A cryptocurrency is a digital asset with some value associated with it. Digital assets are stored in a blockchain, built on distributed ledger technology. The blockchain uses cryptography to secure transactions and ownership records.
Cryptocurrency is for the real big first use case with blockchain. They were designed to solve some of the problems with a traditional currency like cash and credit-based systems that we’re familiar with.
Let’s take a look into these economic systems now and start building more of an understanding of how cryptocurrencies differ. Traditional currency like cash is referred to as fiat money. Fiat money is a government-issued currency that isn’t backed by commodities such as gold.
Fiat money gives banks control over the economy because they can control how much money is printed. One problem with fiat money is that governments can print too much of it, which results in hyperinflation. On the other hand, cash allows anonymity and fast offline processing, which are a really nice benefit, and you could only spend how much cash currency that you have.
With fiat money, there are three questions that you have to ask; how is it dispensed? How do we give it a value? How do we use it? These are the same three questions that we have to ask with any economic system. Alternatives to cash-based systems are credit-based systems.
Credit involves risk, but no resource allocation problems. Credit cards have high transaction fees, and you have to provide your details to each vendor unless you use an intermediary like PayPal that you can use with various merchants.
This keeps you from dealing with the merchant directly and requires everyone to have a centralized account, but also ties your purchases directly to your identity.
With credit, you can potentially spend more money than you have or able to pay back. This is why in credit-based systems, the person assigning credit takes the risk that they might not be paid back.
However, we can still ask the same three questions about how credit is dispensed; how it is assigned a value, and how we use it. Cash has a resource allocation problem but allows us to be precise. Credit involves risk but doesn’t require allocation.
We generally engage in a blended model where people typically use both cash and credit. Cryptocurrencies are an attempt at solving several of the problems of cash and credit with the use of digital assets.
We have seen an explosion of cryptocurrencies over the past decade since Bitcoin was introduced, and we will continue to see more cases of blockchain technologies and cryptocurrencies for a long time to come.
We still need to address some problems of scarcity and resource allocation with this currency, and how it gets built into the blockchain. We can ask the same questions about how to give it a value and how to distribute it.
With cryptocurrency, we need an ecosystem that allows participants who do not trust each other to come to a consensus about the current and accurate state of the blockchain. Different platforms handle this differently, but common solutions are proof-of-work and proof of stake, which we’ll discuss later on.
For a cryptocurrency to be successful, three things need to happen. First, people must believe that the coins are valuable and likely to hold their value. Then they must agree on what the rules are and how to enforce and verify them.
Third, they must be able to verify the state of the blockchain from the beginning of its operation of time, to guarantee that no one is changing the rules. This is why there have been hundreds of cryptocurrencies, but only a handful that really stands out.
Because there is consensus about the rules, value, and history. Now, that I’ve discussed the evolution of digital assets or cryptocurrencies, let me get into describing the two most popular cryptocurrencies around. Those are Bitcoin and Ethereum.
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