Cryptocurrency 101: Understanding the basics of Digital Currency
If there’s one asset that has managed to capture the attention and imagination of investors across the world. With all the news surrounding digital currency, many are keen to obtain an understanding of cryptocurrency basics.
Ever since explosive returns generated by Bitcoin & Ethereum made news, there has been no stopping new altcoins with features differentiating them from the others.
This guide explains cryptocurrency basics by breaking down complicated concepts into simple subjects to help understand what cryptocurrency is and how it works.
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What is Cryptocurrency?
Cryptocurrency is, in simple words, a digital currency. Also referred to as altcoins (alternative coins) and virtual currency, cryptocurrency is a currency that exists in digital form.
As it is digital, there is no physical bill or coin associated with it. Therefore, it does not correspond to assets or anything else in the real world. Famously, this makes their value vulnerable to heavy fluctuations.
Cryptocurrency is essentially a medium of exchange, just like other currencies but created to facilitate the exchange of digital information.
It is a currency that you can exchange for online goods and services and uses cryptography for security. As a result, it is entirely safe for online transactions and not owned by any government or regulatory body.
Cryptocurrency can be exchanged for real money and traded like stocks, real estate, and valuable assets. Where it differs is that cryptocurrencies do not have any value outside possession. It costs money only because somebody else owns it.
A form of cryptocurrency, Bitcoin, was created to solve these problems. It uses encryption and blockchain technology to prevent fraudulent transactions and thereby negating the need for a central authority for its regulation.
Understanding How Cryptocurrency Works
Cryptocurrencies employ decentralized technology to allow users to make secure payments and store money without using their name or going via a bank. They operate on the blockchain, a distributed public ledger, which records all transactions updated and held by currency holders.
We’ll walk through a hypothetical digital currency transaction to help gain a better understanding of how cryptocurrency works.
Example of a Virtual Currency Transaction
Imagine that Joseph wants to send $10 worth of cryptocurrency to Scott. Here is how it is executed.
- Scott sends his Bitcoin address or ‘hashed public key’ to Joseph. The address is linked to the cryptocurrency wallet Scott has set up for transactions. It is a length of code consisting of letters and numbers.
- Joseph enters this address in his cryptocurrency wallet or exchange and the Bitcoin amount he wants to transfer and selects the option for ‘Send’.
- Scott would receive the amount in some time after the deduction of a small fee, depending on the time taken for the transfer. This fee remains unchanged whether you send $10 or $10,000,000.
Let us try to understand how all this gets accomplished.
When Joseph initiated the transaction to the blockchain, the nodes (miners) in the Bitcoin network receive the request. Then, each of the nodes tries to verify the validity of the transaction by making sure that:
- Joseph is who he claims to be. The nodes validate the identity of the user through his private key that represents the source of funds. Anybody having access to the key can access your money. This means you should keep your private key secure.
- Joseph possesses the amount he is willing to transfer to Scott. All the nodes contain a copy of the ledger of transactions they can check to ensure this.
If a minimum of 51 per cent of the nodes agree on these two criteria, the transaction gets executed, and the nodes update the ledger with the transaction.
Since virtual currency is relatively new, the technologies behind them are still in a state of development.
To gain a concise understanding of how cryptocurrency works, a comprehension of the technologies that underpin digital currencies is essential.
Cryptocurrency works based on cryptography – a method used to conceal information to keep user information and transactions secure.
Cryptocurrency has no central server or computer. A network without a central server is known as a decentralized network. Digital currency is distributed across a network that contains a vast number of systems, ensuring that there is no single point of failure.
No intermediaries, such as banks or payment processors (i.e. Paypal), are involved. Instead, transactions are conducted through the internet directly from one person to another.
A distributed ledger, or distributed ledger technology (DLT), is a database that is distributed and synchronized across several computers across multiple sites, institutions, or countries. It allows for public “witnesses” to be present during transactions. Blockchain is a sort of distributed ledger that is employed by some digital currencies.
