Cryptocurrencies for Beginners

Cryptocurrencies for Beginners

Basic Terms

Address - address is what we would, in classic banking, call bank account. It is represented by a sequence of numbers and letters (in classic banking system, IBAN has letters, we still call it “number” even though it would be more appropriate to say that it is the account address). Some cryptocurrencies alter the address after each transaction, but all addresses and transactions stay within one wallet. After the completion of the transaction, the address changes and a new one forms automatically. Examples of such cryptocurrencies are Bitcoin and Litecoin. With other types of crypto, the address is always the same, much like with classic banking and examples of such cryptocurrencies are Ether and Waves. The account address is a sequence of symbols you can send to someone in order to receive funds on your account or, in the reverse case, symbols someone needs to send to you in order for you to transfer money from your account to their account.

The address is ultimately a public information, it needs to be shared with someone in order to receive funds through a payment. But you are not required to make your name publicly linked to the address which protects your privacy should you choose it, it is not necessarily linked to your name nor does the system require it anywhere in order for it to work. It does not ask for it at any point.

Seed - a seed is a sequence of 12 to 24 words, the number of words varies depending on the type of crypto or even the type of wallet within one crypto. For instance, Bitcoin has wallets that have seeds with a different number of words. The seed is a completely private information. It is a back up of a sort; in other words - if you know your seed words, you can use your wallet from any computer connected to the internet. It should be take care of with high regard because the seed is that which allows the owner to spend money from the account - a specific address.

Furthermore, when it is inserted in a wallet (or if you make a new account and get a new seed), it shows all the transactions that were made on the address and enables spending money and transactions from the account.

Be sure to always save your seed well because you alone are responsible for your account and your funds since the system does not have a central organization to take the responsibility. Never show anyone your seed, the only valid use of the seed is backup or switching to another wallet which you trust more. Should you lose your seed, you will lose access to your account.

Blockchain - blockchain is a revolution that drives the world of cryptocurrency. It is a distributed database that organizes its own infrastructure without it being governed by an organization, association, company, state or anything similar. It is organized fairly simple, by using game theory. The base, on its own, rewards those who maintain its infrastructure by handing over the transaction profit and using them to distribute new denomination into circulation.

With care for its own infrastructure, blockchain is a distributed base scattered on computers connected to the Internet across the world which means that a lot of computers (servers) has an identical copy of the base and has installed safety mechanisms that ensure that all the copies stay identical.

Game theory - game theory is a scientific discipline in economy that can be described easiest as “programming” human behavior within a group. It is the base for all cryptocurrencies and through it, they “communicate” with the outside world. In other words, the program “plays” with its users by having them “play” with it and that game is essential for maintaining the infrastructure for that specific program.

It can easiest be described using a simple example: if a program enables profit somewhere, by studying human nature we know that they will gladly do the said action because they are getting paid for it.

In this way, cryptocurrencies alone, as a program, reward people who configure and maintain the servers/network of computers on the Internet used as the cryptocurrency infrastructure and such admin gets a payment of a sort.

Wallet - a wallet is the main app to use a certain cryptocurrency. It is the equivalent of an Internet/mobile banking app of the regular banking systems. Some wallets support only one crypto, some multiple but to this moment there is no wallet that supports all of them (to my knowledge). Wallets often come with bank cards and can be used on cash machines and POS devices in Croatia and other countries.

Trust – in order for cryptocurrencies to work, there is one other component necessary. Because it is a distributed network and copies of the same data base without an owner (apart from app itself), as we have described in the description of blockchain, there is a massive potential problem appearing with the possibility of falsifying transactions and stealing money from someone else’s account.

All it takes is to create your own background server to falsify the information, wait for a wallet to choose that particular server for its inquiry and the transaction can be easily faked which is why a system like cryptocurrency required the addition of the trust component. A way of trusting a certain server that it has no intention of falsifying data. There are two basic principles that allow that when it comes to cryptocurrency (and smart contract).

The first was Bitcoin with its Proof of Work (PoW) principle. In order for a server to legitimize itself in Bitcoin network, it has to have a loaded processor, use electricity and in that way prove that it is investing something, a value of a sort and that it can be trusted to have legitimate and honorable intentions for the whole network. Shortly afterwards it has shown itself as not entirely optimal solution because the system started using more power than certain big countries as the Bitcoin’s price increased and the two are closely related. That is why Proof of Stale (PoS) was introduced as a new principle.

Proof of Stake (PoS) principle skips the whole part of investment into work to make it legitimate and from the very stake, it expects to be valuable; for instance one of the existing cryptocurrencies. So, in order for someone to configure or maintain a Waves server, the individual has to have a certain value in Waves cryptocurrency itself.

