Cryptocurrencies: how do they work and are they worth investing?
Cryptomania
We often hear about cryptocurrencies nowadays. We hear fabulous stories about cryptocurrency millionaires, the incredible popularity of mining, the theft of millions of dollars in cryptocurrencies, blockchain technology - technology that is said to change this world. But what, really, are those - cryptocurrencies, bitcoin, blockchain, mining - and why have they become so popular?
In this article we will try to understand the basic concepts of digital currencies, find out how you can get or earn them, and also, since they are money, where to spend them?
Cryptocurrencies are, in fact, the same money as that which is stored on your bank card. They are suitable for payments, as well as “real” currencies, but not all sellers accept them. The most important difference between cryptocurrency money and fiat money (the “real” money issued by central banks) is that you cannot cash it out at an ATM, you cannot touch it and put it in your wallet - cryptocurrencies do not have a material form.
Why were cryptocurrencies created? A tour of the history of digital money
The first and most famous cryptocurrency - Bitcoin - was invented in 2008. Only the pseudonym of the bitcoin creator is known - Satoshi Nakamoto. Whether he is a man, a woman or a group of people is still unknown. In order to explain what bitcoin is and why it was created, it is necessary to understand what the blockchain, the technology underlying this cryptocurrency, is.
Blockchain is a technology that allows you to transfer information, including financial transfers (cryptocurrency transactions or fiat transactions), without the participation of a trusted third party, without an intermediary. All information is recorded in blocks and cannot be changed or deleted, as it is stored on all computers (nodes) of the network at the same time. If you try to change the information in one place, all other computers on the network will not confirm the change and cancel it.
For money transfers, this means that the transaction will take place directly from one user to another, bypassing the intermediary in the form of a bank, payment system or state. These traditional payment systems can affect the transaction, delay it, require various confirmations. This was one of the main tasks of Satoshi Nakamoto. He wanted to create a system in which transactions would not require an intermediary and would be reliable and anonymous. bitcoin was introduced by him in 2008 as such a system.
Also, for transfers using the blockchain, the geographic location of the sender and the recipient does not matter - you can make a transfer from any country to any other country, regardless of their political differences and sanctions. Now international bank transfers of fiat money are processed and delivered within 3-5 days. With the use of blockchain, this time can be reduced to hours and even minutes.
Where do bitcoins come from?
bitcoins are created using mining. This English word draws an analogy between bitcoin, “digital gold”, and real minerals. So, bitcoin is mined. The mining process consists of solving complex mathematical problems using computing power. At the same time, all transactions with bitcoin are recorded in a chain of blocks, which are also checked for authenticity by computers (nodes) of this network. Since the nodes have information about all transactions in the network, they can confirm the transaction or recognize it as illegitimate in the case of, for example, trying to use the same funds twice.
In order for the number of blocks mined in one day to remain unchanged, mathematical tasks are being complicated in proportion to the increase in computing power of computers in the bitcoin network.
A total of 21 million bitcoins can be mined, of which about 17.5 million already exist. The last bitcoin, due to the increasing complexity of mining, will be mined only in 2140.
How transactions in the bitcoin network are processed?
As there are no actual bitcoin coins, so there are no bitcoins as files in the Internet. All bitcoins are only records of transactions in the network. For example, in the transaction of transferring one bitcoin will be indicated:
- Data on how that particular sum of bitcoins ended up on that wallet (records of previous transactions);
- The number of bitcoins to be sent;
- The address of the bitcoin wallet of the person to whom the transfer is made.
Further, transaction records for a certain amount will be removed from the sender’s wallet and attached to the recipient's wallet. If in the wallet initiating a transaction there are no transaction records for a specific amount that is transferred, a transaction record with a larger amount of bitcoins will be attached to the recipient’s wallet. In turn, a reverse transaction with “change” will be created, which will be attached to the sender's cryptocurrency wallet.
For the transfer one will have to to pay a commission. It is the main source of income for many miners who confirm transactions. Usually, the commission is low, but if the sender wants his transaction to be confirmed faster, he may pay extra. It is noteworthy that during the time of bitcoin price peak in 2017, the transaction fee reached $55.
How does Blockchain work?
The system shown above will be true, in one way or another, for most cryptocoins. Some, however, will have significant differences in the number of coins, the blockchain network, the speed and anonymity of transactions. Each project sees its flaws in bitcoin, which it seeks to eradicate and, if possible, surpass bitcoin in all respects.
How many cryptocurrencies? How do new cryptocurrencies appear? Can I create my own?
At the moment there are about 1600 cryptocurrencies. The figure is constantly growing. You can create your own cryptocurrency by conducting an ICO. This is the name of the initial coin offering, by analogy with the initial public offering (IPO). During the ICO, the creators of cryptocoins are trying to convince the public of the usefulness of their cryptocurrency (the blockchain behind it), that it will find extensive use, and hence the price of it will take off and go, in crypto terms, “to the moon.” So the people who create a cryptocurrency attract buyers, sell a predetermined amount of coins and, after collecting money, begin full-scale development and implementation of their blockchain into the business area announced in the White Paper.
