What is cryptocurrency? A cryptocurrency is a digital currency based on cryptography. When we talk about currencies, we’re not necessarily talking about money. To avoid misunderstandings, it would be more correct to say that cryptocurrencies are means to get something else: according to the type of crypto – you will discover that not all cryptos are the same – you can use it as digital money, or as a token to get access to a particular system or service.
Even if this definition might seem complicated, in reality, the whole system is very logical and straightforward. When it comes to cryptos, it’s mandatory to consider the technology behind them, otherwise, it would be very hard to justify their existence and their functioning.
But don’t worry: we will try to explain everything very easily, so you will be able to understand all you need to know about these revolutionary currencies.
Different Types Of Cryptos
First off, not all cryptos are the same. We can divide them into two macro-categories: coins and tokens.
Coins are those cryptos that work on their own blockchains; tokens are those cryptos that exploit the blockchains of other projects.
We can make an example by talking about Ethereum and Ether (ETH).
Even if many people use these two words as synonyms, in reality, Ethereum represents the project – blockchain and ecosystem – behind Ether. ETH is just the native coin of Ethereum’s blockchain.
But Ethereum was created to allow users to build on top of its blockchain: thanks to smart contracts, today many famous cryptos are working on the blockchain of Ethereum: THETA, DAI, USDT are just a few names. All these are tokens.
Among tokens and coins then you can identify other categories, like stablecoins, utility tokens and so on.
Some cryptos can be used exclusively as digital money – like Bitcoin – others allow you to use specific platforms – like MANA, which allows you to buy your land on Decentraland.
To better understand their functioning, we will try to give you a general explanation of how blockchains work because, also in this case, not all blockchains are equal.
How Do Blockchains Work?
Blockchains are literally chains of blocks, and this is a good starting point: by imagining a shape you can understand far more easily what we are going to explain.
Each block of the chain is linked to the previous and the next blocks, except for the first block – called genesis.
Each block is made up of a certain number of transactions. Please, note that the number of transactions for each block is not random: depending on the structure of the blockchain, developers may need to set a specific amount of transactions to make the network work faster.
Don’t make the mistake to think that transactions are not something concrete: as any set of data, they take up space.
Think of them as messages. Making a transaction is like sending a message. This message will reach the right receiver after it is sent to the members of the network of specific cryptos.
These members of the network – validators – use devices – nodes – to check these messages.
They work to verify that the message is sent correctly, but above all that the same message is not sent twice: if this were possible, people could make the same transaction, with the same cryptos, twice.
This is one of the main functions of validators: they solve the double-spending problem.
With fiat currencies this problem doesn’t exist: you can’t spend a banknote to buy a sandwich, and soon after use that same banknote to buy a coke. You can’t spend more than the funds you have on your bank account – unless you use a credit card (but also in that case you need to repay it) – because there is an intermediary, the bank, who keeps track of what you do with your money.
Cryptos have no intermediaries, that’s why we say that they are decentralized – or distributed, but we still need someone who can verify the validity of transactions, and a ledger that can record every single transaction in an immutable way.
And here is a fundamental function of blockchains: they work as ledgers that record each message – to go on with our analogy – and they can be stored by anyone who has the resources and knowledge to understand them.
This whole system makes blockchains tamper-evident mechanisms: it is very hard to deceive the whole network, and since the blockchain has a specific structure – we will see it later – anyone who wants to manipulate a part of the blockchain should modify the whole ledger.
But wait. Do you remember that we said that those messages take up space? What if there is not enough space to store those messages, what if validators are not fast enough?
Unfortunately, this happens and leads us to the famous blockchain trilemma.
The Blockchain Trilemma: How Different Projects Are Trying To Solve It
Messages sent by users are made up of data.
While they travel across the network, if no one takes them to include them into blocks, there could be issues related to security.
If those data are not blocked, they continue to travel and any good hacker could intercept them to damage the network and steal data – and cryptos.
So, validators need to act very fast. But how to make it possible when there are too many transactions? Validators should have more computational resources: the stronger they are, the faster they can operate.
Data would be more secure, but another issue arises. The larger the nodes, the more opportunities they have to intercept data. Even if this can seem like a good solution, in reality, it would harm decentralization: the purpose of decentralization is to give as many people as possible the opportunity to work as validators. Only this can guarantee that no one has so much power to prevent others from joining the network or to manipulate transactions.
So, the blockchain trilemma involves three main topics:
- Security: the more the network is decentralized, the more secure it is;
- Decentralization: the more the network is decentralized, the less scalable it is;
- Scalability: the more the network is scalable, the less secure it is.
To solve this trilemma, blockchains born after Bitcoin tried to develop new types of consensus algorithms, that is, new ways to make the networks agree on transactions.
To better understand this point, we will compare the two largest cryptos by market capitalization: Bitcoin and Ethereum.
Bitcoin vs. Ethereum
To produce new cryptocurrencies, different blockchains use different methods.
Please, note that new coins are not created from scratch: they are just the output of transaction validations.
Basically, cryptocurrencies are just strings of data. But there are different ways to get these strings.
We will compare the two most known methods: Proof-of-Work and Proof-of-Stake.
Both Bitcoin and Ethereum use PoW, but Ethereum is moving to PoS, so we will make reference to its future functioning.
When we talk about Proof-of-Work, we are talking about a consensus mechanism where each member of the network has to prove that a certain amount of work has been done – that’s the reason for the name.
