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Introduction to cryptocurrencies (Part 2/4)

Introduction to cryptocurrencies (Part 2/4)

What are crypto currencies?

Put simply, cryptocurrencies are digital assets that are intended to be used as a medium of exchange.

Cryptocurrencies didn’t begin with Bitcoin, but started back in the 80s with companies such as DigiCash, then moved onto initiatives such as e-gold. Bitcoin became the first decentralised digital currency in 2009, and since then hundreds of crypto currencies have come into existence.

For the purposes of this I will only focus on Bitcoin and Ethereum in this post, focusing on the many other cryptocurrencies in future posts. 

What is Bitcoin?

Bitcoin, the standard bearer for cryptocurrencies, was launched in 2009 following the publication in 2008 of this (still interesting) paper by Satoshi Nakamoto.

Bitcoin marked a radical departure from traditional currencies. Whereas central banks issue new currency (e.g. the US Treasury Department print new currency, which is then distributed by the Federal Reserve Banks), Bitcoin has no central monetary authority and instead is ‘made up’ of the distributed computing network that supports it (each computer connected to the blockchain is called a ‘node’). This distinction is its most important characteristic, as no single institution controls the network.

Bitcoins are generated through ‘mining’, which is the act of computers on the network solving mathematical problems. There will only ever be a total of 21 million Bitcoins, and the difficulty of the problems increases so that over time less and less Bitcoins can be generated. The last Bitcoin will be mined in 2140. When Bitcoin started, anyone with a computer could generate Bitcoins themselves (and in huge numbers) as the solutions were simple. Now it takes huge computational power and most miners organise themselves in ‘pools’. Around 16 million Bitcoins are already in circulation, so there will just be another 5 million Bitcoins minded over the next 123 years.

The same computing network also processes all transactions made with Bitcoin (for instance if I send some BTC to a friend). Therefore, the Bitcoin network both creates its own currency and acts as its own payment network. Every time I send some BTC, I pay a tiny transaction fee. This is to incentivise the community to not just create the currency, but also to verify the blockchain ledger (as discussed in the opening section).

Why is Bitcoin important?

Decentralisation – as discussed, there is no central authority. No-one can just decide to take your Bitcoins away, no-one can issue more Bitcoin and devalue the remaining supply. The Bitcoin network is distributed, so if one part of it goes offline the rest of the network continues. Bitcoins completely bypass banks, meaning there is no middleman charging hefty fees (bar the small transaction fees mentioned) or regulating trades. There is no asset behind Bitcoin other than Bitcoin itself. It is not backed by gold or any other commodity, and it is not pegged to any other currency

Transparency – The Bitcoin blockchain, as discussed in the opening section, is completely transparent, storing every single detail that has ever happened on the blockchain. No-one can alter the records and no human error can make a mistake and change your account details. Transactions are 100% irreversible. Once BTC is transferred, it is gone. As in Part 1, this transparency is one of the defining qualities of the Blockchain. Everything is open for anyone to view, and no middleman is needed to verify that the transaction took place. By planning for dishonesty, everyone is kept honest

Anonymous – While it’s not completely anonymous, you don’t have to provide your name or any other details when using Bitcoin. You do not need to set up an account or go through banking regulation to send Bitcoin

How are Bitcoins able to be used?

In theory, Bitcoins can be used just like any other currency. Any store that accepts them will take BTC in exchange for goods and services. You can store your BTC in a digital wallet (more on them later). You can hold it and hope it appreciates in value, as you might any other commodity or currency. Real world usage remains very limited but there are thousands of places (both online and offline) that accept Bitcoin as a payment method.

What is Ethereum?

Ethereum was introduced in 2014 by Vitalik Buterin and launched in 2015. The Ethereum Foundation describes Ethereum as “a decentralised platform that runs smart contracts (more on these later); applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference”.

While a digital cryptocurrency, Ethereum differs in several important respects to Bitcoin. Both are based on blockchain technology but whereas Bitcoin is essentially a digital alternative to currency, Ethereum has arguably a much wider set of use cases. Some have labelled it as ‘digital oil’ as opposed to Bitcoins ‘digital gold’ (which is not necessarily a good analogy, but it serves a point), as Ethereum powers the various applications that use the Ethereum network (some examples of these can be found here https://etherian.world/ ). As an example, Golem is another cryptocurrency that aims to use a decentralised computing network for rendering videos and other media. However, Golem is based on and uses the Ethereum platform to clear payments between providers, requestors and software developers.

Ethereum therefore uses the blockchain to verify and enforce contracts, rather than Bitcoin which uses the blockchain to verify transactions. Therefore, there does not need to necessarily be a ‘winner’, as both have different objectives.

There are a whole host of technical differences between the two, but for the purposes of this beginners guide we don’t need to go into them.

What are smart contracts?

As previously explained, Bitcoin is a means of skipping out banks and third parties when processing payments. Ethereum, through its smart contracts feature, is an attempt to exchange multiple goods and services without using a third party. The distributive model and trustless nature of the blockchain results in the ability to provide this service, where pre-written computer code stored on the blockchain carries out the function when pre-set conditions are met. This allows the automation of processes in a secure and trustless environment. 

You can use smart contracts for all sort of situations that range from financial derivatives to insurance premiums, breach contracts, property law, credit enforcement, financial services, legal processes and crowd funding agreements. I’ve copied the below example from blockgeeks.com as I think it covers it well:

Suppose you rent an apartment from me. You can do this through the blockchain by paying in cryptocurrency. You get a receipt which is held in our virtual contract; I give you the digital entry key which comes to you by a specified date. If the key doesn’t come on time, the blockchain releases a refund. If I send the key before the rental date, the function holds it releasing both the fee and key to you and me respectively when the date arrives. The system works on the If-Then premise and is witnessed by hundreds of people, so you can expect a faultless delivery. If I give you the key, I’m sure to be paid. If you send a certain amount in bitcoins, you receive the key. The document is automatically cancelled after the time, and the code cannot be interfered by either of us without the other knowing, since all participants are simultaneously alerted.
— blockgeeks.com

It’s quite hard to define smart contracts, as they have very wide use cases and the term ‘contracts’ is slightly misleading. There is a longer explanation on this here:

http://www.coindesk.com/making-sense-smart-contracts/

What is the difference between proof of stake and proof of work?

This is not something that is necessarily important to understand when first setting out but it is worth learning. 

Proof of work – which is how Bitcoin operates – means that to create blocks and add them to the blockchain (e.g. creating new Bitcoins) network participants must solve complex mathematical problems. The downside of this is the huge wasted energy expense of the large computing farms that are running 24/7. 

Whilst Ethereum currently operates on proof of work basis too, it is working towards changing to a proof of stake model. In this model, network participants are no longer miners but rather are validators. There are no mathematical challenges to complete, but rather these validators will put their own Ether up (hence the staking) to validate a block. 

There are other means through which cryptocurrencies operate, but these are the most important two as of today. 

Part 3 of this series will focus on the practicalities of investing in cryptocurrencies, namely how to buy/sell, how to store safely, how to send or receive and how to invest in Initial Coin Offerings. 

Introduction to cryptocurrencies (Part 3/4)

Introduction to cryptocurrencies (Part 3/4)

Introduction to cryptocurrencies (Part 1/4)

Introduction to cryptocurrencies (Part 1/4)