Chapter 1

What Is Cryptocurrency?

1. History of Bitcoin & Co.

The early years

In 1993 David Schaum invented DigiCash, the world's first form of digital money in the Netherlands.

DigiCash transactions were unique in that they were anonymous due to several cryptographic protocols. In 1998 Nick Szabo and Wei Dei published their ideas about a purely digital currency -- "bit gold" and "B-money". While both were never officially launched, they were central to the inspiration behind Bitcoin.

Satoshi Nakamoto creates Bitcoin

In October 2008, in the aftermath of the financial crisis, a person (or group of people) under the pseudonym "Satoshi Nakamoto" published a paper titled Bitcoin: A Peer-to-Peer Electronic Cash System. In November, the Bitcoin project was registered at the open-source-projects community SourceForge.net. The first-ever Bitcoin, known as the "genesis block" was mined on January 3rd, 2009. In essence, Satoshi Nakamoto performed the first transaction of 50 BTC to the now hallowed address :1A1zP1eP5QGefi2DMPT fTL5SLmv7DivfNa. Nine days later, on 12th January 2009, Hal Finney, another pioneering cryptographer started running the Bitcoin software. Since the inception of Bitcoin, analysts estimate that Satoshi Nakamoto mined about one million Bitcoins before disappearing in 2011. However, since Nakamoto's disappearance, the estimated $19 billion worth of Bitcoins belonging to Nakamoto ( at the 2017 all-time-high), have never been touched . In fact, to this day, Satoshi Nakamoto's identity remains a mystery.

Fun fact: The first known commercial transaction using Bitcoin took place when a programmer bought two pizzas for 10,000 BTC.

Growth Era

In 2011 Silk Road, an online marketplace operating on the dark web launched, using Bitcoin as its main currency of transaction until it was shut down by the FBI. In 2011 more and more Bitcoin exchanges launched, with Bitcoin reaching parity with the US dollar (1 USD = 1 BTC).

In 2012 the Bitcoin foundation was announced, with the aim to accelerate the growth and reach of Bitcoin. The first Halving Day took place on November 28th, 2012, and the reward per block mined on Bitcoin's blockchain was reduced to 25 BTC. Total Market Capitalization of Bitcoin exceeded USD 1 billion a year later.

Figure 1 - The halving is based on the Bitcoin algorithm to "split" the reward to decrease supply

Additionally, due to the open-source code of Bitcoin, other cryptocurrency developers were able to create alternative coins based on its network. The first Altcoin called "Name Coin" was launched on April 18, 2011. Between 2011 and 2014, the rate of Altcoin launches started to grow exponentially.

Perhaps one of the greatest success stories to come from Bitcoin's open-source nature came in the form of Vitalik Buterin, a Russian-Canadian programmer. In 2013, Buterin invented Ethereum, a platform that runs on its own blockchain and allows the user to create smart cont racts. Ethereum was another milestone for the cryptocurrency market and currently holds the second highest market cap for any crypto behind Bitcoin.

Figure 2 - Smart Contracts Main Features and Added Value
Mt. Gox and Mainstream Adoption

In February 2014, Mt. Gox (handling over 70% of all Bitcoin transactions at the time) was hacked, closed its exchange service and filed for bankruptcy. While the Mt. Gox debacle led to the rise of negative perceptions towards Bitcoin, the first sign of mainstream adoption occurred.

The ICO Hype and Bitcoin's Bullrun

Increasingly, more coins and tokens started to appear in 2017 as the year of the ICO (Initial Coin Offering) hype took place. ICOs enabled developers to create liquidity overnight and for individuals to speculate on hundreds of projects, even before knowing if there was a real usage for a coin or token. The creation of ICOs has led to the rise of fraudulent coin offerings and left thousands of investors out of pocket.

