As an informed investor, understanding what cryptocurrency is and how it continues to reshape the global financial sector is essential. At its core, cryptocurrency is an internet-based, decentralized medium of exchange. These unique financial instruments differ from traditional fiat currencies in several key ways.
Unlike the US dollar, cryptocurrencies are not controlled by a central authority for issuance and transactions. Instead, a network of computers, known as a blockchain, works together to secure and operate the system. This structure makes blockchain networks significantly more secure than traditional systems, as there is no centralized point of failure.
Crucially, blockchain technology offers a more secure and efficient market experience. It is both immutable and tamper-resistant. These attributes make it ideal for peer-to-peer transactions.
In this way, cryptocurrencies represent one of the first successful alternatives to government-backed money. For cryptocurrencies like Bitcoin, a combination of public and private keys enables encrypted P2P transactions via a distributed ledger.
The History of Cryptocurrency
The history of cryptocurrency began in 1998. At that time, the internet was gaining popularity, though high-speed adoption was still nearly five years away. Interestingly, records show that a computer engineer named Wei Dai conceptualized an early form of digital currency through his idea of "B-money." In his paper, he proposed a digital form of money that used privacy protocols to create an anonymous cash system.
Later that year, another now-famous programmer, Nick Szabo, introduced the concept of Bit Gold. Szabo argued that decentralization needed to be at the heart of any digital currency to prevent centralized manipulation. Unfortunately, neither project made it to market, but they did inspire the infamous creator of Bitcoin—Satoshi Nakamoto.
The Double-Spend Problem
One of the main obstacles to developing a reliable form of digital currency was the double-spend problem. Double-spending refers to a hacker using the same digital currency multiple times. This was a significant issue that puzzled some of the most advanced computer minds of the time.
To create a trustworthy digital currency, someone needed to figure out how to make a digital asset that could only be used once. Moreover, it had to be impossible to copy or counterfeit to serve its purpose. The double-spend problem was not a concern in traditional financial systems because banks use third-party verification systems and operate a centralized system that allows edits, refunds, and corrections.
Hashcash
In 2002, the now-famous Bitcoin programmer Adam Back began unraveling part of the double-spend mystery. He proposed a system that would ensure every participating network node did its fair share. Specifically, Back suggested that Hashcash use a decentralized system requiring users to solve a difficult mathematical equation to process transactions.
Importantly, this strategy reduced malicious intent because it required hackers to harness substantial computing power to infiltrate the network. This new form of network consensus was called the Proof-of-Work (PoW) algorithm. Today, PoW algorithms are used in various types of cryptocurrencies.
Understanding Cryptocurrency Fundamentals
In 2008, Satoshi Nakamoto introduced the world to the first cryptocurrency—Bitcoin. Bitcoin became a significant milestone for multiple reasons. It marked the first successful implementation of a "trustless" system based on cryptographic proof.
Instead of a centralized network, Bitcoin relies on an international network of transaction validators known as nodes or miners. The primary purpose of nodes is to secure the network by validating "blocks" of transactions. In Bitcoin’s case, these blocks appear every ten minutes and contain 1MB of data.
Critically, all nodes validate transactions, but only one node can add the block to the chain of transactions forming the "blockchain." In acknowledgment of Adam Back’s earlier work, Satoshi Nakamoto credited the HashCash project, stating in his communication, "We need to use a proof-of-work system similar to Adam Back’s Hashcash."
Solving Double-Spending
Satoshi Nakamoto solved the double-spend problem by introducing timestamps into the consensus algorithm. A consensus algorithm is a cryptographic function used to secure the network. In Bitcoin’s case, the algorithm is called SHA-256. In the early days of PoW, HashCash used the SHA-1 PoW algorithm.
Each block in the blockchain contains a portion of the previous block’s hash. Each block also includes a timestamp. In this way, the blockchain is essentially one long mathematical equation. This strategy makes it extremely difficult to hack a blockchain network.