Confirmations - the number o conformations is a very important information which refers to the transaction of cryptocurrencies. Upon explanation of everything before, they are easy to explain. Since we are talking about a distributed network and data base, the number of conformations tells us how many computers in the network (servers/nods) has signed a certain transaction intoits copy of the database.

The greater the number of conformations, the more we can rely on a transaction not to be possible to be faked within the communal data base copying from one server to another.

Mining - mining is nothing else but running a program of the cryptocurrency on computers within a network using Internet. They work using PoW or PoS principles. During the process, with PoW principle they are rewarded by a fee as well, which the user has paid by doing a transaction with the new denominations of the cryptocurrency. That is why we use expression “mining” because it actually implies that new denominations are being made and a slight inflation is being made.

With PoS principle, most commonly, there are no new denominations, rather the admin of the server is being rewarded only from the transaction fee so the term “mining” is not actually sensible but is used as such (sometimes often as “minting”).

What are smart contracts?

When we talk about the ‘crypto world’, we usually talk about cryptocurrencies and smart contracts.

As we stated in the blockchain description, it is a distributed database located on computers around the world. Smart contract is a program that, together with the blockchain database, is located on all computers around the world, as well as the blockchain itself, and basically writes into the database and reads from it according to some rules.

In the case of cryptocurrencies, these are simple and predefined rules, and the smart contract takes previously described care that all data in all databases are identical. In cryptocurrencies, a smart contract is just a simple program that does transactions.

However, smart contracts can be much more complex programs and even complete distributed and decentralised applications as we know them today, such as social networks, taxi applications and the like.

These applications have servers in the background, i.e. computers on the network that do real tasks, while on our mobile phones there is practically only a user interface, so in classic applications these servers are always in the possession of some organization - e.g. Facebook. Therefore, these companies also have data.

Smart contracts provide software self-sustaining and automated background infrastructure for these types of applications, and thus the protection of our data, they ensure that these applications work for the benefit of users and not company shareholders, excluding monitoring, eavesdropping, censorship and the like.

In systems in which it is possible to write smart contracts, without them being predefined as in the case of cryptocurrencies, it is possible to create new cryptocurrencies, ie. subvalues. Examples of this are the Ethereum and Waves platforms. On these platforms, it is very easy to create your own cryptocurrency that uses the infrastructure of the home currency, but has its own smart contract as a program that manages that currency.

Types of cryptocurrencies and their examples?

Cryptocurrencies and accompanying ecosystems can be divided according to several different criteria: according to the way of gaining trust they are divided into Proof of Work (PoW) and Proof of Stake (PoS), according to the purpose they can be specific, intended only for one project or ecosystems for writing smart contracts, in other words, to create new cryptocurrencies within one parent cryptocurrency, and according to the volatility of their values to variable and stable. Here are a few for all combinations:

  • Bitcoin - the most famous Proof of Work (PoW) currency of general, but specific purpose - only a currency of variable value. We could probably consider Bitcoin the gold of a new and fairer monetary system.
  • Litecoin - the same combination of types as Bitcoin.
  • Ethereum - the most famous Proof of Work (PoW) cryptocurrency that has an accompanying ecosystem for writing smart contracts, i.e. general purpose.
  • DAI - stablecoin ‘hooked’ on the dollar in the Ethereum ecosystem.
  • Waves - Proof of Stake (PoS) cryptocurrency which also has an accompanying ecosystem for writing smart contracts and thus general purpose.
  • Neutrino dollar - stablecoin ‘hooked’ on the dollar in the Waves ecosystem.
  • AnonEuro - stablecoin ‘hooked’ on the kuna in the Waves ecosystem.

A brief history of cryptocurrencies, smart contracts and the ‘crypto world’

Although Bitcoin was created as the first successful cryptocurrency in 2008, the idea itself is much older, it was created in 1994 by defining the idea of a smart contract. Because although a smart contract in cryptocurrency is a very simple distributed and decentralised program, it is still a program that had to exist for cryptocurrency to be possible.

Scientists and volunteers who write open source applications and enthusiasts of various kinds, especially cryptography enthusiasts, have long been aware that the concept of cryptocurrency as an electronic money that drives and regulates itself was possible and they talked about it a lot for many years even though it is basically a very simple concept for developers.

31.10.2008 a hacktivist appeared under the pseudonym Satoshi Nakamoto who sent a link to the ‘whitepaper’ of decentralised electronic money to the online communities of the above enthusiasts. Whitepaper basically set it up as the technical documentation of that new money that had long been talked about in those circles, but no one had until then defined it so exactly, concisely, simply, and in one place.

