What is Cryptocurrency and how does it work?

Cryptocurrency is digital currency secured by cryptography, enabling secure transactions and decentralized control. It operates on blockchain technology, a distributed ledger maintained by a network of computers. Transactions are verified through cryptographic techniques, ensuring transparency, security, and autonomy from central authorities like banks or governments.

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What is Cryptocurrency?

Cryptocurrencies are digital assets secured by cryptography and primarily used for online transactions. They emerged alongside blockchain technology, which revolutionized digital cash systems.

By the late 1990s, hopes for a functional e-market dwindled following the failures of promising startups like DigiCash. However, the advent of blockchain technology transformed this dream into a feasible reality of a decentralized and trustworthy online market.

Opinions on cryptocurrencies vary widely, from being hailed as revolutionary to being criticized as market illusions.

Before forming your own opinion on digital coins, explore our detailed guide on cryptocurrencies. We cover their history, the motivations behind their creation, their appeal and sustainability, the proliferation of unique cryptocurrencies, practical applications, and their potential benefits for the global economy.

For those eager to delve into this realm, we recommend exploring our curated list of top crypto exchanges to begin your journey into the world of digital currencies.

An Overview of Cryptocurrencies

If you’re intrigued by cryptocurrencies, you might be curious about what makes them so remarkable.

Their revolutionary nature lies in their application of core blockchain principles: decentralization, privacy, trust, and immutability.

The Evolution of Blockchains

Before diving into the specifics, it’s important to understand the foundational concept behind blockchain technology. Invented in 2008 by an individual known as Satoshi Nakamoto, whose true identity remains anonymous, blockchain is a digital ledger designed to store information on a decentralized peer-to-peer network. “It operates based on cryptographic verification instead of relying on trust.

At the time of its inception, trust-based payment systems were predominant. The traditional financial system facilitated transactions like sending money to friends and family, trading stocks, and securing loans. However, this system came with significant drawbacks, both in terms of cost and privacy. High transaction fees, lengthy international transfer times, and limited accessibility were common issues.

The 2008 global financial crisis served as a catalyst, eroding public trust in financial institutions. Government bailouts funded by taxpayer money further fueled dissatisfaction. These events spurred cryptographers, including Satoshi Nakamoto, to explore alternative payment systems like blockchain.

What Lies Beyond Trust? Exploring Further

In 2009, on the P2P Foundation website, a discussion titled ‘Bitcoin: A Peer-to-Peer Electronic Cash System,’ initiated by Satoshi Nakamoto, began with the following statement:

The core problem with traditional currency lies in the substantial trust it requires to operate. Central banks must be trusted to maintain the value of the currency, but throughout history, fiat currencies have frequently experienced breaches of this trust. Banks require trust to safeguard and electronically transfer our money, but they frequently lend it out in cycles of credit expansions with minimal reserves. We trust them with our privacy and to prevent identity theft from draining our accounts. Moreover, their substantial operational costs render micropayments impractical.

Cryptocurrencies have overcome these limitations and inconveniences by operating independently of third parties. They are resistant to government interference and the trust-based exchange models that compromise privacy. Additionally, they are highly cost-effective, especially for micropayments, as there are no intermediaries imposing high processing fees.

What Defines a 'Good' Currency?

For cryptocurrencies to achieve widespread acceptance and usage, they must meet specific criteria of a currency. As you know, a currency serves as a unit of monetary value for transactions and investments.

Currencies, by themselves, lack intrinsic value based on cash flows, but their worth can be determined relative to other currencies. The purchasing power of a currency fluctuates due to economic factors like inflation, deflation, and governmental policies such as interest rates and quantitative easing.

To assess the viability of a currency, consider how well it fulfills the following objectives:

Standard for Measuring Value

The primary role of a currency is to act as a unit of account, serving as a standard for measuring the value of goods, services, assets, labor, income, expenses, and liabilities. This enables us to assess and compare everything we produce or consume in monetary terms across different currencies like the US dollar or the Euro. For a currency to effectively fulfill its role as a unit of account, it must be fungible, divisible, and quantifiable.

Medium of Exchange

The second function of a currency is to facilitate the exchange of goods and services, acting as a widely recognized and accepted medium of transaction and debt settlement. This requires both buyers and sellers to recognize and trust the value of the currency, along with affordable transaction costs. A currency is more effective if it is easily accessible and portable.

Preservation of Value.

A currency qualifies as a store of value if it maintains its purchasing power over time. This ensures that holding or investing in the currency will yield a profit in the future, allowing you to save, retrieve, and exchange it without incurring losses.

What Defines Cryptocurrency as a Currency?

Before addressing the question, let’s classify the different types of money to better understand how cryptocurrencies differ from traditional fiat currencies. This classification, outlined in a 2018 monetary dialogue requested by the European Parliament Committee on Economic and Monetary Affairs and based on criteria discussed by Bech and Garratt (2017), focuses on three key aspects: a) issuer (government or private), b) form (physical or digital), and c) settlement of transactions (centralized or decentralized).

