Cryptocurrencies: What’s behind these digital currency systems?
In 2008, an unknown individual or group published the whitepaper for Bitcoin under the pseudonym Satoshi Nakamoto, thereby paving the way for cryptocurrencies. To this day, it is still unclear who’s behind the pseudonym and the idea for this revolutionary, digital payment instrument. For many people today, it’s just as unclear what exactly a cryptocurrency is – despite the fact that, one decade after the invention of Bitcoin, there are now more than 2,000 different providers of these digital payment systems, as the impressive list on the web portal CoinMarketCap shows.
- What is a cryptocurrency?
- Main characteristics of a cryptocurrency
- What are cryptocurrencies used for?
- How do you pay using a cryptocurrency?
- Why invest in a cryptocurrency?
- What cryptocurrencies exist?
- Summary: Overview of the benefits and risks of cryptocurrencies
What is a cryptocurrency?
A cryptocurrency (or cryptoasset) is a digital means of payment, typically based on blockchain technology and cryptographic processes such as hash functions and digital signatures. Unlike conventional currencies, cryptocurrencies do not involve physical coins or notes. All units of the currency are exclusively digital. These asymmetrically encrypted units of currency are usually generated collaboratively by the whole system, although in most cases, a predetermined quantity of units is defined at the launch of a cryptocurrency. The term “mining” was coined for the process of generating units, which is why people talk about “mining cryptocurrencies”.
The classification of cryptoassets as currency is controversial. For instance, the US tax authority (IRS – Internal Revenue Service) classified cryptocurrencies as financial assets back in 2014, meaning they are subject to the same rules and taxation as equities, for example.
Most cryptocurrency systems are characterized by a decentralized nature: Not only the generation of new currency units, but also the individual transactions are typically executed collectively, as multiple participants verify and countersign them in the respective system. Communication normally occurs in a peer-to-peer network in which all nodes operate as equals. In contrast to money printed by central banks, classic cryptocurrencies have no “single point of failure” – i.e. there is no individual point in the network that can jeopardize or dominate the functioning or trading of the currency system. An exception can be found in cryptocurrencies like Ripple, which are run by private companies that perform most of the unit generation process themselves and distribute them according to their own rules.
Cryptocurrencies or cryptoassets are payment systems that only involve payment units in digital form. Typically, these cryptosystems are built on a decentralized peer-to-peer network in which all participants have equal rights and generate currency units and execute transactions through collective effort. Their classification as currency is controversial as they lack a consistent value basis. The concept of cryptocurrencies or rather the first and most well-known example Bitcoin was published in 2008.
Main characteristics of a cryptocurrency
As a result of the hyperinflation of the bolívar fuerte, Venezuela not only introduced the new currency, the bolívar soberano, but also tied it to the Petro cryptosystem. Even though the Venezuelan government proclaims it to be the “first national cryptocurrency”, the Petro lacks key characteristics of a cryptocurrency precisely due to its state governance, such as the decentrality of the system or the equality of all participants. Similar controversy surrounds the privately managed systems already mentioned, like Ripple.
A closer look at the three elementary components of a cryptocurrency reveals that, although private and state-run systems fulfill the “crypto” aspect, they have little to do with the classic principle of Bitcoin.
Cryptography not only gives these currencies their name, it is also a critical discipline for the security of cryptocurrencies. The term “cryptography” refers to the science behind encryption and the general protection of data and information. Both are vital for a cashless and fully digital payment system that, as standard, operates without a central regulatory body. Cryptocurrencies primarily use two cryptographic processes:
- Hash functions
- Digital signatures
Hash functions represent the elementary pieces of the puzzle for checking the integrity of the data and encoding the account addresses and transactions of participants. They also provide the basis for the blockchain and block mining. Digital signatures enable the status of encrypted information to be verified without disclosure. This technology is employed, for example, in order to protect the content of e-mails. In the case of cryptocurrencies, it is used to sign transactions and communicate to the network that a transaction has been approved.
Blockchain refers to the decentralized ledger of a cryptocurrency that records all transactions in what are known as blocks. The recording of the individual blocks takes place in fragments and in chronological order, so that a (mostly) public, immutable and verifiable record emerges over time. It is maintained by the participants of the underlying peer-to-peer network, who follow a defined protocol in order to validate new transactions. In this process, all nodes automatically download a complete copy of the blockchain, dispensing with the need for a central authority to inspect executed transactions.