First, you would need to recalculate the entire blockchain from the beginning, which requires immense computational power. Additionally, you would need to compromise over 51% of the blockchain to ensure your new chain is approved by validators. In Bitcoin’s case, this would mean attacking over 150,000 computers simultaneously. The cost of such an attack would exceed the value of all Bitcoin in existence.
Bitcoin Mining
The first node to complete the SHA-256 algorithm gets to add the next block to the transaction chain and receives a reward for its mining efforts. Think of this reward as a refund for the computational and electrical contributions to the network. Originally, this reward was 50 Bitcoin. Of course, at the time, Bitcoin was worth only a few cents. Today, the block reward is 6.25 coins per block. At current pricing, that is worth approximately $60,000.
Cleverly, the miner’s reward is automatically reduced by 50% every 210,000 blocks. On average, this halving occurs approximately every four years. The first halving took place on November 28, 2012. The second occurred on July 9, 2016. The most recent halving happened in May 2020.
Bitcoin’s Maximum Supply
The mining reward serves another purpose in the Bitcoin ecosystem. Crucially, it is the only time new Bitcoin is introduced into the blockchain. In this way, Bitcoin provides a predictable money supply that cannot be manipulated like central bank currency.
Furthermore, since Bitcoin is limited, with an expected issuance of only 21 million coins, it becomes scarcer over time. Currently, 87.68% of all Bitcoin has been mined. That equates to 18,413,369 Bitcoin in circulation today. Of these coins, approximately one million reside in Satoshi Nakamoto’s wallet. These coins have remained untouched since Satoshi first mined them during the currency’s early days.
Notable Bitcoin Dates
October 31, 2008, is the day Satoshi Nakamoto chose to change the world forever. It was on this day that he first published the Bitcoin whitepaper. In the paper, he delved into his concept and how he solved the double-spend problem.
Two years later, Bitcoin made a significant leap in economic relevance after the first real-world purchase. On May 22, 2010, an early Bitcoin enthusiast named Laszlo Hanyecz made the first real-world transaction using Bitcoin. He ordered two pizzas from a local shop in Jacksonville, Florida. The price he paid for these delicious pies and a piece of Bitcoin history was 10,000 Bitcoin—worth around $90,000 in today’s market.
Crypto Exchanges
By March 2010, the first cryptocurrency exchange entered the market. The platform, now defunct, was called bitcoinmarket.com. It allowed users to buy, sell, and trade Bitcoin. Later that year, the now-infamous Mt. Gox cryptocurrency exchange took trading to the next level.
Altcoins Enter the Market
No one can say for sure whether Satoshi Nakamoto predicted the birth of the cryptocurrency market, but shortly after his invention, the emergence of crypto exchanges led to the development of other popular cryptocurrencies. At first, these cryptocurrencies resembled Bitcoin but with slight tweaks, such as larger block sizes.
A perfect example of these early cryptocurrencies is Litecoin. According to its creator, Charlie Lee, he developed the token to serve as the silver to Bitcoin’s gold. Thus, Litecoin shares the same cryptographic features as Bitcoin, albeit with minor variations.
By 2013, the industry saw ten major cryptocurrencies trading. It was here that cryptocurrencies began to emerge with more features and alternative use cases. For example, the introduction of Ethereum brought smart contracts to the forefront of the crypto space.
Smart Contracts
Smart contracts feature pre-programmed protocols that execute once a specified amount of cryptocurrency is received. These automated protocols provide advanced options for crypto users. As a result, Ethereum pioneered a new era of functionality in the crypto realm. Today, smart contracts are central to the cryptocurrency landscape.
Another example of the changing crypto industry landscape was Ripple (XRP). This early cryptocurrency entered the market with a very unique strategy. Unlike Bitcoin, which many viewed as a means to replace the current financial system, XRP aimed to provide banks with blockchain technology and all its benefits.
