Crypto Fundamentals

If you’re already familiar with the core concepts around Blockchains, Cryptocurrency vs Digital Assets, Mining, and Proof of Work vs Proof of Stake, feel free to skip ahead to the 3 Waves of Crypto. 🙂

Everything complex can be broken down into a series of simple things. So, let’s start with a few fundamental concepts.

What is a Blockchain anyway?

It’s just a distributed database. Data is stored in blocks, which are then chained together chronologically to maintain a record of everything that happened and when it happened. Hence, the name Blockchain.

Still fuzzy? Think of a spreadsheet between you and your friends that is shared across everyone’s computer. Every time someone updates the spreadsheet, it updates on everyone’s computer, so everyone has a copy and can see what happened. That’s how Blockchain-based cryptocurrencies like Bitcoin work, but instead of just between you and your friends, they are distributed on hundreds of thousands of computers around the world. Further down this page, we’ll cover how crypto projects are able to add in economic incentives and consequences to ensure everything stays honest.

The idea here is that Blockchains are immutable, transparent, tamper-resistant, and don’t require you to trust any one person or entity in order to use them. They’re often called “trustless” because rather than trusting a bank or a corporation to always act honestly, or not make any mistakes — you’re only trusting cryptography and math, which tends to be a lot more honest than humans. 😉

Blockchain is the backbone technology that most cryptocurrencies are built on top of. There are other similar technologies that are also used as well, but for the purposes of getting started, you can just think of Blockchain as being the backend foundation that all of crypto is built on.

So what is a Cryptocurrency then?

A cryptocurrency is just a digital currency that is secured by cryptography, typically running on a Blockchain. This makes it virtually impossible to counterfeit, duplicate, or spend the same coin twice. Bitcoin is the poster child for this.

One of the most important uses for a cryptocurrency coin or token inside its respective system, is to incentivize honest behavior. While Blockchains themselves are perfectly predictable, since they’re based on mathematics and deterministic computing, humans still have to run these machines, and there is the tricky part of any human-designed system.

However, if you really dig into incentives, human beings become pretty predictable too. Humans tend to act in their own self interest. Whether they’re a “good or bad” person, that’s pretty consistent. So, having a real economic reward (in a cryptocurrency like Bitcoin for example) for honest behavior that supports the network (like mining), helps the machinery keep moving forward rain or shine, and results in a 24/7 reliable, honest, and functional network.

Cryptocurrency vs Digital Assets

As a side note, while most people use the term cryptocurrency as a blanket term for anything in the space, it is really a bit of a misnomer for most modern projects. A currency is typically defined as a medium of exchange. Bitcoin is designed to be just that: its own sovereign digital money, digital gold, etc.

But… Ethereum is not, Cardano is not, Polkadot is not, Solana is not, etc. These aren’t simply other weird internet currencies competing with Bitcoin. These newer cryptos are all smart contract platforms where the “coin” is an ownership share in the network. These coins are often entitled to fees generated on the network via Staking, and often entitled to a vote on protocol upgrades as well. Especially with regard to coins that are entitled to fees and rewards via staking, this is real, quantifiable economic value, not speculation. This is also much more functional than merely a “currency” that you would either hold hoping it appreciates or spend it, in fact, there is a much stronger value prop for these crypto “coins” than there is for many publicly traded stocks, especially those without dividends! A more accurate term for the “coins” of these other projects would be Digital Assets, and there are many different classes of digital assets beyond the ones I just listed.

This is a small clarification that I don’t belabor much, since everyone knows the space as “crypto” (even the site name is Clarity in Crypto after all), but this is an important distinction to make in your own mind if you’re serious about investing in this space.

What is “Mining”?

The transparency aspect of blockchains and crypto is not enough of a value proposition by itself. After all, if you just wanted everyone to see the same spreadsheet, why not just have an open Google sheet that everyone can see? That might be fine to view-only, but if you give everyone edit access… the ability to trust the data in the sheet will go downhill fast.

The thing that blockchains and cryptocurrencies solve for is the power aspect of the equation. Who is able to edit the database. So, how do we know that only honest and valid transactions are added to the ledger?

As I mentioned earlier, cryptocurrencies solve this through setting certain economic incentives for participants to only validate honest transactions, and this was Bitcoin’s core innovation. That brings us to the concept of “miners”.

I’m sure everyone has heard of “Bitcoin Mining” by now. Bitcoin uses a mining process called “Proof of Work” to arrive at a consensus between nodes on the network. This is the process where computers compete to solve the ever-changing Bitcoin puzzle, and the winner gets to “mine” the next block on the Blockchain, and get paid by the system for doing so. If you’re dishonest, everyone else can see that, and they have zero incentive to go along with your lie. So they’ll go back to the block before where you lied, and solve the puzzle to mine from there. That means, not only did the dishonest miner not get away with anything, but they wasted all the money they spent on the electricity and computing power to mine the block (quite expensive these days!).

This system is not perfect, but it’s pretty damn good at keeping things honest. If you’d like to dig into specifics or “what if” scenarios, I encourage you to do so, there are plenty of great sites that a quick Google search will bring you. However, for the skeptics reading this, think about this for a second: For over a decade, the smartest academics, hackers, governments, criminals, and institutions have tried to hack or break Bitcoin. Multiple governments have attacked and even banned it numerous times. Yet, Bitcoin still stands. So, rest assured that your hypothetical “what if” is almost guaranteed to have been accounted for during that time. 🤓

Proof of Work vs Proof of Stake

In the last section, we covered what Miners are, and how they use a “Proof of Work” system to secure the blockchain. This is effective, and Bitcoin is evidence of that. However, this is not the most scalable solution. As more and more computing resources compete, the Bitcoin puzzle adjusts difficulty to match the competition. This means more electricity and computing power is required to solve the puzzle. This boxes out small time miners, and means you need more sophisticated machinery to compete. As people add more sophisticated mining rigs, this further increases the difficulty and energy required.

See the problem? It has gone from you being able to mine Bitcoin on your laptop, to needing a GPU, to needing an ASIC (a custom built chip that’s sole purpose now is effectively just guessing at the Bitcoin puzzle). This has also made the energy costs of Bitcoin skyrocket to larger than many countries.

Enter: Proof of Stake.

This is an alternative method for solving the question of power around who gets to update the ledger. It gets rid of the miners and wasteful computing, and basically creates a system of voting, where the more of the system you own, the more often you get to vote. Also, rather than the miners receiving these new rewards from the system, anyone who participates in the process of Staking is entitled to these rewards.

So, that means if you hold a Proof of Stake crypto, like Cardano, Polkadot, Solana, or (after ETH2.0) Ethereum, you are able to receive anywhere from 5-15% APR in staking rewards by participating.

More on this in a future section, but it’s a very strong economic driver for the value of Proof of Stake coins.