The Beginner’s Guide to Understanding Cryptocurrencies and the Blockchain
by: Tam Ging Wien
author of REITs to Riches: Everything You Need to Know About Investing Profitably in REITs
The article was first published on ProButterfly.com on 05-Jun-2017.
Understanding Cryptocurrencies and the Blockchain
In the simplest of terms, a cryptocurrency is nothing more than a digital form of cash which serves as a medium of value. Instead of being secured with complex set of anti-counterfeiting designs such as microprinting, security threads, watermarks and holograms, cryptocurrencies are secured with advanced cryptography which protects it from being counterfeited.
Bitcoin was the first implementation of a cryptocurrency. In January 2009, an unknown person or group of persons under the pseudonym of Satoshi Nakamoto released the source codes and a document outlining the design behind Bitcoin. In just 31 thousand lines of code, Satoshi Nakamoto had invented a brand new form of money.
Underlying Nakamoto’s Bitcoin was a publicly verifiable distributed digital database technology known as a blockchain. This novel design chains a series of records known as blocks by using cryptographic techniques; effectively creating a distributed temper proof ledger of financial transactions.
The biggest problem when creating a new form of money to ensuring that it cannot be double-spent. Traditionally, money is implemented in a centralised fashion by relying on a trusted 3rd party to independently verify and clear transactions. This happens every day when we swipe our credit cards, make bank transfers or deduct prepaid credits.
The blockchain instead uses a decentralized method by relying on incentivizing independent transaction verifiers to chain blocks together in the ledger and broadcasting the chain to all other verifiers. For each successful block that is chained together, new Bitcoins are created as a reward to the verifier. The Bitcoin blockchain makes chaining block an incredibly difficult task by forcing the verifiers to find solutions to computationally intensive problems first before the block can be chained to the rest of the blockchain. These independent verifiers are known as miners and the process of chaining blocks together is known as mining; this is akin to mining for new resources.
As a reward for helping maintain the public ledger, miners earn these newly created Bitcoins. The Bitcoin blockchain halves the Bitcoin rewards every after every 210,000 blocks (or approximately 4 years). Eventually, the reward will tend to zero; limiting the total number of Bitcoins created to 21 million. It is estimated that this limit will be reached sometime in 2140 where no new Bitcoins will be created, resulting in a scarcity. If demand for Bitcoins continues to increase while supply is limited, the value of Bitcoins will continue to appreciate.
A Bitcoin (BTC) consist of 100 million Satoshis, named in honour of its creator. Therefore, the smallest Bitcoin denomination possible is a 100th of a million (BTC 0.00000001) or 1 Satoshi.
In order to own Bitcoins, it needs to be transferred to a specific address associated with the owner. Any person can create any number of addresses just like creating multiple bank accounts. Each address has an associated private key. The address can be thought of as a vault while the private key is the specific combination that can unlock the vault. Therefore every time an owner spends Bitcoins, they need to open the vault with the private key. The transaction will only be confirmed and cleared by the miners when they have verified that only the specific private key was used to spend of Bitcoins from the specific address. Upon successful verification, the corresponding amount of Bitcoins are exchanges and the transaction ledger is updated and broadcasted to all other miners. If the private key to an address is lost, nobody is able to access those Bitcoins and it will be lost forever.
The underlying concept of Bitcoin really is the issue of trust. We can really only trust a system if we can be assured of its integrity and reputation. For example, when 2 persons transaction without trust, usually an independent 3rd party known as an escrow is involved to verify both parties have fulfilled their respective obligations and transfer ownership of an asset. Merchants and clients trust the credit card issuers, stock market traders trust the exchange, landlords and tenants trust the land office.
The promise of the blockchain is to replace the need for these trusted 3rd parties to assist in a transaction and ensure still ensure that the ownership of the assets will still be transferred. This makes transactions faster, cheaper, temper proof, transparent, irreversible and anonymous. Applications of blockchains go far beyond money, they could be used to implement smart contracts, maintain asset ownerships, allow peer-to-peer transactions, simplify crowdsourcing, online voting and tallying, enforcing distribution limits of copyrighted material and so on.
As a result, the implications for the financial industry is immense. With blockchains, there is no need for trusted 3rd parties like lawyers, banks or even governments to ensure integrity of asset transactions. This brings down transaction cost as well and keeps the transactions anonymous. Blockchain transactions are now peer-to-peer instead of going through a centralised authority. Even though blockchain ledgers and addresses are publicly available, the ownership of each of those addresses are unknown making tracing a transaction between 2 individuals almost impossible.
I marvel and the genius of Nakamoto’s work. He has taken something as ingrained and mundane as our money system and breathe new life into it. But the real innovation that Nakamoto offered isn’t the brand new form of currency that he is proposing, but rather its the trust mechanism that powers Bitcoin that promises so much more.
