A Beginner’s Guide to Cryptocurrency
Many of us have been investing in crypto assets without knowing what we are getting into. We hardly know what is the essence of these assets, what do these currencies/ tokens do, how our investment gets utilized, or how to make sound investments. Most importantly, many of us who are new do not know the different use cases of a cryptocurrency — digital cash, financing, smart contracts, collectibles, and so on. We are merely placing bets based on the herd mentality, and not actually looking at it from an investment perspective.
Now, What is Cryptocurrency?
Think of cryptocurrency as your existing bank account. The difference being, cryptocurrency is like banking online but without a central bank. Here, an algorithm issues the currency instead of a central bank. Similar to the bank account, a cryptocurrency account also has a transaction ledger, unique account number, and balances. To delve deeper into cryptocurrency we need to understand the aBCD of it:
- Blockchain: Think of it as your MS Excel spreadsheet, and treat each cell as a block. In blockchain, these cells are linked together in an order, making it a chain (therefore Blockchain!). Each process of the transaction is secured by cryptographic code called ‘hash’ — a 64-digit number specific to a given block.
So, blockchain is a type of database, with the data sorted out into blocks. This database is generally decentralized and distributed on multiple systems. There is no one central entity managing the database. - Cryptography: Crypto in Greek stands for ‘secret’. Cryptography is the study and practice of sending secure, encrypted messages or data between two or more parties. The purpose of this is to obscure the content of the data to a third party.
The sender “encrypts” the message, and the receiver uses a private key to “decrypt” the message, making it legible again.
3. Digital Currency: As the name suggests, it is a form of currency that is available only in a digital or electronic form, and it never takes any physical form.
So, to sum up, Cryptocurrency is a digital currency that records your transactions on a public digital ledger called a blockchain. Every process of this transaction is secured by cryptography.
Now, this piece aims to help one understand the fundamentals of this technology and the digital assets involved. In traditional stock market investing, a sound investor has some level of fundamental understanding of where her money is going, how is the industry, and the company’s business. However, when it comes to crypto investments, how many of us really understand where our money is going?
Okay so, how does it work?
The cryptocurrency process is broadly a three-stage cycle, involving - a transaction, the blockchain, and a process known as ‘mining’. However, given the growing number of different currencies, not all of them may work in the same way.
Initiating with a Transaction: Say, you want to send money to your friend, so the first thing you need to do is store the currency in a cryptocurrency wallet. This is a simple way to think of a wallet, even though technically the cryptocurrency is not stored in the wallet. Unlike conventional currency, the transaction is not facilitated by a central bank or clearinghouse. In fact, it is directly transferred from peer to peer. This makes crypto transactions cheaper and faster than conventional currencies.
Btw, a wallet is software that allows you to store your private keys, view balances associated with public addresses, and create and sign outgoing transactions. There are also custodial wallets where third parties host the wallet for you and are in control of the private keys (eg: Binance, Coinbase, WazirX).
So, how does the transaction go through? Here comes Blockchain.
The Blockchain: Blockchain is crucial since the information in one block is dependent on its previous blocks. So, it is very difficult for someone to hack, since they cannot change the information in one block without changing the entire chain.
So now, the payment that you have made to your friend gets recorded in a block: the sender and recipient IDs, the amount, and a timestamp. What also needs to be included in cryptographic proof, a complex mathematical problem requiring serious computer power to solve. This verifies that the transaction happened and also determines the block’s place in the chain. We will come to how this is produced in a moment.
Since blockchain is held on multiple servers across the world, all of these different versions are updated simultaneously. So, you change one and you have to change them all.
Mining: Mining is what makes cryptographic proof happen. It is responsible for the two most important elements of crypto: producing the proof and allowing more coins to enter circulation.
If the miners successfully find the right hash (64-digit number specific to that given block), they get cryptocurrency as a reward. That is the only way that new cryptocurrency can be minted. However, this is not as simple as it sounds. The chances of finding the hash are apparently one in 14 trillion.
Did you know that you could use your cryptocurrency to buy other cryptocurrencies? You can reduce one leg of transaction cost associated with it.
Not all Fingers are the Same
Lately, we have come across many crypto assets being traded online. However, not every crypto asset is meant to be used as a currency like Bitcoin is. To give you an example, the main use of Ether cryptocurrency is to pay for the transaction costs on the Ethereum Network, a decentralized application platform.
