Cryptocurrencies are becoming increasingly popular, and more and more people are turning to crypto as payment and investment. However, did you know there are many types of cryptocurrencies, each serving a different purpose?
In this guide, we’ll discuss cryptocurrencies in three parts. First, we’ll explain what they exactly are. Second, we’ll explain how cryptocurrencies are used. And finally, we’ll describe tokens and how they are being used by decentralized applications.
- 1 So what are cryptocurrencies?
- 2 Differences between crypto and fiat
- 3 How does cryptocurrency work?
- 4 How are cryptocurrencies used?
- 5 Where to store cryptocurrencies
- 6 How cryptocurrency tokens work
- 7 Examples of decentralized applications
- 8 How decentralized exchanges (DEX) operate
- 9 How cryptocurrencies work – conclusion
So what are cryptocurrencies?
In other guides, we already learned that cryptocurrencies like Bitcoin and Ethereum exist on blockchains and that, unlike the fiat money we use in our daily lives, they aren’t issued by central banks. Apart from that, they are also transparent and programmable.
There are thousands of different cryptocurrencies nowadays. At a basic level, cryptocurrency is a digital currency that you can use to transact with others. Just like you can use PayPal or Venmo to send money to other people and businesses, you can do the same with cryptocurrencies.
Cryptocurrencies are essentially a combination of cryptography and currency. This is because they rely heavily on cryptography to function. Cryptography is a way to protect information and communications between people or entities by using secret codes. Using secret codes, only those for whom the information is intended can read it.
Cryptocurrencies use advanced cryptography techniques, which have been used in civilian, industrial, government, and military operations going as far back as the 1970s. Although you might not be aware of it, you use cryptography hundreds of times every day without realizing it. It’s in our phones, computers, credit cards, cars, and TVs, for instance.
Differences between crypto and fiat
The fundamental difference between cryptocurrencies and other currencies, like the American dollar, is that they aren’t controlled or issued by a central bank or company. They cannot be printed at will. This is called decentralized. There is no central point of control of cryptocurrencies.
Things that are decentralized are more resistant to shutdown or censorship. Big banks, internet companies, and governments are constantly under attack by hackers and foreign powers. The fact that they are centralized makes them vulnerable and easy to target.
On the other hand, when a system is decentralized, it’s much more robust and difficult to shut down or attack because one would need to attack every network participant at once.
Although earlier projects tentatively existed before, Bitcoin was the first true pioneer in allowing people to transact without needing a trusted intermediary (or, in other words, a middleman). In essence, Bitcoin was the first version of true decentralized digital money.
How does cryptocurrency work?
With cryptocurrencies, thousands of individual computers, called nodes, keep copies of the database (blockchain) and work together to update any changes simultaneously. If one node goes offline, the others continue to operate 24 hours a day, 7 days a week.
Crypto is decentralized and peer-to-peer
All transactions within a cryptocurrency network happen peer-to-peer. This means from person to person or from person to business. Peer-to-peer is a crucial term to remember in this guide, meaning that information or values are exchanged directly between two parties. Once more – there’s no middleman to intermediate transactions.
It is a permissionless system
Another important aspect of cryptocurrencies is that they are permissionless. This means that everyone can use them, interact with them, or participate in securing the network without requiring permission or prior verification from some company or organization. Hence, cryptocurrencies are truly open systems that exist for the good of humanity. You can see them as a sort of public good on a global scale, like city roads or even the internet itself.
To sum it up, cryptocurrencies use cryptography to create a digital currency, which is decentralized, peer-to-peer, always on, and permissionless.
Since the invention of Bitcoin, there has been a massive proliferation of projects which compete or innovate on their original idea. The one thing they have in common is the idea of decentralization.
In previous guides, we already discussed Bitcoin as a sort of decentralized digital gold and that Ethereum is a decentralized world computer. Since the idea of decentralized digital currencies took hold, people have extended the concept to decentralize all sorts of things like social networks, financial markets, and even entire companies and organizations.
How are cryptocurrencies used?
The primary use for cryptocurrency is as money. This is Bitcoin’s vision, and many other cryptocurrency projects have tried to copy it. Litecoin, Zcash, Bitcoin Cash, and Dogecoin are all different copies of Bitcoin, which have slightly different visions and features. Ultimately, their goal is to be used either as a decentralized store of value or as a medium of exchange, similar to cash.
In the cryptocurrency world, these coins are called Altcoins (alternative coins). There are thousands of them, all with varying degrees of seriousness and potential. We recommend doing your research before investing in any cryptocurrency.
What is Ethereum?
Ethereum introduced the notion of programmability and the ability to write programs that run on a decentralized computer. This computer is operated by thousands of nodes that work in sync to run applications built by developers.
The Ether cryptocurrency can be used as money, just like Bitcoin. It can act as a store of value and as a medium of exchange. However, it also acts as a commodity. A commodity is a type of money with intrinsic value, which you can do something with, like gold or wood.
In our second guide, we discussed that Ether is the gas that fuels the world computer. When someone wants to deploy an application on Ethereum or when someone wants to interact with an application hosted on the Ethereum network, they have to pay some Ether gas fees. For this reason, Ether can be seen as a commodity.
One thing is certain on any blockchain platform: cryptocurrencies are paid to miners that secure the network. In our first guide, we discussed how miners receive incentives for validating transactions. On the Bitcoin blockchain, they are paid with Bitcoin. On the Ethereum blockchain, they are paid in Ether. On other blockchains, they will receive payments in other currencies.
