, the network makes constant checks to make sure that all of the records are the same.
Here’s what a transaction would look like on blockchain:
Step One
- A transaction or trade is made between two parties and the record of this is stored inside a block.
- The record lists the details of the transaction and contains a signature from each party.
Step Two
- The record is added to the network and checked by other computers.
- The computers in the network, called ‘nodes’, check the details of the trade to make sure that it is valid.
Step Three
- The records that the network accepts as valid are then added to a block.
- Each block contains a unique code called a hash code (which is visualised as the added # in the diagram below). Each block also contains the hash code of the previous block in the chain.
- The block is then added to the blockchain. These new hash codes connect the blocks together in a specific order.
Hash Codes
A hash code is created by a mathematical function that takes digital information and generates a string of letters and numbers from it.
Let’s take a closer look at two important characteristics of hash codes:
First, no matter what the size of the original file, a hash function will always generate a code of the same length. For example, a tweet that I make on Twitter is much shorter than the Bible, but they would both have hash codes of the same length.
Second, and most importantly: any change to the original input will generate a new hash. So, if someone decided to delete a single letter from anyone of the Bible’s 783,137 words, it would show up, because the new hash would change entirely.
Hash Codes Keep Blockchain Secure
- As we’ve just learned: a changed hash code breaks the chain.
- The next block in the chain still has the old hash, so to restore the functionality of the chain a hacker would have to recalculate that. And the next, and the next, and so on.
- Recalculating all those hashes would take an enormous amount of computing power. Like evil genius supercomputer level power.
Even if you were capable of taking over the Fugaku supercomputer in Japan and wield its awesome 7.6 million cores of processing power, it’s still pretty much impossible to successfully attack a sufficiently de-centralized blockchain.
Types of Blockchain
Now that we’ve gotten the real nitty gritty of blockchain out of the way, let’s take a look at the two main models of blockchain that cryptocurrencies can use:
- Proof of Work: This is used by Bitcoin & Ethereum.
- Proof of Stake: This is used by Cardano & Binance Coin.
In simple terms, Proof of Work and Proof of Stake are two different ways that you can mine cryptocurrencies.
Proof of Work
This model that requires computers to solve extremely complex cryptographic problems in order to generate new cryptocurrency and validate the transactions on the blockchain. This is what people are referring to when they use the term “mining”, because the computers are quite literally doing lots of work to create new cryptocurrency, the same way that physical labour is used to dig minerals out of the ground.
The upside of this model is that it guarantees an extremely secure blockchain network, constantly validated and secured by massive amounts of raw computing power. In order to hack a Proof of Work system the hacker would have to have a computer or more aptly, thousands of computers that are more powerful than 51% of the total network. This makes Proof of Work incredibly secure.
The downside to this, is that it requires dizzying amounts of computing power to mine new crypto and validate the transactions on the network. To put this in perspective, Bitcoin mining currently uses the same amount of energy as Argentina…
Proof of Stake
The Proof of Stake model, in very simple terms, only requires computers to validate new blocks rather than actually “mining” them, although the term mining is still used when talking about Proof of Stake. This stakeholder validation method is a good deal faster and uses substantially less energy. It is one of the largest and most obvious differentiators that you should consider when looking at a cryptocurrency.
How does it work?
Let’s say that you’re mining a Proof of Stake cryptocurrency. What happens when you do this, is the Proof of Stake system temporarily takes a sizeable chunk of your cryptocurrency for a few seconds and uses that as a form of insurance whilst validating and recording transactions. If you were a malicious hacker seeking to alter the blockchain then then your cryptocurrency would be immediately taken from you and it would disappear back into the network as a consequence. This heavily incentivizes users to make sure they’re doing the right thing, or they’re guaranteed to lose a massive chunk of their holdings.
To ensure long term security on the blockchain, an algorithm randomly selects which nodes and stakeholders can become validators for each block so that participants are unable to intentionally utilise large sums of the given cryptocurrency to sabotage the blockchain.
The same way a Proof of Work system requires the hacker to have control of more than 51% of the total computational power of the blockchain, a Proof of Stake system can only be hacked if the stakeholder holds more than 51% of the entire supply of coins on the network. The randomized algorithmic selection process mentioned before, ensures that 51% of the total sum of coins will never be used in the staking process.
Because of Proof of Stake’s less computing intensive model, it requires nearly 99% less energy than a Proof of Work system. It also means that smaller, individual stakeholders have a much higher potential to earn more crypto without possessing computer farms the size of small countries. This makes a Proof of Stake model more enticing to smaller holders.
It’s still early on in the development phase for Proof of Stake, so there is bound to be some security concerns surround the staking model, however it is quickly becoming the preferred option among professional investors and cryptocurrency pundits alike.
