Cryptocurrency – What is it and how does it work?

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Cryptocurrency

Cryptocurrency is booming. But what is cryptocurrency anyway? We explain this in this blog.

What is it?

Cryptocurrency stands for cryptographic currency. In other words: encrypted money. Where we all know the euros and dollars as the currency, there is also a development going on on the internet to eliminate the disadvantages of traditional money. Cryptocurrency can be seen as internet money in that sense. You have undoubtedly heard of the best known cryptocoin: Bitcoin. Many people know Bitcoin “as the internet currency that you can use to pay anonymously” or “as the currency that online criminals use to get paid.” Both are partially true. To explain how cryptocurrency works, it is important to understand the technique behind cryptocurrency such as the Bitcoin. The innovative feature of the Bitcoin, for example, is that it is a fully decentralized currency. There is no central body that manages or issues Bitcoins. With traditional money there are always ‘trusted parties’ who act as intermediaries: banks. So if you transfer money from yourself to someone else, your money always first passes through the bank. This works differently with cryptocurrency. With this you can directly transfer ‘money’ (in the form of cryptocurrency such as Bitcoin) to another person without the intervention of a third party. The advantage of this is that transactions can in principle take place much faster and cheaper. It does not, of course, matter where that person is. This can be in the Netherlands or elsewhere in the world. The power of cryptocurrency such as Bitcoin is furthermore that in principle it is completely fraud-proof. So if you transfer money from yourself to someone else, your money always first passes through the bank. This works differently with cryptocurrency. With this you can directly transfer ‘money’ (in the form of cryptocurrency such as Bitcoin) to another person without the intervention of a third party. The advantage of this is that transactions can in principle take place much faster and cheaper. It does not, of course, matter where that person is. This can be in the Netherlands or elsewhere in the world. The power of cryptocurrency such as Bitcoin is furthermore that in principle it is completely fraud-proof. So if you transfer money from yourself to someone else, your money always first passes through the bank. This works differently with cryptocurrency. With this you can directly transfer ‘money’ (in the form of cryptocurrency such as Bitcoin) to another person without the intervention of a third party. The advantage of this is that transactions can in principle take place much faster and cheaper. It does not, of course, matter where that person is. This can be in the Netherlands or elsewhere in the world. The power of cryptocurrency such as Bitcoin is furthermore that in principle it is completely fraud-proof. (in the form of cryptocurrency such as for example Bitcoin) transfer to another person without the intervention of a third party. The advantage of this is that transactions can in principle take place much faster and cheaper. It does not, of course, matter where that person is. This can be in the Netherlands or elsewhere in the world. The power of cryptocurrency such as Bitcoin is furthermore that in principle it is completely fraud-proof. (in the form of cryptocurrency such as for example Bitcoin) transfer to another person without the intervention of a third party. The advantage of this is that transactions can in principle take place much faster and cheaper. It does not, of course, matter where that person is. This can be in the Netherlands or elsewhere in the world. The power of cryptocurrency such as Bitcoin is furthermore that in principle it is completely fraud-proof.

Blockchain

But how does this work in practice? For this it is important to know how the technology behind Bitcoin and other internet currencies works: via the blockchain. You can view the blockchain as a large database in which all transactions are stored. It is actually a digital ledger. This, however, and that makes it unique, is not a central database that is located in one place. No, this database is continuously copied and updated across all users. So there is not one database, but there are millions that contain the same data. This immediately makes it fraud-proof. Suppose a hacker would try to change a transaction in such a database, then that was only done in one place. There are, however, millions of copies of the blockchain database in circulation. These blockchains synchronize changes to each other, whereby it would immediately be detected that there is a difference in a transaction. The majority would then refuse this change because it does not match what is in the remaining blockchain databases. It is of course impossible to ‘hack’ millions of databases at the same time. This principle in combination with mathematical crypographic (hence the name cryptocurrency) encryption has made fraud virtually impossible.

Blockchain is, I believe, one of the biggest revolutions of the internet. Decentralized blockchain technology can be used for many more things in the future, things for which we still need ‘trusted parties’. Consider the decentralized storage of trade contracts, employment contracts or contracts for which you still need a civil-law notary as a trusted third party. Or think of our recent elections, where we were still coloring a box with an old-fashioned red pencil. Digital voting where the votes are stored in a blockchain and, due to the decentralized design of blockchain, fraud cannot be used. I even believe that we have bureaucracy with governments, municipalities and companies can significantly reduce through the use of blockchain, because far fewer human control mechanisms are required. The possibilities of blockchain are endless. However, we are only at the beginning of this revolution.

