This is a great article for the beginner who wants to get a good understanding of how cryptocurrencies work.
If you are just looking to buy Bitcoin or Ethereum fast I recommend you check out this article I published earlier instead.
Or check out our list of top rated crypto exchanges.
Now let me guide you through the wonderful world of cryptocurrencies:
1. What is a cryptocurrency?
So you want to learn about Ethereum and Bitcoin? First you need to know what a cryptocurrency is.
A cryptocurrency is a currency that only exists on the internet. It is a digital currency.
“But why is it called a cryptocurrency?”
Crypto comes from the word cryptography. Cryptography keeps your currency safe and stops other people from using it.
Cryptography encrypts your information, and you can only decrypt it with a personal key.
Think of it as a bank safe on the internet. There is only one key to open it, which you hold. Instead of a real key, you have a decryption code.
A cryptocurrency, such as Ethereum or Bitcoin, is very different from a traditional currency like the $USD, £GBP or €EUR, also known as FIAT.
But what are the key differences between a cryptocurrency and a FIAT currency?
a) There are no cryptocurrencies in physical form.
They only exist in code. You may see some coins with a printed B on it sold on various websites, but those are not bitcoins.
b) Central banks control FIAT currencies.
They do not control cryptocurrencies.
c) Regular currencies require a third party (a bank) to make online transfers.
Cryptocurrency transfers are peer-to-peer and do not require a third party.
d) Regular currencies are expensive and slow to transfer across nation borders.
Cryptocurrencies ignore national borders and are almost instant and free, no matter the size.
e) Only 1/6’th of the worlds population has access to modern banking which allows easy money transfers.
A lot of more people have access to the internet, which is the only requirement to use cryptocurrencies.
So more people can use cryptocurrency than regular banking services.
Many of you are probably thinking:
“Okay, so encryption protects my money and data and the transfers seem great. But how does it really work?”
To explain this, I need to introduce you to the blockchain technology.
Instead of being all technical, I will use an anology to first introduce the concept of a blockchain.
Imagine a magic notebook, and every person all over the world can easily get a copy of it for free.
Every time someone writes something in it, it appears in everyone else’s copy.
The more people who read what is written in their book, the harder it becomes to erase.
After a while, everyone with a notebook are in agreement, or consensus about what is written in it.
Your entry becomes the truth according to the network.
For example, Alice writes in her notebook that she transfers 5 bitcoin to Bob.
As 10 people holding the notebook have read it, it is now accepted as the truth and Alice can not take it back.
“Cool, but how do I know who I am transfering my currency to?”
Instead of your name, the network assigns you a long string of letters and numbers, an address.
Your real identity has no connection to the address unless you enter your personal information on an exchange or if you use an unprotected IP-address.
With the notebook I can transfer money by writing the amount I wish to transfer and the address of my recipient in the notebook.
This notebook is the blockchain.
Every page in the notebook is a block on the blockchain.
Every copy of the notebook is a ledger, and every user connected to the blockchain network has one.
People who read the notebook, miners, verify the transactions people write in it.
Ethereum has its own blockchain. Bitcoin has its own too.
“All right, I understand the blockchain technology. But why can’t just a bank run it instead?”
Since everyone is anonymous and is running the same code (everyone has an identical copy of the notebook), the power is distributed among all of the owners of the notebook.
Every person with a notebook is part of running the network, and in order to make any changes to the rules of the network, at least 51% of notebooks need to agree by running the new code.
As a result of this, the notebook (or in reality the public blockchain), is decentralized.
Banks and governments are centralized. A small group of people have the power to make decisions that affects a large group of people, the users.
Centralization is very efficient, but also very insecure.
From a political view, centralization enables the leaders to make decisions that benefit a few at the cost of many.
From a more technical view, centralization is very efficient but also very insecure.
Centralized entitys, such as banks, are security holes.
A bank only holds one or a few copies of the notebook and is constantly under attack. Someone can succesfully hack it and break in and steal or destroy the data.
It’s impossible for someone to steal and destroy every copy of the notebook, distributed to millions of users all over the world.
This is why blockchain technology combined with decentralization offers both more security and freedom to its users than the centralized alternatives today.
“Okay, it is a clever way to transfer money. But is that it?”
