Cryptocurrencies are a fascinating technology that combines the economics of money with the math of cryptography, and the science of computers! This technology has evolved over the years, with Bitcoin being the first successful project to put itself into the media spotlight (for both positive and negative reasons). Just like many new technologies, with Bitcoin’s introduction in 2009 very few people took notice of its release, but within less than a decade you begin to see worldwide change beginning to start. Fast forward to present day and cryptocurrencies are quickly earning the reputation that they will be a fundamental technology of the future; inevitably touching many aspects of our day-to-day lives. It’s this world view and belief that prompted us, at Cybrid, to make it easier to not only understand but connect to these exciting new opportunities. To help ease you into all of this, we’ve put together this Crypto Primer to help understand some of the basics so let’s get started!
Cryptocurrencies, and their underlying blockchains, compose a fairly complex set of technologies. While you don’t necessarily need to be experts in every aspect of cryptocurrencies - and truthfully it’s nearly impossible to be with how fast the market is growing - it’s worthwhile to have a high-level understanding of some of the core tenets of what makes crypto tick.
Blockchain, as we know it today, is tied to the introduction of Bitcoin in 2009, which was based on a late 2008 paper released by Satoshi Nakamoto. While many argue that Bitcoin isn’t a great blockchain for a number of reasons (such as scalability and extensibility), it started a chain reaction (pun intended) within the technology industry that has yet to slow down.
Blockchains are composed of several different characteristics, but you can effectively think of them as a database, that have been distributed instead of centralized, and which use cryptography to secure the database and associated transactions.
The underlying cryptography ensures several key aspects, including:
By relying on these mechanisms, in a large-scale distributed system, blockchain has been able to solve the underlying problem of how to transact digitally, in a safe and secure way, without all the traditional financial intermediaries.
In order to process transactions on blockchains, they employ a consensus mechanism used to reach a shared agreement on what changes have occurred on the blockchain, and to commit that in an immutable (unchangeable) manner. The two core consensus mechanisms are Proof of Work, and Proof of Stake.
Proof of Work consensus leans more heavily into cryptography, and uses algorithms to generate unique hashes. Systems running these algorithms are generally referred to as miners, and when miners find a specific type of hash (just a long unique string of characters) they are granted the right to commit the next transaction in the blockchain. Additionally, they receive a reward for this process, which both provides incentives to mine new blocks as well as introduces new coins in the network. Over time the size of the rewards often decreases, creating deflationary pressure on the coin. Some people shy away from this style of consensus due to the sheer amount of computing power it requires, and the related downstream environmental impacts.
A major alternative is Proof of Stake, which is gaining rapid adoption in newer blockchains and cryptocurrencies. In a Proof of Stake model, instead of ‘spending’ compute in order for the right to commit the next block in the chain, a certain amount of coins are staked or locked into the network in exchange for the right to commit blocks. Typically these coins are staked in something called a validator which performs the validation of transactions and committing of blocks. Validators are rewarded, in the same way that miners are rewarded, based on the percentage of coins that are staked.
Regardless of the model, consensus mechanisms are a critical function to handle the settlement of cryptocurrencies, and are a key focus on scaling the underlying blockchains and driving part of the economics of the currencies themselves.
The basic blockchain mechanism is a fairly powerful construct, however with the addition of smart contracts the capabilities and possibilities are taken to the next level. You can think of smart contracts as a small program, or bit of code, that can run when a transaction occurs on a blockchain.
More concretely, smart contracts are a set of instructions that can be stored on a blockchain and can be performed when called upon via a transaction. The more instruction data that is required, the larger the transaction fee. Smart contracts can come in the form of dApps, which are a set of instructions allowing users to access some specialized kind of functionality in ‘web3’.
In more advanced forms, a set of smart contract instructions can come together to codify the rules of a digital organization, often referred to as a DAO, or Decentralized Autonomous Organization. The rules of a DAO smart contract can govern everything from membership and voting, to operational workflow and capacity, and effectively merge the idea of a corporation with that of an application.
If blockchains were the first step in turning money into a software base layer, smart contracts represent the next step of turning transactions, businesses, and possibly even future governments into applications which run on top of blockchains.
