How does a cryptocurrency work?

A cryptocurrency like bitcoin is a digital asset and a form to exchange value between peers, without going through a third party to facilitate the transfer. (Compared to paper money, that needs to go through a bank or some institution). It runs on a network called blockchain (explained here). This network verifies itself – each transaction is recorded into the blockchain and once it’s there, it can’t be altered, it’s public, for everyone to see. If person A sends a transaction to person B, it is verified across the network, confirmed by various sources and recorded (written into the blockchain – ledger and stored).

There’s usually only a limited amount of a cryptocurrency – in case of bitcoin, there’s 21 million bitcoins – around 80% already in circulation. This creates scarcity which means the price rises with rising demand, which creates value.

The verification and writing of the transactions into the blockchain (chain of blocks of transactions) is called mining. Miners have to compete against each other by resolving mathematical puzzles. They buy very powerful machines to do that. They are rewarded for resolving the puzzles and writing the transactions into the blockchain. That’s how remaining cryptocurrencies (in case of the biggest one – Bitcoin) are released into circulation – as rewards to the miners, at the rate of about 1800 bitcoins per day.

You can think of miners as accountants, who have to compete against each other to be able to write and store your transactions into the public blockchain. The ones that win get rewarded.

What makes this whole system very safe is fact that all transactions are public and stored on every miners device. Each transaction is then verified against various devices to ensure it’s valid. It is therefore very hard to hack this system – if you make a fake transaction, it will not be verified on various devices (because you can hack one device or a small number). If you wanted to really hack the whole network, you would need to falsify the transaction at the same time on at least 51% of the network (devices). Which is very, very difficult.

Key questions you might have about cryptocurrencies:

How is value created?

With paper money, it is backed with gold. (Or is it nowadays… – we don’t really know anymore). With cryptocurrencies, scarcity creates value – there’s only a limited amount. The more people want it, the higher its value. The more useful it is, the wider its adoption, the higher its value.

Therefore as long as it is accepted by enough people as a form of transacting value – I send you some amount and you accept it, this gives it value. The more people use it, the higher the value is.

Is it safe? If it’s only in cyberspace (not physical), can it be hacked?

What makes it very safe is the fact, that it’s running on many computers of many users. So if a hacker wants to change something, they would need to do it on majority of the computers that the cryptocurrency transactions are stored on – which is virtually impossible. Therefore it’s very safe – your transactions can’t be faked or deleted, you won’t lose them. For example if there is once written that you own 1 bitcoin, you can’t lose that information.

What isn’t safe is the way you store access to your transactions. The transaction that verifies you as the owner of 1 bitcoin is very safe. But your access to it is through crypto wallets. These wallets have a password and a recovery key that you have to safely stored. Hackers can find ways to get this information from you – same as in case of your email or facebook accounts. They can scam you into thinking you are doing something safe, but they just gain your password.

Therefore the whole system is only as safe from your perspective, as safe is your PC and your ways of keeping your passwords away from bad people. That’s not completely an issue with cryptocurrencies, more with general internet safety. For example, they can scam you out of your online banking information as well as out of your crypto wallet password.

What makes cryptocurrencies so useful and in demand?

I have explained that in more detail in my article about blockchain and bitcoin, but will summarize the key things that make cryptocurrencies so useful here:

  • they are public and not owned by a single company – therefore much harder to influence for political or profit reasons (this is referred to as decentralisation)
  • their code is open source – so anyone with good knowledge can improve it or build better versions of it. This is what’s creating many alternative cryptocurrencies (or altcoins) like ethereum, ripple, IOTA and many more. They each work slightly differently and improve the system in some way. This creates a lot of room for improvement and new ways of doing things. (It’s like android on phones – anyone can develop applications for it, that’s why it’s so popular and we have so many useful apps. Well, and so many not so useful too, but that’s the nature of things 🙂
  • they remove bureaucracy – you don’t need to be approved by a bank and their rules to use the system
  • they are cheaper and faster (generally) – although the cost of transactions with bitcoin raised to unexpected levels in november 2017, it’s an issue that can be resolved. Generally, it’s cheaper to send cryptocurrencies across the world than sending money. Therefore they are very good for less developed countries or moving money across the world.

Is investing into cryptocurrencies risky?

In short, it is. We are seeing today what is called a bubble – very fast inflation of the price of an asset, created by a sudden interest in this asset. But most bubbles are there for good reason – the asset / technology behind them has massive potential. So a lot of early adopters and investors try to get in early. But the problem is that during a bubble, the technology might still evolve and change – and the investments of today might not be the big companies of tomorrow. If you compare it to the internet (dot.com) bubble around 2000, many companies promised a lot and many failed. But later many exploded – Google, Amazon, Facebook, Ebay, PayPal etc. It just took a bit longer. The underlying technology was powerful – the internet. We just needed time to figure out what to do with it. Same thing is happening now with blockchain and cryptocurrencies – the technology has great potential, but not all companies or coins that you can buy today might grow into big ones tomorrow.

As of time of writing (end of november 2017), the cryptocurrency market is unregulated around most of the world, therefore your money isn’t very protected in case something unexpected happens. Consider this therefore a risky and speculators market and don’t invest money you are not prepared to lose.

Facebook wasn’t first – there was Myspace or Friendster. But only Facebook made it big. Bitcoin is the first – will it remain or will it follow Myspace? That is the risk we’re talking about – no one really knows. So it’s good to invest, but invest . Find out how on this website :).

 

 

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