I would like to mention that i have no written this guide. I found it on Reddit and it is amazing. I asked the author if i can share it on steemit and he agreed. All steem dollars that this post generates will be going to the original author. I hope you enjoy it, and please don't forget to upvote.
Tony
The Guide
Introduction
This guide is meant to serve as both an easy-to-understand introduction to the world of cryptocurrencies as well as an insightful view into the different projects competing for your investments and market dominance and a look at the underlying technology, history and trends.
For many years Bitcoin would occasionally appear in the media after it spiked in price. I didn’t think there was anything inherently useful about it. I thought it was a novelty, a ponzi scheme, hysteria. It was only after the most recent price spike in another cryptocurrency, Ethereum, that the crazy returns finally tempted me. What started out as a skeptical look into a get-rich-quick scheme led me down a rabbit hole and my mind was promptly blown at the potential of the technology. The hype surrounding it is nothing short of mania, but it’s not without merit. Cryptocurrencies will almost certainly revolutionize everything from insurance, logistics and the stock market to ownership and even create entire economies which don’t currently exist. You may feel skeptical when hearing something so optimistic but when banks, governments and research institutions start to take notice and want to work with these projects maybe it’s time we paid some attention.
Many of you reading may be likening the current craze with the dotcom bubble and I’m afraid I absolutely agree with you. The speculation surrounding cryptocurrencies and the ease of which the average person can invest has created an environment where an idea can raise hundreds of millions of dollars without even a proof of concept. This is part of the reason this guide was written, to steer you clear of these massively overvalued “pet.com” equivalents and towards the future Amazons and Googles.
Chapter 1: An Overview
What Are Cryptocurrencies?
How much of the money supply in the world is digital? Most estimates place it around 90%. That is, 90% of all money in existence doesn’t really exist except for ones and zeros on a bank’s server. Countries used to print money, sometimes with devastating effects like hyperinflation, but now it’s far far easier. Just add a couple of zeros to the end of an entry in your database and voila, you’ve created another trillion dollars. If you’ve been paying attention to the news lately you will have seen countless reports on hacks: from the presidential elections to SONY and HBO. How much longer do you think it will be before your money, the ones and zeros on the bank server, become vulnerable? These were among the first reasons for the creation of Bitcoin. Immune to inflation, immune to hacking, but it doesn’t stop there. Over the past decade the community of developers have started to realize that the scope of what they’re creating is much larger than first meets the eye. If you want to, you can jump straight to Use Cases to see what they are currently being used for and what the future holds.
If you’re looking for a precise definition then cryptocurrencies can be defined as:
A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.
The term cryptocurrencies can be misleading as some of the projects I’ll be discussing in this guide aren’t currencies. Some are assets, some are “platforms”, some are businesses. For the sake of accuracy I will simply refer to them as cryptos
Despite all this talk you will still likely be asking why should you care about any of this. Below I will outline where the true value of cryptos lie.
Why are they important?
The importance of something is derived from how valuable it is. Sometimes this manifests purely from a shared belief such as in the case of gold, but most of the time it’s because something is useful. I’m sure you’ve heard Bitcoin being compared to “Digital Gold” and while the analogy serves as an entry point it is far far more useful than gold.
While many cryptos try and differentiate themselves to address specific problems, most of them share a common set of inherent values: security, transparency (or lack thereof), immutability, global accessibility, speed and price. This is a shared characteristic of almost all cryptos with some caveats.
Security: Centrally controlled assets such as FIAT currencies, bonds, securities and title deeds are all vulnerable to tampering. Either a central bank can change the money supply, a corrupt or incompetent government can change or lose records or records of ownership can be damaged by water and fire, even if they’re stored in digital form. Cryptos are, by their nature, decentralised. Records don’t exist in one location but in hundreds or thousands of servers around the world. In the case of Bitcoin, records can only be compromised if 51% of the computing power of the servers is directing a coordinated attack with the explicit intention of making an alteration. This becomes an economically impossible task given the already huge amount of computing power distributed around the world. The individuals taking part in the system have economic incentives not to tamper with the network (Note that whilst it’s almost impossible to hack the network, the same cannot be said for individual security…)
Transparency: Almost every crypto is open source, ie. Its source code is available for everyone to see. For those who understand the programming the inner workings are completely transparent. It is possible then to trust the system without needing to trust any one person as code only obeys logic. Furthermore, with the use of “explorers” it is possible for anyone to see every transaction that has ever been executed since the crypto’s creation. Some cryptos differentiate themselves by doing the opposite and making it impossible (or so they claim) for anybody to trace your transactions.
