In this article, I’ll try to describe the basics of blockchain, Bitcoin and generally what the so-called cryptocurrencies are all about. This will entail a bit of simplification since the article is intended for those who are just starting out in the topic.
For starters, I’d like to make 2 observations, the first regarding the origin of the name “cryptocurrency”. This does not mean, as many people believe, some kind of hidden or quasi-currency, but rather a currency which is based on cryptography – more on that topic later in the article. The second observation is that the aim of the article is not to provide investment advice, but rather to describe certain material, so that you can make any future decision by yourself.
The history of money
A good introduction to the topic is provided by a short history of money and the monetary system. Every item widely understood to be money must meet two main criteria:
- it must be a means of exchange and payment (so that every thing or service can be valued according to a given scale)
- it must be a measure of value (the value of one thing on this scale must be relative to the value of another thing on this same scale)
Additionally, money should have several other features as well:
- durability (it should be difficult to damage or destroy)
- exchangeability (each piece of money should be worth exactly as much as every other)
- portability (so that it can be easily carried)
- divisibility (so that change can be given)
- sustainability of value over a long period of time
In primitive economies, the first form of payment was what is called barter exchange, that is exchange of goods. I give you one item and in exchange you give me back another. But what if you don’t want the item that I have, but I still want yours? It is for this reason that barter exchange was not a perfect system. So a search began for certain items which everyone would consider valuable (making them a carrier of value). At first, grain was tried out, then cattle or salt, but none of these turned out to be a good form of money – cattle were too hard to divide or carry, grain was subject to decay, and salt weathered badly and also dissolved in water. So the search continued until finally metals were chosen. First these were non-precious metals, such as iron or bronze. It was only after some time that interest grew in gold, silver, and platinum, which turned out to be the best solutions so far. Unfortunately, certain problems still remained, and new ones arose as well.
The main challenge with metals was the fact that the ingots were heavy, depriving them of the feature of portability. And so these ingots were then broken down into smaller pieces, until we arrived at small lumps in the shape of coins, on which the seals of rulers were stamped. In this way, the gold and silver coins which people used to use were born.
The next problem was for individuals to store these coins, which in most cases was both inconvenient and dangerous. So coins began to be stored with bankers who issued receipts for particular amounts of coins possessed by the depositor. So you could say that these receipts became the first banknotes which represented the value of coins deposited in a treasury with a banker.
A further problem was the lack of unification of these receipts. Each banker issued receipts in his own format, and in this respect, there was total chaos (imagine that you have ten different kinds of 10-dollar (10-euro / 10-pound) bills in your wallet; strange, isn’t it?). Thanks to intervention from the state, the institution of the central bank came into existence, issuing unified receipts confirming ownership of a certain amount of coins.
But as often happens, the intervention of the state gave rise to a further problem when it was decided to abandon the gold standard (or silver standard), that is, when the receipts issued by the central bank no longer were covered by equivalent amounts of deposited gold or silver. It was then that the money that we know today, that is fiduciary money, came into existence. This is a type of money whose value is based on belief in its value.
Why did the state make such a decision? It was because the gold standard limited the possibilities of the state; every banknote had to be matched by an amount of gold, and every banknote could be exchanged for that amount of gold. Since the abandonment of the gold standard, banks have been able to create money, driving in this way inflation and reducing the purchasing power of the currency. And this is one of the problems which cryptocurrencies try to address – a core idea with cryptocurrencies in the concept of limited supply, that is that the amount of money in circulation is relatively stable. Every cryptocurrency has a defined maximum amount of coins comprising it. From the moment that the cryptocurrency is created until it reaches this maximum number, the coins are mined (usually, although there are cryptocurrencies where all of the coins are mined from the very beginning) – more about this later in the article.
A second core idea of cryptocurrencies is the absence of a middleman in the form of a bank or government with control over your money. This idea is based on the fact that we create our own cryptocurrency accounts (we can create any amount) and send money to other accounts ourselves. This happens without the participation of any bank or government, and so banks/governments lose control of the money (no debt collector or state institution can seize the money in our accounts because there is no intermediate institution, i.e., a bank, which would make this possible).
But before we get into the details of this all, we must first discuss the technology which cryptocurrencies are mainly based on, that is a blockchain.