Getting Started with Bitcoin and Ethereum
Similar to Bitcoin, Ethereum is also an alternative open-source blockchain platform that implements a key feature absent in the Bitcoin blockchain – smart contracts. Having this additional feature allows Ethereum to be used for much wider applications. Ethereum as a platform developed from The DAO project (Decentralised Autonomous Organisation) meant to provide a generic decentralized business model for enterprises. It has its own cyptocurrency known as Ether (ETH).
This article is mean to help beginners quickly getting their hands on small amount of cryptocurrency so that they can appreciate the concepts better through action. It is not meant to be investment advice or sharing of trading strategy, but rather an early starting place to better appreciate the blockchain revolution. I believe that only by getting your hands dirty and using the system can you then truly appreciate how cryptocurrencies work.
In cryptocurrency lingo, there are Bitcoins and then there are Altcoins. The latter being a fusion of the words “Alternative to Bitcoins”. Examples of altcoins include Ether and Litecoin. Collectively, all crypotocurrencies are colloquially referred to as “coins”.
In order to own your first coin, you will need to first be able to transfer your money for the purchase.
Step 1: Setup a Payment Link
As at time of writing, there is no easy way to make payments for cryptocurrency. Traditional internet banking, funds transfer and credit card payments don’t make it easy to pay for cryptocurrency. Therefore to start today, the best way would be to setup a payment link. I personally use Xfers (https://www.xfers.com/sg/payment-link/) which I found simple to setup. Navigate to the site and setup a “Personal Account” and follow the setup instructions.
Xfers limits digital goods (including cryptocurrencies) total transactions to $50 per day anonymously. Therefore, in order to make larger purchases, you will need to verify both your identity and phone number. This can easily be done using their “Account Verification” functions. After the verification is successfully done, you daily transaction limit will be increased to $200. Increasing your daily transaction limit is a matter of simply making more transactions. While $200 isn’t much, it is still sufficient to get started on buying your first Bitcoin and Ethereum.
Next you will need to fund your Xfers account with some money. Xfers support bank transfers from many Singapore based banks including the 3 major local banks. After transferring some money to your Xfers account, you will receive a successfully notification of top up within 15mins. Your top up amount will be reflected in your Xfers balance.
Diagram 1: Screenshot of Xfers Daily Limits
Step 2: Setup a Cryptocurrency Exchange Account
Bitcoins can be obtained through an exchange. The important thing is to ensure that the site you are buying from is secure and reputable. As Bitcoin is still it its early stages of adoption and decentralised, Bitcoin exchanges are not regulated.
The most popular Bitcoin exchange is Coinbase (https://www.coinbase.com/) which has been around since 2012 and boast over 7.3 million users. Coinbase supports 3 major cryptocurrencies namely Bitcoin (BTC), Ethereum (ETH) and Litecoin (LTC). If you use this link to sign-up and transaction at least US$100 worth of cryptocurrency, we both will be rewarded with an additional US$10 worth of Bitcoins:-
Make sure you also download the Coinbase mobile app to your smart phone so that you can view your balance and make Bitcoin transactions anywhere.
Other exchanges which I have used include CoinHako (https://www.coinhako.com/), Luno (https://www.luno.com/) and CoinMama (https://www.coinmama.com/). They are both easy to setup and have a simple to understand user interface. However my experience is that I seem to be able to obtain a slightly cheaper price on Coinbase for the same amount of cryptocurrency.
Next you will need to link up your Xfers account as a mode of payment on Coinbase or whichever exchange that you have decided. Upon verification, you are ready to buy your first cryptocurrency.
Step 3: Buy Some Coins
Now that you are done setting up the exchange account and linked it up with the payment link, we are ready to buy some Bitcoins!
The exchanges makes it incredibly simple to make your first cryptocurrency purchase. You simply click on the Buy/Sell function and key in the amount that you want and hit the “Buy” button.
Diagram 2: Screenshot of Coinbase Buy Screen
Be sure to limit your purchase to under the Xfers daily transaction limit or else the transaction will fail.
As cryptocurrencies require miners to chain the blocks together and verify the transaction, clearing could take time. It could be as fast as 5mins but sometimes as long as 2 hours. Check back about 15 to 20mins later to see if your coins have arrived. If they have still not arrived, don’t be alarmed, check back again 1 hour later.
The cryptocurrencies that you have successfully purchased would automatically be deposited into your corresponding wallet. It is stored there until your transfer or sell them.
Selling the coins are as simple and buying them. Explore these functions and get familiar with them.
Diagram 3: Screenshot of Coinbase Wallet
Navigate to your dashboard to check the price trends of the various coins. The amount of coins that you have in your wallet is shown together with the corresponding exchange rate to the currency of your choice.
