Basics

Here we discuss the basics of blockchain and cryptocurrencies and how they apply to new users in the space.

What is Blockchain?

Blockchain is a technology that has sprung into popularity in the last decade with cryptocurrencies and other virtual assets. A blockchain, as the name suggests, is a continuous list of blocks of information that live on a network of computers. New blocks are added to the list by some of the computers on a periodic basis, and the other computers verify the same using special algorithms. Blockchains are particularly useful to form the basis of digital money, as they help create and maintain scarce virtual assets. This is in stark contrast to the typical understanding of digital data, where making copies of things is an easy task. This is also the fundamental property of blockchains that allows them to hold digital objects (such as cryptocurrencies), which society can grow to value because of the inherent property of being limited in number. A fundamental thing to note about public blockchains today is the idea of decentralisation which inspires them. This simply means that we build systems that do not rely on a single authority, and instead work by sharing responsibility across a wide group of smaller participants, which could be anyone from the public.

What are Cryptocurrencies?

Cryptocurrencies are digital assets that have similar characteristics as normal, government-issued money known as Fiat (e.g. USD, EUR), but with an added advantage of operating on a decentralised, global network that is immune to the control of any one authority or jurisdiction. Just like normal money, you can use cryptocurrencies as a medium of exchange for goods or services on the internet, with growing adoption in offline retail stores around the world. One of the common concerns is that cryptocurrencies also offer anonymity, which means it is that much harder to trace fraudulent or criminal transactions. Cryptocurrencies are created using cryptography, which is the discipline of writing and solving codes, usually involving high-level mathematics. Such a grounding in math provides the currencies with a global level of trust, where individuals who don’t know anything about each other can trust the network process and the transaction, and be safe in the knowledge that their funds are legitimate.

What is mining?

With currencies such as USD or EUR (also known as fiat money), a central authority such as a government or a bank has the responsibility of keeping track of all the currency in circulation and also of printing new currency when required. To achieve the same with cryptocurrencies that do not have any central regulator, we require miners. Miners are participants on the blockchain who contribute resources such as processing power (CPU) to help maintain the list of blocks and the transactions within them. They do this by solving complex mathematical puzzles, thereby validating the authenticity of the transactions (as someone had to spend real-world resources to do so). As each new block is mined, a small, new amount of the currency is generated which serves as the reward for miners.

What is a decentralised market?

A cryptocurrency market is typically decentralized, which means that the technology enables participants to directly deal with each other instead of trusting a centralized authority, such as a bank. Decentralized markets have all kinds of tools to widely communicate commodity prices in real-time. If everything works as it should, then people do not need to be in the same place to make a transaction go through, i.e. they only need to be connected to one node of the network which will pass on their data. A decentralised market is a good example of a peer-to-peer network.

What is a centralised market?

The main point of centralized markets is that all orders are led to one central exchange with no other competing authority or validator. On centralized markets, the prices of different commodities shown on the exchange are the only prices that are available to the public. The New York Stock Exchange is a good example of a centralised market. All bids (i.e. buy orders) go to an exchange where they are appropriately matched with an ask (i.e. sell orders).

What is Bitcoin?

Bitcoin (BTC) is the first widely known cryptocurrency, and was released in January 2009. It was invented by a pseudonymous individual (or group) known as Satoshi Nakamoto. As an honour, the smallest unit of Bitcoin is known as a ‘satoshi’, i.e. 0.00000001 BTC. The ideas that birthed Bitcoin can best be understood from the whitepaper published by Nakamoto, which contains the now famous sentence: "The root problem with conventional currencies is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust." Bitcoin works on a Proof of Work consensus algorithm, which means that computers on the network known as ‘miners’ contribute their CPU power to solve mathematical problems, and are rewarded with appropriate amounts of BTC in return. The miners are important as they ensure the validity of the transactions going through the network.

What is Ethereum?

