Getting started with cryptocurrency
Cryptocurrency is a digital or virtual medium of exchange that uses cryptography to verify transactions. In early 2018 there were estimated to be more than 1,300 cryptocurrencies, including well-known examples such as Bitcoin, Ethereum and Litecoin. Understanding how they work requires a brief explanation of how traditional – or ‘fiat’ – currency works.
All forms of currency, such as coins and notes, are simply tokens. They have no value in themselves, but they work as forms of exchange because buyers and sellers accept that they have value. The system is usually underwritten by a government or central bank which guarantees that, if nobody is willing to exchange your token, you will always be able to take it to a bank and exchange it there.
Sometimes payments can be taken with no token changing hands, for example in direct debit payments by card. Here the store reports the transaction to the bank, which removes the amount from the buyer’s account, records the transaction in a ledger and sends the money to the seller’s bank.
Various attempts at creating a digital or virtual currency have floundered in the past because without a trusted third party or a central authority, like the bank, to verify the transaction, the system is prone to fraud. Someone could, for example, copy their own digital payment information and spend the same ‘money’ with two vendors at once.
The current generation of cryptocurrency owes its origins to Bitcoin, which emerged in 2009, and uses a technology called the ‘blockchain’ to create a decentralised network in which every node keeps a copy of the transaction ledger.
On the user end, each transaction is secured by public key encryption, a well-established cryptography method that involves pairs of keys – one public and one private – to send secure information. To make a cryptocurrency transaction, a sender uses their private key to create a ‘digital signature’.
The public key, which is available to the whole network, can then be used to verify that the private key used to make the signature was the one associated with the sender’s account. The private key itself, however, is not visible to the network and thus keeps the sender’s account secure.
The resulting system removes the middle man in currency transactions allowing for a faster and cheaper payment system.
What is the blockchain?
The blockchain is a cryptographically-secured information chain, each block of which is formed when a computer successfully solves a cryptographic puzzle. When a computer completes this task, which is known as ‘mining’, it broadcasts the solution to the network, which bundles up transactions to make a block, which is then added to the chain.
Although the earliest work on using cryptography to secure a chain of information blocks dates back to the early 1990s, the term ‘blockchain’ comes from a white paper by Satoshi Nakamoto proposing the Bitcoin cryptocurrency.
Nakamoto, whose real identity has remained a secret, created a way to create a digital currency that solved the ‘double-spending’ problem without the need for an independent third party. All previous digital currencies had required a third party to verify transactions, because otherwise people would be able to spend the same money with two different vendors before either one was aware of the problem.
Bitcoin solved this by using the blockchain to verify transactions and make it virtually impossible for fraudulent transactions to occur without requiring a third party. Each block in the chain contains a cryptographic hash – a string of characters that forms a kind of digital fingerprint of data – of the previous block. The previous block contains the cryptographic hash of the one before that and so on, all the way back to the very first block.
This makes it practically impossible to alter a transaction once it has been added to the blockchain. Doing so would mean that the blocks either side would no longer be correct.
The chain forms a digital ledger which each computer on the network holds a copy of and can access. The distributed and decentralised architecture further protects the system because fraudsters or hackers cannot target a central point. It also means that no single user can control the system, in the way that a central bank can influence a country’s economy. Every user is equally powerful since every user has equal access to the ledger.
Though the blockchain was designed to underpin a cryptocurrency there are lots of other uses for the technology. The Swedish Land Registry has tested blockchain technology as a way to make land sales faster and cheaper. Various companies are exploring the possibilities of blockchain-based smart contracts that can be executed or enforced without the need for human oversight.
This technology could play a major role in the future in how we manage ownership of property and assets, and how our rights and responsibilities are managed by employers and governments.
How does cryptocurrency mining work?
Mining, in cryptocurrency and blockchain terms, is the process by which blocks of transactions on the network are verified. Mining computers compete to be the first to find the cryptographic hash, mentioned above, that will verify a block of transactions. The winning miner gets rewarded with new coins.
Not every computer on the network is mining. Some of these network ‘nodes’ simply run the cryptocurrency software, which helps to spread transaction information around the network. However, some nodes are actively involved in verifying transactions – and these are the ‘miners’.
Imagine a competition where you have to guess how many peanuts are in a glass jar. Getting the right answer cannot be done by working out – counting the peanuts would be against the rules – so every participant has to guess until one stumbles across the right answer. Everyone can guess as often as they like and the winner gets a prize.
Cryptocurrency mining works in a comparable way. Computers across the network compete to find the cryptographic hash that fulfils certain criteria for the current block. This is not an advanced mathematical problem – more a matter of guesswork that involves the computer constantly generating hashes until it finds one that matches the criteria. This is a process known as ‘proof of work’.
