Investing in Crypto ProjectsFor the amateur, getting into crypto investing can be intimidating. Although cryptocurrency has shown itself to be a proven system, there is a lot of conflicting and misleading information and myths out there. Terms like blockchain, crypto exchange, ledger, wallet, hash, peer to peer(P2P) are thrown around, and they just expect people to put the pieces together. How to successfully invest in crypto projects? Successful crypto investing depends on a lot of factors:
- Avoid crypto exchanges
- Do research about a blockchain
- Research the coin/token that you are interested in
- Understand cryptocurrency culture
- Connect with people in crypto communities
- Know what your long term and short term investment goals are
Some Background first…Before investing in a crypto project, the investor needs to understand what a cryptocurrency is. The first cryptocurrency was Bitcoin which revolutionized the world with blockchain technology. This made it possible for people to transact anonymously with peer-to-peer transactions while cutting out middlemen like banks, governments, and exchanges. It was a new system, so Bitcoin had to prove itself to the world before people would be willing to trust it. Today, most people have heard about bitcoin and those who had invested early have now become millionaires. Since then, many people have taken an interest in crypto investing. Because the software that Bitcoin runs on is open source, people that saw potential in the technology were able to create their own cryptocurrencies. That is why crypto investors are able to diversify their portfolios today. However, this isn’t the main reason why the creators of Bitcoin chose to make their source code widely available. The creators of Bitcoin wanted to create an immortal system that cannot be manipulated or shut down by powerful institutions like banks, governments, or exchanges. By ensuring that anyone has access to the code Satoshi’s vision (not bitcoin sv) could continue if anything ever did happen to bitcoin. With a large number of cryptocurrency projects out there, it’s virtually impossible to regulate or shut the technology down. That’s because anyone can easily start up their own cryptocurrency if they wanted to.
Moving Your Crypto Off Centralized Exchanges (CEXs)With that bit of history out of the way, it’s time to start talking about how to invest in cryptocurrency projects. The first thing to know is that successful crypto investors own the keys to their own wallets. What is a cryptocurrency wallet? And what is a key. Cryptocurrencies work on a decentralized network of computers. Instead of being controlled and regulated by a central entity or bank, it’s run by thousands of computers that are connected via the internet. If one computer goes down, it doesn’t really matter because there are thousands of others still running the network. A wallet is software that you use to connect with this network and interact with the blockchain. The entire blockchain works with cryptographic keys which provides anonymity and security to the users. Another word for a cryptographic key is a hash. A cryptographic key is an encrypted cipher or code which is very difficult to break. That is where cryptocurrency gets its name from. Each wallet has two cryptographic keys:
- A private key
- A public key
KYC (Know your customer)A popular objection that people have against cryptocurrency is that governments are putting measures into place to regulate it. This is why most cryptocurrency exchanges (like Binance) ask people for their KYC information. When you trade through a crypto exchange all of your personal information (passport, identification number, photograph, phone number, physical address, etc.) can be traced back to the private key of your wallet, and anonymity is lost. They may be able to regulate the exchanges, but they will never be able to regulate P2P transactions on the blockchain. This is why it is recommended that investors avoid crypto exchanges altogether when investing in crypto projects. It’s your crypto and your wallet, only you should have access to it.
Research the Source Code of the BlockchainNot all cryptocurrency projects are created equal. Some cryptocurrencies behave like commodities while other cryptocurrencies behave like fiat money. That is why it is important to do your research about crypto projects before getting involved. There are different methods used to evaluate and price cryptocurrencies. For example, the value of stable coins is linked to a fiat currency while a proof of work (PoW) coin is a commodity like gold, silver, platinum, etc. In this article, we are not going to touch on the subject of stable coins. Another factor to be aware of early on is the difference between coins and tokens. When a cryptocurrency has its own blockchain (and doesn’t have to share it with other crypto projects), we say it’s a coin. When a cryptocurrency shares a blockchain with other smart contracts, we say it’s a token. Cryptocurrency projects like Bitcoin, Litecoin, DogeCoin, and other coins all exist on their own independent blockchains. ERC20 Tokens like Presearch, DAI, Don-Key, AXIS Token, Unistake, etc. all share an environment on the Ethereum blockchain. It’s important to know what you are in the market as an investor. Smart investors know the value proof of work blockchains(PoW) and understand the risks involved with proof of stake (PoS)blockchains.
