Cryptocurrency Basics

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This page explains cryptocurrency basics such as type and consensus algorithm to foster understanding.

Definitions

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Cryptocurrencies are virtual assets based on a blockchain that is distributed over a peer-to-peer network to record transactions and ownership without an intermediary secured by cryptography, hence the name (own definition).

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A blockchain is a growing list of transaction records called blocks, linked and secured through cryptography, each containing a timestamp, transaction data, and the previous block's hash (Narayanan et al., 2016; Nofer et al., 2017).

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Hileman and Rauchs (2017) characterize cryptocurrency payments as general payments denominated in cryptocurrency. Payments with cryptocurrency can occur online, for example, on overstock.com, or in the real world, like at the Bitcoin Rock Cafe in Spain, where customers can pay in up to 2000 different cryptocurrencies.

Types

Cryptocurrencies can be classified into either coins or tokens. Furthermore, it is also possible to distinguish between cryptocurrencies with a floating value (e.g. BTC ) and ones with a fixed price, so-called stablecoins.

Coins

Coins are classified as the native cryptocurrencies of their blockchain. Notable examples are BTC, DOGE, LUNA, or ETH, which is the native cryptocurrency of the popular blockchain Ethereum. Regardless of its primary function, a coin acts as a currency within its system and can be traded at an established value subject to current market conditions.

Tokens

Tokens are, by this definition, dependable on the blockchain of a coin and could not function without it. Blockchains such as Ethereum (ETH) and Solana (SOL) are programmable and allow users to develop their own cryptocurrencies with unique features that leverage the blockchain provided. Also, this enables the creation of new blockchains on top of these ecosystems, which are then so-called sidechains like the Harmony blockchain (ONE). Therefore, tokens either run on the provided blockchain or their sidechain.

Stablecoins

Stablecoins are coins or tokens designed to remain at a stable market price. In contrast to regular cryptocurrencies, stablecoins have close to zero price volatility because they are pegged against other assets, most often a fiat currency like the US Dollar.

It is noteworthy that stablecoins mostly are not tied to a single blockchain and rather exist on multiple. For example, USDC is available as a token on the blockchains of Ethereum, Algorand, Avalanche, Hedera, Solana, Stellar, and Tron.

There are three main types of stablecoins: fiat-, crypto-, and algorithmic backed.

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FIAT-backed stablecoins are backed 1 to 1 by the FIAT currency they are trying to emulate. Notable examples are the cryptocurrencies

USDT and

USDC. Each token is worth $1.00, is issued by the emitter for exactly $1.00, and is backed precisely by one dollar or an asset with the equivalent value. Therefore, the integrity and price of FIAT-backed stablecoins depend on the reputation of the issuing entity.

Crypto-backed stablecoins are also backed by collateral, not in FIAT currencies but with cryptocurrencies. These stablecoins are overcollateralized to ensure stability as the underlying cryptocurrencies like

ETH can be volatile, meaning $1 stablecoin is backed by more than $1 in cryptocurrencies. This form of stablecoin like

DAI is not issued by a central authority as it is fully decentralized.

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Algorithmic-backed stablecoins are not backed by underlying assets. Instead, an algorithm will sell or supply tokens if the price of the stablecoins drops below or rises above the targeted value. Projects like Terra stabilize their various Terra stablecoins (such as

UST) by selling or supplying the blockchain's native cryptocurrency

LUNA.

Consensus Algorithm

A consensus algorithm is an underlying mechanism on the blockchain enabling cryptocurrencies to be decentralized. It allows all network participants to agree on the validity of all recorded transactions on a blockchain and agree upon new transactions included in the next block added to the chain. The consensus algorithm secures the blockchain and gives integrity to the whole system by making compromising attacks too costly.

Besides BTC’s proof of work (PoW) consensus, other algorithms such as proof of stake (PoS) are commonly used in cryptocurrencies, using a different resource to secure the system.

Proof of Work

The resource spent in the PoW algorithm is computational power. In this mechanism, so-called miners, try to solve a computational challenge by finding the hash for the next block in the chain and, therefore, prove their invested work.

All miners in the network compete simultaneously to find the next block and receive the rewards. Thus, this process is resource-intensive, and the energy consumption of PoW blockchains is high. Additionally, energy demand increases with the popularity of a cryptocurrency.

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BTC’s energy consumption is comparable to a country like Portugal (Vries, 2018).

System security depends on the amount of mining power available on the network and thus on the cost of a 51% attack. The more mining power, the higher the cost and the lower the likelihood of an attack. Nakamoto (2008) shows that only attackers owning more than half of all resources have a high chance of a successful attack. Furthermore, even in this costly case, Nakamoto (2008) argues that attacking the system would undermine the entity's investment in the coin and mining hardware and is therefore not attainable.

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As the security of the blockchain depends on doing work to create a new block, which takes time, scalability in terms of throughput and speed is limited compared to PoS.

Proof of Stake

In contrast to PoW relying on external investments, the PoS consensus uses cryptocurrency ownership as a resource. Validators need to stake a certain number of coins to participate, meaning locking up the coins for the duration of participation.

As validators get chosen one at a time for new block creation, with chances based on the staked amount and time of stake, there is no wasted resource as writers do not compete simultaneously. Additionally, there is no competition for computational power as creating a new block does not require solving a challenge, and therefore, no special equipment is needed.

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PoS substantially decreases energy consumption compared to PoW and makes this mechanism more environmentally friendly (Platt et al., 2021).

In addition, this concept increases scalability, as no time-consuming work is involved, and decentralization, as no special hardware, is required.

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ETH currently upgrades its system from PoW to PoS (

ETH2) in order to increase scalability, reduce energy consumption and lessen transaction costs.

As the writer's investment is now more closely related to his work as a validator and can even be slashed in case of fraudulent behavior, the incentive for malicious behavior decreases. To conduct a 51% attack, one would need to own over 50% of all coins, which would be highly costly and directly undermine the staked coins' value.

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Kwaasteniet (2018) ranks the security of the stake-based consensus slightly higher than PoW.

Other Consensus Algorithms

The two consensus algorithms most commonly used in cryptocurrencies also form the basis for nearly all other consensus methods, which use variants with different advantages and disadvantages.

Delegated proof of stake (dPoS), used in cryptocurrencies like TRX or EOS, is a slight variation of PoS and is generally considered faster but less secure. SOL uses a consensus optimized for speed and throughput, called proof of history, a form of PoS that relies additionally on cryptographic proof that a certain amount of time has passed. There are also cryptocurrencies like DASH using a combination of two consensuses called hybrid PoW / PoS, trying to combine features of both mechanisms.