All-Time High
In December 2017, Bitcoin reached an all-time high of around $20,000. It was here that scalability issues came to a head. The massive influx of Bitcoin users led many in the crypto space to declare that Bitcoin could not fully achieve its goal as a "peer-to-peer electronic cash system." These concerns eventually led to various hard forks and the development of the Lightning Network.
New Cryptocurrencies Emerge
Importantly, a hard fork occurs when a new cryptocurrency launches from another cryptocurrency’s blockchain. The new cryptocurrency shares all previous transactions of the original blockchain, but all future transactions are placed on a new ledger. Therefore, miners of the old blockchain cannot mine the new currency without updating their nodes.
Hard Forks
Hard forks are often controversial in the market. For example, Bitcoin Cash arose from a split in the Bitcoin community over increasing the block size from 1MB to 2MB. Even after the hard fork, tensions within the community remained high, as many felt the Bitcoin Cash team wanted to hijack Bitcoin. Conversely, Bitcoin Cash supporters argued that Bitcoin in its current state failed to achieve its primary purpose.
Alternatives to the PoW Algorithm
As more cryptocurrencies emerged, so did alternative methods for securing blockchains. Notably, Bitcoin’s PoW consensus system requires significant computational power. As a result, the entire network consumes a substantial amount of electricity to operate. In the past, research has shown that Bitcoin uses more electricity than some countries.
This power consumption led to the development of less energy-intensive options, such as the Proof-of-Stake (PoS) consensus mechanism. In a PoS system, users earn rewards by holding a certain amount of cryptocurrency in a network wallet. These "staked" tokens help validate the state of the network. Importantly, the more tokens you stake, the more transactions you validate.
This strategy works well because it requires any hacker to stake a large amount of cryptocurrency to enter the network. Therefore, if they then attack the blockchain responsible for securing their staked tokens, they forfeit all their funds. Notably, Ethereum developers have announced plans to transition to a PoS consensus system.
Lightning Network
The Lightning Network offers another option for those seeking to alleviate congestion on the Bitcoin blockchain. It utilizes private payment channels located off-chain. This allows users to conduct unlimited transactions without clogging the Bitcoin network. Only when the private payment channel is closed is the transaction added to the blockchain. Additionally, the Lightning Network introduces many new features to the world’s first cryptocurrency.
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Cryptocurrencies continue to revolutionize the concept of money. You can expect these unique financial instruments to take center stage in the coming years, as many of the world’s most powerful fiat currencies appear mathematically unsound. Currently, the world is still debating how to handle these new-age currencies, with new regulations emerging monthly.
Frequently Asked Questions
What is the main purpose of cryptocurrency?
Cryptocurrency aims to provide a decentralized, secure, and efficient medium of exchange. It allows peer-to-peer transactions without the need for intermediaries like banks, reducing costs and increasing financial inclusion.
How does blockchain technology enhance security?
Blockchain technology uses cryptographic hashing and decentralization to create an immutable ledger. Each block contains a timestamp and a link to the previous block, making it extremely difficult to alter past transactions without consensus.
What is the difference between Proof-of-Work and Proof-of-Stake?
Proof-of-Work requires miners to solve complex mathematical problems to validate transactions, consuming significant energy. Proof-of-Stake allows validators to stake their coins to secure the network, which is more energy-efficient and scalable.
Can cryptocurrency be converted to traditional money?
Yes, cryptocurrencies can be converted into traditional fiat currencies through cryptocurrency exchanges. These platforms facilitate buying, selling, and trading digital assets for government-issued money like US dollars or euros.
What are the risks of investing in cryptocurrency?
Cryptocurrency investments carry risks such as price volatility, regulatory changes, and cybersecurity threats. It’s essential to research thoroughly and consider diversifying your investment portfolio to manage potential losses.
How can I store my cryptocurrency safely?
You can store cryptocurrencies in digital wallets, which come in various forms like hardware wallets, software wallets, and paper wallets. Hardware wallets are considered among the most secure options for long-term storage.