The Basics of Cryptocurrency
Once the stuff of dreams, cryptocurrencies have become some of the world’s highest yielding investments. Even music CDs now come with cryptocurrency add-ons and bonuses. But few people understand what they are, where they come from, and what they mean for companies, governments and society as a whole.
So, what is this global phenomenon, and how can we harness its potential? Let’s take a look:
The History of Cryptocurrency
Back in 2008, the first and most well-known crypto-currency of our times was invented. The person or group that goes under the pseudonym, Satoshi Nakamoto had intended for the Bitcoin be an electronic peer-to-peer ‘cash system’. The point of this tool had been to avoid double spending. It was completely decentralized, without a server or a central authority to administer it; in other words, digital money.
Many have tried and failed before him, because they had tried it with a central entity administering the transfers. But Satoshi tried to emulate a peer-to-peer network instead, just like the ones used for file sharing.
Cryptocurrency was born as a side-product of digital money. Traditionally, digital cash could only be traded with a payment network that can prevent double-spending (i.e. a charge must only be made once), there needs to be a central server to keep track of the balance.
But a decentralized network would do away with the need for a server. Rather than having a server prevent double spending, every entity on the network would have a list of transactions to check against when they decide a transaction is valid or a duplicate. Satoshi created just such a thing: a network with absolute consensus among users.
The Role of Cryptocurrencies
From a software engineer’s perspective, cryptocurrencies are simply limited database entries that can only be changed when you fulfil a specific condition. Just like money in your account, a crypto-currency can only be drawn out if you’re entitled to it based on a verified entry.
The only difference is that crypto-currencies are created using cryptography. Unlike money, they aren’t secured by people, banks, trusts or governments. They are secured by maths. This makes it less likely to have a compromised address than the likelihood of an asteroid impact in your back garden.
Crypto-currencies are mediums of exchange with no intrinsic value and no physical form. They only exist on the network and they can’t be exchanged for physical commodities. They can be created and supplied freely, with no central bank to administer or regulate them.
Types of Cryptocurrency
Bitcoin is by far the most well-known type of cryptocurrency with hundreds of thousands of daily transactions, but also the gold standard of cyber-crime.
Ethereum is the second most popular type, and it applies not only to transactions, but also to contracts and programs. But because if hosts a range of tokens, such as DAO, Augur and DigixDAO, Ethereum is not so much a currency as a family of crypto-currencies.
Monero has what Bitcoin’s codebase lacks: privacy. Using ring signatures, Monero’s kryptonite algorithm breaks the trail left behind by a blockchain, so you can’t trace the transactions.
Litecoin is one of the pioneers of crypto-tokens. It’s faster and more productive than Bit-coin, which is why other crypto-currencies use the Litecoin codebase.
Ripple is not that popular with miners, but gaining traction with banks. It’s more of an IOU processing network than a crypto-currency network, and it’s not considered a good investment by miners.
The Properties of Crypto-Currency
Crypto-currency transactions are irreversible and there is no safety net for scams or hacking. They happen in the virtual world under the guise of pseudonyms that are generated randomly and untraceable. They happen globally within seconds or minutes, and distance is irrelevant. They are secure due to a cryptography system that’s virtually unbreakable. The software is open and free for all to download and use.
Crypto-currency supplies are limited. Bitcoin should be exhausted by 2140. Because the last supply day is written in the code, you can estimate how much crypto-currency will be worth in the future. They’re also debt-free. They can’t be exchanged as loans, like the money in your account can. In that sense, they’re as hard as gold coins.
Cryptocurrencies are created based on a network of peers. Each peer keeps a complete record of transactions, with each transaction file stating the amount, the sender and the recipient. The transaction file is signed with the sender’s private key, and broadcast to every member of the network (a.k.a. ‘node’).
When a transaction is validated by the nodes, the crypto-currency is created. It then joins other transactions recorded in a ledger in the form of a ‘block’ of data. Several blocks form a blockchain. Transactions must be completed and confirmed after a specific amount of time to be added to the block-chain.
Mining involves confirming those transactions. Miners access these transactions over a crypto-currency network and approve them. They will then be added to the database as part of the block-chain. In return, miners get a token of the crypto-currency. Bit-coin is just such an example.
Creating Virtual Money on a Crypto-Currency Network
Everyone can be a miner, in theory. In practice, you need to fulfil some conditions put in place by Satoshi. Every block needs to connect with its predecessor by means of a hash. For Bit-coin, this system, called proof-of-work, is based on an algorithm known as SHA 256 Hash.
To build a block that gets added to the blockchain, a miner needs to complete a cryptologic puzzle based on this SHA 256 algorithm. The incentive is a certain number of ‘coins’. The harder the puzzle, the more computer power miners must invest and the more tokens they get. But the number of tokens a miner gets is part of a pre-established consensus.
So, Bitcoins are tokens you get from confirming cryptocurrency transactions. But if you think about it from another perspective, the token is in itself a currency that’s no more surreal than the money in a bank account.