Basics of Cryptocurrency

Understanding Fiat Money

Rising demand for products due to either an increase in demand (for example, alcohol for sanitizers during the COVID-19 pandemic) or supply shortages (for example, edible oils due to the Russia-Ukraine conflict, Russia being a major supplier), can cause prices to rise. This leads to a phenomena called inflation. Fiat currency is an inflationary asset and current inflation levels are at 8% per year. Imagine you visit a Pizza parlor in New York. A pizza listed for $20 today would cost $21.60 one year later. Compound this effect over a decade and the price of that exact same pizza increases to $36. In other words, your $36 today is worth only $20 a decade later.

You are losing money every single day.

Furthermore, government entities are responsible for printing money. For example, the U.S. Treasury prints paper currency and mints the coins we see in circulation today. Thus, these government entities are able to act at will to support their own national or geopolitical interests and the people of the country or the rest of the world have no say in how they function. In other words, Fiat money is centralized and the vast majority of the holders exercise no power and have little transparency about its deeper functioning. Therefore, two central takeaways from this section are as follows:

1) Fiat Money is Inflationary
2) Fiat Money is Centralized

This offers a brief insight into how our Fiat system functions and sheds light on some of its limitations. This background was essential towards understanding why we are in dire need of a more reliable, secure and distributed network of transactions and how Cryptocurrency might just be the answer.

The Blockchain

Bitcoin is a Cryptocurrency token, based on the blockchain technology that validates each transaction. A Cryptocurrency Token is synonymous to Money. It can be sent or received and traded for goods or services just like fiat currency.

Going back to our Pizza parlor, you order a Pizza worth $20 but give a AED 20 ($6) note to the cashier. The cashier is able to visually inspect the currency note and declines. The Blockchain can be thought of as a giant Pool of Computers which authenticates each transaction. This video gives an excellent visual representation of the fundamentals behind blockchain technology.

Deflationary

One fundamental idea behind the world's first and most popular Cryptocurrency, Bitcoin, was to make it deflationary. Unlike Fiat currency, which has no fixed supply and is minted by the government, Bitcoin has a fixed supply of 21 million coins and is minted or mined by the people. There will never exist more than 21 million coins, over 19 million of which are already in circulation today. Thus, purchasing power of Bitcoin increases over time due to its limited supply and rising institutional and countrywide adoption.

Decentralized

Anyone can mine Bitcoin. It relies on the Proof-Of-Work (PoW) algorithm, has no central governing body and anyone with decent hardware can mint Bitcoin and get paid in Bitcoin for the same. Miners use their machine power to solve complex mathematical problems to mine each block and a part of the block reward is given to the miner based on their contribution towards solving the problem. The total block reward for Bitcoin halves after every 210,000 blocks mined, which is roughly every 4 years and last block is estimated to be mined in 2140. Today, there exist over 17,000 Cryptocurrencies and many of them rely on different algorithms such as PoS, PoH and others but discussing the various algorithms is beyond the scope of this article.

Furthermore, Bitcoin has peer-to-peer (P2P) functionality which elimates the middle-man such as banks or the government and gives users complete access and freedom to transfer, deposit or withdraw their funds as they please. This freedom and security is not offered with traditional currency as your funds can be frozen or transactions can be halted by the banks or the government and you are not fully in control of your money.

The Ugly Side

Cryptocurrency is far from perfect. The world's first Cryptocurrency, Bitcoin, has seen a 3.25m percentage increase in price from launch to it's peak. That is a 3,250,000% growth in 10 years and no other asset on this planet comes even close. However, it can turn ugly very quickly. At the time of writing, the top 3 cryptocurrencies have on average lost 70% of their value in 6 months' time. Thus, the cryptocurrency market can definitely not be treated as an inflation hedge. With inflation, you lose 8% a year whereas you've lost 70% in 6 months with cryptocurrencies had you purchased at the All Time High (ATH).

While the network itself is extremely secure, the users can be gullible. Falling for phishing scams, having unsecure systems or wallets and sending their assets to the wrong wallet are some very common occurences. Users who are not very tech-savvy can have difficulty navigating the space and securing their assets, and losing their assets can make them wary of the crypto world.

Cryptocurrencies are also subject to pump-and-dump schemes, wherein institutions or wealthy investors, known as whales, purchase large quantities of an asset which causes the price to rise and creates a positive sentiment in the market. More buyers hop in and when the price reaches a certain level the whales dump their assets and take profits while the price tumbles. It was reported very recently that billionaire Elon Musk has been sued for $258b for running a pyramid scheme to promote a cryptocurrency, Dogecoin, which offers no intrinsic value of its own and is refered to as a "meme-coin". Last month, the LUNA token, which took great pride in being a stable asset, lost 99% of it's value in just 36 hours, wiping fortunes.

Conclusion

Personally, I believe we are still very early and a significant number of retail investors do not possess the background to comprehend the technology behind cryptocurrencies. We must find ways to spread awareness, eliminate traders and pump-and-dump schemes and gain more knowledge about the fundamentals of cryptocurrencies. It must not be seen as a get-rich-quick scheme, but a long term investment meant to fight the traditional currency system and gain total control of our money. We must eliminate the need for banks, governments and recognize the power of peer-to-peer (P2P) networks. The world was skeptical of the internet for years after it launched and the skepticism was a result of insufficient knowledge about it's core fundamentals and the discomfort of venturing into the unknown. Knowledge breeds familiarity and familiarity drives innovation.

“It must be considered that there is nothing more difficult to carry out, nor more doubtful of success, nor more dangerous to handle, than to initiate a new order of things.”

― Niccolo Machiavelli