Introduced by Satoshi Nakamoto for Bitcoin, blockchain is a database of cryptocurrency transactions and the technology powering altcoins.
Blocks of information add to the database one by one and make a linear chain called the blockchain. Once information enters the blockchain, it cannot be edited or deleted. Instead, it remains on the database for everyone to access.
Another concept that applies to the blockchain is consensus. Any new information can be stored on the blockchain only when half of the nodes approve its validity.
This aspect sets cryptocurrency apart from banks, where the bank staff verify the validity of transactions stored in the bank’s database.
For example, Charles owes $20 to William and Harry but has only $20 in his bank account. If Charles tries to transfer 20 dollars each to William and Robert simultaneously, the transaction is rejected. It stopped Harry from indulging in double-spending, a type of fraud. Banks spend a lot on preventing such frauds.
Digital currencies use a system called mining to verify transactions.
The purpose of cryptocurrency mining is to verify and confirm new transactions. Mining uses a system of nodes (computers knows as miners) to carry out designated tasks to make transactions possible. Let us try to understand this process using an example of a Bitcoin network.
- Harry owes 10 bitcoins to William and decides to send the amount to the Bitcoin network. Miners take this information and encrypt it. This process is called hashing. Next, the nodes add other information related to the transaction and hash it as well. More information is added until a block is formed.
- Then, the miners compete to guess the code assigned to the block before adding it to the blockchain. The node that guesses it right gets the block. Then, all other nodes on the network check this information in the block against the entire blockchain to verify its validity. If more than half of the total nodes verify it, the miner can add it to the blockchain.
- Such a procedure is called confirmation and is used to verify a transaction. Once the transaction is confirmed, William receives 10 bitcoins from Harry.
- Mining takes up a lot of power, so each miner who does some work receives a reward. For example, on the Bitcoin network, miners who confirm new blocks receive 12.5 BTC.
Mining for altcoins helps stop frauds like double-spending without having to use trusted entities like banks. Blockchains in a digital currency system are not secured by people or trust. Instead, they rely on a computerized security system to verify transactions.
While cryptocurrency is anonymous in the sense that you can keep a crypto address without revealing anything about your identity. One person could have multiple addresses in theory, and there would be nothing to connect them or show that the person owned them.
Sending and receiving virtual cash, on the other hand, is akin to writing under a pen name. If an author’s pseudonym is ever linked to their identity, everything they’ve ever written under that pseudonym will be linked to them as well.
Altcoins use a unique code for each user to prevent access to their details by others. This technology is also called cryptography and is what makes information secure. The data hidden with cryptography is known as encrypted.
A virtual currency system does not require members to know or trust each other or a third party to function. There is no single entity with authority over the system in a trustless setting, and the consensus is reached without participants knowing or trusting anything other than the system itself.
Despite the increasing popularity of cryptocurrency, not everybody favors the idea of using digital currency or investing in this emerging asset class. Regardless of the advancement in technology, people prefer using cash for their transactions.
Here are some of the benefits of using cryptocurrency as your financial medium:
Most transactions involve many intermediaries that earn in the process while making the transaction easier, adding up costs for the user. Cryptocurrency cuts out these costs by eliminating intermediaries from transactions, making it easier and more cost-effective.
Cryptocurrency allows foreign business individuals or parties to conduct one-on-one internet transactions without the hassles and additional expenses typically associated with international currency exchanges via third intermediaries.
No middle man
Cryptocurrencies don’t use intermediaries, so transactions are usually more accessible, faster and require less or no additional transaction fees.
While there are several ways to pay online for your transactions, most of them have some charges associated with them. Cryptocurrency is a great medium to avoid paying huge fees for using a convenient platform as most transactions involve no transaction fees, unlike credit cards and banks.
Some experts believe, however, that taking out the middle man goes beyond these simple benefits.