Two distinct elements make up the crypto universe: Bitcoin, and Everything else, also known as AltCoins or Alternative Cryptocurrencies
- Bitcoin: Bitcoin emerged during the 2008 financial crisis as an alternative to the existing banking system, moreover “the free market money competing against the monopoly money”. Like the internet is a set of open protocols for exchanging information, Bitcoin is a set of open protocols for exchanging value.
The network is an e-payment system that relies on cryptographic evidence rather than trust, which means that two parties may trade directly with each other without the need for a trusted third party, such as a bank. It is “the Internet of Value” - AltCoins: Bitcoin is an opensource technology which means it is freely available to public. So anyone could go ahead, copy and create their own currency. This is where new coins started coming up to fill the shortcomings of Bitcoin, which could be a higher block size, privacy, et all. An analogy here would be ‘.com’ URL which evolved first, followed by ‘.biz’ ‘.org’ ‘.io’. Everyone knows .com and would prefer using it over others. In that sense, Bitcoin is a ‘.com’ and everything else are the smaller URL derivatives. One should be super careful while investing in AltCoins. The usual claim to fame for AltCoins is speed, security and scalability.
- Tokens: Tokens do not have a blockchain of their own. They are created on top of blockchains such as Ethereum. The majority of tokens are designed to be utilized with decentralized apps, or dApps. Tokens have a far broader range of applications than coins and may symbolize a variety of items such as a piece of artwork, an education credential, and so on. Tokens, unlike coins, are not a fundamental component of the blockchain security mechanism.
Technically, these three types can be bucketed into:
A. Base layer blockchain and associated cryptocurrency
The base layer protocol defines the overall network rules, including the consensus method, where network users decide to add new blocks to the blockchain ledger, transaction throughput, and so on. This is where cryptocurrencies are generated, stored, and transferred. The most well-known base layer coins include Bitcoin, Ether, XRP.
B. Second layer Protocol
It refers to the additional framework or protocol created on top of the existing blockchain. These protocols offer a multitude of extra features and applications to users and solve a specific problem. The prominent second layer tokens include Compound, Uniswap, Bancor.
Before we bet, let's understand the fundamentals
But you only made money in those investments, if you understood why they were good investments AND you had a reason to keep those investments for the long term.
Just like mainstream investing, it is crucial to conduct thorough research of the crypto project associated with the related cryptocurrency. For eg: if you want to invest in Polkadot (DOT), then you should really know what the project is about, how your funds would be utilized, the future scope of the project, what are the use cases and who will use them, the team, and so on.
Here is a checklist to strategize your investment:
- Whitepaper: The whitepaper is a technical document that summarises the project. It explains the network’s aims, the technology used, the problem it attempts to solve, and the roadmap for future updates and additional features. It is sort of a prospectus. You will find the whitepaper on the websites related to the crypto projects.
- Team and Partnerships: One of the most essential factors is the project’s team and their experience. The team members’ skills will determine whether or not the project will succeed. Other variables, such as their prior initiatives in the cryptocurrency field, are also essential. Examining the collaborations with other groups can provide insight into the project. The quality of partnerships might indicate whether or not a project will endure in the long run.
- Assessment in terms of the work done: Understand if the idea interesting and promising, is there an MVP, progress made so far, roadmap, are they meeting the deadlines.
- Understand the view of the Community: what is the general vibe around the project, follow the specialized forums to get to know better.
- Existing Investors: More the reputation of the existing investors, the more likely the project to be good. Some reputed investors include a16z, Microstrategy, Grayscale.
Enfin, be on the Lookout for Potential ICOs
Like Initial Public Offering (IPO), Initial Coin Offering is a go-to method for the crypto projects to raise capital, by rolling out new crypto assets. Since you are investing at level 0, investing in a good ICO will help you achieve big gains. But again, do keep the checklist in mind before making the call.
Stay tuned for the deep dives!
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Credits: Pavish Saravanan, Vikas Kabra
Appendix: Few Cryptocurrencies and Their Use Cases
(other than Bitcoin which has already been discussed above)
Ethereum (ETH):
Ether is the Ethereum blockchain’s native currency. It is used as “gas” to pay for the execution of smart contracts on the network. ETH enables smart contracts which is used to build Decentralized apps. According to State of the DApps, the Ethereum network is home to over 3,000 decentralized apps.
