What are cryptocurrencies?
What are cryptocurrencies?
Cryptocurrencies do not replace Euro or US Dollar. They complement it.
Cryptocurrencies are mostly decentralized currencies that exist exclusively digitally and are intended for use on the internet. They primarily serve as fuel for blockchain technology. Additionally, as a medium of exchange, they can enable a direct transaction between two people without the need for an intermediary such as a bank to be involved.
The first cryptocurrency, Bitcoin, was introduced in 2008 by Satoshi Nakamoto with the whitepaper Bitcoin: A Peer-to-Peer Electronic Cash System. To this day, it is not known who is behind this pseudonym. Only the first digital wallet can be clearly assigned to Satoshi. The wallet contains 1.1 million Bitcoins and has not been used since.
Although Bitcoin is the largest, best-known and most influential cryptocurrency, numerous other cryptocurrencies have been able to establish themselves with their own solutions. The most well-known examples are Ethereum and Cardano. These alternative coins - therefore often referred to as altcoins - offer solutions to various areas: Blockchain, Payment, DeFi (decentralized finance), NFT (non-fungible token), Metaverse, Gaming, IoT (internet of things) and many more. Payment or DeFi projects, for example, offer an alternative by settling real-time payments with cryptocurrencies instead of FIAT money. IoT projects take a completely different approach. They use the blockchain to enable the sending of data between two or more devices, placing themselves as a more cost-effective alternative to the mobile internet.
No intermediary, such as a bank or broker, is needed when transacting a cryptocurrency. This means that transfers can be made in real time at any time and from any location in the world.
If conditions are required for a particular exchange transaction, these are recorded in a so-called smart contract instead of a conventional contract. The conditions are written as lines of code in a protocol. The smart contract checks them and as soon as all parties involved in the exchange meet the conditions, the specified transaction is automatically executed.
What is the role of the blockchain?
Blockchain is a groundbreaking technology that will revolutionize our future for good. It is the result of decades of innovation in computer science, cryptography and mathematics. The possibilities for its applicability are almost limitless and can be applied to almost any area that can be digitized.
Cryptocurrencies are typically managed by a peer-to-peer network using open source software and stored on a blockchain. The blockchain can be compared to a bank's account book or a journal. On it, all transactions including all details such as sender and recipient, amount, date, time, identification number and much more are recorded in blocks. All blocks are chronologically numbered, indissolubly anchored to each other and connected to form a long chain. In contrast to a ledger at a bank, where the respective data is stored centrally on a main computer, the blockchain is distributed to all participants in the respective peer-to-peer network of the digital currency (distributed ledger technology). Each new block is checked for correctness using a so-called consensus mechanism and requires the approval of the majority of the peer-to-peer network. Thus, no state, institution or third-party provider can gain control over the network. But everyone can participate and become part of it.
Why are cryptocurrencies the fuel of the blockchain?
To send a transaction, the initiator of the transaction must pay so called gas (fee or gas fee). The gas is used to provide a financial incentive for validating the transaction. Once a transaction is validated, a block is written from it and firmly anchored in the blockchain. The previously paid gas is distributed to the validators in the same move. This process is called mining (proof-of-work) or staking (proof-of-stake), depending on the consensus mechanism. So-called "Bitcoin mining" thus means validating transactions on the Bitcoin blockchain.
Apart from their function as a medium of exchange and to pay transaction costs, cryptocurrencies usually have other functions. The most important is to ensure that all participants behave "correctly." Even in a decentralized solution, rules and ensuring compliance with them are important. This so-called governance guarantees all owners of a cryptocurrency a voting right with which they can co-determine the further development. Some cryptocurrencies relinquish complete control to the community. As a decentralized autonomous organization, DAO for short, the responsibility lies with the owners of the cryptocurrency and no longer with the project team or the founders. In most cases, however, they can continue to exert significant influence through their ownership shares.
What advantages do cryptocurrencies have over other currencies?
- Security All cryptocurrencies are stored on a blockchain. The blockchain is continuous, traceable and unchangeable. A block cannot be changed retroactively.
- Transparency Every transaction is stored on the blockchain and can be viewed from there. Fraud or hacker attacks can thus be traced, making it more difficult for criminals to use the stolen cryptocurrency.
- Mobility Since transactions are not tied to a financial institution or government entity, real-time transactions can be executed regardless of location or other environmental factors.
- Privacy When transacting a cryptocurrency, no personal or other sensitive data is revealed to third parties. Only the public key (identification number) intended for transactions is required. The public key can be compared to an e-mail address or a mailbox. In contrast, there is the private key, which grants access to the (own) cryptocurrency. This can be compared to the mailbox key or the password belonging to the e-mail address. By issuing the public key during a transaction, the risk of financial data or (financial) identities being stolen is therefore extremely low.
- Irrevocability Transactions by cryptocurrency cannot be revoked. This significantly reduces the risk of fraud for traders. On the other hand, however, it can lead to the total loss of the transferred cryptocurrency in case of erroneous or incorrect execution.
Are cryptocurrencies good or bad for the environment?
One of the biggest criticisms of cryptocurrencies overall is the seemingly horrendous energy consumption. This criticism should be taken with a grain of salt, as the energy consumption of Bitcoin is 56 times lower than the energy consumption of the classic electronic payment system. When comparing the energy consumption between different blockchains the difference is primarily due to the consensus mechanism that is used.
When blockchain technology first appeared in 2009 with bitcoin and the proof-of-work consensus mechanism, bitcoins could be mined using your own computer. At first, the CPU was sufficient, then you had to switch to more powerful graphics cards. Today, mining is only profitable for professional operators or mining companies with access to favorable electricity prices. For example, to mine Bitcoin, a special algorithm must be solved. Only if the solution is successful, a block reward is paid out and only to the person who was able to solve the algorithm first.
To solve the problem of high energy consumption, another consensus mechanism was introduced in 2012: The Proof-of-Stake consensus mechanism. Numerous recent blockchain projects use proof-of-stake and consume only a fraction of the energy for staking that is used for mining. The best-known examples are Solana, Cardano, and Polygon. Ethereum, the second largest cryptocurrency, is also planning a groundbreaking update expected in August 2022: "The Merge" will complete the transition from proof-of-work to proof-of-stake. Today, numerous variations of the Proof-of-Stake consensus mechanism also exist.
But what exactly is a consensus mechanism needed for?
Consensus means "agreement" and is an essential part of the verification of new blocks in the blockchain. In addition to the individual blocks themselves, the blockchain consists of a peer-to-peer network, which in turn is managed by many nodes and validators. They verify the current status of the blockchain.
In order to guarantee that the database is not manipulated, the majority of all participants must recognize the same status of the blockchain, i.e. a consensus must be found. In simple terms, a consensus mechanism is an algorithm that provides the infrastructure for reaching consensus on the status of the blockchain within the peer-to-peer network. One uses these mechanisms to ensure that all participants have an identical copy of the database.
Thus, the network can only be manipulated if the majority of validators (51%) agree that a manipulated status of the blockchain is correct. This process is referred to as a 51% attack.
Do cryptocurrencies have a future?
Judging by the statement from the investment bank Wells Fargo (see below), the clear answer is YES. Blockchain technology is still in its infancy and many use cases are still scratching the surface of what the technology can enable. While the crypto market has known almost only one direction so far, the next few years are more likely to see some cryptocurrencies experience strong growth while many cryptocurrencies disappear from the market again. The crux is to discover those that have long term value.
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