Each validator adds transactions to each block by solving puzzles: the first one who finds the solution is rewarded with a certain amount of cryptos. The lucky validator will find those cryptos as the first transaction of the block that follows the one solved by the validator – this first transaction of each block is called coinbase. Every time a validator manages to find the right hash, he produces new outcomes – that is, new cryptos, and this process is called mining.
But why do validators need to solve puzzles? Because they have to find the right hash value. The hash is a sort of unique code that works as a timestamp: once it is attached to a block, that block becomes unique and can be linked to the next block correctly.
This sequentiality allows blockchains to be more secure: if any hacker wants to manipulate the blockchain, he should modify the whole ledger to be successful, because every change made modifies the following outcomes and blocks, and validators would discover the manipulation very easily – that’s why we say that blockchains are tamper-evident. This is also the reason why validators are rewarded: it is far more convenient to play by the rules.
There are many problems with this kind of consensus:
- It is not scalable;
- Requires a lot of computational power;
- It is not sustainable.
When it comes to Bitcoin, it is not a huge problem: after all, its only function is to make payments, and even if the network can be congested, it is nothing compared to what happens with Ethereum.
Ethereum was built to allow the creation of new projects and applications on top of its blockchain, thanks to smart contracts. So, its blockchain is far more used than the one of Bitcoin, and this often results in congestion and very high fees – there have been times in which fees were higher than the transaction itself.
In fact, Ethereum was using the same method of Bitcoin to manage fees: at each transaction, users were able to choose the amount of fees to pay through a sort of bidding system, and the more they paid the faster their transactions were validated.
So, Ethereum decided that it will move to Proof-of-Stake, a totally different consensus mechanism.
In this case, to be considered as a validator you have to prove that you own a certain amount of that crypto, that you are holding it – or hodling, to use a word that is specific to the crypto space. With PoS, validators only need to agree on the validity of a transaction to approve it and create new outcomes, and they will be rewarded according to the number of cryptos they are staking – that is, hodling.
This doesn’t require a lot of computational power, so there are more people able to join the network, making it more decentralized – hence, more secure. Moreover, the system is more scalable if compared to PoW, because transactions are validated faster.
Usually, when a project starts with PoS, cryptos are pre-mined, and since validators don’t need to do a lot of work, the term “mining” started to be perceived as incorrect, and new words are used to indicate the creation of new outcomes with Proof-of-Stake, like “minting” or “forging”.
Cryptocurrency: Why this name and how do they work?
The name “cryptocurrency” derives from the fact that they are currencies based on cryptography.
Cryptography is a type of communication that allows only the sender and the receiver to understand the content of a message. It’s like something private, a sort of code.
In the previous paragraphs we saw that cryptocurrencies are strings of data, and they are encrypted so that not anyone can use the data they are carrying.
To use cryptos, you need a wallet: no matter if you are using an address provided by an exchange or your personal wallet, in any case, you need an address where you can store them, to use them when you want.
There are many types of wallets, but also in this case let’s see two macro-categories, hot and cold wallets:
- Cold wallets are the most secure wallets because they are offline;
- Hot wallets are online – like crypto wallet apps.
Wallets provide you with a public address and a private key – from which the public address is derived.
When you use a centralized exchange – like Binance or Coinbase – your private key is stored by the exchange. You will see that usually these exchanges use multisignature addresses, for security reasons: basically, every time you need to send and receive cryptos they use multiple private keys to sign the transaction.
When you use a decentralized exchange – or DEX – you need to associate your personal wallet to make transactions, and you are the sole responsible for your data – private key included. Thanks to the private key, when you use an independent wallet you will also receive a seed phrase, a bunch of words with a non-logic connection that you’ll need to recover your cryptos in case you accidentally lose your wallet.
You need to keep your data in a very safe place, and never on your phone or computer – hackers may steal them, so pay attention and write your private key down on a piece of paper!
You, or your CEX, need those private keys to sign transactions, so to confirm them.
And what miners do is just validate the information you send: in the case of Proof-of-Work they need to use their computational power to find the right hash value; when it comes to Proof-of-Stake that power is assigned by the network of the project according to the number of cryptos they are staking. Of course, there are various methods for encryption and decryption, but we don’t want to overwhelm you with too much technical information.
But what you need to know is that your transactions are secure: when you send your cryptos you are encrypting the info including a specific public address, and only the owner of that public address will be able to decrypt your message by using his private key.
This decryption allows your transactions to reach the right address and to confirm that you signed that transaction, and this allows the crypto economy to get rid of intermediaries like banks. It is true that CEXs set rules and limits, but also in this case the functioning of blockchains allows these platforms to have fewer costs and decisional power so, also in this case, you can profit from a more inclusive and free financial system.
By providing you with all this info, we wanted to show you why cryptocurrencies exist, and why they are so important.
They gave people an alternative: before cryptos, people had to trust intermediaries, they had no choice.
This led to one of the worst crises in history: 2008 proved that a few powerful people could decide for the financial destiny of millions – or billions – of people.
In fact, Satoshi Nakamoto created Bitcoin in 2008: he – or she, or they, we don’t know – provided people with an alternative, and since the problem of the previous system was trust, this new system eliminated trust. Everything is verifiable, anyone can participate in the market, people are really able to control their financial destiny. That’s why cryptos are so important.
But you need a lot of education to use cryptos: this system has its downsides because privacy allows people with bad intentions to operate in the market.
So, when you decide to deal with cryptos, keep in mind their purpose and choose the right project. With cryptos, what really matters is knowledge, not financial means. The market is at its beginnings, but it is developed enough to offer financial services to everyone – today, people have the opportunity to get loans without collateral thanks to cryptos. Could you have ever imagined this 15 years ago?