Cryptocurrencies and How they Work

Every year, technology enthusiasts make their bets and predictions on the latest innovation that would be out in the coming weeks and months. But it’s been at least a couple of decades since something radical surfaced, which shook the entire industry up. The last time this happened was when the Internet started becoming mainstream and people who denied it’s adoption and viability stood corrected.

This time around a similar trend is being observed with Blockchain and Cryptocurrencies. The latter half of the year 2017 was dominated by news about Bitcoin reaching all-time highs and exceeding every possible expectation and people on the Wall Street and other major finance moguls trying to outright deny it’s validity in the long run.

Like it or not this technology is here to stay and since it’s all the buzz right now, it only made sense that we educate a wider audience on what these things are and how they impact our lives. You see getting involved with a technology deeply is always one’s own choice, but it’s only once in a few decades that a paradigm shift like the internet or blockchain happens. And like it or hate it, you will have to get yourself familiar with the technology. Unless you want to live like a dinosaur in the modern age.

With Cryptocurrencies and Blockchain, it’s extremely important that we take the correct approach to explaining them so that it doesn’t become too daunting for the average person. This is why we’re taking a bottom-up approach to these series. We first focused on getting the fundamentals clear with the Grokking Blockchain article which I highly recommend you read before proceeding with this post. And in this post, we’ll build on top of that post to explain how Cryptocurrencies work.

It’s still important to give a brief refresher to those who have read the Grokking Blockchain post are at least familiar with the working of the blockchain.

The blockchain is basically a public, append-only, distributed ledger where transactions are added to the network and are validated by all parties present on the network.

This is most minimal definition there is to what blockchain is. If you want to really get into the nitty-gritty details of the underlying tech and how it operates, refer to the previous post in this series.

Let me make a strong disclaimer before proceeding though, without having read the previous post or without having the understanding of the working of a blockchain, this post is not going to be helpful to you. It’s probably just gonna confuse you more. So moving on I’m assuming that you have researched about the blockchain and have a working understanding of the same.

Alright, let’s move along!

We took an illustrative approach to explaining things in the previous post and we’re gonna do the same here based on the initial feedback received.

To understand the benefits of using Cryptocurrencies we’ll go through an example of a typical payment/transaction flow.

Let’s say you Steve go to Starbucks to get yourself a hot cup of Coffee (Pumpkin Spiced Latte!). You place the order and you choose to make the payment via your card, you swipe your card, enter the PIN and then take the receipt and then you sit patiently and wait for your order.

This is the flow most of us are familiar with and most of us use. What’s worth noticing here is the fact that what people assume with respect to the transaction. As soon as the receipt is out of the POS/Card machine, 90% of us think that the amount has been deducted from our bank account and transferred across the network and is immediately reflected into Starbucks’ bank account.

This is not true actually. In real life, for the amount to finally reflect into the recipient’s bank account, it takes roughly 3 to 5 business days (This is also the case when an e-commerce issues a refund but it gets to your account after a couple of days).

There are formal procedures in place which attribute to the long delay. When you swipe your card and enter your PIN you notify your bank that you want to transfer a certain amount to the recipient, which is then transferred as an instrument to a clearinghouse, the clearinghouse then approves the transaction after certain checks and finally, the amount is reflected in the recipient’s account. Since most of this process is manual and verified by actual employees sitting on desks, there’s a lot of latency involved in the process.

Latency in processing is definitely not the only thing that businesses and consumers need to worry about. There’s significant transaction fee levied at each stage of this process, making the actual amount received by the recipient be at least a couple of % lesser than the amount paid by you.

This is the reason why smaller businesses refrain from using a card for accepting payments for a small-value transaction.

This is what Bitcoin and other cryptocurrencies are trying to change.

Let’s consider the same example again but instead of using a card for payment, let’s use a Cryptocurrency. For sake of simplicity, we’ll assume that you Steve are using Bitcoin to pay the barista at Starbucks. You place the order, the order is billed and a QR code is displayed on the POS which is the wallet address of the store.

You open your wallet and initiate a payment by scanning the QR code. Once you’ve successfully entered the PIN, that transaction is appended to the blockchain. The network which maintains and keeps the ledger in sync verifies the transaction and this usually takes roughly 10 minutes. Once this is done the amount (in bitcoins) is reflected in the recipients’ wallet.