Immutability: Given the previous two points, it is not only nigh on impossible to change the transaction history, but fully verifiable, allowing for complete confidence that said transactions have taken place without the need to place faith in a third party. These records can never be changed bar a complete collapse of the ecosystem.
Global accessibility: Geography is irrelevant when it comes to sending and receiving cryptos. As long as you have access to the internet the cost and speed of transaction is the same for somebody with an optic fiber connection in London as it is for someone with a mobile connection in Ethiopia.
Speed and price Bank transfers typically take 3-5 business days and offer poor exchange rates between currencies. Cryptos solve this with transaction times ranging from instantaneous to 1 hour depending on the crypto being used. Furthermore there is no need to change currency so the amount sent will be the amount received minus a (usually) small or zero transaction fee.
So what?
Hopefully you will start to see the implications of these common characteristics. With these transactions there is no need to put your trust in a potentially corrupt or inefficient third party. From a purely financial perspective it not only allows you to conduct “trustless” deals across the globe and lower any associated fees but opens up new markets which previously suffered from institutional corruption, unstable currencies and poor business practices.
This is only the beginning, new cryptos are appearing on the scene with vastly improved capabilities: automatically settle futures trading, automate supply lines and allow machines to purchase products and services from each other as the need arises. This may sound outlandish but keep reading.
Chapter 2: How it all works
Consensus and the blockchain.
In this chapter I will try and explain how cryptos work (at least in their basic form) in an easily understandably way. If you’re not interested you can skip this part and go directly to Smart Contracts although I’d recommend at least having a basic understanding of what you’re investing in.
As mentioned in Chapter 1, two of the defining characteristics of cryptos are their security and immutability. But how do they achieve that? Centralized organisations spend large amounts of money on maintaining their security. Despite this, not only are they still vulnerable from outside forces, but they are especially vulnerable to inside forces. If someone has the right keys they can abuse their power for their own benefit. It isn’t comforting to think that all that’s preventing this is a moral conscience or a fear of being caught. With cryptos this becomes irrelevant as nobody has all the keys. Instead, individuals numbering from the hundreds to the thousands collectively own the keys and are not only rewarded for obeying the rules, but penalized for attempting to break them. Let’s look at how this works with an analogy.
Imagine a simple bank where people can deposit their money for safekeeping. The bank writes down all the transactions in a ledger so as to keep track of everything. Unfortunately, a clever thief breaks into the bank’s office and makes some changes to the ledger so that when they go to withdraw their money the next day the somehow have more than they deposited. The bank checks his ledger and everything seems in order.
Now imagine a second situation where we have a bank with 11 different branches. None of the branches trust each other so they come up with a system. Each one decides not only to keep a record of their own transactions but sends a representative to every other branch to independently write down every transaction their colleagues make. This way if there’s a dispute the branches can compare their ledgers and decide by majority which one is correct. But there’s still a problem: when the representatives are on their way between the branches to compare ledgers they are attacked by the thieves and the ledgers of more than 6 branches are changed. So they add an additional step: at the end of every page of the ledger the banks will put all the values of the transactions from that page into a complex equation and write down what they get in a document for safekeeping. At the end of the next page they will add up all the values again but also use their answer from the previous page. How does this help anything other than making things more complicated?
Now when a band of thieves attack the representatives they not only have to change the entries but make sure that the changes they make still give the same answer when they’re put into the complex equation. This takes the thieves a long time, several weeks in fact. Long before that point the bank realizes something is wrong and take out one of the many copies of the ledger.
There is actually one more thing which makes the system even safer. To stop the bank from colluding against their customers the branches are offered a reward everytime they agree with the majority of the other banks, if they are in the minority they are fined. It turns out to be much more beneficial for the branches to play by the rules than try to break them.
In the next section we will see how this analogy relates to “the blockchain” (the system of ledgers) and the differences between consensus methods.
Below is a very good instructional video from Ivan on Tech explaining this in a slightly different context. This problem is commonly known as “The Byzantine Generals Problem”. His channel is a very informative and objective look at cryptos for those of you who understand the basics.
