How Cryptocurrencies actually work

Blockchain, Bitcoin, Dogecoin, Ethereum, NFTs…

Everyone is talking about Cryptocurrencies right now. It is so popular that when entering this keyword on Google, there will be more than 2,250,000,000 results (in 0.54 seconds) and this number is constantly increasing. Google Trends also shows that interest in this keyword has been high.

Figure 1: Google Trends for ‘Cryptocurrency’ keyword

But what does all of it mean? In this post, we try to take you from Crypto Noob to Crypto conversant. We explain what it is, why it keeps becoming more important, and the dark side of it.

To tackle a problem, we often break the problem down into small parts and assemble them into a complete picture to make things easier to understand. Shall we try to do the same here?

Cryptocurrency – right from its name is also two nouns combined – Crypto and Currency. So to understand Cryptocurrency, we must understand what Crypto and Currency are.

Currency

Figure 2: Currency

In early society, there was no such thing as money. We’ll call this Stage ONE. The only way to buy something off someone was to go up to them and barter: “Oh, I really like your horse. I’ll trade you my cat for it.” But the issue with a barter system is that the counterparty may think that his horse is worth more than a cat. So chances that trades happen were low. That’s where currency came in.

Stage TWO: Coins: Because they were made of precious and scarce materials like gold and silver, everyone accepted that they were worth something.

 

Quick Trivia: The British pound was called pounds because one pound literally used to be one pound of silver.  Figure 3: One Pound (British Coin)

With coins, all of a sudden it did not matter that the counterparty did not want the cat. You could still buy the horse for coins. Even if you had no use at all for the silver, you still have the reassurance that you can take those coins, give them to someone else, and trade them for something that you do want.

Convenient right? 

But then this evolved to stage THREE.

As banks were established and governments had central authority, people realized that as long as there was trust in the system, they could move away from carrying blocks of precious metal towards something even more convenient: paper money.

 

Figure 4: Paper money

Paper money does the same thing but does not have intrinsic value because it was not made of pure silver. Paper money just had value because the government says it has value and people trusted the government. Paper money acts as a receipt, a kind of proof that you own a certain amount of money.

But as technologies improved even further, we found even more convenient ways of storing and trading our stuff. 

We’re now in what I would call: Stage FOUR. 

More people than ever are buying things online and using credit cards, and really when you’re at that stage, you don’t see your paper money anymore. It’s not about coins or notes or cats, money is just entries on a spreadsheet. 

When I buy a music album from Amazon, all that is happening is that my bank adds an entry in my spreadsheet (called a “ledger”) that says James now has ten dollars less, and then Amazon’s bank adds an entry that says they have ten dollars more. 

So the reason I’ve given you this entire intro is to provide you with the context of how Cryptocurrency works. Cryptocurrency is seen by many people as the most convenient mode of exchange ever.

Stage FIVE: Cryptocurrency is 100% virtual. 

I know, the logo for bitcoin looks like a physical coin but with crypto, there is no gold, no silver, there is no paper. It really is just the transfer of digital assets.

The core concept is the same. Think of cryptocurrencies as literally just spreadsheets of who’s paid what to who. But instead of multiple banks keeping their own separate records, with crypto, there is just one enormous spreadsheet of every transaction that has been made using that currency called a LEDGER.

Figure 8: A (cryptocurrency) LEDGER

Hopefully, the formal definition below now makes more sense. “A cryptocurrency, crypto-currency, or crypto is a collection of binary data designed to work as a medium of exchange. Individual coin ownership records are stored in a ledger, a computerized database using strong cryptography to secure transaction records, control the creation of additional coins, and verify the transfer of coin ownership.”

More than a good spreadsheet

Okay, so cryptocurrency is about having a good spreadsheet, but is that all? Why is everyone going crypto crazy? Well, there are some distinct advantages to a currency system like this.

One, it’s decentralized. Decentralization refers to transferring control and decision-making from a centralized entity (individual, organization, or group) to a distributed network. Decentralized networks strive to reduce the need that participants must trust one another. This deters any single participant’s ability to exert authority or control over one another.

This means that every transaction of a given cryptocurrency is recorded on the same ledger. There are many copies of that ledger, and anyone who is a part of the network can have one. 

You might have heard of cryptocurrency mining or bitcoin mining. Well, it is someone who set up a computer to crunch through transactions on their copy of this ledger or spreadsheet. There are already about a million bitcoin miners worldwide, and bitcoin is just one type of cryptocurrency. Miners dedicate their computer’s power to mining, say bitcoin, and as compensation, stand to earn some bitcoin. 

So the result of this is that if I go into a store and spend some bitcoins. Instead of just checking with one bank’s records, the store would instead check with the ledger. If I have enough bitcoins, then that transaction will be queued to be entered into the ledger. Once entered, everyone will update their ledger records independently.

Figure 11: A complete transaction (update all ledger and their copies)

Since there are many copies of exactly the same ledger, even without a central authority, it becomes easy to tell if anyone’s trying anything fishy. 

Figure 12: A rejected transaction (ledger and copies does not match)

TWO, and I’ve kind of implied this already, but one main perk of crypto is that banks are no longer needed as intermediaries.

International payments can be made almost instantly instead of it taking half a day with:

• No spending limits 
• No worry about exchange rates 
• No worry about interest rates 
• Transaction fees could also be close to zero for some cryptocurrencies

This is where the real fun begins.

Cryptocurrencies are called cryptocurrencies because cryptographic techniques are utilized. In particular, most cryptocurrencies use blockchain technology, which in turn uses cryptographic techniques. 