There are a couple of subtle things to note here. First would be the speed of transaction. Since there’s no manual intervention required in the process, it is exponentially faster than a typical bank transfer. Second, there’s no transaction fee or a very minute transaction fee that is levied per transaction. Third, since the transaction is verified by the entire network, it eliminates the problem of double spending or fraudulent transactions.

This is how game-changing Cryptocurrencies are. Just imagine how easy it would be for you transfer money from anywhere in the world irrespective of the currency and amount in a matter of minutes.

Now I agree that people who are even a fair bit aware of how Cryptocurrencies work have some pretty legitimate questions regarding my explanation. Don’t worry I have accumulated a list of the most common ones and I hope they cover most of your concerns if there’s anything more that you’re not clear about, write it to us in the comments section or tweet it out to us and we’ll respond.

Here’s a List of Frequently Asked Questions

1. I want to learn more about Bitcoin, what is the best resource?

Among the various cryptocurrencies available today, Bitcoin stands out as the pioneer and most well-known. For those who are new to the world of digital currencies and want to learn the basics of Bitcoin, I recommend checking out ‘Bitcoin for beginners‘ on CoinGeek. This beginner-friendly guide covers everything you need to know about Bitcoin. It’s an excellent resource to kickstart your journey into the exciting realm of cryptocurrencies.

2. You say transacting with Cryptocurrencies would not incur any significant fees but I see people paying exorbitant fees for transfers, what’s up with that?

Ok, so let’s get a very basic premise clear. Currently there more than 1300 Cryptocurrencies out there. It’s safe to say that 1295 or more of them will never amount to anything in the long run, so that limits our target set to about let’s say 5 or at best 10 Cryptocurrencies. In this set of 10 coins we have the more popular coins like Bitcoin and Ether and then some less known but rising coins like Ripple, IOTA and the likes. What you need to understand very clearly is that every coin works on a completely different principle. Essentially every coin that is launched tries to solve a problem with existing coins. The question that you just had can be isolated to Bitcoin.

Let me explain, yes there’s a huge transaction fee associated with transferring Bitcoins from one address to another. The reason behind that is the fact that Bitcoin is the most popular Cryptocurrency out there and like it or hate it, despite the fact that people may not know anything about Cryptocurrencies or Blockchain, they still want to get involved with Bitcoin. It’s pure craze.

Bitcoin works on a supply to demand ratio principle (almost like gold) which decides the price of a coin. Meaning if the demand for Bitcoin increases, the price will also increase as the supply is always limited.

That being said, if you read the previous post about blockchain, you know that to add a block of transactions to the ledger, miners are rewarded in Cryptocurrencies. As the number of transactions increases the complexity of the cryptographic problem also increases which increases the reward for the miner, and which finally boils down to you paying a higher fee per transaction. I get it it’s rough but there’s nothing to worry about.

When the white paper on Bitcoin was authored, it stood for decentralized, peer to peer instantaneous microtransactions and the current state of Bitcoin in no way fulfils that goal. But what you need to realize is that Cryptocurrencies are fairly new and it’s still early days to call anything final. Bitcoin is a pure software solution and like every other software system, things get better iteratively instead of immediately.

A new system has been proposed to solve this problem with Bitcoin, it’s called the Lightning Network and while I’m going cover it in a separate post exclusively about Bitcoin, here’s a gist of how it works. Since the Bitcoin blockchain is extremely large and there are several thousand transactions happening per second pending approval, the lighting network would be an abstract network on top of the current blockchain.

This would make microtransactions possible in seconds or milliseconds and at the same time eliminating the high transaction fee. It’s currently in development and should be launched later this year. The lightning network would also enable off chain transactions so even if you’re transacting in a currency which is incompatible with the said blockchain, the transaction will come through. More on this in an upcoming post.

3. Banks take too long to transfer, but what if I use something like Apple Pay?

Something worth noting here is those online payments via card, contactless payments etc provide an abstraction to the procedure to us the consumers. It just looks like the transaction was approved once we get the printed receipt. Entering the PIN and approving that withdrawal is only the first step in a series of steps that are taken by the regulatory authorities to prevent fraud and theft, as mentioned previously the actual transfer takes a couple of days at best.

When speaking about solutions like Apple Pay or Android Pay etc, what you need to know is that even though it looks and feels and sounds like a Cryptocurrency transaction, meaning it would be instantaneous, it’s actually not. Most of these solutions are built on top of our current financial system and provide only a certain level of digital flexibility and abstraction.