Bitcoin, Ethereum and other cryptocurrencies are known for being exactly that, currencies. However, they can be used for so much more.
Blockchains allows you to safely, and very inexpensivly, store sensitive and important data.
They also enable you to make contracts online, smart contracts, which are verified by the blockchain network and do not require a third party to be validated.
This is just the tip of the iceberg. There is already many more uses for cryptocurrencies, but the best is still to come.
Right now cryptocurrencies are like the internet in 1995.
So, simply calling bitcoin a currency is like saying the internet is a clever way to call your aunt on her birthday.
Blockchains will revolutionize a lot of industries and markets. Banking, contract law and data storage are just a few areas which all benefit massively from blockchains and cryptocurrencies.
What ideas can you come up with to put on the blockchain?
2. What determines the value of a currency?
So now you know what a cryptocurrency is, but how do you decide its value?
Well, how do you decide what a dollar bill is worth? Or any other currency for that matter.
Isn’t it just a piece of paper?
To answer this question we need to go back in time:
Before there was paper money, goods were traded for each other.
Let’s make an example:
I am a fisherman, you are a corn farmer and we want to trade.
Pretty fast a few complications arise:
Your harvest comes in once per year and I can’t trade you for a harvest you don’t have yet.
The extra fish I caught today will be pretty rot by the time your harvest comes in.
Even though this seems like a pretty specific example, trade for food was the most common trade in the ancient world.
We need to find a universal third good that we all want and can trade for.
All money is, is a third good that we all agree has value and doesn’t spoil.
Therefore becoming a unit of exchange and a way to store value
In the beginning money came in forms of collectibles like shells or gold nuggets.
It’s value was determined by its scarcity, how rare it was.
Many different items that have some form of scarcity have served as money.
When the Europeans arrived to America alcohol served as a form of money. In prisons cigarettes serve as a form of money.
The list goes on…
As it turns out gold was the third good most people agreed on had value.
Therefore golden coins were crafted and used for trade and storing value.
For many reasons gold coins were not optimal as a means of exchange.
The biggest problem of them all was that over time countries evolved and transactions got bigger.
Imagine you are selling your farm and you receive payment in gold coins.
It’s going to be quite a pain in the ass to transport all those gold coins.
So money had its first technological revolution:
Central banks were created and started distributing paper money backed by gold.
Meaning you can actually trade the paper bill at the central bank for gold.
This was called “The Gold Standard”. The paper money was easier to store and transport making it possible for economies to grow even further.
Now here’s where it gets interesting:
During the second world war every country except one abandoned the gold standard and started printing money in excess.
The United States of America.
How would the other countries decide what their currencies were worth when they weren’t backed by anything?
The solution was simple, just peg all other currencies to the US dollar.
As a result of this the US dollar is redeemable in gold and all other currencies are redeemable in US dollars.
This was how it worked up until the USA decided to take the dollar off the gold standard in year 1971.
This didn’t stop other countries from keeping their currency pegged to the US dollar.
Now you had other currencies redeemable for US dollar and the US dollar pegged to nothing. This is where the term “floating currency” was born.
A floating currency basically means that the currency is worth whatever we agree that it’s worth.
You might still be wondering:
“How do we decide the value of a cryptocurrency?”
Well, let’s look at it:
It has scarcity, it’s impossible to counterfeit, it’s easy to store and divide, doesn’t spoil, and it’s the currency that is hands down the smoothest to transport.
It’s traded 24 hours per day 365 days per year on global exchanges.
The bottom line?
The value of a cryptocurrency is decided by what we agree on that it’s worth. And its the latest technological revolution thats happened to money since the credit card was invented about 60 years ago.
3. Cryptocurrency Mythbusting
3.1 Cryptocurrencies are only used for illegal things
It is true cryptocurrencies, primarily Bitcoin, have been used for illegal trade online.
Silk Road dominated the market for illegal drugs online and used bitcoin as a means of payment.
But simply because criminals use a currency doesn’t mean that the currency itself should be illegal.
The majority of all drug trade in the world uses $U.S Dollars. No one claims that the U.S Government enables drug trafficking by printing the dollar, right?
Okay, but you might think:
“Anonymous cryptocurrencies makes illegal activity a lot easier for criminals”
Yes, this is also true.
