Buch EN indd CRYPTOCURRENCIES simply explained Dr Julian Hosp Cryptocurrencies simply explained Copyright © 2020 by Dr Julian Hosp All rights reserved No part of this book may be reproduced in any for.
FROM GOLD TO CRYPTO
CHAPTER 1 - FROM GOLD TO CRYPTO
A currency is the actual execution of the theoretical concept of money For this to work, a currency needs to fulfill three criteria:
1 Be a good store of value.
2 Provide an efficient method of transfer.
3 Be a good unit of account, so you can measure and compare.
Trust from the community is essential for a currency's effectiveness, which is why animals, livestock, and shells are not suitable as money These forms lack reliable value storage, are challenging to transport, and are difficult to measure and compare Among all currencies, gold remains the oldest and most recognized form of money, valued for its stability and universal acceptance.
Gold, as the oldest known form of money, offers significant advantages over other goods because it has maintained its value over time, making it a reliable store of wealth Its scarcity and durability ensure that it remains a trusted medium of exchange and a stable store of value Additionally, gold's divisibility and portability make it an effective form of currency, facilitating trade and economic growth while retaining its status as a universal and enduring form of money.
Gold is a rare and non-reproducible resource that must be carefully mined, unlike other commodities such as animals, sugar, or salt Its enduring nature means it does not perish, change, or become consumable, making it a highly valuable and unique asset in the economy.
GOLD AS MONEY up very little space This is a big advantage over, for example, livestock, and makes gold seem like a good method of trans-
Gold's fungibility means that one ounce of pure gold holds the same value as any other ounce, simplifying trade and serving as a reliable unit of account Unlike goods such as diamonds, which vary in value due to factors like Cut, Color, and Clarity (the 3 C rule), gold's uniformity ensures consistency, making it a preferred choice for trade and financial transactions This inherent interchangeability was a key factor in humanity's shift away from less uniform assets like shells or precious stones.
Trust is the most important factor for a currency to be seen as money, and gold is definitely trusted Why is that?
Understanding the three key factors that define a currency is essential for evaluating its value, especially when comparing gold to other forms of money like fiat currency and cryptocurrencies Gold often surpasses these modern currencies because it meets core criteria—such as scarcity, durability, and intrinsic value—more effectively To determine whether a particular asset can function as a reliable currency, it is crucial to examine all relevant characteristics against these three fundamental points The more attributes an asset possesses aligning with these core principles, the stronger its case as a stable and trustworthy medium of exchange.
Gold was used as the main type of money for over 3,500 years (2,000 BC to 1,500 AD) In the mid-1500s, people began to notice a
CHAPTER 1 - FROM GOLD TO CRYPTO
When asked about the best form of money, most people instinctively reply "gold" due to their deep-rooted trust in its value This trust is rooted in the widespread acceptance of gold, which people believe others will also accept in exchange Thousands of years of historical familiarity have solidified gold’s reputation as a reliable store of value.
Gold's value is based on trust rather than inherent worth, as it cannot be eaten, drunk, or used directly Its historical significance as a rare, fungible, portable, and non-perishable asset has cemented its role as a reliable store of value However, distinguishing one gold piece from another can be challenging for the average person, which can undermine its effectiveness as a true store of value Over time, the increased abundance of gold coins has reduced their rarity, impacting their ability to serve as a secure and stable asset.
2 Second, people grew tired of having to carry something ex- tremely heavy with them They looked for alternatives, as gold was not such a good method of transfer after all.
Gold is theoretically divisible, but in practice, splitting an ounce into two half-ounces can be difficult in most stores This practical challenge highlights that gold may not be the most efficient unit of account, despite its divisibility in theory.
People sought a “better” currency system beyond gold, leading to the adoption of paper money pegged to gold This system involved depositing gold or silver in banks in exchange for IOUs, which could be used as currency in daily transactions Paper money offered advantages such as being lighter, easier to divide into smaller denominations, and more secure against counterfeiting Comparing these features, IOUs proved to be a practical and efficient form of money, transforming the way value was stored and exchanged.
