Cryptocurrency has recently become very popular as an investment option. It is therefore pertinent to know the basics of cryptocurrency and how it works. The cryptocurrency concept is not new. But there are many question related to cryptocurrency, which still awaiting answer. Let us first understand basics of cryptocurrency and how it work.
What is Cryptocurrency?
It is derived from two words – cryptology & currency. Cryptology is a science of computer coding language. The code does developed can only be understood between sender and receiver. No third party. The code itself is a store of value. Its value changes as per market demand and supply. So cryptocurrency is nothing but coded digital currency. It does not have a physical presence. Currently there are 2000 cryptocurrencies in circulation and valued around USD 1.03 trillion. The owners are not identifiable, but all transactions are publicly available.
History of Cryptocurrencies
It started way back in 1983 when American cryptographer David Chaum conceived anonymous cryptographic electronic money called ecash which was implemented in 1995 for cryptographic electronic payment system through a platform called Digicash. Thereafter it went on development and the first decentralized cryptocurrency, Bitcoin, was created in 2009 by pseudonymous programmer Satoshi Nakamoto. It uses a highly secured cryptographic hash function known as SHA-256, in its proof-of-work scheme. Later in April 2011, Namecoin was created as an attempt at forming a decentralized DNS (Domain Name system), which would make internet censorship very difficult. Soon after, in October 2011, Litecoin was released. It used scrypt as its hash function instead of SHA-256. Another notable cryptocurrency, Peercoin used a proof-of-work/proof-of-stake in hybrid.
Bitcoin is the pioneer in cryptocurrency evolution. All such cryptocoin developed after Bitcoin is collectively known as Alternative cryptocoin or Altcoin.
How it works?
Let me explain with an illustration. Suppose Mr.X from India wants to send USD100 to Mr.Y in USA. He can do it through his banker in India, The bank after establishing credential transfer the money to Mr.Y in USA in his account. In case of cryptocurrencies, Mr.X can send it to Mr.Y in USA or anywhere in the world directly without any intermediary through technical platforms known as Cryptocurrency exchange or crypto exchange which is available online. The difference is that it does not require an intermediary and Mr.Y in USA would not be able to take out the money is physical form. It will remain in digital form. He may choose to exchange cryptocurrency for physical goods.
Anybody who wants to buy or sell cryptocurrencies can be a member of crypto exchange with a public account like in google, facebook, instagram etc. Anybody wants buy a cryptocurrency say Bitcoin can do so by paying real money or exchanging other cryptocurrencies. Similarly for sales. The buy and sell of cryptocurrencies between two parties is called a transaction. Before the transaction is actually executed it goes to ‘Miners’. Each transaction coded by both the party with a secret private and public key. The Miners job is to match the keys and authenticate the transaction which is known as ‘proof of work’. It is a very complicated job carried out in high end computing system.
Miners put each set of transaction in a block and put it as a public record in a ledger. Such transaction blocks are connected with each other which is known as blockchain.
Associated terms of cryptocurrencies
Decentralised system – The money that we use in day to day life is controlled by a central authority of the country. Therefore it is called a centralized system. But cryptocurrency is decentralized and produced by the entire cryptocurrency system collectively. All records are available publicly at different computer nodes. In centralized system there is backing by way of gold deposit to the extent of money in circulation in the economy. In decentralized system there is no such backing.
Blockchain
A transaction of buy or sell is known as a block. All such blocks or transaction are linked with one another. It is called the blockchain. It is continuously growing list of records and secured using cryptography. By design, blockchains are inherently resistant to modification of the data. A blockchain is typically managed by a peer-to-peer (person to person) network collectively adhering to a protocol for validating new blocks.
Distributed ledger
In a centralize system transaction recording book (ledger) is maintained centrally at one place. In decentralized system the ledger is consensually shared and synchronized across multiple sites, institutions, or geographies, accessible by multiple people. It allows transactions to have public view. Therefore it is known as distributed ledger. All blockchain are published as a distributed ledger which record transactions between two parties efficiently and in a verifiable and permanent way.
Timestamping
Cryptocurrencies use various timestamping schemes to “prove” the validity of transactions added to the blockchain ledger without the need for a trusted third party. It helps to identify the exact time and location from where transaction carried out.
