You’ve probably heard of Bitcoin by now, and at the time of this writing, meaning mid-April 2013, it’s currently experiencing a blossom that has caught everyone by surprise and made a lot of people very rich.
What you may not know, though, is that Bitcoin is just one of several emerging virtual currencies. Bitcoin is definitely the biggest, but it’s important to understand the other currencies too, especially if you plan on investing or mining coin.
In this article, part of the Understanding Bitcoin series, I’ll talk about each of the different cryptocurrencies and what distinguishes them from each other. I’ll focus mostly on the two largest, Bitcoin and Litecoin, and then give you a brief overview of some of the other cryptocurrencies out there.
Let’s start with the basics. A cryptocurrency is a virtual currency that people use for various purchases. Currently, it’s used a lot of places online, but even offline brick-and-mortar stores are beginning to accept cryptocurrencies. This is especially true for Bitcoins.
There are already several cryptocurrencies in existence, each having slightly different characteristics and have uses in different scenarios. Which one will be used and which will die is a matter of great speculation, and as with all things that have a geeky nature, it’s often becoming a debate of passion. When I read these debates, I’m often reminded of Linux vs. Windows vs. Mac debates, or Android vs. iPhone, or similar debates where the underlying differences aren’t really that huge but people still get massively passionate about their particular favorite.
What most agree, though, is that digital currencies have a place in society now, and especially on the internet. With the democratic, global, and decentralized nature of cryptocoins, the ease of use for anyone, the inherent security and potential anonymity, as well as the technical abilities, cryptocurrencies are starting to look like a perfect model for internet heavy economies. Cryptocoins, although certainly not the only form of digital currency, seems to have the characteristics that users and society covets.
Cryptocurrencies work in much the same way as regular currencies and are in their simplest form nothing more. It’s money, and that’s really all you need to know. Whether the money is worth anything is up to society, if society adopts it as an accepted measure of value, then cryptocurrencies have value just like ‘hard’ (or fiat) currencies. Adoption is rising rapidly so there is evidence to support the idea that cryptocurrencies have merit and thus value.
On the flip-side, cryptocurrencies are extremely young and nobody really knows where they will go. The technology hasn’t been proven on a large scale and we know there are inherent problems that need to be resolved at some point. We do not know how governments around the world will react, although we do know that the US have declared digital money as just another foreign currency, giving it at least some credibility. We also have no way of determining value. Cryptocoins can take over online trade completely, and if so, even the current pricing is ridiculously low, or not exist at all in a year or two, in which case any value is overrated, even at one US cent per Bitcoin.
For the purposes of the rest of this article, I’m going to focus on two of the cryptocurrencies that derive from the open-source Bitcoin code. Bitcoin was the first of these currencies, but several other currencies have since appeared with different characteristics making them useful and beneficial in different situations. The other one is Litecoin.
Bitcoin was the first and remains by far the largest cryptocurrency. It is largest in market capitalization, acceptance by merchants, transactions, and mining power.
On the downside, Bitcoins’ size is starting to become a problem, or will shortly. For example, by design, a particular transaction block can be up to 1 Mb in size and must contain every transaction since the previous block was solved. This means that as more transactions happen, the block fills faster, and some transactions must wait until the next block, delaying transactions.
The mechanism designed to solve this is a voluntary transaction fee, which is added to the bonus of the block. As Bitcoin evolves and transactions increase, this voluntary transaction fee becomes the main revenue for mining operations, and if the market decides so, the fee will effectively be mandatory by giving low fee transactions less priority and slower transaction times, with a larger fee ensuring a faster transaction.
At the moment, mid-April 2013, BTC is seeing a rocket ride in terms of price. Be aware, though, that the actual value (as opposed to price) is still very undetermined and absolutely unknown. Anyone claiming to know is wrong at this point, whether they are warning against a bubble or hailing this as the most important thing on the planet.
Bitcoins have a fixed distribution rate and will end up with a maximum of 21 million coins. Most of those coins will be mined by 2032, though so after that (or even before) transaction fees will make up most of mining profitability. Bitcoins are mined using an SHA-256 based algorithm.
For Bitcoin based financial and investment services, there are currently both currency exchanges and stock markets, and other services from traditional financial markets are emerging. Still, because of the nature of Bitcoin, there is no government regulation or guarantees for these markets, so it is extremely risk to invest in BTC-based markets. The largest BTC/USD exchange by far is MTGox. Two other prominent currency markets are BTC-E and Vircurex, while MPEx (large, but expensive and somewhat difficult), (smallest but easier), and Bitfunder corners the market on stock trades.