Diagram 4: Screenshot of Coinbase Dashboard
Congratulations, you now own a small amount of cyrptocurrency. You have just dipped your toes into this brave new world!
Step 4: Get a Bitcoin Wallet
You are probably wondering why this is even a necessary step. After all, these exchanges already have built in wallet functions. You could simply just use it as it is right?
We technically yes, you could continue using the wallets provided by these exchanges. However do note that cryptocurrencies can only be accessed when the private key is available. In order for the exchanges to access your coin portfolio and balanced, they would definitely have to store a copy of your private key on your behalf. In the unlikely event that these exchanges are attacked, an attacker could potentially take control of a vast number of private keys and make coin transfers out of the exchange. In cryptocurrency speak, this is known as putting your coins in “cold storage”.
If this is your first foray into owning some coins and your quantity is low, you can afford to take the risk and leave your coins on the exchange for convenience. However, as your progress on this journey, its best that you consider storing your private keys offline from the exchanges and keep it in a secure location. Be sure to have multiple backups as once your private keys are lost, nobody is able to retrieve your coins for you!
There are various types of offline wallets available including physical wallets, desktop wallets, mobile wallets and even paper wallets. A wallet is simply a cryptocurrency address coupled with the private key and a means of securing them.
Ledger Nano (https://www.ledgerwallet.com/) and TREZOR (https://trezor.io/) are among the most common Bitcoin physical wallets. As for other types of wallets, there is Exodus (https://www.exodus.io/), MultiBit (https://multibit.org/), Armory (https://www.bitcoinarmory.com/) and Mycelium (https://wallet.mycelium.com/). For paper wallets, consider using MyEtherWallet (https://www.myetherwallet.com/) for Ether.
Step 5: Explore, Explore, Explore
Now that you have finally own some coins and have prepared a safe place to secure them offline, its time to explore, explore, explore!
Try sending coins from your exchange to your offline wallet and transferring back again. Get a hang of how works and familisarise yourself with the long cryptic string of cryptocurrency addresses. Alternatively, try using the QR Code to perform the transfer. Be careful though, if you send them to a wrong address, there is no way to reverse the transaction! Also there is a small fee associated with each transactions.
Register for a Bitcoin debit card! This allows you to transfer your Bitcoins to the debit card wallet and utilise your Bitcoins for payments at merchant that accepts Visa or MasterCard. The popular choices of Bitcoin debt cards include BitPay (https://bitpay.com/card/), Xapo (https://xapo.com/card/), BitPlastic (https://bitplastic.com/), SpectroCoin (https://spectrocoin.com/en/bitcoin-debit-c...) and Bitwala (http://www.bitwala.io/). At point of writing, Bitwala (http://www.bitwala.io/) appears to provide the lowest cost for owning a Bitcoin debit card.’
How about shopping with Bitcoin? Considering using Purse (https://app.purse.io/) account where you could save up to 25% on your Amazon purchases. How about a 20% discount at your local Starbucks store with Folderapp (https://coffee.foldapp.com/)? As Bitcoin becomes more widely accepted, your potential for such service and savings increase!
Be sure to follow up on the prices and market capitalisations of all available cryptocurrencies at Coin Market Cap (http://www.coinmarketcap.com/).
And for those who love a trill, try signing up for a cryptocurrency trading account at Poloniex (https://poloniex.com/). It an entire trading platform for cryptocurrencies!
There is really no end to this brave new world of cryptocurrencies. Aren’t you glad you got started?
The Risk of Investing in Cryptocurrencies
Just like any other investments, an investor also takes on risk when getting involved in cryptocurrencies. While we discussed many of the benefits of investing in cryptocurrencies, this guide would not be complete if we did not caution readers with regards to the risk that they are taking on.
Here are our list of top cryptocurrencies risk that all investors should be aware of.
1. Cryptocurrencies Have No Intrinsic Value
Cryptocurrencies are similar to fiat currencies that they have no intrinsic value. The value of a coin is simply governed by simple demand and supply mechanics; it derives its value simply based on what the market is willing to pay for it. So long as people continue to trust in a particular coin and its acceptance continues to gain traction, its value will hold or increase. However if people lose faith in the particular coin, it will lead to poor acceptance and finally its demise rendering is valueless.
Cryptocurrencies also have no intrinsic function other than as a medium of exchange, unlike gold, silver, oil, wheat or cotton which have industrial uses. Therefore unlike physical commodities, crytocurrencies being virtual commodities can be used for any other purpose which restricts is demand.
2. Cryptocurrencies Generally Do Not Have Productive Value
Cryptocurrencies are designed to be a medium of exchange and it is itself a form of commodity. Commodities in general do not have productive value as the asset itself can be difficult to put into productive use to earn income.
The concept of banks in the cryptocurrency world is also somewhat limited at the moment. There is few entities out that that will pay you an interest for your coin deposits.
