eToro
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The Technology Behind the World of Crypto

How Does Cryptocurrency Work?

To begin to understand cryptocurrency, we have to examine the technology that powers it, and consequently, certain concepts to which cryptocurrency owes its existence. Let us first start by defining what cryptocurrency is. In short, it is money that:

  • has no cash form
  • is not issued by a government

Cryptocurrency owes its properties and existence to the advent of blockchain technology. Blockchain technology is the lynchpin of the entire cryptocurrency universe and among other things, enables cryptocurrency to function as a cashless, digital medium of exchange.

What is Blockchain?

The term ‘blockchain’ is a reference to a constantly growing, digital list of records, termed ‘blocks,’ which are secured and connected to each other, through the use of cryptography. Cryptography – the namesake of cryptocurrency – is the science of digitally encrypting information in such a manner that would make it impossible for unauthorised parties to access or alter it in any way. It is the application of cryptography that makes information stored in blocks secure and reliable. These digital blocks of data come together to form an electronic database, which is essentially a publicly accessible (i.e. decentralised) ledger.

Decentralisation, is in fact, a key aspect of how the blockchain functions and keeps itself immutable – secure and free of malicious interference. In a decentralised network, information is not locked up in a central server, since there simply isn’t one. Instead, it is stored in the computers of all the participants of a given network. Every participant (or peer) has access to the ledger, that records and maintains the complete history of all transactions and can be referenced to check if a potential transaction is legitimate or not. Due to these factors, any sort of unauthorised transaction could not take place by definition, as in order for any transaction to proceed, it would require all the peers in the network to review (and subsequently approve) it, before it could take place.

Pros & Cons:

           As blockchain technology started to come into its own in the last few years, the vigorous debate regarding its utility, application, and role in the global economy has continued to grow unabated. Proponents have posited that blockchain technology has the potential to:

  • Help individuals around the world transact freely, without government interference
  • Offer increased security by virtue of the unassailable nature of the blockchain
  • Remove the need (and associated cost) of third party escrow services

Just as there are those who are enthusiastic about the potential benefits of cryptocurrency, there are plenty of others who do not share this enthusiasm and voice consternation about the potential to use this technology for nefarious purposes such as:

  • Purchase of illegal/illicit items
  • Tax evasion
  • Financing of terrorism or other criminal activity

1.0 – Cryptocurrency

It is the distributed ledger aspect of blockchain technology that allows it to power cryptocurrencies such as Bitcoin, Ethereum, as well as over a thousand others. Because every peer has a complete record of the history of all transactions, he or she, therefore, knows the balance of every account at all times. The ledger, as an immutable record of all transactions, can be relied on to confirm if an upcoming transaction is valid or an attempt to double spend. It is these properties that enable cryptocurrency to serve as a purely digital, cashless, medium of exchange.

2.0 – What is a Smart Contract?

In a more traditional, centralised system, different parties that wished to conduct some kind of a transaction had to rely on a (presumably) trustworthy third party, such as a bank, an attorney, or a government agency to provide escrow services. In other words, to adjudicate the transaction – to make certain that all parties fulfill their contractual obligations.

In a decentralised system, the validation and adjudication functions are delegated to every peer in the network, thus, eliminating the need for third party oversight altogether. Such an application of blockchain technology is referred to as ‘smart contracts’. These smart contracts are essentially blockchain-based computer programs that are coded to automatically execute certain predetermined actions, only after all parties have met their contractual obligations. In effect, these programs make sure that no one receives what they want, until they fulfill their end of the bargain. The really fascinating implication here is that the decentralised aspect of blockchain technology eliminates the need for third party escrow services. Instead, the decentralised nature of this technology, itself acts as the escrow service provider, thus, potentially saving tremendous amounts of money and work hours.

3.0 Decentralized Apps:

The advent of decentralised blockchain technology not only paved the way for cryptocurrency and smart contracts but also for a new generation of computer programs/applications known as decentralised applications or ‘Dapps.’  The code of these programs is not stored on centralised servers, but is instead – as the name suggests – stored on a decentralised, peer-to-peer network.

This means that Dapps offer protection from unwelcome interference that their centralised counterparts are not able to, as they do not have a central server that can be attacked in any shape or form. As such, they are far more secure and are not vulnerable to attacks that a centralised piece of software might be, such as denial-of-service attacks. This aspect of Dapps has the potential to appeal to a very wide range of users. Both those concerned about security, as well as those anxious about censorship, could potentially find very attractive the fact that Dapps lack the capacity to be hacked or to be vulnerable to other attempts to disable them.

What are Forks?

A cryptocurrency fork is – an attempt to reconfigure its protocol (i.e. computer code) with the ostensible aim of improving the said cryptocurrency’s performance or remedying some sort of problem with it. More simply put: a fork is a change to the software of a cryptocurrency that creates two separate versions of the blockchain with a shared history.

