What's Backing Cryptocurrency?
Christine Legarde, President of the European Central Bank, shared her opinions on cryptocurrencies during an interview on a Dutch talk show called College Tour. She said that bitcoin and other cryptocurrencies are “based on nothing” and have “no underlying asset to act as an anchor of safety.”
While skepticism regarding cryptocurrencies is nothing new, the myth that cryptocurrencies are based on nothing needs to finally be dispelled.
Consensus Mechanisms
A blockchain derives its value primarily through a protocol called the consensus mechanism. This system is how a blockchain verifies coins across the network to prevent duplicates.
There are a variety of different consensus mechanisms but the two most common types are Proof-of-Work and Proof-of-Stake.
Proof-of-Work
A proof-of-work consensus is when computational power is used in order to verify and mint a coin. This is known as mining.
The process begins when a miner creates a ‘nonce’ which contains a hash (bitcoin uses a SHA-256 hash). At the same time, the block being mined releases a difficulty target.
In order to successfully mine a block, the miner must generate a nonce which is equal or lesser to the target difficulty set by the block.
The value here, which many including Lagarde are missing, is the massive computational power necessary to create a token. The hash rates that CPUs generate are extreme. It is not a process which can be replicated by humans. Bitcoin, in this case, is backed by the resources necessary to create and power the network.
Proof-of-Stake
A proof-of-Stake consensus is the primary alternative to most Proof-of-Work protocols.
Instead of using mass computational power to create coins, it focuses on nodes that act as validators to verify transactions on the network.
The value from this style of consensus draws from validators which hold a certain number of coins. Decentralization (the primary goal of most cryptocurrencies) is then able to grow as more nodes join the network as validators.
Stablecoins Backed by Assets
Stablecoins are also crypto assets which also have clear backing from fiat currencies. These coins are meant to remain at stable prices (hence the name) so that they can be used in transactions where buyers and sellers want the price to remain stagnant.
BUSD
Binance USD is a notable stablecoin which is backed by fiat so that traders on the Binance network are able to lock in gains when trading from different cryptocurrencies.
The price remains at a stable $1 peg because of the tokenomics behind the coins. Traders are incentivized to purchase the coin any time that it dips beneath a single dollar (even at .99) so that when it rises back to $1 the traders see a small profit.
This routine goes on constantly due to consistent price fluctuations in the crypto market so traders are encouraged to take advantage of these small gains which in turn cause the coin to remain stable for other Binance users.
USDC
The United States Dollar Coin is another stablecoin which is backed by fiat to remain at a $1 peg.
The coin uses the accounting firm Grant Thornton LLP to regularly audit the USDC reserves so that prices remain consistent. This allows traders to remain confident about the reliability of the coin.
While the stable price will not allow traders to earn massive gains, the USD Coin is extremely common in DeFi where stable prices are necessary for financial practices to remain realistic.
Understanding blockchain technology
Criticizing cryptocurrency is a common expectation. People that are unfamiliar or don’t understand the technology tend to struggle recognizing its value. In order to push blockchain technology forward in a positive direction, it is necessary for everyone to understand how these coins function and where exactly their value comes from.