See Ivan’s channel for more insightful videos. Personally, I also like Box Mining
Different consensus methods
In the previous example we saw that there were competing branches. The “nodes” or “bookkeepers” in cryptos can be thought of as these competing branches. Every time they fill out a page in their ledgers they cross reference it with everyone else’s ledgers. The “blocks” in the blockchain can be thought of as the pages. Finally the complex equation they have to solve with the value of the transactions on the page is called hashing and is much harder to do in reverse (as the thieves were attempting). So what is the benefit of being a “node”? Well every transaction that’s carried out pays a fee to the nodes for processing it and ensuring their security. The fines we talked about in the bank analogy depend on the consensus method, of which there are many types. I will discuss the most important/popular ones below:
(In depth analysis of each is in the works for the more technical minded)
Proof of Work (PoW)
Proof of work was the first method of ensuring consensus and the most widely used. In order to finish a page or “block” a node has to figure out a really complex math equation. The only purpose of this math equation is to make sure the node works really hard and uses a lot of electricity. In return the node is awarded some currency for figuring it out, known as a “block reward” plus the transaction fees. This is known as “Mining”. The nodes in PoW are known as “Miners” and there is potentially a lot of money to be earned by being a miner. For more details on mining CLICK HERE(Coming Soon). If a miner gets a different answer to the other miners their answer will be rejected. The miners don’t want to waste money on electricity for nothing so they are incentivized not to lie. In this way the only method of cheating the system is by controlling 51% of the ledgers, or more correctly, 51% of the computing power. Given the amount of capital investment required it doesn’t make economic sense to attempt this.
The more computing power a node has the more likely they are to guess the answer to the equation first before the other nodes and net themselves the block reward. It is common for many users to pool together their resources into a conglomerate known as a “mining pool” in order to have a more consistent income.
The “Block difficulty” is how difficult the math equation is to solve. If blocks are taking too long to solve then the difficulty is reduced, it they are being solved too quickly then the difficulty is increased. Block timing determines how often a new page of the ledger is used. So if the size of the pages remain the same and you have a lot of transactions, a lower block time can help deal with that. However there are technical security risks with having lower block times if there aren’t enough transactions.
Pros:
It is highly capital intensive and therefore requires a node to be highly invested in the currency it’s mining, providing a disincentive to cheating.
There are economic incentives for mining leading to large number of nodes and computing power. The larger the number of nodes and computing power the more secure the network.
Cons:
Uses a lot of energy. One transaction requires the same amount of energy as a household for an entire day.
longer confirmation times than other methods
Low transactions per second capacity (around 7 Tx/s for Bitcoin)
Computing power tends to centralize in parts of the world where electricity is cheap
Cryptos that use PoW:
Bitcoin
Litecoin
Bitcoin Cash
TL;DR PoW uses the cost of electricity as a way of penalizing nodes trying to cheat the system.
Proof of Stake (PoS)
In proof of stake there is no mining. Instead one node will be chosen and simply process the transactions without needing to solve any complex math puzzle. The other nodes will verify the block. In order to penalize any attempts at cheating the nodes must lock some of their currency in a virtual safe and this stake will be forfeited if any funny business is detected(This system is called Staking and can be thought of as similar to mining for PoW but without the large electricity bills). The more currency you stake the more likely it is you will be chosen to create the next block, therefore the more you have to lose if you try and cheat.
Pros:
Faster confirmation times
More transactions per second (Tx/s)
Cons:
There are still questions about the security of PoS and how Game Theory applies to the nodes
Cryptos that use PoS
Peercoin
NXT
Ethereum will move to PoS soon
TL;DR PoS takes your currency if you try and cheat the system
Proof of Importance (PoI)
Users must stake a fixed amount of their currency to become a node. The likelihood of their node being chosen to create a block (and claim the fees) depends on their “Importance Score” which is determined by how much you use the network. Sending large amounts of currency frequently will keep your importance score high.
Pros:
Encourages use as a currency
Rewards users who are actively engaged in the currency
Seemingly very secure and efficient
Very scalable
Cons:
Complicated criteria for establishing Importance score may scare new investors
Cryptos that use PoI
NEM
TL;DR PoI rewards you for sending lots of transactions
Delegated Byzantine Fault Tolerance (dBFT)
The delegated part of this consensus method refers to the nodes being elected by the shareholders. In order to be up for election a node must stake some of their crypto and in this sense it is similar to PoS. However, nodes aren’t weighted by the amount they stake, instead every node has equal weighting. A minimum amount must be staked for every node you wish to control. It becomes increasingly expensive to control more nodes and increasingly unlikely any one of those will be voted in. Shareholders will likely vote in nodes that charge the lowest transaction fees as this promotes usage of the network. Low transaction fees reduce economic incentive to becoming nodes preventing attackers from being rewarded for attempting to set up a node monopoly. There is no mining in this method, transaction fees are paid to the nodes.
