What is Cryptocurrency? | How Cryptocurrency Works Explained
The term cryptocurrency is used to refer to any digital asset designed to be used as a medium of exchange. — Of course, you already knew that. The big question isn’t, ‘what is a cryptocurrency?’ The big question is how does cryptocurrency work and how do digital assets have value?
What is Cryptocurrency? — A Complete Beginners Guide
Hundreds of different cryptocurrencies are currently on the market. Each works slightly differently and each serves a slightly different purpose. To understand how cryptocurrency works, we’ll, therefore, focus for now on just Bitcoin.
Cryptocurrency is Surprisingly Similar to Regular Cash
To understand what cryptocurrency is, imagine for a moment that you are a bank.
At their most basic, banks keep track of who owns money and where cash is deposited, by maintaining a simple digital transaction ledger. When you transfer cash from one account to another, your bank updates their transaction ledger accordingly.
In principle, cryptocurrency works just like a bank transaction ledger. The Bitcoin blockchain is itself a transaction ledger and real-time audit trail of 21 million individual Bitcoin. However, there are some key differences.
- Bitcoin and most other cryptocurrency transaction ledgers are decentralized. This means that copies of the Bitcoin transaction ledger exist on millions of computers around the world simultaneously.
- Unlike banks which can create and print money, Bitcoin has a fixed supply of 21 million Bitcoin.
- No individual or single entity can alter the Bitcoin transaction ledger. New transactions are only recorded on the Bitcoin blockchain when all people maintaining a copy agree that transactions are accurate.
How Does Cryptocurrency Work in Simple Terms?
Digital assets like Bitcoin which you might buy on an exchange, are made up of two cryptographic keys. One of these is a public address key. This is what you would give to someone in the same way you would give a PayPal address to receive payments.
The second cryptographic key is called a private key. This represents the amount of a cryptocurrency you own and this key should never be given to anyone.
Understanding Cryptocurrency Transactions
Whenever someone sends cryptocurrency like Bitcoin to a different wallet address (public key), the transaction is bundled with others into an encrypted block of code. This block is then passed onto the Bitcoin miners who maintain the Bitcoin blockchain.
Once miners receive transaction blocks, they use raw computational power to break the encryption of each block. Once this is done, all miners compare transaction details bundled in each block to verify that they all have the same information. If they do, transactions are added to the Bitcoin transaction ledger and the next block is processed.
What is Cryptocurrency Mining?
Cryptocurrency mining maintains cryptocurrency blockchains by adding new transaction information in blocks. (Hence the name blockchain.) In return, miners receive a share of transaction fees and newly minted cryptocurrency coins.
How Does Bitcoin Mining Work to Keep the Blockchain Secure?
Bitcoin mining keeps the Bitcoin blockchain secure, by ensuring that only correct information is ever added to the Bitcoin transaction ledger.
- If blocks of transactions received by miners don’t all contain the same transaction information, blocks are rejected.
- Theoretically, miners could organize and attempt to simultaneously submit inaccurate information to the Bitcoin transaction ledger. However, this would require 51% of all miners to do so. It would also result in Bitcoin losing value, meaning that there will never be a financial incentive to do so.
- New transactions are only processed when all miners confirm that they still hold an identical copy of the same Bitcoin transaction ledger.
What is Cryptocurrency Used For?
The decentralized, ultra-secure way cryptocurrency works, means that cryptocurrency has several advantages over cash as a payment method.
- Cryptocurrency transactions can not be reversed. This eliminates problems like chargeback fraud.
- Sending cryptocurrency anywhere in the world takes minutes. (By comparison, international money transfers can take days to settle.)
- Digital assets like Bitcoin have a fixed supply. This makes many cryptocurrencies deflationary. By comparison, regular cash is inflationary and loses value over time.
What can You Buy with Bitcoin and Other Cryptos?
Many people mistakenly believe that Bitcoin and other cryptocurrencies aren’t reliable for use in real-world payment contexts. Today, coin prices might be up, but tomorrow, prices might go down. Businesses would, therefore, stand to make a loss by accepting cryptocurrency, wouldn’t they?
Contrary to what you might think, it is possible to use cryptocurrency to buy (and sell) everything from fast food to real estate. This is thanks to the fact that cryptocurrency merchants exist who automatically convert coins like Bitcoin to fiat cash, as transactions process.
Just some major brands who already accept cryptocurrency payments include:
- Burger King
- Whole Foods
- Unilever
- Overstock
- Shopify
Why are There so Many Different forms of Cryptocurrency?
If you are new to the cryptocurrency market, it can be confusing to see so many different types of cryptocurrency changing hands. However, why this is the case is easy to explain.
Above, we’ve looked at how cryptocurrency works by looking at Bitcoin. The technology behind Bitcoin, though, is over ten years old already. Since Satoshi Nakamoto launched Bitcoin in 2009, developers have created alternative forms of cryptocurrency which suit a variety of use cases.
- Digital assets like Ethereum can be used to automate complex transactions like real estate sales.
- Cryptocurrencies like DASH and Monero can be used to send anonymous cryptocurrency transactions to help safeguard user privacy.
- Digital assets like Litecoin and XRP allow users to transact cryptocurrency much faster than coins like Bitcoin.
Is Cryptocurrency a Good Investment?
At present, many people treat coins like Bitcoin as speculative investments. Why this is the case is simple. If you had bought $100 of Bitcoin in 2009, you would be a millionaire already.
Because cryptocurrencies like Bitcoin are algorithmically designed to increase in value, there is a chance that investing today could prove very lucrative long-term. In every case, though, it should be kept in mind that markets could eventually crash. This being the case, do consider investing in cryptocurrency, but only if you are aware of the risks involved.