Cryptocurrency is all the rage these days. Equally valued by investors and criminal hackers, cryptocurrency is not particularly well-understood. In this blog post we will try to explain and de-mystify cryptocurrency so that you might have a better understanding.
So what is the first thing that crosses your mind when you hear the word “cryptocurrency”? Most folks immediately think “bitcoin” and in many ways, the two words are somewhat interchangeable.
History of Crypto
The concept of cryptocurrency was introduced to the public in 2008 with the publishing of a white paper by an individual or a group using the pseudonym of “Satoshi Nakamoto”. This white paper outlined the technical blueprint for what would become bitcoin. Today there are approximately 6,000 different cryptocurrencies in existence with bitcoin being the best-known and the largest in terms of market adoption and capitalization.
Bitcoin owes a significant portion of its notoriety and growth in value to its adoption as an investment vehicle, growing well beyond the original design as an alternative, all-digital payment technology. Earlier this year, the value of one bitcoin was over $60,000. This represents about 300% growth in value during the past decade. However, bitcoin is one of the most volatile investments, with impressive peak values often bookended by precipitous drops in value. Investing in crypto is not for the faint of heart.
For example, the Chinese government recently outlawed all cryptocurrencies which send the value of bitcoin and others plummeting. Bitcoin and other cryptos are highly speculative investments and not suitable for all investors.
For investors new to the world of crypto, the scene in Alice’s Adventures in Wonderland in which Alice follows the rabbit down a rabbit hole and into Wonderland is a common analogy. Learning the technological concepts behind crypto can feel like stumbling into an upside-down world of make believe.
Shortly after Satoshi’s white paper appeared in 2008, cryptocurrencies began to emerge. The convergence of decentralized applications (think smartphone apps) and the growth of blockchain adoption fueled the development of Decentralized Finance (DeFi) technologies.
Decentralization is the driving force behind cryptocurrencies. In a decentralized model, information is not stored in a central location, rather it is distributed between many nodes. Any user can access the network anywhere, at any time, like a non-proprietary operating system, or an open-source application.
Fundamentals of Cryptocurrency
What does blockchain mean? The term blockchain was not referenced in the 2008 white paper. Blockchain is a system that combines cryptographic algorithms and software programs that create a permanent, decentralized database. The data stored in the blockchain cannot be altered or changed, and there is no central control of the database itself.
So why is blockchain technology essential to cryptocurrencies? Physical assets like currency or gift cards can only be spent one time. Digital information can be easily duplicated and used more than once. Because blockchain is decentralized and unable to be edited or changed, once a cryptocurrency transaction is logged it becomes a permanent data set. Blockchain prevents the duplication of assets and makes the infrastructure of cryptocurrency nearly impossible to falsify.
These fundamental components describe what blockchain is and does. So who runs and maintains the crypto system? It’s not like it is run by a company or a government. The system is a self-run, self-governed environment manned by two important user groups: miners and node operators. Without these groups working together in a cooperative manner, the blockchain security would be compromised.
Crypto miners create coins by using supercomputers to solve complex cryptography algorithms. By competing with other miners, they share a direct financial benefit by logging and verifying transactions and keeping the blockchain secure. Miners earn fees for validating transactions.
Node operators are the referees of the system. They make sure the environment is secure and functioning as it should. Ironically, there is no financial reward for running a node. Node operators do what they do simply to keep the system running. Without this committed team of miners and node operators, a blockchain system would be a target of fraud or theft, which would make the cryptocurrency worthless.
When a blockchain system and its cryptocurrencies are secure and well-managed, more people will participate, which increases active users and the overall network effect. Network effect works like competing search or social media platforms. Recall how Google eventually buried Yahoo, Facebook strangled MySpace, or GMail killed off AOL. It is a technological “survival of the fittest”.
How Does Crypto Build Value?
Since anyone can observe all transactions on a decentralized blockchain, cryptocurrency investors can tell how long users are holding onto their coins, which is similar to stock and bond turnover.
Holding period data is one of the chief metrics to assess the strength of the network, and to potentially gauge trends in a crypto’s value and price. Network effects are important measures of a decentralized blockchain. Growth in the number of long-term users strengthens the blockchain ecosystem, which helps maintain its value.
Crypto Valuation is Hard!
Crypto’s perceived limitations contribute to user and investor skepticism. Can a currency that is assigned value from its network effect really have a dollar value equivalent? The volatility of crypto markets also makes valuations challenging. What traditional investor measures can be applied to cryptocurrency? Buying low, which is a common tactic in stock trading, doesn’t really work for crypto investing.
The Bottom of the Rabbit Hole
Despite its relative newness, DeFi is hardly a flash in the pan. This year, the digital asset ecosystem is expected to surpass the $1 trillion mark in total market value, outpacing many traditional Small Cap Indices. As the adoption of decentralized blockchain systems increases over time, there will be significant long-term growth in DeFi.
Bitcoin will likely continue to be interchangeable for cryptocurrency in the modern money lexicon. As users become used to how DeFi works, demand for decentralized blockchain technology will continue to expand. If Bitcoin ends up being the dominant crypto brand, it may become a household word.
If after reading this post you are still pretty fuzzy on bitcoin, cryptocurrency, and DeFi in general, that’s OK. The goal was to explain some of the simpler concepts so that the next time you are at a cocktail party, and some nerd starts talking about blockchain, you might be able to understand what he or she is talking about!
For more detailed information on this topic, please visit https://learncrypto.com/knowledge-base.