Pros:
Fast confirmation times
Very high transactions per second capacity (in the 1000s Tx/s)
The blockchain will shut itself down before it allows a fork meaning a focus on consistency as opposed to liveness which is important when trading assets
Low transaction fees (currently free)
Cons:
As of yet untested at a large scale
Cryptos that use dBFT
NEO
TL;DR dBFT allows users to elect nodes who have staked a minimum amount. Each node has equal say. Keeps transaction fees low.
Delegated Proof of Stake (dPoS)
Delegated proof of stake has two types of nodes: Witnesses, those that confirm the transactions and are paid fees, and Delegates who make decisions about the transaction fees, block times and size amongst other things. Both of these node types are elected by majority vote.
Pros:
The Witnesses and the Delegates are elected separately potentially solving conflicts of interest
Adaptable. The parameters of the blockchain can be changed quickly depending on the needs of the users
Cons:
Difficult to have a high participation rate in the voting process when users must remain constantly informed on the blockchain and the behaviors of their witnesses and delegates.
Frequent parameter changes may turn away users looking for stability.
Cryptos that use dPoS
BitShares
TL;DR dPoS allows users to elect Witnesses who process transactions and Delegates who decide on the rules
Tangle
This consensus method deserves a category of its own and isn’t even technically a blockchain. The tangle network relies on every user acting as a node. Before a transaction can be confirmed the user must validate two or more previous transactions. After you have done this another user will validate your transaction in order to make a transaction of their own. In this way rather than a chain of blocks we have a net of transactions. This allows for free instantaneous transactions and scales extremely well. However there are still questions about security and so “oracles” are needed to serve as a kind of supernode and police the system.
tangle
Pros:
Immediate transactions
Free transactions (No fees)
Allows for very small micropayments ($0.0001 if the user wants)
Designed to operate on systems with very low capacities (eliminates the need to have a lot of computational power on every device)
Cons:
Seemingly less secure than the other consensus methods
Currently uses a “Coordinator” which can be thought of as training wheels until the network is large enough to run without it. There is uncertainty as to how the network will behave without it once it’s removed.
Cryptos that use Tangle
IOTA
TL;DR Tangle allows instantaneous free transactions by making everyone a node at the cost of security
Smart Contracts
The next advancement in blockchain is heralded to be Smart Contracts and the use of Dapps. You might have heard these buzzwords before but what do they actually mean?
In a normal contract you have two or more parties agreeing to some terms. If I do this, you will do this. If you fail to do this then the transaction will be cancelled etc. These contracts are legally binding so if any party breaks the terms they can be taken to court to be prosecuted.
Smart contracts make this whole process a lot easier. Instead of the terms being legally binding they are bound by the blockchain, meaning that once the contract has been signed by all the parties the terms will be carried through no matter what.
Dapps
Dapps stand for Decentralized Apps. These work in conjunction with smart contracts by automating the job of middlemen, such as a broker.
For example, let’s say you want to carry out an options contract. Usually the process involves having a broker match your ask with someone else’s bid and once the time arrives making sure that the agreement is honored. With the use of a Dapp the matching can be done by the blockchain itself without any need for a broker. The Smart contract deals with actually enforcing the terms. Once you click buy everything is automated without the need to trust a third party or any administrative costs.
This is just one application. More and more startups are being created around the huge number of possibilities surrounding this technology, from crowdfunded science to advertisers paying the content creators directly and even the consumers for not blocking their advertisements.
Digital Assets
This is where things get really exciting. Smart Contracts and Dapps by themselves are limited to dealing with the digital realm, ones and zeros. Some projects are attempting to bridge the gap between the digital and the physical realm by taking things such as commodities, title deeds and products and putting them on the blockchain, assigning them a digital certificate which is legally binding. Let’s look at an example.
Currently buying a house requires lawyers and is a painful and lengthy process. By issuing legally binding digital title deeds and implementing Smart contracts it will be possible to buy a house as easily as you can order an Uber. This also opens up the possibilities of partial ownership of real estate, art, cars, ip etc. in a very intuitive and liquid way.
