What Is Cryptocurrency (For Dummies)
So you’ve decided to read up on what Cryptocurrencies really are! Perhaps after seeing all the hype? Welcome! To get started, we are going to look at what a Cryptocurrency is and its related topics. This is meant as an introductory guide to those with no prior technical knowledge or background.
Far from a shady way of hiding money, most cryptocurrencies are tackling modern problems. They have expanded horizons, rapidly solving infrastructure problems in many industries. A Cryptocurrency, by definition, is a digital medium of exchange (currency) that runs on encryption networks to verify authenticity and validity. Because they run on a network spread out across the world, they are defined as “decentralised”. As in, no one company, bank, entity or government can influence the entire “ecosystem”.
What is “money”?
You might be surprised to learn that the fiat currency you own is based on trust of your government. Their choices and economic principles affect fiat, and its actual value is based purely on trust. Governments influence fiat with their central banks, fiscal policies, and interest rates. Once upon a time, fiat was backed by gold or silver. Every dollar you had, had an equivalent value in gold in a vault. Today, this is not the case. Your fiat money only has value because the government says it does – and the economy had no other alternative, until now.
Bitcoin is the first genuine Cryptocurrency. It works in what we call a “Proof of Work” system. What this means, is that “miners” get paid small amounts of Bitcoin in exchange for letting the network use their computers as a server to verify the transactions that happen across the network. They also receive transaction fees that are slightly different to the mining fee they get.
If I sent 1 Bitcoin to my Aunt Christine, I login to my wallet like you login to your bank account. I then need to have her recipient address. Just like you would need to have the bank account number of your receiver. Once I click send, instead of being processed by a bank’s system, it goes out into the Bitcoin Encryption World… There, miners process “unconfirmed” transactions, and once they have been processed, they are recorded on the blockchain as a block. Hence the word Block-Chain.
Each block is called a confirmation.
If your transaction first got processed on block #7, then block #8 is called the second confirmation. Usually, 6 confirmations means that your transaction is basically irreversible, because in order to undo anything done in block #7, every block thereafter has to be undone. Due to the fact transactions are confirmed by computers solving complex algorithms, the difficulty increases exponentially with each block confirmed after your one.
6 Confirmations can take approximately an hour.
So while your money will show up after the first confirmation, different exchanges will require different numbers of confirmations before fully releasing the funds. This is considered to be too-slow by today’s standards, and this is why second and third generation blockchain technologies have burst onto the scene with virtually instant processing speeds, more scalability and unlimited potential.
How Cryptocurrency Works.
Virtually all Cryptocurrencies work by a decentralised network that runs by either Proof of Work (miners get paid for computational power), Proof of Stake (token/stake holders get paid for locking up their tokens in a wallet like a long term investment) . There is a hybrid of these two models called Proof of Activity as well, but let’s investigate how Cryptocurrency works first.
Proof of Work Explanation:
PoW is how you will see it abbreviated in the blockchain space. Using Bitcoin as an example, the network sets complex algorithms that increase in difficulty as time passes. This means it requires more computing power to solve each puzzle before the next block can be added. Every time a block is “mined” the miner who solved it is paid in Bitcoin. The amount paid is set in stone (digitally speaking) in the Bitcoin Organisation’s GitHub coding. The amount halves every 4 years. By 2020, the amount will be 6.25 bitcoins.
The drawback to this system is the high computational and power costs. It has been regularly reported that mining Bitcoin is more expensive to the world than it is to run Ireland. That’s an entire country! For this reason, new generation blockchains have aimed to combat this, and the Proof of Stake concept was realised.
Proof of Stake Explanation:
Abbreviated as PoS, Proof of stake is much like locking up money in a term deposit. When you “stake” your coins, it’s called a Node. These Nodes perform the same function as miners, confirming transactions on the network they originate from. Your node is selected in one of 3 ways: randomly, by age, or based on the amount of value locked up.
This addresses the high power consumption Bitcoin presented. However, the PoS system also has its own drawbacks. One of the main ones, depending on the individual Cryptocurrency’s rules, is that Nodes could agree on multiple histories, thus stopping the network from finding consensus(agreement) and progressing. Each individual Cryptocurrency has addressed this issue differently.
How is Bitcoin created?
Bitcoins are created through the mining process mentioned above. There is a set limit, meaning a maximum of 21,000,000 will only ever be available. Some sources cite that around 25% of these are already lost/missing! This means the available volumes are far lower than that. After the last Bitcoin has been mined, the Bitcoin organisation assumes that value of transaction fees alone will still be enough to entice miners to confirm blocks on the blockchain.
What is Cryptocurrency Mining?
Cryptocurrency Mining is the setup of a computer to run akin to a web server with specific programs derived from whichever Cryptocurrency the owner wants to mine. Each PoW cryptocurrency will have instructions available for configuring the mining rig. Mining allows people to get paid for their computer space, and just requires electricity and an active internet connection. Mining can be a great way to use surplus computational or bandwidth available, but is also highly competitive in today’s age.