Cryptocurrency Explained: What is It and How Does It Work?

Many investors, computer scientists, and business leaders have touted cryptocurrencies as a major development in the way that societies exchange money for goods and services. But what are cryptocurrencies and how does one make use of them? You may have encountered terms like virtual currency, digital currency, or crypto token used interchangeably with the term cryptocurrency. The most popular cryptocurrency to emerge in the past decade is Bitcoin. Below, we’ll provide a straightforward explanation of what these terms mean and how cryptocurrencies work.

Overview for Fast Readers

  • Cryptocurrencies are digital assets typically aiming to be a medium of exchange.
  • Most cryptocurrencies utilize blockchain technology to maintain a ledger of transactions.
  • Cryptocurrencies are decentralized, anonymous, and transparent.
  • Without a central bank or other authority, cryptocurrencies rely on the individual members of their networks to verify transactions and “mine” for new tokens.
  • Investors can acquire crypto tokens through dedicated exchanges and can hold them in digital wallets.

Cryptocurrency Explained Simply

A cryptocurrency is a digital asset that aims to be a medium of exchange—an instrument used to facilitate transactions including the sale and purchase of goods and services. Cryptocurrencies are based on complex cryptographic rules called protocols which determine how new digital tokens are added into circulation and help to ensure the security of transactions and of token supplies. Many cryptocurrencies also depend on blockchain technology, a decentralized, peer-to-peer database network spread over thousands or even millions of individual computers, to record and verify transactions and facilitate the creation of new crypto tokens. Unlike fiat currency, cryptocurrencies typically are not issued by a central bank or governmental authority, which allows them a high degree of independence but also introduces potential concerns. Cryptos also differ from fiat currencies in that they are typically not redeemable for another commodity (gold, for instance) and they exist only in digital form, not in physical form. You can change your fiat to crypto on those exchanges.

Differences Between Cryptocurrencies and Fiat Currencies

How Do Cryptocurrencies Work?

Unlike traditional money, you cannot physically exchange a cryptocurrency for something you wish to buy. In fact, you can’t hold a cryptocurrency in your hand at all, as it exists only as a set of digital records in a ledger like a blockchain.

When a cryptocurrency transaction occurs, it involves the creation of a digital record noting that tokens have been transferred between two participants’ digital wallets. Crypto wallets function similarly to real-life wallets in that they provide access to your store of cryptocurrency tokens. They do this by maintaining two cryptographic passwords known as a public key and a private key. The public key is a bit like a business address in that it is available to the public and is used to link a transaction with a particular account. The private key is more like a password to an account; it is available only to the individual user and is used to access the crypto tokens. Together, the keys encrypt and decrypt information about a transaction so that it can be conducted securely. Before the record of the transaction can be added to the database, however, it must be verified.

Cryptos and Blockchain

Cryptocurrency transactions must be verified in order to protect against double spending, or the spending of the same tokens in more than one transaction. Theoretically, because cryptocurrency transactions are just digital records, if someone could input two records into the blockchain ledger at once that person could successfully spend the same tokens more than once. This would have disastrous consequences for the ledger and the crypto network overall.

In a traditional payment system, a central authority would oversee this issue. However, cryptocurrencies are designed to be distributed and to not rely on a central authority, so in this case the responsibility for protecting against double spending falls to the individual participants in the network. The way that this is achieved is through transparency, as a blockchain ledger is a public database of every single transaction that has occurred within a particular cryptocurrency system, and it is viewable to everyone.

When a cryptocurrency transaction record is created, each individual computer (or node) in the network must confirm the transaction, along with the entire record of previous transactions, before that record can be added to the ledger. Transaction records are grouped together in blocks and blocks are added to a chronological chain one at a time as they are verified.

How Are Cryptocurrencies Created?

Many cryptocurrencies are created by a process known as mining. Mining in this case does not refer to digging tokens out of the ground, but rather to the reward system in place to incentivize individual participants in the network to confirm transactions. In the case of Bitcoin and other similar coins, cryptocurrency miners dedicate computer processing power—sometimes a huge amount of it—to this confirmation process. In exchange, those miners are eligible to receive a reward in the form of newly “minted” tokens (or a portion thereof). This process has the double benefit of both encouraging network users to facilitate the verification process and controlling the introduction of new tokens into circulation.

How Cryptocurrencies are Mined Infographic

What Are Examples of Cryptocurrencies?

Although Bitcoin is the most popular cryptocurrency and by far the largest by market capitalization, there are thousands of other digital currencies that have launched in the past several years. Other major cryptocurrencies today include Ethereum, which introduced a new application of blockchain technology called smart contracts, Tether, a stable coin which aims to be pegged to the U.S. dollar, and Litecoin, which processes blocks at a rate four times as fast as Bitcoin.

Pros and Cons of Cryptocurrencies

While cryptocurrency advocates point to several compelling advantages of digital tokens, there are also some potential disadvantages to keep in mind before investing as well.

