Cryptocurrencies - introduction

“Those on the inside see cryptocurrencies as prions, infecting and transmuting corporate structure into distributed networks.” – Rafe Furst

What are cryptocurrencies?

Cryptocurrencies are decentralized digital currencies that use advanced encryption to facilitate trustless online payments without the need for traditional financial institutions. Unlike state-authorised, bank-issued fiat currencies (e.g. the dollar or the euro), cryptocurrencies do not have a central issuing authority. Instead, cryptocurrencies are ‘decentralized’, meaning they are maintained by a network of independent nodes spread around the world. 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.

The first and most popular cryptocurrency is of course Bitcoin, which was invented in 2009 by a mysterious person (or persons) using the pseudonym Satoshi Nakamoto. Satoshi’s true identity remains a mystery to this day, but the mark he/she/they left on the world is undeniable.

Bitcoin was described in its official white paper as a “peer-to-peer electronic cash system”. Since then, thousands of cryptocurrencies have been created for an extremely broad range of purposes. Unfortunately, many of these projects are scams or failures; either they are unable to deliver a finished product or they never intended on producing one in the first place.

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.

The actual ‘work’ in PoW mining is done by powerful computers that require extraordinary amounts of energy. This is one of the main problems with cryptocurrencies, as many environmentalists consider them a contributing factor to global climate change.

It is for this reason (among others) that many cryptocurrencies utilize alternative mining algorithms, the most popular of which is called proof-of-stake (PoS). In contrast to PoW, PoS mining skips the puzzle altogether and simply gives out newly mined coins randomly to users based on the amount of the cryptocurrency they have ‘staked’ on the network. Cryptocurrencies that make use of PoS (or variants of PoS) mining include EOS and FairCoin.

It should be pointed out that while PoS algorithms are widely considered to be more environmentally friendly than PoW systems, they have still faced criticism for their tendency to give even more money to those who already have the most on the network.

What are the benefits?

• Disruptive to the global financial system: cryptocurrencies by their very nature take power away from traditional financial institutions and give it to the people. 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. In fact, Bitcoin was largely inspired by the failures of the global financial system in the 2008 recession. Some cryptocurrency enthusiasts believe that widespread cryptocurrency adoption will be a key part in doing away with banks and government-controlled money altogether.
• Privacy: while most cryptocurrencies are not completely anonymous, they provide much more privacy than traditional online payments. Every time you pay for something using a normal credit or debit card, your bank maintains a record of that purchase that goes alongside all of the personal information they have in your account. Cryptocurrencies, on the other hand, include very few details about the participants or purpose of each transaction. While this ‘pseudoanonymity’ has earned cryptocurrencies a rather unsavory reputation due to their potential use in money laundering, the vast majority of cryptocurrency transactions are used for perfectly legitimate purposes.
• 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.
• Resilience: because of their decentralized structure, cryptocurrency networks will never be brought down due to the failure of a centralized server.
• Non-inflationary: many cryptocurrencies are explicitly designed to be non-inflationary, meaning that the value of your cryptocurrencies will not be manipulated by the Federal Reserve or any other faceless financial institution.

… 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 their cryptocurrency in the first place. 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.

Animated video outlining the concept of cryptocurrencies in 190 seconds.

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.

Given Bitcoin’s reliance on PoW mining, however, you may want to consider other cryptocurrencies that utilize more sustainable models. EOS, Stellar, and Ethereum (once Ethereum switches to PoS mining) are all viable options among the top cryptocurrencies with significantly lower energy demands—though there will likely be fewer online resources available if you have questions about these projects.

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.

Thanks to Enric Duran of FairCoin for information.

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Matthew Slater develops software for complementary currencies. He co-founded Community Forge, which free hosts software for collaborative credit schemes; he co-authored the Money & Society MOOC, a free masters level multidisciplinary online course. He co-drafted the Credit Commons white paper, a proposal for a global solidarity economy money system, based on mutual credit principles.

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The views expressed here are those of the author and not necessarily lowimpact.org's

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