Before we provide any definition of a blockchain, let’s try to envision the problem which this technology is trying to solve. And that problem is the transfer of money. Traditionally, if person A living in Europe wanted to send money to person B living in Australia, the process looked like this:
Through the agency of some trusted third party where we keep our money (such as a bank and the account which we have open in it) we want to transfer the amount of 10 dollars (we’d like to buy a friend a beer, for example). The bank charges us a fee for making the money transfer, contacts our friend’s bank, checks whether the data we have provided matches, and transfers the money. This process usually takes several days (from the moment that we request the transfer to the moment that the money is recorded on the account in Australia so that our friend can have access to it). As can be seen, this process is characterised by two features:
- It’s time-consuming
- We have to pay a considerable amount for the money transfer (including for a large number of services associated with carrying out the transfer – fees for managing the account, for the card, etc), and we cannot request a transfer to a bank on the other side of the world without having our own account
What blockchain technology tries to make possible can be shown as below:
Blockchain is thus a technology which aims to facilitate the transfer of money:
- without intermediaries
- without waiting several days
- with far lower (in some cases amounting to zero) fees for the transfer
So now, how does blockchain attempt to realise these aims?
Blockchain is a so-called “open digital ledger” – meaning that the value of every account in the net is public, as are all transfers between accounts (from the beginning of the blockchain’s existence). Let’s say that we have four persons and our starting point is as follows:
Person A – 10 dollars
Person B – 10 dollars
Person C – 20 dollars
Person D – 5 dollars
Person A wants to send persons B and C two dollars each, and person C wants to send person D 10 dollars. This will look as follows:
Transactions which have taken place within a given time frame (for example every 10 minutes or every hour) are collected and published in a ledger, creating in this way a block. Each block is added to the end of the previous block at regular intervals, creating in this way a chain of blocks, leading to the name blockchain.
Blocks can be added to only at the end of the previous block, meaning that no information can be altered about blocks which have already been recorded and which are in the ledger. In our case, the block would look like this:
And so at regular intervals, a further block is added containing transactions which have taken place since the last block was added. Let’s say that in our blockchain, blocks are added on average every 10 minutes, and that after the block shown above has been added, all of the persons involved want to return the money which they have received. After 10 minutes, the blockchain would look like this:
And so on and so on, every 10 minutes a block is added containing the transactions which have taken place in the previous 10 minutes. The blocks themselves do not indicate the balance of the accounts, only the transactions, but this is not a problem – the balance of the accounts can be calculated by following all the transactions in the blockchain, which is done on our behalf by a number of services such as BitInfoCharts.
Here we can provide the address of a given account (it is a series of alphanumerical characters, more on this in a further section of the article) and obtain information about the account balance, when the first or latest transfer was accepted, in which blocks and at what times did these transfers take place, etc. But nowhere is the owner of the account listed (a completely different security model is applied – being the owner of the account does not involve being person X or Y, but rather having access to a private key for authorising outgoing transfers from a given address, more on this in a further part of the article).
An example of a Bitcoin cryptocurrency account address:
An interesting titbit – you can find a list of the 100 Bitcoin accounts with the highest balances here – 100 Richest Bitcoin Addresses.
The next key feature of a blockchain is its decentralisation. It is basically a decentralised open digital ledger. But what does this mean?
It means that there is no one central place where a list of all transactions is stored. There is no central server to store this information. There is no single central institution (such as a bank) in charge of this. Every account owner can have his or her own local copy of this open digital ledger containing all transactions which have taken place since the beginning of a given blockchain.
There is one problem associated with decentralisation – and that is synchronisation. If I have my own local copy of the ledger, and you have your own copy, and millions of other people have their own local copies, how can we be sure that after the passage of a given time period all of the ledgers have been updated with the same block containing the same transactions? In other words, how can we guarantee consensus regarding the blockchain? The answer depends on whether the cryptocurrency is still being mined or whether all the coins have already been mined (or were mined at the beginning of the currency’s existence, and some system of distributing the coins has been implemented).
Let’s start with the majority of cryptocurrencies, in which coins are still being mined – the answer to the question regarding consensus requires that we introduce a new concept, that of the miner. Anyone can be a miner, it is simply a particular role. It is a role which, after satisfying certain criteria, makes it possible to add new blocks to the end of a chain.
Let’s return to our starting point and discuss the issue using the example of just one transaction.
Let’s assume that:
- person A wants to send person C two dollars
- persons B and D play the role of miners in this network, and store their own copies of the ledger locally
At the moment when person A sends two dollars to person C, what really happens is that person A sends the entire network a request to conduct the following transaction:
A -> C 2
This still does not mean, however, that the transfer has been carried out. It must be included in the next block which is added to the end of the ledger, and only then is the transaction considered finalised. Until the next block is generated and added to the end of the ledger by one of the miners, we can say that the transaction status is “waiting for confirmation.”
Miners compete with each other. They compete to see who will have the chance to add another block to the end of a chain, recording all transactions which have taken place within a given time period (in our example, juts this one transaction). The miner who does this receives a reward for their work.
