Cryptocurrencies are digital assets that are an alternative to the traditional banking system and offer a cheaper, faster, and safer way to exchange money for goods and services online. They are an innovative payment system with advantages over previous payment methods and traditional asset classes. Here is a quick guide to the basics of cryptocurrencies that will help you learn more about this financial innovation.
What is cryptocurrency?
A cryptocurrency is a type of digital currency that uses cryptography to secure transactions and control the creation of new coins. Advanced encryption techniques are used to store and transfer digital currency data between wallets and public ledgers. The purpose of encryption is to ensure security in cryptocurrency transactions.
Cryptocurrency is not physical money but a digital currency that exists decentralized and transmitted digitally from one person to another over the Internet. Crypto is a peer-to-peer payment system allowing anyone to send and receive payments anywhere.
Many cryptocurrencies are based on the blockchain. Transactions are recorded in a digital public ledger. No central authority issues them, so governments cannot manipulate decentralized networks. Digital assets are stored in blockchain-based digital wallets.
How does cryptocurrency work?
Most cryptocurrencies operate independently of a central bank or government. Instead of a government-backed currency, blockchain technology is at the core of how digital assets work. Cryptocurrencies don’t exist physically, so all coins are virtual currencies. They are only available online and are classified as virtual assets. Their value on the market is determined by the forces generated by buyers and sellers.
Cryptocurrencies, like Bitcoin, use encryption technology to ensure the security of transactions and users’ personal data. Blockchains rely on a distributed consensus mechanism to validate transactions and maintain the blockchain. The two most popular consensus mechanisms are Proof of Work, of PoW in short, and Proof of Stake, or PoS.
Digital assets based on PoW protocol are generated through a complex process known as mining. This process uses computational power to solve complex mathematical problems.
PoW works based on the so-called miners who use special-purpose computers for verifying transactions. For maintaining the network, miners receive rewards.
PoS cryptocurrencies distribute rewards to help launch the network by holding assets in certain designated wallets. This more complex stake process usually requires a certain minimum number of coins, which typically receive block rewards in addition to transaction fees. Some PoS cryptocurrencies also allow the use of masternodes.
What is a blockchain?
A blockchain is a database shared by nodes on a computer network. It stores information in digital format. Blockchains provide a secure and decentralized record of cryptocurrency transactions. The blockchain guarantees the fidelity and security of data and eliminates the need for a third party.
A blockchain actually works as a database, but differently than the one you have been using. That’s because the data in a blockchain is organized differently — into groups called blocks that store specific information. When a block has accumulated as much data as possible, it is closed and linked to the previously filled block, creating a chain known as a blockchain. The new information is combined into a newly formed block, which is then added to the chain once it is filled.
This structure inherently forms an irreversible timeline of data when implemented in a decentralized manner. When the block is added to the chain, it becomes part of the overall timeline. Blocks are given timestamps when they are added to a chain.
Main features of cryptocurrency
Before bitcoin, every form of currency required a central authority that you had to trust to use it. That central authority became the major weakness and led to the currency’s demise in all cases. Bitcoin is a trustless currency because it was designed so that no single entity can control it.
The bitcoin network relies on redundancy and trustworthiness. When you send a bitcoin transaction, every node in the network receives it, verifies its signatures, and then confirms that the transaction is correct.
The blockchain is a shared ledger that everyone has access to because they have a copy of it. It allows us to have trust without having to trust a single organization or a third party because we can simply look at the ledger and be sure that things are being done correctly.
The idea of using the proof of work consensus algorithm to incentivize individual network actors is one of the most exciting and groundbreaking ideas in modern economics.
Immutability means “not subject to change” and refers to a cryptocurrency transaction that cannot be reversed in the context of blockchain. Immutability usually follows three principles:
- Rewriting the history of transactions will not be easy.
- Only the owner of a private key should be able to move funds.
- Transactions are recorded on a decentralized public blockchain.
If you want to check your banking account balance, you can view your transaction history at the bank. You should trust your bank not to counterfeit transactions or tamper with your money. Furthermore, you also need to trust centralized organizations to forward your transactions to the recipients. If there are fraudulent transactions, the bank should clean up the situation.
Cryptocurrencies eliminate the need for trusted third parties by making the transaction record public and immutable. Cryptographic security makes the opportunity to change a transaction ledger extremely difficult, as you would have to compromise the entire network.
Blockchains are politically (no one controls them) and architecturally (no central infrastructural point of failure) decentralized but have a logically centralized database.
- Fault tolerance means decentralized systems are less likely to fail randomly because they rely on networks of separate components.
- Attack resistance means decentralized systems are more difficult to attack and destroy or tamper with. It will require more effort to attack the whole network than one centralized weak point.
- Collusion resistance means that there is no central authority in a decentralized system. Therefore, it is more difficult for members of the system to work against the interests of other members. On the other hand, corporations and governments work together, which means they can collude and harm people not affiliated with or who do not benefit from the entity.
Governments and central banks control the supply and creation of money through money issuance and interest rates. Users of fiat currencies are at the whims of these institutions in printing money. With cryptocurrencies, on the other hand, no single person or group can have a significant impact or influence the supply of money without the consent of the majority.
Types of cryptocurrencies
Coins and tokens are forms of cryptocurrencies, but they serve different functions in the blockchain ecosystem. Coins rely on their own blockchains and act as means of payment. For example, Ethereum (ETH) is a coin based on the Ethereum blockchain.
Coins are used as money and are created on their own blockchain. For example, Ethereum is a cryptocurrency based on the Ethereum blockchain. Some cryptocurrencies, like BTC, have a limited supply that helps boost their perceived value. For instance, the maximum number of bitcoins is capped at 21 million, but more than 12 million are already in circulation.
Tokens are pieces of code that can represent any form of value, including real-world items such as electricity, money, points, coins, and digital assets. Unlike coins, tokens are built on top of existing blockchain technology. They are used to let people use blockchain applications with less friction. They are programmable assets that enable the creation and execution of unique smart contracts. They can be sent and received over a blockchain network.
An altcoin is a nickname for an “alternative coin.” Altcoin refers to any cryptocurrency created as an alternative to Bitcoin to improve certain aspects of Bitcoin. Examples of Altcoins include Ethereum (ETH) or Litecoin (LTC).
Stablecoins are created to have a stable value, and most of them are pegged to the dollar. The dollar offers users the opportunity to sell an asset with the same value as a national currency but can still be used as a transaction in cryptocurrency systems.
Another type of cryptocurrency, non-fungible tokens, are unique assets that others cannot replace. Bitcoin, for example, is fungible because you can exchange one bitcoin for another and get the same thing. However, each card is unique and can never be replicated.
The Role of Consensus in Cryptography
In a centralized system, anyone with the authority to maintain and update the database can access the information it holds. The task of making updates, like adding, deleting, or updating names, is carried out by an editing authority who is the sole in-charge of maintaining open records.
Public blockchains are decentralized by their very nature. Verification of transactions occurring on the blockchain is a responsibility that lies with the entire community. A consensus mechanism allows network members to agree on a value or a state of the system.
Proof of Work vs. Proof of Stake
Cryptocurrencies often use a PoW or a PoS to verify transactions before adding them to the blockchain. A verifier is rewarded with more cryptocurrency the more transactions they validate.
Proof of Work
PoW verifies transactions on the blockchain by posing a mathematical problem that computers attempt to solve. When computers “mine” cryptocurrency, they contribute to the transaction validation process. The first miner to complete this process correctly is rewarded with a small amount of cryptocurrency.
Forcing the blockchain to validate a transaction can be computationally intensive. In practice, this means that individual miners can barely cover the cost of electricity and computing power.
Proof of Stake
Some cryptocurrencies use a method called PoS to prevent people from consuming a lot of energy to verify transactions. The number of transactions that each person can verify is limited to the amount of cryptocurrency they are willing to “put” into a shared vault or temporarily lock in order to participate in the process.
Proof of Stake reduces transaction validation/confirmation times by eliminating energy-intensive equation solving. When a stakeholder validates a new set of transactions, he is rewarded with cryptocurrency. If he validates an invalid block, he loses his stake.
Why are cryptocurrencies so volatile?
Cryptocurrencies are still a new industry, and their value is constantly changing. Investors try to experiment with digital assets to make more profits quickly. The number of people trading, holding, or using a particular cryptocurrency coin in their daily lives affects its price. The price increases when more people buy digital assets compared to the number of participants that want to sell this asset.
One thing that drives the value of cryptocurrencies is their finite mechanism. The Bitcoin protocol sets the maximum amount of BTC that can be mined at 21 million. Some crypto projects use buyback and burn mechanisms to reduce the asset supply to affect the asset value. For instance, PointPay is regularly burning PXP tokens. Since September 2, 2021, we have burned 20.5 million PXP with a total value of more than $841.2 thousand.
Advantages and disadvantages of cryptocurrency
Advantages of using cryptocurrency
- Sending crypto from one digital wallet to another can be quick and easy using only your smartphone or computer. You can send assets to the person in another corner of the world in a couple of minutes.
- The blockchain is a public list of cryptocurrency transactions. It makes it possible to trace the history and make copies or undo transactions.
- Blockchain automatically manages transactions and cuts out the need for intermediaries such as banks, so transaction fees are much lower. Furthermore, you don’t need to trust another party when transferring funds.
Disadvantages of using cryptocurrency
- Cryptocurrency can often be vulnerable to cyber attacks, fraud, and scams.
- Cryptocurrencies are not regulated, so there are no laws in place to protect your business. Furthermore, they became popular among criminals who use digital assets for financial crimes.
- The value of digital assets fluctuates significantly. So you are risking that the coin you invested in can dump in a short period of time.
- Since there is no central agency, you are solely responsible for managing your wallet and funds. There is no way to access your holdings if you lose your private key.
What is the future of cryptocurrency?
Cryptocurrencies have grown at an incredible rate in the last decade, evolving more quickly than anyone could have predicted. It was facilitated by the emerging trends in the crypto space, such as decentralized finance (DeFi), non-fungible tokens, or rising numbers of decentralized apps (Dapps). Blockchain technology can soon be integrated into the supply chains of major companies. The future of digital currency looks bright, given the recent growth and adoption seen since the release of Bitcoin in 2008.
PointPay offers you an easy way to enter the crypto market. You can easily buy or sell digital assets with fiat via one of the payment providers integrated into our platform. Furthermore, you can trade popular digital assets on our liquid crypto exchange. Our blockchain-based bank also allows you to easily deposit funds to start earning rewards or take out a crypto loan. PointPay crypto school will help you learn the basics of cryptocurrency.
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