Proof of Work vs Proof of StakeThe reason why cryptocurrencies are valuable is because of something called consensus. The consensus between thousands of computers to verify transactions is what eliminates the need for middlemen like banks. The financial incentives behind these mechanisms influence the value of the blockchain. Consensus in the blockchain is important because it solves the double-spending problem. To avoid double-spending, people have traditionally used banks and other financial institutions to verify their transactions. However, blockchain technology has given us a more effective system for verifying transactions securely. The major consensus mechanisms that blockchains use today are:
- Proof of Work
- Proof of Stake
The potential loopholeHowever, there is a loophole, and the system can be undermined. One person in the group wants to go to the theme park and decides to manipulate the outcome. So they invite three friends to join the group and vote in favor of the theme park.Â Because the majority determines the outcome, the results have turned in favor of the theme park. The same risk of consensus manipulation is present on blockchains. It’s known as a 51% attack. In the same way that the person in our example called on extra friends, an attacker may be incentivized to connect additional computers or nodes to manipulate consensus outcomes on a blockchain. The only solution to prevent this is to incentivize computers on the network to validate transactions properly i.e. 51 preventing the blockchain wouldn’t be worth the effort. Pow and PoS have different ways of tackling the issue.
Proof of Work AlgorithmGold gets its value from the cost of extraction. Mining and refining gold is an expensive process that requires heavy machines, labor, and time. This extraction cost of gold is called proof of work. In 1993, a digital proof of work mechanism was invented to combat email spam. Satoshi realized that the same mechanism can be to secure a P2P network. When a computer wants to process transactions on a PoW blockchain, it needs to solve a cryptographic puzzle. A cryptographic puzzle is a random number that is extremely difficult to guess. To achieve this, there is a time and electricity cost. In the earlier beach vs theme park example, this is the equivalent of giving every person a sudoku puzzle and only allowing them to vote once/if they solved it. Computers with more hashing power (computing power) are more likely to solve the puzzle. This would be like one person in the group is extremely intelligent and more likely to solve the sudoku puzzle first. The incentive for them to solve the puzzle first would be that they get to vote and decide whether everyone goes to the beach or theme park.
Incentives behind PoWWith PoW cryptocurrencies, the incentive for solving a block is a financial reward i.e. coins. Every time a cryptographic puzzle is solved a new block is created and some coins are minted. Then a new puzzle is generated that needs to be solved for a computer to earn the right to process transactions. This would be like handing out a new sudoku puzzle every time someone solved theirs to get a vote. This means that the same person would be allowed to vote more than once as long as they solve the puzzle first. To ensure that a supercomputer doesn’t solve the cryptographic puzzle every time before anyone else can have a chance, the PoW adjusts the difficulty of its network. This is like increasing the difficulty of the sudoku puzzles to ensure that the same person doesn’t get to vote all the time. Because PoW blockchains adjust their hash rate, carrying out a 51% attack becomes very expensive. That is because they would need multiple powerful computers, and pay for the electricity. In the end, the costs would be higher than the reward. Individuals can also work together and combine their computing power to solve cryptographic puzzles. Once a block is mined they can then split the reward among each other evenly. This is known as a mining pool and is the same as allowing people to work together when solving sudoku puzzles. Aside from that, attacking a proof of work blockchain requires more than powerful computers and lots of energy. Attackers would also need to continuously produce faulty blocks to ensure that transactions are approved.
The risks?When someone produces conflicting information on a blockchain, a temporary fork is produced and people continue building on the longest chain. An entity that wants to manipulate the network won’t be able to maintain this chain. This is akin to a person being unable to solve enough sudoku puzzles in a row to get their way. The idea behind a PoW algorithm is to protect a network against attackers by making it as difficult as possible for them. Proof of work is also a proven system as no one has ever managed a successful attack on the Bitcoin network.
