The Basics of Crypto — For Dummies
A basic introduction to the world of Bitcoin and cryptocurrencies.
Cryptocurrencies are becoming very popular. Whether it’s to invest or just plain curiosity, more and more people are becoming interested in learning about them.
I currently work in the cryptocurrency industry. Read my recent blog article to learn a bit more about what I’m involved in. However before I started working for my current employer, I became fascinated with this space and I learned a great deal about it.
I know this can be a complicated subject and a bit overwhelming. I’d like to share some aspects that I believe are basic for anyone wanting to learn more about crypto.
This article is definitely not to provide financial advice; its purpose is to educate. I think it’s an understatement to say that what I write about here is just the tip of the iceberg. Not everything will make sense to you, and that’s ok, but hopefully this basic introduction can help you continue with your own research.
What is Bitcoin and how does it work?
In 2009, right after the Great Recession, a yet to be identified person (or group of people) with the pseudonym Satoshi Nakamoto revealed Bitcoin to the world. Just a few years after that, alternative cryptocurrencies emerged along with new applications, other than just forms of payment. It was quickly becoming clear that the technology behind Bitcoin had potential for innovation. As ominous as the way it was created sounds, Bitcoin has stood the test of time, and there is no doubt in my mind that it is here to stay. But, what is it exactly?
Strictly speaking, Bitcoin is a digital form of payment that uses the distributed ledger technology called blockchain. What makes it different from traditional forms of payment is that Bitcoin functions with no central authority; in other words, it’s decentralized.
The word blockchain derives from how the technology works. Approximately every 10 minutes, various transactions in a public digital registry are grouped together in blocks to be verified, mostly to prove that they really were generated by the parties that claim they did. Every verified block is tied together in a digital chain; hence the word blockchain. Instead of relying on centralized institutions, like banks, independent entities use specialized computers, called miners, to perform complex mathematical calculations that can accurately verify everything. Thanks to the cryptographic nature of the technology, all this can be done without publicly revealing sensitive information about the user.
The incentive these independent entities have to give their time and energy to validate transactions is that they get rewarded, in Bitcoin, for doing so. This creates a virtuous cycle; people can generate income and at the same time they maintain the network.
Mining, also known as Proof of Work, does bring a fresh supply of Bitcoins to the network, but there will only be so much that can exist, 21 million to be exact. It is estimated that the last Bitcoin will be mined in the year 2140, so this practice still has a long way to go. Actually, Proof of Work isn’t the only way blockchain networks are maintained. New and even more efficient methods have been gaining traction. I’ll describe one in particular next.
Proof of Work vs. Proof of Stake
Proof of Work is a consensus mechanism. That is, it is a way to determine which decentralized entities will be validating transactions in a blockchain network and in what order. Basically, the network selects miners based on their computing power. So, the more computing power a mining operation has, the more likely it is to be selected to validate transactions, and thus earn Bitcoin in the process. This naturally creates the incentive for these operations to increase their computing power and consequently, their electricity consumption.
It’s no surprise that there are a lot of activists claiming that Bitcoin is a burden to the environment. I personally think this is a bit extreme. There is evidence that proves that Bitcoin mining is much less energy intensive than gold mining or operations in traditional finance and mining with renewable energy is becoming more popular, but I digress.
In any case, another, more efficient consensus mechanism already exists; it’s called Proof of Stake. The way it works is the network selects which independent entity will validate transactions based on the amount of the native token, or “stake”, it has. For example, the native token of a popular Proof of Stake crypto called Solana is SOL, just like BTC is for Bitcoin. Like in Proof of Work, Proof of Stake has decentralized entities that use computers to validate transactions and they’re rewarded in the native token for their work. In this case they’re called “validators” and the incentive is to have a higher stake of the native token, rather than computing power, making the process much less energy intensive.
