There are hundreds of cryptocurrencies, and many of them are very similar, so rather than focusing on Bitcoin, I’ll talk about cryptocurrencies in general. I may generalize some points.
For those of you who might be technical, I welcome feedback, keep in mind that the audience I’m going for is looking to purchase their first cryptocurrency.
How do cryptocurrencies work?
The problem with centralized currencies is that the database is controlled by a third party and could be a single point of failure. If you did something the issuer didn’t like, they could impose fines or confiscate your funds. If the centralized database was hacked, your money could also be reallocated or stolen. With a centralized model, you are trusting a third party with your “money.”
Cryptocurrencies are different because they use a shared public ledger to keep track of funds. The ledger is distributed across a peer-to-peer network that consists of miners, nodes, and users. The miners and nodes keep a full copy of the ledger, known as the blockchain, which records every transaction that has ever happened. This blockchain/ledger is propagated across the world and is cryptographically checked approximately every 10 minutes using a process called mining. In basic terms, the miners on the network look for pending transactions on the network, check to make sure they are valid and that the funds have not already been spent and add them to the blockchain. The miners take a small fee from each transaction and are rewarded with 12.5 new bitcoins for each block mined. There is much more to mining, but that will be a separate blog post.
Otherways of acquiring cryptocurrencies is to request them as payment for work, think freelancers, or to trade bitcoin for cash in real life. If you would like, I might be willing sell you some bitcoin or litecoin in real life (minus the fees and probably a beer).
A single bitcoin/litecoin is divisible into 1 million units called satoshis (for bitcoin). This is similar to how a US dollar is divided into 100 pennies. Because of this division, you don’t have to purchase a whole coin. In fact, the first time you try this, it might be best to buy a small fraction, say $50 worth. This way you can test the process out in a relatively stressfree setting.
When you purchase an item with a credit card, the credit card company offers protection in case or fraud and can reverse transactions. This is one of the reasons that credit card processing companies charge merchants a higher fee for transactions. Refunds are not possible with cryptocurrencies because cryptocurrency transactions are irreversible. As such, Coinbase will usually wait a few days for the money from your bank account to clear their bank account before depositing your cryptocurrencies into your Coinbase account. At this point, you don’t fully own your cryptocurrency, just an IOU for that cryptocurrency.
Holding your keys
When you purchase cryptocurrencies from an exchange you don’t own the coins; you own an IOU for that cryptocurrency. Think of an exchange like a bank. You have an account at the bank with money in it, but you don’t possess the money. The bank can use that money to lend to others, you just have an IOU for that money that you can redeem at any time. Banks are considered safe in the United States since your deposit is insured through the FDIC. With exchanges, you are trusting the exchange to keep your funds safe, and there have been many instances where crypto-exchanges have been hacked, lost money or were straight up frauds. Not trusting exchanges could be an entire post, if you are interested, check out what happened with Mt. Gox.
The ideal solution is for you to become your own bank and hold the keys to your funds yourself. The simplest is to download a trusted mobile wallet from the App or Play Store. For Bitcoin, I would recommend Copay, I use the iPhone version, but they also have an Android version (I haven’t used it though). Their code is opensource, and anyone can audit it for security issues. Using a trusted wallet is crucial because this app will hold your private keys it contains the access to your funds. More on the public and private keys in the next section.
A third option is to store your keys in the real world using a paper wallet. I haven’t used this method so I’m not going to go into it.
Public and private keys
Your wallet will hold two keys, a public key, and private key. At a low level, the public key is used to create an address that cryptocurrencies get sent to. The private key is used to authorize transfers of currency out of your wallet. As such, it is essential to keep your private key private!
Setting up your wallet
With these sixteen words you can get access to your public and private key and from there get access to your wallet. If these words are compromised then your money is compromised! Never type them into a computer as specific malware has been created to search for these phrases.
Transfering funds from the exchange to your wallet
After you hit continue, there will be a screen to verify (Coinbase), and after you have confirmed that your address is where the currency is going, hit send. Within a few minutes, your wallet should recognize that the transaction is on the network. It won’t be fully transferred until a miner has found the transaction and placed it in a block. This process takes on average every 10 minutes.
Once a miner has added your transaction to a block, it is considered to have one confirmation. Each block that gets added to the blockchain is an additional confirmation. So after five blocks are added, the transaction has five confirmations. As I mentioned above, confirmations, which is part of mining should be covered in its own post.
You now own your cryptocurrencies and you are your own bank! Within your wallet, you can send funds to other addresses or hold them. If you want to convert back to fiat currency the easiest way is through an exchange. You can send that money back to the exchange and from there exchange it back to fiat. Or find a friend who wants to buy some cryptocurrencies and help them set up a wallet. They will give your fiat and you can send them some coins!
If you only remember two things it would be this:
- If you don’t own your (private/public) keys, you don’t own your cryptocurrency. Do not keep your cryptocurrencies in an exchange!
- Don’t share your private key with ANYONE and never type it into a computer as it could be compromised.
If you have comments, additions or questions please leave them below or email me!