Fiat currencies benefit from government backing, physical form, and regulation through intermediaries. However, they can also face challenges, such as becoming nearly worthless during episodes of hyperinflation, although such occurrences are rare. How do cryptocurrencies compare? They are privately issued, digital, and decentralized. But how effectively do they fulfill the fundamental functions of a currency?

Cryptocurrencies serve well as units of account due to their fungibility, divisibility, and countability.

In economic terms, fungibility means that individual units of a currency have identical value and can be exchanged at the same rate. For instance, one Bitcoin is equivalent in value to another Bitcoin. Additionally, cryptocurrencies are highly divisible compared to fiat currencies. One Satoshi represents a minute fraction of a Bitcoin—specifically, one hundredth of a millionth. For example, if one Bitcoin is valued at $100,000, one Satoshi would be valued at $0.0010.

Initially, digital coins faced challenges as mediums of exchange and stores of value because many merchants were hesitant to accept them as payment methods. Those who did, such as Overstock in 2014, often restricted their acceptance to specific items and relied on third-party services to convert cryptocurrencies into fiat currencies. Fortunately, attitudes have begun to shift over the past few years.

The Evolution of Cryptocurrencies

Satoshi Nakamoto is often credited with creating blockchain, but his idea was inspired by earlier projects and innovations. A decade before his white paper describing blockchain’s function, renowned cryptographer Wei Dai proposed his own concept of digital money called B-Money.

Similar to Satoshi’s vision, Dai aimed to enable anonymous digital payments using pseudonyms. He outlined two protocols for verifying online transactions, although he did not fully resolve the double-spend problem. Satoshi was the first to overcome this challenge with a decentralized cash system.

In his seminal White Paper, Satoshi introduced the term ‘Bitcoin’ to describe the entire peer-to-peer electronic cash payment system he had developed over a year. The term ‘blockchain’ emerged later, representing the core technology where data (such as transactions) is stored in “blocks” that are sequentially “chained” together using a hash function.

Bitcoin

On January 3rd, 2009, Satoshi Nakamoto mined the inaugural Bitcoin block (Block 0) on the blockchain network, marking the beginning of his electronic cash system. This block, known as the Genesis Block, served as the prototype for all subsequent blocks.
A few months later, on October 12th, 2009, Satoshi Nakamoto conducted the world’s first bitcoin transaction on the blockchain. He sent 10 BTC to his friend and supporter Hal Finney, a prominent programmer who was among the earliest adopters of the software upon its release, along with Wei Dai, the creator of B-Money mentioned earlier.

This milestone also marked the first instance of Bitcoin acquiring value. Finnish developer Martti Malmi sold 5,050 BTC to NewLibertyStandard for $5.02 via PayPal on the same day. This valuation meant that 1 BTC was worth $0.0009 at that time.

Despite its volatility, Bitcoin has maintained its position as the leading cryptocurrency for over a decade. It has made significant strides towards acceptance as a potential form of payment by billion-dollar companies and has garnered interest from numerous financial institutions worldwide.

Process of Cryptocurrency Mining

Similar to how gold is mined from the ground, Bitcoin must also be digitally mined. This mining process occurs within the blockchain’s peer-to-peer network, where transactions are broadcasted to users’ computers. Miners validate these transactions and earn coins by solving complex mathematical problems using hash functions.

Once a miner finds a solution, it must be verified and accepted by other miners, after which the transaction is added to the chain of data blocks. Due to the intensive computational requirements, miners receive cryptocurrencies as a reward for their role in maintaining the blockchain network. On average, Bitcoin adds a new block to its blockchain every 10 minutes.

However, there’s a set limit of 21 million bitcoins that can be mined in total. Once this limit is reached, global bitcoin mining will stop. Experts estimate that it will take more than a century to mine all 21 million bitcoins, so there’s no immediate concern about reaching this limit.

Cryptocurrency Characteristics

So far, we’ve explored what cryptocurrencies are, how they originated, and the reasons behind their existence. However, these discussions may have sparked more questions than answers. Yes, digital coins are mined on the blockchain, and they offer benefits such as decentralization, which translates to enhanced privacy, lower transaction costs, and faster transaction speeds. But how does all of this function in practice?

Decentralization and Its Role in Security

If blockchain technology had started as a project owned by a specific company acting as its central authority, the entire concept and vision behind it would have been doomed from the beginning. Instead, blockchain operates on a network where anyone can participate, contribute work, and be rewarded, with the freedom to join or leave at will. Importantly, no solitary entity can dominate the network.

