What is cryptocurrency? A beginner’s guide
Curious about cryptocurrency? Learn what crypto is, how it works, as well as the advantages and risks in this comprehensive guide for newbies.
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Blockchain is the innovative, foundational technology underlying most cryptocurrencies. It's a decentralised and distributed digital ledger that records all transactions in a secure and transparent manner. Instead of being stored on a single central server, the blockchain is maintained by a network of computers (called miners or nodes) spread across the world. Each block in the chain holds a set of transactions and a reference to the previous block, forming a chronological chain of data.
While ledgers aren't a novel concept, blockchain technology is crucially different because of two main features. Firstly, blockchain is distributed, meaning that the entire set of records can be accessed by anyone, anywhere, not only specific sections or records.
This is critical when it comes to mining, which we’ll cover shortly. It also means that blockchain is open to the public to view or analyse, offering transparency.
Secondly, blockchain records are immutable, meaning that once they’re confirmed, they’re not able to be changed or deleted. This feature ensures the integrity of transactional history.
Cryptography involves advanced computer coding and encryption techniques. It plays a crucial role in sustaining the security and privacy of cryptocurrency transactions, as well as in controlling the distribution of new coins.
Public-key cryptography is commonly used, where each user has a pair of cryptographic keys: a public key (address) and a private key. The public key is visible to everyone and serves as an address to receive funds. Similar to giving out your bank account number to someone. The private key, on the other hand, is kept secret and is used to sign transactions, comparable to your PIN or login details for your banking app.
When a transaction is initiated, the sender's private key signs it, and this signature can be verified using the corresponding public key. This ensures that only the owner of the private key can initiate transactions.
Mining is the process by which transactions are added to the blockchain and new cryptocurrency coins are created. As we mentioned before, cryptocurrency blockchains are maintained by a network of computers around the world. These computers are called miners, or nodes.
The miners are economically incentivised to compete to solve complex mathematical puzzles. The first miner to solve the puzzle adds a new block of transactions to the blockchain and is rewarded with a fixed amount of newly minted cryptocurrency, as well as the total transactions fees for the transactions within the mined block.
Solving these puzzles requires significant computational power (called hash rate), which makes the process resource-intensive and secure. As such, this consensus method, or validation process, is called proof-of-work (PoW).
Mining helps preserve the integrity of the blockchain by making it next to impossible to tamper with or change past transactions. As a result, we can use cryptocurrency as a reliable and trusted payment method.
Each miner has access to the full blockchain, meaning that even if an unlikely catastrophic event wiped out all but one computer, the blockchain records – in their entirety – will be preserved.
As a summary of how cryptocurrency works, blockchain provides a secure and transparent ledger of transactions, cryptography safeguards the security and privacy of these transactions, and the incentivised mining process adds new transactions to the blockchain, while also creating new cryptocurrency coins. These components together enable the decentralised and trustless nature of cryptocurrencies.
Why use cryptocurrency?
At this point, you may be interested to understand why people are inclined to explore and use cryptocurrency as a payment method, a store of value or, more broadly speaking, an alternative financial system.
Crypto offers several advantages over the traditional money system.
These, of course, should be weighed against the potential risks.
Advantages of cryptocurrency
Cryptos operate on decentralised networks, which remove the need for intermediaries such as financial institutions, banks, or payment processors.
This means greater autonomy and control over your financial transactions.
Crypto is universal, meaning it transcends geographical boundaries.
Anyone with an internet connection can take part in financial activities, no matter their location.
Efficiency, speed, and cost
Traditional financial systems often involve time-consuming and expensive processes, most especially for cross-border transactions.
Crypto transactions are comparably faster, in some cases almost instant, and far cheaper.
Cryptocurrencies have the potential to provide financial services to the unbanked and underbanked populations, offering them opportunities for economic empowerment and participation globally.
Crypto’s underlying blockchain technology has led to the creation of groundbreaking applications beyond currency, including smart contracts, decentralised identity systems, and supply chain management, with a vast amount of untapped potential and applications yet to be created.