Well, at least that's how it works in theory. In real life, everything is a little bit different. A study conducted in 2018 found that 80% of all ICOs conducted in 2017 were fraudulent. Those responsible for such projects were not going to develop their cryptocurrency after the ICO. Their aims had been achieved by the time the ICO took place.
Where do I spend cryptocurrencies?
Due to strong price fluctuations many sellers and service providers are not ready to accept bitcoin and other cryptocurrencies as payment. However, the list of the places that do accept them is not short. Starting with retail stores and coffee shops, ending with such giants as Microsoft - there are quite a few places that are ready to accept some cryptocurrencies as payment along with fiat money. One still has to find them. Numerous online maps will help with that.
How to get cryptocurrency without mining?
Since mining has now become an occupation that requires enormous electrical power, and therefore enormous investments (mining equipment is very expensive), it would be logical to ask about alternative ways to earn cryptocurrency without investments. There are several ways to earn cryptocurrency without mining:
- Reward for participation in projects. Many cryptocurrencies have been specifically created to support blockchain ecosystems. There are social networks, games, even sites for adults-only that use internal cryptocoins. So, on the social network Steem, users receive crypto coins for their activity. The better and more popular the user's content, the more coins he will receive.
- Bounty hunting. Many crypto projects at the stage of promotion distribute cryptocurrency (or tokens that can be exchanged for cryptocurrency) to those who advertise, comment and write articles about the project on social networks or in various blockchain-related forums.
- Faucets. Faucets distribute crypto coins in exchange for certain actions made by the visitor, for example: viewing commercials, playing games, opening captcha, clicking banners.
- Cloud mining. Such mining implies the rental of computing power from those who possess it for mining cryptocurrencies which you consider promising.
- Cryptocurrency trading. Speculative cryptocurrency trading on the exchanges will help increase the cryptocurrency status. It should be noted that cryptocurrencies have greater volatility than traditional trading tools. In one day, you can either become a millionaire or go bankrupt.
- Arbitrage cryptocurrency trading. This method involves buying/selling cryptocurrency on different exchanges. Now it has somewhat lost its relevance, since the difference in the rates of virtual currencies (bitcoin plays the main role in this method) has decreased on different platforms.
What’s the catch?
Perhaps, every one of us asked such a question in youth: “Why can’t you print enough money for all?” It’s not that simple, our parents told us. The same is true for cryptocurrencies. If they are so good, so safe, so reliable, why can’t we just start using them in our everyday lives? It’s not that simple.
The real value of, for example, bitcoin is defined by the readiness of people to buy/sell/receive wages in bitcoin or in what volumes such actions are already taking place. The want to buy cryptocurrency because just because it may rise in price is one of the surest signs of a financial bubble.
Other problematic issues with cryptocurrencies are:
- Cryptocurrencies are not backed by anything and not tied to any of the world economies directly. The case of Tether, a cryptocurrency allegedly backed with gold as 1:1, is rather proves the statement, as during all the years of existence of the cryptocurrency it has not been audited properly, not once. To add to that, Tether’s price has went both up and down from one dollar.
- A price of any cryptocurrency is formed only by market. It can have thousands of dollars price hikes and falls in a matter of days, and that we have already seen.
- According to research conducted by “Nature Sustainability” in 2018, the amount of energy that is required to mine one dollar’s worth of bitcoin is more than twice that is required to mine the same value of copper, gold or platinum. That said, bitcoin mining (and many other cryptocurrencies) can be described as an irrational use of highly productive computers and electricity.
- Great amounts of crypto are left in the wallets of its creators. Also, an enormous amount of bitcoins - roughly 40% (nearly $50 bln at the time) are held by only two thousand holders. That means that the market may be manipulated and, most likely, it has already happened.
- As there are no regulating mechanisms, there is no safety guarantee for crypto wallets. Numerous cryptocurrency exchanges hacks and thefts do not support the alleged safety and reliability of cryptocurrencies.
Another frequently discussed topic about anonymity of cryptocurrencies is also quite problematic. Anonymity is first of all benefits those who are involved in illegal activities. Cryptocurrencies have found the widest application in this sphere. That could but damage their reputation.
How do I profit from cryptocurrency trading?
Although cryptocurrencies are perhaps not the best find for the long-term investors, they possess significant potential for margin trading. As many cryptocurrencies have strong volatility, to trade them with a large leverage may be risky. Nevertheless, it is not advisable to trade cryptocurrencies with low price volatility - such trading with leverage is unlikely to earn you anything, yet you will have to pay commission anyway.
In either case, try trading a currency with a minimum leverage to find out how it behave in the market, on what does it’s price depend. As with any investment, one should first of all learn something about the chosen cryptocurrency with the help of technical and fundamental analyses.
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