Cryptocurrencies – aka ‘digital assets’ – have been growing in popularity since Bitcoin was created in 2009. Its creation was based on a white paper that described a currency immune to manipulation by using mathematical algorithms as a method of regulation. Since then, thousands of cryptocurrencies have popped up; some survive, others have died. Today we’ll explore what cryptocurrency is, and how you use it.
A cryptocurrency such as Bitcoin is designed to be regulated by mathematical algorithms to both generate units of the currency as well as secure it. This is as opposed to a central bank providing these functions. There are currently about 16.5M bitcoins in circulation and only 21M will ever exist. Bitcoins are generated as transactions are processed, but a logarithmic function cuts production in half every time 210k ‘blocks’ of data are processed. This function combats inflation, since more bitcoin cannot simply be ‘minted,’ as is the case with a fiat currency. All of this happens on a network that is decentralized, thus ensuring that no one entity can make a change to bitcoin. Depending on what a proposed change is, it may require as much as a 95% consensus among individuals that process bitcoin transactions before a change can be implemented. These individual transaction processors – aka ‘miners’ – are scattered around the world. This decentralization makes it impossible to change the way the currency operates in a way that is unfair to any group. To provide security, every miner has a full copy of the entire ledger of previous transactions as they validate new transactions, adding them to the ledger. This layer provides the security necessary to make sure the previous transactions have not been tampered with, that funds are available, and that they can prevent things like double spending. Compare this to a centralized processing agency like Visa/MasterCard, where all transactions are processed by a central authority in order to validate funds and prevent double spends.
To transact in cryptocurrencies, you’ll need a ‘wallet’ in which to store your money. This wallet consists of a unique address or identifier. The most common way to fund your new wallet is by exchanging US dollars for cryptocurrencies through exchanges such as CoinBase. When funds are added to your wallet, the transaction is written to the public ledger aka ‘blockchain’ (more on this in an upcoming blog).
When you intend to spend money from this wallet, the balance is validated by the network, then transferred, and then the ledger is updated for everyone else to see. Your wallet can be stored on any type of medium – online at your favorite exchange, on your computer hard drive, on a USB key or even on paper. Regardless, your wallet is protected by a ‘key’ – generated at creation – that you will need to know to access it. If you lose/forget your key, you lose the funds in your wallet too… just like losing paper cash.
So, why would anyone want to use this? Ease and speed. Whether it be bitcoin or another cryptocurrency, any individual can now transact with another individual or merchant directly, anywhere in the world, without having to go through a bank or processing agency. Transactions take place 24/7/365 and settle instantly. There is no 3-4 day waiting period for your ACH transfer, no linking bank accounts, and no running to Western Union. You simply send funds to someone, the network validates the transaction, and funds become available immediately. If an ACH transfer is like sending mail through the post office, a bitcoin transaction is like sending an e-mail.
Users do pay fees to the miners that process the transactions, but fees are generally smaller in percentage than what credit card companies would charge, and vary greatly based on the cryptocurrency in play.
Time will tell whether we can call cryptocurrency the currency of the future.