Since the release of Bitcoin in 2009, there have been over 6,000 altcoins introduced to the cryptocurrency markets. While the definition of the term “altcoin” is debated within the crypto world, it is generally accepted as any form of cryptocurrency other than the seminal Bitcoin. The emergence of so many new cryptos is a sure sign of their financial potential, right?
How do cryptocurrency companies make money? Cryptocurrency companies can make money in a number of different ways, including, but not limited to, the following:
- Development fees
- Community donations
- Initial coin offering (ICO)
As the competition in the cryptocurrency industry has increased, it is becoming increasingly difficult for altcoin developers to make money in their ventures. Therefore, those making the journey into crypto land must carefully plan how they will raise their money and get their currency taken seriously as a viable altcoin option. We’ve found 5 ways they can do this.
Five Ways Cryptocurrencies Make Money
Even though you may not have taken the plunge and invested in cryptocurrency yet, it is extremely unlikely that you haven’t at least heard the term “cryptocurrency” in 2020. However, while many people have heard of cryptocurrency, many people (even some of those invested in it) remain somewhat hazy on what exactly what cryptocurrency is.
A cryptocurrency is “a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double spend.” – Investopedia.com
While most forms of traditional currency are centralized, meaning that governments or large banks, such as the U.S. Federal Reserve, control the production of currency and protect against theft and fraud, cryptocurrency is distributed and controlled on decentralized networks of disparate users and blockchain technology, protecting cryptocurrencies from government manipulation.
Without the backing of a federal reserve system, how is it possible for cryptocurrency companies to seemingly make money out of thin air? Let’s take a look at the different ways that cryptocurrency companies can create value for their digital coins.
Option #1: Mining
Mining is one of the fundamental ways in which cryptocurrencies gain value, and to understand how cryptocurrency works; it is important to fully understand this concept. And while we’re not talking about the kind of mining with a hard hat, pick, and the side of a mountain, the two are actually not that different at their cores.
Mining, or cryptomining, is the process in which digital transactions are verified, through a proof-of-work timestamping algorithm, and added to the blockchain ledger.
What Is a Blockchain Ledger?
The blockchain is the record of all digital information surrounding cryptocurrency transactions that is stored in a public database. There are three specific characteristics of the blockchain:
- A block stores specific information about each unique cryptocurrency transaction. This may include the date, time, and amount of the exchange that took place
- A block also stores information about who was involved in a transaction. In the exchange of cryptocurrency, this would include both the sender and receiver address. This helps prevent double sending currency. On the blockchain, a type of digital signature is used, sort of like a transaction number, to authorize transactions and protect the identity of currency holders
- Each block has a unique code to distinguish it from other blocks, called a hash. Hashes are distinguished between blocks using cryptographic codes that are created using a special set of algorithms. Even if you exchanged an exact amount of cryptocurrency multiple times, each transaction would come with its own code to identify it uniquely.
A single block can contain up to one megabyte of data, so in order for the blockchain to be able to service billions of units of currency exchange, a significant amount of computing capacity and software is required. This is where miners come in.
What Do Cryptominers Do?
Whereas traditional miners use their tools to move dirt and rock to uncover precious metals, cryptominers agree to provide their technology in exchange for a share of the altcoin they are “mining” for. Some of the technology cryptominers will need includes:
- Specific computer hardware with a specialized graphical processing unit (GPU) chip
- An application-specific integrated circuit (ASIC)
- Sufficient cooling means for the hardware
- An Internet connection that is at high speed and never turns off
- Blockchain-specific cryptocurrency protocol mining software
- Membership in an online cryptocurrency exchange if they want to sell
Once established with the appropriate technology, the miner will have several functions in maintaining the blockchain.
- They will keep track of the transactions that occur on their block or blocks
- They will verify the authenticity of all transactions. Miners will check the transaction ID (remember, holders of cryptocurrency use personalized codes and not their government names), date, and amount of transactions
- They will store the transaction in the block. Each digital transaction will be for a given amount and must be signed digitally with the currency holders’ digital code. Once it gets the “green light” as legitimate from the miner in charge of the transaction, it is stored among the thousands of other entries on a given block
- They will assign a hash to their block. Once all transactions on a block have been verified, the miner will assign it a hash to distinguish it from the thousands of other blocks on the blockchain, securing the accuracy and authenticity of the crypto holder’s currency
As you can see, there is quite a lot required of a cryptominer. Some reports claim that for Bitcoin alone, 2.55 gigawatts (GW) of electricity per year are required to run the servers that operate the Bitcoin software. To put that in perspective, 2.55 GW is approximately the same yearly electricity consumption of the entire country of Ireland!
