Ever since the official release of bitcoin in January 2009, cryptocurrencies have been making waves in the financial industry. Yet, while many have heard about them, few know how they work and why they’re important. In this guide, we’ll take a broad look at cryptocurrencies such as bitcoin and Ethereum, where they come from, how and what you need to get started and what you need to look out for.
What is cryptocurrency?
In a world where everything’s gone digital, cash and money in general have been left behind. Even considering the widespread use of credit cards and online transfers, we still expect physical money to exist somewhere – whether that’s a bank or a wallet. Cryptocurrencies aim to change these antiquated notions of third parties and physical cash by not existing anywhere but in a digital database called a “blockchain”.
In its simplest form, a cryptocurrency allows users to transfer money almost instantly, with cheap transaction fees and no third parties involved. Over the years, many cryptocurrencies have moved beyond this core component and built platforms that allow users to transfer anything from money to real-life assets such as cars and real estate, all using the blockchain technology introduced by bitcoin.
The crypto part in the name “cryptocurrency” comes from the fact that transactions – the act of transferring assets such as currency and digital or real-life assets between a sender and a recipient – are encrypted for security, a process known as “cryptography”. Cryptography is used for three reasons:
- To protect transactions from being tampered with
- To protect the identity of parties acting in a transaction
- To enable the creation of new coins via the mining process
A brief history of cryptocurrency
The road to cryptocurrencies starts in the 1980s. In an effort to protect the cash of small shops and gas stations, banks began investigating and pushing the idea of points of sale, where a customer can use a credit card instead of cash to pay for products.
Later, in the 90s, came a web-based payment system still used today: PayPal. This gave merchants the power to accept credit card payments online and it introduced the idea of transferring fiat currencies directly between end users entirely online. With PayPal proving that the web is a viable medium for transferring currency, similar services were created, such as WebMoney (a Russian PayPal alternative) and e-Gold, an American corporation that let users buy gold online – gold that it would then hold for them.
In the 2000s, after the FBI shut down e-Gold, cryptocurrencies began popping up in the cryptography community and mailing lists. Known as the Cypherpunks, people like Julian Assange, the founder of WikiLeaks, and Jacob Appelbaum, the developer of Tor, were members.
Unfortunately, none of these cryptocurrencies could gather the necessary momentum to push them into the public’s consciousness until, in 2008, Satoshi Nakamoto published a paper titled “Bitcoin: A Peer-to-Peer Electronic Cash System”.
In the years to come, bitcoin grew to become not only the number one cryptocurrency available on the market, but a household name amongst even those who have no interest in cryptocurrencies.
Bitcoin eventually gave rise to hundreds of cryptocurrencies, known collectively as altcoins. Some of these altcoins are little more than copies of bitcoin, but others are attempting to do things with the underlying blockchain technology that not only disrupt the financial sector but also our understanding of apps and website services, all in an attempt to fix today’s problem of centralisation.
The problem with centralisation
Read any literature relating to bitcoin and cryptocurrencies and you’ll eventually stumble upon the concept of decentralisation. To understand decentralisation, you first need to understand the problem with centralisation.
If we take a close look at the world we inhabit today, a world of information and data about who we are, what we do and what we like, we realise that our information is held by a few large organisations: private and public corporations and the government. The dataset representing you (financial records, emails, Facebook messages and likes etc) is held on servers that exist in a central location. For example, your financial records, every transaction you’ve ever been a part of, your current balance and all your loans, exist on your bank’s servers. Your bank might have multiple servers for backup and audit purposes, but it still all exists in virtually one location: your bank.
So let’s say a cracker – a malicious hacker – attacks your bank’s servers and tampers with your account reducing your balance to $0. How can you prove that you didn’t just withdraw all your money? How can your bank verify your claim that you were hacked?
The Cypherpunks, the community from which cryptocurrencies first arose, understood this bleak scenario and aimed to fix it. Cryptocurrencies are said to be decentralised systems because every user of a cryptocurrency keeps a copy of everyone’s transaction history. The moment you join a blockchain you receive the entire history of that cryptocurrency, including all transactions ever made. If a user disagrees with a transaction (say a cracker changes their wallet value from 1 BTC to 1,000 BTC), a consensus must be reached by at least 51% of the users of that cryptocurrency. That 51% then decides what the correct amount should be.
This automatic consensus is the beauty behind cryptocurrencies and decentralisation. There is no one server that crackers can attack. They would need to convince 51% of all users because every user keeps a copy of the blockchain.
What is the blockchain?
The blockchain is the entire history of transactions made with a certain cryptocurrency. Because the blockchain is the technology behind every single cryptocurrency, it’s critical for our understanding of cryptocurrencies. So let’s break that down.
Whenever two users of a cryptocurrency, say bitcoin, send coins to each other, a transaction is created. This transaction contains, among other details, the wallet address of the sender, the wallet address of the recipient and the amount of currency sent.
These transactions are added to an unverified block, with each block containing the maximum of a pre-specified number of transactions, depending on the cryptocurrency in question. Once the transaction is added to a block, it is said to be immutable: it cannot be edited and cannot be removed.