Ethereum is a cryptocurrency network that was launched in 2015. It circulates a currency known as Ether (ETH), and much like Bitcoin, started off with a Proof of Work consensus algorithm. Ethereum is currently transitioning to Proof of Stake (PoS). This means that the network is secured not by lots of computers contributing their CPU power (while this will still occur), but by the participants on the network ‘staking’ or locking up relatively large funds in exchange for small amounts in periodic rewards. PoS is designed to be a lot more energy efficient than PoW, and will also broaden the opportunity for the public to participate in mining for the network. The core idea here is that if someone locks up their funds for the network, then, by extension, they care about the overall health and validity of the network, i.e. their interests are aligned with the collective. To add to this, miners are also kept in check by a penalty for illegal or malicious behaviour, which takes away a portion of their staked tokens. The main innovation that Ethereum brought over Bitcoin is the smart contract. Smart contracts are sets of instructions that live on the blockchain and allow programmers to create new and interesting applications which can be coded into the cryptocurrency and the network, as opposed to being solely restricted to financial transactions as with Bitcoin. The decentralised applications which are built on top of smart contracts are commonly known as dApps, and so far they have forayed into spaces such as insurance, derivative markets, IoT, supply chains, etc.

How can one buy and sell cryptocurrencies?

One can buy and sell cryptocurrencies in mainly two kinds of places: Decentralised Exchanges (DEXs) and Centralised Exchanges. Decentralised Exchanges are essentially market makers which match the price and quantity of assets that people want to sell or buy. The exchange itself is not under any company’s control, which means that the market dynamics are much fairer to the public. However, DEXs are relatively difficult to deal with, and require users to have a working knowledge of how to safely store and secure their digital assets. Centralised Exchanges or CEXs are a lot more user-friendly, in that they offer a central place to deal with all of one’s crypto-assets, and come with typical account features such as the recovery of lost passwords. The fundamental drawback of a CEX, however, is that the user is not in control of their private keys, i.e. the string of letters and numbers that can be used to access their personal funds on the blockchain. It is important that users understand their own financial needs well, and make an appropriate tradeoff between various exchanges in terms of credibility, ease of use, speed and security.

How do keys and addresses work?

An address is a unique location on a blockchain network, which can receive, hold and send tokens. Every address consists of two parts: a public key and a private key. The idea is that it is safe to share one’s public key widely to receive funds, much like an email address; while the private key is especially sensitive and needs to be kept private, and has the power to send funds by signing transactions, similar to a password. Every public key and private key pair is linked by a special cryptographic algorithm, which allows them to function in the manner described above. When written in text, the keys look like a long string of unintelligible letters and numbers which can be very hard to remember. This is where wallets are useful.

What is a wallet?

A wallet is a piece of software that can hold cryptocurrencies by storing their private keys, which are used in cooperation with the appropriate public keys. There are many kinds of wallets available, which can be categorised as: mobile, hardware, desktop and web wallets. Wallets are useful because they save us the hard work of memorising or writing down long cryptographic keys, and instead work on passwords and key phrases, which are much easier to remember. However, in most cases, it is best to also note down one’s private key in a separate and safe location as a backup. When browsing for wallets you could also come across these two terms: ‘Cold Wallet’ and ‘Hot Wallet’. The wallets that are not connected to the internet are called Cold wallets. The ones opposite this are known as Hot wallets, which are connected to the web. As you can suspect, Cold wallets are safer to use and we recommend using them when you hold large amounts of coins. If you have a small number of coins and regularly use your wallet then it is easier to use a Hot wallet.

What are the different types of wallets?

Desktop wallets are made to be used on a desktop computer or laptop and can be installed on many operating systems (Windows, Mac, and Linux). You can simply download the wallet you desire from the web and follow the instructions on how to install it. These wallets enable easy access from a computer when offline. Web wallets are those which can be accessed only via the internet. They are easy to use as you do not have to download them and everything is taken care of by the provider. Web wallets do have some disadvantages, in that they are actively connected to the internet (i.e. they are ‘hot wallets’). This means one has to be careful with the applications they are interacting with. Some web wallets are also custodial, which means that users trust a company to hold keys on their behalf. This may seem like a convenient option but one has to exercise caution in verifying the reputation of the company and the terms they are agreeing to. As a general guideline, it is better to educate oneself and hold private keys independently. Hardware wallets are small devices, similar to USB drives, that can store private keys. They are the safest way to send, receive or hold cryptocurrencies, as they are portable and also offline. Depending on the design, hardware wallets feature small LCD screens and buttons which can be used to navigate options. They need to be physically plugged into a computer to be put to use. The simplest way to store cryptocurrencies is to use a ‘paper wallet’. This can take the form of physically writing down or printing one’s private key on paper. The key can also take the form of a QR code or a key phrase depending on other complementary online services which can generate the same. As a general security guideline, it is best to use a minimum number of services or providers when generating or storing one’s address or key pair.