Those same people often ignore the current energy usage of the global banking and finance system, which is not insubstantial. Should bitcoin ever replace fiat, the energy usage drop from traditional banks would offset bitcoin’s energy requirements. And developers are working to reduce the energy requirements.
As Bitcoin is just one of the thousands of cryptocurrencies currently on the market, the need for computing hardware, software, and electricity is evident. Obtaining all of these resources would be cost-prohibitive for any one person or business to do alone, so cryptocurrency companies are reliant on a large network of outsiders to provide their infrastructure. This is where mining comes in.
What Is the Role of Cryptomining?
As coins are released, a host of miners will rush in to try and crack the cryptographically secure code that protects the coin. Once the code is cracked, the miner is able to authenticate the transaction, and he or she can then store the transaction on the block. In exchange for this service, the miner is rewarded with a percentage of the currency for him or herself.
As you can see, this mining process is not all that different, fundamentally, from how precious metal is mined from the side of a mountain.
During a gold rush, miners rush in to try and beat their competition in extracting gold. When a miner claims to uncover gold, there are many skeptical competitors trying to deny the authenticity of the gold that their opponent has uncovered. Because there is a finite amount of gold, the miner who unearths real gold becomes “rich” when his or her gold is verified.
The same concept applies to cryptomining. Hence, the term.
While many people wonder how decentralized currency verified by random entities can ever be secure, it is actually more secure than centralized currency. With a multitude of cryptominers working to crack the code of a coin, the checks and balances competitors place on each other ensure that only 100% legitimate transactions get the green light to be stored in the block.
As each specific cryptocurrency is released in limited, finite quantities and is sought out by a sea of cryptominers aiming to crack the code, the value of cryptocurrency rises every time it is exchanged.
How Cryptocurrency Gains Value As It Is Mined
Think about the following example to visualize how cryptocurrency gains value as it is mined. The quantities and values are hypothetical for ease of illustration:
- A cryptocurrency company releases one altcoin, protected by a cryptographically secure code. For simplicity, we will say that the altcoin is worth $1
- A host of cryptominers, using their own hardware, software, and electricity, rush in to try and crack the code
- Once the code is successfully cracked and verified, the transaction is stored on the block. The “winning” miner gets a share of the sale
- In 100 days, the new owner of the altcoin gets an offer to sell his or her coin for $2
- A new rush of cryptominers rush in to try and verify the transaction, as a successful verification will lead to an even more lucrative share than the original sale
While this example is overly simplistic, it successfully demonstrates how cryptocurrencies gain value. For example, in February 2009, a single Bitcoin was worth about $.20 USD. After eleven years of mining, a single Bitcoin trades for about $10,000 USD in February 2020!
In this respect, cryptocurrency is no different from any other scarce and valuable commodity, such as gold or real estate. As time passes and transactions take place, natural price inflation occurs. However, given that all cryptocurrency transactions are public information that have been verified on the blockchain ledger, it gains value much quicker than other assets.
Option #2: Pre-Mining
While mining is the most fundamental and organic manner in which cryptocurrency gains value, it can also take a while for a cryptocurrency to gain traction–especially now that there is so much competition in crypto land.
Think about it: in the early days of cryptocurrency, when it was just Bitcoin and a few others, there were more miners who wanted a piece of the crypto pie than there was cryptocurrency to fill the demand.
Therefore, early cryptocurrency developers could simply “mint” new coins, release them to the mining pool, and have a swarm of miners rush in to crack the code, store the transaction on the blockchain, and secure their share. This led to rapid gains in valuation.
Now that the legitimacy of cryptocurrency has been proven, there are a host of other companies who want to make digital money out of thin air. However, because miners have so much more to gain in mining for bitcoin, litecoin, and the other more established cryptos in circulation, newer altcoins that trade for cents can sometimes have difficulty attracting miners.
To combat this problem, many newer cryptocurrency companies are using a technique known as pre-mining to get their coins into circulation.
Pre-mining? Isn’t that the same as mining, just done earlier?
Well, not really. Let’s dig in a little deeper to sort this out.
So, What Is Pre-Mining?