1 Store of value? Yes, because every IOU is pegged to gold and that is rare.
2 Method of transfer? Better than gold, as paper is very light.
3 Unit of account? Better than gold, as one paper is like the other, and it is divisible into smaller papers.
CHAPTER 1 - FROM GOLD TO CRYPTO
Many people criticize today’s paper money as “bad money” because the gold-backed system no longer exists Despite common beliefs, most modern currencies are no longer backed by gold, which might come as a surprise The truth is that, after approximately 450 years, most countries officially abandoned the gold standard in the 1950s, disconnecting their money supply from gold to create the fiat currencies we use today.
US Dollar, the world’s re-serve currency, abandoned the gold standard in favor of “free floating” on the open exchange market in
In 1971, the primary goal was to enable governments to better manage inflation and deflation by controlling the money supply This shift allowed central banks to increase or decrease currency at will, transforming money into a commodity valued based on foreign exchange rates or local trust This new form of currency, unpegged from gold, is known as "fiat money," fundamentally changing how money retains its value and functions in the global economy.
This book avoids the term “backed by gold” because it raises the fundamental question, “What is gold backed by?” Ultimately, all gold is supported by the essential qualities of a good currency and its historical role in building trust Since this trust is deeply ingrained in our perception, we often view something as the “gold standard” when it meets these core criteria Instead of focusing on gold-backed money, it’s more important to understand the three key points that define a reliable currency, especially when examining fiat money—paper currency not pegged to any physical commodity.
Fiat money is often perceived as a poor store of value because, unlike gold-backed currencies, central authorities can simply print more money without restrictions Since the end of the gold standard, governments are not pegged to gold, allowing them to increase the money supply at will This increase, known as inflation, reduces the purchasing power of money, making fiat currency unreliable as a long-term store of value Consequently, excessive money printing by governments can lead to inflationary erosion, diminishing the real worth of fiat money over time.
In today's evolving financial landscape, we are shifting from relying on gold as a trusted store of value to placing our trust in a centralized authority This new scenario depends on a central entity to manage fiat money effectively, ensuring its stability and reliability as a safe store of value.
WHAT ARE THE ROLES IN A MONETARY SYSTEM?
For a monetary system to work, three things have to be governed:
These three points can either be governed in a centralized or decentralized manner.
WHAT ARE ROLES IN A MONETARY SYSTEM?
If you want to summarize what happened in one sentence, you could say: With fiat-money, money became centralized During the times of gold, it was decentralized.
Decentralization ensures that all participants in a community or system enjoy equal rights and opportunities, with no one holding more power than another Historically, gold exemplified decentralization by regulating financial matters collectively, allowing anyone to mine or own it without restrictions In contrast, fiat money is controlled centrally by a government’s central bank, creating a centralized financial system where authority resides with a single institution.
CHAPTER 1 - FROM GOLD TO CRYPTO
BLOCKCHAIN AND
In 2008, an anonymous individual or group known as Satoshi Nakamoto introduced a groundbreaking solution to the double-spending problem in their whitepaper, "Bitcoin: A Peer-to-Peer Electronic Cash System" (https://bitcoin.org/bitcoin.pdf) The key innovation in this concise eight-page document is the creation of a blockchain technology that eliminates the need for a central authority, ensuring secure and tamper-proof transactions This revolutionary approach enables peer-to-peer digital currency exchanges with trustless verification, fundamentally transforming the landscape of electronic cash systems.
A blockchain is a decentralized and immutable transaction ledger that is universally agreed upon within the community This secure ledger is automatically updated at regular intervals, stored on each participant’s computer, and accepted as a factual record by all members By removing the need for a central authority, blockchain prevents double-spending and ensures transparent, conflict-free transaction histories for all participants.
CHAPTER 2 - BLOCKCHAIN AND CRYPTOCURRENCY BASICS
Decentralized communities now define "reality" collectively, shifting authority away from central parties Blockchain technology enables the secure and transparent storage of various forms of "reality"—including ownership, identification, knowledge, and currency—without the need for a governing body This innovation has transformative potential across multiple sectors, empowering individuals and organizations to maintain verifiable records in a decentralized manner.
HOW IS A BLOCKCHAIN USED FOR A DIGITAL
Blockchain technology enables the existence of digital currencies without the need for a central bank, providing a decentralized infrastructure As one of many applications built on blockchain, digital currency benefits from increased security, transparency, and independence Decentralization in the digital world enhances the efficiency and resilience of currency systems, making blockchain a foundational technology for modern digital payments.
Since this currency on a blockchain uses cryptography, it is called cryptocurrency.
Cryptocurrencies are digital currencies secured and regulated by cryptographic algorithms embedded within their decentralized networks This integration of advanced cryptography with digital currency technology is the origin of their name, reflecting the rare and secure nature of these assets Blockchain-based rules and protocols ensure transparency, security, and trust within the cryptocurrency community.
CHAPTER 2 - BLOCKCHAIN AND CRYPTOCURRENCY BASICS
Trust in cryptocurrency is built on robust cryptography, providing a secure and transparent digital asset system As a relatively new concept compared to thousands of years of using precious metals, it requires time for widespread understanding and acceptance Over time, more people will recognize the innovative benefits of this revolutionary financial technology.
To clear up some confusion, let’s define a few terms:
Blockchain: the immutable transaction history of a decentralized community.
Cryptocurrency: an application using blockchain technologies by which the transaction history and therefore the exact amount of cur- rency everyone owns gets stored via a blockchain
Bitcoin (B capital): is used to name the idea and protocol of the first decentralized cryptocurrency on a blockchain bitcoin(s)—lower case b: the currency itself.
Thomas is passionate about cryptocurrencies and blockchain technology, believing in the growing value of digital assets He owns 12.7 bitcoins, anticipating their value will increase over time While he finds blockchain innovation exciting, he recognizes that investing directly into the blockchain itself isn't feasible His interest extends beyond specific applications, focusing on the broader potential of blockchain to revolutionize industries.
WHAT WAS THE FIRST DECENTRALIZED CURRENCY?
Throughout history, various cultures have rejected centralized monetary systems, highlighting diverse approaches to currency The Rai stones of Yap Island exemplify a fascinating form of decentralized currency that mirrors blockchain technology, showcasing a community-driven monetary system Due to limited gold resources, Yap Island inhabitants created large, carved stones as a form of currency, ensuring widespread access and social value This unique system exemplifies how societies can develop alternative, decentralized forms of money that function effectively without traditional banking institutions.
Chapter 2: Blockchain and Cryptocurrency Basics explain how decentralized systems enable secure transactions, such as selling products or services in exchange for digital assets like stones These systems are fully open and accessible to anyone, ensuring equal rights and participation for all users in the network.
Transportation was a major challenge for Rai stones, making them difficult to move across islands To solve this, islanders adopted a system of virtual ownership, where they stored the stones at fixed locations and passed on ownership through community communication This decentralized approach allowed the stones to serve as a reliable store of value and unit of account without physically moving them, as everyone knew who owned each specific stone.
The first decentralized currency was Yap's Rai stones, which decentralized key functions of a monetary system by making the stones difficult to produce and easy to transfer through virtual ownership Cryptocurrencies rely on blockchain technology to act as a distributed ledger that prevents double-spending by ensuring all transactions are traceable by participants This decentralized approach addresses the core tasks of a monetary system—access to money, sending and receiving funds, and supply management—and future developments will explore how cryptocurrencies continue to solve these essential features.
The first thing we have to solve in a digital monetary system, when we want to send money from one person to another, are accounts.
HOW DOES DECENTRALIZED ACCOUNT MANAGE- MENT WORK?
In banking, your unique bank account number ensures that only you can receive money, preventing others from accessing your funds if shared Similarly, email services like Gmail verify whether your email address is already in use during sign-up to avoid conflicts, highlighting the importance of unique identifiers These functions rely on centralized services, which must perform reliably; however, if such a service decides to close your account or restrict access, it raises concerns about centralized control Relying on centralized platforms like banks and Gmail can pose risks if they misuse their power or fail to maintain user access.
In a decentralized system, this is exactly what cannot happen because there is no central party that owns the database of
PRIVATE KEYS AND PUBLIC ADDRESSES
The number of possible cryptocurrency accounts is astronomically high, comparable to the number of atoms in the visible universe Typically, the private key is not shown as a numeric value but is represented in a 64-character hexadecimal format This hexadecimal representation provides a secure and compact way to manage private keys, ensuring robust protection for digital assets.
E9873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA33262
CHAPTER 3 - PRIVATE KEYS AND PUBLIC ADDRESSES
The solution comes through cryptography with a private key and a public address.
WHAT IS A PRIVATE KEY AND A PUBLIC ADDRESS?
When you register for a cryptocurrency account, there is no centralized database to select your account; instead, you receive a randomly generated private key or seed This private key is typically a string of letters and digits or a set of random words, serving as your unique access credential In the case of Bitcoin, the most well-known cryptocurrency, your private key is a randomly generated number from a vast pool of 2^256 possibilities, representing a number with a 1 followed by 80 zeros This immense number space ensures the security and uniqueness of each Bitcoin wallet.
A private key in cryptocurrency functions like a password that grants access to your funds, while the public address is a mathematically derived identifier, similar to an email address generated from your password Unlike choosing your public address, it is automatically generated from the private key using advanced cryptographic methods such as Elliptic Curve Cryptography, SHA256, and RIPEMD160 functions Understanding this process is essential for secure cryptocurrency management; for more detailed insights, search for “Julian Hosp cryptography” online, where numerous videos and blog posts explain these complex concepts.
Mathematical functions used in encryption make it nearly impossible to guess a private key from just knowing a public address, such as an email Conversely, deriving a public address from a private key is straightforward, exemplified by the concept that the public address is the square of the private key—if the private key is 8, the public address is 64 However, reversing this process—finding the private key from the public address—is much more complex, especially with large numbers; for example, given a public address of 289, the private key is found by calculating the square root, which is 17 While this is simple with small numbers, identifying the private key from a 50-digit number takes significant computational effort, demonstrating the asymmetry in these cryptographic functions.
Private keys are nearly impossible to guess from public addresses due to their astronomical complexity, making it statistically more likely to pass through walls via quantum tunneling than to randomly generate the same private key as someone else The security of Bitcoin relies on this impossibility, similar to how opening billions of safes would take longer than the universe’s existence, yet some supercomputers have successfully generated Bitcoin addresses containing actual funds This occurs when address generators lack proper randomness, emphasizing the importance of using open-source, well-tested services for creating private keys to prevent vulnerabilities like predictable passwords such as "1234."
For those interested in the technical aspects of Bitcoin, this guide provides a detailed explanation of its cryptographic processes, including the underlying mathematics, which can be skipped by readers who prefer a simplified overview.
WHAT IS A PRIVATE KEY AND A PUBLIC ADDRESS?
In the chapter about wallets, you will learn about great services that do not have this problem and the generation of addresses is truly random.
A Bitcoin address, for example, starts with a 1 or 3 and could look like this with 34 characters:
(This address is a random address, so do NOT send any funds there)
WHAT DOES OPEN SOURCE MEAN?
Open source software and blockchain technology are characterized by publicly accessible code, enabling anyone to review, verify, and audit the program's functionality This transparency promotes trust, as users can identify potential vulnerabilities, suggest improvements, and detect malicious or faulty services By embracing open source principles, developers foster community collaboration, enhance security, and ensure greater reliability in digital applications.
CHAPTER 3 - PRIVATE KEYS AND PUBLIC ADDRESSES
1 Start with a randomly chosen private key from 1 to 2^256.
2 Use Elliptic Curve Cryptography, where the private key is the “multiplier.”
3 This is your public key.
4 Do a “Hash160” by using a SHA256, followed by a RIPEMD-160.
5 Do a Base58Check as a “Checksum” (similar check, like in credit card numbers).
6 This is your public address.
WHY DO WE NEED PRIVATE KEYS AND PUBLIC ADDRESSES?
WHY DO WE NEED PRIVATE KEYS AND PUBLIC
This blockchain system is fully inclusive, allowing anyone or anything to join a community without restriction By simply generating a private key and deriving a public address, users can participate securely and privately This decentralized approach offers significant advantages, especially in regions with limited traditional banking access, by enabling borderless transactions Public addresses function like email addresses, allowing others to send funds, while private keys act as passwords required to authorize outgoing transactions, ensuring security Although phishing scams exist, the system's design prioritizes user control and security, making it a powerful tool for global financial inclusivity.