Cryptocurrency has the potential to abolish current societal structures and practices that deprive people of their rights, providing the foundations of a system that’s transparent yet secure. Particularly useful where corruption is exposed, and rampant inflation ended.
People avoid sharing their transaction details and want to keep them confidential to the maximum possible. The use of cryptocurrency helps you achieve this goal. This type of transaction involves just two parties, and you need not get involved with any bank or institution to transfer money, keeping your transaction secure.
Types of Crypto Assets
Digital assets, also referred to as crypto assets, are nontangible assets created, traded, and stored digitally.
Crypto assets are classified into three types: cryptocurrencies, crypto tokens, and crypto commodities. If you’re new to blockchain and cryptocurrency, it’s useful to understand the distinctions between these crypto asset classes.
Tokens and cryptocurrency are distinct subclasses of digital assets that employ cryptography, an advanced encryption technology that ensures the legitimacy of crypto assets by eliminating the potential of counterfeiting or double-spending.
In this section, we explain each of the digital asset classes in detail and explain the key differences between each one.
A cryptocurrency coin is exclusive to its blockchain. It is a virtual currency that may be used to make payments, with transactions in a cryptocurrency coin taking place solely through its own blockchain. The original cryptocurrency, Bitcoin, is the best example of a cryptocurrency coin. It exists as a monetary unit — with its own independent ledger.
Coins can be further classified depending on their uses. For example, some cryptocurrency coins, such as Bitcoin, are limited in their supply. Their value is, therefore, influenced by the basic principle of supply and demand.
On the other hand, many alternative cryptocurrency coins have been developed to function on their own unique blockchain and protocol. Ripple (XRP) is one of the best instances of this, operating as a bridge between fiat currencies and a unique kind of liquidity for B2B and B2C transactions to make cross-border payments more inexpensive.
In many cases, cryptocurrency tokens are established to encourage user involvement and innovation within a network community. Blockchain tokens can be distributed as a form of compensation for participating in an activity on a blockchain network.
Tokens differ from coins in that they have no blockchain of their own. They are built on another blockchain. For example, a dApp can run on a blockchain of Ethereum. Tokens generally stand for projects and are sold during the initial public sale, just like an IPO (Initial Public Offering) in the stock market.
Tokens are further classified into two types:
- Utility Token – Intended to be used to buy products and services from the company offering it. These are designed to encourage interaction between users and a company’s crypto services.
- Security Token – A digital version of financial security and represents the share value of a company. These are designed to offer users part ownership of a digital company, acting as a form of investment.
In simple words, security tokens earn profits, pay interest, dividends and allow investing in other tokens or assets to help generate profit. They should also comply with some regulations and standards.
dApps are just like apps on a download store but their own entities rather than being centralized through a platform. They are decentralized applications that leverage all the benefits of blockchain. They are open source, have an uptime of 100%, and autonomous. There are about 3000 dApps that use blockchains from Ethereum and its peers like NEO, EOS and more.
While there is considerable disagreement over what constitutes crypto commodities, the phrase is often used to denote a tradable or fungible asset representing a commodity, utility, or contract in the real or virtual world via exclusive tokens on a blockchain network.
Some people consider blockchains used to generate tokens to be crypto commodities. Others have described cryptocurrency in terms of computer system attributes such as CPU power. However, in both cases, crypto commodities are designated as building blocks for cryptocurrency.
Crypto commodities include computational power (or the speed and number of processors used to generate cryptos) and the storage capacity of a system.
Another example is Ethereum’s blockchain, which serves as a foundation for creating smart contract tokens. Several significant corporations have joined together to form the Ethereum Enterprise Alliance (EEA) to provide a framework and standard technology for developing apps that use Ethereum’s blockchain.
What can you use Cryptocurrency for?
1. Buy goods
Previously, finding a merchant who accepted cryptocurrencies was exceedingly difficult, if not impossible. Today, though, the situation is very different.