Layer 1 vs Layer 2
According to CoinMarketCap, there are nearly 20,000 cryptocurrencies, and they diverge quite significantly in terms of underlying blockchains and technology. Layer 1 blockchains are full cryptocurrency platforms or networks by themselves, while Layer 2 blockchains, which are often referred to as side-chains, are an extension of their Layer 1 parent chains with the purpose of introducing additional benefits.
Layer 1 is often described as the base layer of a protocol whereas layer 2 is often a 3rd party solution meant to specialize or abstract portions of base layer functionality while adding functionality or features. Those additional features can vary, but can include one or more of the following:
The predominant Layer 1 solutions include Bitcoin (BTC), Ethereum (ETH), Solana (SOL), Cardana (ADA), and Terra (LUNA) while Layer 2 solutions of note include Lightning Network (LN), Polkadot (DOT), Polygon (MATIC), Arbitrum, and Optimism.
Coin vs Token
Coins typically have their own native blockchain solution, while tokens are assets that can run on top of an existing blockchain. A good example of native coins include Bitcoin (BTC), Ethereum (ETH) or Solana (SOL).
With the introduction of Ethereum, and its innovative smart contract capabilities, it became possible to create non-native cryptocurrencies that effectively used the template of ethereum. Specifically, Ethereum introduced the ERC token definition, which allowed other developers to fairly easily launch their own cryptocurrency without building all of the underlying Layer 1 technologies that would normally be required. These ERC tokens ride on top of the Ethereum blockchain, making use of all ETH’s benefits, while providing additional and unique benefits or features.
Newer blockchains such as Solana (SOL) with its SPL tokens, are also introducing this concept in order to drive innovation and network growth factors on its platform.
The core activity of cryptocurrency, and their underlying blockchain technology, is the efficient processing of transactions. A transaction is a signed (approved) record of change to a blockchain which is irreversible once validated. As previously discussed, each blockchain has their own consensus model, which is one of the reasons it can become complex to develop and maintain solutions across a number of different currencies and DeFi protocols.
At its root, a transaction is responsible for taking a concrete and immutable action, such as moving coins or tokens from one wallet holder to another. Transactions have a number of properties and external factors that influence the operation, including:
A nonce is an integer-based number that increments with every transaction associated with a cryptocurrency wallet. It starts at zero when a wallet is first initialized, and when processing transactions, validation of the transaction will include checking that the nonce is the last validated nonce for your account + 1.
Understanding nonces is important as each currencies’ wallet transactions are processed in the order of their nonces. What this means is that if a transaction gets stuck due to low gas fees, any subsequently submitted transactions from that account will be held up until the first is processed. Occasionally it’s even required to resubmit a transaction with the same nonce as a previous transaction in order to cancel it.
There’s no free lunch as they say, and the same is true for crypto. Even though the technology is distributed, there can still be substantial capital and operational costs associated with approving transactions. Gas fees are the real-time market costs required for the computation to process a transaction (in Proof-of-Work systems), and the payment rewarded to staking validators (in a Proof-of-Stake systems). If a transaction is submitted with the gas fee set too low, it will sit in the memory pool until market fees match what was set.
Knowing what gas fees to use, and how that impacts transaction performance and settlement is key to operating crypto infrastructure.
The mempool is like a waiting room for transactions that have not yet been confirmed to the blockchain. To exit the mempool, a transaction must be validated in a block. Having a clear view into mempool queue sizes help to understand when transactions will clear, and also when to potentially adjust gas fees.
Most blockchains do not allow a transaction to be canceled once submitted with approval. In order to ‘cancel’ a transaction, submitting a transaction of no value, with the same nonce as the transaction you wish to cancel, and a higher gas fee is required. You ultimately still pay a transaction fee, but the initial transaction data is not computed.
Mempool sizes, gas fees and how they’re changing, and current transaction nonce all effect the verification time of transactions. Ultimately the verification time is dependent on the above network performance and the specific gas fee paid.
Fungible vs non-fungible
The term ‘fungible’ simply means that one asset is just like another. There is no difference, and both assets are interchangeable. This is the fundamental mechanism describing money. We all recognize $20 USD is $20 USD, and can easily exchange that for other goods and services. Prior to fungible asset classes we generally needed to use some type of barter system, trying to come to agreements such as my basket of apples is worth half a bucket of your turnips, which made trade much more difficult.
When assets are non-fungible, this means that an asset, while similar to others, has a unique value and is differentiated from others. While I could easily exchange $1 for $1, we can’t easily exchange an apple with a Picasso, since each has their own unique and different value.
