Cryptocurrency basics — Uses and Mechanism
Introduction
For the past few days I had taken it upon myself, to learn about blockchains, cryptocurrency. This article is my attempt to present information from all sources I referred to, in a simple and coherent way. Let’s dive in!
Disclaimer: I am, by all means, a beginner in the cryptocurrency space and my objective with this article is for it to be a high level overview or a starting point. By no means is this a financial or investment advice.
Store of Value vs Medium of Exchange
Store of value:
This is a term that you will come across often when referring to articles on cryptocurrencies. Basically store of value is something that is valued by consensus and hence is a safe bet to collect or store in exchange of money.
The most well-known example of store of value is gold. Since governments, financial institutions and members of society, all value gold, it is a safe bet to convert your money into gold in hope that you can either convert it back to money when the conditions are favorable or exchange it for services/products of equivalent amount of money. This is possible because gold is valued by the consensus. It retains value only as long as the consensus remains intact.
You can refer to this article read about the attributes a good store of value should have.
Medium of Exchange:
When the store of value is owned by a majority of the people, it can be transitioned to a medium of exchange i.e. it can used to buy goods and services from sellers.
Currently the gold serves primarily as a store of value (you don’t use gold to buy groceries) and fiat money serves as a medium of exchange.
And while we are at it here’s the definition of fiat money from investopedia:
“Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies”
Now why is understanding these terms important?
Well the debate about bitcoin (and other cryptocurrency) is whether it is a medium of exchange, meaning something that we use for everyday purchases, or a store of value, meaning like a brick of gold, that we buy purely as an investment.
One argument is that bitcoin combines both, it is a store of value and also a potential medium of exchange. A bit like using gold coins that can be transferred from A to B in seconds. The properties of being secure and fast while enabling day-to-day transactions is what helps it to grow as a store of value.
For example: If we assume that micro-transactions of fractions of bitcoin for day-to-day exchange become commonplace (they aren’t yet), it will be safe to convert your fiat currency into bitcoin when you have less confidence in the institution that issues the fiat currency.
Here bitcoin acts as your gold — or store of value as well as your rupees — or medium of exchange.
However the debate is still ongoing and the current transaction fees for bitcoin transactions do not make sense for small transactions. Bitcoin Cash is a fork of bitcoin and is trying to solve this problem. You can read more about BTC vs BCH here.
Now that we know how these new currencies can influence day-to-day transactions and long-term investments, let’s see in brief how they work.
Blockchain
What is a block?
“A block is a record in the block chain that contains and confirms many waiting transactions. Roughly every 10 minutes, on average, a new block including transactions is appended to the block chain through mining.” (source)
A block chain is what the Bitcoin or any cryptocurrency is based on. Here is the definition from bitcoin.org:
“The block chain is a public record of Bitcoin transactions in chronological order. The block chain is shared between all Bitcoin users. It is used to verify the permanence of Bitcoin transactions and to prevent double spending.”
Bitcoin — How does it work?
The transactions in a bitcoin network are kept in a public record called the ledger. All the participants of the network refer to the ledger to figure out what each participant, including themselves, is worth in terms of spending power.
The transactions are committed to the ledger only when they are confirmed by the network, i.e. everyone in the network uses mathematical proof to verify the new transaction. The job is to check if transaction is valid — this includes checking if sender is authentic and worth the amount he is sending. The checking process also requires the data from previous blocks. Hence if the previous blocks are changed the new transaction confirmation fails. Hence once a transaction is confirmed and added to the block it is very hard to alter it.
The process of carrying out the confirmation is called mining and the computer (called node) which carries out this task gets a particular number of bitcoins as reward. This is how bitcoins are created. (Similar to minting of fiat currencies)
The process of confirmation through majority participants and using already committed transactions for confirming every new transaction, the bitcoin blockchain remains secure and ensures that the participants cannot rollback on any committed transaction.
Conclusion
So there you have it, you now have a general overview of what bitcoin is and how it works.
Let me know your thoughts on cryptocurrencies and also any good resources to dive in deep.
Until next time.
I will leave a few resources from where I got started:
