6 basic concepts to understand the cryptocurrencies

Now that we already know what the DLT networks are and how their consensus protocols work, it is time for us to take a deeper look into their components. Every network is different to each other, and some of their elements can be difficult to understand. In some cases, these elements are mandatory to fully understand their structure, as well as their risks and benefits. Given the necessary technical language of the cryptocurrencies, we will analyse now some complex concepts to get a better overall understanding.

In some other cases, these elements are useful to understand the technological progress of cryptocurrencies for the last years. In this post we will see most of the aforementioned concepts, which are some of the most common in the cryptocurrency industry.

Halving

The halving is an event defined in the protocol of some cryptocurrencies, for instance Bitcoin. This event divides by a factor of 2 the reward of the mining activities, and it occurs every 4 years in Bitcoin. This event tries to control the issue of new cryptocurrency, and it takes place until the reward for mining becomes zero. From that moment on, the only incentive for the miners to keep mining are the fees charged on every transaction.

The halving event tries to preserve or event to increase the intrinsic value of the cryptocurrency. The more halvings take place, the higher will be the price of the token if the buy appetite remains the same. In fact, this behavior has been already observed in the cases of Bitcoin and Litecoin after their halving events. The halving is, in fact, the main reason why we consider Bitcoin as a non inflationary currency. The issue is controlled by the algorithm and its growth rate is finite and defined, so the value of the cryptocurrency does not decrease over time.

However, this event can cause two negative effects. On one side, if the rewards are decreasing over time, it is quite likely that the transaction fees increase simultaneously. This would maintain the yield for the miners, but the cryptocurrency would become less attractive for the users.

On the other side, the number of nodes willing to mine would also decrease due to the effect of the hash rate. Consequently, not every node will be able to mine the cryptocurrencies and obtain benefits with the new rewards structure. In the long term, the level of decentralization will be affected by this situation. This is something already present in Bitcoin, and in fact it is subject to criticism.

Staking

This is a concept exclusive for blockchains in which the consensus protocol is Proof of Stake or something similar. We refer to “staking” when one node stakes part of its tokens in order to validate a new block of transactions. According to these protocols, the nodes compete among themselves to validate the new block and win the reward. The protocol uses the stake of each node to assign the probability to validate the block. Therefore, the higher your stake is, the higher your probability is for validating the next block.

While the validation takes place, the stake cannot be transferred or used for any other purpose. This way, if a node have a stake of 50 ETH, its probabilities of validating the next block will be lower than a node whose stake is 75 ETH, regardless of the total amount of tokens owned of each node.

Every network can define in its protocol the code for the staking process. Within this code we should find the minimum stake for the nodes to participate in the validation process. These activities allow the normal performance of the network, and therefore they are rewarded. In fact, several investors use this activity to get a yield through the staking of their cryptocurrencies. This is, in terms of computational power, much cheaper than the traditional mining.

To sum up, we can consider the staking as another way of opting to blocks validation apart from the mining process. Both are the most popular in the crypto community, as they are used by the most important protocols, Ethereum and Bitcoin. Every blockchain define its processes depending on their needs of decentralization, security, etc.

Fork

The fork is, in terms of cryptocurrencies, the bifurcation of the blockchain network to apply a new version of the protocol. This update is used to amend errors of the code or to add new functionalities. The concept is not exclusive for the blockchain networks, but thanks to them its popularity has grown.

The fork consists in adding the new version of the protocol from one block on, but is does not apply to the previous blocks of the chain. This way, every new block from the first block with the new protocol works under the new version. All the nodes of the network should also update their version of the protocol. Otherwise, their software could become obsolete and there they would be enable to interact with the network.

The new version of the protocol does not have to be compatible with the previous one. In fact, if both versions remain compatible, we will consider it as a soft fork. Otherwise, it will be a hard fork. With this process we get a new chain, which runs in parallel with the one with the old version. After the fork, both chains keep growing with their own version of the protocol.

