It is clear that money has taken on varied forms during human history such as shells, gold bars, printed money and currently it is the numbers stored inside a computer at the bank that represents money. Every time it changes, it is a change of society’s way of determining and handing over value. One of the most recent and perhaps the most aggressive shifts is cryptocurrency; a digital-only money form that does not require any governmental or central bank permission, which is protected and validated through the means of mathematics rather than by the trust in institutions. In 2009, with the creation of the Bitcoin, cryptocurrency was still regarded as a peculiar technological occurrence; but today it has emerged as a global trillion-dollar asset class that has given rise to hundreds of different types of cryptocurrencies. Also, the dialogue over the future of money, finance and the economic right of the state has already been transformed by it. Understanding what is cryptocurrency and how it works are no longer obscure topics. Rather, they are becoming twenty-first century literacy financial topics.
What Cryptocurrency Really Is
Cryptocurrency is a type of digital or virtual currency that relies on cryptography, the science of encoding and decoding information, to secure transactions, control the creation of new units, and verify the transfer of assets. Most cryptocurrencies aren’t issued by governments or controlled by central banks, but run on decentralized networks, with no central authority in charge. There is no Federal Reserve controlling the supply of Bitcoin. Ethereum doesn’t have a central bank setting interest rates like Europe does. Instead, the rules that govern these currencies are held in open-source computer code running on a distributed network of computers around the world, and no one person, company or government can change those rules on their own.
The term cryptocurrency is a nod to this cryptographic foundation. Each transaction is protected by complex mathematical algorithms so it is effectively impossible to make any fraudulent changes. You don’t own a cryptocurrency because a bank has your name in a database. You own it because you have a private key — a unique string of characters that acts as an unforgeable digital signature proving you have the right to spend or transfer the money it controls.
The Blockchain: The Technology Behind All This
Most cryptocurrencies are built on the blockchain, a shared digital ledger that records all transactions made in a particular currency through thousands of computers in a network simultaneously. Understanding the blockchain is key to understanding how cryptocurrency does something that no previous form of digital money has been able to do: transfer value between parties without needing a trusted intermediary (like a bank) to verify and record the transaction.
A blockchain is literally a chain of blocks as the word implies. Each block contains a set of recent transactions, a timestamp and a cryptographic reference to the previous block in the chain, the hash. So, if you wanted to change a previously-verified or -recorded event (say, the number of tokens transferred in a transaction), you would have to recalculate not just the hash of the “changed” block but also the hashes of all of the succeeding blocks in the chain for every single copy of the ledger that every computer on the network holds – all at the same time. The cost of doing that is so prohibitive so as it’s essentially a technical impossibility, which is why blockchain is secure, reliable and doesn’t require any external authority to enforce it.
As soon as a new transaction is made, let’s say person A transfers Bitcoin to person B, the transaction is announced through the network and placed as a pending transaction there till it gets verified. These verified transactions will be compiled into a new block and added to the chain. This whole thing is the process of mining or validation based on the type of cryptocurrency in question.
Mining and consensus protocols
The procedure ensuring that new transactions are checked and included in the blockchain is managed by a set of rules that cryptographers refer to as a consensus mechanism, the rules allowing a distributed network of computers to agree on the actual state of the ledger. Proof of work and proof of stake are generally regarded as the consensus mechanisms most widely used. The mechanism by which Bitcoin verifies transactions and controls blockchain growth is proof of work.
Miners – so called network computers – solve cryptographic puzzles by running computational processes, in return for getting to append the next block in the ledger to earn a pre-determined amount of the freshly created cryptocurrency as well as the transaction fees. Such a work intensive and resource demanding a process is also a security assurance mechanism since a dishonest actor would need at least a majority of the network’s computational power to override and alter transactions, which is a very expensive, resource consuming task in practical.
Ethereum’s transition to proof of stake in 2022 meant that it no longer needed to perform computational-intensive processes and that the block creators – the validators – would receive their right to create a new block mainly determined by the cryptocurrency amount they locked as security – their stakes. It was designed to deliver the same security level as proof of work without consuming as much energy – so that has been a popular feature mostly to blockchain startups where energy consumption is a major concern.
Wallets, keys, ownership
Cryptocurrency isn’t held in an account at a bank, but rather in a digital wallet — software that contains the private and public keys linked to a user’s holdings. The public key is like a bank account number, it’s the address where other people send cryptocurrency. The private key is like a PIN or password – it is the secret that allows the holder to authorize transactions from the wallet. The difference to traditional banking is that there is no institution that can reset a forgotten private key or reverse an unauthorized transaction. Once a private key is lost, the cryptocurrency it governs is lost forever. The funds are untraceable and can be moved if stolen, with no recourse. This places the security burden squarely on the individual, which is the freedom and responsibility that comes with cryptocurrency ownership.
Differences Between Major Cryptocurrencies
The most common store of value, in the language of its advocates, is Bitcoin, the largest cryptocurrency by market capitalization, created in 2009 by the pseudonymous Satoshi Nakamoto. Its supply is limited to 21 million coins, a scarcity that its advocates say makes it a hedge against inflation that government-issued currencies that are subject to unlimited printing cannot match.
Ethereum, the second-largest cryptocurrency, took the idea of blockchain from a currency to a programmable platform. Its network supports intelligent contracts – self-executing agreements written right into the blockchain that automatically perform pre-determined actions when certain conditions are met – and decentralized applications that operate without any central controlling authority. This programmability has made Ethereum the backbone of the decentralized finance movement, non-fungible tokens and a broad ecosystem of blockchain-based products and services.
Besides these two, there are thousands of cryptocurrencies — collectively known as altcoins — that fulfilll a range of functions. Some are for quick, low-cost transactions. Some specific decentralized power platforms. Others, known as stablecoins, are pegged to the value of traditional currencies, such as the US dollar, to prevent the price volatility that characterizes most cryptocurrencies.
The Risks & The Rewards
Cryptocurrency has actual benefits. It allows for near-instantaneous transfer of value, without borders or middle men. This gives financial access to the hundreds of millions of people worldwide who do not have access to traditional banking infrastructure. It creates financial structures that are transparent, auditable, and difficult to tamper with. It also brings programmable money: currency with logic embedded in it that enables entirely new categories of financial product and service.
It also carries considerable risk. Prices are volatile to an extreme degree, with currencies gaining or losing significant percentages of their value in days or even hours. The regulatory environment is very uncertain and varies a lot between different jurisdictions. There’s no consumer protection, and transactions are irreversible so the cost of mistakes and fraud is much higher than in conventional financial systems. While the industry is slowly moving toward more energy-efficient alternatives, the environmental impact of proof-of-work mining is still a real concern.
Cryptocurrency is neither the financial revolution its most ardent supporters claim nor the elaborate fraud its most skeptical critics insist. It’s a truly new technology with real capabilities and real limitations, still in the relatively early days of it’s development and adoption. The essential starting point for any view of what it means – for money, for finance, for the broader question of who controls the systems through which value moves in the world – is to understand how it works.
