What is Cryptocurrency? Understanding Cryptocurrencies and How They Work
Cryptocurrencies are digital money. You can use a cryptocurrency like Bitcoin or Ethereum to buy products and services. You can hold on to them for a rainy day. You can exchange them for other cryptocurrencies, just as you might exchange U.S. Dollars for Euros. But, despite all the similarities, cryptocurrencies don’t work the same way as traditional currencies like sterling and yen.
You don’t have to know how cryptocurrencies work to use or trade them. Most of us don’t know how our country’s monetary system works, but we know how to use money. Nevertheless, it’s good to comprehend some of what goes on under the hood, not least to dispel misconceptions about what cryptocurrencies are and how they work.
What Are Fiat Currencies?
To understand how cryptocurrencies work and why they were invented, it’s helpful to compare them to traditional non-digital currencies. Before the middle of the 20th century, many of the most familiar currencies were commodity currencies. Their value was linked to the value of a commodity, often gold—you could, in theory, take a dollar and exchange it for a dollar’s worth of gold. The reality is more complex, especially where the U.S. Dollar is concerned. Under the Bretton Woods agreement, the dollar was a fractional reserve currency to which many other currencies were pegged, but the basic principle holds. One dollar could be exchanged for one dollar worth of gold.
Modern fiat currencies don’t work like that. Instead of deriving value from the price of a commodity, the U.S. Dollar has value because the U.S. government says so. It issues the currency and backs its value, which is derived from the stability of the monetary system and supply and demand in the market. People who own dollars can be confident they will be accepted in exchange for goods and services. Fiat is Latin for “let it be done,” and fiat currencies have value because the government says, “let this be our currency.”
There are benefits to operating a fiat currency. They are less expensive to manage than commodity currencies. The government can create fiat money whenever it needs to and control how much money is printed. Fiat currencies are particularly useful during economic crises because central banks can control the amount of money in the economy, hopefully avoiding boom and bust cycles.
But fiat currencies have one big shortcoming: they depend entirely on governments and central banks. Fiat currencies are centralized. In fact, centralization is a necessary consequence of the way traditional currencies work. Some entity has to be in charge of making the money and managing the monetary system. Until relatively recently, the technology to create a non-centralized currency did not exist.
That changed with the development of the blockchain decentralized ledger and cryptocurrencies, which were created to provide a new type of currency that doesn’t depend on governments, central banks, and the banking system.
What is a Cryptocurrency?
A cryptocurrency is digital money that exists on a blockchain, a shared ledger distributed across lots of computers joined in a network so they can communicate with each other. Unlike fiat currencies, cryptocurrencies are distributed and decentralized. They do not depend on a trusted authority or intermediary, allowing cryptocurrency users to transact directly with each other.
Decentralized cryptocurrencies have many differences from fiat currencies.
- Cryptocurrencies don’t require intermediaries like banks.
- Transactions are typically faster compared to traditional financial transactions.
- Transactions are pseudonymous. The user’s personal information is not stored on the blockchain and is not required to spend coins.
- Cryptocurrencies are global, reducing the difficulty and expense of transferring money around the world.
- Buying and selling cryptocurrencies via a cryptocurrency exchange is fast and easy.
- There are thousands of cryptocurrencies, many of which can be exchanged for other cryptocurrencies or for fiat currency.
How Does Cryptocurrency Get Its Value?
As we’ve said, fiat currencies have value because governments and banks back them. That’s not true of cryptocurrencies. So why do Bitcoin and Ethereum have any value at all? To answer this question, we can first answer a more general one: why is any asset valuable?
- Scarcity: The asset is available in limited supply.
- Desirability: There is demand for the asset.
- Utility: The asset is useful.
- Market liquidity: It is possible to buy and sell the asset relatively freely.
Let’s see if cryptocurrencies like Bitcoin and Ethereum have these qualities.
Cryptocurrencies are often scarce by design. There is a limited supply and new coins cannot be created easily. Most cryptocurrencies include a mechanism for increasing the number of coins over time, whether that’s mining, staking, or simply minting new coins. But the number of coins available at any one time is often limited.
There is market demand for cryptocurrencies. The source of demand differs. For some currencies, their usefulness as a decentralized currency drives their value. People want cryptocurrencies to buy goods and services or to conduct global money transfers. Other cryptocurrencies are useful as a store of value or for trading.
Cryptocurrency exchanges create market liquidity, allowing traders to buy and sell easily. Exchanges aren’t necessary for cryptocurrency trading, but matching buyers with sellers significantly reduces trading friction and cost.
In short, the value of a cryptocurrency is determined by supply and demand. As demand increases, so does value. If supply outstrips demand, the value goes down. Cryptocurrency exchanges create market liquidity, enabling a coin’s value to find its level as determined by supply and demand.
