What are Cryptocurrencies?

Explaining your biggest questions in plain English

Before we get started: in the interest of simplicity and brevity, there are details that I skip over. It’s not that I don’t know how that part works, I just want to give newcomers this overview without making them read for an hour.

Distributed Ledger Technology

The basis of every blockchain, no matter how complex, is a distributed ledger. In traditional finance, banks and financial institutions keep all their transactions on one or multiple spreadsheets called ledgers. We trust and pay banks to keep track of that spreadsheet and make sure malicious actors don’t tamper with it. Blockchains enable that ledger to be publicly available for everyone to see and even assist in processing transactions. Each blockchain is one big distributed ledger and when you contribute your computer’s computational power to process transactions, you get rewarded in the blockchain’s cryptocurrency. That transaction processing is what’s known as mining. The biggest benefits of distributed ledgers are being able to process transactions without having to trust a middleman, as well as enabling a high degree of interoperability between applications that plug into the various blockchains.

Bitcoin

With its first block being mined on January 3rd, 2009, Bitcoin became the first cryptocurrency. It was designed to be a way to digitally store value and be used as a financial asset. It also pioneered the distributed ledger technology now known as blockchain.

Anyone can contribute to the processing of Bitcoin transactions in the process discussed earlier called mining. Miners are rewarded in Bitcoin as a proportion of the computing power they contributed. This process is called proof-of-work.

As Bitcoin became more and more popular, its blockchain became more complex and therefore harder for computers to process transactions. This has led to many credible worries about the effects mining has on the environment. A single coal plant going offline in China temporarily killed one-third of Bitcoin’s global computing capacity. This complexity has also driven small-time miners away from Bitcoin, as it’s no longer profitable to mine unless you have expensive, highly specialized equipment.

As a reaction to these complications, Bitcoin has inspired several spinoff cryptocurrencies that made tweaks to the original code to make improvements in certain places.

• Bitcoin Cash: allows for block sizes of 32 MB over Bitcoin’s 1 MB
• Bitcoin Gold: tweaked mining algorithm to make mining a more even playing field for small-time miners.
• Litecoin: tweaked processing algorithm to allow for 4x faster processing time
• Dogecoin: highly similar to Litecoin but was created to poke fun at the speculation in cryptocurrency markets. 5 billion new Dogecoins enter circulation each year. It has gained popularity recently as a meme.

Ethereum

Ethereum took Bitcoin’s original concept of a distributed ledger and expanded on it with the integration of smart contracts.

What are smart contracts? Simply put, they’re a contract on the blockchain. In the real world, a contract is a legally binding document that says when one person does something, another person is obliged to do another and a third party agrees to make sure that obligation is carried out. So translating that onto the blockchain, it means when you perform one task, a pre-determined event will take place without the need of a third party to enforce. The most common purpose of these smart contracts is a transaction on the blockchain, which is what allows Ethereum to be a store of value. However, what really makes them revolutionary is that they can also facilitate other events such as voting in a DAO (if you don’t know what a DAO is, take a look at this article I wrote earlier in the week) or proving ownership over goods. Smart contracts also have several advantages over traditional contracts.

1. Smart contracts are administered automatically by the blockchain and don’t require a third-party authority to enforce it.
2. Smart contracts are coded like traditional software and are open-source (with some rare exceptions) this means that anyone with sufficient knowledge of how to develop on Ethereum can audit these contracts.

Smart contracts also have enabled several categories of decentralized apps (dApps):

• Tokens — Tokens are cryptocurrencies that are built on top of another blockchain. Instead of coding an entire blockchain themselves, developers of a token may simply write a smart contract on the parent blockchain that governs how they want their cryptocurrency to behave.
• Non-fungible tokens (NFTs) — NFTs have seen a massive increase in popularity recently. They are different from traditional tokens because instead of trying to be a currency, they prove ownership over a (usually digital) good. This is actually the answer to a common misconception when it comes to NFTs. Many people think that buying an NFT is buying the digital good directly, which isn’t entirely the case. What they’re actually doing is buying a smart contract grants them certain privileges relating to that digital object.
• Decentralized Finance (DeFi) — Decentralized Finance has a variety of applications, but the most common form this takes is a Decentralized Exchange (DEX). Decentralized Exchanges such as Uniswap and TraderJoe use smart contracts to facilitate financial transactions directly between two individuals or between an individual and an organization.
• Enterprise software — while no final applications have been released, large corporations such as IBM, Microsoft, JPMorgan Chase, Visa, and others have announced that they are developing and testing dApps based on the Ethereum blockchain for enterprise use cases.

Problems with Ethereum

As promising as Ethereum is as a project, there are two major problems with its platform at the moment.

The first problem is concerns over the environmental impact of mining Ethereum. Much like Bitcoin, Ethereum currently processes transactions using a proof-of-work algorithm. This comes with the same environmental concerns as Bitcoin. However, they are even more significant because Ethereum transactions can be even more complex and power-hungry. To fix these issues, Ethereum has plans to change its algorithm to what’s known as proof-of-stake. In a proof-of-stake system, miners must hold a certain amount of Ethereum to process transactions, and they can only process transactions as a proportion to the amount of Ethereum they hold. In addition to this, individuals can lend their Ethereum to miners in a process called Delegating to allow miners to process more transactions without having to purchase Ethereum themselves. In return, the miners give a portion of the rewards they receive back to the people who delegated their Ethereum to them. Ethereum’s plans to switch to a proof-of-stake system were supposed to be implemented last year but has since been delayed to the second quarter of 2022.

The second problem Ethereum faces is transaction fees. Transaction fees are a reality in any electronic payment processing system. However, as Ethereum gained popularity, its network became more congested and skyrocketed the cost of performing transactions on its blockchains. These transaction fees on blockchains are called gas fees and Ethereum has by far the highest gas fees of any popular blockchain with a current average of $35 — $50 per transaction. This means there’s a very high chance that the value of the transaction you want to perform is less than the cost of performing the transaction itself. This is another problem the move to proof-of-stake aims to fix, as it’s a significantly more efficient algorithm.

As a stop-gap solution for high transaction fees, several projects have sprung up that plug into the main Ethereum blockchain. These projects offload some of the processing from Ethereum and enables significantly lower gas fees. The two most popular of these solutions are Polygon and Loopring.

Other Blockchains

In the wake of Ethereum, there have been various projects that have sought to improve aspects of smart contracts, whether it be speed, security, or scalability. For the sake of brevity, I won’t go in-depth, but many of the core concepts from Ethereum apply to these blockchain projects. Some of the most popular of these are:

• Binance — more centralized than many other blockchain projects, organized under a single company’s brand.
• Avalanche — heavily based on Ethereum but optimized for significantly faster transaction speeds.
• Solana — another project heavily based on Ethereum that is also optimized for faster transaction speeds.

Conclusion

Blockchain technology is incredibly fascinating, so it’s no wonder that there’s so much excitement around it. Possible applications of distributed ledgers have only begun to be explored. It seems like every day there’s a new startup who has come up with a new way of doing things on the blockchain and it’s so much more interesting than just a shiny new financial asset.