A data record based on blockchain technology cannot be altered without the consent of the other network participants.
Thanks to its enormous potential, blockchain is meanwhile used in applications far beyond digital cryptocurrencies. For instance, the R3 consortium in cooperation with over 200 technology and industry partners has developed a blockchain platform called Corda, which enables contact as well as transactions (e.g. legally binding agreements or goods exchange) between two or more companies.
The third important pillar of cryptocurrencies is known as block mining. This refers to the process necessary in order to append new transactions in the cryptosystem as blocks to the blockchain. Mining requires certain software that can solve mathematical problems and thereby find the underlying hash functions. All network participants can attempt to solve each mathematical problem for validating a new block of transactions. This procedure is also known as the “Proof of Work” that has to be produced. Once a block is correctly mined and the output of the hash function is guaranteed, all network participants can check whether the solution is correct.
However, the reward for successful mining is only received by the miner whose computer solved the problem first. Typically, a block reward – as this type of reward is called – is a set number of currency units as well as all transaction fees associated with the newly added block.
In order to increase the chances of receiving block rewards, miners of cryptocurrency networks often band together in mining pools – comparable with player pools in the lottery. In this case, instead of combining stakes, the users pool hardware resources to work together to solve the mathematical problems.
What are cryptocurrencies used for?
They're called cryptocurrencies for a reason: their similarity to real currencies with notes and coins, as well as the fact that users of Bitcoin or similar influential alternatives like Ethereum, IOTA or Monero possess an exchange value (demand and use) have brought the digital currency systems into discussion as the potential means of payment of the future. Bitcoin in particular is already in use in this respect. Various online sales platforms such as Overstock have adopted Bitcoin payments into their repertoire of available payment methods. But even the top cryptocurrency has not yet established itself as a means of payment, primarily due to the significant fluctuations in value.
On May 22, 2010, Laszlo Hanvecz made the world’s first payment in bitcoins. For 10,000 BTC, he ordered two pizzas from the American restaurant chain Papa John’s. At Bitcoin’s exchange rate back then of around 0.00649 dollars, he could enjoy his meal for around 67 dollars. He probably had no idea that it would likely be the most expensive pizza in human history at the current price: On the eight-year anniversary of “Bitcoin Pizza Day”, the seemingly worthless 10,000 BTC spent in 2010 would have amounted to around 85 million dollars.
Cryptocurrencies are also being used for other purposes especially in the start-up sector:
|Raising capital||Start-ups are increasingly taking advantage of cryptocurrencies and blockchain technology by using them to collect investment. To this end, fledgling companies develop their own cryptocurrencies and launch what are known as Initial Coin Offerings (ICOs): In exchange for financial contributions, investors receive one or more units of the new cryptocurrency.|
|Connection with a service or company||Connecting a cryptocurrency to a product or service also represents an easily implementable financing solution for start-ups. Here, the use of the product or service or a say in the company is tied to the ownership of currency units, for example. It’s also possible to allocate shares in a company in this way.|
|Trading (speculation)||Traders have long adapted cryptocurrencies to their needs: trading new as well as established currencies represents an attractive alternative to equities trading and other speculative activities. The lack of market regulation means that profit margins as well as risks of losses have been very high to date.|
How do you pay using a cryptocurrency?
So long as the units of a cryptocurrency have a certain exchange value that can be converted to a central bank currency like the dollar, cryptocurrency can in principle be used as a means of payment. But to actually pay with digital money, the vendor must also accept the cryptocurrency. In order to execute a payment, a pair of keys is required, comprising a public and private key.
The public key is visible to anyone and essentially has the same role as a bank account number: it serves as the sender’s address from which a user carries out a payment with the respective cryptocurrency. Conversely, the private key is used for verifying a transaction, a bit like a password or PIN. It should only be visible to the owner of the crypto address used to sign a transaction. In the case of the latter, this is usually automatically performed by a wallet, the virtual account that stores a cryptocurrency. In other words, users only have to enter the amount and the target address, i.e. the public key, of the payee when making a payment.