Validators even allow individuals to vote for them using the native tokens they hold and they get part of the rewards for doing so; a process known as staking. This vote counts towards the validator’s overall stake and the individuals, or “delegators”, don’t lose custody of their funds through this process. They just can’t use the funds for the period of time they’d like to receive rewards for. Delegators can choose to get out of staking, or to unbond their tokens, at any time. However, most networks don’t allow immediate access to them. Delegators need to wait a period of time before they’re able to use their funds. This is called the unbonding period and it varies depending on the network.
Staking is similar to putting your money into an investment account, but without relinquishing custody of your funds. It has become a great and relatively simple way to generate passive income. In the next section you’ll read about other interesting applications that can help increase your crypto wealth even further.
What is DeFi?
The term DeFi comes from Decentralized Finance and it refers to financial instruments that are able to function without relying on intermediaries, such as brokerages; in other words, they’re decentralized. This is possible thanks to blockchain technology.
As I mentioned before, new versions of Bitcoin have emerged that offer applications other than forms of payment. The best example is the second biggest cryptocurrency by market capitalization, Ethereum, which was the first to offer a programmable infrastructure. Ethereum introduced smart contracts, which are basically programs stored on the blockchain that run when predetermined conditions are met. They serve the purpose of normal contracts, but again, without the need of intermediaries. Thanks to this innovation, a variety of applications can be built using the Ethereum network that are similar to financial instruments. For instance, some applications provide access to loans without the need of paperwork or credit checks. You only need to have cryptocurrency to use as collateral and a smart contract takes care of the rest.
Another popular application is an Automated Market Maker (AMM). Just like traditional market makers do, AMMs let individuals provide liquidity to tradable assets. In the case of crypto, these assets are a pair of tokens that can be exchanged with each other; for instance, Bitcoin for Ethereum. The main purpose of providing liquidity to the token pair is to reduce slippage, which is the difference between the trade price and executed price of a tradable asset. Traders like this and decentralized exchanges, or DEXes, incentivize individuals to provide liquidity to token pairs, also known as liquidity pools, by giving them part of the fee they receive for each trade. This is all automated thanks to smart contracts.
Similar to staking rewards, liquidity providers get rewarded for putting their funds to good use. These rewards can be relatively high in some cases, especially for token pairs that just started trading. However, there are some risks associated with liquidity pools, mainly one called Impermanent Loss. I encourage you to learn more about this and other risks in DeFi before participating. Just like with any other asset class, it is important to manage risk when investing in crypto. Next I’ll cover a good resource to tap into that many consider can help reduce risk.
Stablecoins
The prices of cryptocurrencies are known to be quite volatile, similar to other risk assets like technology stocks. By prices I mean their exchange rate against traditional, or fiat, currencies, like the US dollar. This matters because at the end of the day, you still need fiat currencies to pay for things. There may be some things that can be exchanged for crypto, but it’s extremely limited at the moment. It’s not realistic to live off cryptocurrencies alone, at least not yet.
This is why it’s best to allocate a portion of your portfolio to stablecoins. These are cryptocurrencies with a price that’s fixed, or pegged, to the price of a fiat currency. Typically, they’re pegged to the US dollar; that is, each one is worth one dollar. Not all crypto exchanges enable conversions to fiat currencies, and some even limit the amount possible, but practically all allow converting any amount to stablecoins. Crypto transactions are relatively fast and easy, as long as they’re within blockchain networks. This gives crypto investors the ability to quickly capture profits or limit losses.
Most stablecoins are able to peg their value to the dollar by using low risk investment assets, along with cash, as collateral. Some options even use programmable algorithms instead of collateral. There is always the risk of stablecoins losing their peg. How much this is a risk mainly depends on the mechanism they use to achieve it. It’s also worth mentioning that governments, most notably the US, have expressed interest towards regulating stablecoins, but it’s difficult to know what the implications of this may be. I encourage you to research more about their risk profile before including any of them in your portfolio.
Again, this is not investment advice, but in my opinion USDC is one of the most reliable options out there, specifically because of the large amount of cash they use as collateral. Stablecoins with algorithmic pegs, like DAI, have also worked surprisingly well, but I personally prefer not to rely on them too much.
Now, let’s explore a slightly more exciting, and increasingly popular, sector in crypto.