For instance, if you want to send bitcoins to your friends from your digital wallet, they simply need their own wallet, similar to sending a regular email. To verify your transaction and ensure the coins are sent to your friend’s wallet, consensus among all network participants is required to confirm the transaction’s validity. The more participants who validate it, the more secure the transfer becomes. But how does this work?

Participants use their computers to compete in solving algorithms necessary for processing transactions. This process involves substantial computing power, advanced cryptography, and encoding. When someone successfully solves the algorithm, they distribute the solution to all other computers in the network. These computers can then verify and confirm the transaction based on the provided solution. The validated transaction is recorded and stored on every participating computer.

This consensus method is known as proof-of-work, where miners collectively ensure the security of the decentralized blockchain network by preventing double-spending and counterfeit coin creation. Furthermore, any attempt to alter a recorded transaction will be detected because the altered records won’t match the copies stored on other computers in the network, resulting in rejection. The sheer scale of computing power required to control the entire network makes it practically impossible to manipulate.

Privacy

One of the key benefits of cryptocurrency transactions is their lack of association with real identities. However, if you believed cryptocurrencies are entirely anonymous by design, it’s important to note they are actually pseudonymous. Each transaction is linked only to an electronic address, serving as your digital pseudonym. As long as your pseudonym remains unknown, your cryptocurrency buying and selling activities remain private. Maintaining control over your digital identity ensures your privacy is preserved.

Transparency

The blockchain records the complete history of all transactions ever conducted on the network. This dual nature makes cryptocurrencies both private and public, or more accurately, transparent. If a company publicly shares its electronic address, anyone can go online and observe its holdings of BTC or other cryptocurrencies, as well as its transaction frequency. However, if the company rigorously protects its address internally, tracking it requires highly advanced software.

This is why companies frequently use unique electronic addresses for each new transaction to maintain full privacy.

Speed

Another significant benefit of cryptocurrencies is the speed at which transactions are completed. Unlike traditional banking transfers and credit card transactions, which can take several days, especially for international transfers involving multiple banks, cryptocurrency transfers happen instantaneously. This quick transfer capability applies regardless of your location and the recipient’s, as long as both parties have access to the necessary software.

This advantage makes cryptocurrencies particularly suited for today’s fast-paced lifestyle.

Portability

Fiat currencies require physical presence and must be carried in your pocket or presented physically for purchases. While many people now use debit or credit cards, this still involves reliance on a third-party, typically a bank. In contrast, cryptocurrencies can be transferred between accounts or used for payments directly from any device, including smartphones, regardless of the transaction amount.

The Advantages of Cryptocurrency Usage

Critics of cryptocurrencies question whether digital coins offer any additional functionality beyond what traditional currencies already provide. Aside from enhanced privacy, which is sometimes associated with illicit activities, skeptics are unsure about what other value digital assets bring to consumers worldwide.

The Benefits of Push-Based Payments

Traditional payment systems like credit cards and the ACH network operate on a pull-based model. This means that while customers perceive they are initiating transactions, they are actually instructing their financial institution (e.g., their bank) to authorize the merchant to “pull” funds from their account.

However, this model has drawbacks. It requires placing trust not only in the merchant but also in third parties such as their IT provider and bank, as well as your own card issuer.

In contrast, cryptocurrency payments are push-based. They invert the transaction process by empowering customers to take control. Customers obtain the merchant’s account details and initiate the transaction, instructing their financial institution to “push” funds from their account. This approach alleviates concerns about merchants potentially misusing account information or making unauthorized charges.

The Benefits of Micropayments

Before cryptocurrencies, electronic payments always incurred additional transaction costs levied by third-party financial institutions for their services. Consequently, if you wanted to make a very small payment or money transfer, known as a micropayment, the transaction fee often exceeded the payment itself.

Using cryptocurrencies makes micropayments feasible and enables a range of new business models. For instance, consider “The Geek’s Guide to Britain,” a travel guide originally sold in paperback for $25 by The Register. On a cryptocurrency platform, you can purchase the digital version of the guide for around $3, or even buy just one chapter for $0.12—an amount that would typically be impractical with credit cards or on the ACH network.

Where to Purchase Cryptocurrencies?

Cryptocurrency exchanges serve as online platforms where individuals can buy, sell, or trade cryptocurrencies, acting as intermediaries between buyers and sellers. These exchanges offer investors a convenient means to engage with the global cryptocurrency market.

When selecting a cryptocurrency exchange, ensuring trustworthiness and security is crucial. Leading exchanges provide a diverse array of features to facilitate trading activities. Moreover, exchanges typically levy fees for transactions, and these fee structures can vary significantly. It is important for investors to compare these fees and select an exchange that best aligns with their trading preferences and financial goals.

Additionally, the liquidity provided by cryptocurrency exchanges is a vital factor to consider. Exchanges with higher liquidity tend to offer more competitive prices and expedited transaction processing times, enhancing the efficiency and effectiveness of trading activities.

What is Cryptocurrency and how does it work?