To beat other miners in this competition, a given miner must do two things:
- find a specific key which will enable adding a block to the ledger and attaching it to the last block which appears there. To find this key, the miner must invest in a computer with high processing power capable of solving a particular mathematical problem (more details in the following two videos – Hashes with Mining and Markle Trees oraz How does a blockchain work)
- validate all transactions from a given timeframe, assessing whether they make sense (the ledgers including all transactions is publicly available, so it can be calculated whether person A has enough funds to send person B two dollars, and if this is not the case, the transaction is rejected and not attached to the chain)
Immediately when the mathematical problem is solved, the miner publishes the solution; other miners see that the key for adding another block has been published, and stop working on the problem (because someone else was quicker), then they use the published key to validate transactions within a given timeframe, and add another block to their copy of the ledger.
Only after this process has been completed do we find ourselves in the situation that a given transaction has been validated and confirmed – person C finally sees the two dollars sent by person A in his or her account.
That’s what it looks like in theory; in practice, several confirmations are usually applied, that is, if our transaction is recorded in block number X, then the funds can only be seen in our account when block X+5, for example, is published. This is related to “forks” which can spontaneously arise in the currency – more explanation of this in a further section of the article. The difficulty of the mathematical problems is adjusted every so often (for example, with Bitcoin every two weeks) to the number of miners attempting to solve them, ensuring regular addition of blocks to the ledger.
This whole mechanism ensuring consensus is known as proof of work, or PoW; the miner is rewarded for adding a block (for proving the work required to solve the mathematical problem), usually in units of the cryptocurrency. In the case of Bitcoin, this is currently 12.5 BTC for adding a block – it’s easy to see that at current Bitcoin trading rates this is no small sum of money (~15-20 thousand USD for 1 BTC, or ~180-250 thousand USD for adding a block). It can be generally said that at a given moment, the blockchain contains a list of all transactions which have taken place in its history, as well as the number of coins which exist (each time there are a few more of them, as miners receive as rewards newly generated coins).
And what if a given cryptocurrency already has all of its coins mined (for example, because it had them mined from the very beginning)? In this case, the mechanism which ensures consensus is the proof of stake, or PoS – simply put, the balance of the cryptocurrency held by the miner determines participation in the confirmation of the transaction, with the addition of various algorithms to prevent the formation of a monopoly. But what about the reward for the miners? In the PoS mechanism, a very small additional fee is charged and transferred to the miner for each transaction.
As you can see from this simplified explanation of blockchain technology, it is this that cryptocurrency is based on. We identified a problem which cryptocurrencies try to solve. As a reminder, since abandoning the gold standard, central banks have been able to create money themselves and drive inflation, reducing the purchasing power of the currency. A key aspect of cryptocurrencies is their independence from intermediary institutions. Based on the example of the currently most popular cryptocurrency, Bitcoin, I’ll try to show how these ideas are being implemented. For reference, here is a list of all the cryptocurrencies which currently exist, along with their market value – CoinMarketCup.
A general introduction to Bitcoin, the fork mechanism
The aims of the creation of every cryptocurrency are outlined in a whitepaper, a document which describes all the fundamental assumptions. The whitepaper describing Bitcoin is available at this address – Bitcoin Whitepaper. The author of this document is Satoshi Nakamoto – however it is not known whether this is one person or a group of people operating under a pseudonym.
The community of each cryptocurrency can be divided into 5 groups:
- users, who conduct transactions
- miners, who add subsequent blocks to the blockchain
- markets, which make it possible to trade cryptocurrencies
- business people operating in the real-world economy, who make it possible for customers to pay for products and services with cryptocurrency
- developers, who have written the code for a given blockchain, and are responsible for its further development and maintenance
Each group believes that it is in charge, but in fact the system requires the cooperation of all five groups to work.
So what if developers work out an incredible technology if no one wants to adopt it?
So what if people want to use it, if no business people accept payments in cryptocurrency?
The addition of empty blocks to the chain (when the miners are working and adding blocks but there are no users conducting transactions) is as senseless as when users want to validate transactions, but there is no way to do so (there are no miners adding blocks, so no transaction can be confirmed). What’s more, you have to buy your first Bitcoin one some market somewhere, right?
All these groups form a system of linked units, and for this system to work well, they must cooperate. This is the main idea of Bitcoin – the absence of a single centre which decides what happens with the currency. Instead of this, a compromise has been worked out in which the various groups agree on the direction and principles of the further development and operation of Bitcoin.
One question arises immediately – what if there is no compromise? If this happens, then in the code of a given blockchain (and Bitcoin is a blockchain) there is a so-called fork, and an altcoin is created, that is, a cryptocurrency with a different name from its parent currency.