Risks of cryptocurrency
The value of cryptocurrencies can experience extreme fluctuations in a short amount of time, leading to substantial gains or losses for investors and users if they don't have adequate risk mitigation in place.
The regulatory landscape for cryptocurrencies varies widely across different jurisdictions, and regulatory guidelines constantly evolve as the industry grows.
This can pose legal challenges, limitations, and uncertainties for users and businesses.
While blockchain technology itself is extremely secure, the broader crypto ecosystem – such as exchanges and online wallets - is susceptible to hacks, scams, and phishing attacks, needing extra vigilance and security.
Lack of consumer protection
Crypto transactions are irreversible. If funds are lost due to errors or malicious activity, recovery can be challenging.
Many have also fallen victim to significant losses through defunct or bankrupt exchanges.
Lack of understanding or technical ability
Cryptocurrency remains a mostly technical subject. Many individuals may not fully comprehend the complexities of cryptocurrencies, leading to errors, misconceptions, and potentially compromised security.
The future of cryptocurrency
As we continue to adapt to the digital age, cryptocurrency holds immense potential to transform various aspects of our lives beyond the scope of purely currency. Here are a few areas we could expect to see ongoing development for crypto application and utility.
Mainstream adoption and integration
Cryptocurrencies are gradually making their way into mainstream consciousness and acceptance. Major financial institutions and companies are recognizing the value of blockchain technology and cryptocurrencies, leading to increased adoption and integration into existing systems.
Traditional banks and financial institutions are exploring ways to incorporate cryptocurrencies into their services. This includes offering cryptocurrency trading, custody services, and even integrating cryptocurrencies into investment portfolios.
Cryptocurrencies like Bitcoin and stablecoins are being considered as potential methods of payment. Some businesses have started accepting cryptocurrencies for goods and services, giving users more options for transacting.
Decentralized Finance (DeFi)
Decentralized Finance, or DeFi, is a rapidly growing sector within the cryptocurrency space that aims to recreate traditional financial services without intermediaries. DeFi platforms offer lending, borrowing, trading, and other financial services in a decentralized and permissionless manner.
Smart contracts, which are self-executing contracts with the terms or conditions of the agreement directly written into code, have the potential to be adopted in a wide range of industries. DeFi applications leverage smart contracts to automate complex financial transactions.
DeFi protocols allow users to contribute to liquidity pools and earn rewards. These pools are used to facilitate trading and lending outside of traditional financial institutions.
Non-Fungible Tokens (NFTs)
Non-fungible tokens (NFTs) have gained significant attention for their potential to tokenise and trade unique digital assets, such as art, collectibles, music, and virtual real estate.
NFTs enable verifiable ownership of digital items, providing a new way for creators to monetise their work and for collectors to own and trade digital assets.
Tokenising real-world assets
NFTs have the potential to tokenise real-world assets like real estate, enabling fractional ownership and increased liquidity in traditionally illiquid markets.
Cross-border transactions and financial inclusion
Cryptocurrencies have the power to transform cross-border transactions and bring financial services to the unbanked and underbanked populations around the world.
Cryptocurrencies offer a faster and more cost-effective alternative to traditional remittance methods, particularly for people sending money across borders.
Cryptocurrencies and blockchain technology can provide financial services to individuals without access to traditional banking systems, allowing them to participate in the global economy.
Improved supply chain management
Blockchain technology's transparency and traceability are enhancing supply chain management across various industries.
Blockchain-based systems can track the origin and journey of products, ensuring authenticity and reducing fraud in supply chains.
By providing a tamper-proof record of transactions, blockchain technology enhances transparency, reduces paperwork, and streamlines supply chain processes.
Government and Central Bank Digital Currencies (CBDCs)
Several governments and central banks are either exploring the idea or already creating their own digital currencies, known as Central Bank Digital Currencies (CBDCs).
Digital sovereign currency
CBDCs would provide a government-backed digital version of their national currency, potentially offering more efficient payment systems and improved monetary policy tools.
Efficient policy administration
CBDCs could facilitate programmable money, enabling automation. This capability has far-reaching and positive potential for the administration and management of monetary policy, financial services, and economic activities.