What is Cryptocurrency? A beginner’s guide to Blockchain, Bitcoin, and Ethereum
Unless you have been lost in the Himalayas, you must have heard of the word “cryptocurrency” somewhere: in a social setting, on the news, or during a conference (like the ongoing Singapore FinTech Festival) — but you may be unable to really grasp what this word means. Very simply, “cryptocurrency” is made up of two words — “cryptography” and “currency”.
What is cryptography?
Cryptography is an advanced encryption method to protect the transmission of information and communications using mathematical algorithms so that only the intended recipients can read and process it.
Cryptography converts plain text into unintelligible texts and allows only the intended recipients to decipher the unintelligible texts back to plain text. It aims to achieve 4 main objectives:
1) Confidentiality — Information is transmitted in a way that cannot be understood by others.
2) Integrity — Information cannot be altered during transmission or in storage.
3) Non-repudiation — Sender is not allowed to backtrack or change the original intention of creating or transmitting the information.
4) Authentication — Sender and recipient can verify each other’s identities and the destination of the message to ensure that the information is transmitted to the right intended party.
What is currency?
Most of us know what currency is, it is sometimes loosely used interchangeably with money. Currency is the medium that people use to exchange for what they need (e.g. paying $5 for a cup of coffee). It can exist in tangible form like notes and coins or virtually. Currencies are typically issued and backed by a central government and deemed the legal tender for goods and services in a country.
This brings us back to the original question of “what is cryptocurrency?”. Cryptocurrency is thus digital money that can be used to make payments (virtually) in exchange for goods and services. The creation of, and transactions in relation to, cryptocurrencies are conducted through cryptography and logged on a blockchain network.
There are two main types of cryptocurrencies —
1) digital money where the objective is to be used for payments
2) utility currency where the objective is to provide services.
I’ll further elaborate on each type of cryptocurrency later on in this article. But first, let’s explore what’s blockchain.
What is blockchain?
Blockchain is simply what the word means — a chain of blocks chained together. From a cryptocurrency perspective, it means that it is a chain of blocks of transactions that have occurred for a cryptocurrency.
Imagine that each block is a page documenting the transactions that occurred, the blockchain is merely the book that contains all the pages. It provides the story of all the past transactions and will continue to document future transactions. It is essentially a ledger containing all the transactions for a cryptocurrency.
How does blockchain make cryptocurrency different?
In traditional finance, we use currencies in a centralised model where the value of the currencies is based on our trust in the government, and the intermediaries (for example, banks) to keep an honest ledger of the amount of assets we have.
Whenever we purchase anything (using cash/credit card for a cup of coffee), we trust that the cash that we hand over will be accepted or the credit card issued by the bank will be validated. However, this model relies heavily on the central authority which makes the authority very powerful, and that power can sometimes be corrupted. This is where cryptocurrencies aim to be different.
Cryptocurrencies are built and distributed utilising a publicly distributed blockchain where anybody can access and see the transactions. By making the ledger public, each transaction will be broadcasted to everyone in the network.
It eliminates the need for a central ledger that is controlled by a central party or intermediary because there is no need for an intermediary (banks) to validate any transactions. Each block of transactions is validated by “miners” of the blockchain.
Fun fact 1: Anybody can be a miner (no, you do not have to be physically fit nor have a post-doctorate degree in computer science). Miners are people who validate transactions and add blocks of transactions to the blockchain. They are rewarded with cryptocurrency for the work they put in to validate transactions and upkeep the integrity of the blockchain.
What is Bitcoin?
The first cryptocurrency that was created using blockchain technology is Bitcoin (BTC). Bitcoin was created in 2008 by an unknown person or a group of people using the name Satoshi Nakamoto (I personally hope that Satoshi Nakamoto is a woman or a group of women — just to shock the world a little J). There are around 6000 different cryptocurrencies currently and BTC has the largest market capitalization of $1.184 trillion USD.
