The Basics of Cryptocurrency Explained

Investments in cryptocurrencies have soared in the last decade, with over 560 million users in the world collectively owning over $2.4 trillion in cryptocurrencies at the time of writing. This unique new asset class has captured the interest of individual and institutional investors who see the immense potential that lies in the crypto world as decentralized finance systems and desire for financial self-sovereignty grow.

While many have heard of Bitcoin, Ethereum or the emerging USDC and USDT tied to the US dollar, and many hold strong opinions about them, it turns out not nearly as many understand crypto assets. 

Let’s start decrypting them together.

What Is a Cryptocurrency?

Cryptocurrencies are alternative digital currencies to those issued by governments. They are unique because they are not controlled by a country's central bank. While cryptocurrencies are not legal tender in most countries, including Canada, El Salvador and the Central African Republic, on the other hand, have recognized Bitcoin as legal tender. 

The value of cryptocurrency is not controlled by any country's monetary policy but is determined by factors such as supply and demand, market sentiment and media coverage.

Cryptocurrency is made secure by an advanced mathematical technique known as cryptography at every level of operation, from the mining process to the validation of transactions within the blockchain, as well as safeguarding wallets. Cryptography ensures the secure transmission of information from one end to another by obscuring them.

In particular, cryptographic algorithms generate a unique private key and a corresponding public key. The public key is then used to derive a wallet address — a shorter, user-friendly identifier that can be shared to receive funds. The private key, created alongside the public key, is essential for the holder to authorize transactions. A wallet can hold multiple crypto assets.

As such, cryptography eliminates the need to rely on a third party institution.

What Is a Blockchain?

Cryptocurrency is held in public blockchain databases which reflect transactions in a secure and highly verifiable fashion. It acts in a way similar to a bank ledger which records when we deposit or withdraw cash and make purchases using a debit card, with the particularity that the public can consult it.

A blockchain consists of blocks, each containing transaction data, a timestamp, and a reference to the previous block (hash). This chain of blocks is stored across multiple computers (called nodes) in a network, creating a distributed ledger that is shared among participants.

Cryptocurrency has been the subject of the news in the last years, but they remain a mystery for many.

As such, a blockchain exists across a decentralized network of computers. It stores cryptocurrency. Most particular is the immutable character of the data it contains, meaning it cannot be changed or tampered with from a single source, as the rest of the network keeps the data in check, making blockchain a reliable way to record transactions. 

This decentralization also means there isn’t a likely point of failure that can single-handedly take down the rest of the system.

What Is a Crypto Wallet?

Public and Private Keys

A crypto wallet is a digital tool that allows users to store, send and receive cryptocurrencies securely. Unlike traditional wallets, which hold physical currency, crypto wallets store the private keys needed to access and manage the digital assets on the blockchain.

Private keys, in their raw form, are complex strings of binary code — long sequences of ones and zeros — that are typically represented as lengthy, randomized alphanumeric characters. This complexity makes them impractical for users to memorize or manage directly. This is where the usefulness of wallets come into play. Accessing all the keys to crypto accounts requires a seed phrase, which is a randomized sequence of words which acts as a wallet’s master key.

Each wallet also has a public key, derived from the private key through cryptographic algorithms. This public key is transformed into a wallet address — think of it as a bank account number or email address — that can be shared with others to receive funds.

Unlike a bank account, anyone is able to autonomously create a self-custodial wallet without the involvement of a centralized entity. While transactions are publicly reflected on the blockchain, pseudonymization protects the identity of crypto users. However, today, it is becoming more and more common to trace the identity of users, thanks to specialized blockchain investigation firms and technologies, especially in the case of illicit activities as the data is permanently available.

Making cryptocurrency transactions requires keys which act as a password or a physical key that grant access to the funds. The public and private keys are stored in a digital wallet which has an address that is akin to the bank account number and allows access to the blockchain.

Types of Wallets

It's crucial to distinguish between hot and cold wallets as well as between self-custodial and custodial wallets when choosing how to manage cryptocurrency. These differences affect the security, convenience and ownership of assets. 

Hot and cold wallets refer to how the wallet is connected to the internet, which impacts its vulnerability to hacks, while self-custodial and custodial wallets relate to who controls the private keys, determining whether the user or a third party has the ultimate responsibility over the funds. 

Understanding these distinctions is key to making informed decisions based on the security needs and usage preferences.

Hot Wallets 

Hot wallets remain connected to the internet, making them highly accessible for frequent transactions. These wallets are available as mobile apps, desktop applications or browser-based interfaces, allowing users to interact seamlessly with blockchain networks. 