You can think of a block as a page of a ledger containing a list of transactions. Once the block is filled, miners will verify the transactions (more on mining later) and the block is ready to be attached to the chain.
Each mined block is then attached to the rest of the blocks in the blockchain. This chain of blocks contains every single transaction executed in the history of the cryptocurrency. The block is given a new identifier and also the previous block’s identifier. This attaches the block to the previous one in the chain and so on. Any one block can only be attached to one previous block and can only have one child block at any one time.
For a more detailed explanation of the blockchain, check out our guide here.
The highly important task of maintaining the blockchain, verifying transactions and adding blocks to the blockchain, rests in the hands of miners. Working not with pick-axes but with very powerful computers running specialised mining software, miners look at unverified blocks and the transactions on them and solve a mathematically difficult, cryptographic puzzle involving everything on the block.
This puzzle can take anywhere between a minute and ten minutes to solve. While the exact process by which miners verify these blocks is beyond the scope of this guide, once a miner verifies a block, it’s assumed for all intents and purposes to be valid and ready for attachment to the blockchain.
The miner then pulls the last block’s identifier from the blockchain and attaches it to the new block. He also gives the new block its own identifier. This process makes the new block an official part of the blockchain, and this new information is then propagated to everyone using that particular cryptocurrency.
As reimbursement for this work, the miner receives payment in the cryptocurrency just mined. Some cryptocurrencies choose to award a portion of the transaction fees on the block just mined while others, like bitcoin, generate new coins and those coins are then given to the miner.
The rise of altcoins
Many cryptocurrencies have been attempting to replicate bitcoin’s success, some with better results than others. With over 800 altcoins at the time of writing (October 2017), this market does not seem to be slowing down. While most altcoins are merely a copy of bitcoin (with very few modifications or improvements), others are attempting to do new things with the underlying bitcoin technology.
Some altcoins, like Ethereum, have been using the blockchain to allow the development of decentralised applications where the data is held by every user of the blockchain instead of a single server. Others, like Monero, have put their focus on anonymity, building on the cryptography used by the bitcoin blockchain to further obfuscate recipient and sender wallet addresses.
While prices rise and fall dramatically, here’s a list of just a few of the top traded cryptocurrencies you can buy and sell today.
- Ether (ETH). Commonly referred to by its platform, Ethereum, Ether’s marketed as a “next-generation” currency allowing for “smart contract” exchanges without a middleman.
- Litecoin (LTC). Announced in 2011, Litecoin is most similar to bitcoin but with one of the highest market caps among cryptocurrencies.
- Dogecoin (DOGE). Founded on the jokey “doge” memes, Dogecoin has since gained traction for targeted donations and online tipping.
- Monero (XMR). Focused on privacy, Monero claims it’s “secure, private and untraceable” through a multilayered signature process.
- Dash (DASH). Named for “digital cash,” Dash focuses on speed and privacy with the ability to spend it through debit cards accepted worldwide.
- Ripple (XRP). Integrated with the Earthport blockchain, Ripple can now be used for services with select banks that include Bank of America and HSBC.
- Tether (USDT). Introduced in 2014, this currency is “tethered” to the US dollar, offering a more stable value for traders.
- BitShares (BTS). Among the more popular cryptocurrencies, BitShares’ founder describes this altcoin as “shares” distributed among a network and software that embraces public keys.
What do I need to get started?
Getting your feet wet in the world of cryptocurrencies is not as hard as it might seem. With a little research, you will be ready to go in no time. So what do you need?
Choose a cryptocurrency
There are over 800 cryptocurrencies at the time of writing (October 2017). These cryptocurrencies all have their own specific set of advantages and disadvantages. Choosing the cryptocurrency that’s right for you involves some research. Luckily, we’re here to help.
Check out our altcoin page for guides on some of the most commonly traded cryptocurrencies on the market today.
Get a wallet
Now that you’ve chosen a cryptocurrency, it’s time to get yourself a wallet. A wallet is your gateway into the blockchain, a piece of software that lets you connect to the blockchain, send and receive cryptocoins, and view your balance. Several types exist and choosing the right one for your needs involves a lot of trial and error. Start by downloading your cryptocurrency’s official wallet and going from there once you have some experience.
Buy from an exchange
Next, it’s time to fill your wallet with some coins. Just like regular currencies, you’ll need an exchange to convert fiat currency (such as USD, AUD or EUR) to your chosen cryptocurrency. Make sure you choose a reliable and secure exchange.
After exchanging fiat currency to cryptocurrency, simply transfer the coins to your software wallet and you’re ready to go!
Where to buy, sell and exchange cryptocurrency
Where can I use cryptocurrencies?
The use of cryptocurrency is common and at the time of writing in the fall of 2017 is well and truly on the rise. There are various uses for bitcoin and the numerous altcoins available. Here are some of the more common uses for cryptocurrencies:
Purchase products or services
The simplest and most common use for cryptocurrencies is as an alternative to regular currencies when purchasing products or services on the web. Many merchants at the time of writing accept the more popular cryptocurrencies as a means of payment, especially bitcoin. Even big name brands like Microsoft and Dell have given customers the facility to pay with bitcoin for a lot of their products.
