The Purpose of this Page
Cryptocurrency can be confusing, even for seasoned veterans. For the novice, this confusion can be overwhelming. For the investor, this confusion can be very costly. This page is intended to replace this confusion with a solid (but not overly technical) understanding of cryptocurrency in general, as well as a look at the specific differentiating characteristics between a number of different cryptocurrencies. It is hoped that this will provide the reader with sufficient guidance in making informed determinations regarding his or her personal use of and investment in cryptocurrency.
The Desireable Characteristics of Money
Before looking at cryptocurrency, let’s first take a brief look at other forms of money. The most common and successful things which have been used as money throughout history have been things such as “precious metals,” most notably gold and silver, and also government issued currency. Often such government issued currency was itself actually made of precious metals, as in the case of gold and silver coins. Alternatively it was instead made of less precious metals or even paper which was backed by precious metals held in reserve; such paper money could often be exchanged (for example at a bank) for the amount of precious metal (gold or silver) by which it was backed.
One very essential thing which each of these forms of money have is the element of rarity. Gold and silver are very rare, with gold being much more rare than silver; hence a certain amount of gold is worth much more than an equivalent amount of silver. Less precious metals are less rare, so they are suitable as coins of smaller value. The value of paper money which is actually fully backed by a reserve of some precious metal is determined by the value of that precious metal.
These forms of money have something else in common: ease of exchange. It is relatively easy to carry and exchange bits of metal or paper. There are all sorts of things of value in the world — cars, homes, food, etc. — but these things can be rather unwieldy and difficult to carry around and exchange, and even when this is possible their exact values may be subject to debate. The value of coins and paper bills, however, are set at exact, fixed amounts, which makes exchanging them for goods and services a much more straight-forward process.
Precious metals like gold and silver do not rust or otherwise degrade, which allows then to be used as a long-term store of value, another important characteristic of money. Coins (even when they are not truly made of precious metals) and paper currency (provided it is properly stored) are also good long-term stores of value.
A final important characteristic of money is that it should be counterfeit-resistant. After all, if one could create convincing counterfeit money, then this would have the effect of negating the rarity of legitimate money, which would in turn reduce its value. This simultaneously would have the further effect of eroding the usefulness of legitimate money as a store of value.
The Problems with Traditional Money
This brings us to the problems with traditional forms of money. There is the problem of counterfeiting, just mentioned above. In the past, when coins of precious metals were used, it was not uncommon for people to “shave” bits of metal off of the coins, and then melt down these bits of metal to create new coins. In more modern times, the use of paper money has lead to the counterfeiting of paper money by simply printing convincing looking copies of paper money. Counterfeiting has the negative effect of increasing the money supply, and therefore lowering the effective value of each unit of the money in question, as mentioned above. (This is due to the fundamental economic law of “supply and demand,” which states that the value or price of a thing decreases as supply increases, and decreases as demand increases. Counterfeiting serves to increase the supply of money, and decrease its value.) This phenomenon, i.e., an increasing supply of money causing a decrease in the buying power, is known as “inflation.” Probably the most recognizable aspect of inflation is a general increase in prices for all sorts of goods and services.
There is another cause for inflation which is much more significant than that which is caused by counterfeiting. Somewhat ironically, while counterfeiting is universally punished as a criminal activity by governments around the world, this other more significant cause for inflation is actually perpetrated by governments themselves. This inflation occurs when governments create more money than is actually backed by any sort of precious metal, or by any other rare thing, for that matter. Even worse is when governments stop backing their currency with anything at all; such completely unbacked currencies are known as “fiat currency.”
Fiat currency would not really be problematic if governments only issued a certain fixed amount. In such a case the currency itself would be a limited “rare” thing, and perfectly suitable for storing and exchanging value. (Of course there would still be the smaller inflationary effect caused by counterfeiting.) Governments could also choose to create a very limited, fixed amount of new currency per year, which would cause a small but very predictable amount of inflation. Being small and predictable, such inflation could be accounted for by individuals and business, and would therefore not be very problematic.
Historically, however, once governments are in the position to simply create more and more currency, all of them eventually succumb to the very strong temptation to relax their discipline over the creation of new currency, and inflation then begins to spin wildly out of control. Simply “creating” money is an “easy” way for governments (and the politicians behind them) to acquire new money to fund all sorts of government projects and programs without resorting to the politically unfavorable approach of raising taxes. (While raising taxes is typically very obvious and unpopular, the act of printing excessive money is less obvious, and therefore less likely to cost a politician an election.) This “money creation” is done at the expense of creating inflation, however. People’s savings, sometimes money they have worked and sacrificed for decades to acquire, has less and less buying power, as inflation causes prices to rise uncontrollably. You may live in a country where inflation is at “reasonable” levels right now, but the reality is that ultimately every country is vulnerable to such hyper-inflation, and there is nothing to protect you from it. You simply have to “trust” your government, which ultimately means “trusting” politicians. Enough said about that.
