Cryptocurrency is a digital currency that uses cryptography to secure transactions and control the creation of new units. Cryptocurrencies operate independently of banks and governments, allowing for direct peer-to-peer transactions between users. This beginner’s guide will explain what cryptocurrency is, how it works, its history, and real-world applications.
What is Cryptocurrency?
A cryptocurrency is a digital asset designed to work as a medium of exchange. It uses cryptography to secure and verify transactions and control the creation of new units of the cryptocurrency. This makes counterfeiting or double-spending nearly impossible.
The “crypto” in cryptocurrency refers to the cryptography techniques used to keep information secure. Cryptography allows for secure communication in the presence of malicious third parties. This is done using techniques like public-private key pairs, hashing functions, and digital signatures.
Most cryptocurrencies are decentralized networks based on blockchain technology. A blockchain is an immutable distributed public ledger that records transactions. Decentralized means no central authority like a bank or government controlling it.
Here are some key properties of cryptocurrency:
- Digital – Exists only in digital form, not physical. This allows a global, borderless transfer of value.
- Decentralized – Uses a distributed public ledger called blockchain to record transactions. This avoids centralized control.
- Secure – Uses cryptography for security and verification of transactions. Prevents counterfeiting and double spending.
- Limited supply – New units are created through a process called mining. Total supply is limited by design.
|Top 5 Cryptocurrencies by Market Cap
How Does Cryptocurrency Work?
Cryptocurrencies run on distributed networks consisting of computers around the world called nodes. Here is an overview of how cryptocurrencies work:
- Digital wallets – Each user has a digital wallet with a unique address, similar to a bank account number. Wallets allow users to send, receive, and store cryptocurrency.
- Transactions – Transactions involve the transfer of cryptocurrency between wallets. These transfers are recorded on the blockchain.
- Blockchain – The blockchain is a decentralized, public ledger containing the history of all transaction records. It is distributed across nodes on the network.
- Mining – Special nodes called miners verify and record transactions on the blockchain. As a reward, miners earn cryptocurrency themselves through this process.
- Private keys – Each wallet has a private key to access, spend, and transfer funds. These keys provide cryptographic security and digital ownership of the cryptocurrency.
Let’s look at these components more closely.
Digital wallets store your public and private keys and interface with various blockchains to allow you to send, receive, and monitor your cryptocurrency holdings. Software wallets are applications installed on devices like computers and mobile phones. Web wallets run through internet browsers. Hardware wallets are physical devices that store your private keys offline for extra security.
Each wallet has a public address to which others can send cryptocurrency to and a private key known only to the holder. This private key is like the password to your wallet. You use it to access your wallet and authorize transactions to send money. You should never reveal your private key because anyone accessing it can spend your funds.
Transactions are transfers of cryptocurrency between wallets. They represent exchanges of value between wallet addresses carried out via the blockchain. For example, if John wants to send 10 BTC to Mary:
- John’s wallet digitally signs a message requesting to send 10 BTC to Mary’s address. This transaction message is broadcast to the Bitcoin network.
- Once received by the network, the transaction is pending validation until confirmed on the next block.
- Miners add the transaction to the next block and verify it is valid by checking factors like digital signatures and account balances.
- The confirmed block containing the transaction is added to the blockchain. The network records the transfer of 10 BTC from John’s wallet address to Mary’s.
- Mary can now see the 10 BTC credited to her wallet. John’s wallet has a balance of 10 BTC less.
Each wallet keeps a record of incoming and outgoing transactions. The balance represents the difference between the cryptocurrency received and sent. Transactions are included in blocks and immutably recorded on the blockchain.
The blockchain is a digital ledger containing transaction records that are duplicated and distributed across the entire network. It is a decentralized database that is consensually shared and synchronized across multiple sites, countries, and institutions. No central party controls the blockchain, allowing it to avoid manipulation or interference by a single actor.
Cryptocurrency blockchains use cryptography and a consensus mechanism to ensure security, transparency, and decentralization. Transactions are verified by network nodes and recorded in timestamped blocks that link to preceding blocks. This creates a chronological chain of validated activity. The blockchain grows over time as new blocks are added to the chain.
Blockchain technology allows cryptocurrencies to operate without relying on a central authority to verify transactions. Decentralization and transparency allow blockchains to establish trust between untrusted parties.
Mining is the process where blockchain transactions are verified and added to the blockchain. It involves competing to solve complex mathematical puzzles based on cryptographic hash functions. The first miner to solve the puzzle adds a verified block of transactions to the blockchain and is rewarded with newly minted cryptocurrency.