The value of cryptocoins

Back to the cryptocurrency. As you have become clear by now, this form of digital ‘money’ is one of the application options that makes use of blockchain technology. However, it is a very interesting application. Because be honest, the added value of traditional banks is not increasing. You have hardly received any interest on your savings account for years, the costs for banking are increasing and if you do a transaction on Friday evening to another bank, you can quietly wait until Monday before it is processed. In fact, a very old-fashioned and inefficient system for transferring money between themselves. But then you will say: what is such a Bitcoin worth? Good question: it is actually also very abstract. A Bitcoin is really nothing but a certain ‘code’ in the blockchain. A line of bits and bytes. How can you value that? My position on this is: what is the value of traditional money? That used to be clear. Then money was linked to gold. If you had 1000 guilders, then you knew that those 1000 guilders represented a certain amount of gold. Strictly speaking, you could then go to your bank and claim the corresponding amount of gold that corresponded to your guilders. We called this the gold standard. In fact, the price of gold (and silver) determined the value of goods and services. Gold was therefore the fixed unit of account. However, this principle was abandoned in 1971. Since that year, the value of money is no longer linked to the gold rate. That of course offered enormous opportunities for governments and banks. It could only be printed correctly. However, this had of course the effect that since then the only value of traditional money is the value that users assign to it. Basically, money is nothing at all. A piece of printed paper or a digital line in a bank computer. Only because we citizens ‘value money’ and accept it as a means of exchange makes money ‘worth something’. Money only works because we all (still) believe in it en masse, in its fictional value.

In line with this, it is therefore easier to explain why people value cryptocurrency such as the Bitcoin. There is a scarcity of Bitcoins (a maximum of 21 million can be spent of which more than 16 million are currently in circulation) and people trust Bitcoin as an alternative to traditional money. You could also call it a safe haven, not a bad idea at this time when the European Central Bank is printing money at a bizarre pace. You can speculate on the value of Bitcoin, and that is done enthusiastically. Via so-called exchanges you can exchange money (or fiat, as we call it in cryptocurrencyland) for Bitcoins. However, the EUR / BTC exchange rate is, just as with a normal currency, variable. For example, at the time of writing, 1 Bitcoin is worth approximately € 2,400. However, this rate is volatile and, like everything in our economy, determined on the basis of supply and demand. Because it is still relatively new technology, you sometimes see huge price spikes and troughs (or high volatility as the economists call it). It may therefore be that the rate per day rises or falls by several hundred euros. If you speculate on that and you estimate it well, then you can earn a nice pocket money.

Acceptance

However, it is more important to know that Bitcoin is increasingly being accepted as legal tender. More and more countries accept Bitcoin (or BTC, as the abbreviation reads) as an official payment method. In Asia there are more and more ATMs where you can exchange BTC for cash. The acceptance of BTC also applies to more and more companies. You probably know the most famous organization in the Netherlands that accepts Bitcoins as a payment method: Thuisbezorgd.nl. Of course your pizza doesn’t cost a whole Bitcoin (would be an expensive joke) but for example 0.0005 BTC. And to tell a nice anecdote about this: when the Bitcoin was invented about 7 years ago, the first transaction was to order 2 pizzas. The pizza restaurant received 10,000 Bitcoins for those 2 pizzas.

Wallets

But how does that work in practice, with the transfer of BTC between 2 people. Very simple actually. What you need with a coin like Bitcoin is a so-called wallet. This wallet is your wallet or ‘bank account’. Please note: there is no central authority that manages the wallets, because there are simply no central authorities with cryptocurrency. You are therefore responsible for the management and access to your wallet. So never lose the access data of your wallet, then you can never reach your digital money again! And there is no bank or central body that can help you with this. This wallet has a unique address (a very long string). Suppose you want to buy 0.5 BTC worth. € 1200, and save it in your wallet. To do this, you go to an Exchange where you can exchange traditional money for Bitcoin. In the Netherlands, for example, Bitonic, BTCDirect or LiteBit. You buy there (just via iDeal) 0.5 BTC and enter the unique address of your wallet as delivery address. Please wait (it can take half an hour) and voila: you will see the 0.5 BTC in your wallet. From your wallet you can then make payments to other people. The only thing you need is the address of their wallet. For example, you could transfer 0.1 BTC to their wallet.

