What is Cryptocurrency? – A Beginner’s Guide to Digital Gold

What is Cryptocurrency? A Beginner's Guide to Digital Gold

Cryptocurrency is a digital currency, in which transactions are recorded on a decentralized public ledger, using blockchain technology and cryptography.

In the past year, a buzz around cryptocurrency has skyrocketed. Everyone is talking about Blockchain, Bitcoin, Decentralization, Ethereum, Dogecoin, Dash, and the list goes on. But, only a few really understand what cryptocurrency is, and why it has the potential to change the way current financial systems work. This blog post has summarized everything that you need to know about cryptocurrency:

  1. From Barter System to Fiat: The Evolution of Currency
  2. How did “Financial Crisis of 2008” pave a path towards Cryptocurrency?
  3. Why does cryptocurrency have the potential to change how current financial systems work?
  4. How does Cryptocurrency work? How does it achieve decentralization?
  5. Is cryptocurrency safe? What gives value to a cryptocurrency?
  6. How to buy cryptocurrency?
  7. Is cryptocurrency legal?

From Barter System to Fiat: The Evolution of Currency

Since the dawn of time, currency has been an integral part of human lives. In 6000 BC, barter system was adopted, where goods and services were exchanged among each other. But, this system required people’s needs to coincide. Say, you want to exchange wheat for a dozen fruits. You had to find someone who has a dozen fruits and needs wheat.

To solve this problem, gold coins entered the system, where gold coins were exchanged for goods or services. But, as the trades increased, we realized that it was getting difficult to carry large amounts of gold coins everywhere. To tackle this, governments decided to print currency notes, whose value was tied to gold. Because of this, the amount of currency that circulated in a country was dependent on it’s gold reserves. It helped to keep inflation in check, because the global gold supply grows slowly. (Inflation refers to the increase in price of commodities)

But, international trades were settled using physical gold. During the World War I, countries who imported war weapons from other countries started losing their gold reserves. As a result, circulation of currency notes within their countries declined and the price of commodities also decreased. So, smaller countries started holding more of U.S. Dollars instead of gold, for their international trades.

As the World War II was coming to an end, delegates from 44 countries met and developed the “Bretton Woods Agreement”. It stated that all national currencies within the Bretton Woods system, were tied to the value of U.S. dollar, which in turn was pegged to gold at a fixed rate. However, gold reserves of the U.S started declining because of it’s own high demand for imports. Therefore, the U.S Dollar also cut ties with the value of gold.

Around 1971, fiat currency (today’s financial system) came into existence, which was adopted globally. Fiat currency is nothing but exchange rates between two currencies, which varies based on demand and supply. Since central banks can control how much money is being printed, they now have complete power over the economy. They can print as many currency notes as they want. But, if too much is printed, it can result in hyper-inflation.

How did “Financial Crisis of 2008” pave a path towards Cryptocurrency?

Today’s financial system (Fiat Currency) had flaws, that were highlighted during the 2008 Financial Crisis. When you deposit some amount at the bank, say $100. The bank will not actually store all of your money. Legally, it is allowed to spend 90% of your deposit, i.e., $90, in investments. A bank is allowed to only keep 10% of their net deposits in liquid cash. (Liquid cash refers to cash that is readily available to pay off consumers who demand to withdraw)

Banks started providing loans to borrowers who had poor credit ratings, at rates that were higher than the prime rate. Since getting a loan was now easy, borrowers were buying homes that were significantly inflated in value. But, as these loans increased, the homes’ artificially inflated value started dropping. Banks were left holding assets that were significantly less than the amount they had lent.

Several banks and other financial institutions no longer had the money that customers had given them, which led to their bankruptcy. The health of our monetary system is dependent on decisions that the banks and other financial institutions take. We trust banks with our money. But, the banks breached our trust during the 2008 crisis. That is when cryptocurrency and bitcoin came into the picture.

On 1st November 2008, a techie, under a pseudonymous name “Satoshi Nakamoto”, shared his paper about a new digital currency system (cryptocurrency) which uses the blockchain technology to decentralize digital transactions. Decentralize means that, digital transactions would be peer-to-peer, wherein it does not need a centralized authority like central banks to facilitate the transaction. All transactions are recorded on a decentralized public ledger system.

For example: Adam lives in Australia. He wants to send $1000 to his friend Rohan, who is living in India. He needs a third party like the bank or a UPI to facilitate this transaction. But, if Adam wants to send cryptocurrency to Rohan, he can directly send it to Rohan’s account, and the transaction gets recorded on the decentralized public ledger.

After a few months of sharing his idea of cryptocurrency, Satoshi produced 50 Bitcoins (The first ever cryptocurrency), on 3rd January 2009. The system is set up in such a way that the first 50 Bitcoins can never be utilized or spent. Cryptocurrency and Bitcoin gained popularity by 2011, and many other cryptocurrencies like Litecoin and Ethereum were developed by 2015.

Why does cryptocurrency have the potential to change how current financial systems work?

As we explained above, the key problem with current financial system is that a central authority like central banks control the supply of currency and execute our transactions for us. A breach from their end, causes a great harm to us.