Bitcoin is accepted as payment by a large number of merchants, both online and offline. They range from large online stores such as Overstock and Newegg to tiny neighborhood shops, taverns, and restaurants.
Bitcoins may be used to pay for hotels, flights, jewelry, apps, computer parts, and even a college education.
Altcoins, such as Ethereum, Litecoin, and Ripple, are not yet widely accepted. However, acceptance of virtual currency as a method of payment for goods is being increasingly adopted, with Apple now accepting at least ten different cryptocurrencies as payment on the App Store.
Of course, users of other cryptocurrencies can always exchange their coins for BTCs. Furthermore, some websites sell Gift Cards, such as Gift Off, which accepts about 20 different virtual currencies. Using gift cards, you can buy almost anything with digital currency.
Finally, there are cryptocurrency-only marketplaces such as Bitify and OpenBazaar.
Many individuals believe that cryptocurrencies are the most exciting investing possibility accessible right now. Indeed, there are numerous accounts of people becoming “digital” billionaires due to their Bitcoin investments.
Bitcoin is the most well-known digital money to date, and the price of one Bitcoin is currently experiencing surpassing all previous records. Ethereum, maybe the second most valuable cryptocurrency, has had the quickest increase of any digital currency. Since mid-2013, the market cap of all cryptocurrencies has increased by more than 10,000 per cent.
It should be noted, however, that digital currencies are high-risk investments. Their market value swings more than any other asset. Furthermore, it is somewhat unregulated, there is always the chance of them becoming illegal in certain areas, and any cryptocurrency exchange can potentially be hacked.
Trading in virtual currencies
If you decide to invest in a digital currency, Bitcoin is perhaps the most popular. While it is relatively simple to buy Bitcoins, various exchanges sell in BTC – other cryptocurrencies are not as simple to obtain.
However, the situation is gradually improving, with major exchanges, including Kraken, BitFinex, BitStamp, and many more, beginning to sell Litecoin, Ethereum, Monero, Ripple, and other digital currencies. There are a few alternative ways to obtain altcoins, such as trading face-to-face with a seller or using a Bitcoin ATM.
You’ll need a place to keep your bitcoin once you’ve purchased it. Wallet services are available on all major exchanges. However, while it may appear to be more handy, it is advisable to keep your assets in an offline wallet on your hard drive or even invest in a hardware wallet. This method is the safest way of holding your currencies, and it provides you with complete control over your assets.
As with any other investment, you must pay close attention to the market value of cryptocurrencies as well as any related news. Coinmarketcap is a one-stop shop for tracking the price, volume, circulating supply, and market capitalization of most existing cryptocurrencies.
Depending on the country you live in, you may be required to include a profit or loss from investing in cryptocurrencies in your tax return.
In terms of taxation, cryptocurrencies are viewed significantly different in each country. The Internal Revenue Service ruled in the United States that Bitcoins and other digital currencies should be taxed as property rather than cash.
For investors, this means that long-term gains and losses from bitcoin trading are taxed at the applicable capital gains rate, which is capped at 15%.
Miners are the most critical component of any cryptocurrency network, and mining, like trading, is an investment.
Miners essentially serve as bookkeepers for their communities. They contribute their computing power to solving complex cryptographic challenges required to confirm a transaction and record it in the Blockchain, a distributed public ledger.
One of the fascinating aspects of mining is that the difficulty of the riddles increases in direct proportion to the number of individuals attempting to answer them. As a result, the more popular a cryptocurrency becomes, the more people try to mine it, and the more complex the process becomes.
Many people have made significant amounts of money through Bitcoin mining. Back in the day, you could make a lot of money mining with just your computer or a strong enough laptop. Bitcoin mining is now only profitable if you are ready to invest in industrial-grade mining hardware. This, of course, results in high electrical costs on top of the cost of all necessary equipment.
