Insert the word "cryptocurrency" into a conversation and you'll undoubtedly hear a flurry of differing opinions. Some will say that this is the biggest technological breakthrough since the launch of the Internet, others will say that it is a scam. But how many people are actually able to explain what it is?
Thanks to Bitcoin, the word has found its way to unexpected places, including nursing homes, where it has infiltrated the conversations of grandmothers discussing the morning news.
But here's the thing. Even though Bitcoin and cryptocurrencies have exploded onto the news, boardroom agendas and billboards, most people still don't have a clear understanding of what they're talking about.
So, it's time to get to know this phenomenon better.
Definition of Cryptocurrency
In the name alone you can see two clues that can be easily deciphered: “crypto” and “currency”.
“Crypto” refers to cryptography, which is the practice of encrypting plain text or data by turning it into an unrecognizable and incomprehensible form. Only if the intended recipient is able to decipher this code, having a confidential and secure means of exchanging information, will he be able to extract the information.
The word "currency" is traditionally associated with the monetary units of a particular state, but in fact, a currency is any system of money used as a medium of exchange.
Put this together and you have cryptocurrency, a digital form of currency where cryptography governs the creation of new funds and also enables transactions.
So, is cryptocurrency just an encrypted form of digital money?
You can't go wrong with this answer, but it sounds pretty unhelpful. To understand why cryptocurrency is so much more than just encrypted money, let's go back a few years.
Legal status
States have different attitudes towards Bitcoin - from complete rejection and even ban to encouragement. In those countries where transactions with crypto are legalized, digital money is regarded as investment assets or goods. In Germany and Japan, BTC is recognized as a unit of account. But in China, cryptocurrency transactions are allowed only to individuals.
Switzerland is considered the most loyal, where Bitcoin is accepted on the same terms as foreign currency. It is believed that Switzerland is the most favorable environment for launching blockchain startups.
In Russia, discussions about cryptocurrencies have been going on for a long time, but they have not yet been assigned a specific status, although most officials speak in a negative way.
Where did cryptocurrency come from?
The fact is that cryptocurrencies are not the first form of digital money. Attempts to create digital currencies began in the early 90s, but all these inventions could not compete with electronic bank money or third-party systems such as PayPal.
David Schaum paved the way for digital currency when he launched DigiCash in 1989. It was an electronic network used to send currency anonymously. Ten years after DigiCash's bankruptcy, we saw the likes of E-gold and Liberty Reserve also go bankrupt after facing criminal charges. Soon the idea itself began to seem far-fetched and unrealizable to people.
Why did all this fail? You can just remember the saying that the first pancake is lumpy. But a more plausible explanation is that there was no demand for digital currency because e-commerce had not yet arrived on the scene, nor had widespread internet access.
Now fast forward to 2008. Then a mysterious figure known as Satoshi Nakamoto gave a new explanation for the previous failures: all these systems were centralized and therefore based on trust. And, according to the enigmatic Nakamoto, this was the biggest problem.
A detailed explanation can be found in a document written by Satoshi in 2008: Bitcoin: A Peer-to-Peer Electronic Cash System. In it, Nakamoto identified two fundamental problems: the operation of conventional financial systems and the properties of fiat currency (for example, the US dollar).
Stablecoins
A stablecoin is a cryptocurrency whose value is tied to the value of a real asset. A striking example is the Tether coin (USDT), the rate of which is always 1 dollar, plus or minus a fraction of a percent.
The purpose of creating such currencies is to eliminate volatility - one of the main disadvantages of digital money. However, this also has its drawbacks: the principles of decentralization and free price formation, originally inherent in the idea of cryptocurrencies, are violated.
What's the problem with regular money?
You may not have thought about it, but your assets in US dollars, pounds, euros or any other fiat currency make you dependent on the government. Most of these currencies once represented real tangible assets (like gold), but those days are long gone and cash has no value other than your belief in it. This is why any government can easily manipulate your funds and thus interfere with your personal life.