Where to store cryptocurrencies
You can send, store, and receive cryptocurrencies in a cryptocurrency wallet. This is an app that you can install on your phone or computer.
Example: Let’s say Alice wants to send Ether to Bob. Bob would then share his Ethereum address with Alice, and she would enter the transaction in her wallet. She specifies how much she wants to send to Bob, confirms the transaction, and hits ‘Send’. In just a few minutes, Bob would see the Ether arrive in his wallet.
That’s it. If you have ever sent money using PayPal or made a wire transfer, you did precisely the same. In a different guide, we’ll dive deeper into how these cryptocurrency wallets work exactly.
Although the way you send and receive cryptocurrencies feels like how you send and receive money using more conventional methods, there are some differences. For instance, with cryptocurrencies, no banks or companies are acting as an intermediary. Additionally, balances and operations are recorded on the blockchain, a shared ledger that cannot be forged.
To wrap it up: you can use a cryptocurrency wallet to send, store, and receive crypto. This crypto sometimes acts as money and sometimes as commodities. In other cases, crypto acts as investment products. Eventually, it all depends on who you ask and how they use them.
How cryptocurrency tokens work
In the last section, we discussed how Ethereum works and how it allows developers to build decentralized applications. People and companies are building decentralized trading services, lending markets, crowdfunding platforms, and even social media platforms nowadays.
All these applications have their own currencies that create a mini economy within these apps. These currencies are called tokens.
Example: Let’s say Instagram had its own currency. Every time you like a post, you would send that person Instacoins that would show up in their Instagram wallet. Whenever you post great content, people will like it and send you Instacoins as well.
This would incentivize people to post great content only, as the more likes they get, the more coins they would receive.
These coins could have other use cases as well. When companies advertise products on Instagram, people could buy them with Instacoins. They could also be used as special stickers for Instagram stories, as well as other things along those lines.
Influencers with millions of followers and lots of Instacoins could organize contests or help fund unknown artists. Advertisers would pay influencers with Instacoins when they feature their products, etc.
Do you get where we’re going at? A micro-economy would exist inside Instagram, and as Instagram grows, more people would be using Instacoins, increasing their value.
This is just one example of how decentralized applications use tokens. However, instead of a centralized company like Instagram issuing coins and deciding how many get created, decentralized applications issue tokens based on transparency and strictly enforced rules.
Examples of decentralized applications
So, what are some examples of decentralized applications and the tokens they’re issuing to their users?
One example is decentralized financial exchanges (DEX). We’re all familiar with the concept of a stock exchange – they list company stocks and are the central place where those assets are traded.
Companies in the crypto ecosystem are building applications that resemble decentralized versions of stock exchanges. Instead of a company running an exchange and executing people’s trades, the blockchain does this and replaces the middleman.
These decentralized exchanges allow people to trade different cryptocurrencies and tokens. For example, you can trade Bitcoin for Ethereum.
Example: Alice wants to trade Bitcoin for Ethereum. To do that, she goes to her favorite decentralized exchange. This site looks a bit like Google Translate; on one side she enters the token she wants to trade, like 1 Bitcoin, and on the other side, she picks the tokens she wants in return, Ethereum in this case.
How decentralized exchanges (DEX) operate
The DEX will tell how much Ether Alice will be getting for that trade based on the current BTC and ETH prices. Let’s say she gets 15 ETH for 1 Bitcoin. Alice agrees with this offer and executes the trade. The DEX will now do its magic, and after a few minutes, Alice will receive her 15 Ether whilst the Bitcoin is removed from her wallet.
The DEX also has a token. Every time Alice trades, she receives a few of these. These tokens work a bit like a loyalty program, but unlike a loyalty program, she can sell them or trade them for different ones. Alice doesn’t have to keep the tokens forever on her account, like airline miles, which can only be used to save on flights.
Added to this, the DEX tokens give Alice a few other perks as well. She can vote on which features get added to the DEX. As Alice uses the DEX often, she loves that she’s able to have a say on how the platform evolves.
She can even use those tokens to be proactive and make proposals to the community about what features she thinks the DEX should have, for instance, new cryptocurrencies or changing the fee structure.
This is called a governance token. Many decentralized apps issue them to users, who then get a say on the product roadmap and financially benefit from the success of the dApp.
Another widespread use of tokens is to represent things in the physician world. For example, a token can represent shares in a holiday property. Those who hold the token can receive dividends when the holiday property generates income.
Because it’s built on a blockchain, dividends are paid automatically and instantly without needing a middleman to initiate the payment. Also, these tokens are just as easy to transfer as any other cryptocurrency. For this reason, they can quickly be sold on the open market.
How cryptocurrencies work – conclusion
Basically, when it comes to cryptocurrency tokens, they are application-specific financial assets that can serve different purposes. When used in a decentralized application, tokens can act as a form of loyalty points, voting rights, or payment methods. However, they can only be used in conjunction with the issuing dApp.
When used to represent something in the real world, like real estate or gold, cryptocurrency tokens act more like a representative currency. In this case, the token just makes it easier for those assets to transact.
Ultimately, whether it’s a blockchain’s native cryptocurrency or a token created inside a decentralized app, they all benefit from decentralized control, permissionless access, and transparency.