I mention this now because in the world of cryptocurrency there have been many such forks – a quick look at the two most popular cryptocurrencies will suffice:
- Bitcoin includes -> Bitcoin (listed on exchanges as BTC or XBT), Bitcoin Cash (BCC or BCH), Bitcoin Gold (BTG) and other
- Ethereum includes -> Ethereum (ETH) and Ethereum Classic (ETC)
Both in the case of Bitcoin and of Ethereum, to a certain time there was consensus, but then this ended and altcoins of these currencies were created. They share a common transaction history up to the moment of the fork, which is why if we owned X number of units of a given cryptocurrency before the fork, then automatically we own an additional X number of the new altcoin. From this moment on, the blockchains fork, and transactions which are conducted for example in Bitcoin do not appear in the blockchain of Bitcoin Cash and vice versa. You can think of it this way – the people associated with a given blockchain have divided into two groups and they part ways when it comes to the further development and maintenance of the blockchain.
Forks can be intentional or spontaneous. I’ll give a fuller explanation of only the first type, as the second type are a temporary state which disappears after 2 or 3 confirmations. More information for those interested can be found here – Forkology.
Intentional forks can be classified as:
- hard – when rules broaden
- soft – when rules become more restrictive
The difference is simple – in a hard fork, things begin to appear in the blocks added to the blockchain which were not permitted before, requiring the software to be updated for compatibility with the new rules, so that these new things are permitted. This means that it is a forced update of rules. In a soft for, we stop seeing a part of those things which up until now we had seen in the blocks. But this does not entail the need to update the rules, as everything that is now permitted was permitted before (we have only added new restrictions).
Limited supply– theory and practice
Every cryptocurrency has a predefined supply. In the case of Bitcoin this is 21 million coins. There will never be more, excluding the possibility of inflation in Bitcoin. After the last coin has been acquired, a very small additional transaction fee will be introduced which will be the reward to the miners for their work.
So much for theory. And now practice.
It is my subjective opinion that this theory would be true if Bitcoin was the only cryptocurrency in the world. But it is not. Let’s consider, for example, Litecoin. It has the same properties as Bitcoin and serves the same end – the easy and simple transfer of money. In total, there may be 84 million Litecoins. So we can say that by creating Litecoin, we have minted 84 million coins which serve the same purpose as the 21 million Bitcoins.
So the answer to the question regarding inflation in cryptocurrencies depends on the degree of adoption of particular cryptocurrencies in the future; put simply, on how popular a given cryptocurrency is. Several scenarios are possible:
- Example scenario no. 1 – Bitcoin is decisively the most popular cryptocurrency adopted globally by various branches of the economy (shops, business, and also for use in the payment of salaries), and no other cryptocurrency has a comparable level of popularity. In this situation we can speak of an absence of vulnerability to inflation.
- Example scenario no. 2 – apart from Bitcoin we have 9 other popular cryptocurrencies commonly accepted for payment. In this case, we must add to the 21 million Bitcoins the sum of the coins of the other cryptocurrencies – in total, this is 10 cryptocurrencies which serve the same purpose. Let’s say that a new cryptocurrency is created and becomes popular, and all operators of pay points and service outlets begin to accept this eleventh cryptocurrency – this is de facto cryptocurrency inflation, since we are adding subsequent millions of coins serving the same purpose to the pool.
To sum up, the question of inflation in the world of cryptocurrencies is really a question of their popularity; the more types of popular cryptocurrency there are which are accepted in the economy, the greater will be inflation in the cryptocurrencies (instead of creating new money in the form of additionally printed banknotes, we create new money by adding alternate cryptocurrencies or due to forks in existing currencies).
It is a separate question whether the very fact of the possible universality of a cryptocurrency will have an inflationary effect on an economy operating on the basis of traditional currencies. I will not, however, attempt to answer this question. The inflationary mechanism in cryptocurrencies is only starting and has not yet been as well explored as the question of inflation in traditional currencies.
Bitcoin, just like every other cryptocurrency, can be bought on a cryptocurrency exchange. These exchanges can be divided into two main types:
- Those where one of the more popular cryptocurrencies such as Bitcoin, Ethereum, Litecoin or Dash can be bought or sold using traditional currencies. Examples of such exchanges are CEX.IO, Kraken and BitBay
- Those where cryptocurrencies can only be traded and exchanged for others, but not for traditional currencies. Examples of this kind of exchange are Bittrex, Poloniex and Binance
Note – due to applicable regulations regarding money laundering, in order to transfer money in traditional currencies, we must first verify our account. The particular steps may vary from exchange to exchange, as may the degree of verification (in which the more details and authorisations you are able to provide, the larger are the amounts that you can transfer). Most often this involves sending a scan of your ID card, a photo of your face with your ID visible next to it, or with a relatively recent document confirming your address (such as various types of bills), Some may balk at the idea of sending data such as this, however it is necessary if we want to purchase a cryptocurrency on these exchanges.
Here is an example of classifications of types of accounts and degrees of verification on Kraken:
The lack of verification means that the exchange operates like the second kind of exchange, in which we can freely trade funds as cryptocurrencies from one place to another, but cannot exchange into traditional currencies.