Just as with the peanuts are in the jar, the best approach is to have as many guesses as possible, so miners calculate as many hashes as they can. Whichever miner gets there first gets a reward. In the case of a cryptocurrency this is usually a transaction fee and a small amount of the currency. The currency they get is new to the network, making mining the only way to generate new coins.
It used to be possible to mine Bitcoin using a personal computer at home, but as more coins are mined so the difficulty of calculating the hashes has been increased. Increasingly powerful processors were needed, to the point that most miners now use chips that have been specifically designed for mining.
Not only are these setups expensive, but they also need to be constantly switched on to maximise the chances of success – and electricity can be expensive too. Mining operations are getting larger, making it even harder for smaller miners to have any success. Because successful mining, even with the right equipment, is basically a matter of luck, most miners spend their income on covering their costs.
Nevertheless, without their work blockchain-based networks would not function. They act as bookkeepers for the whole network, ensuring that transactions are being processed honestly and that they cannot be changed retrospectively.
Cryptocurrency pros and cons
Digital currency has pros and cons like any new technology. How you weigh these up will determine how willing you are to embrace cryptocurrency, and how they stack up over time will be key to which currencies succeed and which fail. Here are three of the biggest pros and three of the biggest cons of digital currency today.
1. Secure: Once a transaction is added to the blockchain it becomes near impossible to alter, adding to the security of the system.
2. Decentralised: No one node on the network can control the currency.
3. Low transaction cost: Without a central source acting as a gatekeeper, transaction costs can be kept low. This can make it more efficient to, for example, send money to another country.
1. Lack of regulation: Cryptocurrencies are still new enough that regulators are only beginning to come to grips with them. Some, such as the Securities and Exchange Commission in the US, are treating them with caution. Others, for example regulators in China, have called on local governments to encourage cryptocurrency mining. This period while the regulation is settled is difficult for users, who may face restrictions in future. More immediately, the lack of regulation means that digital currency owners who lose their money, by accident or through theft, are unlikely to have much protection.
2. Volatility: The rapidly rising price of some cryptocurrencies, particularly Bitcoin, has led investors to jump on them in the hope of realising similar returns. However, prices have proved highly volatile, with prices as likely to suddenly crash as they are to soar.
3. The use case: Critics maintain that there is still no digital currency use case for which a traditional currency could not be used instead. The digital currency might be slightly cheaper or slightly faster in some cases but that, say critics, will not be enough to win mass adoption, without which they are unlikely to succeed over the long term.
How to invest in cryptocurrencies
Although envisaged as a challenger to fiat currency, cryptocurrencies have become attractive to investors because some of them have risen in value with extraordinary speed. At the beginning of 2017, the cost of a single Bitcoin was $1,000 and by the end of the year it was $14,000.
However, if you are going to invest in cryptocurrencies then you should proceed with caution. Unless you understand investing, it is sensible to seek advice from someone who does. An article such as this one, for example, does not constitute investment advice.
The volatility of prices means that they can go down as well as up. It’s easy to see your investment wiped out when a bubble bursts or eaten up by exchange fees and taxes. Therefore, the old rule applies: don’t invest any money that you aren’t prepared to lose.
The first thing you need to do is consider your portfolio. You could invest in just one cryptocurrency, but it is more sensible to spread your investment across several currencies, with different degrees of risk. A website like CoinMarketCap will allow you to compare rates for the best-known examples like Bitcoin, Ethereum and Ripple, and lesser known coins.
One option is to invest without actually buying coins. You are effectively betting on the price. This can be done through mechanisms like the Bitcoin investment trust at Grayscale in the US, in Germany through Bitcoin ETI, or in Germany and Sweden via the XBT Tracker. This is less risky than buying coins yourself but comes with investment fees.
If you want to buy coins, then you need an exchange, such as Coinbase in the USA or UK, BitPanda in Europe, or Huobi in China. Look for one that has been running for a long time, has a good reputation and is transparent about ownership. You will also need your own wallet to store your currency. Some exchanges offer them, but having your own – especially a hardware wallet – is more secure.
You also need to be aware of any taxes that might apply to your cryptocurrency profits and transaction fees as you buy and sell.
There are two other ways to invest in cryptocurrencies but both come with drawbacks. First, you could try your hand at ‘mining’. However, mining is mostly the province of large, well-financed operations these days and it is very hard for smaller players to make anything.
The other option is to invest in an ICO (Initial Coin Offering). This usually means paying a cryptocurrency to a business in return for tokens that will increase in value if the business achieves its goals. However, this is more akin to investing on the stock market than currency trading.