This topic is part of Digital & media and Economy & finance.
Cryptocurrencies
“Those on the inside see cryptocurrencies as prions, infecting and transmuting corporate structure into distributed networks.” - Rafe Furst
What are cryptocurrencies?
Cryptocurrencies are digital 'coins' which can be owned by anybody, in principal anonymously, and which can be transferred without the aid of a trusted 3rd party like a bank, or Paypal or Western Union. Instead of that institution holding a definitive ledger of how much is in each account, a blockchain is a ledger stored on many, many computers which allows anyone to pay out of their account and prevents anyone from altering its history.
Ultimately, cryptocurrencies allow users to engage in direct, peer-to-peer transactions with the same (or greater) security one would expect from traditional online payment methods without having to go through large financial institutions or governments. While the privacy they offer is welcome, it creates a tension with governments which want to surveil all financial transactions.
The first and most popular cryptocurrency is of course Bitcoin, whose protocol and first block was published in 2009 by a pseudonymous person (or persons), Satoshi Nakamoto.
Bitcoin was described in its official white paper as a “peer-to-peer electronic cash system”. The ideology behind it was metallist, and even though there is no precious metal in a Bitcoin, the issuance is controlled by a predictable algorithm in a process called in the paper, mining. With no fixed dollar value, a limited supply, and global interest, the sky was the limit for the price of bitcoin and many people have become very rich, especially those who bought it as an investment in the early days. On the other hand, with no intrinsic value, the price has been driven almost entirely by hype, and has fluctuated wildly on the way up, sometimes losing 80% of its value. When Cryptocurrencies were a brand new asset class there was no regulation, so the field was thick with scams.
After a while tech entrepreneurs (and scammers) realised they could finance blockchain innovation (and scams) by selling a new coin, like ordinary companies sell shares except without the regulatory oversight, or indeed the profit sharing or voting rights that go with shares. There was a race to rebuild the financial system using cryptocurrencies, but it struggled because of the prevalence of fraud, the opposition of the incumbent financial system, and the difficulty that non-tech users had managing private keys, understanding new jargon and assessing new types of risk.
How do cryptocurrencies work?
The fundamental technology behind cryptocurrencies is a network structure called a ‘blockchain’. Often described as a ‘distributed ledger’, the idea behind a blockchain is fairly straightforward: a publicly verifiable, tamper-proof record of all transactions on a network. Unlike traditional networks which are often hosted on centralized servers, blockchains are maintained by a decentralized network of ‘nodes’. Each node records its own copy of the network, and these nodes are in communication with one another to ensure that there is consensus between them.
Transactions on a blockchain network are lumped together into groups called ‘blocks’. These blocks are then linked together in chronological order using extremely secure encryption. If one were to look at the complete chain, they would see a comprehensive record of every transaction that has ever been made on the network. The encryption, along with the network’s distributed structure, ensures that the chain cannot be tampered with, meaning a properly maintained blockchain is immutable and incredibly secure.
Cryptocurrency mining
Cryptocurrencies are created through a process called ‘mining’. Bitcoin and many other coins utilize a system called proof-of-work (PoW) mining, in which ‘miners’ compete with one another in a race to solve an extremely difficult computational puzzle. The first miner to find the solution is given the right to add the next block to the chain and is rewarded with newly minted coins.
Although Satoshi intended that everyone could allocate a portion of their computer's processor to mining and the mining rewards would therefore be allocated randomly to users, mining quickly became a specialist activity requiring special chips, data centres, cooling systems and cheap electricity. By about 2017 Bitcoin alone was reportedly using as much electricity as a smallish country. This is one of the main problems with cryptocurrencies, as many environmentalists consider them a contributing factor to global climate change, while advocates say the wasted energy is 'worth it' or argue that Bitcoin could be beneficial for environment if by helping to load balance the grid, using electricity that was already being wasted, it could help finance the adoption of renewable energy.
Other mining algorithms were soon designed such as Proof of Stake and no new coins these days use proof of work. Unfortunately Bitcoin's internal politics, dominated by the very people consuming the electricity, has made it unable to switch, as did the second most successful cryptocurrency, Ethereum.
What are the benefits of cryptocurrencies?
A technology like this is very disruptive, which means that it creates many winners and losers, and can change the political landscape. It took a while, but government have largely managed to prevent cryptocurrencies from undermining their own fiat currencies, or from spreading too much freedom!
- Disruptive to the global financial system: By allowing users to engage in direct, peer-to-peer transactions, cryptocurrencies eliminate unnecessary middlemen in financial transactions. Additionally, cryptocurrencies will never be subject to the whims of bank executives or politicians. Some cryptocurrency enthusiasts believe that widespread cryptocurrency adoption will be a key part in doing away with banks and government-controlled money altogether, but this author contends they haven't understood what finance is, what is the role of money within finance, and that you can't build a financial system with just payments and without counterparty risk.
- Privacy: while anyone can create a wallet and use it without furnishing the authorities with 3 types of proof of identity, governments and rogue actors can usually work out who is using a wallet through routine internet surveillance. Nonetheless a crypto payment doesn't pass through a handful of institutions, doesn't require authorisation and for practical purposes can be considered private unless you are a person of interest.