In cryptocurrency, a fungible coin or token is one that can be easily exchanged for another of its kind. An example would be Ethereum. Once added to your account there is no way to tell one ETH from another, and I can easily exchange them. On the other hand, a good example of non-functional token, or NFT, is a CryptoPunk or similar piece of digital art that has been ‘minted’ on the blockchain. You can’t easily exchange one CryptoPunk or Bored Ape for another, since each has its own unique value. You need to convert (or sell) those assets to some type of fungible common denominator, like Ethereum.
There are a variety of different tokens that can be created on multiple of blockchains. Each of these tokens has their own base standard. Token standards are the set of rules that smart contracts interact with. Each blockchain will have its own standard(s). Sometimes new standards are simple improvements, and in other cases some are defined for generic use cases.
Sometimes tokens are used for the purposes of adding some type of abstraction layer on top of existing coins, such as an IOU. This coin or token may be located on the same blockchain (e.g. wETH on Ethereum), but it might also represent an asset from another chain (e.g. wBTC on Ethereum).
While digital wallets have notionally been around for a number of years, especially with the advent of smartphones and the integration of debit and credit cards, blockchains and cryptocurrency bring wallets to a whole different level.
Some have referred to web3 technologies as read-write-own, versus web2 technologies which were just read-write. Blockchain-based wallets are what enables that ownership, since the cryptocurrency coins and tokens you own, if you hold them in your own wallet, are literally in your wallet. They aren’t stored as a number in a database somewhere that could be changed or taken away in a moment's notice, but rather on a secure piece of software or hardware that requires your digital signature in order to perform any transaction.
Here are a few of underlying components of wallets that are good to understand:
Public & Private Keys
The public and private key provide access to a wallet (account) on a blockchain. The public key is your receive address, which anyone and everyone can see, and is what would be provided to other parties so they can send funds. The public key is like read only access for an account.
The private key is what you use to sign (approve) transactions for a wallet, and without the private key you cannot access your funds at all. The private key is like having admin access.
This is a significantly different model than how we normally access and control our money, and is a key area where those that are new to cryptocurrency can make mistakes. Losing a private key, or having it compromised, means someone could take all of your funds with no further recourse. So it’s critically important that keys are protected.
Hot vs Warm vs Cold
There are a couple of ways wallets can be configured which change how they are used and how they are protected. Hot vs cold is more of a sliding scale than a toggle switch, where the ‘temperature’ of the wallet indicates the permissions or accessibility surrounding the keys.
On one end of the spectrum, an example of hot wallets would be browser based wallets with limited password protection; access to the wallet is open and transactions can easily be signed. On the other end of the spectrum, a cold wallet would have an air gapped hardware device; access to the wallet is limited to physical access plus performing a required protected sequence to sign transactions.
In the middle of these two extremes is the growing concept of warm wallets, which are not air-gapped like cold wallets, but they do have significant levels of additional security layered on. Usually this includes some type of multi-key or multi-signature cryptography, so that there is more than one key, often stored in more than one location. It also usually means levels of policy and approval workflows, in order to protect large or anomalous transactions.
Custodial vs Non-Custodial
A custodial wallet is one where the owner of the assets in the wallet and the holder of the wallet’s private keys are different entities. Users or organizations who are not comfortable managing their own wallets directly may want to leverage a custodial wallet, so they can still easily store their cryptocurrency, but they defer all of the risk and security to a third party.
It should be noted that there is a distinction between regulated and non-regulated custodians; regulated custodians offer greater assurance towards the quality of vendors, and usually operate in accordance with specific regulations or guidelines associated with the country they operate in, but this isn’t always necessary.
A non-custodial wallet is one where the owner of assets is in control of the wallet’s private keys. These are sometimes referred to as self-custody wallets, though there are large scale custodial wallets that are used for both individuals and institutions which are considered non-custodial, but are better described by the growing area of warm wallets.
Exchanges exist to convert one currency for another, and are often used as onramps into, or offramps out of, crypto. Someone can take their fiat currency, such as USD, and exchange that into cryptocurrency, such as Ethereum.
Exchanges need some amount of funds in the variety of currencies they convert, and this is referred to as liquidity. The more liquidity an exchange has in a given currency, the more easily (and cost effectively) you’ll be able to convert to or from it.
