Guide: Cryptocurrency 101

Summary 

Essentially, cryptocurrency is a technology used to enhance the security, efficiency and productivity of various areas of finance, ranging from international monetary transfers; to micro-payments; to issuing, holding and transferring securities or other assets. The technology is seen as being the ‘internet for finance’.

A key difference is that, unlike the internet, people are able to invest in this technology, and many do so on the basis of the potential future value if/when the technology is applied to its intended purpose. Largely for this reason, the technology is also widely held as a speculative commodity-type investment.

 

Bitcoin history and background 
Bitcoin is the first major ‘modern’ cryptocurrency. It was created in late 2009 under the pseudonym ‘Satoshi Nakamoto’ – the creator’s real identity is not known. The first reported bitcoin transaction used 10,000 bitcoin to buy 2 pizzas. It value has grown exponentially since then, and has exceeded US20,000 per bitcoin, with a market cap of around USD330 billion. Bitcoin’s key uses include as a commodity-type investment; as an alternative currency; and as a technological platform for improving the efficiency and security of financial centres and transactions.

Since bitcoin, a range of competing cryptocurrencies have arisen, which try to provide an improved take on the foundational bitcoin software. This includes adapting it so that it is better-able to perform certain tasks and thus, better suited to certain specific applications. Bitcoin was established following the Global Financial Crisis, and its success is supposedly a partial reaction to the lack of trust in financial institutions caused by the global recession. The decentralised nature of bitcoin is what allows bitcoin to act independently from governments and central banks, with no single person in control.

Unlike traditional ‘fiat’ currency which can be issued or cancelled by central governments (subject to their particular constitutions and laws) Bitcoin has a limited supply and the underlying software that governs its creation and operation cannot be changed (at least not without consensus or a ‘hard fork’).

Bitcoin’s Operation
Peer to Peer Technology
Essentially, peer to peer technology involves the sharing and storage of data on various computers connected to a particular network, rather than on a single centralised server, database or computer. This also means that the network itself exists by virtue of computers connecting to it and sharing data across it, rather than relying on a single computer to be connected and available (unlike say websites hosted from a single server).

Peer to peer technology has been around for some time, as was made famous (or infamous) through copyright infringements that were enabled by file-sharing technologies like napster and frostwire/limewire. These technologies were so successfully applied to copyright infringement because it is difficult to close down the entire peer-to-peer network — in simple terms, each individual computer/server would need to be closed down to fully do so.

The Blockchain
Bitcoin uses peer to peer technology to create a decentralised ledger of ownership of all bitcoins, known as the blockchain. This technological development is key to the cryptocurrency ‘revolution’, as it provides a ‘trustless transfer technology’. Because ownership records are stored on all users’ computers, bitcoin owners do not have to trust a specific or identified person or entity to hold their bitcoin.

As no single person or entity is responsible for bitcoin’s security, and no single computer is vulnerable to hacking (unlike the computers of major financial institutions). In other words, all computers on the bitcoin network record who owns each bitcoin, so ‘stealing’ someone’s bitcoin would effectively require hacking every computer on the network (or at least the vast majority of then) and altering their respective data records of ownership. Various entities (like stock exchanges and banks) have expressed a significant interest in this system.

Bitcoin Transactions
Bitcoin transactions are validated using cryptographic principles, whereby computers verify the ‘keys’ used by transacting parties (a little like a sophisticated version of unique passwords). This process is called ‘mining’ and the first computer to validated a pending transaction is rewarded through payment of a small amount of bitcoin.

 

What are Altcoins?
The blockchain concept has been widely adopted by other cryptocurrencies (also known as “Altcoins”), and major financial institutions and government have also explored adopting it. There are around a thousand altcoins, and more are created every week. Most other cryptocurrencies build on bitcoin’s foundation with various additions or alterations to the software to make it more efficiency (e.g. litecoin [link]) or use the blockchain technology as a basis for a more extensive software and potential uses (e.g. ethereum).

