What is a Cryptocurrency?
Updated: Jan 20, 2022
Cryptocurrency is one of those words that pretty much everybody knows, and yet not quite everybody knows what it means.
It's also a word that people tend to get very excited about, although not always for the right reasons.
From the shady beginnings of the blockchain and the enigmatic Mr(?) Satoshi Nakamoto, both of which we covered in our last post in the series, to the "live fast, die young" tales of boom and bust in the online market, crypto doesn't always get viewed in the best light.
The fact that several governments around the globe have elected to ban cryptocurrency trading has only added to the "bad boy/girl" image.
But let's keep calm here. Let's ignore all the hype and hyperbole for a minute, and get down to facts.
Cryptocurrency is nothing to be afraid of.
Cryptocurrency is simpler than many people realize.
Cryptocurrency is going to be even more of a big deal in the coming years, so it pays to be well informed.
With this established, let's get into our beginners' guide to all things crypto.
What exactly is a cryptocurrency?
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In our last post, we took a close look at the blockchain, and explored how this digital structure works. Today, we're taking that a step further, and looking at the cryptocurrency networks that are built upon this blockchain.
Simply put, a cryptocurrency is a digitized form of currency that is traded across a blockchain-based network.
But let's go deeper than this. Let's start right at the beginning...
What does the word "cryptocurrency" actually mean?
Well, for starters, it is a portmanteau word, combining two components – "crypto" and "currency."
It's safe to assume that you already know what a currency is, so let's focus on that other component: "crypto."
The word "crypto" sounds... well... it sounds weird. It's a pretty mysterious word, and adds to the intrigue surrounding the whole idea of cryptocurrency.
In reality, though, the meaning itself is not weird. It simply means "cryptographic." Remember, in the last chapter, we talked about network nodes needing to solve certain puzzles to register their proof of work? Well, these puzzles are cryptographic puzzles. Hence, cryptocurrency.
What is a cryptocurrency unit?
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So, a cryptocurrency is a currency like any other. Except, it is available only in digital form. There is no need for coins, or notes, or any other physical representation.
This might seem shocking at first. As humans, we are conditioned to value the tangible, after all, and to put our faith in things we can touch and hold in our hands. But, in practical terms, is an intangible currency so different to just inputting our card details when we pay for something online? There is no physical object involved in this transaction either, just data.
Chances are, you use physical cash much less often today than you did ten years ago. Cryptocurrencies are simply a continuation of this trend.
What has caused alarm among some opponents of crypto networks is that the currencies themselves are not backed up with assets of any physical value. While traditional national currencies – also known as fiat currencies – have values that are backed up by gold reserves or other assets with widely accepted values, cryptocurrencies are not backed up in this way.
But, as we will see, this is not actually an issue.
How do cryptocurrencies retain value?
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A currency is nothing without its value. A ten-dollar bill is worthless unless that shopkeeper, or this waiter, or that person you borrowed ten dollars from agrees that the piece of paper represents ten dollars – no more, no less. This is how currencies work.
So, how about cryptocurrencies?
Well, the value of a cryptocurrency is based on a few different factors.
The reliability and security of the network
The circulating supply of the currency
The perceived value of the currency
Let's take a look at these in more detail.
1. The security of the cryptocurrency network
In the last article, we talked about how the blockchain works. We discussed how:
The blockchain is not owned by any centralized party.
Nor is it stored in any central location.
Instead, it is stored as copies across the computing devices (nodes) of the network users.
Each new transaction is written into a batch of transactions known as a block.
When the block is complete, it is added to the chain.
Each block in the chain is marked with a hash code.
If the transaction data in the block is tampered with, the code changes.
If the code changes, it does not match the hash codes of the multiple copies of the chain.
If the code does not match, the change is rejected, and fraud is prevented.
This, in a nutshell, is why these networks are so secure. This also means that users can trust the cryptocurrency tokens they are using. Why is this? Because...
There is no possibility of fraud as it is close to impossible to be able to hack or manipulate the network.
There is no possibility of data theft as transactions are carried out anonymously across the network.
And, crucially, there is no possibility of double spending currency tokens. Once the transaction is complete, the network automatically re-routes the funds to the recipient. In this sense, Bitcoin and other similar currencies are more reliable than their fiat counterparts, which are vulnerable to counterfeiting.
So, all of this shows us why users can trust the network, and how the payment network can retain value. But, how does it get that value in the first place? And how can this value grow?
This brings us to part 2.
2. The circulating supply of the currency
We all could do with an extra few dollars a month.
So why doesn't the government just print a bunch more dollars and give everyone a few more?
Because this will devalue the dollar. We'll have more of the notes, but the notes will be worth less than they were, and we'll be back where we started.
The same is true of cryptocurrencies. The tokens themselves are purely digital. They do not cost anything to produce. However, the network cannot just churn these tokens out as that will devalue them.
Instead, most networks launch with an initial coin offering, or ICO. This is a lump sum of coins that are "minted" before the network launches, and are sold off to users at a price set by the network's developers. This is usually the last point at which the developer has any direct influence over the coin value.
After the currency is launched, the supply is increased incrementally with the slow release of new coins. This release is designed to manage the circulating supply – i.e., the number of tokens currently doing the rounds on the network – and to also prevent the devaluing of the currency.
Eventually, this release will expire. There will be no more coins added to the network, which means the currency itself has a finite limit in terms of volume. Just in the same way as the finite nature of gold reserves in the ground keeps the price of jewelry high, this limit maintains the value of cryptocurrency.
But, as of March 28, 2020, the market capitalization (circulation volume x token value) of Bitcoin was $114.52 billion, and a single BTC (Bitcoin unit) was worth over $6,260. How does this kind of exponential value increase occur? This is not just down to a secure network and a carefully managed coin release – there must be something else at play here.
3. Perceived value
Think back to that analogy to the ten-dollar bill. Consider the bill itself. It's not just the shopkeeper, the waiter, and the friend you owe money to that agree on the value of this bill – it is practically everyone, at least in the United States.
So why is this bill worth ten dollars? Because you, the shopkeeper, the waiter, your friend, and millions of other people agree that it is.
So, why do these people agree the bill is worth ten dollars? Because you can exchange it for exactly ten dollars worth of goods or services.
When we look at it this way, it doesn't seem so crazy that something like BTC could skyrocket in value like that. After all, Bitcoin is the granddaddy – the prodigy that started it all.
Speculators got involved in BTC, driving the price up. Fintech specialists and economists got on board, too, not to mention the hundreds or even thousands of people who had just fallen in love with the idea.
Bitcoin became the poster boy/girl for the crypto movement. Most currencies are not like this.
Going back to that same day, March 28, 2020, we can see BTC there in first place, with a value of over $6,000 per token. But what comes next in the value stakes?
Well, we've got Maker (MKR) in second, we've got the off-shoot of Bitcoin, Bitcoin Cash (BCH) in third, followed by another Bitcoin-associated currency, Bitcoin SV (BSV) in fourth, and Ethereum in (ETH) in fifth.
And the values of these currencies?
As we can see, these values are way, way behind Bitcoin up there in number one. But who cares? Bitcoin is the freak, the monster, the prototype, the anomaly. All of these values from second down to fifth represent incredible strength against the dollar – many people have made a lot of money on these currencies.
But currencies are not just investment tools. As cryptonetworks become more sophisticated, and cryptocurrency tokens grow increasingly versatile, this will only add to their value in the eyes of the public.
But that, perhaps, is another story for another time. Thanks for joining us again for another guide to all things crypto. We hope you can join us next time for the next chapter in the journey.
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