What are Cryptocurrencies and How do they Work?

What are Cryptocurrencies

*This is a guest post submitted by Walter Lim from Cooler Insights.

What are cryptocurrencies and how do they work? Bitcoin, Ethereum, Ripple, Monero, Litecoin, Dash… huh? The names of these cryptocurrencies sound like they belong to a different time zone in the future (think science fiction novels).

For some, cryptocurrencies and Initial Coin Offerings (ICOs) sound like the next Internet bubble. Horrified by the huge daily fluctuations in value, they wouldn’t touch it with a 10-metre pole.

For others, cryptos are the biggest thing since sliced bread – or maybe even the Internet. Some even predicted that they would take over traditional physical currencies.

Like them or loathe them, it does look like blockchain-based cryptocurrencies are here to stay. In fact, the oldest and priciest of them all – Bitcoin – has been around since 2009.

Before we look at how new blockchain technology fuelled companies looking to launch ICOs can tap on content marketing, it may be useful for us to revisit some basic concepts about this new space.

How It All Started: Bitcoin and Blockchains

The whole story first began when a mythical entity called Satoshi Nakamoto published a white paper on Bitcoin way back on 31 Oct 2008. In the paper, it was proposed that a peer-to-peer version of digital payment could be developed to reduce the transaction costs imposed by financial intermediaries. A few months later, in January 2009, Bitcoin was born.

At its core, Bitcoin is supported by a computing technology called a blockchain. Very simplistically, a blockchain comprises a series of public ledgers (blocks) duplicated across a distributed network of computers (ie nodes). These will record the amount of cryptocurrency which each person holds.

How does a Blockchain Works?

Source: Financial Times

Here’s a simple diagram showing how a blockchain works:

Each time this “spreadsheet” is updated with new transactions (for example when Bitcoins or other cryptocurrencies are transferred from party A to party B,) it would be recorded publicly by all the different “nodes” in this Peer to Peer (P2P) network.

To ensure validity, there should be no double-spending, valid signatures for each transaction, authentication through a public key and a private key, and limit to only one cryptocurrency (or other units) at any time.

In the process of updating each ledger (called a “block”), a series of cryptographic problem-solving functions (kind of like a complex randomised mathematical problem) has to be performed by “mining” computers to generate what is called a “proof of work” or POW.

This puzzle-solving process takes both time and energy to do so, and miners are rewarded with cryptocurrencies if they successfully solve the problem.

Each time a block is completed and authenticated by POW, it gives way to the next block in the blockchain. To prevent abuse, the algorithm selects the block with the most work done to be appended to the chain.

(In future, this may be replaced by other systems of verification like a proof of stake which states that a person can mine or validate block transactions according to how many coins he or she holds.)

Advantages of Blockchain

What’s the big deal about conducting financial (or other) transactions using a blockchain? Consider the following:

  1. Transparent yet Anonymous: Blockchains are publicly accessible but the identities of each party in the ledge cannot be resolved. This protects the identity of each user while minimising abuse.
  2. Immutable: The data stored in the blockchain is permanent and unalterable.
  3. Decentralised and Democratised: All nodes within a blockchain have to validate the transaction using known algorithms before it is approved. This prevents any consolidation of power by anyone authority.
  4. Time Stamped: Every transaction is time-stamped and recorded in a hash function.
  5. Sequential: Once a new block is verified and combined with other transactions to create a new block of data for the ledger, it is added to the existing blockchain.
  6. Security: Due to the distributed and immutable nature of the blockchain, plus the need for cryptographic puzzle-solving, transactions here tend to be highly secure.

Understanding Cryptocurrencies, Exchanges and Wallets

Following Bitcoins’ phenomenal success, other cryptocurrencies followed suit.

Like the former, these virtual currencies (also known as coins, altcoins or tokens) work as a medium of exchange. They use cryptographic methods to secure their data, ride on blockchain technology to validate and verify transactions, and function like limited entries in a public ledger that are unalterable unless specific conditions are fulfilled.