Why invest in a cryptocurrency?
Ever since Bitcoin’s spectacular price boom in 2017, cryptocurrencies have been a popular speculative investment. In just a short space of time, interest in investing in the cryptocurrency sector has risen considerably. And there are some different ways to invest in one of the currencies available on the market.
Like foreign exchange trading, cryptocurrencies can also be used as a tradable commodity, with the aim of exploiting price swings in order to increase the investor’s capital. The difference with cryptocurrencies is that there are no central banks, financial supervisory bodies or government regulatory authorities to monitor the monetary supply and step in when the market overheats. Units of various cryptocurrencies can be bought, sold and exchanged on trading platforms like CoinSwitch, which always display the most up-to-date prices. Alternatively, it’s also possible to invest indirectly in cryptocurrencies via conventional exchanges, by betting on price fluctuations or purchasing the shares of companies involved in the cryptocurrency sector.
The price of cryptocurrencies is determined solely by the demand for the currency units. On the one hand, this enables rapid growth – as seen with Bitcoin over many years. On the other hand, sudden price drops are also possible, with the risk of suffering a total loss. An investment in cryptocurrency should only be considered if the invested capital is ultimately expendable.
What cryptocurrencies exist?
Due to the fact that there are more than 2,000 different cryptocurrencies worldwide, it’s no wonder that even recognized experts are not familiar with all the different providers and their models. Anyone who wishes to invest in cryptocurrency has no choice but to monitor the market closely and seek out suitable solutions. Especially for newer or more unknown currencies, there is always the risk of falling victim to fraud or the system completely collapsing. The following list contains some of the established cryptocurrencies characterized by a high market capitalization (a high value of total shares in circulation):
|Bitcoin||BTC||Bitcoin, released in 2009, is not only the forerunner of the crypto movement, it’s also still the most important digital currency with the highest value against the dollar, euro and other central bank currencies. As at the end of 2018, over 17.4 million of the maximum 21 million Bitcoins are in circulation. They are only rarely used for payments, and are instead primarily held as investments.|
|Ethereum||ETH||The Ethereum cryptocurrency – known as units of ether – was officially launched in 2015. Digital payments play a subordinate role in the system developed by Vitalik Buterin: the focus here is on the ability to conclude smart contracts without the use of intermediaries. They can be placed on the Ethereum blockchain in the form of code scripts.|
|Ripple||XRP||Ripple is likewise not a conventional cryptocurrency and instead provides a universal settlement platform for all kinds of currencies (the “blockchain of banks”), whether they are euros, dollars or cryptocurrencies. The company responsible for Ripple is Ripple Labs, which acts as the central administrator, ignoring the decentralized aspect of cryptocurrencies. Moreover, Ripple Labs holds the majority of the currency units in existence.|
|Monero||XMR||Monero focuses on user anonymity, ensured by features like concealed addresses and group signatures. The CryptoNight algorithm it uses is intended to prevent mining with ASICs (specific mining hardware). Instead, the developers want to force the mining process to be performed using conventional PCs. With Monero, the mining difficulty is continually adjusted in order to maintain a constant pace of block generation.|
Summary: Overview of the benefits and risks of cryptocurrencies
Cryptocurrencies offer key opportunities and possibilities that conventional currencies lack. In particular, blockchain technology has so far offered compelling potential in a variety of sectors, which is why it is also being used in numerous projects beyond the financial industry. The lack of a central authority anchored in most cryptosystems also generally represents a promising innovation. The associated freedom from market regulation, however, also poses one of the greatest problems with cryptocurrencies. Since there is also a lack of a consistent exchange value, the prices of cryptocurrencies are subject to severe fluctuations and the ever-present risk of a total system crash.
The pros and cons of cryptocurrencies compared to conventional monetary and currency systems are summarized in the following table:
|Advantages of cryptocurrencies||Disadvantages of cryptocurrencies|
|Anonymity||Major price fluctuations|
|Fast transactions||Potential speculative bubbles|
|Simple use||Potential for hacker attacks|
|Global availability (transcending national borders)||No ability to access an account after losing the access key|
|No limit to transaction amounts||Exclusively virtual money|
|Free from the influence of banks||No loss insurance whatsoever|