What is Bitcoin Mining and How Does It Work?

In brief

  • Bitcoin mining is the process of adding and verifying blocks of transactions to Bitcoin’s public blockchain.
  • Bitcoin uses the “proof of work” consensus mechanism, which demands commitment from miners in the form of expensive mining hardware and electricity.
  • Miners compete to solve a complex cryptographic puzzle, and are rewarded with newly-minted Bitcoin.

Bitcoin mining is the process by which blocks of transactions are added to the public blockchain and verified. It’s also the process by which new Bitcoin is created—a mechanism that both secures the integrity of the blockchain and incentivizes participation in the network.

Miners compete to add new blocks to the blockchain. Mining Bitcoin demands a substantial commitment on the part of miners; it’s a costly, time-consuming task, and one that’s necessary for the cryptocurrency to work and for people to have faith in its legitimacy.

Over a decade since Bitcoin was created by Satoshi Nakamoto, most people have heard of mining. But what does it really mean—and how do you go about mining Bitcoin?

What is Bitcoin mining?

Mining Bitcoin isn’t like digging for gold or coal deep underground. It refers to verifying the transactions made using Bitcoin. Miners are those individuals or companies that sustain and audit the blockchain network that supports the cryptocurrency.

They do so by completing “blocks” of verified transactions, which are added to the blockchain; when a miner completes a block, they are rewarded with Bitcoin.

Did you know?

Approximately every four years, the reward for mining Bitcoin is halved, an event known (unsurprisingly) as the “halving”. In May 2020, the block reward dropped from 12.5 BTC per block to 6.25 BTC.

Mining for Bitcoin isn’t as cheap as it once was, but this still doesn’t prevent investors from carrying out this activity. The block reward of Bitcoin is the incentive that powers cryptocurrency transactions through legitimizing and monitoring the network. Because this responsibility is carried out by many users throughout the world, Bitcoin is a decentralized cryptocurrency, meaning that it relies on no central authority such as a government or bank for its trustworthiness.

Why does Bitcoin need miners?

Mining is, in effect, a process of auditing and verifying Bitcoin transactions to prevent the problem of “double spending”. Double spending is where someone with cryptocurrency tries to spend the same coin twice. With physical currency, you can’t buy a drink in a pub with a £20 note and then pop to the shops to buy some groceries with the same £20 note.

With cryptocurrency, there is a risk that someone with Bitcoin could make a copy of that Bitcoin and send that to a merchant instead of the real thing. In the real world, the cashier looks at a £20 note to ensure it is not fake—and this is what Bitcoin miners are trying to do with cryptocurrency; they are checking to ensure that a transaction has not been made twice.

What is the process of Bitcoin mining and what can you do with it?

Bitcoin uses a consensus mechanism called proof of work.

The process of mining Bitcoin works as follows:

  • 🖥️ A miner’s computer, called a node, collects and packages individual Bitcoin transactions from the last ten minutes into a block.
  • 🖧 This node competes with other nodes in the network to solve a complicated cryptographic problem to be the first to validate the new block for the blockchain.
  • 📡 The first miner to solve the problem broadcasts their success to the entire network.
  • 🧮 Other nodes then check if their solution is correct. If correct, the new block is added to the blockchain and the whole process starts again.
  • 💰 As the miner was first to solve the problem, it gets rewarded with Bitcoin.

Bitcoin mining hardware runs a cryptographic hashing function on a block header.

What that means is that each miner creates a “candidate block” with unconfirmed transactions from the node’s memory pool, or mempool. This block includes a block header that summarizes the data inside the block, along with a reference to an existing block in the blockchain and a nonce (“number only used once”). In Bitcoin, the nonce is a whole number somewhere between 0 and 4,294,967,296.

This block header is then put through the SHA256 hash function; if the resulting number is higher than the current target hash, the miner adjusts the nonce and tries again. Miners do this many thousands of times per second. The difficulty target is a 256-bit number; it is adjusted every 2016 blocks (roughly every two weeks), to ensure that a block is mined on average once every 10 minutes.



When a lucky miner’s hash function spits out a result that’s lower than the current target hash, the block is broadcast to the network. Each node checks that the block header hashes to meet the target, and if confirmed the newly mined block is added to the blockchain. The miner receives a reward of Bitcoin; this transaction, which creates new Bitcoin out of thin air, is known as the “coinbase transaction” and is included in the candidate block.

These rewards serve to incentivize participation and keep things running smoothly.

The rate at which coins are issued is set by the mining code, ensuring that the time it takes for a miner to win a block is always approximately 10 minutes. This is to protect the system and prevent miners from creating their own Bitcoin.

Every time Bitcoin is mined, the cryptographic problem becomes harder to solve, meaning that miners will require a higher hash rate to succeed in earning block rewards. This means that more computing power is needed to earn the same amount of cryptocurrency.

The first Bitcoin miners used their computers’ CPUs to complete the cryptographic problems. Soon, miners discovered that graphics processing units (GPUs) were more effective than CPUs, sparking an arms race in mining hardware. Now, Bitcoin miners use dedicated hardware known as ASIC (application-specific integrated circuit) miners—though miners of Ethereum and other cryptocurrencies still typically use GPUs, which has led to shortages of graphics cards.

Solving cryptographic problems is necessary to protect the Bitcoin network from attacks. To reverse transactions in the blockchain would require 51% of the whole network’s computing power. This ensures that any attack is difficult and pointless as an attacker would have to own more mining hardware than anyone else.

China’s Bitcoin mining crackdown, and beyond

As Bitcoin mining has matured, the barrier to entry for individual miners has been raised. Now, most mining is carried out by “pools” of miners who combine their resources and attempt to use their cumulative computing power to earn Bitcoin rewards.

Up until mid-2021, the majority of mining pools were based in China. That changed in May 2021, when China’s State Council included Bitcoin mining in a list of financial risks that required monitoring. It marked the start of a sweeping crackdown on crypto mining across China, prompted by the country’s commitments to carbon neutrality and the imminent launch of its digital yuan, a central bank digital currency and Bitcoin rival.

A succession of mining bans imposed by provincial governments including Inner Mongolia, Xinjiang, Qinghai, Yunnan and Sichuan followed, causing a collapse in the Bitcoin mining hash rate. Since then, Chinese miners have relocated to countries including Kazakhstan, while miners in other countries have picked up the slack, with the result that by October 2021, the U.S. had overtaken China as the world’s largest market for Bitcoin mining.

Miners are heavily influenced by electricity prices, since proof of work mining uses large quantities of electricity; many miners relocate their operations to make the most of cheap electricity.

Did you know?

The supply of Bitcoin is capped at 21 million. When all 21 million BTC are mined, in around 2140, miners will be rewarded with transaction fees.

Bitcoin mining has come in for criticism over its high energy consumption, which in 2021 was around 11.8 GW or 103.31 terawatt-hours—more than the output of twelve nuclear power plants.

Some advocates of the cryptocurrency argue that it functions as an “energy currency” that incentivizes the use of surplus energy; indeed, several power plants in the USA and Iran are now using surplus natural gas to operate large-scale Bitcoin mining operations. Other miners are looking to nuclear power. The government of El Salvador, which made Bitcoin legal tender in 2021, has even started mining Bitcoin using geothermal energy from volcanoes.

Figures for how much of Bitcoin’s total energy consumption comes from renewables vary, with estimates ranging from 39% to as much as 75% (though the higher estimates typically come from firms involved in the crypto industry). Bitcoin miners currently generate a carbon footprint equivalent to that of Bangladesh.