To get access to cryptocurrencies, traders have to exchange fiat currency (ie traditional currencies like US Dollars) for cryptocurrencies at what are called cryptocurrency exchanges.

Cryptocurrency exchanges charge transaction fees for listing and exchanging of cryptocurrencies to fiat currencies or vice versa. Popular ones include Coinbase, Kraken, Coinmama, and Coinhako (see this list to compare their charges and services.)

After trading your fiat currency for cryptocurrencies, you need to keep your newfound possessions in a cryptocurrency wallet. This is a software programme that stores both your private and public keys and interacts with various blockchains to enable users to send and receive digital currency and monitor their balance. Some include a hardware component (like a thumb drive sized dongle) which you can plug into your computer.

Like other forms of assets, the prices of cryptocurrencies are linked to how many people are buying (ie exchanging fiat for crypto) or selling (ie exchanging crypto for fiat) the coin or token. The volumes of purchases and sales can be erratic. Cryptocurrency valuations are highly volatile and they fluctuate in large swings. It is definitely not for the faint-hearted.

How Ethereum and Smart Contracts Change The Game?

Ethereum is the most famous (and the next highly valued) cryptocurrency after Bitcoin. Like Bitcoin, it uses blockchain technology to secure its transactions across multiple computers distributed across the world. Unlike Bitcoin, however, Ethereum’s blockchain uses a smart contract to facilitate, verify or enforce contract negotiations.

A smart contract is essentially a protocol whereby an asset or currency is transferred to a programme which automatically validates a condition and automatically determines how the asset should be managed. It enjoys the benefits of a blockchain (autonomy, trust, safety, and permanence) while providing speed and savings by the automation of tasks.

The infographic from Blockgeeks below illustrates how a smart contract works.

Crypto pundits have popularly stated that while Bitcoin functions like virtual currency, Ethereum (or Ether) functions more like a programming language running on a blockchain.

By being Turing complete, it can fully execute any algorithm given the necessary time and memory. This makes it a powerful platform for developers to build decentralised applications which involve managing funds, identities, voting and governance.

Introducing Initial Coin Offerings (ICOs)

According to Investopedia, an Initial Coin Offering or ICO is an “unregulated means by which funds are raised for a new cryptocurrency venture” which allows fund-raisers to “bypass the rigorous and regulated capital-raising process required by venture capitalists or bank.”

ICOs are usually characterised by the following:

  1. Raised by a start-up in a blockchain technology or virtual currency associated space seeking to introduce radical new changes to the status quo.
  2. Drafting a white paper which describes what the project does, how it changes the current operating environment, what it seeks to accomplish, and how much money is required.
  3. A distribution plan (contained in the white paper) for the virtual tokens (or coins) which includes the shares kept by the project founders and sponsors, fiat and virtual currencies accepted, and duration of the ICO campaign.
  4. If the funds raised do not meet the minimum funds established by the founders, the money has to be returned to the backers and the ICO will be deemed unsuccessful.

Unlike an Initial Public Offering (IPO), an ICO could offer founders opportunities to become instant millionaires if their newly launched crypto coins can generate tremendous trading demand the moment they are launched.

All is not bliss, however. The danger for ICOs is that many do not raise enough funds to become a going concern.

According to the Bitcoin Market Journal, out of the more than 600 digital token sales evaluated, only 394 (or 2/3) were completed. Of these, about 35% reported their funding figures. This showed that less than 23% were successful.

A popular Reddit post claimed that as much as 95% of ICOs may go bankrupt. Often, these “copycat” projects do not deliver any real value to the ecosystem or traders, lack a working prototype, or do not have a viable business model.

Opportunities for Cryptocurrencies and Blockchain Technologies

Now that you’ve read about what cryptocurrencies and blockchain technologies are, your next question would probably be this:

What’s the big deal about a distributed public ledger using cryptographic means to securitize transactions?

Apparently quite a lot it seems.

