Crypto and the Blockchain Explained
Few things are as hot right now (in early 2022) as cryptocurrencies, but that doesn't mean the general public knows very much about them. Crypto tokens such as Bitcoin may be defined as virtual stores of value that can be exchanged for goods and services, comparable in purpose to the American dollar. However, many have embraced crypto as an investment vehicle in recent years, with wild price fluctuations offering the potential for both substantial gains and total losses in a matter of days.
This article won't try to persuade you that crypto is a giant scam or the next big thing. Instead, it will look at how cryptocurrencies work from an unbiased perspective and encourage readers to decide for themselves what to make of crypto and the blockchain. Starting with the basics makes the most sense.
What Is a Blockchain? The blockchain is a decentralized public ledger where all crypto transactions are verified and recorded. The name is derived from its electronic structure, as "blocks" of data are "chained" together to create a system with unlimited memory. It is "decentralized" because there is no central authority akin to the U.S. Federal Reserve, meaning that market forces and the will of the majority are the sole drivers of each token's value and any changes to its underlying code. Finally, it is "public" because anybody can review any transaction at any time.
Each coin has its own blockchain, so you won't find Ethereum transactions on Bitcoin's blockchain and vice versa. Certain blockchains offer special features that play a role in determining their corresponding coin's value. For example, the Ethereum blockchain is programmable, allowing third parties to add functionality to it such as new coins. Meanwhile, the Monero blockchain is known for security features that make it the go-to for those looking for privacy.
What Information Is Stored on the Blockchain? Some people are alarmed when they discover that anybody can track their transaction history on a public ledger, but it's not the invasion of privacy that you think it is. Using the Bitcoin blockchain as an example, transactions are recorded through three key pieces of information: Input, Output, and Amount. The Input is the Bitcoin addresses (or accounts) that gave you the funds you are now transferring elsewhere. For instance, if Trevor gave Mike three Bitcoin that he is now sending to Nolan, Trevor's address is the Input for the transaction between Mike and Nolan.
This system may sound convoluted, but it allows every coin to be traced back to every account it's ever been in. Suspect coins can therefore be identified and removed from the blockchain.
The other two pieces of information are self-explanatory. Output is simply the account receiving funds, while the Amount is how much money was transferred. Many blockchains support transactions worth far less than $0.01, allowing for the monetization of goods and services that would be too cheap to sell otherwise.
What Is a Crypto Account? Cryptocurrencies are typically stored in wallets consisting of two random strings of characters. The first is your user name, differentiating your account from all of the other ones on the blockchain. The second is your private key or the password you have to enter to make a transaction. Anybody with your private key will have full access to your account, so crypto enthusiasts need to keep it someplace safe.
Getting a wallet once required detailed online research, but that's no longer the case thanks to crypto's popularity. Now, vendors such as CoinBase and Paypal will automatically make you a wallet when you purchase crypto from them. If you plan to go past these introductory-level vendors, however, you may need to find a third-party wallet service that suits your needs.
What Determines a Crypto Token's Value? The market forces of supply and demand determine the price of all cryptocurrencies. Each token has a hard-coded cap on its total supply, making the information available to all investors. For example, Bitcoin has a total planned circulation of 21 million BTC, while an altcoin called Ripple has a much higher supply of 100 billion XRP tokens. Bitcoin is a scarcer commodity, which means that one BTC may always be worth more than one XRP. You can also use resources such as CoinMarketCap to learn how much of a token is currently in circulation, as neither Bitcoin nor Ripple has released all of their coins into the market yet.
Demand is harder to quantify. News such as changes to a major country's taxation policies regarding crypto or crackdowns on crypto mining can cause dramatic price swings up or down immediately, while influencers like Elon Musk can create bull or bear markets with a simple Tweet. Blockchain projects often increase the price of tokens associated with them, and many exchanges (or crypto vendors) have begun advertising directly to the public to increase demand for cryptocurrencies.
Are Cryptocurrencies Safe? All crypto transactions are verified by volunteer miners who use powerful computers to crunch numbers and verify that every token is coming out of the account it's supposed to be in. Any cyber attacker would need to modify the blockchain all at once to ensure that each block was in constant agreement with the rest, a task that's proven impossible to date. Miners are compensated for their efforts, either through new coins held in reserve just for them or through transaction fees.
The actual mining process involves something called a cryptographic hashing function, a mathematical process that takes input data of any size, performs an operation on it, and returns output data of a fixed size. Miners must combine all of the inputs on a block with arbitrary data called a nonce such that the resulting output begins with a fixed number of zeroes. There is no easy way to do this, so the number-crunching comes into play through trial and error. If all of this seems overly complicated, don't despair -- you don't have to understand it to invest in or use crypto.
What Advantages Can Crypto Offer? While fiat currencies like the dollar are tied to specific countries and governments, crypto is not. Advocates argue that this facilitates free trade because everyone has access to the same stable currency. Supporters also call the blockchain "hack-proof," especially since there is no central area like a large bank that would give hackers an easy target.
"Smart contracts," or business deals that automatically deliver payment once the prescribed conditions are met, are also cited as a major advantage. For example, a retail store could hold payment on inventory until the goods arrive in their shop, with the supplier resting assured that payment will be immediate once the merchandise arrives. Alternatively, a will could be executed automatically as soon as the writer is confirmed deceased, potentially reducing inter-family squabbling over assets.
What Are the Disadvantages of Cryptocurrencies? The mining process makes crypto transactions slow and expensive. For instance, the Bitcoin blockchain can process three to seven transactions per second while VISA can handle 24,000. Likewise, miner fees increase dramatically during peak periods, often exceeding the value of the transaction. Furthermore, the wild price swings that make crypto an appealing investment opportunity also make it difficult for vendors to set their prices. An item that costs one BTC could be thousands of dollars cheaper or more expensive at the drop of a dime.
While nobody has successfully hacked the blockchain yet, accounts can still be stolen and exchanges have been hacked in the past. Scam artists may also use the public's lack of knowledge of the space to rip people off. For example, an "expert" might buy a bunch of cheap tokens and then start hyping them up, making a profit off the people who trusted their advice. Some people refuse to acknowledge that non-tangible assets like crypto can have value at all, adding another potential obstacle to its widespread acceptance.
Conclusion Cryptocurrency is a deep topic, and it's possible to go into far more detail than this article has. For example, you could look at how a process called a hard fork can split one token into two distinct ones, review the merits of airdrops, NFTs, or the applications of blockchain technology outside of cryptocurrencies. Still, the information provided should be sufficient to help you decide what you think of crypto and the blockchain.
Disclaimer: E1 Asset Management does not do business with cryptocurrencies. This article is intended for educational purposes.