Chapter 3: Use Cases
Now that we have looked at what cryptos are, what their underlying value is and how they work let’s discuss perhaps the most important part: What they can be used for.
Storage of Value
This is the most commonly associated use of Bitcoin. Many media outlets have referred to Bitcoin as “digital gold” and most of the hedge fund analyses I have seen rely on this concept for their valuations.
The idea is that because Bitcoin has a finite supply, just under 21,000,000 BTC, the value will go up as demand increases. Actually, the circulating supply of BTC is falling as people lose their private keys or BTC is “burnt”. However, these analyses are oversimplified.
Currency
Without getting too philosophical, every currency in existence is a social construct and entirely dependent on people’s faith in the federal reserve, a country’s economy or the simple belief that they and others perceive it to have value. On this front Bitcoin and other cryptos are no different to FIAT currencies except that they are the first truly global currency and therefore not dependent on any one country’s money supply or economic health. Whilst most cryptocurrencies are either very volatile or tethered to a FIAT currency (See TetherUSD) it is foreseeable that this volatility decreases as the market cap increases as the trading volume would be unlikely to increase proportionally if a large part is being used as a currency. This creates a feedback loop where less volatility creates a more viable currency, more people use it as a currency which further decreases volatility.
Crowdfunding Platform
This is the most recent actual implementation of cryptos. If you have been paying any attention to the crypto space at all the past few months you will have heard the term ICO (Initial Coin Offering) being thrown around a lot. Whilst there are many legitimate ICOs which offer fair compensation to their investors and have a real chance of disrupting industries and huge ROI there are many more which mislead, overpromise and some which are simply pyramid schemes or rebranded Bitcoin clones with no real value. The attraction of running an ICO is easy and cheap access to crowdfunding but is not regulated and so the importance of doing due diligence cannot be understated.
For a further look into what constitutes a good investment and what red flags you need to watch out for See Here
Decentralised Services
Now come the really interesting use cases and where the future of cryptos lie, in my opinion. In much the same way AirBnb disrupted the accommodation industry by decentralising the industry away from a a small number of hotels and bnbs to a large number of individuals, blockchain looks to decentralise everything else. From leveraging spare computing power (See Golem) and hard drive space (See SiaCoin, Factom and NEO) to crowdsourcing I.P. addresses for VPNs (A very topical issue given the talks on Net neutrality and the Great Firewall of China, See Mysterium) and advertising (See BAT). The blockchain looks at simultaneously increasing security and productivity, reducing risk of monopoly, reducing costs and lowering or eliminating barriers to entry.
Internet of Value
You may assume that the industries that are up for disruption are online services but cryptos are now looking at bridging the gap between the physical and digital realm as discussed in the Dapps section. If they can pull this off then we will see them take over every aspect of our lives. If it becomes common practice to issue legally binding certificates of ownership of physical goods we can improve liquidity across all asset classes, vastly reduce legal disputes and costs, improve supply chain and logistics management, integrate systems across sectors and countries, allow partial ownership of previously indivisible assets, obtain and analyse Big Data on a scale not seen before and that is only the beginning (See NEO and Stratis)
Machine Economy
IOTA’s unique selling point is the creation of a machine economy where autonomous machines can trade with each other. This idea may seem crazy but I’ll give you an example to illustrate what I mean:
Let’s imagine we have an electric self driving car being rented out for trips via Uber. The car parks itself in a parking lot as it waits for its next user. It communicates with the parking lot which charges it in IOTA for each minute it remains in the car park. When the car starts to run out of battery it can communicate with a local charging station, hook itself up automatically and get charged in IOTA for each Wh. Later on it is broken into by some thugs, it sends out a message to a local security drone to follow the thugs and record their faces and location. It pays the drone in IOTA. It arrives at an automated mechanic which replaces the damaged window. The insurance company is also on the blockchain. The footage from the security drone and the invoice from the automated mechanic are automatically sent to the insurance company and compensation is paid in IOTA. The automated mechanic notes its stock of window panes is running low and contracts a drone for delivery, it pays this in IOTA. This is all done without any human intervention.
This may all sounds like science fiction but the greatest businessmen and minds in the world are all convinced that robotics and AI will usher in a new industrial revolution. The missing piece for this automation to become truly ubiquitous is transactional.