What are cryptocurrencies?

04 May 2021

Cryptocurrencies derive their name from two concepts – cryptography, and currencies. Cryptocurrencies were named as such because of the encryption techniques that are used to secure the digital network on which the cryptocurrencies exist upon.

What can cryptocurrencies do?

Cryptocurrencies were originally envisioned to be a digital form of currency, meant to facilitate quick and cheap online transactions.

The most famous cryptocurrency is Bitcoin, first launched in 2009. Bitcoin itself was meant to be a direct alternative to traditional currencies, and prioritised executing online transactions in BTC tokens without a third-party getting involved.

Bitcoin’s usage and “abilities” are therefore largely restricted to being a store of value, as well a medium of exchange that was relatively cheap and efficient for the time.

At last count in early-2021, there are nearly 9,000 different kinds of cryptocurrencies. Several do not have much utility behind them besides being able to exchange them for other kinds of cryptocurrencies and fiat currencies. However, even more of them now have a whole variety of functions that they were designed to perform. Ether tokens for instance, were made as a currency to power the Ethereum network and was not meant purely for transactions the same way that Bitcoin was.

Development in cryptocurrencies with various use cases has accelerated during the last years of the 2010s, and we now can see a wide variety of cryptocurrencies with utility in industries such as video-streaming, finance, sports, and advertising.

Understanding Fiat currencies

Pictured: The US Dollar, the world’s most circulated fiat currency
Source: Pexels

Fiat money as mentioned above refers to currencies that are issued by governments, and are not backed by any underlying physical asset of value. For instance, the US dollar used to be pegged to gold ($35 per ounce of gold) under the gold standard, where the US government had to safekeep physical gold in a specific proportion to the amount of dollars issued.

However, the world awoke to a new state of affairs in 1971 in the Nixon Shock, where the USA unilaterally abolished the convertibility of gold into dollars. Since then, most modern currencies worldwide have lacked a backing asset or commodity, but is instead guaranteed by the government that issued it. Examples of such fiat currencies are the US Dollar, the Pound Sterling, and even the Singapore Dollar.

Food for thought: If a problem of Fiat currencies is that they are not backed by a physical asset, what are cryptocurrencies such as Bitcoin backed by?

Fiat currencies are of immense interest to the cryptocurrency community, as many believe that the Bitcoin was created as a direct reaction to the perceived mismanagement of the 2008 Financial Crisis by the authorities.

Evidence for this is scattered around Bitcoin’s founding documents, as well as the Genesis Block – the first ever block of Bitcoin mined (which is basically just a list of letters and numbers) containing the headline “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”.

Cryptocurrencies vs. Blockchain

Many (but not all) cryptocurrencies use blockchain data organisation methods to ensure the security and integrity of their databases. Cryptocurrencies are therefore, a distinct and separate concept from blockchain.

Blockchain itself refers to both a kind of technology and data storage method to record data in a chronologically organised way that is incredibly difficult to defraud.

Cryptocurrencies relying on blockchain technology have their transaction ledgers duplicated and simultaneously processed across a large network of independent computers (nodes), resulting in a system that is nearly impossible to alter surreptitiously as such a “bad actor” would have to gain control over a majority of the mostly independent and spread-out network.

Incentive systems for validators are key to cryptocurrencies

Pictured: Traditional credit card payment through a payments provider. Payment providers typically charge a fee for enabling a seamless payments experience.

Source: Pexels

In traditional transactions between two parties, a trusted third-party such as a bank usually processes the transaction with their own infrastructure and methods, and correspondingly charges a fee for handling the transaction.

Cryptocurrencies do not rely on a third-party like a bank to record and guarantee transactions. Most of them instead rely on an incentive structure to attract paid “volunteers” to help validate the same transactions. The two most common incentive systems today are Proof-of-Work (PoW) and Proof-of-Stake (PoS).

In both, these systems attract “volunteers” by rewarding them with newly minted cryptocurrencies for helping to act as a validator. Thus, this keeps transaction costs for the original transactors low, while providing a natural incentive for people to act as a validator for transactions.

Diagram: A simple view of a general cryptocurrency transaction under the Proof-of-Work incentive system

Such incentive systems have been conceived and refined over the last two decades, with the PoW system being first conceived in 2004 by Hal Finney as a way to secure digital money. As a result, these digital systems are highly resistant to modern hacking methods. Due to the increasingly energy-intensive requirements under the PoW incentive structure however, many major cryptocurrencies such as Ether are migrating to or adopting the PoS incentive system.

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