And governments actually do this: they devalue currencies by printing billions of new banknotes to curb inflation or to gamble with interest rates. The 2008 Global Financial Crisis and its aftermath is an example of how governments can manipulate our money supply and economy.
Bank fraud led to the financial crisis, but instead of being punished, the banks received $4 trillion in loans. from the US government. The Fed's magical Quantitative Acceleration program made it possible to do this by buying securities from the market to lower interest rates. Instead of allowing the US economy to recover naturally, the government pumped borrowed money into the very institutions that caused the depression.
Given that fiat currency itself is problematic, what about the centralized systems we use to store and transfer money, such as banks, trusts, and online transfer services? They are also, to put it mildly, imperfect.
Here are some of the problems with centralized systems:
- high transaction fees;
- fraud;
- based on trust (you trust that the bank or service you choose will act honestly, ethically, transparently and always keep your assets safe).
But can we trust an economy controlled by governments and banks? This was in doubt even before 2008, and the global financial crisis was the last straw. But what is our alternative?
A decentralized system that does not rely on trust and is not subject to outside influence. You guessed it right: it's a cryptocurrency.
Advantages and disadvantages
Advantages of digital coins:
- Anonymity.
- Inflation resistance.
- Transparency of all operations.
- No geographical restrictions on payments.
- Commissions for cross-border transfers are significantly lower than those of banks.
Cons of cryptocurrencies:
- Scalability issues, causing transactions to become slower as the network grows.
- Complexity of development, small number of blockchain specialists.
- High volatility, difficulty in predicting prices.
- Lack of recognition in most countries of the world.
- Regular break-ins and hacker attacks, many fraudulent projects.
It is worth noting that most of the shortcomings can be eliminated by improving the code, and the developers are actively doing this.
Cryptocurrencies are decentralized
With cryptocurrencies, new coins are systematically and transparently created by the system. Take Bitcoin: its infrastructure guarantees that only 21 million units will ever exist. Now compare this to the random expansion and contraction of the supply of fiat currencies such as the euro at the hands of governments and central banks.
So how does cryptocurrency work?
In concept, everything is good and almost clear, but how does it work in practice and is it technically implemented? Cryptocurrencies are based on a breakthrough technology called blockchain.
A blockchain is a network of several thousand computers (nodes) that collectively store information. Every time a transaction occurs on the network, a majority of nodes must agree that the transaction is legitimate. In this way consensus is achieved. Each block then securely seals the communication information with the new block.
As long as 51% of nodes remain legitimate, you have a system that reliably records transactions without bias or fraud. Blockchain networks have a number of ways to incentivize their users to ensure system integrity.
Bitcoin, for example, offers a portion of bitcoins to its miners, who solve computational puzzles to expand the network and verify transactions. This process is known as proof-of-work, but realities are constantly changing, and with the advent of new blockchains, several alternative consensus mechanisms have been developed. Some other consensus systems in use today are Proof-of-Stake, Byzantine Fault Tolerance (BFT), Directed Acyclic Graph (DAG), and Hybrid Consensus.
A simplified explanation would be: blockchain supports a decentralized, immutable, trustless network where transactions cannot be counterfeited and funds cannot be double-spended.
Cryptocurrencies are means for transactions in decentralized applications that are built on blockchains.
Storage
Many cryptocurrency owners prefer to store it on an exchange. Since modern exchanges support a large number of altcoins, this storage method is quite convenient. However, this storage method has one significant drawback - you have to trust the funds to a third party.
With the development of the cryptocurrency market, new storage methods are emerging. Today, there are four most common methods of storing digital currency:
- Paper carrier. It contains the wallet address, key and other information, without which access to digital assets is impossible.
- Local wallet. This is special software that can be installed both on a computer and on any portable device (for example, a smartphone). The currency is stored directly on this device.
