What Is Cryptocurrency? Beginner’s Guide to Digital Gold – BearTax

Cryptocurrency is a digital currency, in which transactions are recorded in a decentralized public ledger, using blockchain technology and cryptography.

In the past year, the hype around cryptocurrencies has escalated. Everyone is talking about Blockchain, Bitcoin, decentralization, Ethereum, Dogecoin, Dash and the list goes on. But only a few really understand what cryptocurrency is, and why it has the potential to change the way current financial systems work. This blog post summarized everything you need to know about cryptocurrency:

  1. From the barter system to the fiat system: the evolution of the currency
  2. How did the ‘2008 financial crisis’ pave the way for cryptocurrency?
  3. Why does cryptocurrency have the potential to change how current financial systems work?
  4. How does cryptocurrency work? How to achieve decentralization?
  5. Is cryptocurrency safe? What gives value to cryptocurrency?
  6. How to buy cryptocurrency?
  7. Is cryptocurrency legal?

From the barter system to the fiat system: the evolution of the currency

barter system

Since the dawn of history, currency has been an integral part of human life. In 6000 BC, the barter system appeared. It involves the exchange of goods and services between each other. But this system required that the needs of the people be matched. Let’s say you want to replace wheat with dozens of fruits. You had to find someone who had a dozen fruits and needed wheat.

To solve this problem, we started using gold coins to buy goods or services. But carrying large amounts of gold coins everywhere became difficult. To address this, governments have decided to introduce the “gold standard”.

gold standard

Under the gold standard, governments began printing banknotes and pegged their value to gold. For this reason, the amount of currency in circulation in a country was dependent on its gold reserves. It has helped keep inflation under control, because the global supply of gold is slowly growing. (Inflation refers to the increase in the price of goods)

But countries used physical gold to settle international deals. As a result, countries that imported weapons of war during World War I lost their gold reserves. As a result, the circulation of banknotes within their countries decreased and the price of goods also decreased. Therefore, smaller countries began to hold more US dollars, instead of gold, for their international trades.

As World War II drew to a close, delegates from 44 countries met and developed the “Bretton Woods Agreement”. All countries in the Bretton Woods system agreed to peg the value of their national currencies to the US dollar, which in turn was pegged to gold at a fixed rate. However, the gold reserves in the United States began to decline due to the high demand for imports. Therefore, the US dollar has also cut its relationship to the value of gold.

Fiat currency: a modern financial system

Around 1971, countries around the world adopted fiat currency (the current financial system). Fiat currency is nothing but the exchange rates between two currencies, which vary based on supply and demand. Central banks have complete control over the economy because they can print as many banknotes as they want. But printing too many notes can lead to hyperinflation.

How did the ‘2008 financial crisis’ pave the way for cryptocurrency?

The 2008 financial crisis highlighted the flaws in today’s financial system. When depositing an amount in the bank, say $100. The bank will not actually store all of your money. Banks can spend 90% of your deposit, that is, $90, on investments. Only 10% of net deposits are allowed to be kept in liquid cash. (Liquid cash refers to cash readily available to make payments to consumers who demand withdrawals)

Banks began offering loans to borrowers with poor credit ratings, at rates higher than the base rate. Getting approved for loans just got easier. The value of real estate rose dramatically and borrowers began to take out loans to buy it. But with the increase in loans, the artificially inflated value of real estate began to decline. Banks now hold assets that were much less than the amount they lent.

Many banks and other financial institutions no longer own the money that customers gave them, leading to their bankruptcy. We have come to realize that the health of our monetary system depends on the decisions made by banks and other financial institutions. We trust the banks with our money. But banks broke our trust during the 2008 crisis. This is the time when cryptocurrency and bitcoin came into the picture.

Entering Bitcoin

On November 1, 2008, a technician, under the pseudonym “Satoshi Nakamoto”, shared his research paper on a new digital currency system (cryptocurrency) that uses blockchain technology to decentralize digital transactions. Decentralization means that digital transactions will be peer-to-peer, as you do not need a central authority like central banks to facilitate transactions. A decentralized public ledger system keeps a record of all cryptocurrency transactions.

For example: Adam lives in Australia. He wants to send $1000 to his friend Rohan who lives in India. It needs a third party like a bank or UPI to facilitate this transaction. But, if Adam wants to send cryptocurrency to Rohan, he can send it directly to Rohan’s account. The decentralized general ledger records the transaction.

A few months after sharing his idea for a cryptocurrency, Satoshi produced 50 bitcoins (the first ever cryptocurrency), on January 3, 2009. The first 50 bitcoins can never be used or spent. Cryptocurrency and Bitcoin gained popularity by 2011. Other cryptocurrencies such as Litecoin and Ethereum developed around 2015.

