How Cryptocurrencies Work— What You Need To Know Before Investing In Blockchain

“I am here for the Technology!” Are you, really? As many newcomers enter the cryptocurrency ecosystem, most of them only chase the possibility of achieving quick profits. Others may be genuinely interested in this new technology evolving. Whether you are here for the technology or for the profits, understanding how cryptocurrencies work will allow you to make more educated investment decisions.

The main concept that drives blockchain technology is to allow affordable, secure, and fast transactions worldwide in a decentralized and censorship-proof environment.

A new disruptive Technology

Blockchain technology is a distributed ledger technology. Independent nodes and validators use complex mathematical calculations to guarantee the security and reliability of the whole network. Since digital assets rely on a decentralized network, there is no more need for an intermediary to verify and approve the transactions. A distributed ledger tracks ownership changes and distribution in a transparent way, as was never possible before.

Cutting off middlemen means that the end-user is in full control of their for the first time. To better understand this non-custodial approach, let’s take a step back and define what a custodial system is.

The most straightforward example is the banking system. If you state, “I have $1000 in my bank account”, the sentence is not technically correct. The bank holds $1000 on your behalf and pledges to give it back to you at your request. The bank holds your assets, so you need to have confidence that it will always keep the promise of returning them to you in the future.

On the other hand, thanks to the shift to a non-custodial approach, which Blockchain allows, you become your own bank. When you create a decentralized non-custodial wallet, you have full control over your assets because only you know the associated private key. That is the only way to access your funds. No one else will ever do.

Trust the Consensus

The next question may be. “I know my bank, and I can decide to trust it to hold my assets. How can I trust a decentralized network of mostly anonym validators?”

The reality is that you don’t have to trust who secures the network. It’s enough to rely on the rules that run the network. Every node, validator, or network participant accepts the law of the consensus algorithm. Each Blockchain adopts a different consensus system, and it represents the core of the network itself, with a direct impact on the network’s performance, scalability, transaction fees, and security.

Therefore, the choice of which consensus protocol to adopt is a critical decision that can translate into the network’s success or failure. It is really a pivotal concept to understand how cryptocurrencies work. It’s worth noticing that there is no better consensus mechanism per-se. Each consensus protocol may suit different purposes better depending on the utility of the single cryptocurrency.

Bitcoin is the first cryptocurrency launched over ten years ago, and it uses the oldest and, still most common, consensus algorithm, called Proof-of-Work. In a PoW network, miners perform complex calculations to validate transactions. In every block, they include new transactions and get a reward proportionally according to their efforts.

At the moment, there are over a million computers all over the globe constantly trying to solve mathematical puzzles to mine a new block. The first to solve the calculation is the one that is considered to have “mined” the block and gets the rewards. Then the whole network will start again, trying to validate the next block. This continues over and over.

This process requires a huge amount of energy consumption, leading to one of the most common critics. On the other hand, you may view the energy that the network consumes as the cost of securing the long-term value and security of Bitcoin.

Such high energy levels demanded to participate in the Bitcoin mining business add a significant layer of security. All the transactions are transparent and easily verifiable. Nevertheless, safety doesn’t only come at the cost of the energy consumed by miners. The second main hidden cost of such high security is the lack of scalability in terms of network performance. Generally, PoW networks are on average more secure, while it’s difficult to achieve transaction speed of other centralized networks like Paypal, Visa, or Mastercard.

New consensus algorithms, like Proof-of-Stake, are growing in adoption to catch up with the growing demand for network performances. You can read more about the different mechanisms Blockchains adopt in this article.

Crypto is a new asset class

As your knowledge of how cryptocurrencies work increases, you might realize that you need to rethink your investment paradigm to approach cryptocurrencies. When you buy a coin, you own a certain amount of that digital currency today, whose value you expect to grow in the future. This value growth is not always directly linked to the success of the issuer company. In many cases, there is no company at all behind the development of cryptocurrency. See the case of Bitcoin.

You may buy a stock of a company to profit from its future revenue streams. That is not the case for most of the tokens which are designed as utility tokens, and their value will likely increase as more people use the network.

The nature of the asset itself is not the only difference. Federal agencies and Authorities like the US Securities and Exchanges Commission (SEC) rule over the entire stock market. On the other end, there is no central authority regulating the Crypto market. The governance of each Blockchain relies on its consensus protocol and token holders.

Crypto-currencies are not even strictly currencies or commodities. Their supply is mathematically defined and not subject to Central Banks’ policies. That should make them more reliable and predictable if it weren’t for a very uncertain demand and adoption. Cryptocurrencies are certainly not commodities as no established industrial process includes them. They will eventually become the backbone of a new digital industry, though.

For all these reasons, investing in cryptocurrency is very risky, and you could lose most of the invested capital if you don’t do that carefully. Also, the volatility of stocks and bonds is relatively low compared to cryptocurrencies. You can experience dramatic price movements that require a well-defined investment strategy. Tools like Coinrule definitely help you navigate this volatility with no-stress.

Predicting Crypto prices

Now that you have a better understanding of how cryptocurrencies work and why it’s valuable to invest in Blockchain technology, where can you expect the price to grow from here?

Predicting the price of Bitcoin or other cryptocurrencies is challenging. You need to abandon the traditional valuation models, which can apply only to the legacy financial markets.

One of the metrics to evaluate a Blockchain is the available supply of coins or tokens. Due to the law of supply and demand, if the supply is relatively rigid or fixed, an increased adoption will lead to a price appreciation.

This indicator is generally readily available for all coins, and you can find this data for free online.

Other indicators useful to gauge the state of a Blockchain are:

• The number of transactions that can provide data regarding the usage of that cryptocurrency. A high number of transactions typically indicates that users have found a sound use case for the Blockchain. This can be used as a significant indicator that the price is expected to increase.
• The number of active wallets is a proxy to define cryptocurrency adoption. Other metrics related to wallets can be the wallet size and level of activity of each wallet. That provides insights about the distribution of holders.
• The Hash Rate defines the difficulty of mining one block of crypto. If that hash rate is high, this means that there are a significant number of miners securing the blockchain. It’s also the main proxy for the security of a network.

Final Remarks

• Blockchain is a distributed ledger technology. Decentralization and cryptography guarantee that transactions are immutable and temper-proof.
• You can hold cryptocurrencies on non-custodial wallets, meaning that each user acts as its own bank and that no other has access to the assets held in the wallet.
• The consensus algorithm dictates the main characteristics of a Blockchain, such as performance, transaction fees, and security that the developer decides to use. There are several types of consensus algorithms, the most popular being Proof-of-Work and Proof-of-Stake. The former allows the network to be secure. The latter enables the scalability and performance of the network.
• Cryptocurrencies are speculative assets by nature and are not stocks or commodities. When you own crypto, you do not have any ownership or rights to the company’s revenue that issued the tokens.
• Predicting the exact price of Bitcoin in the future can be challenging or nearly impossible. However, you can use several indicators that are normally unconventional in the traditional world of finance.
• Learning how cryptocurrencies work helps you gain the proper confidence to invest consciously in a whole new asset class. Once you fully realize the potentials and risk of investing in cryptocurrencies, you are ready to use tools like Coinrule to manage your portfolio and optimize your returns.