In much the same way that gold doesn’t really exist until it is mined from the ground, crypto coins don’t really exist until someone cryptographically mines them successfully. A company can say they are releasing 1,000,000 coins into the mining pool, but if no one jumps in to mine them, then there is still nothing.
If a company is having difficulty or anticipates having difficulty getting its coins into circulation, it may choose to pre-mine its coins.
Pre-mining is a practice in which a certain portion of the cryptocurrency is awarded to the developers and early investors of an altcoin. Essentially, in exchange for providing the capital and resources necessary in launching a cryptocurrency and providing momentum, these people or entities will receive a set of cryptographically mined coins. (Bitpanda)
What Happens During the Pre-Mining Process
Think about the following steps to better understand what happens during the pre-mining process:
- An entrepreneur gets an idea for a cryptocurrency but does not have the financial capacity or technological knowhow to get the idea off the ground.
- He or she reaches out to investors in an effort to acquire capital, with a commensurate share of the soon-to-be-launched altcoin as recompense. There is no ownership component.
- The entrepreneur then uses this newly raised capital to pay developers to write the code and make the cryptocurrency functional. These founding team members also have the option of receiving pre-mined altcoins in exchange for their efforts.
- Now that the entrepreneur’s idea is up and running, there will already be a quantifiable number of these cryptographically pre-mined coins in circulation. The company will then have the option of limiting circulation to these pre-mined coins only or releasing additional coins to be mined traditionally.
Advantages of Using Pre-Mining
There are several advantages to using pre-mining as a means of raising money for a cryptocurrency company:
- It attracts and rewards founding members to do their part in helping the currency gain momentum. Without them, the currency may be slow to take hold, with some never catching on, given the current state of competition
- It allows for a broader pool of early adopters, as investors can front capital in exchange for cryptographically pre-mined coins. Traditionally-mined coins may be limited to only those who have sufficient energy and computing capacity to mine for cryptocurrency
- Once the coin is officially launched, pre-mined coins provide proof to outside investors that the currency is actually functional. As the code has already been cracked and stored in the blockchain, investors can rest assured that these coins are “mineable” for future transactions
- The quantity of coins on the market is predictable, right from the very start. As the minting of new altcoins is a byproduct of mining, there is no way to know for certain, with traditionally-mined coins, how many coins will be in circulation from the get-go
Although the pre-mining of coins can be an attractive way for cryptocurrency companies to make money in the early going, it is often criticized within the crypto community. Many contend that it bastardizes the process that makes the trading of cryptocurrency superior to other forms of currency.
Some of the Issues With Pre-Mining
- Pre-mining almost always adds an element of centralization to a cryptocurrency, with groups holding and releasing currency to the public, much like the Federal Reserve. The revolutionary principle of cryptocurrency is established on the idea of decentralized, disparate networks authenticating and securing digital transactions.
- What happens when the pre-mined coins run out? Yes, there are some companies that have both pre-mined and mined coins, and there are some pre-mined coins that continue trading at high values. However, there is also the potential for a dead-end, and without new coins getting minted organically, it can be tough to attract new miners
- This leads to the potential for “pump-and-dump.” Those early adopters and developers who are rewarded with shares of the cryptocurrency may be tempted to use the momentum of the freshly minted coins to sell at an artificially high price, leaving buyers stuck with a bunch of coins that haven’t actually been mined and hold no real value
Through all of the pros and cons of pre-mining, there are a number of reputable cryptocurrency companies who use this technique, such as Ripple, Cardano, and Stellar, with the number continuing to grow as new currencies are introduced.
Option #3: Development Fees
While mining and pre-mining are by far the most common ways in which cryptocurrency companies make money, there are a handful of other ways, although not as prevalent, in which funds can be raised.
While we know that the miners of cryptocurrency get a percentage of each transaction as part of their reward for providing the network with their resources and participation in the mining pool, some cryptocurrencies, such as Zcash, also contribute a certain percentage of coins on each mined block back to the development company.
This can provide for a very predictable income flow, on top of any increases in valuation that accompany the appreciation of its coins, back to the company.
Drawbacks of Development Fees
- When developers receive a share of their own cryptocurrency as part of a fee, they can’t really put it to work until it is converted into cash. However, if they attempt to sell their crypto in exchange for cash before the coins have gained sufficient value, they actually run the risk of driving the value of the coins down.
- An issue similar to that of dividends stocks is this: while having a predictable flow of income is nice, it doesn’t do you much good in low volumes. If the altitude of a company’s blockchain is low, meaning that it has few transactions, then the developers will probably receive insufficient funds for product development and exchange listings.