Stung by this criticism, some cryptocurrencies are switching from a proof of work consensus mechanism to a system known as proof of stake (PoS).

Instead of miners, proof of stake cryptocurrencies have validators. These validators stake their cryptocurrency on betting which blocks will be added next to a chain. If successful, the validators get a block reward in proportion to what they have staked. Ethereum, the second-biggest cryptocurrency by market capitalization after Bitcoin, is switching to a proof of stake model with its Ethereum 2.0 upgrade.

Bitcoin, however, is sticking with the tried-and-true proof of work consensus model espoused by Satoshi Nakamoto in the original Bitcoin whitepaper, over a decade ago.

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What Are Central Bank Digital Currencies (CBDCs)?

Central bank digital currencies, or CBDCs, are exactly what the name suggests: they’re digital versions of a state’s fiat currency. But how does that differ from money sitting in a digital bank account, being used to make cashless transactions with debit cards?

Why do governments even want to have CBDCs? And which countries have launched CBDC projects?

What is a CBDC?

CBDCs are digital versions of a state’s fiat currency. 

They are similar to stablecoins, which are pegged at a 1:1 ratio with a particular fiat currency. But stablecoins like Tether (USDT) are run by private entities that hold central bank-issued cash or cash equivalents. They hold those assets so that their stablecoins can reflect the exact value of fiat currencies. 

The International Monetary Fund (IMF) considers CBDCs to be a new form of money that are:

  • 🤖 In a digital form
  • 🏦 Issued by a country’s central bank
  • 💵 Intended to serve as legal tender

Central banks literally print US dollars or British pounds, so the physical banknotes in your wallet don’t meet the criterion of “digital form.” 

And the money you move digitally through your bank is in fact a series of electronic deposits backed by the assets of commercial banks—97% of the money held by regular people and businesses in the UK are actually commercial bank deposits.



Bitcoin, the world’s largest cryptocurrency, meets two of the above criteria: it’s digital and now serves as legal tender in El Salvador. But Bitcoin has nothing to do with the “CB” in CBDC. It’s not issued by the Central Reserve Bank of El Salvador—even if the bank mined Bitcoin en masse, that wouldn’t count as “money issuance,” as a former IRS counsel told Decrypt in June 2021.

How does a CBDC work?

Sometimes the states developing central bank digital currencies tout blockchain as the underlying technology for CBDCs, but the central bank ultimately maintains authority over the ledgers. In contrast, cryptocurrencies are decentralized with no central authority. 

There are many different ways that CBDCs may be practically deployed by the states. But if early projects are anything to go by, CBDCs tend to work on mobile wallets similar to Apple Pay or Google Wallet.

In the Bahamas, which fully launched a CBDC in October 2020, the central bank issues Sand Dollars just as it issues the Bahamian dollar. It also maintains a ledger of all Sand Dollars in circulation. 



In partnership with private providers, the central bank maintains a KYC infrastructure that citizens need to comply with to open a mobile wallet. Sand Dollars facilitate peer-to-peer electronic payments without an intermediary like a bank account, which is the main idea behind CBDC projects: scan the barcode on your phone to make an in-store payment or send money to another mobile wallet.

Why do governments want a CBDC?

The Bank for International Settlements cites three reasons for the recent rise of CBDCs in its annual report (June 2021): the attention around Bitcoin and other cryptocurrencies, the debate on stablecoins, and the entry of Big Tech into finance.

Concerns over the encroachment of big tech firms in finance, such as the Facebook-backed stablecoin Diem, are also echoed by the European Central Bank (ECB). In a June 2021 report, ECB said that governments that shy away from introducing CBDCs may face threats to their financial systems and monetary autonomy from “foreign tech giants potentially offering artificial currencies in the future.”

But there are many other reasons.

CBDCs could also help speed up money disbursals in times of crisis, as March 2019 research by the Institute and Faculty of Actuaries showed. 

In a July 2021 report, the IMF said that CBDCs can promote financial inclusion because citizens wouldn’t need a bank account to pay with CBDCs. That’s a big deal in countries like Indonesia, where a third of the population don’t have access to traditional finance and yet are more likely to have mobile Internet.

Fan Yifei, deputy governor of the Chinese central bank, said in April 2020 that a CBDC would reduce illicit uses of money as physical money is anonymous and can also be more easily counterfeited.

MasterCard, which has stakes in electronic payments, estimates the cost of managing physical cash to be as much as 1.5% of a country’s GDP. So countries can save a lot by going more—if not necessarily completely—digital.

What countries are working on CBDCs?

As of August 2021, there are 81 countries, including monetary authorities such as the European Union, pursuing a CBDC project in one way or another. They represent 90% of global GDP.

Only five of them have launched CBDCs to date. They’re all Caribbean island nations: the Bahamas, Saint Kitts and Nevis, Antigua and Barbuda, Saint Lucia, and Grenada.

The majority of them—32 countries—are in the “research” stage. That’s when the central banks try to figure out what the whole fuss is about and whether they actually want to have a CBDC. This includes the United States, which has kept a low profile on its digital dollar explorations. Governments are also taking their time in order to study the security implications of CBDCs.

There are 16 countries in the “development” stage, which is when things get more serious as countries develop proof-of-concepts and launch studies. 

In April 2021, the Bank of Japan launched the first phase of a feasibility study for its digital yen, which will run for a year before even more studies. Meanwhile, South Korea is going full steam ahead, with its CBDC expected to move onto the pilot stage as of August 2021. 

14 countries are now in the pilot stage: they have developed a CBDC that is being tested in the real world.

China’s CBDC, the digital yuan, is the hottest pilot at the moment. It’s been used in more than 70.75 million transactions, amounting to 34.5 billion yuan ($5 billion) by the end of June 2021. The country has airdropped millions of digital yuan to citizens as part of an effort to test the technology—and create some buzz around it.

Sweden’s e-krona is also in the pilot stage as of April 2021, but there’s been much less fanfare around it. Cambodia has been piloting its CBDC since July 2020, and anyone who has a Cambodian phone number can join, the vendor that created the blockchain platform for the CBDC project, told Decrypt

Another pilot CBDC is Ukraine’s e-hryvnia, with real-world CBDC tests officially starting as of August 2021. In January 2021, the country’s central bank signed a deal with Stellar Development Foundation—the organization behind the cryptocurrency Stellar (XLM)—but it hasn’t said whether its CBDC would be on Stellar’s blockchain.

The future of CBDCs

More countries will launch fully-fledged CBDCs over the mid-term, with China leading the charge.

China will roll out the digital yuan during the Beijing 2022 Winter Olympics in February. However, some U.S. Senators have urged a ban on American athletes “receiving or using digital yuan” during the tournament, fearing that it could be used to surveil those visiting China “on an unprecedented scale”.

Those concerns over privacy are only likely to grow louder. Some CBDC advocates have touted the digital currencies as a privacy solution; in June 2020, ECB executive board member Fabio Panetta argued that a digital euro would be more private than privately-issued stablecoins because “we have no commercial interest in storing, managing or monetizing the data of users.” 

However, others have raised concerns about the privacy implications of CBDCs, as they present an opportunity for states to keep close tabs on monetary flows on a macro level—and, more problematically, on an individual level. Mu Changchun, the director of the The People’s Bank of China’s Digital Currency Research Institute, has already stated that the digital yuan will have “limited anonymity”, with small payments linked to users’ phone numbers and larger payments requiring more extensive KYC data. 