Litecoin is the second largest cryptocurrency at this time, but is still much smaller than Bitcoin. Although the relative size varies in terms of market capitalization, at present the Litecoin economy is about 1/30 the size of Bitcoin.
Note: Numbers are based on sizes from http://dustcoin.com/mining
Litecoins have some different characteristics from Bitcoins. First, it is mined using a slightly different algorithm, called Scrypt, which is more resistant to massive mining rigs than the SHA-256 based currencies. That means that even personal computers, provided they have sufficiently powerful graphic card, can still participate in profitable mining.
Note: For a mining operations guide, read the previous post in this series on cryptocurrency mining.
Litecoins like Bitcoins are limited in total number of coins too, but its limit is 84 million coins. This really has nothing to do with its price or value, and because Litecoins are generated at a much faster rate, it evens out in the long run.
When I say that the Litecoin economy is much smaller, I mean much smaller, not just in market capitalization but also in adoption. Adoption is growing, though, but it looks like the community and merchants are waiting to see whether Bitcoins take off. Few merchants accept Litecoins yet, at least compared to Bitcoin, so its circulation is mostly based on person to person transactions and not so much for purchasing products or services.
On the plus side, Litecoins have a faster rate of block generation. Where Bitcoin blocks are designed to appear every 10 minutes, Litecoin blocks appear every 2.5 minutes. This has the benefit of giving potentially quicker and cheaper transactions, although it doesn’t necessarily mean that it will be quicker or cheaper.
Also, as the largest of the alternative cryptocurrencies, it may take a place as a backup currency in case Bitcoin transactions have issues like high fees, slow transactions, or even technical issues. Adding support for Litecoins once a merchant has support for Bitcoins is easier than trying to add other backup payment alternatives.
At the moment, Litecoin price is tied closely to the price of Bitcoins, so a rise in Bitcoin price often lead to a rise in Litecoin price. Litecoins are mined using a Scrypt-based algorithm.
Note: You can see an exchange rate for LTC to BTC or USD on BTC-E http://btc-e.com/. MTGox, the largest Bitcoin exchange in the world, is rumored to introduce Litecoin support soon.
Bitcoin and Litecoin combined make up more than 99% of the market at the moment, but that doesn’t mean they are the only currencies available. Other currencies exist, perhaps with more obscure characteristics, and right now, nobody knows whether these will survive or grow alongside their bigger brothers.
Namecoin is a much smaller currency, even compared to Litecoin, having about 0.3% of the market share. It’s designed to work with identities, currently mainly through an alternate DNS system that allows for completely anonymous domain name registrations. Very much a currency and system for privacy freaks bit can also be used to provide secure identification services. Namecoins utilize merged mining, meaning they are mined alongside regular Bitcoin mining at no extra cost to the miner.
Devcoin is a coin designed to support open source development, where mining generates revenue for open source projects. 90% of coin generation goes to open-source projects, the distribution of which is done through bounties administered by a democratic voting process. Anyone can apply and three random administrators vote on whether to approve the project, thus giving revenue to the project.
Novacoin is a bit of a controversial coin due to allegations of fraud in the introduction of the coin. The founder allegedly pre-minded a lot of coins before the introduction, many or all of which were used in a bribe and later destroyed (read more). It is the only alternative coin that uses Scrypt for mining (like Litecoins) so it may be an alternative to Litecoins, should Litecoins need one.
Terracoin is a relatively new coin that has seen some recent troubles due to its similarity to the Bitcoin code. In short, the profitability of mining rose drastically in a short time, making it practically worthless for normal miners to support. The developers have taken steps to correct the issue, which may help the coin survive.
Freicoin is another very interesting but obscure currency with some pretty remarkable characteristics. For one, it effectively implements negative interest, meaning you need to spend your money unless it loses its value gradually through Demurrage. The argument for this is that holding money is bad and circulation is good, encouraging investors to invest and banks to loan rather than hoard money.
Why, Oh Why?
With all these different types of coin in existence, it’s pretty clear there will be confusion for many people. The risk is huge like we saw with Terracoin, that technical issues and exploitation may kill smaller coins completely. New and innovative algorithms may stall this or prevent it completely, but it’s still a very immature technology and subject to malicious intent, like most other technologies.
However, it also shows that there is innovation in the way money works and should work and what society wants from its currencies. Cryptocurrencies is a great tool for encouraging innovation in monetary scenarios.
Even more, we have only seen the start of this innovation, perhaps at the level where the web was around 1997 when it too was four years old (Bitcoin is four years in 2013). Nobody knows yet whether this is a passing fad or whether the world is ready for new ways of using money, but if nothing else, Bitcoin and its smaller siblings have already had an effect on people’s minds.
I’m rooting for the future!
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