The most important lesson to take away from this chapter is:
NEVER, and I mean NEVER EVER EVER EVER give anyone your private key The person controlling a private key controls the coins that get sent to its public address.
I cannot stress this fact often enough There are websites that sell you special looking public addresses—for example having your name inside the address, such as
After participants have established their accounts to send and receive money, a crucial challenge is determining the actual balance of each account without a central authority The key question is how to prevent double-spending in a decentralized system This is where the process called “mining” becomes essential, ensuring the integrity and accuracy of account balances through secure and transparent verification methods.
CHAPTER 3 - PRIVATE KEYS AND PUBLIC ADDRESSES
Mining is one of the most misunderstood things in cryptocurrencies, as most people believe mining is how bitcoins, for example, are created This is partly incorrect.
Mining is the process of how consensus is created.
Consensus refers to the agreement on the amount of money associated with a private key, essentially indicating how much funds each participant’s account holds In centralized systems, such as traditional banking, a central institution monitors account balances and validates transactions Conversely, decentralized systems rely on participants collectively observing and verifying transactions, confirming or rejecting them based on whether the sender has sufficient funds, ensuring transparency and trust without a central authority.
WHAT ARE USERS, NODES AND MINERS?
MINING
Proof of work
Proof of Work remains the most commonly used consensus algorithm, though Proof of Importance is an emerging alternative While Proof of Importance is currently less adopted, it has the potential for increased usage in the coming years, offering a different approach where the participant's influence is determined by their importance within the network.
The "most importance" designation identifies the transactions that are most significant and frequently receive incentives Since multiple participants may hold importance in different transactions, the selection is determined through a probabilistic mix based on transaction significance, ensuring that the most impactful activities are prioritized for rewards.
1 PROOF OF IMPORTANCE combined with the number of other miners trusting them by opting in to receive information from them.
In social media, trust is often built through familiar connections, such as accepting friend requests from longstanding, legitimate-looking profiles connected to mutual friends Similarly, in decentralization systems utilizing Proof of Importance, an individual's significance is determined by their assigned 'importance percentage,' which reflects their value within the network, influencing their voting power, transaction priority, and rewards This approach offers the advantage that anyone, regardless of wealth, can attain a high level of importance, promoting inclusivity However, a notable risk is that the system can be manipulated by creating fake or fraudulent participants who artificially boost each other's importance—akin to fake social media accounts gaining followers through mutual engagement—highlighting the need for additional safeguards and features to ensure scalability and prevent abuse in blockchain algorithms.
The concept of importance is closely linked to financial influence, where control over more money signifies greater importance within the system Critics argue that this reliance on monetary power raises questions about the decentralization of blockchain networks, as it often results in concentrated consensus control among a few wealthy accounts Currently, only a limited number of blockchains utilize this type of consensus mechanism, prompting ongoing debates about fairness and decentralization in the crypto space.
Understanding your voting power in a blockchain community is straightforward: it is calculated by dividing the amount of coins you stake by the total coins staked by the community Staking involves locking your coins in a smart contract for a specified period, which serves as proof of ownership and authority Even if you hold a large amount of coins, your voting rights may be limited if you choose to spend or use them instead of staking For instance, if you stake 1,000 coins out of a total 100,000 coins staked, you would hold a 1% voting power, granting you approximately 1% influence over decisions and rewards This simple ratio ensures that voting power is proportional to the amount of coins actively staked.
Staking rewards are shared among participants based on their contribution, so those who stake more receive a larger percentage of the rewards This allows for accurate calculation of annual returns, making staking a potentially lucrative investment opportunity For instance, if a blockchain offers a 5% annual reward on staked capital, staking 1,000 coins could earn you 50 coins each year, which can be highly valuable depending on the coin’s market value.
• Since money cannot be created out of thin air in a legit blockchain, the possibility of fraudulent attackers, as in proof of im-portance, is rather low.
3 PROOF OF WORK staking on either Developers are still looking for good solutions in that regard This is different than proof of work, as here you have to make a decision on which chain you invest your work into.