Fun fact 2: Bitcoin can be split into smaller units called Satoshi. 1 BTC = 100 million Satoshi
Bitcoin falls under the first category of cryptocurrency mentioned above. It serves as a decentralized digital currency where users are able to send BTC to each other on the BTC network without the need for a central intermediary. The transactions are validated by miners and recorded in the public distributed ledger for BTC. These miners are rewarded with BTC for the work they do.
The price of BTC, as with many other things in the world, is determined by its supply and demand. BTC has a maximum supply of 21 million coins and there is a halving schedule where the supply is halved around every 4 years. With this schedule, it is estimated that all the 21 million BTC will be in circulation by the year 2140.
With a maximum supply and scarcity effect in place, Bitcoin is often seen as a hedge against inflation and digital gold. This is distinct from some other traditional currencies (for eg USD) where there is no maximum supply and the government seems to be able to print as much money as they want, which may result in hyperinflation and a loss of trust in the currency.
What is Ethereum?
The leader (at least currently) of the second type of cryptocurrency and is also the second-largest cryptocurrency by market capitalization ($493 billion USD) is Ethereum (ETH). It was created by Vitalik Buterin in 2014. Ethereum is more than just a currency. It is also a platform for executing smart contracts where developers are able to build decentralised applications (dApps) and deploy them on the Ethereum network.
Hold on… what are DApps?
As the name explains, DApps are applications that do not have a centralised intermediary governing the applications. These applications run on a blockchain network that is public and not controlled by a single authority (in contrast to Facebook controlling the Facebook application).
… And smart contracts?
Smart contracts are the same as contracts we deal with in our daily lives but in this case, they are digital and the intermediary is removed. As smart contracts are operated on the blockchain, they cannot be changed (immutable) and are publicly validated.
For example, when you buy insurance from an insurance company, the insurance company pays you when an event under coverage occurs. This means that the payout is heavily reliant on you trusting the insurance company for claims. In smart contracts, these terms are pre-coded and cannot be changed. When the event occurs, the payout will happen without going through any intermediary.
Using DApps and smart contracts, developers are able to build a marketplace on the Ethereum platform. Examples of dApps are decentralised exchanges, decentralised lending and borrowing services, and decentralised gaming applications.
Developers who want to develop dApps on Ethereum and users of these dApps are required to pay for the services using the ETH coin. This drives up the demand for Ethereum. While there is no maximum supply of ETH, a portion of ETH is destroyed (burned) with each transaction. This helps to control the supply of ETH. The price of ETH has been increasing with more developers developing dApps on the platform and more users using these dApps.
Fun fact 3: Ethereum can be split into smaller units called gwei. 1 ETH = 1 billion gwei
Cryptocurrency vs digital currency
There is another type of currency that you may hear of — digital currency. Apart from both cryptocurrency and digital currency being a virtual currency, they are very different from each other. The digital currency here refers to the usual currency issued and controlled by the government but in a virtual form.
One example of digital currency is China’s digital Yuan. Digital currency is controlled by an authority (centralised) and the value of digital currency ties back to the trust the public has in the authority. Digital currency may or may not use cryptography and may or may not use blockchain technology. It all depends on the authority. The authority has the power to increase/decrease the supply of the digital currency, it is typically not on a public ledger and an intermediary validates the transactions.
SCAMS!
With all the wonderful things you read above about the security of cryptography and the public validation model (decentralised) of the blockchain, you may think that the cryptocurrency space is very safe without any risks of scams. That may not be the case 100% of the time. In fact, scams are very prevalent in the cryptocurrency space. That is mainly because of the hype and people investing into cryptocurrencies that they are not familiar with, hoping for super returns.
For example, a scammer may tell you to transfer some of your cryptocurrencies to him/her and he/she has a code that will return you double the amount immediately. Of course, after you make the transfer, the scammer will disappear and not return you anything. The transfer you made is legit, secure and validated on the relevant blockchain — the blockchain is not compromised — but you still got scammed!
This may sound like an unbelievably simple scam that nobody should fall into, but you will be surprised by the number of people falling into such scams. This is only one example of how the security and legitimacy of the network do not mean that the space is completely safe from scammers and there are many other types of scams out there.
Remember cryptoers, be aware at all times!
Text by Yong Xin Kwek
