The Blockchain For Dummies Guide — Part 6
RECAP: In Part 5, we talked about currencies, how they came about, and what’s needed for an effective currency. We also talked briefly about how blockchain is an effective platform for controlling the “inflation” of digital data.
In this post, we’ll talk about how with blockchain and some creative architecture, we have all the necessary ingredients to create effective digital currencies.
We’ll also explore how cryptocurrencies work, some of their potential use cases, and some of their inherent advantages over traditional fiat currencies.
How Cryptocurrencies Work
Cryptocurrencies are unique in the sense that they provide a way for enabling digital cash. If you recall in our previous post, the way that a currency is able to retain value is that its production or total supply must be either controlled or limited.
With a cryptoeconomic asset such as a cryptocurrency, rather than being controlled by a central bank, the currency’s supply is regulated by a scripting layer that operates over the blockchain (in the case of Bitcoin), or by a smart contract.
Smart contracts are essentially public codebases that establish the rules for a cryptocurrency such as transfer, supply, permissions, and governance features.
Instead of central authority governing the movement of the cryptocurrency, the currency is essentially pre-programmed and managed by the smart contract’s code. All users’ wallets interact with the smart contract when they initiate or receive transactions.
Within the scripting layer or smart contract, all the critical features of the currency can be specified, such as number of decimals for divisibility.
NOTE: While fiat currency is typically denominated with two decimal places, standard coins on blockchains like Ethereum typically are divisible up to 18 decimal places.
Currencies can be stored in a software application known as a wallet and each currency typically has their own wallet software. Some currencies are even compatible with physical hardware wallets that look like a USB stick.
When someone wants to make a payment using a cryptocurrency, they open their wallet software and enter in the cryptographic address for the receiving wallet they want to send the payment to.
This address looks like a random string of characters and numbers, but it represents a unique identifier for a recipient wallet address.
When the person initiates the transfer, the blockchain validators or miners check whether the initiating wallet has the right to send those funds, making sure the sender indeed owns the coins to be sent and the coins aren’t being double-spent from a previous transaction.
If the transaction is determined to be valid, it gets added to blockchain, with the receiving address being updated as the new owner of those particular coins.
Advantages Over Fiat Currencies
One of the main advantages of cryptocurrencies over fiat currencies is that they’re cryptographically secured to the wallet address that owns them. This provides an enormous amount of safety.
For example, if you took your normal everyday wallet and threw it off a bridge, the cash inside of it is gone forever.
Conversely, if you threw your laptop or cryptocurrency hardware wallet off a bridge, the cryptocurrencies contained therein are still owned and retrievable by you because they are still being tracked on the blockchain.
You could simply get another hardware wallet or re-download each cryptocurrency’s wallet software, enter in your private keys (known as the seed) for each wallet and your wallets would re-sync all of your owned cryptocurrency from the blockchain.
That is a dramatic improvement over everyday cash!
Of course, this comes with a disadvantage as well: you need to keep your seeds safely stored. If they’re ever lost or someone else got a hold of them, all of your crypto-cash could be lost forever.
Settlement Times
Another advantage is that cryptocurrencies can be settled a lot faster than fiat currencies. If you’ve ever had to send money overseas, you’re aware of the lag time involved, sometimes taking up to 5 days for funds to be received via the SWIFT system.
Unfortunately, through the current banking system, the fastest way to send money overseas is to literally put the money in a briefcase, get on a plane, and fly it there.
With cryptocurrencies, settlement time is only limited to the transaction time of the underlying blockchain, which can range from a few seconds to about 15 minutes on average.
There are number of other advantages of using cryptocurrencies that vary depending upon the specific cryptocurrency. Things like transaction anonymity, voting rights, and other cool features…which we’ll explore in the next post!
In Part 7, we’ll explore a few of the most popular cryptocurrencies out there today, how they work, and what their potential individual use cases are for the future.
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