When the exchange is of this first type, it is usually limited to only a few of the most popular cryptocurrencies and everything can be bought using traditional currencies. Let’s look at the example of BitBay this time – the exchange offers the possibility to transfer finds from three traditional currencies and use them to purchase funds of 8 cryptocurrencies:
This also means that when setting up an account, the user obtains 11 addresses:
- for each cryptocurrency, a string of alphanumerical characters matching the public address for sending funds in a given cryptocurrency (more on addresses in a further part of the article)
- for each of the three traditional currencies, a bank account number together with instructions on how to fill out the transfer order so that the funds are properly accounted for
So, if we are new in the world of cryptocurrency and want to purchase some cryptocurrency using a traditional currency, we must set up an account on CEX.IO, Kraken, BitBay or another exchange of this type, and buy one of the cryptocurrencies offered on the exchange.
If we would like to purchase one of the less popular cryptocurrencies, we must additionally either:
- exchange purchased Bitcoin/Ethereum/Dash on the same exchange for this less popular currency (if our exchange allows this)
- set up an account on another exchange, such as Bittrex/Poloniex/Binance – where we will also obtain a public address for funds in a given cryptocurrency (such as Bitcoin). We make a transfer from the public address on CEX.IO/BitBay/Kraken to the public address on the other exchange (e.g. Bittrex), and next we exchange the Bitcoins sent to any other cryptocurrency on that exchange.
An example from the Poloniex exchange – the list of cryptocurrencies which can be purchased with Bitcoin (BTC) includes several dozen items:
Transfers, wallets, cryptography
Let’s start with some general information on the security model based on asymmetrical elliptic curve cryptography, in other words public key cryptography, or even simpler the “public key-private key” pair. Basically, we generate two series of alphanumeric characters (comprising letters and numbers) – the shorter of these two is called the public key and the longer the private key. An example key generator is available at the following address – Public and Private Key Generator.
Sample public key:
Sample private key:
These keys are mathematically related to each other in an asymmetrical fashion as regards the private key versus the public key. This means that by using monodirectional mathematical operations, it is possible to go from the private key to the public key, but not the opposite direction (asymmetry):
What does that have to do with Bitcoin?
The shorter alphanumeric series is the public key, or more precisely its form which is made publicly available after being shortened (to refresh the memory – the usage of so-called hash function has been described in this video – Hashes with Mining and Markle Trees). This is the public address for transferring funds in a given cryptocurrency which has been mentioned before:
Let’s take the example of one public address (Bitcoin) generated by the BitBay exchange when the account was set up:
In other words, the public key:
has been shortened in a transformation operation to the address:
and this address is the number of our Bitcoin account. If we want someone to send us funds in Bitcoin, we provide this address.
But if we want to pay out funds, we need to use the longer alphanumeric series, that is the private key. Each transaction has a signature created by the private key and is checked to see if by using asymmetric mathematical operations and the shortening function we can make our way from the private key to the public address from which we want to pay out the funds:
If this check is successful, it is only then that we can prove that we are authorised to transfer funds from this address (commonly known as an account). That is to say, we can receive transfers from anyone to a given public address (an account), but we can only make transfers from a given public address when we know the private key from which this public address is obtained.
Thus, we distance ourselves from a security model based on personal identification in favour of a model based on keys. Even if I lose my credit card, I can have it blocked in the bank and later make a new one (by using documents, the bank can verify that I am in fact the person that I say I am). With cryptocurrencies, this is not the case. If I lose the private key to a given public address (and I don’t have a spare copy anywhere) that’s the end – I will not be able to do any transactions from this address, and all funds that are gathered there will be lost (no one can reset your password or generate a new private key, because there is no top-down institution managing Bitcoin).
Cryptocurrency is held in the account, and accounts are managed from wallets. A wallet is a tool for managing the “public address-private key” pair. Two types of wallets can be distinguished – hot wallets and cold wallets. Hot wallets are connected to the internet while cold wallets are not. They can be further broken down to subtypes (ranked from the most convenient to the most secure).
- exchange wallet – this is simply our account on a given cryptocurrency exchange. The private key is held by the exchange (because it generated the public address to which you transfer your cryptocurrency) and it automatically authorises every transaction that you make
- online/browser wallet – this wallet is part of some external cloud service, such as CoinPayments
- app wallet – we install an application on our telephone or computer, and the “public address-private key” pair is stored in the memory of the telephone or hard disk of the computer, and is used every time we try to conduct a transaction, e.g. Electrum – for computers and Jaxx – for smartphones
- hardware wallet – this is usually a USB pendrive with an application for storing keys. Each time we want to conduct a transaction, we must insert this pendrive into the computer. The most popular are Trezor and Ledger
- paper wallet – using an application, it is possible to generate a new “public address-private key” pair and print it, for example at – BitAddress
The public address is the alphanumeric series on the left, and the private key is the alphanumeric series on the right. Additionally, both series have been generated in the form of QR codes, facilitating their later use, as it is not necessary to rewrite the entire series from the page; it suffices to scan the QR code with your phone.
