Crypto Primer: What are cryptocurrencies?
This is a new series of guides for those who are just getting started and looking for basic information on crypto assets, authored by various team members at Sygnum. If you are looking for a specific topic, contact us and we'll ask the team.
Cryptocurrencies are units of value that are electronically created, cryptographically secured, and stored on distributed ledgers.
Disagreements prevail about the terminology, especially about the term “currencies”, as many blockchain-based digital assets are not used primarily, or at all, as currencies. The term “digital assets”, as an alternative, includes all assets in digital form, not just those that are cryptographically secured and based on blockchain technologies. Currently, the industry is increasingly converging on the term “crypto assets”.
What does “electronically created” mean?
Today, most currencies in the world are created in electronic form. Only a small percent of fiat money exists in notes and coins, and most currency is an electronic entry in banks’ and central banks’ balance sheets. Indeed, several central banks are contemplating and some are beginning to issue national currencies in digital form that will only ever exist electronically.
The distinguishing feature of cryptocurrencies is that there is no central issuing authority. Rather, the supply of digital tokens is determined at the outset by the supply logic coded into the underlying crypto asset. For this reason, the supply mechanism is unalterable (unless there is overwhelming support across the decentralised network for a change), and thus cannot be manipulated to serve political needs. Most cryptocurrencies have either a fixed supply, or a continuously but predictably created supply. Most cryptocurrencies are disinflationary by design.
What does “cryptographically secured” mean?
Instead of centralised entities safeguarding the information relating to the ownership, exact holdings, and transaction details of user accounts, cryptocurrency information is securely encrypted and only the owner of the asset has the key to decrypt the information. Advances in encryption technology have made it possible for this information to be highly secure, more so than most traditional forms of storing assets.
What are “distributed ledgers”?
The veracity of ownership and transactions in cryptocurrencies is ensured through the distributed ledger technology, where each transaction is added to a “block”. Each block is added to the existing set of blocks to form a “chain”. This information is verified by a very large number of computers (“validators”) that constantly compare their versions of the state of the ledger.
Because the system is decentralised, a bad actor’s attempts at falsifying data would be rejected by the consensus of the validators. Validators are compensated for their efforts, either through awarding them newly created cryptocurrency, and/or through distributing the transaction fees charged by the networks to the validators. In some systems, the validators are invited to perform the task for free as a service to the community, but these are less sustainable models.
Types of crypto assets
These are cryptocurrencies that represent original blockchain protocols. These protocols are independent and form the foundations for other applications that are built on them.
These represent an entirely new asset class.
Application layer tokens
For applications built on top of foundational protocols, the transactions are stored in smart contracts that use the blockchain of the protocol layer.
As applications are de facto projects that perform economic activities, they earn a revenue stream which is used to underpin the value of the token.
There have been application layer tokens issued in the past also without any direct link to the economic value created. However, as they do not possess store of value qualities (they are dependent on the technology of the protocol layer “host”), without an anchor to the economics of the project, they risk losing value.
These are tokens that replicate the value of fiat currencies. Their purpose is to facilitate transactions in the digital asset world, without having to interact with the traditional banking system each time.
The legal definition of security tokens is much debated by regulators. However, from an economic perspective, they describe an asset created directly on a blockchain (using a chosen protocol layer) that mimics the economic characteristics of traditional securities (equities, bonds, etc). They represent ownership rights in an underlying entity or rights to underlying cashflows.
These are representations of traditional assets (real estate, security, art, etc) in tokenized form.
Non-fungible tokens are one-of-a-kind digital assets. These may be collectibles, digital art, or a digital memento (eg Jack Dorsey’s first tweet).
The building blocks of the new economy
The various types of crypto assets represent two elements: the building blocks of the emerging new digital economy and digital representations of traditional economic models and assets.
Key to remember
So what are cryptocurrencies? The various types of cryptocurrencies, or crypto assets, typically represent two elements: the building blocks of the emerging new digital economy and the digital representations of traditional economic models and assets.
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