Cryptocurrencies: from the most basic to the most advanced — What are cryptocurrencies?

When we ask people who have not yet invested in cryptocurrencies why they have not done so, most of them tell us that it is because they have no knowledge of the subject.

In this text we will try to give a relatively complete and brief overview of the world of cryptocurrencies and the DeFi world with the intention of facilitating a first approach. We hope that with the concepts given here the reader will be able to go deeper on their own if needed.

As we try to cover a lot of information in a very short space, it is very difficult to be very precise — we will try to be didactic rather than precise.

We will therefore start from the beginning, to end up answering the question that many people ask: do cryptocurrencies have an “intrinsic value”, are they based on “something”, or is it all a scam and has no basis?

In this article, we will only look at theoretical concepts.

What are cryptocurrencies?

Cryptocurrencies are digital currencies that have very diverse uses. The most basic function of all cryptocurrencies is to allow transfers within “their network”, called “blockchain”, which is the technology behind cryptocurrencies.

Each blockchain has its own cryptocurrency. To give a concrete example, the two largest existing cryptocurrencies, Ether (the symbol for that currency is ETH) and Bitcoin (whose symbol is BTC), have their own blockchain, Ethereum and Bitcoin. In the case of Bitcoin, the name of the cryptocurrency coincides with that of the blockchain, and in the case of Ethereum, Ether, and Ethereum are also often used interchangeably.

Apart from BTC and ETH, there are more cryptocurrencies — in this link, you can see what cryptocurrencies there are and what % of the market they represent visually — as you can see, BTC and ETH dominate the market. In this other link, you can see the cryptocurrencies listed.

Blockchains

As we have mentioned, one of the basic functions of cryptocurrencies is to be able to transfer within their network, their blockchain.

We can imagine blockchains as payment networks. Just as there is VISA and MasterCard, which are independent networks, there are Ethereum and Bitcoin, as networks (blockchains) completely independent of each other, which do not talk to each other. Each blockchain uses its own cryptocurrency and does not “talk” to the other blockchains.

In fact, the cryptocurrency of the blockchain functions as a payment currency for the use of the network. That is, ETH is used on the Ethereum network to pay for transactions that take place on Ethereum. And the same thing happens with BTC on the Bitcoin blockchain.

What do you pay to use these networks? To have a payment network you need hardware and software, and someone has to pay for it — it is the user who uses that network who pays for it.

In the case of cryptocurrencies, the hardware is contributed by anyone who installs the software specific to that blockchain on their computer. The blockchain is therefore composed of thousands of people who have installed the software of that blockchain on their computers. When a user of the blockchain wants to send money to another user, for example, he then pays a commission, which is in the currency in which the blockchain works, for example in ETH or BTC.

Therefore, ETH and BTC cryptocurrencies are useful not only as “currencies” (exchange of value), but as a means of payment for the use of a service. In fact, the commissions they hand out to those who provide the hardware are so good that there are publicly traded companies that are in the business of providing that hardware. The hardware is used to validate transactions — BTC uses a so-called “proof of work system”, PoW (Proof of Work), while Ethereum has recently moved to a “proof of stake system”, PoS (Proof of Stake), which is less hardware intensive and therefore more environmentally friendly. Publicly traded companies are engaged in PoW, primarily Bitcoin.

What blockchain technology does is aggregate transactions, validate them, and write the transactions immutably (you can’t go back).

It is therefore a transparent technology: you can trace all the transactions that a given user has made for as long as he or she has participated in that blockchain. It is therefore not as anonymous as one might expect. What happens is that here a user is actually an address, a series of numbers, and that series of numbers (like a bank account number) is not publicly associated with any name or identity document. In other words, it is possible to trace all the transactions of the “account” but it is not possible to make the link between the account and which natural or legal person is behind it in the real world.

Therefore, we have that blockchain technology is decentralized (it runs on the hardware of different users around the world), and therefore is resistant to censorship, it is immutable (each of the users’ transactions is saved) and therefore is transparent and auditable and due to its transaction validation design (PoW or PoS), it is secure, as well as fast (transactions between any part of the world are executed in less than 1 minute, something more in Bitcoin).

Cryptocurrency wallet

To facilitate the interaction of the blockchain user with the address (“your crypto account”), so-called crypto wallets are used.

These allow interaction with the account address via the user interface and in a simple and “user-friendly” way. There are many cryptocurrency wallets, see for example this link

DeFi vs CeFi vs TradFi

If you have come this far without getting lost, you have already understood the most difficult part of cryptocurrencies — using cryptocurrencies on the blockchain is what is called the DeFi (Decentralized Finance) ecosystem, Decentralized Finance, as we have seen transactions between users use hardware that is decentralized.

Unfortunately, this way of operating has so many advantages (decentralization, immutable, secure) is the least used (see for example the volume of cryptocurrencies exchanged in centralized companies vs decentralized protocols).

Taking away part of the meaning that these cryptocurrencies have as a means of payment in their blockchain, cryptocurrencies have been bought and sold in centralized markets, such as Binance, simply for their speculative value — this ecosystem is called CeFi (Centralized Finance).

These companies, such as Binance or Coinbase, are called centralized because they depend on the decisions of one person, the CEO of the company, who could prevent a particular person from making a transaction or expel a particular person from their platform.