Currently, Litecoins, Dogecoins, and Feathercoins are believed to be the best cryptocurrencies for novices in terms of cost-effectiveness. For example, based on the current value of Litecoins, you might earn anywhere from 50 cents to $10 each day using simply consumer-grade technology.
How can miners generate money?
The more processing power they amass, the better their chances of cracking the cryptographic challenges. When a miner solves the challenge, they are rewarded as well as charged a transaction fee.
As cryptocurrency becomes popular, mining becomes more complex, and the number of coins obtained as a reward falls. When Bitcoin was first formed, for example, the prize for successful mining was 50 BTC. The reward is now 12.5 Bitcoins. This occurred because the Bitcoin network is designed to allow just 21 million coins to be in circulation.
Almost 17 million Bitcoins had been produced and distributed as of November 2017. However, as the rewards get smaller and lower, every single Bitcoin mined becomes exponentially more valuable.
All of these variables combine to make cryptocurrency mining a highly competitive arms race that benefits early adopters.
However, depending on where you live, profits from mining may be subject to taxation and Money Transmitting restrictions.
4. Accept as payment for your business
Accepting cryptocurrency as a form of payment may be a solution for you if you own a business and are seeking new customers.
Cryptocurrency interest has never been higher, and it is only going to grow. The number of crypto-ATMs placed around the world is increasing in tandem with the growing interest. Currently, Coin ATM Radar lists around 1,800 ATMs in 58 countries.
First and foremost, inform your clients that your company takes cryptocurrency. Placing a sign near your cash register should suffice. Payments can then be accepted by physical terminals, touch screen apps, or simple wallet addresses via QR codes.
There are numerous services available to enable you to accept cryptocurrency payments. CoinPayments, for example, presently takes over 75 different digital currencies and charges only 0.5 per cent commission for every transaction. Other well-known services include Cryptonator, CoinGate, and BitPay, the latter of which exclusively accepts Bitcoins.
Bitcoin and other altcoins have been recognized as convertible virtual currencies in the United States, which implies that taking them as payment is the same as accepting cash, gold, or gift cards.
For tax purposes, US-based firms that accept cryptocurrencies must keep a record of the sales reference, the amount received in a specific currency, and the transaction date. If sales taxes are needed, the amount is computed using the average exchange rate at the time of sale.
Also read: How to accept Bitcoin Payments
Limitations of Cryptocurrency
Since their introduction in 2009, cryptocurrencies have gotten a lot of attention and have been a hot topic of discussion. However, most people feel that cryptocurrency can be extensively used because it has few laws and no additional fees.
Digital currencies offer both benefits and drawbacks. As their use becomes more widespread, constraints and challenges relating to cryptocurrencies, and crypto-assets in general, will be readily overcome.
Key limitations currently faced by cryptocurrencies are:
- Lack of understanding and awareness about digital currencies. Despite their superiority, not all digital currencies are accepted by merchants.
- The primary disadvantage of Bitcoins is market volatility. As the value of digital currencies fluctuates, so does the value of cryptocurrency. As more people begin trading with Bitcoins, the risk and volatility will eventually reduce.
- Bitcoin, and other altcoins, are yet to reach full maturity and have a long way to go before reaching their full potential.
Digital currency cannot substitute or replace national currencies in the near future until sufficient awareness and understanding of what cryptocurrencies are and the rewards and risks associated with them are fully understood.
While Bitcoin pioneered a new asset class a little more than a decade ago, other virtual currencies are available for investors to learn about and invest in.
However, as with any trend, one must tread carefully – Coinopsy categorizes over 1,700 digital currency coins as nearly worthless.
Furthermore, Bitcoin and other cryptocurrencies have recently come under scrutiny for their ability to be involved in unlawful transactions, thefts, and frauds.
If digital currency is to replace money, cryptocurrency must overcome various obstacles. Unfortunately, at least in the short term, the chances of winning the race appear slim.
That is only one reason why investing in the list of cryptocurrencies available still bears a high level of risk.