- Investors looking to exchange fiat currency (U.S. dollars, Euros, etc.) for cryptocurrency may be deterred by having some of their crypto going toward dev fees, as a percentage is already being taken by miners, exchange listing fees, and conversion fees.
In fact, despite the absurd growth experienced by many cryptocurrencies over the past decade, many economists feel like steep fees are a major barrier to entry for those who have yet to venture into crypto land.
Option #4: Community Donations
From presidential elections to heart disease research, there are always some people out there who are willing to give their money to causes they support. The cryptocurrency market is no different.
Community donations toward a cryptocurrency company differ from investors receiving coins during the pre-mining process in that these donations are made for purely charitable purposes, with no altcoins expected in return.
Primarily, individuals or entities may choose to make a community donation to a cryptocurrency company because they support the idea of decentralized currency and want to fight big banks.
How Does Community Donation Work In Cryptocurrency?
Community donations can be made in a couple of ways:
- The charitable entity can provide cash “directly to the pocket” of those who are designing a specific currency
- Charitable mining pools are established in which the fees usually acquired by the miners are directed back to the company
While community donations don’t raise a very large percentage of the capital acquired by crypto companies, nor do many established companies rely on this method of funding, one notable exception is BitcoinZ (not to be confused with the seminal Bitcoin), which is totally community-driven and does not have a traditional corporate structure, with the aim of total decentralization.
The advantage of cultivating community donations is that they are totally independent. You do not need to have a certain amount of coins mined and stored on the block, nor do your coins need to be trading at a certain fiat price to acquire this type of funding. It’s strictly a matter of getting donors to give to your cause.
The downside is the numbers game. While there are some people with generous hearts who enjoy giving to causes in which they believe, the vast majority of people want something in return for their money–in this case, their share of cryptocurrency. As such, it is difficult to pay for necessary product development and exchange listing fees solely through donations.
Option #5: Initial Coin Offering (ICO)
This is closely related to pre-mining and can often be lumped under the same heading, as those who buy crypto as part of an ICO are among the early adopters who are rewarded with pre-mined coins.
The difference lies for the developers of the company, who, instead of getting pre-mined cryptocurrency that has yet to establish value, are getting ready-to-use cash that can be put to work right away in making improvements to the crypto company.
How Does Initial Coin Offering (ICO) Work?
The concept behind an ICO is very simple: A company can offer a quantity of cryptographically mined coins to the public at a given price, with the buyers claiming their stake then on the hook for any gains or losses the coins may experience relative to the purchase price.
In this respect, it is very similar to how traditional corporations raise funds through IPOs (initial public offerings), in which private investors provide the company with cash equity in exchange for shares of the company, claiming a commensurate percentage of the gains or losses the company may experience. Except that traditional IPO’s are used by companies that already have proven products or services generating revenue upon which to base the value of the company and its IPO price.
An advantage of an ICO is that, in addition to the cash raised through an ICO, the company will gain a large and active community of users. Exchanging fiat currency for crypto makes it possible for people to be involved in the crypto game without having all of the technological resources necessary to be a cryptominer.
The downside to ICOs is that the competition has saturated many crypto exchanges. The battle for the next investor is fierce, with some companies ending up having to spend more money marketing their currency to investors than the actual investment dollars received. This can make reaching the minimum required funding for operations impossible.
And it took investors 2-3 years to figure out, but 90% of ICO’s never follow through with product development. Many are outright scams from the beginning, with the team making off with the raised capital never to be heard from again. Because of this, I don’t expect the ICO model to survive much longer.
Five Ways Cryptocurrencies Make Money
While most people have heard of cryptocurrency and heard of people getting rich on cryptocurrency, few understand what crypto companies do to seemingly make money out of thin air. While it’s not exactly that magical, many of us still find the idea of it quite nebulous. Hopefully, learning about the five ways above makes the business of cryptocurrency a little less cryptic. But even with some knowledge, keep in mind cryptocurrencies are extremely high risk investments at best and full on scams at worst.
No doubt many good blockchain services will eventually develop using tokens and currencies as network incentives and sold as fees for use. I think the prototype for the model in 2020 will be logistics and tracking industries. Search the site for our content on several examples. They are a legitimate use of blockchain tokens that truly show what cryptocurrency and blockchain is capable of. We just need more of those and many fewer useless coins going forward.
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