But how do you create such a wallet? That can be done in different ways. The easiest is with an online Exchange. Many exchanges (where you can buy / trade Bitcoins and other internet coins) offer an online wallet as a free service. This has a unique address (they also call this the public key) and the advantage of this is the convenience. However, there is also a disadvantage: you are completely dependent on them. All your digital coins are in your wallet with an external party. The access code to that wallet (the private key) is also on their system. If their system is ‘hacked’ (or in the most extreme case: the owners of the site appear not to trust), malicious parties can gain access to your wallet and transfer your balance from there to their own wallet. Then you just lost your (crypto) money. This has happened in the past, just google on ‘Mt. Gox ‘.

A second option is to save your wallet locally on your PC or laptop. Well-known wallet software for Bitcoin is, for example, Electrum. You install this on your PC / laptop and then create a new wallet within this software. The advantage is that you are not dependent on an online Exchange, then you have everything in-house. You are then responsible for the backup of and access to your wallet. And it is important that your PC / laptop is not infected with a virus / ransomware. This could theoretically also gain access to your local wallet and steal the coins from there.

A third option is a hardware wallet such as the wallets from the French company Ledger. This is the nicest and safest solution, especially when it concerns larger amounts. The wallet is then on a separate device (sort of USB stick) that you disconnect if you do not use it. This is the most secure solution.

If you want to start purchasing some cryptocurrency, I advise you not to park large amounts on an online Exchange. Small amounts are fine (secure your account well with a difficult password and preferably with an additional security solution such as Google Authenticator), but larger amounts are better kept in-house.

Anonymous?

I wrote at the beginning of this blog that people think that Bitcoin is completely anonymous. That’s not actually it. Transactions are not anonymous. Every transaction can be followed exactly, from which wallet it was sent, when it was sent, what the amount was and to which wallet it was sent. However, what is anonymous are the owners of the wallets. You do not know who owns the wallet, you do not need a name and address. to specify when creating a wallet. After all, there is no central body that manages BTC. So you can see what transactions have been sent but you do not know who the sending and receiving parties are. Bitcoin is therefore anonymous in that respect.

Altcoins

You will notice that so far I am mainly talking about Bitcoin in this blog. Bitcoin is therefore the largest, oldest and by far the most famous cryptocoin. There are, however, many more variants, at the time of writing just under 1000. The best-known alternative coins (as they are also called: altcoins, this is the collective name for all cryptocoins in addition to the Bitcoin) are coins such as Ethereum, Litecoin and Stratis. Especially nowadays new coins are added daily, coins that often add something in a specific area that Bitcoin does not have. You don’t know if they have a chance of survival. Some are, some are not. Some coins are innovative (such as Stratis in my eyes), some coins seem to be purely launched to make the creator rich. And all these altcoins are also speculated. There is even a new coin called: Gulden. Whether you should have faith in it? I do not know. If investors believe in the viability of certain altcoins, you will see that their price rises. But it remains a highly volatile market where you can easily lose a lot. It is still a very new market and phenomenon, with all the teething and instability that entails. However, that is no reason not to pay attention to the cryptocurrency phenomenon. with all teething problems and the instability that entails. However, that is no reason not to pay attention to the cryptocurrency phenomenon. with all teething problems and the instability that entails. However, that is no reason not to pay attention to the cryptocurrency phenomenon.

The future

Of course governments and traditional banks are not happy with this development, at least that is my estimation. With this they lose some power, power over the money. Whereas a tax authorities can now easily look at your bank accounts to see what your assets are in Euros, that is much more difficult with cryptocurrency. They really need your cooperation for that, otherwise you simply cannot see it. From a privacy point of view it is a positive development in my eyes. And of course, this is completely dangerous for banks because they are simply unnecessary in an economy that would run entirely on cryptocurrency.

But it is not all there yet. We will continue to pay for our groceries and invoices in traditional Euros. But the fact is that cryptocurrency such as the Bitcoin and various altcoins have absolute right to exist. In my view, this is no longer going to disappear, but will only become much larger. Cryptocurrency is here to stay.

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