Are they the future of money?
The rapid rise in the price of bitcoin and other cryptocurrencies during the recent weeks has attracted the attention of investors, financial companies, regulators, and the media alike. Today, bitcoin is everywhere — in the news, in conversations, in the money market, even in ATMs. The cryptocurrency has gained so much attention that even the layman has his sights set on it. But beyond the noise and the press releases the overwhelming majority of people – even bankers, consultants, scientists, and developers – have a very limited knowledge about cryptocurrencies. They often fail to even understand the basic concepts.
While many have had their interest piqued, it can be challenging to understand the basics of bitcoin and other cryptocurrencies. There are a few reasons for that. First, there is a lot of technical language involved, particularly if you’re trying to understand how the software works. Also, many cryptocurrencies are experimental open-source projects and there is disagreement about how they should evolve among developers, miners, and early investors who have large holdings, and therefore a lot of influence. Then there is the issue that the concept alone challenges many people’s conventional notions of money. Cryptocurrencies have been called everything from the future of currency to outright scams and Ponzi schemes.
A cryptocurrency, also known as digital currency, is a digital or virtual currency that uses cryptography for security. It is just some lines of a computer code that hold monetary value. Those lines of code are created by electricity and high-performance computers. A cryptocurrency is difficult to counterfeit because of this security feature. This form of digital public money is created by painstaking mathematical computations and policed by millions of computer users called ‘miners’. Physically, there is nothing to hold.
A defining feature of a cryptocurrency, and arguably its most endearing allure, is its organic nature; it is not issued by any central authority, rendering it theoretically immune to government interference or manipulation.
Bitcoin: The First cryptocurrency
The first cryptocurrency to capture the public imagination was Bitcoin. No one knows exactly who created it – cryptocurrencies are designed for maximum anonymity – but bitcoins first appeared in 2009 by an individual or group known under the pseudonym Satoshi Nakamoto who has since disappeared and left behind a Bitcoin fortune.
Cryptocurrencies are secured through one-way cryptography, the enciphering and deciphering of messages in secret code or cipher. Many of them rely on public blockchain technology—a distributed ledger of all transactions that is decentralized and unable to be changed under most circumstances as long as nobody controls more than 50% of the computing power on the network.
Because Bitcoin was the first cryptocurrency to exist, all digital currencies created since then are called Altcoins, or alternative coins. Litecoin, Peercoin, Feathercoin, Ethereum and hundreds of other coins are all Altcoins because they are not Bitcoin.
How does it work?
“Bitcoin is nothing more than a mobile app or computer programme that provides a personal Bitcoin wallet and allows a user to send and receive bitcoins with them. This is how Bitcoin works for most users,” bitcoin.org says. The Bitcoin network has recorded details of all transactions ever made. A transaction’s authenticity is ensured through digital signatures. “All users have full control over sending bitcoins from their own addresses… Anyone can process transactions using the computing power of specialised hardware and earn a reward in bitcoins for this service.”
How are Bitcoin and Cryptocurrencies Used?
There are some merchants that accept bitcoin and other cryptocurrencies directly from a user’s wallet. Even though some of them have very high prices, they are divisible into very small fractions. Bitcoin, for example, is divisible down to a “satoshi”, which represents 0.00000001 of one bitcoin.
Some companies have created ATMs where you can use US dollars and other fiat currencies to buy bitcoin and sell them to get cash. There are also companies that have created debit cards where you can convert bitcoin into dollars and use just like you would any other debit card.
Other cryptocurrencies have more specific uses and are used to pay for services on a certain network. For example, Ether is the digital currency used for operating smart contracts on the Ethereum network.
What miners do?
Principally everybody can be a miner. Since a decentralized network has no authority to delegate this task, a cryptocurrency needs some kind of mechanism to prevent one ruling party from abusing it. Imagine someone creates thousands of peers and spreads forged transactions. The system would break immediately.
So, Satoshi set the rule that the miners need to invest some work of their computers to qualify for this task. In fact, they have to find a hash – a product of a cryptographic function – that connects the new block with its predecessor. This is called the Proof-of-Work. In Bitcoin, it is based on the SHA 256 Hash algorithm.
Is it safe to use the technology?
“The Bitcoin technology — the protocol and the cryptography — has a strong security track record, and the Bitcoin network is probably the biggest distributed computing project in the world. Bitcoin’s most common vulnerability is in user error. Bitcoin wallet files that store the necessary private keys can be accidentally deleted, lost or stolen. This is pretty similar to physical cash stored in a digital form. Fortunately, users can employ sound security practices to protect their money or use service providers that offer good levels of security and insurance against theft or loss,” bitcoin.org says.
However, a Tokyo-based bourse halted withdrawals earlier this month after detecting “unusual activity”. It later abruptly stopped trading. An unverified document circulating on the internet purporting to be a crisis plan for Mt. Gox said more than 744,000 bitcoins were “missing due to malleability-related theft.”