In the U.S., conservative lawmakers have argued that China’s digital yuan could be used to “expand domestic surveillance initiatives” or even to “enforce party discipline.” Congressman Tom Emmer (R-MN) noted that a CBDC would only be beneficial if it was “open, permissionless and private.”

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How to Use IPFS: The Backbone of Web3

In brief

  • IPFS is a peer-to-peer decentralized network that lets users back up files and websites by hosting them across numerous nodes.
  • This ensures that content is resistant to censorship and centralized points of failure, such as server issues or coordinated attacks.

When a website goes down, often it’s due to the failure of a centralized service, such as a hosting server or domain name system (DNS) issue, or a distributed denial of service (DDOS) attack. Sometimes, it’s a matter of Internet censorship, particularly in countries that suppress certain content to keep it from their citizens.

What can you do? That’s a problem that IPFS, or the InterPlanetary File System, aims to solve. It’s a decentralized, peer-to-peer file-sharing network and open-source Web3 service designed to overcome centralized points of failure and censorship efforts, to ensure that the web is freely accessible to all.

It’s also a way to back up digital files, such as non-fungible token (NFT) crypto collectibles, so that they don’t suddenly disappear from the web. Here’s a look at how IPFS works and how you can use it.

What is IPFS?

Built by Protocol Labs, IPFS is a service that relies on a distributed network of computers that host content, such as mirrored web pages, files, and apps, all of which you can pull up by entering a link.

Rather than point you towards a location, IPFS links point you towards the content, which could be stored on any number of nodes or computers around the world. As long as the website or content is hosted on at least one computer, however, it will always be accessible.

Did you know?

As of August 2021, IPFS claims to have 2 million unique weekly users, some 200,000 network nodes, and about 125TB worth of gateway traffic per week.

How does IPFS work?

Files uploaded to IPFS are split into smaller chunks, distributed across multiple computers, and assigned a hash to allow users to locate them. Rather than use a familiar location-based link like the normal web, IPFS links are based on the unique hash identifier of each item. That helps locate which node or nodes have the file or website available; it’s then served to the user via a peer-to-peer connection, similar to BitTorrent technology.

IPFS isn’t based on blockchain, but it is similarly immutable: the contents cannot be changed, otherwise the hash itself would also change. However, IPFS has a versioning system that lets you add a new version of a file and connect it to the previous one, ensuring that the entire history is maintained.

Who’s using IPFS?

There’s a variety of Web3 services already making use of IPFS, across a wide range of different applications. Here are a few of the headline services:

  • 📁 Filecoin, Protocol Labs’ own distributed storage network, is based on IPFS. It incentivizes node operators to host files via cryptocurrency rewards.

  • 🎧 Audius, a decentralized music service, uses IPFS to host its audio files.

  • 🃏 Pinata is an NFT hosting service that uses IPFS to back up crypto collectibles for partners like Rarible and Sorare.

  • 🛍️ OpenBazaar is a peer-to-peer ecommerce platform driven by IPFS.

  • 🚛 Morpheus.Network is a supply chain network service that also utilizes IPFS.

How to use IPFS

Some browsers support IPFS browsing natively, while others require an add-on. Brave and Opera both support IPFS links directly: you can just paste the link into your browser and go to the site or file. Brave gives you the option to access IPFS content through a public gateway or through your own local node—the latter option is for those who want to verify content locally.

Alternatively, you can access IPFS content from any browser by using a public gateway such as https://ipfs.io or https://cloudflare-ipfs.com. A gateway will automatically route you to IPFS content using the link, and there’s a long list of alternative gateways available.

Running an IPFS node

Want to run your own IPFS node and add content to the network? The easiest way to get started is with IPFS Desktop, the official software suite from Protocol Labs. It’s available for Windows, Mac, and Ubuntu, and lets you install and operate your own node, so you can add your own files to the network. Want to upload a photo of your cats? It’s easy as pie.

Meanwhile, IPFS Companion is a web browser add-on available for Chrome, Edge, Brave, Firefox, and Opera. It lets you interact with IPFS Desktop and your installed IPFS node right from your browser. It also adds support for ipfs:// addresses to browsers that don’t natively support them.

The future

IPFS has not updated its official roadmap since early 2020, as of this writing, but IPFS Project Lead Molly Mackinlay wrote on GitHub that her team is focused on a bevy of technical enhancements, as well as further browser integrations. Perhaps most interesting, her team is working on better telling the story of why to use IPFS.

It’s the pitch, essentially. While IPFS should make sense to any web-savvy user at a very basic level, how many of those users want to download and operate a node, and use clunky content identifier (CID) links instead of standard, familiar web URLs?

IPFS is not as smooth and easy to use as standard websites, but like a lot of Web3 platforms right now, that should improve over time—particularly as native link support comes to more web browsers. There’s also a service called Unstoppable Domains that provides easier-to-remember URLs to point to IPFS content, and more browsers are starting to support those as well.

IPFS has smartly latched onto the burgeoning NFT market as a way to help make its pitch. When NFT collectibles blew up in early 2021, suddenly there were stories about people’s pricey new purchases going missing because the platform or server hosting it went down. IPFS offers a way to effectively back up NFTs to the distributed network: there’s a dedicated website for doing so, plus NFT marketplaces like OpenSea have implemented the functionality as well.

Otherwise, Protocol Labs looks to be focused on expanding the core premise of IPFS into new products and use cases. IPFS led to Filecoin, a distributed web storage platform that pays node operators in cryptocurrency for their spare storage space and bandwidth. In August 2021, the firm added Web3.storage, a service that ties into both IPFS and Filecoin to facilitate the creation of Web3 applications.

IPFS is being used in a variety of other interesting ways to fuel the future of Web3 development. For example, a governance voting system called Snapshot allows token holders to vote on proposals within decentralized autonomous organizations (DAOs), an increasingly common component of decentralized finance (DeFi) projects.

Decrypt’s own DAO uses Snapshot to poll readers on which articles they’d like to see next. Indeed, the very article you’re reading is the second in a series chosen by Decrypt NFT holders using Snapshot voting. The next step in the DAO’s development will see voting functionalities expanded as we transition to an ERC-20 token.

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What Are Stablecoins and How Do You Use Them?

Since their inception, cryptocurrencies have been considered particularly volatile investment instruments when it comes to their price. That’s led to price jumps and crashes, preventing cryptocurrencies from being used for everyday goods and services in some cases, due to the risks for vendors and merchants.

That’s where stablecoins come in. The theory goes, if you create a currency that is ‘pegged’ or attached to a regular fiat currency like the US dollar or something else with a relatively stable price, it will prevent price swings.

We explore these more below.

What is a stablecoin?



Stablecoins are cryptocurrencies that claim to be backed by fiat currencies—dollars, pounds, shekels, rubles, etc.

The idea is that, unlike cryptocurrencies like Bitcoin, stablecoins’ prices remain steady, in accordance with whichever fiat currency backs them.

What are some examples of stablecoins?

Centralized stablecoins

💵 Tether (USDT): Tether is one of the first stablecoins and the most famous. It claims it is backed by a reserve of real dollars—”collateral”—that is “off-chain,” i.e. in a real-world location that is controlled by a centralized third party.