Proof of Work (PoW) is the most established and widely used consensus algorithm, favored by major cryptocurrencies like Bitcoin due to its extensive testing and resistance to forking attacks Instead of staking coins or proving importance, miners demonstrate they have done computational work; the first to solve a problem can select transaction order and earn rewards These rewards include all transaction fees within a block and, for cryptocurrencies like Bitcoin, a fixed incentive such as 12.5 bitcoins per block Understanding PoW is crucial because it underpins many fundamental blockchain concepts, with Bitcoin serving as the most tested example of this reliable consensus mechanism.
HOW DOES A TRANSACTION GET CONFIRMED?
Sending Bitcoin is similar to how Yap islanders “sent” Rai stones—publicly notifying the network of new ownership without immediate confirmation Transactions remain unconfirmed until included in a block, which signifies confirmation In blockchain consensus mechanisms like Proof of Stake and Proof of Importance, participants gain the right to select transactions based on their stake or importance, with the process occurring at fixed intervals such as every 3 seconds or 60 seconds Conversely, in Proof of Work, miners compete by solving complex cryptographic puzzles, with the first to succeed earning the right to add the next block Miners continuously monitor the network for new transactions, adding them to their pool of unconfirmed transactions, and perform intensive computational work—analogous to solving a puzzle—by repeatedly trying to find a cryptographic solution to confirm transactions and secure the network.
HOW DO YOU FIND BLOCKS?
Miners select transactions based on transaction fees, prioritizing those with the highest fees to maximize their earnings Due to block size limitations, miners must carefully choose which transactions to include in each block Since many miners are working on different puzzles, or blocks, the chances of multiple miners solving separate puzzles simultaneously are high These blocks are constructed in a way that requires solving a cryptographic puzzle, ensuring the integrity and security of the blockchain.
HOW DO YOU FIND BLOCKS?
A nonce is a random value that miners must include in a block during the mining process To be considered valid, the completed puzzle, or block, must meet specific criteria, similar to fitting the last piece of a puzzle seamlessly The nonce acts as the missing link, ensuring the puzzle has no gaps, and must have a precise value that aligns with the other data in the block Its primary purpose is to help miners find a hash that satisfies the network’s difficulty requirements by adjusting it until the desired outcome is achieved.
Once a miner finds a valid solution, they broadcast the block to other nodes and miners, who quickly verify its correctness before forwarding it further While verifying a puzzle takes only milliseconds, constructing the puzzle can take miners minutes, hours, or even days, similar to assembling a complex jigsaw puzzle with thousands of pieces In blockchain cryptography, this process underscores that verifying a block is swift, whereas creating it requires significant time and effort.
Miners face the challenge of not knowing whether a puzzle piece fits until they attempt to validate it through trial and error They systematically try trillions of possible nonces until discovering one that validates the block In blockchain terminology, this process is known as "finding a new block," which involves solving complex cryptographic puzzles to add a new record to the blockchain securely.
What the miner actually managed to do is back-calculate several SHA256 cryptographic algorithms by guessing a random input for a fixed output.
HOW ARE BLOCKS CONNECTED TO A BLOCKCHAIN?
HOW ARE BLOCKS CONNECTED TO A BLOCKCHAIN?
A completed block is uniquely identified by a timestamp, and the miner who discovers it receives the transaction fees from all included transactions along with a block reward, such as 12.5 bitcoins for Bitcoin, which decreases over time When a transaction is included in a block, it becomes confirmed for the first time Once a block is found, thousands or even millions of miners quickly copy it, using the last puzzle piece—the previous block—to mine the next block by adding new transactions and finding a nonce that solves the new puzzle This process creates a chain of blocks, with each new block built upon the previous one, forming the blockchain's numbered sequence.
A blockchain is formed when all blocks are cryptographically linked together, ensuring the integrity and immutability of the data Any attempt to alter a past block would require undoing all subsequent blocks, effectively destroying the entire blockchain This interconnected structure makes tampering highly difficult, as changing a single transaction affects the entire block and all following blocks Consequently, it generally requires more effort to modify the blockchain than the potential benefits gained from such an alteration, highlighting its security and trustworthiness.
In the case of Bitcoin, once a transaction has been confirmed 4 or