Centralized Exchanges (CEX)
In traditional finance, exchanges have been centralized, and this is largely how the cryptocurrency space grew as well. A centralized exchange relies on an orderbook that is controlled by a business and often these exchanges share similarities to a stock market exchange. A CEX’s orderbook is often limited to the subset of its users and market makers.
Decentralized Exchanges (DEX)
A growing alternative to centralized exchanges is the concept of decentralized exchanges. Instead of any one organization owning and funding the exchange, it relies on blockchain technology as infrastructure to maintain and manage the orderbook activity between buyers and sellers, usually referred to as Automated Market Makers (AMM’s). DEX order books can be connected between applications, with cross-chain liquidity arbitrage opportunities. Funding a decentralized exchange is open to the market, so anyone can participate in, and get rewards from, providing liquidity to a pool.
While most cryptocurrencies are speculative in nature, it’s come as no surprise that efforts have been made to match some coins with a specific fiat currency, like USD. In order to match a currency, a crypto coin needs to remain pegged to the exact price, for example being able to exchange $1 USD with 1 USDC. Mechanisms are used to ensure that the crypto-to-fiat peg remains intact, and usually rely on buying and holding the exact amount of fiat vs crypto dollars, or, using some kind of algorithmic approach to keep the coin price at $1 USD.
The latter model is growing in popularity, and there are a number of algorithmically stable coins such as DAI, and UST, which use a variety of software mechanisms to ensure a peg to $1 USD remains in place.
Some stablecoins are controlled by specific organizations, such as USDC by Circle, and USDT by Tether. Alternatively, stablecoins can be decentralized, such as DAI by MakerDao, or RAI by Reflexer Labs.
Lastly, there is a significant amount of ongoing discussion, and debate, about CBDC’s, or Central Bank Digital Currencies. A CBDC, instead of being issued by a corporation or a decentralized project, would be issued and controlled directly by a central bank or government, and regulated just like fiat currency or cash. CBDC’s could play a major role in the future of money and simplifying the traditional complexity of financial infrastructure.
Like cryptocurrencies themselves, the decentralized finance movement has largely grown on the backs of retail traders, usually operating without any type of user validation. This is both an interesting feature of DeFi, while also being a major roadblock in adopting these new financial mechanisms in a broader and more regulated market.
Permissined DeFi aims to solve this problem by providing full KYB (Know-your-business) or KYC (Know-your-customer) vetting in order to access and participate in certain DeFi protocols or capabilities. By doing so, AML requirements can be met along with solving some of the issues regarding pooling of funds (e.g. Aave ARC, 1Inch Pro, or Tinlake).
With all the different blockchains, like Ethereum and Solana, the need for these protocols to communicate and exchange data to reduce information/value segregation proved to be an industry issue. As a result, cross-chain interoperability solutions began to emerge to bridge networks. These solutions aim to allow messages, tokens, and actions to be able to flow from one blockchain to another, while maintaining security and decentralization.
One technical feature that certain cryptocurrencies have is something called staking, which is the activity of pledging or voting using coins/tokens to participate in network governance. In reward for participation in governance, the ‘stakers’ will generally receive additional tokens similar to a dividend. Unlike the simplicity of a dividend, which is issued monthly, quarterly or yearly simply by holding a stock, for each cryptocurrency, there are differing warm up times, payout schedules and unbonding periods to be aware of. On top of the technical aspects of entering and exiting staking, choosing and voting for the correct ‘validators’ is an important task as poor performance can cause some loss of the assets through a process called slashing. As networks mature and governance importance increases, staking of coins and tokens will generally be defaulted to on and as such, a seamless user experience is vital. Let Cybrid’s technology, experience and knowledge provide the backbone to your organization's staking functionality.
While this guide only scratches the surface for cryptocurrency knowledge, we hope it’s provided you with the basics required to begin to understand the space. We don’t mean to overwhelm, but the knowledge uplift alone to get into crypto can seem daunting. If your organization wishes to enter this exciting new space, but feels the technology development and legal legwork, on top of operational resources to maintain a crypto presence makes the thought seem like a pipe dream, let’s have a discussion on how Cybrid can help empower your offerings through our easy to integrate APIs and SDKs.
If you’d like to learn more about how cryptocurrency might be useful within your organization, make sure to check out our FinTech Guide to Crypto.