In January 2017, the price of Bitcoin broke the $1,000 mark for the first time since 2014. As the number of businesses accepting Bitcoin continued to increase, lawmakers and financial companies became even more interested in cryptocurrencies. Japan passed a law to accept Bitcoin, and Russia announced the legal use of cryptocurrencies. Trading volumes continued to increase and banks, including Barclays, Citi Bank, Deutsche Bank and BNP Paribas, said they were investigating ways on how they might be able to work with Bitcoin. The CME Group announced the launch of Bitcoin futures in late October 2017.

Bitcoin's greatest all-time-high price occured on December 18, 2017. The price of Bitcoin reached

$19,891 according to Coin Market Cap, with the all-time high Bitcoin market cap hitting $334 billion US dollars.

Figure 3 - Bitcoin All-Time-High in December 18, 2017
What's next?

The bubble began to burst just before Christmas and by the end of January 2018, Bitcoin had fallen from almost $20,000 per coin to a mere $10,000. In 2018 Facebook, Google, and Twitter banned crypto advertisements to protect investors from ICO scams. Furthermore, in October 2018, Coinbase Custody received a New York state banking license. With the new license, financial analysts anticipated even more traditional financial institutions, such as banks and hedge funds, to enter and invest in the cryptocurrency space by the end of 2018.

Governments recognized cryptocurrencies were here to stay and started to join forces to cooperate on establishing regulations.

In 2019, Facebook announced the creation of its cryptocurrency, and payments network called Libra.

Bitcoin prices surpassed $10,000 again for the first time after 15 months in June 2019. In 2020 the 3rd Halving took place, and the reward per block mined on Bitcoin's blockchain was again reduced to 6.25 BTC. The current global coronavirus crisis hit the financial markets in March, leading central banks, and governments to inject trillions of dollars of stimulus packages into the financial system. Ultimately, the unprecedented printing of money leads to inflation, as excessive money supply in the market devalues the value of money, Bitcoin is considered to be a safe-haven asset due to its decentralized nature alongside a fixed inflation rate (1.80%), making Bitcoin the ultimate hedge against inflation .

2. How do Cryptocurrencies work?

To understand how cryptocurrencies work, we have to take a look at Bitcoin first. Bitcoin is the first, and most widely known example of a cryptocurrency: a new form of digital money based on a blockchain protocol.

Cryptocurrencies use advanced cryptographic principles to transfer value in a decentralized network. Unlike other assets, Bitcoin gives its holders complete control over their money -- anywhere and everywhere in the world.

How does Bitcoin work?

One can think about the Bitcoin network as a large public ledger or a computer file that records every transaction in a public list called the blockchain. Every block represents a collection of valid transactions in the network. To create a block, the operations need to be verified by nodes (computers) by checking that the person spending the cryptocurrency has enough funds to complete a transaction. Then, the computers compare the current transactions against the previous transaction history stored in the existing blockchain. If the transaction is valid, it can be added to the block.

Bitcoin is based on a distributor ledger or rather a specific kind of distributed ledger: a blockchain
Figure 4 - Bitcoin ledger is it's blockchain by recording all financial transactions, allowing to have traceability of every movement made from one block to another

Now, the block needs a signature to add it to the blockchain. This signature is known as the block's 'hash'. The unscrambling of the hash symbolizes that a miner has spent computing power to solve a mathematical calculation. Each block of transactions gets different hash's to solve and every miner will work on a different problem that is unique to the block they have built. Hence, one could say that the hash is a block's unique fingerprint. Additionally, the miner who solves the block's hash first receives the block reward of, at present, 6.25 BTC and the transaction costs of all transactions in the block. This activity of solving a complex puzzle by mathematical calculation is known as mining, and this is the way new coins are created in the network. The Bitcoin network is a public distributed network, meaning nobody owns it.

A Bitcoin Transaction

Figure 5 - Step by step of a bitcoin transaction and it's validation process

If you would like to learn more about the details, check out the white paper and explore additional resources in Chapter 9.

As a new user, you can get started with Bitcoin without understanding all the technical details. If you're more interested in where to buy Bitcoin and how to store it check out Chapters 3 and 4.