With this stash safely in the vault of a bank, investors can be confident that their tethers really are worth one dollar each, keeping the price steady. The stablecoin accounts for a whopping 48% of all cryptocurrency trading volume. There’s only one problem: Tether Ltd, which mints Tether tokens, has never conclusively proven that the currency really is fully backed, fuelling doubts among investors. (More on this below)

💰 Gemini Dollar (GUSD)/Paxos Dollar (PAX)/USDC: Developed by venture capitalists the Winklevoss twins, blockchain startup Paxos, and crypto exchange Coinbase (in concert with payment platform Circle) respectively, these stablecoins are currying favor with the institutional investors—all have been closely audited by Wall Street firms and are compliant with local regulatory regimes. As Tether becomes less trusted, these tokens only become more popular.

🛢️ Petro: The petro is a cryptocurrency developed by Venezuela. The government claims it is backed by the country’s oil reserves, among other valuable commodities, like gold. At its heart, it’s an attempt to create an alternative to the hyperinflationary Venezuelan bolivar. The coin has been airdropped to young people and doctors in the country, but there’s been criticism that it functions as a tool of mass surveillance, and that there are discrepancies between the official government price and the reality on secondary markets.

Gold-backed stablecoins

While the vast majority of stablecoins are backed by US dollars stored in a bank vault, weakening sentiment around the USD and the fiat, in general, has led to the elaboration of stablecoins backed by other assets, including various gold-backed cryptocurrencies. These differ considerably in their form and usability but are all backed by investment-grade gold.

CACHE gold (CGT) is among the most popular of these. Each CGT is backed by 1g of pure gold held in the vaults stored around the world. Sending CGT tokens is the equivalent of sending 1g of gold per token since they can be easily redeemed for physical gold at any time.

There’s also Tether Gold (XAUt) and PAX Gold (PAXG), which operate in a similar way, but are instead pegged to one troy ounce of investment-grade gold. They also have a higher minimum redemption amount than CACHE.

Algorithmic stablecoins

Terra (LUNA) is a decentralized stablecoin, which means rather than relying on a trusted third party it uses a complex algorithm to keep stable. To do this, it balances “on-chain” reserves—i.e. the funds are held in smart contracts—with supply and demand automatically, mitigating the chances of traders accidentally—or intentionally—fiddling the price.

Ampleforth (AMPL) relies on a similar process. Instead of physically backing each AMPL with 1 USD, it instead uses a process known as a “rebase” to automatically adjust the circulating supply of the cryptocurrency in response to changes in supply and demand. If the price of AMPL is more than 5% above or below the USD reference price, then it will increase or decrease the circulating supply in an effort to push the price back towards $1. Since this rebase is proportional across all wallets, AMPL holders always maintain their share of the overall AMPL network.

A comprehensive list of popular stablecoins

USD-pegged

  • Tether (USDT)
  • True USD (TUSD)
  • Gemini Dollar (GUSD)
  • USD Coin (USDC)
  • Paxos Standard (PAX)
  • Binance USD (BUSD)
  • DAI
  • HUSD
  • sUSD (SUSD)
  • mStable USD (MUSD)
  • Ampleforth (AMPL) (algorithmic)

GBP-pegged

  • Binance GBP Stable Coin (BGBP)

EUR-pegged

  • Stasis Euro (EURS)

TRY-pegged

  • BiLira (TRYB)

KRW-pegged

  • Binance KRW (BKRW)

Gold-backed

  • CACHE Gold (CGT)
  • Tether Gold (XAUt)
  • Paxos Gold (PAXG)

Other

  • Petro (PTR) (oil-backed)
  • Libra (basket backed)

How are stablecoins used?

Like most digital assets, stablecoins are primarily used as a store of value and as a medium of exchange. They give traders temporary reprieve from volatility when the market is tumbling, and can also be used in the rapidly growing world of decentralized finance (DeFi) for things like yield-farming, lending, and liquidity provision.

Most traders and investors gain exposure to stablecoins by purchasing them from exchange platforms, but it is also often possible to mint fresh stablecoins by depositing the requisite collateral with the issuing company, such as US dollars with Tether or physical gold with CACHE gold.

Why have stablecoins become so popular?

Stablecoins are enormously popular: Tether, for instance, is the second most traded cryptocurrency after Bitcoin, with a 24-hour trading volume of $31.4 billion (at the time of writing).

The two main reasons why people choose stablecoins over cryptocurrencies like Bitcoin

They’re (relatively) stable. Because they are supposedly backed by fiat currency, investors can be confident that their tokens will always sell for one dollar each. This supposedly means that the prices won’t fall: coin prices are driven by belief, so if investors believe their stablecoins are worth and backed by one dollar each, the price should reflect that.

They’re a safe haven for worried investors. Many exchanges—including Binance, the world’s largest—don’t let traders buy fiat currency, and only let them buy and sell cryptocurrencies. This means it’s often tricky for investors to swiftly cash out their cryptocurrencies when the going gets tough. To do so they might have to transfer across several exchanges, or even wait several days.

This is where stablecoins come in. Because they are cryptocurrencies, they live on most exchanges. Yet because they hew to the value of a single fiat currency, they act as a sort of temporary refuge for investors looking to secure their funds during a bear market. In this way, stablecoins are like blockchain-enabled versions of the dollar. That’s if they retain their value.

Disadvantages of stablecoins

Investors need proof the coins are backed by reserves. In Tether’s case, this has never been conclusively provided, sparking rumors that the currency was unbacked and was in fact minted out of thin air.

Stablecoins aren’t necessarily stable. The Gemini Dollar has increased by a few cents several times in the last year as traders poured money into it. Ironically, many of those investors’ funds had come from Tether—which has previously sunk to as low as $0.51 on some exchanges. As such, stablecoins can be considered ‘relatively’ stable, rather than absolutely stable—particularly when compared to volatile assets like Bitcoin.

Did you know?

Tether has consistently failed to provide proof of its dollar reserves. It managed to release one audit but the law firm that carried it out, Freeh, Sporkin & Sullivan LLP, swiftly downplayed its auditing credentials when scrutinized. In 2019, a Tether lawyer revealed that USDT is only 74% backed, but the firm later stated that it is in fact 100% backed.

The future of stablecoins

With the crypto boom of 2017 behind us, investors are increasingly looking to stablecoins as a safer way to experiment with the technology. In the first half of 2020, the supply of stablecoins swelled by 94% to hit $11 billion in June. And regulators are warming up to them, too; in September 2020, the US Office of the Comptroller of the Currency (OCC) gave national banks and federal savings associations the green light to hold reserves for stablecoin issuers.

As more respected players throw in their weight—the Winklevoss twins, Circle, and Coinbase, for instance—the idea of a digital dollar, a shadow currency that takes fiat onto the blockchain without risking its value, is ever more tantalizing.

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What is Proof of Work? How The Bitcoin Network Is Maintained

In brief

  • Proof of work is the consensus algorithm that secures the decentralized Bitcoin blockchain network.
  • Bitcoin miners attempt to solve complex math equations with the energy-intensive process, all to generate new blocks and earn BTC rewards.

The blockchain technology that powers Bitcoin and many other cryptocurrencies is essentially a database, but it’s far different than any typical, centralized ledger. It’s decentralized and powered by peer-operated nodes distributed all around the world, with no supervising authority to call the shots or set the rules.

So how do you secure a decentralized network and ensure that everyone agrees on the contents of the ledger? That’s where Bitcoin’s proof of work consensus algorithm comes in.