- Hardware wallets. All information about a cryptocurrency account is stored on a device similar to a USB flash drive, without connecting to the Internet.
- Online wallet. It can be either simply an online resource for cloud storage or serve as an exchange, with the ability to store and trade.
All options have their advantages and disadvantages. The choice depends on the convenience required by the particular owner.
The evolution of cryptocurrencies
Having formulated the essence of the “correct” currency and created the blockchain, Nakamoto became the founding father of the first cryptocurrency - Bitcoin. Mining of the first block took place in January 2009, and the following text was encrypted in it, referring to the financial crisis: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Goodbye banks; hello bitcoin.
As with any innovative technology, followers are not far behind the pioneer. Less than ten years after the invention of Bitcoin, you can see over 1,500 cryptocurrencies in circulation with a total capitalization close to $500 billion (at the time of writing).
Competition is high, coins compete, wanting to grab a bigger piece. You should remember at least five representatives of this space: Bitcoin, Ethereum, Ripple, Bitcoin Cash and Litecoin. These five giants occupy the majority of the market. If you want to learn more, check out the top 50 cryptocurrencies.
The basic idea of Bitcoin is quite simple, as it is primarily a means of storing and exchanging value. However, this is just the tip of the iceberg as cryptocurrencies have other functions as well.
Recently, innovators have come up with entirely new uses for cryptocurrencies, many of which Satoshi may not have imagined in his wildest dreams.
Take the second largest cryptocurrency, Ethereum. Vitalik Buterin invented this platform in 2013. Unlike Bitcoin, Ethereum is designed to allow the creation of dapps (decentralized applications) and smart contracts based on it.
Bitcoin itself was essentially a dapp designed to serve a specific purpose (a decentralized p2p system for exchanging digital currency). Dapps work on blockchains, just like PC programs are created for Windows or other operating systems.
Instead of creating a new blockchain every time someone wants to create their own dapp, they can use the existing Ethereum infrastructure. Compare building a house on your own in an open field with hiring a team of professionals who thought of everything for you. Ethereum has made it possible for almost anyone to create their own cryptocurrencies and dapps without much hassle.
It's no surprise that there are hundreds of cryptocurrencies built on Ethereum, with individuals, institutions, and startups coming up with all sorts of creative uses for the platform. This is the path of least resistance.
However, many have done the hard work required to create their own blockchains. For example NEM, NEO, Qtum or Litecoin.
For what? While it is relatively easy to create a cryptocurrency or dapp on an existing platform, you will be limited by the capabilities of that platform and the rules it sets. This is why serious projects often prefer their own blockchains.
Peculiarities
Let's name some of the main features of cryptocurrencies compared to regular money:
- Lack of a central governing and issuing authority.
- Anonymity. The owner can only be determined if the wallet was used publicly.
- Transparency of transactions in the blockchain. The history of transactions is available to everyone, but it is impossible to understand who is behind them.
- Speed. A few minutes are enough to transfer cryptocurrency from one end of the world to another. At the bank, this process will take several days.
- Small fees compared to bank transfer.
How can you use cryptocurrency?
We get it that Bitcoin and Ethereum are revolutionary, but what are the benefits of cryptocurrencies in practice?
What makes cryptocurrencies useful is not so much the goods they can buy, but the solution to the problems they solve. This is the core value they provide to the end consumer. It is no coincidence that the most valuable cryptocurrencies are innovative.
Take Bitcoin, which has revolutionized the way we transact and store value by allowing us to send money to anyone, anytime, anywhere, without any permissions.
Like any great idea, Bitcoin has a number of followers who want to improve on what it has achieved. Players such as Litecoin, Dash, IOTA and Ripple have quickly entered the scene, offering faster transactions at lower costs, improved scalability and energy efficiency.
Although to some extent these altcoins are fighting to become the most popular payment system of all, nuances keep them in different markets. For example, Monero is a tracking-protected cryptocurrency with anonymous transactions, allowing users to keep their transactions private and maintain balances without the fear of third parties finding out.