Additionally, some brick-and-mortar shops have started accepting cryptocurrencies as a form of payment as well. Most of these shops have QR codes printed and pinned next to their traditional cash tills, which are then scanned by customers to execute cryptocurrency payments (again, usually with bitcoin).
Money transfers and cryptocurrency tipping
The next most common use for cryptocurrencies is as a way of transferring money and tipping. If, for example, you owe money to a friend, and both of you have an Ethereum wallet, why not transfer the money in ETH coin instead of cash? It would help the Ethereum cryptocurrency grow, might prove to be a good investment for your friend and the transfer is instantaneous with nearly no transaction fees (unlike regular currency transfers). Win-win-win.
On top of that, some cryptocurrencies have built tipping platforms for themselves (eg, Dogecoin). Users of these cryptocurrencies tip each other with coins for entertaining or informative posts on Reddit, Twitter and other social media.
Get paid in cryptocurrency
If you’re a digital goods and services provider, you can start getting paid in cryptocurrency. Offering your customers a way to pay you with their favourite cryptocurrency not only opens you up to a wider market, some people might not be comfortable purchasing your products or services using traditional payment methods, or they might live in a country that does not allow such payments, but the coins in your wallet can also serve as an investment.
With the cryptocurrency market as volatile as it is, some investors have seen the opportunity to make money by buying cryptocurrencies when they’re cheap or early in their development process and selling them when they’re expensive or when they have gained some momentum and value. Of course, this is a risky manoeuvre as the market is very unpredictable, and past performance does not guarantee future gains. However, investors have made large sums of money from investing in cryptocurrencies, especially bitcoin, which has gone from costing less than US$1,000/BTC at the beginning of 2017 to nearly US$6,000/BTC in October 2017!
What to watch out for
Cryptocurrencies are not without their pitfalls and you will need to be careful when handling your digital currency to avoid losing everything you own.
Before jumping into cryptocurrencies, do your research. No one guide will ever be able to cover everything you need to know about all cryptocurrencies. There are too many to cover in one document and each cryptocoin brings its own pros and cons. Additionally, you will need to understand how exchanges and wallets work. So before you do anything, make sure you read as many guides as you can, find reviews and try everything out with small, disposable amounts of money.
There is no safety net when working with cryptocurrencies. There are no police to make a report to if your money gets stolen; there is no bank to protect your money. With the freedom to do whatever you want with your own money anonymously comes a lot of responsibility. Here are a few tips:
- Before you send cryptocoins to someone, always double check their wallet address.
- Never hand over products or services before the transaction on the blockchain is verified. This might take up to ten minutes on some blockchains.
- Always keep the computer on which your wallet is installed safe and clean from viruses and malware.
- Never lose your wallet password. You might not be able to get it back and every cryptocoin you own will be lost.
Bitcoin and cryptocurrencies in general often suffer from sudden dips in value. Whenever purchasing cryptocoins – or investing in them – always be aware that the value of your holdings can fall. For example, if you buy $1,000 worth of bitcoin one day at $5,871.92/BTC and the price falls to $5,770.54 the next day, your 0.170302 BTC will be worth $982.73 instead of the original $1,000 you paid for it.
Of course this could work in your favour if it goes the other way round instead. However, always be aware that the cryptocurrency market is extremely volatile and past performance is not indicative of future performance.
A to H
cryptocurrency. A digital currency for which encryption techniques are used to regulate its use and generate its release. Unlike fiat currency — like US dollars, euros and yen — cryptocurrency is not regulated or controlled by any government or agency.
bitcoin. A digital cryptocurrency using peer-to-peer technology for nearly instant payments. Bitcoin was invented by an unidentified programmer, or group of programmers, under the pseudonym Satoshi Nakamoto.
bitcoin address. Also called a key, a string of alphanumeric characters used to receive bitcoin. Whereas public addresses typically begin with a 1 or 3, private addresses — or addresses that aren’t visible to all users — typically begin with a 5 or 6.
bitcoin exchange. An online website or platform that allows users to buy and sell bitcoin for other currencies.
blockchain. A public digital ledger in which the entire history of a cryptocurrency is recorded chronologically.
block reward. The amount of cryptocurrency mined after a “miner” has succeeded in solving a hash.
digital wallet. Sometimes called an e-wallet, an electronic system or app that securely stores personal information, payment details and passwords so that a consumer can make digital payments online or at retail stores that accept it.
hash. A computational puzzle that a cryptocurrency “miner” must solve in order to add the next block on a blockchain.
I to O
mining. A process by which a cryptocurrency is released into the world. “Miners” complete a computational puzzle to be rewarded with a block of currency along the public blockchain.
node. A computer connected to the bitcoin network.
P to Z
proof of work. A hash — or computational puzzle to unlock a cryptocurrency — that is so difficult, it could only have been solved through significant work or power.
proof of stake. A system that replaces the concept of “mining” a cryptocurrency with a consensus algorithm, whereby miners put up a stake of their currency to verify a block of transactions.
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