Cryptocurrency Basics
Foundational Information for Cryptocurrencies
This is the third part in a series of foundational articles that began with (part 1) the motivations behind creating this site and (part 2) explainations on how to get the most out of cryptotonium before jumping in.
What we will cover in this article:
- Clarifing the distinction between traditional (fiat) monetary systems and digital cryptocurrency systems:
- What makes it all fair:
What they are NOT
Cryptocurrencies are NOT a digital version of regular money, they are not Pounds or Dollars.
Regular currencies, like Pounds, Euros, Dollars, Yen etc are called "fiat" currencies and can be represented digitally (like within an app or Internet banking) but that does not make them Cryptocurrencies.
Cryptocurrencies are entirely different monetary systems with different values, uses and meaning.
Digital Money
A Cryptocurrency is a digital-only version of money intended to be used as a medium of exchange, but unlike "fiat" cash, there is no physical version that you could ever hold.
What Problem are Cryptocurrencies Trying to Solve ?
One the major motivational forces driving crypto adoption is the deep seated desire to fix, what many people feel is, a broken financial system. Many of the people involved in crypto are trying to create a fairer monetary platform for the future. To expand upon this you may be interested in the following article.
... or, continue with the basics of cryptocurrencies below.
No Central Authority
Cryptocurrency is a digital payment system that doesn't rely on banks (or institutions) to verify transactions. Instead, it's a peer-to-peer system that can enable anyone anywhere to send and receive payments.
What should I be asking ? If there is no central authority who ensures everything is fair ? After all, digital data can be copied, so what makes digital money secure ? How does crypto prevent counterfeiting or double-spending ?
Cryptography (prevention of counterfeiting)
Cryptocurrency transactions are secured by cryptography / encryption (secret codes), only the owner of the coins can authorise a transaction. Due to the way that cryptography works, anyone can verify that a rightful person was authorised to sign a transaction but they could not have signed that transaction themselves, making it impossible to counterfeit.
Blockchain (a source of truth, ownership and the prevention of double-spending)
The peer-to-peer system mentioned above is effectively a network of computers that control and manage the "Blockchain". A Blockchain is like a ledger of transactions (like a big spreadsheet of records) although it is not held in any one location, instead it is replicated throughout the entire network - duplicated (identically) - so that thousands of computers hold this valuable source-of-truth.
Explain it like I'm 5: Participants can either be regular people who want to send or receive crypto-money or they can be workers and lend their computer power to help the network function.
In theory, anyone can run a "node" (a computer) on the Blockchain and help to validate transactions - this is often referred to as "Bitcoin Mining"
Consensus
Blockchain networks (like Bitcoin) operate systems of "consensus" which means that ALL (or at least, the majority of) parties in the network need to come to an agreement on ALL transactions.
The combination of cryptography and consensus ensure that transactions can only be authorised by the owner of the crypto and those coins can only be spent once. Once these facts have been agreed by everyone, a new "Block" is created and the Blockchain advances one step.
Definition: blockchain is a decentralised, distributed and public digital ledger that is used to record transactions across many computers so that the record cannot be altered retroactively without the alteration of all subsequent blocks and the consensus of the network.
Explain it like I'm 5: 'Decentralised' and 'distributed' means that the computers are located all over the world without any single computer being the master.
What should I be asking ? How can I trust this network ? If anyone can join, what makes a network participant honest ?
Trustless
If you are a single node operator (or validator) on the Blockchain, there is no financial incentive to be dishonest.
There are a lot of node operators located all over the world. An attempt to manipulate the blockchain would result in all these other node operators discarding your invalid (or fraudulent) transactions / blocks. As stated before, the network needs to reach a consensus, in a worst case scenario, from at least 51% of node operators. To manipulate this system a bad actor would have to convince 1000's of network participants to act irresponsibly.
Decentralised
In the definition above ("blockchain is a decentralised, distributed and public digital ledger") the word decentralised is fundamental to cryptocurrencies and blockchain. The consensus (agreement) of network participants is more meaningful the greater the number of participants.
Explain it like I'm 5: If 100 people say Bob made a payment to Lucy, it is more likely to be true than if just 2 people were to say this. It is even better if those people are spread around the world evenly rather than being in just one country.
The greater the number people, all over the world, who validate transactions (or mine Bitcoin) the better - and we call this "Decentralisation". The more decentralised a blochain network is, the more difficult it would be to corrupt a majority of participants.
Currently, it is estimated that there are around 10,000 active 'full' Bitcoin nodes located around the world.
Financial Incentives of Mining / Validating
In actual fact node operators are financially incentivised to act responsibly. "Bitcoin Mining" is the process of (and gaining the right to) create a new block filled with valid transactions. As a reward, the network pays the operator with brand new "mined" bitcoin, plus any transaction fees payed by people who want to send Bitcoin. However the block must be validated by other participants as being correct, otherwise all the work is pointless as the block will be discarded.
What should I be asking ? I've heared that Bitcoin uses a lot of energy in the form of electricity, is it difficult or time-consuming for the computers to construct a block ?
Actually the the process of constructing a block is easy (and uses relatively little computer resources) however only one of the node operators has the rights to construct the next block of transactions. In order to choose which node operator, there is a prerequisite challenge posed as part of the network rules. Like a race, Bitcoin miners must be the first to solve a complex puzzle with an exact known difficulty. If they are the first to solve the puzzle they gain the right to create the next block.
It is the process of solving a crytographic puzzle that is energy intensive and it is known as Proof-of-Work (PoW). Proof-of-Work has been criticised for its high energy demands, however (as we will discover later) there are alternative consensus methods that are used in other Blockchains.