Proof-of-work
The proof-of-work/stake is a method of securing a cryptocurrency network and achieving distributed consensus through requesting users to show ownership of a certain amount of currency. It is a timestamping process. The most widely used proof-of-work schemes are based on SHA-256 and scrypt novel hash functions computing. Some other hashing algorithms that are used for proof-of-work include CryptoNight, Blake, SHA-3, and X11.
Mining
Cryptocurrency mining, or cryptomining, is a process in which transactions for various forms of cryptocurrency are verified and added to the blockchain digital ledger. The programmer after developing the code releases as a mathematical puzzle. These puzzles are decoded by a group of peoples or companies known as miner. The process known as mining requires high end computers with specialized hardware and software. Miners are rewarded with new Cryptocurrencies. The Cryptocurrencies thus collected by miners is halved in every 4 year to keep a check on oversupply of that Cryptocurrency.
Wallets
A cryptocurrency wallet stores the public and private “keys” or “addresses” which can be used to receive or spend the cryptocurrency. With the private key, it is possible to write in the public ledger, effectively spending the associated cryptocurrency. With the public key, it is possible for others to send currency to the wallet.
Transaction fees
The currency holder can choose a specific transaction fee, while network entities process transactions in order of highest offered fee to lowest. Cryptocurrency exchanges can simplify the process for currency holders by offering priority alternatives and thereby determine which fee will likely cause the transaction to be processed in the requested time.
Atomic swaps
Atomic swaps are a mechanism where one cryptocurrency can be exchanged directly for another cryptocurrency, without the need for a trusted third party such as an exchange.
Good & bad about Cryptocurrencies
Goodside
- It can be transferred very fast.
- The system does not require a central authority; its state is maintained through distributed consensus.
- No intermediary involved.
- Minimal transaction cost
- The system keeps an overview of cryptocurrency units and their ownership. The system defines whether new cryptocurrency units can be created. If new cryptocurrency units can be created, the system defines the circumstances of their origin and how to determine the ownership of these new units.
- The system allows transactions to be performed in which ownership of the cryptographic units is changed. A transaction statement can only be issued by an entity proving the current ownership of these units.
- A number of aid agencies have started accepting donations in cryptocurrencies, including the American Red Cross, UNICEF and the UN World Food Program.
The badside
- Cryptocurrency transactions are normally irreversible after a number of blocks confirm the transaction. Additionally, cryptocurrency private keys can be permanently lost from local storage due to malware, data loss or the destruction of the physical media. This prevents the cryptocurrency from being spent, resulting in its effective removal from the markets.
- Sender & receiver are not known in real world.
- The legal status of cryptocurrencies varies substantially from country to country and is still undefined or changing in many of them. While some countries have explicitly allowed their use and trade others have banned or restricted it.
- Cryptocurrency advertisements were temporarily banned on internet platforms
- Systems of anonymity that most cryptocurrencies offer can also serve as a simpler means to launder money.
- In February 2014 the world’s largest bitcoin exchange, Gox, declared bankruptcy. The company stated that it had lost nearly $473 million of their customers’ bitcoins likely due to theft.
- Homero Josh Garza, who founded the cryptocurrency startups GAW Miners and ZenMiner in 2014, acknowledged in aplea agreement that the companies were part of a pyramid scheme, and pleaded guilty to wire fraud in 2015.
- On 21 November 2017, the Tether cryptocurrency announced they were hacked, losing $31 million in USDT from their primary wallet.
- Cryptocurrencies have been compared to Ponzi schemes, pyramid schemes[and economic bubbles.
- While cryptocurrencies are digital currencies that are managed through advanced encryption techniques, many governments have taken a cautious approach toward them, fearing their lack of central control and the effects they could have on financial security. In India though dealing with cryptocurrencies is permitted, it has nothing to do with the monetary system of the country.
- Cryptocurrency mining consumes significant quantities of electricity and has a large associated carbon footprint.
As one can see from above, the number of points under badside is more than the number of points on goodside. It does not mean that cryptocurrency can be ignored. It definitely has created a space of itself in modern world. May be it will take some more time to evolve to its true self. Till then it is individual’s decision to take the appropriate side.
You may like to read 5 solid ways to earn an extra income If you are looking for the same.