In combination with public key cryptography, the proof of work consensus algorithm secures the distributed ledger and protects the network from “double spend” attacks, all while adding new blocks of transactions to the chain and generating BTC rewards.

The proof of work mechanism requires Bitcoin miners to compete to solve complex mathematical equations using their computers—a very energy-intensive process. It’s difficult on purpose, but the resulting Bitcoin rewards can be incredibly valuable indeed.

Proof of work is essential to Bitcoin’s continued operation, but its energy consumption has received considerable scrutiny and some other cryptocurrencies have embraced a very different proof of stake model instead. Here’s how proof of work functions, why it’s necessary for Bitcoin, and what the drawbacks are.

What is a consensus mechanism?

Unlike a traditional database overseen by an administrator, a public blockchain is a peer-to-peer decentralized network that any participant can potentially contribute to. Consensus is essential for such a distributed network to function, given the potentially thousands of node operators: they must all agree on the state of the network for it to work properly.

A consensus mechanism is the process by which the network reliably and automatically determines which participant’s submitted block—which is a record of recent transactions—will be added to the chain, thus minting and rewarding them with new cryptocurrency in the process.

What is proof of work and how does it work?

Proof of work is the consensus mechanism designed for Bitcoin by its creator, Satoshi Nakamoto. A similar model has been employed by Ethereum, Litecoin, Dogecoin and other cryptocurrencies since then. In the proof of work model, miners run hashing software on their computers, which harnesses their hardware’s power to solve complex math equations.

Ultimately, the math is arbitrary: miners are doing work for the sake of it, to spend precious computing resources in exchange for a potential reward. It’s an intentionally difficult process to prevent potential attacks on the network, but that means that more powerful computers have an advantage. From the early days of the Bitcoin network, there’s been an “arms race” among miners, who initially used their computer’s CPU to mine Bitcoin, before moving on to high-end graphics cards and finally dedicated ASIC mining hardware.

“Proof-of-work has the nice property that it can be relayed through untrusted middlemen.”

Satoshi Nakamoto

Bitcoin users broadcast transactions to the blockchain, and miners collect them up in a block and compete in proof of work to be the first to solve the equation via a process called hashing. The miner or mining pool whose block is accepted earns Bitcoin as a reward. The reward is currently set at 6.25 BTC; it was originally 50 BTC and halves every four years. This process repeats every 10 minutes or so, as new blocks are written and new Bitcoin is effectively minted and awarded.

Did you know?

Bitcoin’s mining process is derived from Hashcash, a proof-of-work system invented by Adam Back in 1997 to fight email spam and denial-of-service attacks. Back, an early Bitcoiner, has denied that he is the cryptocurrency’s creator, Satoshi Nakamoto.

Why is it important?

Proof of work is a critical component of the Bitcoin network. Without such an energy-intensive process, it would be easy for bad actors to attack the network and “double spend” Bitcoin. That’s called a 51% attack, in which a mining group commands a majority of the network’s total hash rate (computing power), thus allowing it to manipulate blocks and take advantage of the system.

“The proof-of-work chain is the solution to the synchronisation problem, and to knowing what the globally shared view is without having to trust anyone.”

Satoshi Nakamoto

However, because Bitcoin’s proof of work is so resource-intensive, it’s nearly impossible for any miner or group to command that much total power.

Which cryptocurrencies use proof of work?

Proof of work is the dominant consensus model among cryptocurrencies, with the two largest coins—Bitcoin and Ethereum—both using it, along with other coins like Litecoin, Dogecoin, Bitcoin Cash, and Monero.

Did you know?

Ethereum is currently in the process of transitioning from proof of work to a proof of stake model with its Ethereum 2.0 launch.

What are the disadvantages of proof of work?

The biggest disadvantage of Bitcoin’s proof of work model is the sheer amount of energy required for mining. Digiconomist suggests that the entire Bitcoin network has a carbon footprint comparable to the country of Morocco, and electric car maker Tesla cited the environmental impact of mining when it decided to stop accepting Bitcoin payments in May 2021.

Given the value of Bitcoin and the rewards at stake, it’s no surprise that this is a heavily contested and controversial topic. Bitcoin advocates often suggest that such estimates of its energy usage are misleading or overstated, or counter that banks and centralized payments services don’t receive the same level of scrutiny.

Some believe that Bitcoin mining incentivizes the use of renewable energy, or suggest that Bitcoin mining uses generated energy that otherwise would have been wasted. The debate isn’t so much focused on whether Bitcoin mining expands a huge amount of collective energy—it does, and that’s by design. It’s also critical to maintaining Bitcoin as the protocol currently operates. Rather, much of the debate focuses on the types of energy being used and whether it’s worthwhile. Bitcoin miners and fans, unsurprisingly, believe that it is.

Also, much to the chagrin of gamers, mining for cryptocurrencies such as Ethereum has sparked immense demand for powerful PC graphics cards (or GPUs), causing widespread shortages and price increases. That’s led manufacturers to weaken the mining capabilities of their graphics cards to make them less desirable to miners.

While the immense scale of Bitcoin’s network means a 51% attack is likely impossible, that’s not true for smaller proof of work blockchain networks. Both Ethereum Classic and Bitcoin Cash faced such attacks in 2020, for example.

Proof of work vs proof of stake

Amidst concerns around the energy consumption of proof of work networks, an alternative consensus mechanism has taken root in the blockchain industry: proof of stake. A proof of stake system relies on validators to hold a large amount of the native cryptocurrency within the network, and those users validate transactions and earn rewards.

Coins like Cardano, Algorand, Cosmos and Binance Coin all use some form of proof of stake model. As mentioned earlier, Ethereum is currently transitioning to that approach with its Ethereum 2.0 upgrade; the new network is estimated to consume 99.95% less energy than the current one.

Proof of stake doesn’t require high-powered computers or mining rigs, so the overall network uses vastly less energy than a proof of work system. On the flipside, detractors claim that proof of stake models help the “rich get richer,” since validators must stake a huge amount of coins to participate, and that it incentivizes users to not spend their coins.

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What is the Bitcoin Halving? How Bitcoin’s Supply is Limited

In brief

  • The Bitcoin halving is an event where mining rewards are cut in half.
  • The event takes place every four years, according to pre-set rules in Bitcoin’s code.

Every four years, the amount of Bitcoin doled out to cryptocurrency miners halves, in a process imaginatively known as the Bitcoin halving (or halvening). Here’s why—and how—it works.

Bitcoin’s supply limit

To understand the Bitcoin halving, we must first understand the theory behind Bitcoin’s supply.

The inventor of Bitcoin, Satoshi Nakamoto, believed that scarcity could create value where there was none before. After all, there’s only one Mona Lisa, only so many Picassos, a limited supply of gold on Earth.

Bitcoin was revolutionary in that it could, for the first time, make a digital product scarce; there will only ever be 21 million Bitcoin.

The idea of limiting Bitcoin’s supply stands in marked opposition to how fiat currencies such as the U.S. dollar work. Fiat currencies such as the U.S. dollar were initially created with firm rules–to create one U.S. dollar, the U.S. government needed to have a certain amount of gold in their reserves. This was known as the gold standard.

Over time, these rules eroded as modernizing economies, during bouts of extreme financial certainty–like the Great Depression and World War II–printed more money to help stimulate struggling economies. Over time, these rules evolved into today’s system, in which governments can (broadly speaking) print money as often as they like.

Satoshi Nakamoto believed that this devaluation of fiat money could have disastrous effects, and so, with code, prevented any single party from being able to print more Bitcoin.

