Comprehending the Confusion of Cryptocurrency
Understanding the ins and outs of cryptocurrency can be a hefty task for someone who knows little to nothing on the topic. There are articles beyond articles attempting to explain, but there is always a need to have some kind of background knowledge. Reading one always leads to another, until it’s three hours later and your brain has turned to mush, without much comprehension along the way.
Unless you are extremely interested in the topic of cryptocurrency and blockchain technology, odds are you do not want to spend hours trying to understand techie language and smarty-pants-investor speak. So I researched the nitty gritty details of cryptocurrency and transferred it to something easier to read, ie. this article; something that I wish I had had before Investopedia became the most visited website on my laptop. I will cover everything from what cryptocurrency is, to how crypto tokens or coins are created, to different ways it is stored and traded. After reading this article, you will have a solid foundation on the basics of cryptocurrency.
What is Cryptocurrency?
Cryptocurrency is just a currency, just like the United States Dollar (USD), that is digital or virtual. It is created, stored, traded, and invested only on digital devices like computers, tablets, or phones. There are many different types of crypto tokens such as bitcoin and ether. The uses of cryptocurrency are the same as any other currency. It lets you buy goods and services, and you are able to invest with it, or even in it. The difficult part to understand is how it works. Unlike the USD (and many other currencies), cryptocurrencies can circulate without a central monetary authority or third party. This means there is no entity that regulates the currency and supply, like the U.S. government or a bank would do with USD. This is what’s called a Decentralized Financial (DeFi) Network. This is an advantage to cryptocurrencies because the whole network would not collapse at a single point of failure — like what happened in 2009 with the stock market crash. So if there’s not one central entity in control, then what is there?
Basics of Blockchain Technology
The decentralized financial network of cryptocurrencies is based on what is called blockchain technology. A blockchain is basically a ledger or database that is found online. It can contain sets of transactions, legal contracts, product inventories, and a wide range of other information. The database is distributed throughout the nodes of the network. The nodes are any physical device that could send, receive, or forward information in the network, such as a computer or phone. This means instead of one entity being in control, each node of the network has the same amount of control, thus making it a secure decentralized network.
The most current use for the blockchain right now is as a ledger for cryptocurrency transactions. When a new transaction is entered, it is sent to every node on the network. Each node then completes multiple sets of equations called cryptographic techniques. These cryptographic techniques are used to secure and confirm the validity of the transaction.
Once a transaction is confirmed to be legitimate, the information regarding that transaction is put into a group called a block. These blocks only have a certain amount of storage. Once a block becomes full, it is closed, given an exact time stamp of when it was filled, and is attached to the previous block of information. This constructs a chronological chain of data, creating the blockchain. This occurs on each node, creating a network where each node holds the exact information. Once a block is added to the blockchain, it cannot be altered, deleted or destroyed. Although there are circumstances where the blockchain could be hacked, that is where advantages of the decentralized network come in.
If the blockchain were to be hacked and information was changed in a block at one node of the database, the other nodes carrying the original block would not be altered. The network could then cross reference all of the nodes and find the one that has the hacked block.
In order for a hacker to successfully change the information in a block, they would need to change 51% or more of the copies of the block on the other nodes of the network. This would take a lot of computational power and would be incredibly hard to accomplish, therefore making the blockchain a secure and redundant ledger that maintains fidelity.
Where Do Cryptocurrency Coins Come From?
The process of creating new cryptocurrency coins is called cryptocurrency mining. The cryptocurrency miners are those who are validating transactions with their nodes in the blockchain network. Once the transaction is validated, the blockchain is updated, as we discussed in the previous section. A new coin is then created to reward the miner for their work in securing the network. The new coin is only rewarded to the miner who validates the transaction first. This is the consensus mechanism called proof of work (POW) that encourages the network users to secure the network in a competitive approach. To do this, the user must have special software that is specifically designed to solve the cryptographic equations.
While this seems like an easy way to earn crypto coins, it is not always profitable. There are many variables that determine if it is worth putting in your computation efforts, such as which cryptocurrency you are mining, how fast your computer is, and the cost of electricity. As more miners join the network, the amount of energy needed is increased. It is very possible that you will end up paying more to validate a transaction than you actually earn back in cryptocurrency.
A way to get by this is to work in a mining pool. This is where multiple miners combine their computational power in order to increase the chances of being the first to mine the block. If they are indeed the first to mine the block and they receive the reward, it is split proportionally to the amount of energy each miner contributed.
The amount of energy that is used to mine cryptocurrencies is concerning for climate change advocates as fossil fuels must be burned to fuel the process. Because of that, the consensus mechanism proof of stake (POS) was created as an alternative to POW. This mechanism requires the users to offer crypto coins as collateral for the chance to be able to validate a block. Coin owners who do this become validators. Then only one user is randomly selected to validate the block. This mechanism reduces the amount of energy needed to verify blocks since it is only one user putting in the power rather than multiple users putting in the work and only having one actually completing it.
How to Store and Trade Cryptocurrency
When learning about cryptocurrency, it is important to know how to safely use and store your coins. There are two different options to do so, Cryptocurrency Exchanges and Cryptocurrency Wallets. You can use one or both. They each have pros and cons, and it is crucial you understand each. Before we get into that, it is important to understand how funds are able to be exchanged from one user to another.
Public and Private Keys
Public and private keys are two different types of identifiers that allow you to complete cryptocurrency transactions. They are two different keys that fit together as a pair.
The public key is used for the user to receive transactions. They are similar to account usernames. It can be shared, and anyone can use this key to begin a transaction with the user. These keys often come in the form of long strings of different characters.
The private key is used to unlock the transaction and gain whatever was transferred. This key must be kept a secret, just like a password. If someone were to get a hold of a users private key, they would have access to any cryptocurrency associated with that key. With the key, the user is able to prove ownership of the cryptocurrency associated with it. These keys can take many forms, from QR codes to 256 character long binary codes. Once the private key is used at the end of a transaction, that means it has been digitally signed. This is the first step in verifying the transaction as authentic. Any transaction not digitally signed will get rejected by the network of nodes.
Cryptocurrency Exchanges
There are many exchange websites and apps out there, such as Gemini or Coinbase. These are essentially like brokers at a bank. They give you the resources to buy and sell your cryptocurrency. Using these you are able to safely complete transactions and use the network of traders to find trading partners. This can be very helpful, although they often include a fee per transaction that is based of the size of the transaction or your level of activity on the site. The best websites will make it easy to buy and sell, with strong security features and low fees.
While cryptocurrency itself is decentralized, most exchanges are centralized. There are a few decentralized exchanges, but they are not currently very popular. Centralized exchanges are much more popular because it has securities features that an individual cannot achieve on their own, as well as resources to find trading partners. Another big bonus of centralized exchanges is that they offer cryptocurrency to cryptocurrency trading. For example, that means one is able to trade bitcoin for ether. Some even allow fiat currency to cryptocurrency trading, meaning USD to crypto. For users who are new to the crypto trading world, they are more likely to use these types of exchanges.
The crypto exchanges are the custodian of the users private keys. This means you do not have access to the key, and if you were to lose access to your account, you would not be able to access any crypto tokens stored on there. While the blockchain is hard to hack, the exchange website is not. Many users trust that this will not happen and continue to store their coins on an exchange, but a safer bet is to store the coins you are not currently trading in an offline crypto wallet.
Cryptocurrency Wallets
A cryptocurrency wallet is a digital wallet where a user can store and manage their cryptocurrencies. There are two different kinds of crypto wallets that have two different purposes.
First is an offline crypto wallet, otherwise called a cold wallet. These wallets are never connected to the internet and can only store cryptocurrencies, not send or receive. This is the most secure way to store your cryptocurrencies. It is safe from cyber attacks and any unauthorized access. Cold wallets are usually stored on a personal device such as a USB drive, hard drive, offline computer or CD. In order to use these cryptocurrencies, you would need to transfer it to either a crypto exchange or a hot wallet.
A hot wallet is a cryptocurrency wallet that always stays online. Unlike the cold wallet, the hot wallet is able to send and receive cryptocurrencies. This is done peer to peer, meaning there is no middle man like an exchange would have. The user is in complete control of their private key, and without it the hot wallet would be effectively useless. This puts a lot more pressure of the user to keep everything safe to where it cannot be compromised. Since this type of wallet is online, the wallet can be hacked and have cryptocurrencies stolen. The owner would have no way to recover their lost coins. Because of this, it is important to keep the majority of your cryptocurrencies in a safe cold wallet, transferring them to either a hot wallet or an exchange when needed.
Why Is This Important To Know Anyway?
If you’ve made it this far, your head is probably at information overload right now. This all might seem like something that isn’t going to really matter until years into the future, but that really is not the case. Everyday cryptocurrency is becoming more and more popular. Cryptocurrency is more secure than traditional payment systems and allows cheaper and faster money transfers. It removes central banks from managing money supply. It is the currency of the future, and right now is a great opportunity to buy them cheap — before they become more valuable. Understanding what crypto is and how it works now will get you one step ahead of everyone when it is something we all use in our day to day lives.
