ELI5 Cryptocurrency

ELI5 Cryptocurrency

If you’re just getting started in the world of cryptocurrencies, then the amount of information may seem a bit overwhelming at first.

Blockchains, forks, stablecoins, mining, staking, exchanges, security, hardware wallets….OMG! Where does it end?!

Cryptocurrencies are a revolutionary new technology, and they bring a whole set of unique concepts with them.

If you’re are just getting started with cryptos, then get ready to forget or recycle many concepts from the legacy financial system.

What is a cryptocurrency, exactly?

Let’s start from the beginning. What is a cryptocurrency? How is it different from a credit card or other instruments from the legacy financial system?

A cryptocurrency is a technology which allows value to be transferred from peer to peer, anywhere in the world, without requiring trust between the parties involved.

Sounds simple, right?

It’s a novel technology that allows anyone to become their own bank. When you need to send money to someone else, simply request their address, paste it into a wallet and hit send. That’s all there is to it.

Cryptocurrencies work from person to person, without a credit card processor, bank or any other middleman involved.

Which brings us to the next subject:

Decentralization

When it comes to cryptocurrencies, there is one magic word you’ll hear a lot: decentralization.

In fact, decentralization is the single biggest difference between cryptocurrencies and the old financial system. Cryptocurrencies make feasible a world where the financial system is governed by individuals, not by centralized institutions.

When you type your password into a credit card machine, you’re actually not sending funds directly to the salesman. There’s at least one bank between you and them (in most cases there may be several banks involved).

You and the salesman both trust the banking institution sitting between you.

You trust that only the amount you authorized will be debited from your account. The salesperson trusts they’ll receive the right amount when the credit card balance gets settled.

There’s a lot of trust involved here!

The architecture where you trust a middleman to complete a financial transaction is called a centralized architecture. There is a central person or institution that actually carries out the financial transaction on your behalf.

Cryptocurrencies, on the other hand, are decentralized.

They do not involve any trust at all. Cryptocurrency systems work because of a solid mathematical foundation, not because you trust the middleman to do the right thing.

Cash

A cash transaction is decentralized. When paying in cash, there is no one standing between you and the clerk. Cash flows from the client to the cashier in real time, without going through a financial institution. This is possible because, unless you’re paying using counterfeit money, it is impossible to double spend cash. No trusted middleman is required to verify a cash transaction. It happens peer to peer, like Bitcoin.

But how do you send cash to someone across the globe?

What if someone picks up a 20 dollar bill you just dropped, does anything keep them from spending it without your consent?

These questions have long challenged researchers who’ve tried to develop a viable payment system that didn’t require trusted middlemen.

For decades, all attempts at creating such a technology failed.

Until a mysterious person/entity/group called Satoshi Nakamoto came along.

Bitcoin

Whoever Satoshi may be, he/she/they developed the first ever viable cash-like payment system that can be freely used by any two people who don’t necessarily trust each other – without employing a middleman.

Bitcoin is a little like cash, in the sense that it allows you to send money straight to someone else, without requiring anyone in between.

But Bitcoin is also somewhat like a credit card in the sense that it requires passwords and protections in order to work. No one can simply “find” some Bitcoin on the ground and spend it like they could using cash.

Bitcoin is also fully traceable.

With cash, you can spend money anonymously. Without some special investigative technique, cash transactions can’t directly be traced.

Bitcoin, on the other hand, allows anyone to see everyone else’s transactions in real time! Illegal transactions can be traced back to their origin forever. Blockchain records are permanent, they can’t be tampered with, deleted, altered or disguised in any way.

Bitcoin has all the benefits of cash plus the security and traceability of digital money.

Bitcoin is cash for the 21st century.

Altcoins

Bitcoin was soon copied and “forked” by developers. (You’ll hear a lot about forks while working with cryptocurrencies!)

Some guy modified basic parameters in the Bitcoin source code and created his own cryptocurrency called Litecoin. Soon after came Dogecoin, and Ripple, and literally hundreds of different cryptocurrencies popped up seemingly from nowhere in a matter of months.

After this explosion, Bitcoin was no longer the only cryptocurrency of the land.

Instead, Satoshi had initiated a worldwide movement that’s still gaining more and more momentum daily.

Since Bitcoin remains the #1 cryptocurrency, we call the other coins alternative coins or altcoins for short.

Exchanges

When the number of cryptocurrencies exploded, so did all the different ways to exchange one for another.

Cryptocurrency exchanges, which are systems where you could send some Bitcoin and receive tens of different coins on the other end, sprung up everywhere.

Exchanges are like stock brokers that allow you to securely trade cryptocurrencies for other cryptocurrencies and also for fiat money (dollars, euros and so on).

Lots of innovative exchanges appeared during Bitcoin’s first decade.

For example, shapeshift.io allowed you to anonymously (no longer anonymous since 2018) send them one cryptocurrency and receive a different cryptocurrency on a different address almost instantly. It’s like a magic box where you could insert euros on one side and receive dollars out of the opposite side – instantly.

Many other exchanges were developed – there was an explosion in the number of businesses based on cryptocurrency technology. (Check out our exchanges article for more on that.)

With great power comes…

….great responsibility.

When you become your own bank, nothing protects you from yourself, or from others. It is entirely your responsibility to keep your funds safe and backed up at all times.

In these early days of cryptocurrency use, a lot of users have lost funds due to not taking precautions. This is one area where having a traditional bank can feel safer than using cryptocurrencies.

One of the greatest differences between credit cards and cryptocurrencies, for instance, is the fact that crypto transactions are irreversible.

They’re not irreversible because someone refuses to undo a transaction, but because it’s technically impossible to revert a cryptocurrency transaction after it’s been mined by the network. (You can read more about cryptocurrency mining here.)

Therefore, if you’re planning on using cryptocurrencies, be prepared to hold your own when it comes to protecting your funds, avoiding theft and online scams.

Conclusion

There’s lots to talk about when the subject is cryptocurrencies.

We couldn’t possibly cover it all under one article, but we hope this introduction has given you an idea about what cryptocurrencies are, how they differ from traditional payment methods and some of the precautions you should take when using crypto.

Related Articles

Check out the following articles to find out more about the revolutionary cryptocurrency technology:

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