Most cryptocurrencies gain and lose value in the way we’ve described, but there is a class of cryptocurrencies that are valued differently. These are stablecoins, whose value is pegged to that of a fiat currency or a commodity, much like the commodity currencies we mentioned earlier. The biggest of these is Tether (USDT).
Because they are backed by other assets, stablecoin value is relatively predictable. But even stablecoins fluctuate in response to supply and demand—they can be worth more or less than the asset that backs them.
How Do Cryptocurrencies Work in Simple Terms?
Cryptocurrencies combine two technologies to create decentralized digital money. The first is the blockchain distributed ledger, and the second is cryptographic technology. Cryptocurrency coins are stored on the blockchain. They are secured with cryptography.
We’ll discuss blockchains in the next section, so let’s focus on the role cryptography plays in cryptocurrency transactions. Let’s say you have ten coins stored on a blockchain. How do you send them to your friend?
- Your coins are stored at an address on the blockchain. You can think of the address as the account where the coins are stored.
- You can only send the coins to your friend if you have the unique private key for that address. The private key is like the account password. It is usually stored in your crypto wallet.
- To send the coins, you ask your friend for their blockchain address, which they get from their crypto wallet. The address is associated with their private key.
- You initiate a transaction in your cryptocurrency wallet that moves the coins to the recipient’s address. You sign the transaction with your private key. Signing the transaction proves that you are authorized to send the coins.
- The coins are now associated with your friend’s address. They can only transact with the coins you sent if they have the private key associated with the new address.
Addresses and private keys are part of the cryptocurrency’s cryptographic system, which we explain in greater depth here.
Crypto Foundations: Peer-to-Peer Networks and Distributed Blockchains
The infrastructure underlying cryptocurrencies is quite complex, but the most important part is the blockchain. A blockchain is a distributed ledger. At its simplest, a ledger is a list of transactions recording money that goes into and out of an account. You probably use a ledger to track your personal finances. Banks use sophisticated electronic ledgers to determine how much money is in your bank account— the difference between credits (incoming transactions) and debits (outgoing transactions).
These are examples of centralized ledgers. They’re controlled by a single individual or institution, which acts as the source of truth about the transactions recorded on the ledger.
Cryptocurrencies, in contrast, use distributed blockchain technology as their ledger. Instead of a single source of truth managed by one entity, a blockchain ledger is shared between hundreds or thousands of computers. No single entity controls the blockchain ledger or the transactions added to it.
A blockchain ledger is a type of database for storing cryptocurrency transactions (and other data). To add new data, transactions are verified and gathered together into a block. The block is then cryptographically linked to the previous blocks in the chain. Once blocks are added, they can’t be removed or edited, a capability essential to cryptocurrency security.
But how do thousands of computers agree on the contents of a blockchain? Cryptocurrency blockchain networks have a consensus system for choosing which node is allowed to propose a new block. In proof-of-work blockchains like Bitcoin’s, the nodes compete to solve a mathematical challenge. The node that wins gets to propose a new block. It also gets a reward for taking part. This process is called crypto mining.
In contrast, proof-of-stake blockchains, including post-Merge Ethereum, ask nodes to put up coins as collateral before they’re given a chance to propose new blocks. The collateral incentivizes these nodes—known as validators—to be honest. The block they propose is checked by many other nodes before it’s officially added to the blockchain.
If you want to learn more about consensus algorithms and cryptocurrency blockchains, read What is a Blockchain and How Does It Work?
How is Cryptocurrency Stored?
Cryptocurrencies are stored on distributed blockchain ledgers. The blockchain is an ordered list of transactions packaged into blocks, which are also strictly ordered. The blockchain itself is stored on many computers spread across the world. Each full node will eventually have a complete copy of the blockchain, so cryptocurrencies are, in fact, stored in many thousands of places.
There are numerous benefits to this type of distributed cryptocurrency storage:
- Blockchains are resilient. Deleting or losing a blockchain is impossible because it exists in so many places. That’s not true of centralized databases, which are more fragile.
- Blockchains are tamper-proof. Because of the blockchain’s structure, distribution, and cryptographic security, it can’t be hacked or tampered with.
- Distributed cryptocurrency blockchains cannot be taken over by malicious individuals or organizations.
As a cryptocurrency trader, you will use a wallet to manage your coins. But coins and tokens are not stored in crypto wallets. Wallets generate and store the private keys you need to access and transact with cryptocurrencies stored on the blockchain.
How to Buy Cryptocurrencies?
The easiest way to buy cryptocurrencies is through a cryptocurrency exchange. An exchange allows users to deposit cryptocurrencies and fiat currencies, which are used to buy other cryptocurrencies. For example, you could deposit U.S. Dollars and buy Bitcoin or Ethereum.
Buying and selling cryptocurrencies is fast and easy on the Bittrex cryptocurrency exchange. With Bittrex, you can buy and sell Bitcoin (BTC), Ethereum (ETH), and more than 150 other cryptocurrencies. Sign up today to start trading Bitcoin in under ten minutes using Instant Buy & Sell.