One can only profit from cryptocurrency by capital appreciation or trading it short.
3. Cryptocurrencies Are Highly Volatile
Cryptocurrencies are traded on the open market and are therefore susceptible to market fluctuations. As adoption of cryptocurrencies are still is very early stages, their value is can be swing in either direction very wildly.
Also due to the international nature of cryptocurrencies, they trade 24 hours a day, 7 days a week. Therefore it is impossible for any one individual to monitor and make fast decisions should any of their coins experience a flash crash. A crash could occur while the individual is sleeping or have no access to the internet to react.
The high volatility and international nature of coins is simply a risk that all coin owners need to live with.
4. Cryptocurrencies Stored Can Be Lost or Misplaced
All cryptocurrencies are designed to be stored against a public ledger which tracked its balance. Each of these virtual addresses or accounts have a corresponding private key which is required to release the funds in the account. Therefore losing the private key will result in the coins in the corresponding account going dormant as nobody is able to find the private keys to spend those coins. This will result in fewer coins in circulation and potentially increase the demand and value for the coins in circulation.
The coin addresses also do no store personal information, therefore there is nothing linking your ownership to a particular coin address. The only proof of ownership is the possession of the private key. Should your private keys be stolen, the thieve is able access and withdraw your coins. And there is no recourse for you to get those lost coins back.
Ensure that your private keys and wallets are backed-up regularly and stored in multiple backup devices. Ensure that your backup devices are stored securely to prevent such losses.
5. Cryptocurrencies Stored on Exchanges and Online Wallets Are Vulnerable to Hacks
As your coins need to be accessed by the online coin exchanges and wallet services, a copy of the corresponding private key will be stored with them. Therefore if these online services are compromised, an attacker could gain control of those private keys and quickly transfer large amounts of coins out of the exchange. In early 2014, Tokyo based Mt. Gox exchange was hacked with over BTC 750,000 transferred out. In a similar event in August 2016, Bitfinex had also lost about BTC 120,000 to cyber thieves.
The only save place to keep your coins away from these cyber thieves are to store your private keys offline away for these exchanges. Even then, they could be physically stolen or lost.
6. Cryptocurrencies Transactions Are Irreversible
By design, the blockchain that enables the transactions of cryptocurrencies are secure, anonymous, irreversible and resistant to modifications. As a result, errors in cryptocurrency transfers are also irreversible. In the event that you transferred your coins to the wrong address or made and error in the transfer process, the coins may be permanently lost. The onus lies with you to ensure that all entries and steps are correct before a transfer takes place.
7. Impossible to Keep Track of All Cryptocurrencies
It is estimated that there are more than 2000 unique cryptocurrencies in circulation today each with its own unique features. New ones are being created on a regular basis and circulated quickly in the markets through ICOs. Therefore, it would be almost impossible to keep track of the benefits and risk of each of these coins. It also makes it difficult to predict which coin will eventually succeed and gain widespread adoption and which will fall out of favour.
Various news sources and media could also quickly sway public opinion on which coins to favour.
The current financial system is not able to support such a large number of coins and in the coming years, majority of these coins will likely fall out of favour and died a natural death.
Therefore for early investors and adopters of cryptocurrency, it would be wise to diversity your coin holdings to manage the systemic risk. A basket of cryptocurrencies is more likely to preserve its value in the long run than putting all your bets on one single coin.
8. No Clear Regulations Governing Cryptocurrencies
As cryptocurrencies are designed to be decentralized without a trusted entity, there is no central governing authority to regulate them. Therefore owners of coins have no legal recourse should any fraud, accidents or negligence happen to them.
9. Cryptocurrencies Could Be Restricted By Jurisdiction
For every emerging technology, there will always be supporters and opponents. Nations choose to embrace the technology will recognise it and put regulatory controls to govern how, when and what it can be used for. On the other hand, nations that oppose the technology could outright ban its use, take legal action against users or force its citizen owners to surrender their holdings in a compulsory confiscation.
In April 2017, Japan recognised Bitcoin as legal tender becoming the first nation to do so. Japan’s recognition of Bitcoin has made other nations consider the potential and risk of cryptocurrency more seriously. To add to this, Bitcoin has a history of being used for illicit trades such as money laundering and payments for illegal goods such as drugs, weapons, prostitution and ransom. Fearing its wide spread adoption and anonymity, governments will likely impose regulations to curb its criminal use.
Governments may also choose to invent their own cryptocurrency and ignore other generic forms. For example, the Royal Canadian Mint created MintChip which is a form of cryptocurrency which is held on a smartcard but backed by the Canadian dollar.
All these will create uncertainly within the cryptocurrency space leading to more volatility in its value.
I hope you have enjoyed this educational piece. Do provide us feedback or ideas for future content!