In the first part of Don't skip crypto basics before you invest we discovered elementary, but technical jargon related to crypto currency.
Here, in part two, we go through eight key crypto technical terms you need to know.
1. Fiat currencies
Fiat currencies are a medium of exchange established as money, often by government regulation. Fiat money does not have intrinsic value and does not have use value.
It has value only because a government maintains its value, or because parties engaging in exchange agree on its value. They are not backed by anything physical. Most currencies today are fiat currencies.
Fiat currency can be:
Any money declared by a government to be legal tender.
State-issued money which is neither convertible through a central bank to anything else nor fixed in value in terms of any objective standard.
Any money used because of government decree.
An otherwise non-valuable object that serves as a medium of exchange (also known as fiduciary money).
Well-known examples of fiat currencies include the pound sterling, the euro and the US dollar.
2. Hard Fork
A hard fork is a radical update to the blockchain that can make previously unvalidated blocks valid or previously validated blocks invalid.
A hard fork requires all nodes or users to upgrade to the latest version of the protocol software. It can result in a new cryptocurrency being created. One well-known example would be Bitcoin and Bitcoin Cash.
Forks may be initiated by developers or members of a crypto community who grow dissatisfied with functionalities offered by existing blockchain implementations.
To understand what a hard fork is, it’s essential to first understand blockchain technology. A blockchain is essentially a chain made out of blocks of data that work as a digital ledger in which each new block is only valid after the previous one has been confirmed by the network validators.
Data on the blockchain can be traced all the way back to the first-ever transaction on the network. This is why we can still see the first block on the Bitcoin blockchain.
A hard fork is basically a permanent divergence from a blockchain’s latest version, leading to a separation of the blockchain, as some nodes no longer meet consensus, and two different versions of the network are run separately.
3. Soft Fork
A soft fork is a backward-compatible upgrade, soft fork allows upgraded nodes to continue communicating with the non-upgraded ones.
In a soft fork, you typically see the addition of a new rule that doesn’t clash with the older rules.
For example, a block size decrease can be implemented by soft-forking.
Though there’s a limit on how big a block can be, there isn’t a limit on how small it can be. If you want to only accept blocks below a certain size, you just need to reject bigger ones.
However, doing so doesn’t automatically disconnect you from the network. You still communicate with nodes that aren’t implementing those rules, but you filter out some of the information they pass on to you.
A perfect example of a soft fork is that of Segregated Witness (SegWit) fork, which occurred shortly after the Bitcoin/Bitcoin Cash split.
To put it simply, the process of validating a block in return for the block reward is called Mining.
Cryptocurrency mining is the process in which transactions between users are verified and added to the blockchain public ledger.
Mining is also responsible for introducing new coins into the existing circulating supply and is one of the key elements that allow cryptocurrencies to work as a peer-to-peer decentralised network, without the need for a third party central authority.
Bitcoin is the most popular and well-established example of a mineable cryptocurrency, but you must note that not all cryptocurrencies are mineable.
We will elaborate on mineable and non-mineable crypto currencies in part three.
5. Proof of Work (PoW)
PoW is one of the most common algorithms in cryptocurrency. It requires miners to mine blocks to validate transactions.
It is a mechanism for preventing double-spends. Most major cryptocurrencies use this as their consensus algorithm, a method for securing the cryptocurrency’s ledger.
PoW was the first consensus algorithm to surface and is still the dominant one. It was introduced by Satoshi Nakamoto in the 2008 Bitcoin white paper, but the technology itself was conceived long before then.
6. Proof of Stake (PoS)
PoS is highly common algorithm that requires users to stake some of their cryptocurrency to validate transactions.
It was introduced in 2011 on the Bitcointalk forum to solve the problems of the current most popular algorithm in use - Proof of Work. While they both share the same goal of reaching consensus in the blockchain, the process to reach the goal is comparatively different.
The PoS algorithm uses a pseudo-random election process to select a node to be the validator of the next block, based on a combination of factors that could include the staking age, randomisation, and the node’s wealth.
In PoW-based systems more and more cryptocurrency is created as rewards for miners, but the PoS system usually uses transaction fees as a reward.
7. Smart contracts
Smart contracts are digitalised contracts that are executed on the blockchain between different parties.
With regards to cryptocurrencies, a smart contract can be defined as an application or program that runs on a blockchain.
Typically, they work as a digital agreement that is enforced by a specific set of rules. These rules are predefined by computer code, which is replicated and executed by all network nodes.
Blockchain smart contracts allow for the creation of trustless protocols. This means that two parties can make commitments via blockchain, without having to know or trust each other. They can be sure that if the conditions aren't fulfilled, the contract won't be executed.
Other than that, the use of smart contracts can remove the need for intermediaries, reducing operational costs significantly.
Note that each blockchain may present a different method of implementing smart contracts.
A whitepaper is a document that outlines what a cryptocurrency is created to do and how it will achieve it.
The first whitepaper was released by Satoshi Nakamoto for Bitcoin. Since then, almost every cryptocurrency has released one.
Whitepapers explain the purpose and technology behind a project.
They usually provide statistics, diagrams and facts to convince interested investors to purchase the cryptocurrency.
Producing a whitepaper is key a step required for a crypto startup to be considered legitimate and professional, as it helps investors understand how a business is different from rivals in the space.
Read more: What Ray Dalio gets wrong about Bitcoin