Why does cryptocurrency have the potential to change how current financial systems work?

As we explained above, the main problem with the current financial system is that a central authority like central banks controls the supply of currency and carries out our transactions for us. Breach of its end causes us great harm.

Here are some of the main features of cryptocurrency, which give it scope to change the current financial system:

  • Scarcity: Banks can print banknotes without any limits. But the blockchain system produces a limited amount of cryptocurrency for trading. For example: There are only 21 million bitcoins in the world. Nobody can produce more bitcoins.
  • Transparency: Everyone has access to view all cryptocurrency transactions recorded in the decentralized ledger.
  • Authenticity: Unlike the way counterfeit banknotes can enter the market through hacking, counterfeit cryptocurrency can never be produced. Nobody can change the money supply or manipulate any transaction.
  • Durability: currency notes can burn or tear because they are made of paper. But since bitcoin is a digital currency, it can never be corrupted.
  • Portability: Digital wallets store cryptocurrencies. So carrying billions of dollars will not feel heavy and you can make transactions through exchange platforms.

Let’s take a look at the techniques cryptocurrency uses to achieve these attributes.

How does cryptocurrency work? How to achieve decentralization?

Every cryptocurrency transaction ever made is recorded in an online block. The blocks are linked in the transaction history sequence, forming a chain of blocks called the blockchain. But how do these blocks relate to the sequence?

Each block records the following details:

  • Transaction details: A complete ledger, indicating the balance of each account on the network, after the new transaction.
  • Nunes (we’ll talk about it more in the next section)
  • A cryptographically generated hash number that serves as the reference number for the requested transaction. If the data recorded in the block changes even slightly, the hash also changes.
  • The hash of the previous block or previous transaction

The hash number associates a single block with the data of the previous transaction.

With an example, let’s understand how crypto transactions work for decentralization.

Adam wants to send 10 Bitcoins to Mary. A block representing this transaction request is created. The block is distributed to all nodes/participants in the blockchain network to validate the transaction.

All network participants, also known as nodes, run their own infrastructure to validate the blocks. They do not know each other, they are geographically distributed and only participate to get the incentives offered by a particular cryptocurrency. Hence it is called as a decentralized system. They also have their own version of the blockchain, which they can access, modify, and add a new block to. For this reason, the “blockchain” that runs in the ledger of all crypto transactions is known as a decentralized or distributed ledger.

If more than 51% of network participants validate the new block, it will be added to the rest of the blockchain. Once the block is added to the blockchain, the transaction is accepted and Mary receives 10 Bitcoins. The new blockchain is sent to every node/participant in the network.

Is cryptocurrency safe? What gives it value?

If everyone had access to the blockchain and could modify it, what if someone modified the transaction details of the block or added some amount of new cryptocurrency to the chain? How is it safe then?

Let’s take an example to better understand this. Suppose a blockchain contains 10 blocks. Adam has a balance of $0. He decided to add $100 to his account by freeing up the fourth block on his copy of the blockchain. This is close to impossible since there are only two ways he can add cryptocurrency to his account:

  • Actual transaction: Another person with cryptocurrency sends an amount of their cryptocurrency to your account.
  • Predefined rule: It is not easy to generate the hash number / block reference number. It involves solving a cipher puzzle to calculate a number called “nonce (the number is only used once), which in turn will generate a valid hash for the transaction. Network participants compete with each other to count the number of “Nonce”. This calculation requires huge amounts of electricity and equipment. Therefore, the system generates new digital coins to reward the first person who finds the number “Nonce”. This program is what gives value to any cryptocurrency, because efforts have been made to generate these currencies.

If Adam is adamant about changing block #4, he has to update and create a valid hash for all blocks from block #4 to block #10. Then, all network participants must validate the new chain. This whole process is very expensive because it needs to get everyone in the network to spend huge amounts of electricity and equipment to run a different chain, which is way above the actual money that anyone can make by changing transactions. This is why it is almost impossible for anyone to hack a blockchain system.

How to buy cryptocurrency?

The easiest way to buy cryptocurrency is through an exchange platform. When you create an account on a trading platform, you will have an “exchange wallet” that stores your cryptocurrencies. First you need to buy bitcoin using your fiat currency (government issued currency like INR, USD, EUR). You can use your bitcoins to buy other cryptocurrencies such as Ethereum. Keep in mind that you can buy cryptocurrency in fractions. The smallest fraction of a bitcoin that can be bought is 0.00000001.

The legal aspect of cryptocurrencies depends on the individual countries. Before buying, investing or trading any cryptocurrency, do your research on the legal implications of cryptocurrency investments and trading in your individual country.

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