What is the Bitcoin halving?

Embedded in the Bitcoin code is a hard supply limit of 21 million coins. New Bitcoin is released through mining as block rewards. Miners do the work of maintaining and securing the Bitcoin ledger; as a reward, they receive newly minted Bitcoin.

However, about every four years, the reward for mining is halved–hence “the halving.” Each halving reduces the rate of new Bitcoin entering into the supply, until no more new Bitcoin is created at all in the year 2140.

A brief history

  • 2009 – Bitcoin mining rewards start at 50 BTC per block
  • 2012 – The first Bitcoin halving reduces mining rewards to 25 BTC
  • 2016 – In the second halving, mining rewards go down to 12.5 BTC
  • 2020 – In the third halving, mining rewards drop to 6.25 BTC
  • 2140 – The 64th and last halving occurs and no new Bitcoin will ever be created

What’s so special about the halving?

If a person, group, or government is trusted to set up the money supply, they must also be trusted to not mess with it. Bitcoin is supposed to be decentralized and trustless–no one in control and no one to trust. Since Bitcoin is not controlled by any one person or group, there must be hard and set rules about how many Bitcoin gets created and how they are released.

By writing a total supply and halving event into the Bitcoin code, the monetary system of Bitcoin is essentially set in stone and practically impossible to change. This “hard cap” means Bitcoin is a kind of “hard money” like gold, which has a total supply that is also practically impossible to change.

What happens to Bitcoin miners?

Bitcoin miners invest money in specialized mining hardware as well as the electricity required to run their rigs. The cost of this is offset by their mining rewards—but what happens when their rewards are halved?

Since the halving reduces mining rewards, the incentive for miners to work on the Bitcoin network is also reduced over time, leading to fewer miners and less security for the network.

For this reason, once the last Bitcoin is mined, miners will (assuming there haven’t been any major changes to the Bitcoin protocol) receive rewards in the form of transaction fees for maintaining the Bitcoin network.

At present, transaction fees make up a small proportion of a miner’s revenues; miners currently mint around 900 BTC (~$33.5 million) a day, but earn between 60 and 100 BTC ($2.2 million to $3.7 million) in transaction fees each day. That means transaction fees currently make up as little as 6.5% of a miner’s revenue—but in 2140, that’ll shoot up to 100%.

“Transaction fees will likely grow in an inverse correlation to, and as a compensation for, the diminishing mining returns,” Ben Zhou, CEO of crypto exchange ByBit, told Decrypt.

It’s also possible that the reward mechanism for Bitcoin could change before the final block is mined. Bitcoin currently runs on a proof of work consensus mechanism, which has attracted criticism from the likes of Tesla CEO Elon Musk for its high energy consumption and carbon footprint.

Rival cryptocurrency Ethereum is in the process of switching from proof of work to the less energy-intensive proof of stake consensus mechanism, in which the network is secured by having validators lock up, or “stake,” their cryptocurrency.

It’s possible that Bitcoin could follow suit. In an interview originally shot for German TV show Galileo, Niklas Nikolajsen, the founder of Swiss crypto broker Bitcoin Suisse, was quoted as saying “I’m sure, once [proof of stake] technology is proven, that Bitcoin will adapt to it as well.”

The halving’s impact on the price of Bitcoin

The debate over whether Bitcoin halvings impact on the cryptocurrency’s price, or whether they’re already “priced in”, continues to rage.

According to the laws of supply and demand, the dwindling Bitcoin supply should increase demand for Bitcoin, and would presumably push up prices. One theory, known as the stock-to-flow model, calculates a ratio based on the current supply of Bitcoin and how much is entering circulation, with each halving (unsurprisingly) impacting on that ratio. However, others have disputed the underlying assumptions upon which the theory is based.

Historically, after previous halving events, the price of Bitcoin has increased—but not immediately, and other factors have played a part.

At the time of the June 2016 halving, the price of Bitcoin had was around $660; following the halving, Bitcoin continued to trade horizontally until the end of the month, before crashing to as low as $533 in August. But following the crash, Bitcoin’s price shot up to its then all-time high of over $20,000 by the end of the year, an increase of 2,916%.

Similarly, in the wake of the 2020 halving, Bitcoin’s price increased from just over $9,000 to over $27,000 by the end of the year—but in the two months following the halving the price failed to break $10,000. It’s also important to note that other factors also influenced Bitcoin’s 2020 bull run, most notably growing institutional investment from the likes of MicroStrategy, and PayPal’s decision to enable its users to buy and hold Bitcoin.

Disclaimer

The views and opinions expressed by the authors are for informational purposes only and do not constitute financial, investment, or other advice.

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What Is a Decentralized Autonomous Organization (DAO)?

In brief

  • A DAO, or decentralized autonomous organization, is a business structure where control is spread out rather than hierarchical.
  • DAOs are organized using smart contracts, with participants using governance tokens to vote on topics such as fund allocation.

Ever feel like your boss doesn’t listen to you? It’s a common gripe at work. A new type of organization is changing that, with a flatter management structure, and a set of rules automatically enforced on a blockchain.

Decentralized Autonomous Organizations (DAOs) allow everyone to take part in discussions, encouraging teamwork. And they’ve created some pretty cool things.

What is a DAO?

A DAO is a business structure where control is spread out, across the team members instead of being centered around one authority figure.

A DAO can be seen as operating like a machine, with the job it is instructed to carry out determined by pre-written smart contracts.

How do DAOs work?

A community can adapt a DAO and program it according to its own goals.

  • 👩‍💻 Code is written in the form of smart contracts, which provides some sort of governance mechanism.
  • 🗳️ Members typically use governance tokens to vote on topics such as fund allocation.
  • 📊 In the case of many DAOs, the impact of a member’s vote can increase based on the amount they have contributed to the project.
  • 💪 The outcome can be based on the degree of participation as well as voting preference.

What was The DAO?

The DAO was the biggest and earliest example of a DAO. It was created by Slock.it and was built on the Ethereum network. Its code was open source, which anyone could contribute to.

The DAO was designed to work as a venture fund platform for crypto projects. A pitch would be made and anyone with DAO tokens could vote on projects to award funding. However, The DAO never made it to liftoff.

Did you know?

The DAO raised 12.7M Ether, worth around $150M at the time.

What went wrong with The DAO?

On June 17, 2016, a hacker managed to exploit a few lines of code allowing the move of 3.6 million Ether, worth $70 million. Yet the funds were moved to a “Child DAO” and couldn’t be moved for 28 days, giving the Ethereum community time to make a fix.

They made a hard fork to the chain now known as Ethereum, leaving the old fork, Ethereum Classic, behind. During this fork, they re-wrote the blockchain so the hack never happened, meaning the blockchain was no longer immutable.

“[The DAO] raised massive awareness around the platform […] demonstrating unequivocally the need for a decentralized structure of this nature.”

Stephan Tual, founder of Slock.it

A dark time for DAOs

Development on DAOs continued, but out of the limelight. Projects such as Aragon, DAOstack, DAOHaus, and Colony learned key lessons from the original DAO, and now build and run DAOs for some of the largest decentralized finance (DeFi) protocols. The 2020 DeFi boom brought a fresh wave of interest to the DAOs that underpinned many of the leading projects.