The Solution to the Problems with Traditional Money, in the Digital Age
Bitcoin: The First Cryptocurrency
DESCRIBE WHAT THE SOFTWARE DOES FROM USER PERSPECTIVE, THEN GO UNDER THE HOOD
The first cryptocurrency, “Bitcoin,” was released by an otherwise anonymous entity, known as “Satoshi Nakamoto,” on January 3rd, 2009. (A “whitepaper” detailing technical aspects of Bitcoin was release in 2008.) Because Bitcoin was the first, it is helpful to first understand just what Bitcoin is and how it works, before learning about other cryptocurrencies. These other cryptocurrencies can then be most easily understood in terms of their differences from Bitcoin. (It should also be noted that, precisely because Bitcoin was the first cryptocurrency, it is also the most primitive in certain ways. We will look at the implications of this later.)
The Blockchain: The Fundamental Innovation of Bitcoin
It was possible to make payments electronically, well before the advent of Bitcoin, of course. We are all familiar with using debit or credit cards, so we will use that as our example.
Imagine you are visiting a coffee shop, and are paying for a cup of coffee using a debit card. Your card contains a magnetic strip and perhaps also a small electronic chip; these are used to electronically identify the bank or other financial institution which issued the card, as well as identifying your unique account with that institution. Your card is scanned in the coffee shop, and this information – along with the amount of the sale – are transferred to the bank. The bank checks to see whether or not you have enough money in your account to cover the transaction. If you do, then you see a message something like, “Transaction Approved,” and the bank subtracts the amount of the sale from your account, and adds that amount to the account of the coffee shop. If, however, you don’t have enough in your account to cover the sale, then you get the dreaded “Transaction Denied” message.
In the example above, the bank acts as a central authority. It is the bank which keeps a centralized ledger of accounts and transactions, it is the bank which determines whether a transaction is approved or denied, and it is the bank which actually moves the funds from one account to another. Both the customer and the coffee shop are dependent upon the bank for its services, and must pay for these services. Furthermore, the bank has access to the financial information (income, spending, savings, etc.) of both the customer and the coffee shop, which both might prefer to keep private, rather than sharing with some third party. (It is quite possible that the customer and the coffee shop each use different banks, of course, but this merely means that the customer and the coffee shop must depend upon two banks to ultimately move funds from one account to the other, rather than just one.) Furthermore, banks have the ability to freeze accounts or deny transactions for all sorts of reasons, even if there are sufficient funds to cover the transaction.
To avoid the need to rely on banks, or any third party at all, to process transactions, Satoshi Nakomoto anonymously developed the Bitcoin software. and released it on January 3, 2009. This software
This allows any two individuals, anywhere in the world, to directly exchange “Bitcoins” in a peer-to-peer fashion, without the involvement of any third party. The fundamental innovation which enables such direct peer-to-peer transaction is the “distributed ledger,” which has come to be known as the “blockchain.” Instead of keeping the ledger of all accounts, balances and transactions under the control of a single, centralized authority (the bank, in the example above) Bitcoin distributes this ledger among all users of the Bitcoin software.
The Bitcoin blockchain consists of “blocks” of Bitcoin transactions, from the very first “genesis block” right up to the present. Users of the Bitcoin software can create an essentially unlimited number of Bitcoin “addresses,” and it is to and from these addresses that the Bitcoin cryptocurrency is sent and received. It is important to know that, while these addresses are created and “owned” anonymously, it is nevertheless possible (because of the distributed nature of the Bitcoin blockchain) to track the movement of the Bitcoin cryptocurrency from address to address. In the event that the ownership of some address does become known (either due to being intentionally or accidentally published) this makes it possible to track the funds which belong to that owner. For this reason, Bitcoin is sometimes called “pseudo-anonymous.” (Since Bitcoin, however, other coins have been created with true anonymity built in, making it impossible to track payments through the blockchain.)
Why the “Crypto” in “Cryptocurrency?”
Since Bitcoin uses a public distributed ledger (the blockchain) containing a record of all accounts (Bitcoin addresses), balances and transactions, there needs to be some method which prevents anyone but the legitimate owner of an address from spending the Bitcoin it contains. This is accomplished through the ingenious use of cryptography. When a Bitcoin user creates a new Bitcoin address using the Bitcoin software, it is actually creating a random, cryptographically related “key pair,” consisting of a “public key” and a “private key.”
The cryptographic relationship between the public key and private key is such that the public key easily can be derived from the private key, but the private key cannot be derived from the public key. It is the public key which is recorded on the blockchain as a Bitcoin address for sending, receiving and storing Bitcoin funds. Anyone can check the balance of any Bitcoin address, and anyone holding Bitcoin funds can send those funds to any other Bitcoin address. In order to send funds from a Bitcoin address, one must use the private key associated with that address, and only the owner of that address (or the software he or she is using) has the private key.
It is due to the use of cryptography that Bitcoin is known as a “cryptocurrency.” Aside from the aforementioned cryptographic relationship between public and private keys, Bitcoin also uses cryptography in several aspects of its operation.
Before delving into the slightly technical details of Bitcoin, it may be best to start with the aspect of Bitcoin which individuals interact with most frequently: Bitcoin addresses. Bitcoin addresses are used to “hold” Bitcoin, and can send or receive Bitcoin to or from other addresses.
Every Bitcoin address has a corresponding “private key.” In fact, the Bitcoin address is generated from the private key (using a cryptographic algorithm which need not concern us here). While the Bitcoin address is used to receive Bitcoin, the private key is needed to spend Bitcoin. (Under most normal circumstances, however, one does not actually need to directly access or interact with these private keys in order to spend Bitcoin; this is automatically handled by their Bitcoin “wallet” software in the background.) It is therefore very important to keep your private keys secret, as revealing them to someone else would allow that person to spend or steal any Bitcoin stored in the corresponding Bitcoin address. Finally, an important mathematical or cryptographic property of these pairs of Bitcoin addresses and their corresponding private keys is that it is possible to derive the Bitcoin address if one knows the private key, but impossible to derive the private key from the Bitcoin address.
The Bitcoin Protocol:
The term, “Bitcoin” may refer to either the “cryptocurrency” itself, or to the “peer-to-peer” networked software which is used to maintain the Bitcoin “blockchain.” The “blockchain” is the central (but not the only) innovation upon which Bitcoin depends. It is a “public ledger” consisting of groups, or “blocks,” of transactions, with these blocks “chained” together sequentially, back to the original “genesis” block, first created by Satoshi Nakamoto in 2009.
Since the entire Bitcoin blockchain serves as a public ledger of all Bitcoin transactions, it is possible to follow the path of Bitcoins as they are created and sent from one Bitcoin address to another. While these addresses are “anonymous” in the sense that they are not inherently associated with particular individuals, in practice it is often possible to determine the ownership and use of addresses by particular individuals, by correlating public addresses whose owners are known (perhaps because they published them in an online store, or otherwise had their identity associated with them) with information publicly available in the blockchain. Bitcoin is thus often said to be “pseudo-anonymous,” rather than truly anonymous.
The protocol of the Bitcoin peer-to-peer software, i.e., the “Bitcoin protocol” is designed so that every “node” in the network contains its own copy of the blockchain, and is able to verify the validity of new blocks and add them to the blockchain as they are created. Blocks are created by “Bitcoin miners” who process Bitcoin transactions, and are paid both a “transaction fee” and a “block reward” for this service. The transaction fee is paid by those spending the Bitcoin, and the block reward consists of new Bitcoins which are created anew, or “mined,” each time a block is processed.
An important part of mining Bitcoin (i.e., processing blocks of transactions) involves solving a unique cryptographic problem, which changes from block to block. Miners compete to be the first to solve this problem, and receive the transaction fees and block reward. The Bitcoin protocol is designed so that, on average, once every ten minutes some miner solves this problem and creates a new block to be added to the blockchain, at which point all the miners then move on to compete to solve the cryptographic problem involved in the next block of transactions. If blocks are being solved too quickly, then the protocol readjusts the cryptographic problems harder; if they are being solved too slowly, then the protocol readjusts the cryptographic problems easier. This readjustment allows the protocol to “tune” the difficulty of the cryptographic problems so that they are solved, on average, once every ten minutes.
Because it takes an average of ten minutes to process a new block, this also means that it take an average of ten minutes to receive one confirmation for a Bitcoin transaction. Furthermore, typically anywhere from two to six such confirmations are considered necessary for a Bitcoin transaction to be considered “finalized.”
