What Is A Cryptocurrency?

This article is the first in a series about blockchain, crytpocurrencies, initial coin offerings, investment opportunities, and decentralized organizations.

There's been a lot of talk about Bitcoin, Ether and LiteCoin and other new forms of cryptocurrencies which are now worth close to $200 billion, having more than doubled in the past 6 months. There is no sign of this frenzy letting up anytime soon, with the estimated market capitalisation of all cryptocurrencies projected to go up 10-fold from here, to $20 trillion, yes trillion, by the end of 2020. That is, in a little over the next three years.

But to understand this asset class, one has to understand money.

What Is A Currency?

A currency is a generally accepted form of money in circulation within a nation serving as a medium of exchange for goods and services. Here’s what the Merriam Webster dictionary has to say about something called fiat money:

“Fiat money refers to any currency lacking intrinsic value that is declared legal tender by a government.”

Since every nation has its own currency, with the Euro being an exception, ‘fiat’ currencies have value only since they are the only form in which trade can happen within a country. The ‘tokens’ for these currencies are circulated in the form of coins and banknotes.

If the confidence in that government or that country’s economic activity were to falter… Venezuela is an extreme example of a recent collapse of a fiat currency, Zimbabwe has been a fiat currency basket case for years.

So, what is better than fiat? A currency that is backed by something, such as gold, but all governments have long since decided that it was more convenient to just print more notes (or create more digital money in their central bank accounts) whenever they saw fit. Yes, whenever the politicians saw fit.

So what now? Can cryptocurrency (or crypto, for short) help this situation? Let’s take a short detour to understand the key technology involved in crypto.

What Is Blockchain?

It all starts with accounting and book-keeping.

A ledger is a book of record-keeping for tracking contracts, payments, buy-sell deals or movement of assets or property in an organisation. In a centralised ledger, a single entity controls what transactions are added to the ledger. This means, for instance, that a bank has complete control. For example, it can directly assess a late-fee, a penalty charge, or a transaction fee, or any other charge, and commit this transaction to their ledger. This would transfer money from your account at the bank, into the bank’s, without any power for anyone to stop it.

The scope of this control was highlighted by the Wells Fargo scandal in the United States where it was discovered that the bank had not only created accounts for customers without their permission but was also charging them recurring fees. This had gone on for years before being brought to light.

A blockchain is a decentralised ledger. There is no central administrator or centralised data storage. The ledger is shared across a large network of multiple sites, entities, and people. This means all the participants have a copy of the ledger. Each transaction is validated on the blockchain by solving a complex math problem, and only then is added to ledgers across the network.

So, now we’re ready…

What Is A Cryptocurrency?

A cryptocurrency is an encrypted digital currency that uses a decentralised ledger, called the blockchain, to record and validate transactions.

This eliminates counter-party risks and cost overheads.

What this actually means, is that one gets to avoid the interbank transactions that potentially take days for clearing, even after paying significant transaction fees, in addition to foreign exchange or other fees.

The transactions on the blockchain are processed within minutes, 24/7, even outside the regular banking hours, and all with a negligible wallet transfer fee.

A transfer of funds between two digital wallets is considered as a transaction. That transaction gets submitted to a public ledger and awaits confirmation. When a transaction is made, wallets use an encrypted electronic signature (an encrypted piece of data called a cryptographic signature) to provide a mathematical proof that the transaction is coming from the owner of the wallet. The confirmation process takes a bit of time (ten minutes for Bitcoin as of now) while other nodes in the blockchain confirm transactions and add legal entries into the distributed ledger.

What Is Bitcoin?

So, Bitcoin. This was the first of its kind and took the world by storm. The ingenious creation of a mysterious organisation or person going by the alias Satoshi Nakamoto. Harnessing the power of the blockchain, ‘Nakamoto’ connected the whole world by giving a singular medium of exchange for services. The popularity of Bitcoin and the wide acceptance of the digital currency is reflected in the price it currently trades at. It recently neared $6000, up nearly 30 times this year alone.

Bitcoin outclassed the returns on any asset class by a thousand times. It is gaining popularity as an alternative to mainstream investment options. It is only natural that governments and the big financial institutions are concerned about their lack of control over the currency.

What is Altcoin?

Altcoins are alternative cryptocurrencies, launched after the success of Bitcoin. Even though Bitcoin is leading the virtual currency pack, newer and more innovative ‘Altcoins’ are getting launched that offer advantages over Bitcoin in areas like transaction speed, privacy, proof-of-stake, DNS resolution and more.

A few of them (Ehtereum, Litecoin, Dash, and more) have gained popularity while many others remain unknown. One of the most popular Altcoins, Ethereum, is a platform built specifically for creating smart contracts. These are programmable digitalised contracts entered on the blockchain that legally bind the participating entities and provide greater security than traditional contracts.

The Future Of Cryptocurrency

The fate of Bitcoin and other cryptocurrencies will always be under constant speculation due to the high volatility and lack of regulation at this time. This air of uncertainty around altcoin leads to the manifestation of fear and doubt, which the traded price boldly defies.

A deeper understanding of the wide scope of applications of the blockchain will shape the development of institutions and businesses. Altcoins will also change the face of industries, by creating virtual economies powered by cryptocurrencies.

In subsequent articles, we will explain what Initial Coin Offerings (ICOs) are all about, and how one can invest in cryptocurrencies. An example of this is PressCoin, something the journalism-media industry is keenly interested in.

Amit Rathore is the founding partner of HigherOrderVC, a venture firm focused on applying blockchain and cryptocurrencies to various spheres; and the founder of Quintype, in which Quintillion Media’s co-founder Raghav Bahl is an investor and board-member.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.