Bitcoin, Litecoin and Ethereum. These are just three cryptocurrencies of the hundreds that are taking over as ways to pay online, all fighting to become the most popular. But what are cryptocurrencies and why do they exist?
You might have heard of Bitcoin in the news or read about it in a blog post. Many believe it will be the next big thing in the financial world. But why? What makes Bitcoin, and all other cryptocurrencies, so special over the use of traditional money like the Euro and the Dollar? In this article, I am going to try to explain some of the features of cryptocurrencies and what the differences are in comparison to ‘classic’ money – often referred to as ‘fiat-money’.
Bitcoin, Litecoin and Ethereum. All three different kinds of cryptocurrencies, but they have one thing in common: they make use of a blockchain.
A blockchain in its essence is exactly what the word says it is: it’s a chain of blocks that contain data. Wikipedia’s definition is maybe more descriptive: “A blockchain is a continuously growing list of records, called blocks, which are linked and secured using cryptography”.
In a blockchain (let’s take Bitcoin’s blockchain for this example) all transactions ever made with Bitcoin are recorded. Every block usually consists of 500 to 2000 transactions, depending on how many transactions were made in the time between the last block and the next one. A transaction is the movement of Bitcoin from one address to another.
Structure of a blockchain, illustrated by Michele D’Alissi/Medium
The Bitcoin blockchain is public. Everyone can see what transactions have been made from and to what address. So how do we know these transactions are correct? Who said that address Y could actually send X Bitcoin to address Z? How does the Bitcoin network make sure Bitcoins aren’t spent twice? The verification of transactions is done by systems that are called miners.
What is Bitcoin mining? Wikipedia’s definition: “Mining is the process of adding transaction records to Bitcoin's public ledger (the blockchain) of past transactions”. When a transaction is made, it enters a pool of transactions that will be included in the next block in the chain. When a transaction is included and the block is added to the chain, the transaction confirmed once. Usually, wallets/merchants wait until a transaction is confirmed at least six times to make sure the transaction is valid. This means that six blocks are added to the blockchain after the transaction was made.
So why six confirmations? Let’s say you wait for only one confirmation and after that you accept the payment. Chances are that the new part of the blockchain is going to be abandoned because the block contains faulty transactions and thus the network will reject the block. If you, as a merchant, already sent the product the buyer bought, you won’t receive your payment since the block isn’t added to the blockchain. After six confirmations, it becomes computationally impossible to tamper with the transaction data in the Blockchain. This is because the blocks, transactions and confirmations are all timestamped on the blockchain and each new block is mathematically related to the previous.
Why you can’t cheat at Bitcoin, illustrated by Mark Montgomery/IEEE Spectrum
When a new block is added to the chain, the miner gets a payout in Bitcoins from the Bitcoin-network as a reward for his work. This is also the way new bitcoins are being created.
So that is in a nutshell what the principle of a blockchain is and how it works. Of course, there are much more details that I didn’t cover in the previous section. For those interested, I provided some links to other articles explaining the blockchain in more detail at the end of this article.
Crypto > Fiat?
Why did people start using cryptocurrencies as a method of paying? What is wrong with the current way we pay? There are a couple of benefits that cryptocurrencies have over fiat money.
You hold and govern your money, not a bank
Normally, a bank holds your money for you. You pay the bank to keep it safe from criminals and to be able to have an account at the bank. Sometimes you also pay a fee to transfer money to another account, especially when you transfer from one currency to another.
With cryptocurrencies, you don’t have to pay any fees to anyone to hold onto your money. You hold onto it yourself in your own wallet. The only fee you pay is when you make a transaction. That small amount of coins is given to the miner as a reward for confirming the transaction and for hosting a node in the network.
But what about safety? Everyone can see every transaction ever made since the blockchain is a public ledger, right? So, everyone can see the balance of my wallet?! Yes, but wallet addresses, unlike IBAN’s, aren’t linked to personal data. When you are sending Bitcoin to an address, unless you know the holder of that address personally, you have no idea who that person might be. For all we know you could be sending money to your fridge that autonomously operates on the Bitcoin network. This has both upsides and downsides. One upside is that the privacy of the users is preserved. A downside is that this allows illegal activity since it is almost impossible to identify and track users.
Another risk of banks is that they can go bankrupt. Let’s take the Icesave bank for example. A lot of people in the Netherlands and the U.K deposited their savings there. In 2008 the bank went bankrupt and people lost their savings because the bank simply couldn’t pay it back.
A cryptocurrency can’t go bankrupt, simply because there is no bank! You are your own bank. Of course, a cryptocurrency can devaluate, just like the fiat money can, but you can never lose your coins.
Speed of transactions
The speed of a transaction when using cryptocurrency is significantly faster when transferring fiat money from one bank account to another. Especially with international transactions. Let’s say I live in The Netherlands and I want to send some money to my friend in India. With a regular transaction, it would normally take between 2-5 business days. With a cryptocurrency, depending on how many confirmations you are waiting for, your transaction could be done within 5 to 60 minutes (depending on which cryptocurrency you are trading with). It doesn’t matter if the other person is living in your country, or on the other side of the world.
In the current situation with fiat money, governments can largely influence the value. They can literally create new money out of thin air. This devaluates all the money of that currency out in the world.
Bitcoin has a set number of Bitcoins that can ever be created: 21 million. These coins are being created by the Bitcoin-network as a reward for the miners. There is no other way to introduce new Bitcoins to the economy.
I can think of many cases where the central bank needs to issue new money. Paper money tears, gets lost in laundry or it can be held for many years before being returned to the bank.
When Bitcoins are spent, they are kept inside the same ecosystem. They just live on another address. Bitcoins cannot get lost in a fire. The only way to lose Bitcoins is by not remembering your information to access your wallet. But that technically does not destroy the Bitcoins, they are still there, you just can’t access them anymore.
I am very positive about the era of cryptocurrencies and all the changes it is bringing along. I’m curious to see what is going to happen in the following years and how the traditional financial world is going to react once cryptocurrencies become mainstream. Do you want to start buying and trading in a cryptocurrency like Bitcoin yourself? Visit blockchain.info. This is a wallet provider for both Bitcoin and Ethereum where you can also purchase coins and view a lot of different statistics about the Bitcoin blockchain.
If you want to know more you can read some of the articles listed below or contact us!