DAOs come in all shapes and sizes

  • Crypto projects – considered to be DAOs if they are managed by decentralized governance where token holders can vote on the direction of the project. e.g. MakerDAO.
  • Grant funding – a DAO can be used to award development funds automatically based on set criteria. e.g. MolochDAO.
  • Investment – MolochDAO has been forked many times to create for-profit DAOs which can distribute and transfer shares and other assets between members. e.g MetaCartel Ventures.
  • Collecting – the non-fungible token (NFT) boom has seen collector DAOs flourish e.g. FlamingoDAO.

Did you know?

MetaCartel Ventures is registered as a Limited Liability Company (LLC) in crypto-friendly Delaware.

What advantages do DAOs have?

  • 📖 Transparency – voting, funding decisions, and other actions are viewable by anyone.
  • 🔥 More firepower – members across the world can contribute, giving DAOs lower barriers to entry than companies.
  • 💵 Cheaper – the concept has firmly taken root in the DeFi, and there are many tools—which can be used like Legos, so little needs to be built from scratch.
  • 👨‍👩‍👦‍👦 Collaborative – giving everyone a voice pools mass knowledge for a proposal and enables experts to invest in the ecosystem they are building.

“We believe the DAO will play a starring role as the world makes the shift to Web 3.0, paving the way for fully decentralized companies.”

Jademont Zheng, Waterdrip Capital

What disadvantages do DAOs have?

  • 🏢 Flat structure – by not having a clear authority figure, or chain of command, decentralized organizations are slower to operate as decisions take longer to make.
  • 😡 Disagreements – when the community disagrees strongly, it could split the organization into two.
  • 👸🏽 No change – in some DAOs, those with the most tokens call the shots, so governance looks very similar to traditional organizations.
  • ⚖️ Legality – minefields abound in relation to token projects that might be deemed to be securities.

Did you know?

Ethereum co-founder Vitalik Buterin developed the idea of DAOs in 2013. At first they were called “Decentralized Autonomous Corporations” (DACs).

The future

DAOs are seeing a big revival of interest; hundreds of developers are working on technical innovations, improvements to governance mechanisms, and voting solutions.

Meanwhile, landmark legislation in the crypto-friendly state of Wyoming is seeking to clarify the legal status of DAOs.

Enthusiasts believe that DAOs will soon become more sophisticated. Trends include anonymity, progressive decentralization, and better incentives towards participation. Future DAOs may employ prediction markets, and begin voting and acting as delegators in other DAOs.

Will they start to change the way that companies operate and raise money? Soon you might be having a discussion about the right way for your business to move forward, without having a boss telling you what to do. The grass certainly looks greener.

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Privacy Coins and zk-SNARKs: How Do They Work?

In brief

  • zk-SNARKs are a form of cryptography that enable privacy coins like Zcash to function.
  • Here’s everything you need to know about how they work in crypto, and where else you might see them pop up.

An important segment of the crypto industry revolves around so-called “privacy coins,” which promise highly anonymous transactions. Privacy coins, notably Zcash (ZEC), rely on a technology called zk-SNARKs, which stands for Zero-Knowledge Succinct Non-Interactive Argument of Knowledge.” This field is also referred to as zero-knowledge cryptography. 

The concept of “zero knowledge” can be somewhat mind-melding, and zk-SNARKs get complicated quickly, so let’s start at the beginning. 

Cryptography

In a nutshell, cryptography is the study of secure communication techniques. People often use cryptography when they only want a sender and recipient to view the contents of a message. 

Cryptography has been around for centuries. One of the earliest examples of cryptography arose in Ancient Egypt where followers of Khumhotep II inscribed his tomb with encrypted symbols that marked a departure from traditional Egyptian hieroglyphics.

A traditional form of cryptography
A traditional form of cryptography. Image: Shutterstock

One of the most common elements of cryptography in the cryptocurrency world is hash functions, the backbone of any blockchain. Hash functions—specifically SHA-256, a hash function found in most blockchains—essentially turn an input such as a word phrase or a number into an encrypted piece of information of a fixed length that look like this:

77077b1f4c3ad44c83dc0bdb8d937e9b71c0ef07a35c2664bb7da85be738eacf

Hash functions (you can read more here) allow blockchains like Bitcoin to process transactions, link blocks to one and other, and ensure the integrity of blockchain data is maintained.

Just like hash functions, zk-SNARKs are a form of cryptography. They are used to guarantee stronger privacy than users would otherwise get on a blockchain. 

Zcash: zk-SNARKs in action

zk-SNARKs are a form of “zero-knowledge” cryptography—hence the zk. 

zk-SNARKs allow crypto users to send transactions on a blockchain in a totally encrypted way—meaning no one can read them—while at the same time signifying the transactions took place in a legitimate manner. But how is that possible? 

Zero knowledge proofs allow person A to prove to person B that statement X is true without revealing any information beyond the validity of statement X itself. Imagine verifying to someone that you’re over the age of 21 without revealing your birthday or the fact you’re 25. That’s a useful way of imagining how zk-SNARKs function. 

This is exactly what takes place when two individuals make a transaction in Zcash, one of the cryptocurrency industry’s leading privacy coins. The goal of Zcash is to anonymize as much information about users and transactions as possible. 

“The strong privacy guarantee of Zcash is derived from the fact that shielded transactions in Zcash can be fully encrypted on the blockchain, yet still be verified as valid under the network’s consensus rules by using zk-SNARK proofs,” the Zcash website reads

Fundamentally, this kind of shielded transaction is the opposite of what we see in, for example, the Bitcoin blockchain, where sender and receiver addresses—as well as the value of a transaction—are available for anyone to see. 

In a shielded transaction, Zcash uses zk-SNARKs to show a sender possesses the funds he or she wishes to transmit, and that the transaction cannot be modified by a third party.

Zcash
Zcash (ZEC) is a privacy-focused cryptocurrency. Image: Shutterstock

For these shielded transactions to work, they must satisfy certain conditions. Specifically, in Zcash, they entail users publishing a “commitment” and revealing a “nullifier.” 

A commitment refers to an unspent balance on the Zcash blockchain. Just like Bitcoin, nodes on Zcash’s network maintain a list of such balances, showing that funds are indeed available. 

A person who wishes to send Zcash publishes a commitment in order to say, “see, I have this amount of money” (albeit without revealing how much). In turn, the nullifier serves to say “this same amount of money is spoken for—it has been sent to someone else.’ 

In other words, nullifiers are tied to commitments—they are numbers that need to be revealed before a commitment can be spent. If Alice wants to sent Bob Zcash, she has to use a commitment to prove she has the authority to spend the funds, and a nullifier to show the requisite amount has been reserved exclusively for Bob (without, of course, revealing Bob is the recipient).

Each new shielded payment gives rise to three types of record on the blockchain—records that are protected by means of a hash. The hashes in question represent: the address of the transaction recipient, the amount that was sent, and a number unique to the transaction itself. 

The upshot is that shielded transactions rely on hash functions just like Bitcoin, but it’s the zk-SNARKs that add a new layer of privacy.

Coins like Zcash and Monero—another popular privacy coin in the crypto sphere—are popular among some users given the fact that the crypto industry is composed of many libertarians. Both coins try to set themselves apart from more popular cryptocurrencies like Bitcoin by claiming that nobody could pry into your private financial lives if you used their coins. 

However, given concerns that cryptocurrencies in general—and privacy coins especially—can serve as tools for criminals, these projects are far from popular with law enforcement agencies and regulators.