Mt. Gox began as a website for exchanging trading cards before turning to Bitcoin.
(1) Irreversible: After confirmation, a transaction can’t be reversed. By nobody. And nobody means nobody. Not you, not your bank, not the president of the United States, not Satoshi, not your miner. Nobody. If you send money, you send it. Period. No one can help you, if you sent your funds to a scammer or if a hacker stole them from your computer. There is no safety net.
(2) Pseudonymous: Neither transactions nor accounts are connected to real-world identities. You receive Bitcoins on so-called addresses, which are randomly seeming chains of around 30 characters. While it is usually possible to analyze the transaction flow, it is not necessarily possible to connect the real world identity of users with those addresses.
(3) Fast and global: Transaction are propagated nearly instantly in the network and are confirmed in a couple of minutes. Since they happen in a global network of computers they are completely indifferent of your physical location. It doesn’t matter if I send Bitcoin to my neighbour or to someone on the other side of the world.
(4) Secure: Cryptocurrency funds are locked in a public key cryptography system. Only the owner of the private key can send cryptocurrency. Strong cryptography and the magic of big numbers makes it impossible to break this scheme. A Bitcoin address is more secure than Fort Knox.
(5) Permissionless: You don’t have to ask anybody to use cryptocurrency. It’s just a software that everybody can download for free. After you installed it, you can receive and send Bitcoins or other cryptocurrencies. No one can prevent you. There is no gatekeeper.
Cryptocurrency Benefits and Drawbacks
Cryptocurrencies make it easier to transfer funds between two parties in a transaction; these transfers are facilitated through the use of public and private keys for security purposes. These fund transfers are done with minimal processing fees, allowing users to avoid the steep fees charged by most banks and financial institutions for wire transfers.
Central to the genius of Bitcoin is the block chain it uses to store an online ledger of all the transactions that have ever been conducted using bitcoins, providing a data structure for this ledger that is exposed to a limited threat from hackers and can be copied across all computers running Bitcoin software. Many experts see this block chain as having important uses in technologies, such as online voting and crowdfunding, and major financial institutions such as JP Morgan Chase see potential in cryptocurrencies to lower transaction costs by making payment processing more efficient.
However, because cryptocurrencies are virtual and do not have a central repository, a digital cryptocurrency balance can be wiped out by a computer crash if a backup copy of the holdings does not exist. Since prices are based on supply and demand, the rate at which a cryptocurrency can be exchanged for another currency can fluctuate widely.
Cryptocurrencies are not immune to the threat of hacking. In Bitcoin’s short history, the company has been subject to over 40 thefts, including a few that exceeded $1 million in value. Still, many observers look at cryptocurrencies as hope that a currency can exist that preserves value, facilitates exchange, is more transportable than hard metals, and is outside the influence of central banks and governments.
Common Cryptocurrency Terms
Here are some of the basic, non-technical terms you’re likely to come across as you read about cryptocurrencies:
Address: Sort of like an e-mail address, you can share your coin-specific address so somebody can send coins to you. Unlike e-mail, people can have many different addresses and it’s typically recommended that you generate a unique one for every transaction.
Altcoin: Short for alternative coin, the term is commonly used to describe any cryptocurrency other than bitcoin.
Blockchain: A cryptographically protected distributed ledger made up of blocks that contain transaction history. As the blockchain grows longer and longer, it becomes increasingly difficult to alter older transactions.
Fork: A software fork occurs when there is a change to the original program, which can result in a split of the original blockchain and the creation of a new coin—Bitcoin Cash and Ethereum Classic are two examples of coins created from forks. There can be hard forks, soft forks and accidental forks.
Hodl: No, I didn’t misspell hold. Traced back to a drunken, profanity-laced misspelling in a forum posting, the term has become the battle cry for early cryptocurrency adopters that are holding onto coins regardless of price volatility.
Initial Coin Offering (ICO): An ICO, also known as a token sale, is a means of crowdfunding where a company offers a new coin in exchange for fiat currency (U.S. dollars for example) or a digital currency (Bitcoin, Ether, Litecoin, etc.) Typically, the funds they received are used to develop the new concept, and the token they issued will be used to transact on their network once it is launched. Both China and South Korea have banned ICOs, and the SEC has stated that they could be considered the offer and sale of securities depending on the circumstances of the offering.
Smart Contract: An agreement that is written in computer code and automatically executes when certain conditions are met. Some networks, most notably Ethereum, support smart contracts while others do not.
Wallet: A cryptocurrency wallet stores private and public keys, which are necessary to send and receive coins. There are hardware, software and paper wallets. Hardware and paper wallets are typically considered more secure than software wallets, although there are pros and cons associated with each. If you lose your private key and can’t access your wallet through back-up methods, you will never be able to recover your coins and they are effectively removed from circulation.