Many people confuse blockchain as being synonymous with cryptocurrencies. They are not. Blockchain technology is just a type of distributed ledger technology. Remember that big spreadsheet that everyone has that is recording transactions? Blockchain is just a way of organizing it. Unsurprisingly, into blocks. 

So every time I pay for something with bitcoin, that transaction is recorded as a block. 

Each block contains transaction data including who was paid and how much, a hash which is a unique identifier of the block, and the hash of the previous block. The key idea is that if anything in a block is changed, then that block’s hash will change. 

You might be starting to see where this is going because each block also contains the previous block’s hash, and in that way, encapsulates every transaction that has happened before. If a block’s hash changes, then the next block will no longer have the correct hash, so every subsequent block becomes invalid.

The requirement to have a valid hash ensures the millions of distributed ledgers are identical. If a hacker wanted to create a transaction to pay himself fraudulently, he would have to tamper with a block and every single block after it; and he would have to do so with the majority of computers that have copies of the ledger. 

Investments

You’ve probably heard of people putting money into Cryptocurrencies. All that means is that they are exchanging standard (known as “fiat”) currencies like dollars for cryptos like bitcoin. They are hoping that those cryptocurrencies become the next big thing and therefore suddenly shoot up in value, at which point they can then either spend them or just exchange them back for more dollars than they bought them for. 

Figure 18: Some popular cryptocurrencies

But beyond bitcoin, there are many other cryptocurrencies. At the time of writing, bitcoin is just one of over 4000 different cryptos. Each of them has different properties and is designed for different purposes. For example, Ethereum, the second most popular crypto in terms of market capitalization, does not only store accounting entries in that big spreadsheet. It can store programming code. This allows Ethereum to not only act as a cryptocurrency but also support the programmatic execution of transactions based on fixed and transparent rules (i.e. “Smart Contracts”).

The Dark Side

This brings me to the dark side of cryptocurrencies. 

Because cryptocurrencies are new and entirely digital, no one knows what they should be worth. Unlike company shares, where one can derive an “intrinsic” value based on dividend cash flows, there is no accepted way to derive an “intrinsic” value for cryptocurrencies. Therefore,  crypto prices are, in general, very speculative and therefore very volatile. 

Crypto prices are often tied to the news cycle. When a glowing article comes out about a particular cryptocurrency, prices go up. When Elon Musk posts a negative tweet, bitcoin prices slide.

Figure 19: Cryptocurrency is tied to the news cycle

Secondly, cryptocurrencies are still not widely accepted as a form of payment. Gradually, more businesses are accepting crypto payments. I can now book holidays with crypto. I can donate to Wikipedia with crypto. But most mainstream businesses still do not accept crypto payment. Microsoft, Tesla, and even Burger King are examples of companies who said they were going to accept bitcoin but then changed their minds. 

Figure 20: Tesla will no longer accept Bitcoin

Thirdly, cryptos are not environmentally friendly. Many cryptos are secured by cryptographic formulas that require huge amounts of processing power, and therefore electricity, to solve. Solving these formulas is a necessary step to verify transactions on the blockchain (i.e. the “mining” mentioned earlier). Whilst newer cryptocurrencies are adopting less power-hungry verification techniques, the established and therefore most popular cryptocurrencies still consume large amounts of electricity for transaction verification.

Fourthly, given that cryptocurrency accounts can be anonymous, they can be the perfect currency for criminals. According to ChainAnalysis, 0.34% of crypto transactions are criminal. To be more precise, cryptocurrencies are not anonymous but pseudonymous. This means that even though a user’s actual personally identifiable details are not visible, his unique account identifier will be permanently baked into the blockchain upon making transactions with it. 

NFTs

Besides the dark side, there is also the gray side of cryptocurrencies. Given the power and flexibility of new cryptocurrencies like Ethereum, novel and somewhat odd investable structures have been created.

For example, you might have heard of an NFT  – a non-fungible token. “Non-fungible” means that it is unique and cannot be easily replaced with something else. For example, a bitcoin is fungible, trade one bitcoin for another bitcoin, and you’ll have precisely the same thing. A one-of-a-kind trading card, however, is non-fungible. If you traded it for a different card, you’d have something completely different. You gave up a Squirtle and got a 1909 T206 Honus Wagner, which StadiumTalk calls “the Mona Lisa of baseball cards.” (I’ll take their word for it.)

If you haven’t heard of an NFT, you might want to take a seat for this one. It’s a bit of a head-scratcher. 

Figure 23: What are NFTs?

So you know how you can go into an art gallery, and you can pay to own a painting; now thanks to the blockchain, you can pay just to have digital ownership over something, which could be say, a JPEG image. It doesn’t stop anyone from using or sharing the image. But it means that your ownership would be written into a blockchain and you would effectively be the owner of the original. 

I think the reason some people find this form of “ownership” weird is that there is a distinct difference between buying an NFT and buying the traditional rights. For example, if you buy the traditional rights for an image, you can create merch or sell licenses. With an NFT, you generally cannot easily do that. The original creator typically still has all the reproduction rights over that image. 

Figure 24: Jack Dorse’s tweet is sold for $2.9 million

Nonetheless, there is clearly still a perceived value of NFTs. The CEO of Twitter, Jack Dorsey, sold the first tweet he ever made as an NFT for 2.9 million dollars. Five words.

Figure 25: $69 million NFT

This one just blows my mind. An NFT of this photo was sold for 69 million dollars.