This is impossible in the blockchain — there is no one person who is responsible for the network. The blockchain is software running on the hardware of people spread around the world, and therefore no one makes decisions about users or transactions. This, for the time being, prevents any one person, group, or country from censoring transactions or people.

Moreover, since the CeFi environment depends on people, it is subject to the (bad) decisions of those people. Most of the large bankruptcies there have been of crypto companies have been CeFi — see this article, for example.

This is not to say that DeFi finance is completely safe — if the cryptocurrency backing of a blockchain is poorly designed, it too can go bankrupt, as happened with Terra, and furthermore since the blockchain is software, it is subject to scams ( hacks, scams (rug pull) ).

That is, DeFi projects may suffer part of the CeFi problems, but they avoid another part of the CeFi problems, because of their decentralized structure (there is no one person who censors), and all transactions are recorded in the blockchain (and therefore their is absolute transparency of what is done with the funds, where they are sent, how much there is).

Why, if DeFi projects are more secure than CeFi, are there so many more people using the CeFi ecosystem than DeFi? Because of the learning curve — it’s easier to open an account with a CeFi broker, which works similarly to a traditional bank than to open a cryptocurrency wallet and use a DeX (Decentralized Exchange), a decentralized marketplace. It’s easier… but not much easier, and it’s less secure — we always recommend using DeFi solutions.

TradFi (Traditional Finances) represents the classic financial ecosystem — banks (Santander, BBVA, Itau, …) regulated by the central banks of each country.

dApps

So far, we have talked about the Ethereum blockchain and Bitcoin as if they were the same. And while they share things (decentralization, immutability, transaction verification), not all blockchains do the same thing.

In particular, while Bitcoin, which was “born” in 2008, is transaction-only oriented, Ethereum, which went live in 2015, in addition to allowing transactions between users, allows programs to be executed on its network, called smart contracts (“smart contracts”).

These smart contracts expand the possibilities of what can be done on the network, and apart from transactions between users, it allows the creation of currency exchange markets (DeX), and lending currency, and there are even video games or metaverse developments on the Ethereum blockchain, so the versatility of the Ethereum blockchain is immense. Each program that enables one of those functionalities, running directly on the blockchain, is called dApps (Decentralized Apps), Decentralized Apps.

Not only Ethereum allows dApps, there are also other blockchains that allow dApps, for example, Cardano, BSC, or Solana. Here you can see a list of the blockchains out there and what % of the total DeFi market they have [Bitcoin, not allowing dApps, is not considered in that list].

Cryptocurrencies vs Tokens vs Stablecoins

Ethereum has a problem and that is that it is capable of processing a few transactions per second (TPS, transactions per second) — it currently processes 15 to 30 TPS, vs VISA which says it can do 24000 TPS. This fact has to do with the trilemma of blockchains, which have to choose between decentralization, scalability, and security. This is where other blockchain alternatives to Ethereum come in, each trying to bring a different factor to Ethereum. Ethereum itself, aware of the importance of this limitation, has launched a roadmap to update and improve TPS.

Therefore, as we have seen, there are different blockchains, and each of these blockchains is paid with the cryptocurrency of the blockchain itself; Ether for Ethereum, Sol for Solana, and BNB for BSC, … these are cryptocurrencies themselves.

It can also happen that a dApp uses its own currency as a form of payment or any other use within that dApp. For example, the UNI coin, a governance token, is used within the UniSwap dApp. When they are currencies of a dApp, they are called tokens (vs. cryptocurrencies, which are the payment element within the blockchain itself).

In addition to cryptocurrencies and tokens, within the crypto ecosystem, there are also other special currencies, the stablecoins (Stablecoins). These coins have a value equal to the fiat currency they represent ($, €, £) — the largest stablecoins in the DeFi world are those worth 1 dollar ($1).

What is the point of stablecoins? Cryptocurrencies and tokens can vary greatly in price over time with respect to the $. Stablecoins, on the other hand, do not vary, they are always worth the same. The largest stablecoins are the Theter (USDT), USD Coin (USDC), Binance USD (BUSD), and DAI.

How do they achieve parity against the dollar? In theory, you give $1 to the entity that manages each of the cryptocurrencies, and they keep that $, and in return they give you whatever token (USDT, USDC, BUSD, …). That’s the theory. In practice, especially with USDT, in order for the company managing the stablecoin to make money, the $ delivered by users is invested in company debt — on this page, in English, you can see how each of the stablecoins is backed by what kind of debt.

A special case is DAI, which is a decentralized stablecoin — it is still worth $1, but the way to get it is not by hoarding fiat currency like the others; in this case what is done is to overcollateralize the backing — a basket of cryptocurrencies (ETH, BTC, …) can be contributed; for every $1 of DAI the user has to contribute $1.5 of cryptocurrencies from that basket.

Stablecoin is not exempt from losing value if they are not well defined or if people distrust reserves that guarantee 1:1 conversion. As examples, you can see the Terra USD (UST) chart, which we mentioned earlier; or in this other chart how USDT has lost some confidence over periods of time.

In BUSD and USDC there is a lot of confidence in how they back their money, and USDT has already solved its problems — as it matures, the crypto world is becoming more robust. [Edit: from the time we wrote the article until we published it, USDC had a depeg from which it has fully recovered — although it was not the fault of the crypto side, of the traditional banking system, because of the collapse of Silicon Valley Bank].