A Newcomers Guide to Cryptocurrency

This is the first photo that shows up if you search crypto on Pexels and I think the physical coins and the SD card just really sell it. Photo by Worldspectrum on Pexels.com

What are cryptocurrencies?

Cryptocurrencies are tokens issued on an append only ledger. This ledger is called a blockchain, because it is composed of discrete ‘blocks’ of transactions each block containing information about which blocks came before so that they can be appropriately ordered. Sometimes like in the case of Bitcoin, Ethereum, Solana, or Avalanche the token is used to incentivize the users who create the ‘blocks’ of transactions that are added to the ledger. Sometimes like in the case of MakerDAO, Uniswap, Compound or a variety of other decentralized finance applications these tokens are instead issued as part of a ‘smart contract’ that resides on the ledger, and which can be interacted with by creating appropriately constructed transactions and getting them included in a block.

What are cryptocurrencies good for?

Cryptocurrencies are potentially useful when you need ‘censorship-resistance’. Bitcoin’s principal innovation is that it provided a protocol that made it difficult to stop any single transaction. Ethereum expanded this idea with a much broader range of possible transactions which enabled a wider array of interactions.

It’s valuable to remember that the censorship-resistance makes it more likely you will be able to send the transaction, but does not spare you from the consequences of that transaction. Since most cryptocurrencies rely on a public ledger they can even potentially exacerbate this problem, because if you are making a risky transaction that could make you a target, you need to be exceedingly careful to ensure that you protected your identity now, and that the tools you used are adequate to ensure you are protected indefinitely into the future.

If your recipient is someone who needs to transact in things where cryptocurrency is not accepted then they will need to convert the cryptocurrency back into cash. This transaction is one that is very likely to be censored, and is the reason that having a circular economy is important for the practical censorship-resistance of cryptocurrencies.

Why are cryptocurrencies (potentially) useful for ‘censorship-resistance’?

Because in order to avoid the centralized intermediaries they have built systems that are more challenging to interfere with (because there is no single intermediary to target). Consider for example Bitcoin, in order to send a transaction on Bitcoin you first broadcast your transaction into the mempool, it will then be seen by all the miners, who each are doing redundant work to hopefully win the ability to include your transaction in a block, which will then be validated by the nodes on the network. When these systems are designed carefully they can rely on this duplication of efforts to help reduce the probability of censorship.

The problem of course is that this duplication of efforts has a cost associated with it. Using cryptocurrencies will nearly always be more expensive than centralized alternatives.

What are cryptocurrencies not good for?

Anything that does not require censorship resistance will almost certainly not benefit from cryptocurrencies. Using cryptocurrencies for things that do not require censorship-resistance will nearly always result in a more expensive solution. Trust and centralization make things much more efficient.

Why do people keep using cryptocurrencies for things?

Because it is your opportunity to create a thing with no intrinsic value and sell it to others, who hope that someday they will be able to sell it to someone else.

This allows the creator an opportunity to get significant wealth from their project. It also potentially enables early adopters to get significant wealth, so long as they do an adequate job of convincing late adopters that it is valuable.

There is also often regulatory arbitrage or regulatory non-compliance going on. To issue a security in the United States you need to go through a whole registration process with the SEC. To issue a token you need a couple hundred bucks (or maybe less depending on the chain) and a weekend. You may not get away with it, but often even when the SEC goes after someone, they end up with a fine that is far less than what they raised, so some decide it’s worth the risk.

What about NFTs and DAOs?

A Non Fungible Token is exactly what it sounds like, a unique token on the blockchain. Often these are a bit of text that contains some metadata like an id number for the token, and often a link that you can visit to view the art. Frequently that art is hosted on a website like this one. Sometimes they are hosted on other decentralized networks, and in those cases you need to make sure that you continue to pay to keep it hosted. They are occasionally used for other things, Uniswap for example will issue NFTs that represent a specific position on the exchange.

Decentralized Autonomous Organizations are nearly always a marketing term to describe a group that is neither decentralized nor autonomous. In their most common form they are a Discord and a wallet that several of them control. In their most advanced form they govern smart contracts, changing parameters and creating transactions automatically based on the communicated preferences of the organization’s members.

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Bennett’s Note: This post is clearly inspired by a piece I recently read in the New York Times. I also contributed to a response to that piece, and you can find that here.

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