Cryptocurrency 101: What is cryptocurrency and blockchain?
Cryptocurrencies is one word that sparks interest from finance experts to speculative individual investors alike. To many of us, they seem like a confusing futuristic invention that is hard to get your head around. In essence, a cryptocurrency is a digital currency that uses cryptographic (encryption and decoding) methods to conduct financial transactions. It could be tempting to buy a few hundred dollars of some crypto currency that you’ve read a few articles on, but, as with all investing we think it's important to understand the thing you’re buying. In this series, we aim to demystify some of the confusing parts of cryptocurrency so you can go into the crypto market with confidence. In this article, we will answer the following questions about cryptocurrency:
- How did Cryptocurrencies begin
- What is a cryptocurrency?
- How is Blockchain used in cryptocurrency?
How did Cryptocurrencies Begin?
Nowadays we think of cryptocurrencies as digital currencies with Bitcoin being the first of those. However, the idea of digital currency had been explored by technocrats interested in finance. Engineer Wei Dai produced a paper in 1998 discussing the virtues of a digital currency that could be used by anonymous people. In that same year, Nick Szabo, a blockchain pioneer, wrote a Bit Gold as a decentralized currency which could negate the need for traditional money and state backed currencies. The major issue that these initial attempts failed to overcome was that of preventing double spending - essentially ensuring that a piece of currency was only spent at one time. However, the spurt of 90’s digital cash efforts served as the inspiration for the first cryptocurrency, Bitcoin, that would take a further 11 years to be released.
The birth of Bitcoin
In late 2008, a white paper was released by a person named Satoshi Nakamoto (a pseudonym of an individual that remains anonymous and subject to much mystery to this day). A key difference between Bitcoin and previous failed attempts was leaving a central authority behind making the system a non-trust system. Somewhat similar to a peer-to-peer file sharing network. The big challenge was to ensure that accounts, balances, and transactions could be verified without something acting as a central entity (think of a bank). This was achieved by the mandating that transactions had to be verified by everyone on the network. But how could this consensus be achieved in a decentralized network? Nakamoto’s white paper includes proof of how this consensus could be achieved using blockchain technology and months later he mined the first bitcoin - cryptocurrency was born. A fun fact for you is that the first purchase using bitcoin was 2 pizza’s bought for 10,000 bitcoins… I hope those pizzas were worth it.
What is a Cryptocurrency?
When you strip out all the complicated terminology and incredibly innovative technology, cryptocurrency can be simply defined. In its most simple form, cryptocurrency is an internet-based medium of exchange which uses cryptographic methods to perform financial transactions. Most cryptocurrencies run on a network of many different computers (decentralized) which theoretically removes the ability of governments or any one individual to control the supply. This system is managed through a technology called blockchain which we will explore in more depth later. Cryptocurrency can be thought of as tokens exchanged for other currencies in order to be used to make payments elsewhere; somewhat similar to buying tokens at an arcade or chips at the casino.
How is Blockchain used in Cryptocurrency?
As we discussed in the first section, a crucial aspect of making digital currency legitimate rests on the ability to ensure there is no double spending. In other words, crypto currencies must provide an undoubtable method of confirming all transactions made within the network. This is where Blockchain and ‘miners’ come into play.
A peer-to-peer network like Bitcoin consists of many nodes (peers or people or computers) in a network. Each one of these nodes has a complete record of all transactions made on the network and therefore every balance on the network. Practically, when a transaction is made a transaction file is created (this includes the transaction amount and the signing using private keys) and distributed to everyone on the network. The transaction is broadcast immediately but it takes some time for it to be confirmed. This period when the transaction is unconfirmed is when any fraud could take place. However, once confirmed that transaction is set in the record forever. At this point it is added to the digital ledger known as the Blockchain.
What are crypto miners?
As we saw above, confirming transactions is fundamental to a digital currency that works. Miners are responsible for confirming transactions. They take transactions and then ensure their legitimacy before broadcasting that transaction across the network. It is only after a miner confirms a transaction that it is added to the blockchain. Fundamentally, a distributed network with no central authority has no way to confirm the legitimacy of a miner which could enable widespread fraud. However, this is solved by making anyone connected to the network as a miner do some form of work before the transaction confirmation is legitimate. In the case of bitcoin, miners have to find the correct hash to connect the new block to the blockchain. As an incentive to perform this work, miners are given a specified amount of bitcoin for each transaction that they confirm.
The concept of a digital currency began with a few early pioneers of the field in the 1990s. After challenges mitigating the double spending problem, Satoshi Nakamoto released a white paper detailing how his currency, Bitcoin, would do exactly that. It soon gained prominence and has since grown into a sizable currency used around the world. In its simplest form, cryptocurrency is an internet-based medium of exchange which uses cryptographic methods to perform financial transactions. It uses blockchain technology and crypto miners to ensure that transactions are authorized and distributed to everyone on the network. In doing so, cryptocurrencies are decentralized, transparent, and immutable. Making them one of most secure ways of transacting.