The first and most obvious use of cryptocurrencies is for payments, with a growing list of companies accepting Bitcoin to pay for goods and services, and cash-out ATMs located around the world. The race is on to create a standard form of payment using cryptocurrency debit cards, such as Bitpay, that will allow their owners to pay for purchases through regular terminals in stores.
While this is all great, blockchain technology is not limited to the financial sector. It can be used to solve many problems that exist in today's digital world. Therefore, now we can see hundreds of new projects with truly incredible ideas.
Following Ethereum, dozens of smart contract platforms have been created, offering innovative solutions to problems related to agriculture, medicine, IT, logistics and almost every other sector.
For example, Sia allows you to rent out unused hard drive space. In exchange for connecting this empty space to the blockchain, you will receive some Siacoin, the project’s own cryptocurrency.
Something to note here is the difference between coins and tokens. Coins exist solely as a form of digital money on their own blockchains. Bitcoin and Litecoin are prime examples of coins.
Tokens occupy a different niche and serve alternative purposes - for example, representing a digital asset, a share, a fee for using the system, etc. Dragonchain, Waltonchain and Civic are ERC20 tokens. This means that they exist on the Ethereum blockchain, and they all serve the corresponding utilities provided by the project.
It is important to note that the utility of a cryptocurrency is its main characteristic: if a token has a practical application and solves an existing problem, it is likely to increase in value.
At the same time, many worthless coins ended up receiving more than they should have. For example, Dogecoin was originally a joke cryptocurrency with no value or real market application. With a market capitalization of around $600 million (at the time of writing), it may be the world's most profitable joke.
Despite some low quality projects (or joke projects), it is fair to say that cryptocurrencies do not exist in a vacuum, but depend on the value of the decentralized application, platform or blockchain on which they are based.
As you reflect on what you've read, you'll likely begin to realize that cryptocurrency is just a great idea. So why is it ten years later and we still aren't buying hamburgers with Bitcoin?
Problems of mass acceptance of cryptocurrency
Despite all its revolutionary properties, the cryptocurrency industry faces a number of problems that make mass acceptance a slow and even somewhat painful process. Let's look at the biggest hurdles that cryptocurrencies must overcome to gain mass adoption.
Stability is important in any payment method. The volatility of most cryptocurrencies is scary at times: they can drop or rise in value significantly in a matter of minutes. This is a good opportunity for investors, but the average merchant or consumer will not resort to cryptocurrencies precisely because of such risks.
Speed and transaction costs are another disadvantage. Few coins can compete with payment systems like Visa. For example, a Bitcoin transaction now takes about an hour on average, and the commission exceeds $15. This makes Bitcoin useless for everyday transactions. It's hopelessly slow and too expensive for small purchases. Not to mention the problem of scalability, which does not allow networks to process a large number of transactions in a certain period of time.
Then there is the question of safety. Millions of dollars worth of crimes have already occurred in the crypto space, such as the hack of the Mt. Gox. Plus, users do not always use cryptocurrency correctly. While cryptocurrencies themselves are incredibly secure, the “security” is still evolving. Think about email: it took decades for users to learn how to recognize spam, infected and phishing emails.
The way new cryptocurrency projects raise funds has prompted increased scrutiny and led to discussions about regulation. China and South Korea have banned their citizens from participating in ICOs, and a number of other countries may well follow suit.
For what? Unfortunately, a few scammers have managed to rip off quite a few people by offering “new coins.” Legitimacy is key to the acceptance of cryptocurrencies, and cowboy-style antics give them a bad reputation and create skepticism about the long-term viability of the technology.
Even after the ICO issue is settled, the legality of using cryptocurrencies will continue to be questionable. Officials will not approve of citizens using cryptocurrencies to evade taxes or finance criminal activities.
