Crypto 101

Cryptocurrencies are virtual tokens that have value attached to them. There are many different types of cryptocurrencies, offering a range of different utilities. The most exciting aspect of cryptocurrencies is their underpinning technology – ‘blockchain’.

Most people start their journey into crypto by first learning about the oldest and largest cryptocurrency – Bitcoin.

At Zerocap, we often say that “Bitcoin is King” – because even though over 10,000 different cryptocurrencies currently exist, Bitcoin is still the most utilised digital asset. So far, it has successfully maintained its dominance as the most valuable and widely adopted asset in the crypto space. For this reason, it makes sense to begin the Crypto 101 series with a discussion about Bitcoin.

For a deeper understanding, read our extended article on What is Cryptocurrency.

Bitcoin was invented by Satoshi Nakamoto, who introduced Bitcoin to the world in 2008 through its “Whitepaper” (the technical and conceptual blueprint for Bitcoin). The true identity of Satoshi is unknown – some people believe them to be a hidden group of people or organisations, while others speculate that he/she/they may have already passed away. Remaining anonymous was a deliberate decision by Satoshi to keep Bitcoin independent from any individual, government or central body.

Bitcoin is used as both a medium of exchange and a store of value.

Medium of exchange

Bitcoin is used as a way of making transactions and exchanges over the internet. While this was already possible using fiat currency – (traditional government issued currency)- , Bitcoin is free from centralised control, unlike traditional banks and government-issued currencies. The underpinning blockchain technology ensures that Bitcoin exchanges are legitimate and secure.

Store of value

While government-issued currencies can be printed as much as necessary, Bitcoin has a finite supply. This is enabled through the deflationary mechanics of Bitcoin’s supply. Only 21 million Bitcoin tokens can ever be minted, a natively coded law incorruptible to the network. Like gold, which is also a finite asset, Bitcoin acts as a solid hedge against inflation. Price movement in Bitcoin has been heavily correlated with changes in the CPI index over the last few years.

El Salvador’s recent adoption of Bitcoin as legal tender is a prime example of Bitcoin’s utility. The nation is known to have suffered from hyperinflation. Bitcoin’s deflationary mechanics are perceived to be a superior model to El Salvador’s inflationary currency. The underlying software of Bitcoin ensures the stability of its supply. Additionally, El Salvador has recognised that the security of the technology which underpins Bitcoin is sufficient to support the stability of the nation’s financial system.

As mentioned, the security and legitimacy of Bitcoin transactions are made possible by the underpinning technology ‘blockchain’. While blockchain technology in its entirety is highly complex, one only needs a general understanding of the key features to engage in the crypto space.

What is Blockchain?

It is important to understand the following 4 key features of blockchain technology:

1. Distributed Ledger Technology
2. Consensus Models
3. Cryptography
4. Decentralisation

1. Distributed Ledger Technology

Ledger

A blockchain acts like a ledger used in accounting (i.e., a record that is kept on a database used to store bookkeeping entries for transactions). On a blockchain, transaction data is sequentially stored on ‘blocks’.

Using Bitcoin as an example, the blocks on Bitcoin’s blockchain hold data for transactions involving Bitcoin.

In this sense, a blockchain can be thought of as a gigantic digital ledger because it maintains a record of every single transaction that has ever taken place.

Distributed

On blockchains, identical copies of the ‘ledger’ are distributed across a network of computers. These computers are responsible for processing the transactions. They are called ‘nodes’ – any electronic device that carries a copy of the blockchain and is connected to the blockchain’s network is called a node.

On the Bitcoin blockchain, anyone can download the relevant software and participate as a node by connecting to the network.

Nodes are responsible for verifying transactions that occur on the blockchain. Transactions on blockchains are always verified to ensure that they are legitimate. It is done so by a consensus model to verify transactions.

2. Consensus Model

The consensus model will decide which transactions are accepted/verified and added to the blockchain or rejected/excluded. The idea is for legitimate transactions to be accepted and illegitimate transactions to be rejected.

Using Bitcoin as an example again, if John wanted to transfer 10 Bitcoin to Mary, John must have enough Bitcoin in his wallet to afford this. If John had less than 10 Bitcoin in his wallet the transaction would be rejected (excluded from the blockchain).

Different blockchain consensus models have different rules and parameters outlining (a) how transactions should be processed and (b) how and when they should be rejected. On Bitcoin’s blockchain, consensus will occur if more than 50% of the nodes can accurately conclude and agree that a transaction is legitimate. Once consensus over a transaction is reached, the transaction can be processed and added to the blockchain’s ledger.

Back to the example from before, if 50% of the nodes can verify that John actually has 10 Bitcoin in his wallet then the transaction will be deemed legitimate and added to the ledger. The blockchain will record that Mary has 10 more Bitcoin in her wallet and John’s wallet has decreased by 10 Bitcoin.

The type of consensus model which has just been described is known as the Proof of Work (PoW) consensus model. While all blockchains use a consensus model, they do not all use PoW – Proof of Stake (PoS) is another popular consensus mechanism used by Blockchains.

3. Cryptography

Blockchains use ‘cryptography’ to certify that the network is highly secure. In short, cryptography ensures that cryptocurrency on the blockchain is only accessible by those who are authorised.

Using the Bitcoin example from above, cryptography would ensure that Mary cannot access John’s Bitcoin without John’s permission. Likewise, if John purchased something from an online website using Bitcoin, cryptography would ensure John permits the website to access his Bitcoin before the purchase is made.

Cryptography ensures that users have autonomy and ultimately control the tokens they hold.

4. Decentralisation

Blockchains are largely decentralised – they are not controlled by any single individual or entity. Unlike traditional accounting ledgers, which are controlled by a particular company or organisation, there is no single party controlling a blockchain network. As mentioned, transactions on blockchains are distributed and recorded across a network of different nodes.

The decentralised nature of blockchains has paved the way for a revolution in the financial space. The recent emergence of decentralised finance is causing huge disruption to traditional financial markets.

Decentralised means that the currency isn’t issued by a central authority like a government or bank. The currency is instead possessed, exchanged, and governed by those who use it.

Decentralised Finance differs from traditional finance because it takes place on blockchains, which are not controlled by a central body. Up until now, every financial transaction involved needed a trusted third party. Whether it be transferring money to someone, which involves a bank or buying/selling assets through a broker. Smart Contracts allow for the absence of a third party because terms are pre-agreed and self-executed. DeFi is creating an entire financial ecosystem of its own with crypto borrowing, lending, yield, insurance and much more, without the need of centralised parties.

Smart contracts, also described as self-executing digitised contracts, are a way of automating digital agreements – they facilitate negotiations between two parties or automatically enforce the performance of a contract. The terms of a smart contract are written into computer code, which automatically executes the transaction upon the fulfilment of predetermined conditions.

Although smart contracts exist on blockchains, not all blockchains have the capabilities to support them. Bitcoin’s blockchain functions such that BTC can be sent or received using a peer-to-peer method and nothing beyond. Though development continues on Bitcoin, smart contracts will not be available for use on the Bitcoin Network.

On the other hand, Ethereum became the first blockchain to support smart contracts – back in 2015. This resulted in Ethereum acting as a building block for most of the innovation the space has seen in the last several years along with the assistance of smart contracts.

Following the efficient adoption of Ethereum and its smart contracts, other teams came together to build similar blockchains which could execute smart contracts such as Solana, Cardano, Avalanche and more.

One of the biggest concerns with cryptocurrency investing is security and safety. Since cryptocurrency transactions—including paying with crypto, investing in crypto, and crypto lending—are anonymous and protected in part by the very way blockchain technology is built, it’s not completely immune to tampering.

Whilst the cryptocurrency asset class was once referred to as the “wild west” of the financial world, there has been significant maturation over the last few years with security. Although your crypto investments are likely “secure,” that doesn’t mean it’s always “safe”. There are two elements that make cryptocurrency riskier than holding cash in a bank account: market volatility and lack of Government insurance and regulation.

The double-edged sword of financial freedom and a lack of regulation means that those who wish to invest in small-cap projects and/or are enticed by high yield returns can be taken advantage of without the proper knowledge and experience. Many investors enticed by the stories of people making 100 times their net worth have dived right into the deep end without first assessing the risks of getting involved. While some assets such as Bitcoin are incredibly secure, the volatility can still be devastating to those placing large sums of money that they are not willing to lose.

While this has led to terrible consequences for some, having investor access to the leading edge of this groundbreaking technology and space can be incredibly beneficial to those in contact with the right strategies, knowledge and tools.

This Crypto 101 page is a starting point for investors and enthusiasts to gain a general understanding of the crypto markets and crypto technology. We also have many original insights, reports and a Research Lab to provide you with in-depth detail about nearly any subject related to the crypto ecosystem.

Zerocap’s primary focus however is to give access to the complex asset class of cryptocurrency, enabling clients to gain exposure to the amazing opportunities available in the space whilst removing high-risk investments through knowledge, guidance, institutional-grade custody and insurance.

The complexity of navigating Web 3.0 and DeFi can be daunting for many and is often a blocker to entry. By taking advantage of our expertise and suite of services ranging from on-chain insured custody to yield on holdings and structured products, investors can gain exposure with peace of mind.

Up until recently, Australian authorities had taken a relatively ‘light touch’ approach to regulation of the crypto space – however over the last couple of years this has changed.

While there is no specific legislation that deals with cryptocurrency as a discrete area of law, it is still captured under a number of existing Australian legal regimes. Accordingly there are several regulatory bodies which have taken responsibility for enforcing legal requirements in crypto dealings.

Below is a list of some of these regulatory bodies with links to further guidance and information:

ASIC

– Info 255: a guide for understanding obligations under ASIC and the Corporations Act
– CP 343

ATO

– Guidance on the Tax Treatment of Cryptocurrencies
– Transacting with cryptocurrency
– Cryptocurrency used in business
– Record keeping
– SMSF investing in cryptocurrencies
– GST and Digital Currency

AUSTRAC

– Guidance for Digital Currency Exchange Providers

Further links to:

– Preparing and implementing AML/CTF programs for DCE businesses
– Suspicious matter reporting webinar
– DCE risk management methodology fact sheet

Reserve Bank of Australia

– Cryptocurrency explainer
– Speech by Tony Richards (Head of Payments Policy)

MoneySmart

– Guidance on Cryptocurrencies and ICOs

Future Regulation of Cryptocurrency (The Bragg report)

– Senator Bragg’s website
– AFR – James Eyers and Jessica Sier
– Clayton Utz

Seigniorage is the difference between the face value of money and the cost of producing it. In other words, it is the profit that a government or central bank makes by creating and issuing new money. This profit comes from the fact that the government or central bank can issue new money at face value and then use that money to purchase goods and services, effectively paying less than face value for them. Seigniorage can be used to finance government spending or to reduce debt.

Crypto seigniorage uses a similar process, but with decentralised stablecoins where value stability is accomplished through highly complex mathematics where the seigniorage stablecoin is coupled with a volatile token whose supply availability can be either decrease or increase depending on the needs to ensure that the stablecoin’s value remains leveled.

Learn more about crypto seigniorage in the linked article written by Zerocap Innovation Lead Nathan Lenga.

Our article of the same name, written by Innovation Lead Nathan Lenga, provides a very thorough breakdown of how Decentralised Finance projects are able to generate revenue.