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

Barter System

Since the dawn of time, currency has been an integral part of human lives. In 6000BC, barter system came into existence. It involved exchange of goods and service 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, we started using gold coins to purchase goods or services. But, carrying large amounts of gold coins everywhere became difficult. To tackle this, governments decided to introduce ‘The Gold Standard’.

The Gold Standard

Under the Gold Standard, governments started printing currency notes and linked their value 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, countries used physical gold to settle international trades. This resulted in countries who imported war weapons during the World War I to lose 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”. All countries within the Bretton Woods system agreed to tie the value of their national currencies to 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.

Fiat Currency: Modern Financial System

Around 1971, countries around the globe adopted fiat currency (today’s financial system). Fiat currency is nothing but exchange rates between two currencies, which varies based on demand and supply. Central banks have complete control over the economy because they can print as many currency notes as they want. But, printing too many notes can result in hyper-inflation.

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

The 2008 Financial Crisis highlighted the flaws of today’s financial system. When you deposit some amount at the bank, say $100. The bank will not actually store all of your money. Banks can spend 90% of your deposit, i.e., $90, in investments. It is allowed to keep only 10% of 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. Getting approval for loans became easier. The value of real estate significantly increased and borrowers started taking loans to buy them. But as loans increased, the real estates’ artificially inflated value started dropping. Banks now held assets that were significantly lesser 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. We realized that 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.

Introduction of Bitcoin

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 transactions. A decentralized public ledger system maintains a record of all cryptocurrency transactions.

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. A decentralized public ledger records the transaction.

After a few months of sharing his idea of cryptocurrency, Satoshi produced 50 Bitcoins (The first ever cryptocurrency), on 3rd January 2009. The first 50 Bitcoins can never be utilized or spent. Cryptocurrency and Bitcoin gained popularity by 2011. Other cryptocurrencies like Litecoin and Ethereum developed around 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: Banks can print currency notes without any limit. But, the blockchain system produces limited amount of cryptocurrency for circulation. For example: There are exactly only 21 Million Bitcoins in the world. Nobody can produce more bitcoins.
  • Transparency: Everybody has access to view all cryptocurrency transactions recorded in the decentralized ledger.
  • Authenticity: Unlike how fake currency notes can enter the market through a breach, fake cryptocurrency can never be produced. Nobody can change the money supply or manipulate any transaction.
  • 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: Digital wallets store cryptocurrencies. 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?

Every cryptocurrency transaction that has ever been made is recorded in a block over the internet. Blocks are connected in sequence of the transaction history, forming a chain of blocks called blockchain. But, how are these blocks connected 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)
  • Cryptographically generated hash number that acts as a reference number for the requested transaction. If the data recorded in the block is changed even slightly, the hash also changes.
  • Hash of the previous block or previous transaction

The hash number connects one block to its previous transaction data.

With an example, let’s understand how crypto transactions work to achieve decentralization.

Adam wants to send 10 Bitcoins to Mary. A block representing this transaction request is created. The block is distributed to all the nodes/participants in the blockchain network to validate the transaction.

All network participants, also called as nodes, run their own infrastructure to validate blocks. They don’t know each other, are geographically distributed & participate purely for the incentives that a particular cryptocurrency offers. Hence it is called as a decentralized system.  They also have their own copy of the blockchain, which they can access, edit and add a new block to. Because of this, ‘blockchain’ that acts a ledger of all crypto transaction is known as decentralized or distributed ledger.

If more than 51% of the network participants validate the new block, it will be added to the rest of the blockchain. Once the block is added to the blockchain, transaction is accepted & Mary receives 10 Bitcoins. The new blockchain is sent to every node/participant in the network.

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 a blockchain has 10 blocks. Adam has a balance of $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 there are only two ways in which a person can get cryptocurrency added into their account:

  • Actual transaction: Another person, who has cryptocurrency sends some amount of their cryptocurrency into your account.
  • Pre-Decided Rule: It isn’t easy to generate the hash/reference number for a block. It involves solving a cryptographic puzzle to calculate a number called ‘Nonce (number used only once)‘, which in turn will generate a VALID hash for the transaction. Network participants compete with each other to calculate the ‘Nonce’ number. This calculation requires large huge amounts of electricity and equipment. Therefore, the system generates new cryptocurrency coins to reward the first person who 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. After that, all network participants should also validate the new chain. 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). You can use your bitcoins 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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