I argue that just because something has a partially negative effect, doesn’t mean that we should make it illegal.
Imagine if someone made the same claims about the internet. It makes things a lot easier for a lot of criminals, but the benefits for our whole society far outweigh the negatives.
A lot of people die in car accidents every year. We don’t ban cars, right?
The first people to adopt new technology are always criminals. Andreas Antonopoulos makes a very good argument in his book, Bitcoin – The Internet of Money.
He tells us that robbers were the first to use cars, as get-away vehicles. The first people to use the phone used it to conspire against current leadership.
Cryptocurrencies were adopted early by criminals, but this should be seen a sign of its potential, and not defer us from using it.
Wouldn’t we be foolish to not use all of the potential of the cryptocurrencies?
3.2 Cryptocurrencies are just a bubble
This is a common argument, especially popular in traditional financial media.
- “Bitcoin is just a bubble”,
- “It’s the tulip mania all over again”
- “Cryptocurrencies aren’t backed by anything, it doesn’t have a real value”
So, are cryptocurrencies just a huge bubble?
Are the doomsayers right?
Will Bitcoin be worth 0 once the bubble pops?
Well, I will set things straight.
In any growing industry, bubbles are unavoidable. Many people view bubbles as something inherently bad, but it is a natural part of economic growth and human psychology.
Saying “you shouldn’t buy any cryptocurrency because it’s a bubble” is the same as saying
“the housing market is just a bubble, so you should never buy a house” or
“the stock market is in a bubble, so you should never buy a stock”.
Even if prices were to drastically drop, the underlying technology is always there.
The blockchain technology that was invented with the Bitcoin protocol, that is about to change the way we think about money forever, isn’t a bubble.
Certainly there are overvalued assets and currencies within the cryptocurrency market, just as in any other market.
There will be price corrections, recessions, just as in any other market.
Critics are especially fond of comparing cryptocurrencies to the tulip mania during the 1600’s.
The tulip comparison that critics commonly use is flawed for 2 reasons:
- Tulips are a terrible store of value. They don’t live very long and are very fragile.
- Tulips are difficult to trade and transfer. They require a lot of space and it takes a lot of time to count them for larger trades.
Cryptocurrencies are the exact opposite.
- They last as long as one computer still runs the code and they can not be destroyed.
- Cryptocurrencies are very easy and cheap to transfer and trade.
Every single weakness of the tulip, gold or any other old store of value, is a strength of the cryptocurrency.
3.3 Cryptocurrencies aren’t backed by anything
That’s right, cryptocurrencies aren’t backed by anything.
The US dollar isn’t backed by anything either.
So if a global currency like the US dollar isn’t backed by anything then how can it be worth something?
Well, we have gone through this in depth earlier in this post, but basically:
Forex traders on exchange markets decide the value of the US dollar.
And they take the following into account:
- The current supply and demand for that currency
- Expectations for the future of that currency
So rather than being paralyzed by the fact that a currency like Bitcoin or the USD isn’t backed by anything you should ask yourself this instead:
- Is the supply for this currency increasing? If yes by how much per year?
- Is the demand for this currency increasing? Roughly how many % of the global population is using it today? Is there room for more adoption?
- What expectations do I have for this currency in the future? Is it fully utilised today?
Depending on the answers of these questions you can decide whether or not that specific currency is an interesting investment opportunity or not.
3.4 Risks associated with cryptocurrencies
So now you understand what cryptocurrencies are, how they work and see the advantages over fiat currencies.
But remember this:
Wise investors should always be aware of what risks are associated with their investments.
Now even though Cryptocurrencies are used as money to make purchases of various kinds it’s also considered to be a commodity like gold and silver.
That means that it’s just as vulnerable to market volatility like other commodities and stocks.
Cryptocurrencies are a very young active commodity. This makes the market more volatile than other investments.
Meaning it will swing more wildly up and down than most other investments out there.
The cryptomarkets are unregulated meaning there is no government entity monitoring whats going on. This is the point with a decentralised system.
In theory if a government would try to ban or impose laws against cryptocurrencies the market could see a sudden drop.
At the moment:
Bitcoin also faces scaling issues.
The Bitcoin blockchain can process roughly 7 transactions per second.
In comparison, Visa can do thousands of transactions per second.
The Bitcoin community is split over how to solve this scaling issue.
A new method of computation has been proposed by some and the community is currently holding its breath while this issue unravels. For those who want to read about it in depth you can do that here.
All in all:
This is not meant to discourage anyone from investing in cryptocurrencies.
However you should be aware of potential risks when you enter this world, and see your investment as a long placement.
Don’t let short term drops put you in a state of panic, it’s something you will have to deal with.
Can you handle it?
4. How to buy and store your Bitcoin and Ethereum
Buying and storing cryptocurrencies may seem intimidating to a new user, but there is no need to worry.
I will guide you through and explain every step of:
- Buying your Ethereum and Bitcoin with various methods of payment
- Storing it securely
- Transferring and buying services and goods with Ethereum or Bitcoin
Before we get into the details of buying your first cryptocurrency, there are some things you have to learn.
4.1 What is a wallet?
Cryptocurrencies are stored in a personal wallet. Your wallet has an address connected to it, the same address we talked about in part 1 – What is a Cryptocurrency.
In order to receive cryptocurrency, you provide the sender with your address. It is important your address is correct, as transfers to other wallets are impossible to restore.
An Ethereum address always starts with 0x.
There are different kinds of wallets, some more secure than other. I will rank them by security, with #1 being the most secure.
I recommend using the most secure method possible to store your cryptocurrencies.
4.1.1. Hardware Wallet
A hardware wallet is the most secure way to store your cryptocurrencies.
Remember what I told you about your encryption key in the beginning of the article? Strong encryption protects your wallet, and in order to access it you need your private encryption key.
The thing is, when you create any other kind of wallet than a hardware wallet, your keys will be exposed for a brief moment when you write it off your computer screen.
If there is malware on your computer, a potential hacker could see your private key and access your funds.
A hardware wallet never displays your private key. It is securely stored within the hardware, out of reach for hackers. The hardware wallet is accessible both online and offline.
Only you have access to the wallet as no third party holds your keys. They are exclusively yours. Some of the weaker ways of storing your cryptocurrencies means you trust a third party to keep your keys safe.
This is why I recommend the hardware above anything else.
There are a few different options to choose from. Trezor and Ledger both make excellent hardware wallets. They are both easy to set up and use but have some minor differences.
Here on Coinworld, we have a guide to setting up and using a hardware wallet made by Ledger. You can find the guide here: How to set up and use a Nano Ledger S
4.1.2. Paper Wallet
In my opinion, this is the second safest way to store your cryptocurrency.
A paper wallet means you do not store your personal encryption key anywhere digitally.
You simply write the encryption keys down on a piece of paper, and those keys allow you to access your wallet anywhere.In order to create a paper wallet, you need to generate a new wallet address on the Ethereum network.
- Go to https://www.myetherwallet.com/, a free open-source wallet.
2. Enter a secure password! This is important, read this guide on how to create a strong password in case you are not sure on how to do it.
Strategy 2 is specifically made for cryptocurrency wallets.
3. Download the Keystore file. You either use your keystore file + secure password or your private key to access the wallet.Make a backup of your keystore file and store it on a new, unused USB stick.
4. Save your private key. THIS IS EXTREMELY IMPORTANT. In case you lose the keystore file or forget your password, this is the only way to access your wallet.
5. Print the Paper Wallet and store it securely.
6. Access your wallet by either using the keystore file + password or your private key. In your wallet you will find your personal address.This is the address you provide people with in order to receive Ethereum in your wallet.
4.1.3. Online wallet
In my opinion, this is by far the least secure way to store your cryptocurrencies. Third parties are security holes as mentioned earlier. They can either be hacked or act unethical and steal your funds.
However, they are the easiest to use and many new users prefer them for this reason.
Exchanges often provide their own online wallets, where your funds are initially transferred after purchase.
If you want to use an online wallet, I recommend using Coinbase. Coinbase offers a more secure way to store your cryptocurrencies than most other online wallets.
- Go to http://www.coinbase.com/ and enter your e-mail address.
2. Follow the sign up instructions
3. Activate your account by clicking the link sent to your e-mail
4. If you do not wish to buy cryptocurrency from Coinbase with a Credit Card, you can now simply use their wallet to transfer funds by going to Accounts and generate a new address.
4.2 Buying your first cryptocurrency
Okay, so you have set up your wallet and you have a wallet address that you can send your funds to.
There are a few different ways to buy cryptocurrencies, some easier than other.
Usually, the easiest ways to buy cryptocurrencies are the most expensive. I will cover the most common ways to buy your ethereum. Credit card and bank wire.
4.2.1 Credit card
Buying ethereum with a credit card is the most expensive but also the easiest way. Many exchanges offer simple solutions to use your credit card.
Usually there is a limit to how much you can purchase with a credit card which makes it impractical if you are looking to buy larger amounts. Fees usually range anywhere from 5-15% for purchasing with a credit card.
Most exchanges work the same, but for new users looking to use a credit card I always recommend using Coinbase, so for educational purposes I will use Coinbase to demonstrate.
1. Go to Coinbase or the exchange of your choice to find reviews of all exchanges click here.
2. Open an account. It is important you use correct information as you are required to verify your account in a later step.
3. Go to the Buy / Sell – section and begin the verification process of a Credit Card
4. Fill out the required information. On Coinbase you are required to upload a picture of your ID in order to make purchases. The process is swift and usually only takes 2-3 minutes using their verification method and uploading the picture through your phone.
5. Visit the buy tab and place an order for the amount you wish to buy.
6. The ether or bitcoin will appear in the wallet of your exchange. From this wallet, you can withdraw to your personal wallet.
7. In order to withdraw to your personal wallet, you need the public key (wallet address) of said wallet.
8. Go to withdraw on your exchange, and follow the steps. Some exchanges may require you to confirm the withdrawal by e-mail so make sure to check your inbox and spam folder in case your withdrawal is not approved.
9. Note: Some exchanges transfer directly to your personal wallet. You are required to enter your address at the moment of purchase.
4.2.2 Bank wire
A slightly less practical but cheaper way to buy your cryptocurrency is depositing FIAT from your bank account to an exchange.
Using an exchange like Kraken, GDAX or Gemini allows you to trade cryptocurrencies at market price, paying only a 0.2% – 0.5% fee + any potential bank wire fee, depending on your location.
For users within the European Union, SWIFT transfers are free and quick.
Most exchanges work the same, but I will use Kraken to demonstrate how to buy cryptocurrencies with a bankwire.
1. Go to Kraken or the exchange of your choice
2. Open an account. It is important you use correct information as you are required to verify your account in a later step
3. Verify your account by providing the information asked for. This varies depending on the exchange and what limits you wish to use. In the example pictures from Kraken you are required to provide name and address before you can transfer funds to your account.
4. Wait for the verification process to complete.
5. Go to the Funding-tab in your exchange and choose your prefered method of deposit.
6. The exchange will give you a bank account as well as a personal code to connect your deposit to your account at the exchange. It is important you include this as a message in your bank wire as they won’t be able to credit the deposit otherwise.
7. See your online bank for guidelines and which kind of bank transfer to use. A SEPA-transfer usually takes on 1 bank-day, while other bank wires can take up to 5 days.
8. Once your account is funded, select the pair for the cryptocurrency you wish to buy. In this example, I choose to buy BTC for € on Kraken.
9. There are different kinds of orders. If you wish to buy at market price, simply press this button and the exchange will automatically choose the current lowest ask.
10. Complete the order and wait for it to fill.
11. Once the order is filled, you find your ether or bitcoin in your exchange wallet. Go to withdraw and choose the currency you wish to withdraw.
12. Enter your wallet address and verify the transaction. You may be required to confirm the withdrawal through e-mail.
13. The exchange will review your deposit and credit your wallet. This is usually a swift process but some exchanges may take longer to review it, so do not panic if it hasn’t transferred in a few minutes.
14. Open an account. It is important you use correct information as you are required to verify your account in a later step.
All deposits with bank wire require a verification of some form.
4.3 How to Transfer
Okay, now we have our wallet set up and funded with cryptocurrencies.
It is a very simple process if we wish to transfer funds ourself.
1. Go to your wallet (In this example I am using Coinbase)
2. Enter the recipient address
3. Enter the transfer amount
4. Double-check the information. Lost transactions due to faulty addresses can not be reclaimed.
5. Press transfer.
In order to recieve payments yourself, simply provide the sender with your wallet address.