In answer to the question “Which wallet should I choose?”, I’ll give the most popular answer in the world: “It depends.” ;-)
Starting with the most convenient option, the exchange wallet provides the broadest possibilities when it comes to playing the market; it is not necessary to transfer funds to the exchange account (they’re there already), and at any time you can order a buy/sell cryptocurrency transaction, whether to traditional currency or to another cryptocurrency. The disadvantage is security; if your private key is held by the exchange, then de facto the duns on the account belong to the exchange and not to you. You don’t even know what your private key is when you use it to authorise transactions.
Moreover, if the exchange is the victim of a successful hacking attack, and even some of the addresses with their private keys are stolen by the hackers, they will of course drain the accounts to zero; the users will lose everything and there will be no way to get the funds back. There is no bank or institution to turn to with a claim or to demand return of the stolen funds from. Another snag may be presented by breakdowns in the exchange itself; although the exchange may not have been hacked, you will still not have access to your wallet and will not be able to conduct any transactions. Similar observations can be made about online/browser wallets.
Now taking the most secure into consideration, it is the paper wallet that provides the greatest security, since we must have physical access to a printed sheet in order to rewrite the private key necessary for authorising transactions. An important yet ambiguous issue is the decision to create any kind of spare copy of this key. It is important because if the sheet of paper is destroyed, there will be no way to gain access to the funds in the account. Ambiguous because the more copies there are of the key, the greater is the possibility that one of the copies will fall into the hands of an unauthorised third party.
To sum up, hot wallets are recommended for dealing with small sums on a day to day basis, while cold wallets are recommended for managing larger sums. In the case of wallets other than exchange/online, it is recommended to make at least one emergency copy – as the old IT adage goes, “People can be classed into those who make backups, and those who are about to make a backup.”
An important factor when choosing a wallet (other than an exchange or paper wallet) is the compatibility of a given wallet with the cryptocurrency that interests us. Some applications service only one, while others are able to service dozens of types of cryptocurrency.
At the end, I present a few questions and answers which I myself was curious about at one time:
Q1: What is this Bitcoin 1x, 2x, SegWit, Bitcoin Cash and so on about? Aren’t they all the same thing?
A1: No. These are all forks, some real, and some hypothetical which never became a reality. A short key:
- Bitcoin 1x – Bitcoin with 1MB limit size of data blocks – the original Bitcoin as it was created
- Bitcoin 2x – a fork of Bitcoin, which increased the limit for data blocks to 2MB. It was intended to replace 1X in November of 2017, but was withdrawn a few days before being implemented due to failure to reach a compromise with the Bitcoin community
- Bitcoin SegWit – a soft fork of Bitcoin (an upgrade of rules which did not result in the creation of an altcoin) which introduced the Segregated Witness mechanism (which was basically about separating the private key signature from the transaction data, allowing a greater amount of data to be packed into each block). This fork was introduced to the Bitcoin 1x blockchain in August 2017. It functioned for about two months, but from October 2017 it has been abandoned due to subsequent divisions within the Bitcoin community (SegWit’s adoption can be checked here – Percentage of blocks signalling SegWit support).
- Bitcoin Cash – a hard fork of Bitcoin (an upgrade of rules which resulted in a new altcoin) which increased the limit of blocksize to 8MB
Briefly then, the current Bitcoin (BTC) listed on exchanges is Bitcoin 1x.
Q2: Which is better – Bitcoin or Bitcoin Cash?
A2: There is a lot of discussion on this topic. Bitcoin (BTC) was the first decentralised cryptocurrency, and the computational power behind it is currently the greatest. In terms of market capitalisation, it is clearly the most popular cryptocurrency. But it has one problem with functionality, due to its 1MB limit of blocksize.
Each transaction together with its private key signature represents a certain amount of data, usually a block of 1 MB can hold about 2000 transactions (based on a chart covering a year). If these blocks are mined on average every 10 minutes, then the approximate average capacity of Bitcoin is 6 x 2000 = about 12,000 transactions per hour. Unfortunately, this value is insufficient to service all pending transactions even today, in the early phases of the development of the project.
At this moment, the so-called mempool (the number of pending Bitcoin transactions) is measured in tens, and sometimes hundreds of thousands. For this reason, fees charged to ensure that our transaction will wind up in the next block sometimes reach as much as 20 or 30 dollars or more (regardless of the amount of the transaction). There are even transaction accelerators – BTC Speedy – in which we pay an additional fee for our transaction to be published in a block quicker. This shortage is advantageous to the miners; if there are more transactions than the capacity of Bitcoin, then the miners pick and choose those transactions with the highest transaction fees (because they collect these fees), and only publish these in a given block, meaning that if we don’t want to pay a lot for the money transfer, we may have to wait a long time for it to be realised. There is a classic supply and demand mechanism at work here; demand considerably outpaces supply, and so prices for goods and services rise sharply.