As an example, let’s take Litecoin or Bitcoin Cash. They both were born after a hard fork over the original blockchain. The core elements of their structure are very similar to the originals, but there are some differences. In the case of Bitcoin Cash, the maximum size of the block is 16 times bigger than the allowed size in Bitcoin. This allows Bitcoin Cash to process much more transactions per second, and therefore it increases the scalability.

Hash rate

Another concept which usually is not easy to understand is the Hash Rate. As we mentioned in the post about Bitcoin, the hash function is like the puzzle the miners must solve to add a new block into the network. We can consider then the Hash Rate as the difficulty level of that puzzle. In technical terms, the Hash Rate is the amount of computational operations that the whole pool of miners is able to perform. The computational operation consists in the generation of a new hash, which is a unique alphanumeric combination which identifies each block and which is key for the blockchain technology.

When the Bitcoin project was born, the total hash rate was relatively low. Therefore, almost every person with one simple computer was able to easily mine cryptocurrency, with no expensive costs. However, the protocol of Bitcoin adjusts the hash rate every time a new node tries to connect to the network. Consequently, the mining activities require more resources over time. In the long term, this implies a lower decentralization, because the higher costs become an entry barrier for potential new miners.

Additionally, every time a new node joins the network, its computational capacity is added to the global Hash Rate. That is the reason why a high Hash Rate also means a high level of security. This makes much more difficult for the external attacks to succeed. In fact, the 51% attack is almost impossible to perform nowadays in the Bitcoin network.

Mining

The mining activity shares a double functionality with the staking process. For the investors the mining may become a way of obtaining benefits for the computational power of their computers. For the network as a whole, the mining allows to create new tokens of the cryptocurrency. This is achieved through the Proof of Work, which serves to add new blocks to the chain when the “puzzle” is solved.

It happens also that this concept is closely related to the aforementioned Hash Rate. The more miners collaborate into the network, the higher is the Hash Rate and the security of the blockchain. That is the reason why the mining activities are so important for the cryptocurrencies. However, these activities only make sense for protocols not using the Proof of Stake algorithm, as this uses the staking process to create the new tokens.

mining bitcoin

One of the main problems which appear with the mining process is the amount of energy that requires. This cost is specially high in Bitcoin, due to the level of maturity of its network. Most of the times, this energetic cost is not bearable by the individuals. Furthermore, the basic computers are not able to successfully perform its Proof of Work, due to the high Hash Rate. Therefore, we have observed for the last years the appearance of “mining pools”.

The mining pools are groups of individuals (or even companies) which collaborate and put their resources together in order to mine cryptocurrencies. This way, all the costs are shared among the pool members, and they become more affordable. In fact, nowadays the top 5 mining pools represent the 70% of the total Hash Rate of Bitcoin. This allow the cryptocurrency to keep working, but it affects negatively the level of decentralization.

Sharding

Last but not least, we will talk about the sharding. The sharding is an informatic process which was originally designed for the database management. It existed many years ago, but its popularity has grown significantly with the cryptocurrencies. It consists in the fragmentation of the principal blockchain into several parts or “shards” to increase its scalability. When you divide the blockchain, it becomes lighter and, therefore, it is also easier to handle. This characteristic has been determinant for Ethereum to apply this process in its protocol.

The implementation of the sharding also allows that the whole information of the blockchain is not stored in every single node. Consequently, there are less entry barriers, because the nodes do not need so much computational power to access the network. However, at the same time that the scalability improves, the security may get worse.

This is because the fragmentation of the nodes makes necessary to get an additional way for them to communicate. Furthermore, it would be easier for a hacker to trigger an attack on one single shard of the blockchain. This would not endanger the whole network, but it would impact for sure, and the attack would be easier to lead.

For these reasons, we may consider the sharding a good solution in terms of scalability. However, the cryptocurrencies in which it has been implemented have not showed themselves as successful. It is necessary to keep working on the security of this kind of processes before considering them as a definitive solution.

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