Advantages of Cryptocurrencies

  • Decentralization. As explained above, cryptocurrencies are not distributed by a central bank or authority. Some crypto users value this aspect of cryptocurrencies highly. Cryptocurrencies relying on smart contracts, such as Ethereum, are considered decentralized finances (DeFi) in that they do not rely on central financial intermediaries in any way.
  • Transparency. Records of all transactions are available in the blockchain ledger, ensuring greater transparency than traditional currencies.
  • Anonymity. Although transaction records are maintained, identifying information for users is not available. Thanks to cryptographic procedures, many cryptocurrencies are seen as highly anonymous means of transacting.
  • Security. The verification structure helps to ensure that cryptocurrencies are well protected against hackers and other malicious actors.
  • Speed and cost. In some cases, cryptocurrencies can allow transactions to be accomplished much faster and cheaper than would be possible using fiat currencies.
  • Ease of use. Being entirely digital, cryptocurrencies are more portable than traditional currencies. They do not face the same issues of denomination and division, as one could theoretically divide a cryptocurrency token into smaller denominations of any size.

Disadvantages of Cryptocurrencies

  • Volatility. Due to their decentralized nature and the fact that even the oldest cryptocurrencies are not nearly as well established as fiat currencies, digital tokens tend to have prices that are incredibly volatile. A reasonable comparison of some of this volatility at its most extreme might be to say your dollar bill could be worth $0.01 one day and $10 a week later, or vice versa.
  • Accessibility. Although it is actually relatively straightforward to acquire many of the most popular cryptocurrencies, lack of awareness of this process can lead to accessibility issues.
  • Not established. Cryptocurrencies as a group are not established around the world as mediums of exchange. This means that the goods and services you may be able to buy with your crypto tokens could be limited or—in extreme cases—nonexistent.
  • Security. Despite cryptographic security measures mentioned above, there do exist risks associated with holding cryptocurrencies, and there have been high-profile hacks and thefts throughout the years.
  • Illicit activity. Because of the anonymity they provide, cryptocurrencies have occasionally been used by bad actors to facilitate the purchase and sale of illicit goods and services, money laundering, and tax evasion.

What Can You Do With Cryptocurrencies?

Two of the most common ways of using cryptocurrencies are as investment tools and as a medium of exchange. Especially given the tremendous price swings of popular cryptocurrencies like Bitcoin, many people have purchased crypto tokens in the hopes that their prices will skyrocket so that they can sell them and make a profit. Others have bought digital tokens in order to use them to buy and sell a variety of things, including in everyday transactions. In this latter case, as adoption rates of cryptocurrencies have grown, so too has the range of goods and services you can buy with cryptos.

How Do You Get Cryptocurrencies?

The easiest way to get cryptocurrencies is to buy them on a cryptocurrency exchange. Taking DXone as an example, the process looks like this:

  1. Register for a free account using your email address.
  2. Fund your account using fiat currency from a preexisting source such as a bank account.
  3. Track cryptocurrency prices and information using the exchange’s platform and tools.
  4. When ready, initiate an order for the cryptocurrency of your choice.
  5. Allow time for the transaction to be completed and verified.
  6. As necessary depending upon the cryptocurrency you’ve chosen, set up a wallet (either hot or cold).
  7. Transfer the tokens from your DXone account to the wallet as needed.

Criticism About Cryptocurrencies

Some of the biggest criticisms of cryptocurrencies center around their decentralized nature. Because there is no central authority overseeing these tokens, and they are not backed by a commodity holding such as gold, they are considered a highly risky investment. You may invest in a new cryptocurrency only to see its value plummet or, in the worst-case scenario, the cryptocurrency may fold entirely. In many parts of the world, the legal status of cryptocurrencies is murky, with some governments not viewing them as currencies at all. This can have major tax implications for cryptocurrency investors. In the most extreme cases, cryptocurrencies and/or crypto exchanges may be completely illegal.

Because they are relatively autonomous, cryptocurrencies have developed a reputation, whether merited or not, for playing host to illegal activities and transactions. As indicated above, there are lingering security risks—possibly the most significant of which is not related to hacks or theft at all, but to user error. If an individual crypto investor loses the means of accessing his or her wallet, the tokens within are unavailable.

Perhaps the single greatest criticism of cryptocurrency has to do with its usefulness in the real world. Even Bitcoin has struggled to gain widespread acceptance. As time goes on, one can use cryptocurrencies to buy and sell more and more, but as of now even the most popular cryptocurrencies in the world are not as universally useful as fiat currencies.

What Does the Future of Cryptos Look Like?

It’s difficult to say exactly what the future holds for cryptocurrencies. Bitcoin saw a tremendous boom beginning in late 2017, leading some finance experts to call it a speculative bubble. With the surge in popularity came a flurry of new cryptocurrency tokens as well. As of now there are several thousand types of digital tokens available. It is possible that this number may continue to grow, particularly if cryptocurrencies as a group become more popular and practically useful over time. On the other hand, the future of cryptocurrency might see the majority of these types of digital tokens collapse, with just a few cryptos dominating the scene.

Summary

Cryptocurrencies are digital tokens which use cryptography for security and which aim to be mediums of exchange. They exist primarily as digital ledger records in a blockchain. Crypto networks are comprised of thousands or more individual nodes, with these nodes responsible for maintaining the blockchain and verifying and adding new transaction records to it over time. Individual crypto users can buy, sell, and trade tokens over exchanges and can hold them in special digital wallets. While cryptocurrencies are a relatively new phenomenon and carry inherent risks, they are immensely popular and offer numerous potential advantages over traditional currencies.

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