3. Understanding Bitcoin Properties

Immutability

The first thing that differentiates Bitcoin from fiat money is that once you make a payment, you can't take it back. Immutability brings more trust and integrity to the financial sector, and the data shared every day. The Bitcoin blockchain provides immutable transactions by including meta-data from the previous block in every following block. If anything is changed in a previous block, every following block will recognize it. This immutability solved the double-spending problem (as mentioned above), it increases the security of data exchange or storage, and it simplifies the process of auditing.

Eliminate the Middle Men

Today sending money from one person to another requires a bank, or an intermediary that charges a fee, with a time-lag to process the transaction due to traditional working hours. Companies who control such transactions know (almost) every dollar one spends and how one spends it. Although intermediaries often provide value, there is the fact that, the more intermediaries that are involved in a process, the longer it takes to complete, the more expensive it is, and the more opportunities there are for mistakes or fraud to occur.

The Bitcoin blockchain solves this problem. It decentralizes data, so every participant in the network has the same copy of the transactions, meaning no single entity owns all the data. The blockchain also brings more security to the web with no single point of failure. The operations in the network are controlled by the people using the network, democratizing a system of value and giving power back to the users.

Bank the Unbanked

In the same way the internet allowed people to share information from one side of the world to another, blockchain enables them to share value worldwide without any restrictions or borders. Having a bank account and being able to withdraw and transfer money at any time is one thing that people in developed countries take for granted. However, according to the world bank , there are still an estimated 1.7 billion adults worldwide who don't have a basic bank account.

Provide Transparency

All data on the Bitcoin blockchain is visible to the outside world. This doesn't mean that everybody knows a user's name and account balance. It just means that as soon as a user interacts with one of their addresses (created by your wallet), the addresses will be added to the history of all transactions.

If one were to search for a specific wallet address in Bitcoin Block Explorer, a list detailing all of the transactions in which a given wallet was involved will be made available, and one will get an idea of how much that specific wallet is holding.

The same idea applies to other public blockchains, such as Ethereum. One can browse ether transactions through etherscan. For these reasons, such addresses should only be used once.

Escape Inflation

The Bitcoin code limits the amount of available Bitcoin to 21 million coins. Once Bitcoin reaches that limit, no new Bitcoins will enter the market, becoming the first currency system with a fixed supply. For people who live in countries with hyperinflation, Bitcoin could become the store of value as it already is in some countries today.

Volatility

Although Bitcoin is limited and on its way to become a store of value, it remains an extremely volatile asset due to its speculative nature. The majority of people are using Bitcoin to trade, and not actually to using it in their daily lives. Compared to markets for traditional assets, the market capitalization is still very low. Because cryptocurrencies are still very young technologies, regulations are coming up in different countries, affecting the price. Another factor that can increase volatility in the cryptocurrency market are news sites as with stocks.

4. Types of Cryptocurrencies

Bitcoin

Bitcoin was the first decentralized peer-to-peer currency built on top of the Bitcoin blockchain. Bitcoin was created in 2009 to provide a way to transfer money without a third-party e.g. a bank. The idea behind Bitcoin is to democratize global financial systems by controlling them through open source code and engagement of every participant. Bitcoin is not controlled or owned by any centralized authority. It uses a cryptographic protocol to control the creation and transfer of money. To change the protocol, requires the consensus of the participants on the network.

Ethereum

While Bitcoin has been the landmark of cryptocurrency as a peer to peer electronic cash system, Ethereum has emerged in the last few years as a worthy competitor. Like Bitcoin, Ethereum is a distributed public blockchain network. Ethereum took the technology behind Bitcoin and evolved its capabilities in terms of interacting within the network and its purpose. Most importantly, it allows developers to create decentralized applications (Dapps) on Ethereum's blockchain.

