The Absolute Beginner's Guide to CryptocurrencyCryptocurrency are new technologies disrupting traditional financial transactions and are a huge shift in how we think about money.
What Are Cryptocurrencies?
A cryptocurrency is a digital, or virtual, currency designed to work as a medium of exchange. They are distributed around the internet and rely on extremely strong encryption algorithms to process transactions. Because of this, they don't require a central authority such as a bank, and cryptocurrencies can process transactions in a matter of seconds or minutes as opposed to banks which quite often take days to fully process transactions.
Cryptocurrencies, often referred to as coins, are stored in digital 'wallets' that you use to manage your payments. Your wallet is protected by a private key - think of it like an extremely complex password - that only you know about. You can spend or send money by submitting a transaction from your wallet to someone else's.
Like cash, you can spend the money however you want - whether lending to a friend, paying for lunch, or even paying an employee. Unlike cash though, as cryptocurrencies are digital you can pay with a wallet app on your phone, with a special keychain, and in other ways that make cryptocurrency easier to use.
Cryptocurrencies were developed as an extension of blockchain technology.
A block is a complex mathematical problem based on a cryptographic technology called a "hash" which computers aim to solve. Once the mathematical problem (hash) is solved, the block is "complete". If any information inside of a block changes, such as transaction data, the block becomes invalid.
In a blockchain, if any data in any block is altered, the entire blockchain from that point onwards is broken.
In cryptocurrencies, the blockchain is used to store an immutable transaction ledger for the currency.
The blockchain is available for anyone to view, every transaction made by every wallet is visible to all. While this may seem like a privacy concern as someone can track your balance and spending, you can have as many wallets as you want and the wallet itself is anonymous.
We can now start to see why traditional banks are feeling threatened by cryptocurrencies and are actively looking to criminalise their use.
What Cryptocurrencies Are There
There are many different cryptocurrencies, each having its blockchain using different mathematical hash algorithms. Some of the most popular are:
- Bitcoin (BTC)
- Litecoin (LTC)
- Ethereum (ETH)
- Monero (XMR)
How Do I Get Cryptocurrencies?
There are many different ways of obtaining cryptocurrency which we will cover here and in future articles. But let's start with the basics. Where are cryptocurrencies held?
All cryptocurrencies are held against a digital wallet. There are two common types of wallet, either in your digital wallet or at a cryptocurrency exchange.
A wallet is just a place to store a public key (give this out and get paid) and the private key (this must be kept secret and protected at all costs - whoever owns the private key owns the coins. If you lose your private key you lose the coins. If somebody else gets hold of your private key, you lose your coins.)
Cryptocurrency Wallets
Cryptocurrency Wallets come in various forms which can be broadly categorised as personal and managed.
A personal cryptocurrency wallet is one that you control both the private and public keys. You can use a command line tool or website to generate the keys and you are responsible for the security and the risks involved.
A managed cryptocurrency wallet would be an application or website which allows you to generate a wallet, but it looks after the private key for you, you don't have to worry about the private key.
Paper Wallets
Paper cryptocurrency wallets are generated offline, and printed and the private key is never connected to the internet. The private key is stored on the printout which you must store safely and securely else you risk losing your crypto coins. These tend to be the most secure, but least user-friendly.
Hardware Wallets
A hardware cryptocurrency wallet is a physical device which can generate and store the keys for you. These are also very secure and more user-friendly than paper wallets.
Software Wallets
Software, or application wallets, generate and store the keys on a desktop computer or a smartphone. They are generally regarded as secure but have their risks due to trojans, malware or physical theft of smartphones.
Online Wallets
Online cryptocurrency wallets are services which offer to generate and manage your keys. Typically they are the most user-friendly, and relatively secure, however, they retain your private key, and the private key is the only thing that can be used to access your coins. If the website or service goes offline or is hacked, your digital cryptocurrency may be at risk.
Cryptocurrency Exchange
Cryptocurrency Exchange is similar to online wallet services, except that they are more geared up to currency trading, buying and selling "real" money for crypto coins, and trading between coins. They are a good, user-friendly way to get started with your first cryptocurrencies. As with online wallets, they will retain your private key and thus your currencies may be at risk.
One of the largest and most well-known cryptocurrency exchanges is CoinBase. It is also the one I used to get started trading coins. The registration process is simple and after an identity verification check and a payment via credit card, my bitcoins were available.
Cryptocurrency Mining
Cryptocurrency Mining is a distributed process by which individuals or organisations use processing power to solve mathematical hashes. Typically they bundle together transactions, verify that they are valid and compute the hashes securely and add them to the block. Mining is very computationally heavy and requires especially powerful computers. The specialised equipment costs money and requires a lot of electricity to run. Typical desktop computers use in the region of 0.3kWh (300 watts per hour). Mining rigs require 2kWh (2000 watts per hour).
To incentivize people to mine, they are given a prize for their work - either a share of the new coins generated from the block, transaction fees or both.
In the early day of cryptocurrency it was possible to use a home computer to process enough hashes to be profitable (the reward was greater than the cost of equipment and electricity) however the complexity has increased and energy prices have risen so it is very unlikely to be profitable to solo mine any more.
An alternative is to mine as part of a pool - a group of people get together and use their collective computer power to process the hash and share the rewards between them.
Cryptocurrency Security
As with any time you're dealing with money, security is one of the ultimate concerns.
Cryptocurrencies have numerous security measures designed into the technology to ensure that individuals and the entire network are secure.
The underlying technology of blockchain makes it impossible to edit transactions after they have occurred.
Because of the way transactions are reviewed, cryptocurrencies also aren't susceptible to the "double spending" problem where a person tries to pay two people with the same money, nor will funds be returned after the transaction has been processed.
Transactions are also irreversible, meaning that when you receive money there is no way it can be claimed back or taken away without your private key.
The highest risks involved with cryptocurrency are the security of the private key and market fluctuations.
If you lose your private key, you lose your wallet. If you lose your wallet, you lose your cryptocurrency. It's as easy as that.
The cryptocurrency market is volatile, meaning that the value against the dollar can fall or even crash (Edit: the market did crash in early 2018) and you will lose the value of any investments. This problem is not unique to cryptocurrency though, it can happen with gold, stocks, dollar and sterling investment as well.
Know the risks, research the currency, buy low, and sell high. Keep your private key secret.
Future of Cryptocurrency
What is in store for cryptocurrency in the future?
Personally, I believe that they are here to stay, and as the markets become more stable they will attract larger investments and greater consumer uptake. As more consumers start using cryptocurrency online, more concrete institutions will start accepting them. I predict that in the next 10 years or so, countries may start offering their digital currency, banks will get in on the action and eventually, the system will become regulated, or as regulated as an open system can be.