Here are a few key attributes of cryptocurrency, which gives it a scope to change the current financial system:

  • Scarcity: Unlike fiat currency that can be printed without any limit, supply of cryptocurrency is capped. Only a limited number of cryptocurrency can ever be produced for circulation. For example: There are exactly only 21 Million Bitcoins in the world. Nobody can produce more bitcoins.
  • Transparency: Every transaction done on a cryptocurrency network is recorded in the decentralized ledger, which is published publicly. This means that nobody can change the money supply or manipulate any transaction.
  • Authenticity: Unlike how fake currency notes can enter the market through a breach, fake cryptocurrency can never be produced.
  • Durability: Currency notes can get burnt or torn because they are made of paper. But, since bitcoin is a digital currency, it can never be damaged.
  • Portability: Cryptocurrencies are stored in digital-wallets. So carrying billions of dollars wouldn’t feel heavy and you can make transactions through exchange platforms.

Let’s take a look at the technologies that cryptocurrency uses, to achieve these attributions.

How does cryptocurrency work? How does it achieve decentralization?

Cryptocurrency solves the flaws of our current financial system, through blockchain technology and cryptography. Just like how our current financial system maintains a ledger of all our transactions and validates them, cryptocurrency transactions are also recorded in a ledger. But, this ledger is decentralized, meaning a central authority like the bank is not required to facilitate cryptocurrency transactions. But, how does it achieve this?

Every cryptocurrency transaction that has ever been made in a network, is recorded in a block over the internet. These blocks are connected to each other in sequence of the transaction history, and form a thread called blockchain. Every participant in this network runs their own infrastructure and they are called nodes. Each node or participant has their own copy of the blockchain, which they can access, edit and add a new block to. But, how are these blocks connected to each other in sequence? Each block records the following details:

  • Transaction details: A complete ledger, which denotes the balance of every account on the network, after the new transaction.
  • Nonce (We’ll talk more about it in the next section)
  • A reference number called hash, that is generated for the transaction of the current block, using cryptography. If the data recorded in the block is changed even slightly, the hash also changes.
  • Hash of the previous block or previous transaction

The two reference number or hash is what connects one block to it’s previous transaction data.

When a new transaction is recorded in a block and added to the blockchain, this updated blockchain is shared with all the participants in the network to verify and validate the transaction. For the transaction to be accepted, the new blockchain has to be validated by atleast 51% of the participants in the network. This blockchain acts like a ledger. And since each participant has access to the ledger for validating a transaction, this ledger becomes a distributed or decentralized ledger.

For example, if Adam sends $10 to Rohan, this transaction is recorded on a block, and it is shared to everyone in the network. To validate this transaction, all participants will check the previous transaction history on the blockchain, to ensure that Adam owns $10 that can be transacted. Once they verify that he owns $10 to perform a transaction, the transaction is validated. If 51% of the participants in the network validate it, the transaction is accepted and the payment is done.

Is cryptocurrency safe? What gives value to it?

If everyone has access to the blockchain and can edit it, what if someone were to edit the transaction details of a block or add some amount of new cryptocurrency to the chain? How is it safe then?

Let’s take an example to understand this better. Assume that currently, a blockchain has 10 blocks. Adam has traded all the cryptocurrency in his account and ends up with $0. He decides to add $100 dollars to his account by editing the 4th block in his copy of the blockchain. This is near to impossible. Because, the blockchain is coded in such a way that there are only two ways in which a person can get cryptocurrency added into their account:

  • Another person, who has cryptocurrency sends some amount of their cryptocurrency into your account.
  • There is a pre-decided rule on which the entire blockchain of a cryptocurrency runs. Do you remember that even if a slight change is made to the details recorded in a block, the cryptographically calculated hash/reference number for that transaction also changes? Well, it is not easy to calculate this number. It involves a cryptographic puzzle to calculate a number called ‘Nonce (number used only once)‘, which in turn will generate a VALID hash for the transaction. Everyone in the network competes with each other to find the ‘Nonce’ number. Since huge amounts of electricity and equipment is required to do the calculation, the blockchain is programmed to generate new cryptocurrency coins that are rewarded to the first person that finds the Nonce number. This program is what gives value to any cryptocurrency coin, because efforts were put to generate these coins.

If Adam is adamant about changing block #4, he has to update and generate a valid hash for all blocks from block #4 through block #10. This new chain must also be updated across all the other participants in a network. This whole process is very expensive as it needs getting everybody in the network to spend huge amounts of electricity and equipment to run a different chain, which is much higher than the actual money anyone could make by changing transactions. This is why it is near to impossible for anyone to hack a blockchain system.

How to buy cryptocurrency?

The easiest way to purchase a cryptocurrency is through an exchange platform. When you create an account on an exchange platform, you will have an ‘exchange wallet’, that stores your cryptocurrencies. You first need to buy bitcoin using your fiat currency (government-issued currency like INR, USD, EUR). Bitcoins can then be used to buy other cryptocurrencies like ethereum. Keep in mind, you can buy cryptocurrencies in fractions. The smallest fraction of bitcoin that can be bought is 0.00000001.

The legal aspect of cryptocurrency depends on individual countries. Before buying, investing or trading any cryptocurrency, do your research on the legal implications of cryptocurrency investments and trading in your individual country.

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