Today's apps run on a computer system which is owned by an organization whereas dapps are applications that run on various computers that are part of a P2P network. Dapps have some common features which makes them unique. They work with a decentralized consensus system, meaning that the users on the platform are free to govern themselves. Because Dapps are based on blockchain, the validators of the network must be incentivized to make it secure. By using an open source code other people can access the code and build on top of it, but no one person "owns" the application. The first known dapp in the crypto community was CryptoKitties, a game where users can buy, collect, and sell unique virtual kitties. While this is more of a funny approach, dapps could replace all kinds of centralized applications in the future.

While bitcoin aims to fix the problems in global finance, Ethereum could eliminate the need for third parties in many systems by using smart contracts. Smart contracts are code, simple "if-then" and "if-then-else" statements. Let's think about Ethereum as a vending machine and let's use buying a house as an example were you would have to go to a lawyer, pay him a fee for legal paperwork and wait until you get the documents.

With smart contracts, you simply drop a coin into the vending machine, and your certificate, driver's license, or insurance drops into your account because there is no need for a third party to review the contract, or check if the participants meet the conditions. Instead, it is all written down by code and only executed if valid.

Figure 6 - An example of how a Smart Contract can work for flight tickets
Altcoins

Since the creation of Bitcoin back in 2009, many alternative cryptocurrencies have entered the market. Today there are more than 6000 cryptocurrencies. Generally speaking, the concept behind altcoins is Bitcoin. Some of them simply copied Bitcoin's blockchain, slightly adjusted some network metrics and sold it as a completely new invention. Others are more innovative and cover real needs in the industry.

A few examples of the most popular altcoins include Ether, Ripple, Tether, Cardano, or EOS. As altcoins evolved, distinct categories emerged due to different use cases.

Privacy coins

Privacy coins include the main feature to protect user privacy and identity while transferring value. Manero is by far the most popular privacy coin in the world. The project makes transactions unlinkable and untraceable using a special kind of signatures and addresses. This hides the identities of both the sender and receiver.

Stable coins

Stable coins are pegged to a specific currency to minimize volatility in crypto markets.

There are asset-backed On-Chain stablecoins backed by cryptocurrencies, asset-backed Off-Chain stablecoins backed by a fiat currency such as USD and even algorithmic stablecoins with the aim to support a falling currency value.

Tokens

While coins are fungible, divisible, and limited in supply, tokens represent anything from a store of value to a set of permissions in the physical, digital, or legal world. Transferring tokens on a public blockchain allows fractional ownership and can release liquidity in markets. It can fuel blockchain-based voting systems or function as security. The most popular token is the ERC-20 token, which runs on the Ethereum platform. The main difference between coins and tokens is that tokens can be built on existing blockchains, while coins are based on their own platform.

There are mainly two subcategories of tokens:

Fungible tokens
  • Fungible tokens mean each unit of a token has the same function and value.

  • Utility tokens provide its users with (future) access to products or services.

  • Security tokens use assets like real estate, stocks, gold, etc. as collateral.

  • Platform tokens support dapps (decentralized apps built on the blockchain)

  • Transactional tokens can be used as units of account to exchange goods and services.

  • Governance tokens create voting systems on blockchain.

In some cases, it is not easy to categorize a token because the classification is not 100% clear - many tokens may qualify as security tokens and utility tokens.

Non-Fungible tokens

All non-fungible tokens exist only once-they work as certificates or digital identities to prove the origin of data. You will receive a receipt that shows your ownership. Colored Coins was one of the first projects to tie unique properties to a digital asset (e.g., stocks, bonds, or real estate). It enabled users to create their virtual assets on top of the Bitcoin blockchain. Bringing this unique valuable data to the internet simplifies transferring value for everyone and reduces costs for third parties.

Figure 7 - Colored Coins-one of the first projects to leverage on the Bitcoin blockchain

Disclaimer: Many altcoins or tokens are not decentralized, created, and controlled by companies for fraudulent purposes. Some even say that 90% of cryptos will fade away and never realize their potential. Do research before investing in any kind of cryptocurrency. In Chapter - 5: Checklist for Investing in Crypto Projects, we discuss some additional critical factors when assessing a token.