Here are some of the more apparent ways in which such technologies could change the status quo:

Wealth Management

This is one of the most exciting uses of cryptocurrency technologies. By democratising banking and investment transactions, investors have more power to manage how their wealth is allocated across borders without the strictures of banking and governmental regulations.

Streamlining Stock Exchanges

Apparently, multiple stock exchanges around the world are experimenting with blockchain technologies to see how stock exchanges could record trades made and improve the process. This could possibly help to reduce time, costs, and security risks on such exchanges.

Tamper-Free Elections

Due to the permanent and immutable nature of blockchain transactions, electoral votes may no longer be subject to tampering. This is especially valuable in politically volatile or corrupt jurisdictions.

Online Publishing

By using pay-per-click models where micropayments are made using cryptocurrencies, advertisers can content publishers can “reward” readers who read, like, comment or share a piece of content. This can be done by offering what are called “engagement tokens.”

One example is the Brave Browser which allows users to earn BAT tokens for viewing ads.

Music, Movies and Entertainment

The two biggest challenges for artists, actors, producers and other talents in the entertainment industry are:

  1. High distribution and marketing fees imposed by intermediaries
  2. Online piracy and illegal downloads

By introducing cryptocurrency for music, artistes can directly sell their music to fans more efficiently, offering tiny bits of their new singles for crypto tokens. A system of royalty payments could be set up using blockchain technology, ensuring that talents and fan buyers can benefit. The encryption and security features would also make it difficult for illegal downloads and playing to occur.

Healthcare Records

Blockchain technologies have the potential to greatly improve the security, privacy, and interoperability of health data. It can do so by allowing healthcare records to be more efficiently and securely shared across multiple providers while ensuring the privacy of the patient’s identity.

Customer Loyalty Programmes

Ever got tired of the hundreds of different cards in your wallet?

Using blockchain technology, it may be possible to create a universally accepted loyalty and customer rewards programme. This allows consumers to access all their loyalty programmes in one place, and enjoy greater flexibility in expending them.

Dangers of Cryptocurrencies and Blockchain

Now that I’ve covered the pros, it is only fair to consider the drawbacks of cryptocurrencies and blockchains.

Spoofing and Phishing

Like any online-based transaction, cryptocurrency platforms like exchanges and wallets could possibly be mimicked by phishers tricking users to upload their wallets or enter a password into a fake website. Unlike traditional banking systems, such transactions cannot be cancelled as whatever happens on the blockchain stays on the blockchain.

User Errors and Misplacement

Yes, errors made by the users of cryptocurrency systems are irreversible. Just keying in an extra zero at the end of your transaction may result in a significant financial loss.

Sending funds to the wrong address means losing all your tokens permanently and it can never be recovered back. Losing your private keys mean losing all your money in the wallet. The security of money that used to be the responsibility of banks and financial institutions is now being transferred to the individual user.

Unregulated and Overhyped ICOs

Unlike traditional share investments, ICOs are not regulated by any national or international authority. This means that you may not have any recourse should a coin trade go sour.

Many of them are also not backed by a solid business or financial model, and they do not have any track records of financial or market success beyond the robustness of the idea and the credentials of founders.

Possible Programming Vulnerabilities

As blockchains are decentralised with all nodes running the same code, there is a possibility that vulnerabilities could affect the entire system. However, this has not been fairly widespread due to the robustness of the programming code used thus far (For reference, Bitcoin has 30,000 lines of code.)

Crypto Exchanges Hacks

Over the past few months and years, there are a lot of crypto exchanges that have been hacked. Even top-tier exchanges like Binance were not spared. There is a saying that goes “Not your keys, not your coins.” Whatever tokens you stored on the exchange does not belong to you and the risk of losing it from a hack will always be present.

Walter is the founder and editor of Cooler Insightsa critically thinking content marketing, social media marketing and brand storytelling agency. To fuel your business with the latest insights in digital and content marketing, public relations and personal branding, visit his website here.

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1 Comment

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