With Bitcoin Cash (BCH), due to the 8MB limit of blocksize (as well as the prospect of later increases of this limit) this problem does not currently exist. Referring back to the document prepared by Satoshi Nakamoto – Bitcoin Whitepaper – we can see that the first sentence states that Bitcoin by definition was meant to be an electronic form of cash. At this moment, in my opinion, Bitcoin Cash is considerably closer to this vision than the original Bitcoin. Due to the high fees, the original BTC has become something more of an accounting mechanism for large financial institutions than electronic cash. You might ask what an acceptable level for transaction fees is. As a working definition, let’s say a maximum of 0.1% of the transaction. So $30 (as previously mentioned) at a maximum 0.1%, would mean that the transaction would have to have a value of a minimum of $30 000 for the transaction fee to be 0.1% or less. This does not meet the criterion of being an electronic form of cash for ordinary people. On the other hand, account settlements between large institutions are generally in the millions, so these payments may be as little as 0.0001 % of the transaction (one ten-thousandth of a percent of the transaction).
At BitInfoCharts BTC Transaction Feesyou can find average prices for transactions sent in Bitcoin (data from 1-24 December 2017):
Now let’s look at the same data for Bitcoin Cash (data from 1-24 December 2017) – BitInfoCharts BCH Transaction Fees:
As you can see, the average fee in the Bitcoin community is $20-$30, while the average fee for a Bitcoin Cash transaction in the same period was $0.15 – $0.30, or something like 100 times less. An overview comparison of Bitcoin vs. Bitcoin Cash can be seen here – TX Highway.
This, however, does not guarantee that Bitcoin Cash will take the place of Bitcoin and the price of BCH will exceed that of BTC – it should be remembered that BTC still has the advantage of being first. Many people who are not connected with the cryptocurrency field on a daily basis, when they hear the word “cryptocurrency” automatically think “Bitcoin”. On many exchanges, only BTC can be bought using traditional currency, which can then be converted into something else. The demand for BTC may maintain its high level for some time. Many people believe that BTC will take on the role of a kind of electronic gold, or something that is used as an investment vehicle, but not necessarily used for daily needs.
To sum up, at the moment Bitcoin Cash offers what Bitcoin, due to its 1MB limit of blocksize, has long since stopped offering. But there is still no automatic mechanism determining that “greater usability equals a higher price”. It may well turn out that BTC will remain the account settlement currency for large institutions and a form of electronic gold, while the role of everyday cash is taken over by another cryptocurrency, which need not necessarily be Bitcoin Cash – for example, Dash or some new cryptocurrency which has yet to be created.
Q3: How much will Bitcoin be worth in a year or 10?
A3: No one knows. Technological developments (and the blockchain is a technological development in money transfer) is so dynamic and unpredictable that often the current market leaders wind up with nothing after some time and cease to be relevant. I’ll give you three examples:
- search engines – up to a certain moment they were an integral part of Internet services (or an addition to them), such as Yahoo, which was at one time one of the most popular pages on the Internet, with Google arising two years after Yahoo (’96 vs. ‘94). Today, practically no one uses website-based search engines
- touch-screen telephones – the most popular is the iPhone, and it is still a rising trend which all other manufacturers follow. But this does not mean that Apple invented this solution – several years earlier, the company Palm had a line of palmtops. Apple simply improved the solution significantly
- social networks – at the beginning, the most popular networks were SixDegrees and Friendster, later MySpace, and only after years were these supplanted by Facebook
In each of these cases, the current largest global players are not the ones who delivered these products and services in the early stages of the development of these technologies. With cryptocurrencies, it may turn out the same. The fact that today Bitcoin is the most popular and largest cryptocurrency does not mean that the situation will be the same in a year, two or five. It may well be that in five years, Bitcoin will for practical purposes not exist, just as SixDegrees and the Palm company no longer exist, having been replaced by some other cryptocurrency – one which is currently known or one which has yet to be created.
Q4: What is 2FA?
A4: 2FA stands for 2 Factor Authentication, a method of securing access to some service involving additional authorisation apart from the standard login and password. In the case of cryptocurrency exchanges, the most common forms are:
- single-use e-mail code – every time we want to log in or conduct a transaction, we are sent a code which we must copy
- the Google Authenticator application (you can download it here – Google Play – or here – iTunes). In the security settings of our exchange account, we can activate the Google Authenticator option – if we do so, a special page with a QR code will appear, we start the app on our telephone, scan the code, and the app should next display something like this:
Each service which we attach to the app will have a new code generated which is only valid for a short period of time (measured by the clock in the lower righthand corner). After this time is up, the code changes and the previous code becomes invalid. This is an additional layer of security protecting login to the account itself or any kind of transaction.