The future of zk-SNARKs

zk-SNARKs are a useful tool for anonymizing crypto transactions. But they are also helping to power a growing number of other applications beyond privacy coins. Celo, for instance, is a cryptocurrency protocol that focuses on mobile payments and aspires to create a more inclusive financial world.

Decrypt spoke with Pranay Mohan, who works on product and engineering at Celo. He suggested that Zcash might be where people first hear about zk-SNARKs, but that the technology’s potential extends far beyond privacy hawks. Mohan points in particular to how zk-SNARKs can help people in the developing world.

“If we think about how these people are able to use cryptocurrency now it’s near impossible, they’re not using Metamask and throwing $10,000 into a random DeFi project,” he said. Using zk-SNARKs, Mohan adds, mobile phone users can sync instantly with a blockchain—retaining the same trustless properties of crypto but on devices that don’t have a high degree of technical capacity.

Despite their promise, zk-SNARKs remain very niche. Even in a highly technical industry like crypto, many people aren’t aware of what they are. But that may be changing as more companies begin embracing the technology.

These include Aleo, a startup that recently raised $28 million from blue chip venture capital firms, to build tools that will let web develops integrate zero knowledge proofs in a wide variety of Internet applications—a project that promises to let consumers browse the web without revealing a trove of personal data.

But that hasn’t dissuaded EY, one of the world’s largest accounting firms, from experimenting with this advanced cryptography. 

Paul Brody, global blockchain leader at EY, says the company is using zero knowledge proofs like zk-SNARKs to let clients embrace blockchain’s potential without sacrificing user privacy. 

According to Brody, the accounting firm’s own Nightfall solution provides a means for transacting on the Ethereum network with absolute privacy, while providing enterprises—not just individuals—with these benefits. 

And while there are regulatory concerns surrounding highly private financial transactions, Brody believes zk-SNARKs will gather mainstream momentum in the future. 

“Privacy is essential for business users,” he said, adding, “For enterprises, some of their most sensitive information is about what they buy, from whom, how much they pay and how much they are buying in volume.”

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What Is a Decentralized Exchange (DEX)?

In brief

  • DEXs allow trading without an intermediary.
  • Users don’t need to give up custody of their coins.
  • The main drawback for some: you’re responsible for your own security.

A decentralized exchange or DEX is a place where people can go to trade cryptocurrencies without an intermediary. To better identify what a decentralized exchange is, it’s important to first understand how centralized exchanges work.

How Do Centralized Exchanges Work?

A centralized exchange such as Binance or Coinbase is a site or app where people can buy, sell, or trade cryptocurrencies and tokens listed on that exchange. 

Let’s say you want to buy some Bitcoin.

You can go to an exchange, sign up by providing some banking details and identifying information, and deposit some cash. (Sometimes this process takes days, which is one drawback of centralized exchanges vs. DEXs.) The exchange will tell you the price—based on an “order book” of people buying and selling at different amounts—and you can make the transaction.

So, what happens next?

The exchange will show those Bitcoins in your account, and you can trade for other tokens on the exchange. But you don’t really hold them, because you’re entrusting the exchange to act as a custodian on your behalf. Any trading you do, like swapping Bitcoin for Ethereum, aren’t occurring on a blockchain, but within the exchange’s database.

Exchanges pool users’ cryptocurrencies into wallets (often “hot” wallets connected to the internet) controlled by the exchange. The exchange controls your private keys. (There are ways around this, as exchanges allow you to transfer your tokens to a private wallet, but this adds an extra step later on if you wish to trade that crypto.) 

The appeal of decentralized exchanges, DEX advocates say, is security. A centralized exchange can limit your access to your crypto, restrict or halt your ability to trade it, or even fall vulnerable to hackers.

On the other hand, centralized exchanges are generally far easier to use for newcomers, and they can often offer fast trading because they’re not beholden to blockchain infrastructure. This has been Coinbase’s biggest achievement: making itself the household name in the U.S. for crypto-curious folks looking to dip a toe into buying crypto, but intimidated by the process. For those people, letting Coinbase (or any other centralized exchange) act as custodian of their funds is just fine.

How Do Decentralized Exchanges Work?

A decentralized exchange uses smart contracts (automatically-executed protocols) to facilitate trading between individuals, but doesn’t take control of their coins.

DEXs handle this in one of three ways: an on-chain order book, an off-chain order book, or an automated market maker approach.

In an on-chain order book, every transaction is written onto a blockchain. That’s not just the actual purchase, but also the request to purchase or cancel an order. It’s the ultimate in decentralization, but the need to put everything on a blockchain can make it more expensive and slower. 

A decentralized exchange facilitates trading between individuals, but doesn’t take control of their coins.

With off-chain order books, all of this happens elsewhere, with only the final transaction settled on the blockchain. Since orders aren’t stored on-chain, this method can run into some of the security issues of centralized exchanges but isn’t as slow or costly as on-chain order books.

Automated market makers, or AMMs, forego order books. With order books, if you have Chainlink tokens and want to buy Compound, you’d need to have someone with Compound who wants Chainlink and is willing to trade at an agreed-upon price. AMMs remove counter-parties and introduce algorithms to set the price, letting you trade Chainlink for Compound regardless of whether there’s someone on the other end of the trade. To facilitate this, they typically use “liquidity pools,” essentially paying users to keep some of their funds in a smart contract that can then be tapped for trades. Individual users, therefore, play a key role in facilitating trades.

Did you know?

Bancor created the first AMM on a blockchain after raising $153 million in Ether in 2017.

Advantages of DEXs

Private

Decentralized exchanges don’t ask American citizens to enter private information, such as social security numbers or addresses, that centralized exchanges are compelled to require as part of the Bank Secrecy Act. Thus far, because DEXs don’t take control of assets, they’ve fallen outside such regulations.

Lots of Options

DEXs such as Uniswap allow anyone to create a token pair. You can mint a new token and start swapping it for a friend’s token instantly. In this way, DEXs allow people to own tokens to use in decentralized finance (DeFi), services that allow them to save, borrow, lend, or trade without going through a bank or other financial institution.

Less Risk

Since your coins aren’t being held in a centralized exchange but in a wallet with private keys you hold, you’re immune to hacks. And even though centralized exchanges can go down for maintenance, on a DEX you can keep trading.

Disadvantages of DEXs

No Link to Bank Cards

Decentralized exchanges only work with cryptocurrency assets and not fiat (like USD), as enabling crypto-to-fiat would require involvement with banks. (Dollar transactions can’t settle instantly like blockchain-based ones.) Therefore, you have to already have cryptocurrency assets in order to use a decentralized exchange.

Complexity

Uniswap and many other DEXs are built atop the Ethereum blockchain. Any tokens traded there must be on the Ethereum blockchain, too. That means no Bitcoin and a lot of other popular tokens from competing blockchains. In fact, that technically means no ETH. Users must instead convert their ETH to “Wrapped Ether” (WETH) which is equal in price to ETH so they can trade.

No Customer Service

Centralized exchanges work kind of like banks. They have customers whom they mostly want to keep happy. But in a truly decentralized exchange, there is no actor on the other end. The developers who created the protocol don’t have the same relationship with users. While there are whole communities of DEX users, you’re responsible for your own money.

Your Choice

Decentralized exchanges generally try to embrace blockchain’s ethos of “trustlessness” and privacy. Your tokens remain in your possession until you trade them. Some people find that reassuring from a security perspective. For others, that level of responsibility is intimidating, and the risks are concerning. 

DEX advocates mostly agree: those are the tradeoffs for true decentralization.

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