In general, Ether can be used for payments, similar to bitcoin, where users send funds to one another much like cash. However, this does not require an intermediary to facilitate the transactions.
The Ethereum network aims to be the go-to location for developing decentralized apps and smart contracts with no single point of failure. Users can trade value using smart contracts without the need for an intermediary.
The major objective of the network was to decentralize the internet’s client-server architecture. With Ethereum, servers and private clouds are substituted by thousands of “nodes” maintained by volunteers all over the world.
According to CoinMarketCap, the market cap of ETH is USD 277 Bn.
Ripple (XRP):
Ripple is a payment protocol that enables banks to transmit international payments to each other in real-time without the need for a clearing centre. RippleNet, the company’s payment network provides connectivity to hundreds of financial institutions through a simple plug-and-play solution. This makes money transfer quicker and more trustworthy.
The Ripple blockchain’s native token, XRP, is built for the payments use case. It can handle more than 1500 transactions per second (TPS) and settles in around 3 seconds. The network’s minimum transaction fee is 0.00001 XRP. This transaction cost will rise in direct proportion to the network’s load.
According to CoinMarketCap, the market cap of XRP is USD 39 Bn.
Filecoin (FIL):
Filecoin is a decentralized storage network. This network’s main objective is to eliminate the need for centralized data storage. Instead, it creates a decentralized cloud. The network intends to compete with established cloud storage providers such as Dropbox and Google Drive.
Organizations and individuals can offer unused storage space on the network. They are rewarded in FIL for sharing their resources. It also provides an alternative to traditional cloud storage for people in need of extra storage space. The network promises to be quicker and cheaper.
According to CoinMarketCap, the market cap of FIL is USD 5 Bn.
Litecoin (LTC):
Litecoin is largely regarded as the first and most successful altcoin. It is a decentralized system that allows anybody to make fast and low-cost payments. Litecoin and Bitcoin have similar characteristics. Even though they have similar features, these cryptocurrencies are not the same.
The network’s goal was to be four times quicker than the Bitcoin network. The digital asset of Litecoin serves as a safe and efficient way of exchanging and storing value. Its high transaction capacity and lower cost make it an effective way of cross-border payment.
According to CoinMarketCap, the market cap of LTC is USD 11 Bn.
Zcash (ZEC):
Because blockchains are immutable and transparent, the transactions that happen between all the addresses can be viewed by anybody on the ledger and are thus traceable.
Transactions with Zcash, on the other hand, can be either visible, like in bitcoin, or partially or entirely protected. By using specialized cryptography, data points such as the sender address, the receiver address, and the amount transferred can be masked. Zcash’s primary objective is to be a cryptocurrency centered on privacy.
According to CoinMarketCap, the market cap of ZEC is USD 1 Bn.
Chainlink (LINK):
Chainlink is a decentralized oracle network that links smart contracts on the blockchain to off-chain data (real-world data).
An oracle network is a type of entity that delivers external data to smart contracts. These oracle networks act as a link between blockchains and the rest of the world. They overcome the challenge of linking external data sources to blockchain smart contracts in a language that the blockchain understands.
Persons A and B, for example, bet on who will win the NBA 2021 finals. Person A feels the Suns will win, but Person B believes the Bucks will win. They both agree on the conditions of the bet and lock their funds in a smart contract. Based on the outcome of the NBA finals, the smart contract will distribute all of the funds to the winner. Because the smart contract cannot connect with external data, it must rely on an Oracle network for information. In this scenario, the NBA finals results.
According to CoinMarketCap, the market cap of LINK is USD 10 Bn.
Compound (COMP):
Compound is an Ethereum-based decentralized protocol. It focuses on helping borrowers to obtain loans and lenders make loans by locking up their crypto assets. Interest rates are determined by the supply and demand for each asset.
cTokens are Compound’s native token. It simply represents the funds deposited in the protocol by the users. For example, if you lock up ETH in the protocol, you will receive a cETH token in exchange. It earns interest for you automatically. You can redeem your cETH at any moment for regular ETH plus the interest. Compound’s major objective is to enable crypto assets to be utilized as “productive assets” that may produce interest in the same way that traditional assets in the financial system do.
According to CoinMarketCap, the market cap of COMP is USD 1.6 Bn.