NFTs and the Metaverse
If you’ve recently heard about cryptocurrencies, you’ve probably also heard the terms NFTs and the metaverse. You’ll find out why I lump these two together in this section in a bit. First, let’s explore what these mean.
NFT is an acronym that stands for Non-Fungible Token. Something that is non-fungible means it can’t be replicated and has unique value. For example, a one US dollar bill is fungible and it’s worth the same as another one US dollar bill. Inversely, a painting like the Mona Lisa is non-fungible since it can’t really be replicated, at least not the original, and there’s probably no other asset that has exactly the same value.
Like Bitcoin, NFTs are digital assets. Thanks to blockchain technology, NFTs can achieve and keep their uniqueness. The most popular applications are digital art, digital collectibles and video game items, but they’re definitely not limited to these. Another interesting application is shared property. Multiple users can easily share ownership of a digital asset, like a piece of music. This could, in theory, also be applied to physical assets, like buildings or vehicles.
The sky’s the limit on what NFTs can be used for. One use in particular has to do with the other term you’ve likely heard quite a bit about recently, the metaverse. This term was coined by Neal Stephenson in his 1992 cypherpunk dystopian novel, Snow Crash. He described it as a virtual reality space that could be accessed with 3D goggles, much like in another novel, and movie, you’ve probably heard about, Ready Player One. However, the metaverse doesn’t have to be as sophisticated. You’ve technically accessed the metaverse if you’ve ever been in a Zoom call. In the case of crypto, the metaverse is a virtual space, but mostly in the form of open world video games, similar to Minecraft or Roblox. The difference with crypto metaverses is that players own their profile data, along with their in-game items, which are in the form of NFTs. Users have complete custody of these digital assets and can even sell them in secondary markets. This ability is the key characteristic of a concept known as Web3.
Web3 basically refers to a new era of the internet. To understand it, I’ll explain how it compares to the previous eras, Web1 and Web2. Web1 goes back to the early days of the internet, when people mostly used search engines to find and read information online. Web2 started with social media, which allowed users to create profiles and easily publish content online, like blog articles or posts. Now with Web3, not only can users create their profiles online, but they can also basically own them.
As you can see, NFTs and the metaverse have a lot to do with each other, at least in crypto. They’re quickly becoming very popular, to the point that large brands, including Walmart, McDonald’s and Nike, are tapping into this space to create their own digital experiences. Time will tell if this is just a fad or if it defines the future of how we all interact online. A couple of things are for sure, this sector definitely has potential and it’s just getting started.
Is Bitcoin being replaced?
By now you may be asking yourself, if there are so many alternative and valuable applications for cryptocurrencies, is Bitcoin going away? The short answer is no. This is mostly because crypto is still a bit of an emerging, fringe, space. Most people that want exposure to this market, especially big investors, will probably want to limit their risk and start with Bitcoin. Any other cryptocurrency that is not Bitcoin is actually called an “alt-coin” and there are tens of thousands of options out there. Although a lot of them are promising, it will be extremely difficult for any alt-coin to take the large amount of wealth that Bitcoin holds, at least in the short term. There is currently a belief from many in the industry that Ethereum will eventually hold the number one spot in market capitalization. This is certainly a possibility but it definitely doesn’t mean that Bitcoin will disappear. At the end of the day no one really knows what will happen, but in my humble opinion, Bitcoin will have a long and prosperous life.
Bitcoin and cryptocurrencies have been around for more than a decade, although most people are probably just beginning to understand what they are. I hope I was able to help in anyone’s journey to get a basic understanding about this exciting new space. There is so much more to cover, such as how exactly you can get your hands on crypto or what are all the risks associated with this market, but just a bit more due diligence should be enough to fill these gaps. I’ll probably publish more articles about this subject in the future, so stay tuned. For now, thank you for reading and see you again soon.
Daniel Riojas is a Blockchain Marketer at stakefish. The views expressed in this article are solely his personal opinions and do not reflect those of stakefish. You should not treat anything written in this article as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of his personal opinion.
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