Forks can be temporary, lasting for only a few moments, or permanent. A permanent fork creates a perpetual split in the network – creating two separate versions of the blockchain and subsequently two different cryptocurrencies. Examples of circumstances that may lead to forking are: a change in the rules of the blockchain on which the digital coin operates , reversal of the effects of hacking or catastrophic bugs, or in the event of disagreement between the nodes regarding

historic transaction(s). The two most common types of forks are “hard” forks and “soft” forks.

  • Soft Forks:

Soft forks generally occur in the rare cases when two or more miners validate a block at the same time. In such an event, they will each produce their own hash (verification code) for that block. The most frequent way such a situation gets resolved, is by adding the next block to the blockchain, with the nodes subsequently verifying that this particular chain is the longest and therefore, the most correct, rendering the other chain invalid.

  • Hard Forks:

Hard forks are intentional and are imposed by the developers of a blockchain with the purpose of changing the rules of the blockchain. Since Bitcoin is on an open source blockchain, developers can impose changes at any time. During a hard fork, developers take a “snapshot” of the blockchain ledger at the forked block. For every token that you own at that time, you should receive a certain amount of the new tokens – usually at a 1:1 ratio. There are 2 ways a hard fork can proceed:

  1. The majority of nodes do not agree with the new rules and continue as normal. If the fork occurred and a percentage of nodes did follow the new rules, the majority would reject their blocks and force them to create their own coin.
  2. The majority of nodes agree with the change in rules and the nodes that run the existing rules are forced to either change rules or they fork off and create a new cryptocurrency.

What is Cryptocurrency?

As discussed earlier, cryptocurrency is one of the many applications of blockchain technology. The sole purpose of digital currency is to facilitate commercial transactions by providing a medium of exchange. It does so by providing a publicly accessible ledger that maintains an immutable record of all transactions. Bitcoin currently remains the most widely used and valued cryptocurrency out there, with Ethereum holding second place. However, more than one thousand two hundred different cryptocurrencies have come into existence in the last few years, each competing with the other to be the best.

Bitcoin

Ethereum

Ripple

Bitcoin Cash

Litecoin

Dash

NEM

IOTA

Monero

Zcash

Free Transactions

No No No No No No No No No No

Instant Transactions

No No No No No No No No No No

51% Defence System

No No No No No No No No No No

SegWit Free

No Yes Yes No No Yes Yes Yes Yes Yes

Block SIze

1 mb 1 mb 1 mb 32 mb 1 mb 1 mb 1 mb 1 mb 1 mb 1 mb

Difficulty Retarget

2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks 2016 blocks

On-chain Scaling

No Yes No No No No No No No No

Multi-Pool Resistant

No No No No No No Yes Yes Yes Yes

Satoshi’s vision

No No No Yes No No No No No No

 

What is a Cryptocurrency Wallet?

Wallets are what allows one to store cryptocurrencies which have been purchased. A cryptocurrency wallet is in fact a prerequisite to being able to buy any electronic coins. A wallet can be solely virtual or have a hardware form – this is referred to as “hot storage” and “cold storage” respectively.

A purely software wallet, functions very much like an online bank account. This is known as ‘’hot storage’’ and it is thought to be a more user friendly way to open and use a cryptocurrency. The downside of having this type of wallet is thought to be in the increased risk that is associated with having valuable data stored online, that could potentially become the target of hacker activity.

A hardware wallet functions like a USB key. Storing cryptocurrency in this manner is referred to as “cold storage” and is thought to be more secure than hot storage, as the cryptocurrencies reside inside the USB and have no online account which can be hacked.

Ledger Nano S

Ledger Blue

Coinpayments

Exodus

Jaxx

Anonymity

No No No No No

Multi-coin support

Yes No (about a dozen) Yes Yes No (limited to seven)

Ease of Use

No Yes Yes Yes Yes

Mobile compatibility

No No Yes Yes Yes

Software

No No Yes Yes Yes

Hardware

Yes Yes No No No

Secure

Yes Yes No Yes No

Extra Services

No No No Yes No

 

Looking Into the Future

As the enormous potential of this new technology becomes more recognised around the globe, an jurisdictions are enacting legislation to regulate cryptocurrency. This is a further sign that in the near future, cryptocurrency will lose its volatile, Wild West persona and will be brought into the fold of normal financial instruments. And while the debate around cryptocurrency continues, it is undeniable that a number of people around the globe have already felt the benefit of the introduction of this new technology. For example, those who rely on remittances sent by family members working abroad are able to use cryptocurrency to significantly reduce transaction fees associated with sending money from one country to another.

Looking into the not-too-distant future, one might see how cryptocurrency may be able to assist people in locations where it might be difficult to access the formal banking system, to finally start participating in the global economy. This could be especially relevant to people living in the developing world.

Cryptocurrencies can fluctuate widely in prices and are therefore not appropriate for all investors. Trading cryptocurrencies is not supervised by any EU regulatory framework.

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