- Internationality: cryptocurrencies are not limited to the jurisdiction of any particular country or organization and are therefore the world’s first truly international forms of currency. This characteristic brings with it numerous possibilities as a tool in bringing about positive change in the world. For example, individuals in countries with severe economic struggles like Venezuela and Iran have the option of turning to cryptocurrencies as alternative stores of value to their countries’ rapidly depreciating fiat currencies. Cryptocurrencies are also widely used as a vehicle for remittances because they do not charge additional fees for international transactions. 7th-ranked cryptocurrency Stellar (XLM), for example, has a particular focus on remittances.
- ** Alternative to gold. It turns out that the originally analogy with gold was prescient. Bitcoin has become a financial asset in a class very similar to gold, with the advantage that it costs next to nothing to transport and have custody of.
- Resilience: because of their decentralized structure, cryptocurrency networks will never be brought down due to the failure of a centralized server.
... and the problems?
In spite of the above benefits, cryptocurrencies are also not without their problems. Two such problems were described above: the exorbitant energy consumption of PoW mining and the wealth-centralization of PoS mining.
Another problem with cryptocurrencies is the fact that most users will still use banks or other traditional payment providers to buy and sell their cryptocurrency in the first place. This is the choke point used by regulators to separate the crypto and fiat domains. It is possible to buy Bitcoin with cash through Bitcoin ATMs or to use peer-to-peer websites like LocalBitcoins (which will put you in contact with sellers in your geographic area), but these methods are more difficult than simply using an exchange that allows you to buy cryptocurrencies through a standard wire transfer. This is of course a significant drawback if the ultimate goal of cryptocurrencies is to do-away with traditional financial institutions.
Perhaps the biggest shortcoming of cryptocurrencies, however, is their volatility. It’s true that cryptocurrencies are less volatile than the currencies of some countries, but only for countries in the most dire of economic circumstances. For people in most parts of the world, cryptocurrencies are significantly more volatile than their local fiat currencies. Most cryptocurrency enthusiasts argue that this volatility is a byproduct of cryptocurrency’s limited adoption, meaning that this issue will likely improve over time.
What can I do?
Although cryptocurrencies and their underlying technologies can seem complicated, actually buying and using cryptocurrencies is fairly straightforward.
The first step is deciding which cryptocurrency you would like to purchase. For those who are completely new to cryptocurrency, Bitcoin is the obvious first choice; it is the oldest, the biggest and the most trusted coin on the market today. Bitcoin is also great for beginners because there are abundant resources online to help you, should you ever have any questions.
As stated earlier, there are literally thousands of other coins to choose from should you want to expand your portfolio beyond the top coins; however, it is extremely important to approach smaller cryptocurrencies with a healthy degree of skepticism. You should do a good amount of research into any cryptocurrency before investing, but this is especially true for lesser-known projects. Remember one of the golden rules of investing: If it sounds too good to be true, then it probably is.
Once you’ve decided on a coin you’d like to buy, you should set up a digital wallet for that coin. Different cryptocurrencies are compatible with different wallets, so you have to be sure to choose a wallet that works with your selected coin. Many cryptocurrencies will have a page on their website that will allow you to download a first-party wallet produced by the coin’s developers. There are also many third-party wallets that work with a variety of cryptocurrencies.
Good explanation of cryptocurrency wallets.
The most secure wallets are hardware wallets - small USB devices that store the keys to your cryptocurrencies in offline ‘cold storage’. If you plan on making a significant investment into cryptocurrencies, it is highly recommended that you also invest in a hardware wallet. Just be sure that the wallet supports the coins you want before purchasing a device.
After you’ve got a wallet ready in which to store your cryptocurrencies, you can go ahead and purchase some coins from a cryptocurrency exchange. As with wallets, there are many exchanges to choose from. For your first cryptocurrency purchases you will need to use an exchange that allows you to make purchases using fiat currencies. Coinbase is widely considered to be among the easiest to use fiat-to-crypto exchanges on the market today, and is an excellent choice for the cryptocurrency beginner. You will have to enter your bank information as well as some basic personal information (Coinbase adheres to U.S. ‘know your customer’ regulations). From there, the process of buying a coin is as simple as selecting “Buy Bitcoin” (or whatever coin you’ve chosen) and entering an amount.
Once you’ve acquired your coins from the exchange, you will want to send the coins to your digital wallet. All exchanges will allow you to store your cryptocurrencies in a wallet on the exchange itself, but this is greatly discouraged in the cryptocurrency community. Numerous exchanges have been hacked over the years and you are opening yourself up to unnecessary risks by storing your funds on an exchange. Simply find your wallet’s address in the wallet app and send your coins to it.
What you do with your coins from there is completely up to you. Either keep them as an investment or use them to buy goods or services. The number of retailers who accept Bitcoin and other cryptocurrencies is constantly in flux, but a simple Google search, such as “Buy laptop Bitcoin”, can take you a long way.
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Further resources
- Coin Central - news and analyis
- Faircoin - based on 'proof of stake' rather than proof of work
- Bitcoin: a peer-to-peer electronic cash system - 2009 paper that started it all