Even if you pay for a purchase using Apple Pay, the bank partners take over in the very next step and the same old long process is followed. Sure the amount is deducted from your account, but it’s not yet reflected in the recipients account immediately (this again varies from country to country).

4. I’ve been hearing news about hacks where several million worths of Bitcoins were stolen. Does this mean it’s not safe to use Bitcoin?

No, absolutely not. Bitcoin or for that matter any popular Cryptocurrency is built on top of Blockchain and as illustrated in the Grokking Blockchain article, the blockchain is the most secure thing built in our time. Now the question about hacks, yes there have been and will be multiple hacks resulting in Bitcoin being stolen etc.

But here’s the deal, it’s not a problem with Bitcoin or it’s security or a fault in the Blockchain. It’s the exchanges or places where those Bitcoins were stored that were insecure/vulnerable which resulted in a hack. Hence it’s always advised to store your Cryptocurrencies in a cold storage (hardware wallet like the Ledger Nano S) or at least a software wallet on your smartphone or computer.

5. Ok, what about the legitimacy of my own transactions? At least the conventional way we have the bank to back us up in case of a fraud? What about Bitcoins?

Stressing back on a couple of things I already mentioned earlier. One, Bitcoin is still at its very early ages (10 years compared to the several centuries for which banks and institutions have existed). Two, the technology itself is very secure. The entire ledger is public and anyone can see what amount was sent from which address and to which address. The part where the scope of fraud comes in is mostly in the user’s gullibility.

Since the network is decentralized, it means there’s no authority in place to regulate anything. That’s both a good thing and a bad thing. Good because it brings the control back in people’s hand and bad because in case of a fraud there’s no one to appeal to. In such a case it’s our own responsibility to make wise decisions while using such a technology.

Rule of thumb, if a Nigerian prince asks you to become a partner in a multibillion-dollar business and to join you need to complete a verification procedure which costs a few Bitcoins, stay away from the prince, it’s in your best financial interest.

6. The news has been reporting the misuse of Cryptocurrencies for illegal purchases, am I going to be in trouble if I use it?

Short answer no, the long answer is as follows.

Most Cryptocurrencies, Bitcoin, in particular, have promoted privacy and anonymity as one of the key features. As mentioned earlier, the ledger is public and open to anyone who wants to see but all you get to see per transaction is, how many coins were sent at what time from which wallet address and to which wallet address.

There’s no disclosure of the identity of the owner of either wallet. This means that certainly one could buy some Bitcoins bounce it around to a couple of wallets and finally make some illicit purchase on the dark web fairly easily.

That’s totally possible. But ask yourself this, can’t you do the same with cash? I mean once you have cash in hand you could very well use it to buy weapons or drugs with no one being able to trace the purchase back to you solely based on the transaction. This problem is with Cryptocurrencies and at the same time with Fiat currencies (US Dollar, Indian Rupee etc).

Now there have been advancements made in this direction but they aren’t completely effective. Most major exchanges across the globe require you to verify your identity (KYC or Know Your Customer) before you can make a purchase of a coin on that exchange. This is just an extra line of defence against misuse but you could still very well bounce it to a couple of wallets before making an illegal purchase. There’s no full proof solution to this situation yet.

7. What is a fork in a Cryptocurrency?

Great question! Sometimes in the process of software development, the development team decides to implement something so radically different that if the change was introduced in the current version it would break, thus, the team isolates these changes into a new version. Consider the popular example of Windows Vista. Microsoft made so many changes in the new versions that applications designed for Windows XP no longer worked on Vista.

This is the compatibility issue. A similar thing happens sometimes in Cryptocurrencies as well and they are 2 types a soft fork and a hard fork. While a soft fork is mostly caused by an error in maintaining the ledger, a hard fork is created by the development team in order to solve a problem with the current coin. Take for example Bitcoin Cash which forked from Bitcoin in August 2017. Bitcoin cash aims to solve the latency in approval of transactions that are prevalent on the regular Bitcoin network.

Conclusion

In this article, we presented an isolated view of what a cryptocurrency is and how it works. Agreed Bitcoin is currently the largest and the most popular coin out there. But that may not be the case forever. It’s crucial to understand the underlying principle that all coins are based on, once you are clear about that, every coin announced or to be announced in the future would be a layer on top of that base. In the upcoming posts, I will cover some of the popular and promising Cryptocurrencies as of 2018 and how they stack up against each other. Until then, make sure you read up as much as you can before investing.