This is how new cryptocurrency units are released into circulation as rewards for mining. The supply of most cryptocurrencies is limited by design. This rewards miners for supporting the network and provides an initial distribution method.
The mining process serves two key functions in cryptocurrencies:
- Transaction verification – Miners validate pending transactions by including them in blocks. This helps prevent double spending or other fraudulent activity.
- New currency creation – Miners are rewarded with fees and newly created cryptocurrency for mining. This incentivizes mining activity to support the network.
Not all cryptocurrencies involve mining. Some are non-mineable coins with a finite, limited supply.
Private keys are secret alphanumeric passwords that allow cryptocurrency owners to access and spend their funds. They provide proof of ownership and control over the cryptocurrency associated with a wallet. Their secrecy is what makes cryptocurrencies secure.
If someone gains access to your private key, they have full control over your wallet and any funds it contains. Guarding the secrecy of your private keys is extremely important. Private keys allow transactions to be authorized and prevent unauthorized access or spending.
Think of your private key, like the PIN code to your ATM card. It provides access and control over your cryptocurrency account. Private keys are stored in digital wallets and heavily encrypted for protection.
History of Cryptocurrency
Cryptocurrency originated with Bitcoin, invented by the pseudonymous Satoshi Nakamoto and released as open-source code in 2009. However, the underpinnings of cryptocurrency existed before then. Let’s walk through some key events:
- 1983 – American cryptographer David Chaum conceived an anonymous cryptographic electronic money called ecash. It laid the foundations for future electronic monetary systems like cryptocurrencies.
- 1998 – Wei Dai published the “b-money” proposal outlining creating money through solving computational puzzles. This served as the basis for the proof-of-work system used in Bitcoin.
- 2008 – Nakamoto published the Bitcoin whitepaper describing a peer-to-peer electronic cash system. It built on previous research to outline the technology behind the Bitcoin blockchain and currency.
- January 2009 – The genesis block, the first block on the Bitcoin blockchain, was mined by Nakamoto. It had a reward of 50 bitcoins.
- 2010 – The first known commercial Bitcoin transaction occurred. A Bitcoin user paid 10,000 BTC for two pizzas. At today’s prices, that quantity of Bitcoin is worth over $200 million.
- 2011 – Competitor cryptocurrencies started launching, often called altcoins. Litecoin was an early altcoin that modified Bitcoin’s code.
- 2014 – Ethereum launched with the concept of smart contract functionality, allowing decentralized apps to be built on top of its blockchain.
- 2021 – Bitcoin reached an all-time high price of ~$69,000 driven by increased institutional adoption. Cryptocurrency hit a $3 trillion total market capitalization.
Many other key developments have contributed to cryptocurrencies becoming more mainstream and integrated into the larger financial world.
Real World Use of Cryptocurrencies
While still maturing, cryptocurrencies have real-world utility beyond just financial speculation. Here are some examples:
- Digital payments – Cryptocurrencies provide faster, cheaper international transactions than traditional payment methods.
- Trading – Many people invest and trade cryptocurrencies as speculative investments like stocks.
- International remittance – Cross-border payments avoid high wire transfers and credit card payment fees.
- Donations – Non-profits, including WikiLeaks, accept donations in cryptocurrency for censorship resistance.
- Everyday buying – Major companies like Microsoft, AT&T, and Overstock allow cryptocurrency payments.
- Financial services – Cryptocurrency platforms offer services like loans, savings accounts, and insurance.
- Smart contracts – Self-executing contracts programmatically enforce contractual conditions without intermediaries.
Cryptocurrency as a new asset class also provides portfolio diversification and hedges against inflation or currency devaluation. Increased real-world utility and integration will likely see cryptocurrencies become more mainstream. However, they still have technical, regulatory and adoption challenges to overcome first.
Cryptocurrency represents a major technological leap in the evolution of money. The decentralized, transparent and secure properties of blockchain-based cryptocurrencies enable interesting new possibilities like peer-to-peer electronic cash. This beginner’s guide introduced how cryptocurrencies work at a high level.
Many details are not covered here, like cryptographic hashing, consensus algorithms and p2p networking. But this overview provides a basic understanding of cryptocurrency and how its key components like digital wallets, transactions, blockchain technology and mining, all fit together. Cryptocurrencies like Bitcoin and Ethereum are just getting started so we can expect to see significant developments in the coming years.