If you are thinking about investing in cryptocurrency, there are many questions that you likely have. This brief article describes the basic concepts necessary to set you on track. To start investing in cryptocurrencies it is important to know a bit about the technology and the ethos of the culture that is making digital currency a reality.
What is a cryptocurrency?
Cryptocurrencies are purely digital forms of non-fiat currency, also referred to as altcoins. That means that they are not physical coins nor are they backed by banks or governments. Bitcoin is the best-known cryptocurrency, with Ethereum’s Ether as a close second. As a consequence of the design and utility of these currencies, they have consistently been the most valuable and most traded currencies on exchanges.
What is blockchain technology? And what does it have to do with cryptography?
The next thing you may be wondering is how cryptocurrencies maintain their value and security. The primary mechanisms that make cryptocurrencies like Bitcoin work, is the combination of blockchain technology with strong cryptography.
Blockchain is essentially a ledger of cryptographic blocks, in Bitcoin and Ethereum’s case, these are public ledgers. A blockchain is just a collection of data blocks that are bound together. Each block contains data that is cryptographically stored as well as a hash pointer to the previous block in the blockchain.
The blockchains of Bitcoin and Ethereum function using strong cryptography which relies on the verification of the hash and digital signatures. This means that for a currency like Bitcoin, you can easily see the balance of another’s account (or address), as well as a history of all the transactions that have occurred from that address. All of this is available on a blockchain explorer. However, it is pseudonymous, as there are no names and faces, only encrypted information.
How are security and value maintained with purely digital coins?
Before the creation of Bitcoin in 2008, people were experimenting with digital currencies. But early digital coins were not effective because they were too easy to forge and duplicate transactions. As a consequence, double-spending was a real issue which invalidated those currencies.
Satoshi Nakamoto, the creator of Bitcoin was able to resolve the issue by building Bitcoin on a blockchain and using the strong hash function, SHA-256. All credible cryptocurrencies since Bitcoin function with these same principal components; a strong hash and blockchain.
A hash function is a computational function that looks like a random bunch of numbers. To hash data is to condense input data into a fixed size. The result is an output that is a hash or for cryptocurrencies, the target hash. The larger the hash, the more computationally difficult it is to create, which makes forgeries and double-spending a near impossibility.
In order to add to a blockchain, the miner must solve for the target-hash. Once the transaction is approved by the network of individual nodes (computers) the block is added to the chain. The next block added will be cryptographically bound to the previous block, and so forth.
It is because of this process that the blockchain is immutable. Because each block is bound to the other if you attempt to change one you would have to change the whole blockchain. To do this it would have a domino effect.
However, to change a block would not only be obvious, but it is also nearly impossible. This hypothetical domino effect would be so energetically and computationally expensive that it has a very low probability at this point. If this were to happen, the attackers would have to seize control of the 51% of the network; this is known as a 51% attack.
What is a decentralized network?
Although it is not a necessity, most cryptocurrencies run on decentralized networks. Should Facebook’s Libra succeed, however, it plans to begin as a centralized cryptocurrency.
A decentralized network is again, part of the original design of the Satoshi model of Bitcoin. Decentralized means that no one entity owns the network. Instead, millions of nodes participate in maintaining the network and must adhere to the consensus mechanisms of the network. The miners are rewarded with cryptocurrencies.
So, in order for a new block to be added to the blockchain, it must have a minimum of 51% approval. This is the proof-of-work method. This is where the miner must prove that they met the target hash after running many computations.
How can you buy and trade cryptocurrencies?
It is important to recognize that when you own cryptocurrency you do not actually have any coins. What you own are a series of transactions that are stored using a wallet and an address. In order to access your wallet with your transactions, you need a private key. This is essentially a password that gives you access to your accounts. However, there is no reset feature on a private key, so if you lose it your access is gone forever.
Where does your cryptocurrency live if it doesn’t need a bank or a physical coin?
To store and access your cryptocurrency, you need a digital wallet. There are many kinds of wallets, both totally digital, as well as hardware options. It is a good idea to store your currency on a hardware wallet. Using hardware is a more secure way to keep your currency. If you hold large amounts of currency on your exchanges you open yourself up to a greater risk of theft.
What are ICOs and IEOs?
When it comes time to invest, it is crucial to do your homework and learn about the different cryptocurrencies on the market. There are currently around 2000 traded altcoins. However, the top currencies remain Bitcoin and Ether, and with good reason.
When acquiring altcoins you need to know what you are buying. Bitcoin is often referred to as crypto-gold. This is because like gold, there is no security or asset that backs its value, gold sets its own standard. And like gold, Bitcoin is has a limited supply and is essentially impossible to forge.
Ether is slightly different, however. Ether is traded and used as currency. It is also the native token necessary to run applications on the Ethereum blockchain. And Ethereum, unlike Bitcoin, was not designed strictly as a currency. Vitalik Buterin built Ethereum as a much more malleable platform to run other dApps on.
ICOs are Initial Coin Offerings, which people can invest in. Ethereum currently holds the record for the most successful ICO launch. ICOs are a way of purchasing a native token as an early investor. It gets its name from IPOs, Initial Public Offerings as they are a similar thing.
Although Ethereum’s ICO launch was incredibly successful and profitable for the early investors, this is obviously not the case for all ICOs. The success of Ethereum is due to the success of the platform that Buterin devised, and the Ethereum team continues to improve upon. Some ICOs are complete scams and as a result, more and more regulations are being built around them.
IEOs, or Initial Exchange Offerings, are an effort to improve upon the original model. IEOs are backed by large investors which sponsor the exchange. While the success of an IEO is not a guaranteed success either, there is a lesser risk, as the exchange has put the money and time into backing the perceived value of the project.
The bottom line is, when it comes to ICOs and IEOs, you need to know what the company is offering and determine if it is value-adding. This requires the same time and research as any traditional investment.
If you are new to the world of cryptocurrency keep reading on the blog to learn everything you need to know to feel confident investing in the exciting world of cryptocurrency! Our site is packed with quality information about the technology used, crypto trends, and investing strategies.