Q5: I lost the phone where I had Google Authenticator installed. I want to log in to my account, but I am asked to give the code from the app. What do I do now?
A5: If you have 2FA activated on your telephone, it is recommended that you write down or print the page with the QR code generated by the exchange. Then, it will be enough just to scan this on the new telephone and everything should work again. If you have not done this. you can try to contact the exchange itself and request deactivation of this option.
Some exchanges have a helpline where you will be asked to provide various kinds of verification data and a special PIN number provided when you set up your account; theoretically, only the person who set up the account should know this information.
Depending on the type of wallet, other exchanges may ask for:
- if your transaction is below a certain threshold – sending a mail from the e-mail address with information about the wallet, recent transactions, and IP numbers from which the connection was made (they may direct you to services where you can check your IP number)
- if your transaction is above a certain threshold – additional photo ID documentation held next to your face may be necessary, or a newspaper from a given day – all to prove that you are who you say you are, and that you have the documents to prove it, and that this photo is current and was not made in the past, nor was it intercepted by an unauthorised third party
As you can see, it’s best to write down or print the page with the QR code.
Q6: I’d like to invest in cryptocurrency. How can I…
A6: Let me interrupt for a moment. I’m doing this because the rest of the question is not important, this is about a fundamental mistake. For starters, I’d like to recommend one of my previous articles on the philosophy of Warren Buffet. Allow me to quote one fragment on the words of Benjamin Graham (one of Buffet’s university teachers), who said in his book “The Intelligent Investor” (well worth reading, by the way):
When it comes to the assessment of publicly traded companies, there are many methods of calculating their worth:
- the discounted cash flows method (based on values from financial reports)
- the liquidity method (the value of all elements of equity, tangible assets, such as buildings, and intangible assets, such as patents, which represent the liquidity of the company)
- and many others
But every time in these cases, we can approximately asses the value of what we are considering buying. Now let’s think about cryptocurrencies – how much should one Bitcoin be worth? $100, $10 000 or maybe $1 000 000? And one Ether? A Litecoin? And how should we calculate this value?
In the case of companies, we can make use of data from financial reports, data from the business sector in which the company operates, macroeconomic data for the whole economy, etc. In the case of cryptocurrencies, what indices can be used and how can we define a formula for calculating value?
As of today (January 2018), there is no such formula. And so it is impossible to undertake a thorough analysis ensuring the security of capital and a satisfactory profit. According to Graham’s definition, the operation is speculative. This is one of the most important things I’ve written in this article:
“Investing in cryptocurrency” involves in its entirety the assumption that a certain scenario will play out (generally based on rumours, fragmentary information, and our own sixth sense of how others will react). And that’s it.
I have come to the conclusion that Bitcoin will rise in value? I buy it now at a lower price. I’ve come to the conclusion that Bitcoin will collapse, and that its place will be taken by another cryptocurrency? I’ll buy that currency now, while Bitcoin is still on top and this other currency is relatively cheap.
If I plan to exchange any kind of traditional currency for cryptocurrency, I must answer the following question for myself: Am I ready to accept the loss of this money? This is a kind of equity which is still not legally regulated with a highly speculative character. For this reason, I recommend not putting any more equity into this area than we can safely lose. Only if I can lose 100% of this equity and my life will continue to be at an acceptable level for me, only then should I think about investing in cryptocurrencies.
Finally, I can add one more observation, namely that we should always do the research to find out what the thing that we are interested in is, and what it is for. Not all the tokens available at CoinMarketCup are cryptocurrencies in the strict sense of the word. Some of them are solutions based on blockchain technology, but with other use cases of this technology than cryptocurrency. Some of these tokens aren’t based on blockchain technology. Two examples from the top 10 when it comes to capitalisation:
- Ripple – this is not a cryptocurrency. It is a technological solution based on blockchain intended to reduce transaction costs, mainly for large financial institutions (use cases). Additionally, there are only slightly less than 40 billion XRP tokens, 60% of which belong to the Ripple company, making this de facto a private blockchain for Ripple.
- a cryptocurrency operating based on tangle technology (based on directed acyclic graphs) and not based on blockchain, details of the tangle technology can be found here – IOTA Whitepaper – or here – Tangle vs. Blockchain.
This does not mean that you shouldn’t invest money in these solutions. It may be that in a year or two, solutions based on blockchain technology other than cryptocurrencies, or cryptocurrencies based on a technology other than blockchain will emerge victorious and be widely implemented in business. Before taking any decision, we must simply strive to collect as much information as possible.