With all of the hype about cryptocurrency (especially coins/tokens like Bitcoin, LiteCoin, Ripple, etc), it is really easy to get excited without fully understanding what you are excited about. I have had multiple people ask me:
What exactly is Cryptocurrency?
The more I thought about the question, the more I thought it would be a good idea to write down a guide on cryptocurrency so I could explain it to people when they asked. I like to call it my “Crypto For Dummies” even though most of you are not dummies at all!
Let’s start with the first question:
How/why was Cryptocurrency created?
In short, it was created to allow people to exchange money without a central authority (aka a bank or credit card company). If you haven’t figured it out, most people aren’t a huge fan of large central authorities that apply rules and regulations to money. Getting told how you can send money, to whom you can send it, etc restricts the way currency can be used, so cryptocurrency would fix these issues. It would allow people to send money to others and provide a way for it to be safe and secure so no one gets ripped off.
Now let’s go a little bit further (this might be a little tough to understand, but it is a very important notion). The first question I would ask is “Why do we use a central authority in the first place?” If this is such an inconvenience, why didn’t we have a different system a long time ago? Let’s use an example that might be able to help you understand the reasoning behind this.
Santa has always been known to have a master list of all of the children in the world and if they are naughty or if they are nice. It’s Santa’s responsibility to maintain this list and adjust it throughout the year when a brother kicks a sister or if someone does something nice.
A bank is the same way. They hold a master list of all of the accounts and their balances (children and their naughty/nice status). They are responsible for knowing when a deposit is made and when a withdrawal happens.
So a bank (just like Santa) is essentially just the master of the list.
And this is a really really important list.
Let’s get back to Santa to understand why this is such an important list.
Say Jack and Jill are siblings and Jack does something really mean to Jill (like ate all of her cookies). Most people would agree that this would put Jack on the naughty list. But what if Jack’s parents didn’t get the memo that Jack was mean to Jill? What if their list was out of date compared to Santa’s list?
These are two very important questions and are what create the reality of double spending. Double spending is one of major reasons a central authority exists in the first place. Double spending is what happens if I had $200 and I spent that $200 in two different locations before a “list” could be updated.
Doesn’t sound right does it?
So in order to fix this problem, there has to be only one list. This list is essentially a running total that is adjusted as soon as a transaction is made. Instead of each individual person having a list, a bank creates one master list and this list is final (and unchangeable). Essentially it is the master list and the bank is the master list holder. No one else can touch the list (see how this sounds like Santa)?
Ok. So are you understanding why we use a central authority in the first place in banking? We can’t have everyone running around with different lists that may or may not be up to date.
That’s the crux of what makes cryptocurrency so amazing.
It found a way to have a group of people manage a list (database) and do so in a fashion that acts like a central authority without being one.
When we really dig deep into what a bank really does, we can see that it is really just a database that keeps track of who send who money and when it happens. It takes this information and keeps a running total of who has what amount of money. And only the bank can confirm this transaction actually took place. And there are specific rules that are in place that define what can be changed and that all changes are final.
Cryptocurrency works under the same principle.
There is a public database that shows all of the transactions that take place (with all public identifiers removed) and there are people who confirm that a transaction actually took place (these people are known as miners). Any change in the database must be confirmed and once it is complete, it cannot be changed (ever – no matter what).
So let’s walk through how this works.
I want to give my friend Karl a Bitcoin (because he is an awesome cat). So I go into my wallet and tell it to send Karl a Bitcoin to Karl’s address (it’s like I’m putting money in the mail). When I do this, everyone in the world knows that I just sent the money, but all information about me (name, address, etc) has been removed from the database. All that is shown is that someone sent someone this money and put it in this account.
Now that this has occurred, the transaction needs to be confirmed. Essentially multiple people need to confirm that what happened actually happened.
Once it is confirmed, it becomes unchangeable and official. At this point, it is added to the “official list” called a blockchain.
The next question you should ask is:
Why would people take the time to confirm something happened?
Simple. They are paid to do so.
The people who confirm cryptocurrency transactions are called “miners” and they are the only people in the world that can confirm a transaction. Once they confirm a transaction actually happened, they are rewarded with an incentive (so a portion of a coin or token). The more you confirm, the more you make.
That sounds great, but what stops one person (or company) from confirming all the transactions? Wouldn’t this just lead to a central authority again?
Now you are catching on 🙂
To prevent this from happening, everyone and their brother can be a miner (you could start today if you wanted to do so). To take it one step further, you have to invest some usage of your computer to actually do the mining.
And your computer has to solve a puzzle in order to give you the ability to add a record to the official record.
In short: People have to use computers to solve an increasingly harder puzzle in order to be able to reap the benefits of being a miner. With this set-up, there is a limit to how much mining can happen in a given period of time (aka creating a barrier to people abusing the system).
Essentially: Math makes this possible. Cryptocurrencies rely on math instead of people to make the system work.
That’s a really simple way of explaining something very complex.
Ok – we now understand the why and the process. Now it’s time to understand a few basic features of all cryptocurrencies.
What has to exist in order for a cryptocurrency to be called a cryptocurrency?
There are a few things that all cryptocurrencies have in common:
1 – No permission is required to use the currency. Anyone with a computer can use it.
2 – Once a transaction is complete, it can never be changed. Once something is final, it is final.
3 – Nothing is connected to your real-world identity. You could be a 5 year old sending coins or someone surfing off the coast of Australia. No one knows who you are and that’s the point.
4 – Every transaction is secure by the power of math. Only you can send funds with your private key and the key safer than most vaults.
5 – There are no borders or countries. This digital currency can be traded across the world with the click of a button.
6 – There are no IOUs (or debt) with any cryptocurrency. You can only spend what you have.
7 – There are only some many coins or tokens in existence. This limited supply allows for a known cap to exist and more currency can’t just be printed later.
So now you have had a primer into the world of cryptocurrency. I hope it helps you make a little more sense of how this type of digital currency works.
Chris Wilkey (CW)