The second largest cryptocurrency in the world: Ethereum, is in the process of transition from a Proof of Work model to Proof of Stake. If Ethereum can successfully do so and ensure security across the board against the variety of unknowns that still deter wide-scale adoption of Proof of Stake systems, then it will gain an enormous leg up in the current market of companies looking to cryptocurrencies to process payments.
Now that we have learned about the origins of cryptocurrency and understand the basics of how blockchain technology works, it’s about time that we delved into uncovering the wider world of cryptocurrencies, starting with Bitcoins younger counterpart: Ethereum.
Ether and Ethereum are two separate terms that often used interchangeably but are actually two separate things. Ether is the native cryptocurrency that runs on the Ethereum blockchain, it is the fuel that keeps Ethereum network running. Users of the Ethereum network need to pay fees in Ether, which is the incentive for miners. Ether is currently second largest cryptocurrency in the world with an approximate market cap of US$406 Billion, which is nearly half that of Bitcoin.
- &
- 000
- 2019
- 2020
- 7
- 9
- access
- Account
- Adoption
- algorithm
- All
- Amazon
- among
- analysis
- Announcement
- Announcements
- around
- article
- asset
- Assets
- Bank
- Banks
- Basics
- BEST
- Billion
- binance
- Binance Coin
- Bit
- Bitcoin
- Bitcoin mining
- Bitcoin Price
- blockchain
- blockchain technology
- board
- body
- bugs
- Bunch
- business
- businesses
- buy
- capital
- Cardano
- Cash
- Cause
- caused
- Central Banks
- change
- Checks
- China
- chinese
- closer
- code
- Coding
- Coin
- Coins
- commercial
- community
- Companies
- company
- computers
- computing
- computing power
- contract
- Counterfeit
- countries
- COVID-19
- Crash
- crypto
- cryptocurrencies
- cryptocurrency
- cryptography
- Currency
- Current
- Database
- day
- deal
- Decentralization
- decentralized
- Development
- digital
- Digital Asset
- digital currency
- digital gold
- Digital Money
- disaster
- Dollar
- dollars
- Drugs
- Early
- Economic
- economic downturn
- economy
- Effective
- Elon Musk
- energy
- environmental
- Ether
- ethereum
- ethereum network
- evolution
- exchange
- experts
- fair
- fake
- Farms
- Federal
- Fees
- Figure
- finance
- financial
- Financial institutions
- fine
- First
- flaw
- flow
- For Investors
- form
- Free
- Fuel
- full
- function
- future
- General
- Global
- Gold
- good
- goods
- Google Search
- Government
- Governments
- Group
- Growing
- Growth
- guide
- hack
- hacker
- hacking
- hash
- head
- High
- history
- How
- hr
- HTTPS
- huge
- ia
- idea
- Impact
- Increase
- inflation
- information
- Institution
- Institutional
- institutions
- insurance
- Internet
- investing
- investment
- investor
- Investors
- IT
- Japan
- Labour
- large
- learned
- Led
- Ledger
- Level
- Limited
- Lists
- local
- location
- Long
- LP
- major
- Market
- Market Cap
- Markets
- medium
- million
- minerals
- Miners
- Mining
- Mission
- ML
- model
- money
- months
- move
- MS
- Nasdaq
- Near
- Netflix
- network
- news
- nodes
- Noise
- numbers
- offer
- Offers
- online
- online purchases
- Operations
- Option
- order
- Other
- Outlook
- Paper
- Pay
- payment
- payments
- People
- perspective
- planet
- portfolio
- power
- price
- Production
- project
- projects
- proof
- property
- public
- purchase
- purchases
- Randomized
- Raw
- Reality
- records
- renewable energy
- resource
- Risk
- Run
- running
- S&P 500
- Satoshi
- Satoshi Nakamoto
- School
- Screen
- Search
- security
- sell
- sense
- Services
- set
- Share
- shared
- Short
- Silk Road
- Simple
- Size
- small
- snapchat
- So
- Solutions
- SOLVE
- split
- stake
- Staking
- start
- States
- stimulus
- stimulus package
- stock
- stock market
- Stock markets
- store
- success
- successful
- supply
- system
- Systems
- talking
- Technical
- Technology
- temporary
- The Basics
- time
- top
- trade
- Trading
- traditional forms
- transaction
- Transactions
- transport
- treat
- tweet
- u.s.
- U.S. government
- United
- United States
- us
- US Dollar
- users
- value
- Verification
- volume
- Vulnerable
- Wallet
- Website
- week
- weekly
- WHO
- within
- words
- Work
- works
- world
- worth
- year
- years
- youtube