Somewhat later, on 03.01.2009, Satoshi Nakamoto released the first versions of related programs (software) and launched a network of distributed computers in which he immediately included early enthusiasts as administrators, and the program code of this software opened and allowed the colleagues insight and further development. The programs consisted of two parts - the one that goes to the server and serves as part of the network - node, and the one that is used as a user interface (user application) to handle that money - the wallet.

He named this system Bitcoin and thus the first cryptocurrency in history was born

Soon the Internet was flooded with a huge number of systems that work on a similar principle, new cryptocurrencies that we call altcoins, but Bitcoin remained the largest as the first that people trusted to, and which has never been successfully hacked since its inception.

In the first few years of using Bitcoin and altcoins, developers, enthusiasts and users noticed that money is not the only thing this independent, self-organising and decentralised infrastructure without owners could be used for, but that the same principle could be applied to almost all existing applications.

And so in 2015, Ethereum was created, a system that works like Bitcoin, but allows its developer users to define any smart contract - a new cryptocurrency or a whole new program as a background computer network for an application that will take care of itself, use game theory so that it maintains its own infrastructure without the need for a company or any additional organization to do the job, other than the application itself.

As we said, the first cryptocurrencies used the Proof of Work (PoW) principle, which uses a lot of electricity as proof of good intentions in the network, even though these are simple actions on computers in the network. With the growth of the cryptocurrency world, this proved to be a serious environmental problem because a lot of high value cryptocurrencies started consuming very large amounts of electricity together, and as we noted earlier, it was fundamentally (and in line with the game theory that drives it all) completely unnecessary. And so the idea of the Proof of Stake principle was born.

Proof of Stake (PoS) kicked out electricity consumption as an intermediary in proving a networked computer as a trusted computer and simply introduced that good faith is proven by an already existing value, so the existing cryptocurrency must be kept in a wallet tied to the server and so prove good intentions for the network.

If someone has a certain value in a cryptocurrency, it is to be expected that they will not falsify transactions because it will undermine trust in the entire network, and the result would be a drop in the value of the cryptocurrency they own and connect to the network server. So to speak, it would be a ‘vicious circle’.

Proof of Stake has resulted in both much faster and cheaper transactions.

At this point, cryptocurrencies were already a miracle, everyone was talking about them, everyone wanted a piece of profit, they wanted to buy early, wait for the price to rise and sell expensive and the world of cryptocurrencies was running full steam.

But still, cryptocurrencies could not match the banks, precisely because of that huge interest, because it turned out that a completely open electronic money market enables huge and sudden fluctuations in the price, that is, the value of that money. So one day Bitcoin was worth $100, another day $200, and a third $50. This made cryptocurrencies suitable for brokering and earning on price fluctuations (buy cheap, sell expensive), even quick and easy international transactions between any two entities without third party interference.

In order to use a cryptocurrency as a bank, it is necessary to be able to keep the value in it safely and in the long run, and how to do it if a person cannot be sure how much a cryptocurrency will be worth tomorrow, and let alone in a month or a year? Thus was born the idea of ‘stablecoin’.

Stablecoin is a cryptocurrency that has a stable value that is most often tied to the value of some of the existing fiat (‘normal’) currencies, e.g. dollars. One of the first was DAI, based on Ethereum smart contracts. In addition to the basic elements of cryptocurrency and its simple smart contract and simple game theory, DAI also had additional mechanisms, mechanisms that ensure that the value of the currency follows the value of the dollar, that 1 DAI is always $1 and vice versa.

The mechanisms by which this is achieved are already outside the scope of this article, but one example is quite simple and can be easily explained. If the price of a stable cryptocurrency starts to rise above $1 on open markets, a smart contract, i.e. the cryptocurrency program, will simply start making new denominations at a price lower than $1 and thus attract people to invest less than $1, make a new denomination and then sell it in markets for a price higher than $1 and thus make money while returning the value of open currency markets at $1. This is also an outstanding example of the application of game theory.

With the advent of stablecoins, cryptocurrencies and smart contracts have finally reached all the possibilities that one bank has, decentralised, self-organising, self-sustaining, without owners and the possibility of fraud or control and thus began the silent revolution we are witnessing today - taking control of currencies, money and banks from states and criminal international banking cartels and providing monetary independence and sovereignty to users of monetary systems, financial freedom that is the foundation of every other freedom in the world we currently live in.

Pragmatic, 03.06.2021.