Altcoins have grown exponentially. Most major cryptocurrencies have increased in value by between 10x and 100x in less than a year, as the cryptocurrency market grew from around 15 billion to almost 180 billion. Many have increased far more than that, with increases of 250x in a few months not uncommon. One altcoin saw growth of 25,000% in 1 day (though with fairly low volume).

Ethereum
So far, the most significant and successful rival to bitcoin has been ethereum. This adopts the bitcoin technology to create its own ledger with increased potential uses, chief of which is the introduction of ‘smart contracts’. Through smart contracts, parties can enter into an agreement with set ‘contract-like’ criteria. When those criteria are met, the ether/ethereum tokens (money-like tokens akin to bitcoins) will automatically be transferred to the account of the relevant party in accordance with the criteria set. This is seen as being a key — cheaper and more direct — alternative to using escrow accounts or trusts during transactions, but the potential uses are far more significant.

 

Initial Coin Offerings (ICOs)
In essence, ICOs a method of capital raising a little like Initial Public Offerings in which cryptocurrency tokens are sold instead of conventional securities. The legal characterisation of ICO tokens is a particular focus of regulators currently, as strict rules govern the issue and sale of securities (particularly to retail investors), but it may be that these rules do not apply if the ICO tokens escape the definition of securities in the relevant regulatory frameworks.

Context
The bitcoin and ethereum and blockchains are set up such that it is relatively easy for other software developers to adopt and alter the existing blockchain software in order to create their own cryptocurrency. This is partly why so many new Altcoins have come into existence, as its fairly easy to create a separate cryptocurrency platform with its own cryptocurrency ‘money’ or ‘tokens’. Some of these cryptocurrencies are legitimate attempts to create a bona fide rival to bitcoin and ethereum, with carefully thought-out and potentially useful technologies — for instance, improving the efficacy of online advertising in social media platforms (see Status). Others are not, and many are somewhere in between. One interestingly-illustrated cryptocurrency existed for the sole purpose of providing tips to strippers without detection on banking records.

Process
In essence, when a developer or team have an idea for a way to improve or introduce a revolutionary new cryptocurrency, they can introduce some of the underlying technology by relying on the existing blockchains. They can then gradually develop, hone and improve this software.

This means that the Altcoin tokens can exist long before the software is fully developed. ICOs are a way of that development team funding the required development, marketing etc. of their project through ‘pre-sales’ of those tokens. These tokens are essentially like the ‘bitcoin’ or ethereum token, but exist on a separate blockchain run using the new software.

Essentially, ICOs involve promoting a nascent project as one might to private-equity / venture capital firms, only this is done to the broader market. However, recent crackdowns by the SEC and strict regulatory controls on issuing securities and selling them to retail investors in a conventional way mean that the compliance burden of issuing shares to investors can often be too high for small start-up projects.

The terms of the tokens are usually structured so that they do not appear to constitute securities, as they do not confer rights in relation to the issuing entity or project. In a general sense, many ICOs thereby use a model that is broadly like crowdfunding, but in which people get voucher-like tokens which can be used as payment for services within the technology platform. In the short to medium term, most retain the tokens on the assumption that they will be worth more when the underlying technology platform is successfully developed. As the cryptocurrency industry is itself fairly untested and unproven, investors appetite for this is strong.

Token Sales
Most ICOs sell their tokens in exchange for bitcoin or ethereum. Most have a target pre-sale figure of tokens they intend to issue. Once they have sold the desired amount of tokens and received the target amount of bitcoin/ethereum as payment, the ICO closes (like an IPO).

As the tokens are usually sold at quite a low price with the aim of increasing the price dramatically when the tokens are added to cryptocurrency exchange markets, most token sales receive a significant amount of capital. Some have received over USD100 million. The space is largely unregulated or at most is somewhat ‘under-regulated’, at least in the sense that existing rules do not apply properly to ICOs which can result in unintended or imperfect outcomes. Because of the level of interest, there are lots of ‘scam’ ICOs with no technological potential or intention to carry out the project — instead people just want to issue a token with no long term potential and sell that token in exchange for bitcoin/ethereum. This has attracted particular regulatory attention.

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