At first, each block reward (starting with the “genesis” block) was exactly 50 Bitcoins. The protocol has an automatic “diminishing of returns” built in, so that at some point the block reward dropped to 25 Bitcoins, then 12.5, then 6.25, and so on. The rate at which new coins are mined is known as the “emission rate.” Eventually the emission rate will diminish to zero, so miners will get no block reward at all, but will only get the transaction fees associated with new blocks. This automatic diminishing emission rate is designed so that there will only ever be about 21 million Bitcoins created, with the majority being created within the first few years of its inception.
The Emergence of Altcoins
The Bitcoin software which was released by Satoshi Nakamoto was “open source,” meaning that its code is openly available for review by anyone, and also that it can be freely copied and modified by anyone as well. Due to the incredible success of Bitcoin, and the open source nature of the Bitcoin software, it was really only a matter of time before a number of new cryptocurrencies, often with various differences from Bitcoin, were released; collectively, these other cryptocurrencies are known as “altcoins.”
The first altcoin was “Litecoin.” This was essentially a clone of Bitcoin, with a faster blocktime, a higher total supply, and a modified mining algorithm, but no real significant technological advantages over bitcoin itself.
Another early altcoin was “Dogecoin.” This was created as a sort of “joke coin,” but wound up attracting a rather large following. There was also “Potcoin,” intended for use in the cannabis industry. In fact, countless coins have sprung up which were claimed to be intended for this or that specific industry, or based around some sort of meme or other, but which really had no significant advantage over the original Bitcoin. After all,
Dash and PIVX:
Instant, Cheap, Anonymous Transactions, and Decentralized Autonomous Organization
One early altcoin which did have very significant advantages over Bitcoin was originally known as “Xcoin,” but then rebranded to “Darkcoin,” and later to “Dash.” (We’ll just call it “Dash” in order to avoid confusion between its different names at different points in its history.) The two primary advantages which Dash innovated are instant transactions and true anonymity. This is accomplished through its unique two-tier peer-to-peer network, consisting of “normal” nodes, which are analogous to normal Bitcoin nodes, and a number of special nodes, called “masternodes.” (1000 Dash are required to run a masternode. This serves to ensure that each masternode owner has a significant stake in the “health” of the Dash network.) Masternodes are paid (in Dash, of course) for the services they provide for the Dash network.
Beyond enabling instant and anonymous transactions, the masternode network also provides a means for “Decentralized Governance by Blockchain” (DGB). This makes the Dash Masternode Network the first “Decentralized Autonomous Organization” (DAO) in the cryptocurrency world (even though that term was introduced later). The Dash Masternode Network, in addition to receiving direct payments for each of the masternodes, also receives a quantity of Dash which is allocated for various projects intended to improve or promote the use of Dash. Each masternode owner can propose various projects, and in turn these proposals are then voted upon by the masternode network as a whole.
The Dash Masternode Network (in its role as the DAO which guides Dash) provides funding for such things as software and protocol upgrades, marketing, and other projects which the masternode operators deem valuable to the Dash network as a whole. This system allows the Dash protocol to agilely respond to any problems or technical limitations and “evolve” much faster than any other cryptocurrency.
The success of Dash eventually lead to the creation of a “Dash clone” called “PIVX,” which stands for “Private, Instant, Verified Transactions.” PIVX has many of the same features as Dash, such as instant transactions, anonymous transactions, and a masternode network. PIVX also implements a “Proof of Stake” (PoS) algorithm, which allows PIVX holders to earn additional PIVX simply for holding coin in the official PIVX wallet, and keeping the wallet connected to the network. (PoS stands in contrast to the more traditional “Proof of Work,” or PoW, implemented in the “mining” of Bitcoin, Dash, and many other coins.) It also adds an additional anonymizing protocol, the zCoin protocol, on top of the anonymization already provided by the masternodes, to create an extremely secure, privacy-focused coin.
Both Dash and PIVX have very low transactions fees, compared to other coins. (At the time of this writing, the Dash transaction fee is currently about one cent, or about 215 times cheaper than Bitcoin transactions.) Their far lower transaction fees, combined with instant transactions and anonymity, make Dash and PIVX uniquely suited for a real-world, real-time payment system. Instant transactions, in particular, make it possible to use Dash and PIVX as payment methods in brick-and-mortar retail establishments, without any sort of third party “middleman” needed to complete the transaction.
Other Notable Coins and Innovations