The primary advantage of hot wallets is their convenience, offering near-instant access to crypto holdings for regular transfers, trades or payments. However, constant internet connectivity increases vulnerability to hacking attempts, phishing attacks and malware. To mitigate these risks, strict security practices such as two-factor authentication, strong password management and regular software updates are necessary. 

Hot wallets are best suited for smaller amounts of cryptocurrency, intended for regular use, similar to carrying physical cash.

Cold Wallets

By contrast, cold wallets provide a more secure method of storage by keeping private keys offline and away from potential online threats. These wallets include hardware wallets, which are physical devices that store private keys securely, and paper wallets, which involve printing private keys onto physical documents for offline storage. 

Because cold wallets are disconnected from the internet, they offer a higher level of security, making them ideal for long-term storage or holding significant amounts of cryptocurrency. While cold wallets are highly effective at reducing the risk of cyberattacks, they may be less convenient for those who need quick access to their funds. Retrieving assets from a cold wallet requires connecting it to an online device, which adds an extra step in the process. Additionally, cold wallet users must protect their physical devices or documents from loss, theft, or damage. 

As a result, cold wallets are often preferred for HODLing (holding assets for the long term) and securing the majority of crypto holdings that are meant to be stored for an extended period.

Balancing the use of hot and cold wallets often depends on the specific needs of a user, with many opting for a combination of both. This approach allows for the flexibility of a hot wallet for everyday transactions while leveraging the enhanced security of a cold wallet for long-term asset protection.

Self-Custodial Wallets

Self-Custodial Wallets (also known as non-custodial wallets) are wallets where the user has full control and ownership of their private keys, meaning they are solely responsible for the security of their funds.

Self-custodial wallets often require minimal personal information to set up, increasing user privacy compared to custodial services that may require extensive know-your-customer (KYC) verification.

With self-custodial wallets, "not your keys, not your coins" is a common phrase, emphasizing personal responsibility.

Custodial Wallets

Alternatively, the user may also choose to entrust the keys to a custodian, a third-party such as an exchange or financial institution, that holds the private keys on behalf of the user. The custodian will actively ensure the safeguarding of the funds. Custodial wallets require less involvement on the user’s part. This means while a third-party custodian will need authorization in order to send and receive payments, they effectively have the control over the funds, as they detain the keys.

In this setup, the third party is responsible for securing the assets, making it more convenient but potentially less secure from a decentralization standpoint.

This custodian is usually a crypto exchange, the safest of which conform to local regulations. Centralized exchanges offer lower fees for crypto trading within their platform. Crypto exchanges are sometimes able to offer individual users insurance in the case of an exchange-wide hacking.

The main drawbacks of custodial wallets are reduced privacy and autonomy, in addition to the fact companies can fail. Entrusting access to the crypto assets to a third party leaves them vulnerable to their mismanagement.

What Are Coins and Tokens?

In the same way US dollars differ from Canadian dollars and Euros, there are thousands of cryptocurrencies. Coins are issued directly from different cryptocurrency blockchains and act as mediums of exchange. They hold their own value.

Examples of cryptocurrencies include Bitcoin (BTC), the first to launch in 2009, Ether (ETH), the USD Coin (USDC), a stablecoin which is pegged to the US dollar, or Solana (SOL).

Tokens, on the other hand, are digital assets created on existing blockchains and can serve various purposes. While they can be used as mediums of exchange within specific platforms, they often represent assets, access rights or utilities within a project. These are known as utility tokens, providing functionality like access to services or products.

Meanwhile, non-fungible tokens (NFTs) authenticate ownership of unique digital assets or even physical real estate that has been tokenized. They cannot be replicated on the blockchain they exist on and are not interchangeable.

Two other types of tokens exist which are quite relevant for business start-ups and ongoing blockchain projects. A governance token is a type of utility token which gives the investor the ability to influence future features through voting power.

Security tokens represent ownership interests in assets or enterprises, similar to stocks or bonds, and are regulated under securities laws. Investors acquire them with the expectation of future profits derived from the efforts of others, aligning with traditional investment models.

EZO

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Frequently Asked Questions

What Distinguishes Cryptocurrencies from Fiat Currencies?

Cryptocurrencies are decentralized, meaning no central authority controls their value nor the network they exist in, as opposed to fiat currencies which are issued by governments.

What Are the Advantages of Using a Self-Custodial Wallet?

Using a self-custodial wallet means you effectively own the keys to your crypto assets, which remain in your control, under your care and your responsability. Self-custodial wallets additionally tend to offer more user privacy.

What Services Does EZO Swap Provide?

EZO Swap enables you to seamlessly convert available currencies of your choice between one another, whether it is  cryptocurrencies or fiat currencies, all while ensuring your privacy and your security with each transaction.