What are Digital Currencies?
Cryptocurrencies are a subset of digital or virtual currency, which are based on an electronic medium whilst being cryptographically secured and generated through a process known as “mining”, i.e. proof-of-work (PoW, see below).
Cryptocoins are organised decentrally via a distributed and decentralized network known as the blockchain and can be transferred without an intermediary agent in direct, peer-to-peer transactions. They are not subject to a central and legal authority, which means they fall outside of the traditional monetary regulation system. The most prominent cryptocurrency is Bitcoin (BTC), which was launched in 2008 and has reached a market cap of nearly US $41bn by July 2017 [https://coinmarketcap.com/].
As the source-code for digital currencies is open, it is comparatively simple to create an alternative currency (i.e. altcoin). The majority of cryptocurrencies are largely bitcoin derivates with modifications in parameter values, i.e. different block confirmation time, currency supply, issuance scheme and new features. More than 1,000 of altcoins have been developed over the years. However, with an increase in competition, not all of these altcoins are able to scale sufficiently to be globally adopted.
What is Digital Currency Mining?
Bitcoin, just like many other digital coins, is created through the technological process of “mining”, i.e. proof-of-work (PoW). Unlike the minting/printing of fiat money, this process resembles the mining of commodities, i.e. gold, as it presupposes a prior investment of effort, in this case computational power, for an eventual release or reward of coins.
The blockchain is a distributed data structure which keeps record of the entire transaction history of the relevant coin, past and present. This data structure is maintained by a distributed network of nodes, i.e. miners, but it is also transparent and publicly accessible to anyone. Yet to be confirmed transactions are bundled into blocks by miners, who also cryptographically encode the contained information. In order to validate the new block of transactions, miners use an algorithm to solve a coding problem set by the blockchain’s protocol. This process is time and energy consuming, as it requires a high amount of computational power which can nowadays only be efficiently delivered by professional large-scale mining farms. Once a miner finds the solution to the mathematical problem, the transactions within the block are confirmed and broadcasted to the miners via the blockchain. Bitcoins are then emitted to the successful miner as reward for the invested proof-of-work for the validation of the transactions.
As mining becomes more attractive to users, the blockchain protocol has set rules regulating Bitcoin emission: Bitcoins and many other coins have a capped issuance which limits the overall production, and additionally, the reward is reduced after a certain amount of created blocks (in the case of Bitcoin, the rewards is halved every 210,000 blocks). This prevents the potential inflationary mining of bitcoins.
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Besides Bitcoin, there are various other cryptocurrencies that have evolved into a tradable asset with can be freely exchanged into existing currencies at public exchanges. The most prominent cryptocurrency besides Bitcoin is Ethereum.
The Ethereum blockchain (currency: ETH) was developed in 2014 as an app platform that specialises on running smart contracts, i.e. contracts, which are automatically executed once predefined conditions are met. These apps allow the creation of markets for physical items such as financial products or energy, the storing of registries of debts and promises, the execution of wills and future contracts and much more.
Main characteristics: deflationary (supply cap of 18 million ETh/pa), smart contract execution, Turing-complete coin (Turing-complete programming on the protocol level), faster transactions (average block confirmation time 14s), peer-to-peer (obsolete intermediary).
The Unlike Bitcoin, Litecoin (currency: LTC or XLT) , which was released in 2011 runs on the X11-algorithm and features new code updates, such as SegWit and and the Lightning Network. These aim to solve the scaling problem known from Bitcoin by allowing more transactions to be processed by the network at a given time. Litecoin also has lower transaction fees and executes payments approximately four times faster than Bitcoin.
Main characteristics: deflationary (supply cap of 84 million LTC), faster transactions (average block confirmation time 2.5 mins), reduced transaction fees.