Proof of Stake AlgorithmPoS blockchains aim to achieve the same level of security that a PoW blockchain offers in an environmentally friendly way. PoS was introduced on the Bitcoin talk forum by an alternative consensus mechanism for Bitcoin. Instead of using computing power to solve cryptographic puzzles and process transactions, a crypto token is locked on the blockchain. This is known as staking, which earns individuals a right to process transactions. The stake time and the number of coins/tokens required before transactions can be processed may vary. The likelihood of being chosen to process transactions increases when a person has a higher stake. This would be like having a shared box instead of a sudoku puzzle. The person who puts in the most money gets to decide whether everyone goes to the beach or the theme park. The minimum amount of money required to participate is $10 and they should leave their money in the box for at least 2 rounds. It is already obvious why this system is not very secure. However, PoS consensus mechanisms employ some degree of randomness when deciding which computer gets to process a block and verify transactions. This is like giving loaded dice to each person in proportion to how much money they put into the jar. While some people that put more money into the jar are likely to roll high because of their dice, it’s not a given that they will win every time.
Pos BlockchainsPoS blockchains also punish computers that try to break the rules of the blockchain by destroying some of their coins. This is known as slashing. Think of it this way, if a person tries to cheat by getting some friends to put extra money into the box, you could just confiscate his funds and disqualify him from voting. Because staking is easier than solving cryptographic puzzles, PoS blockchains can process transactions faster than PoW blockchains. This means that PoS Blockchains also grow quicker than PoW blockchains. As an investor, it’s important to know the advantages and disadvantages of each consensus system. Anyone can mine for cryptocurrency in the early stages of a PoW blockchain and earn block rewards. However, as more people start mining on the network with bigger and faster computers, it becomes harder to mine crypto. This leads to miner centralization, where the miners control the blockchain’s hashing power. This makes it difficult to suggest improvements to the blockchain and leads to slower innovation on PoW networks. PoW networks can’t implement changes as quickly as PoS blockchains.
Risks InvolvedPeople can connect their computers to a PoS network and earn block rewards. This is because PoS blockchains don’t need the same computing power the PoW blockchains need. However, the majority of PoS networks have high barriers regarding minimum stake amounts. Most PoS blockchains also pre-mined coins/tokens in advance which they distributed to investors and insiders, giving them an unfair stake advantage. Compare this to most PoW blockchains which have a fair launch where a community collectively started mining the currency from scratch. The result is that most PoS cryptocurrencies are more centralized than PoW blockchains. PoS blockchains also have higher inflation on their cryptocurrency than most PoW blockchains. Inflation incentivizes staking, but also makes it a requirement. PoS crypto projects are also vulnerable to being aggressively taxed as a capital gain. Although PoS is convenient they are also vulnerable to being attacked by people who have enough financial resources to game the system. Some would argue that most PoS networks have built-in measures like slashing to prevent that from happening. However, most PoS crypto projects don’t have slashing enabled due to financial backers being uncomfortable with the idea of their stake being reduced to unexpected downtime.
SummaryThis is not a risk when mining on a PoW blockchain. Because PoS blockchains rely heavily on slashing to ensure the security of their network, a problem arises. There is no question that PoS is more efficient than PoW but there are some concerns about bad actors manipulating the system. PoS is also a very new idea and still has to prove itself. Instead of relying on a network of decentralized computers to store their blockchain history, PoS crypto projects store it on cloud servers. One can argue PoS blockchains are entirely centralized.
Which Algorithm Is Better?Both PoW and PoS algorithms have their shortcomings. However, it is expensive to buy the hardware needed to manipulate a PoW blockchain for an extended period. This is especially true when there are thousands of nodes keeping track of the transaction history. PoS crypto Projects are more vulnerable to centralization, especially when there is a premine. This makes it easier for bad actors to game the system, especially if slashing is disabled. PoS blockchains seem to be centralized from the get-go.
Research Your Crypto Project’s CoinNot all cryptocurrencies are created equal. Dogecoin and Bitcoin are good examples of this. Coins and blockchains all function according to different principles. Therefore, an investor needs to do their research. Here are some examples of different coin/token behaviors: